Michael Spence’s The Next Convergence

On this blog, your correspondent writes book reports. Not book reviews – because that would imply a polished and systematic criticism, going back to the book, etc. But just book reports, that recall (1) the basic thesis and (2) the interesting ideas that stood out and are worth highlighting. They may not be super rigorous or entertaining, but they will be useful exercises for the writer and perhaps informative for readers.

This week’s reading was Michael Spence’s The Next Convergence. Spence is an economics laureate who made his name in microeconomic theory, especially his work on signaling. After that, he moved into academic administration for a while, and then into the global-development-conference circuit. From those experiences, he’s emerged with broader and more accessible thoughts which he has assembled in this, his first non-technical book.

The Next Convergence is basically just one of those “what’s going on in the economy right now” books, with a special focus on the emerging economics and what they need to do in order to/how they will become fully developed affluent nations (that’s the titular “next convergence”).  Most of it won’t be news to the economically literate public, but it’s a nice review anyways.

Here are the basics:

  • Spence explains standard economic consensus about the prerequisites for for economic development in poor countries. The basic idea is that fast catch-up growth ought to happen when borders are open to trade and technology. The dispersion of technology allows developing countries to immediately bear the fruits (in terms of productivity gains) of what developed nations have sown. Global trade allows poorer countries to find a niche in specialization, and to produce and sell a lot more than their domestic economies are ready to consume. So, once the right balls get rolling, we should expect poor nations to grow quickly. Spence is optimistic about this process and predicts that midway through this century, 75% of the world will live in a developed nation.
  • There’s a lot to be optimistic about for the 21st century, but the obvious haunting specter is global climate change. Spence advocates allowing emerging economies privileges in delaying cuts in their carbon emissions — it’s only fair, he argues, to make catch-up growth possible — but stronger international institutions that would be capable of enforcing worldwide tradeable carbon permits.
  • The other big thing that has to change is major global imbalance w.r.t trade and savings/investment. It has a lot of causes, one of which is China’s commitment to an investment-based growth model. Spence predicts a long, long delevering for the United States, so shifting China to a demand-driven economic model is needed quick to avoid a long global recession. Reducing its massive savings imbalances will also require structural reform within China.
  • It will be really interesting to watch 21st century India and China happen geopolitically, because, we often half-forget in all our excitement, they are fundamentally still impoverished nations that are only weighty in total by virtue of their massive populations. Seeing how they do in international leadership will put to the test our theories about what factors determine geopolitical influence beyond GDP.
  • The E.U. needs more fiscal union to match its monetary union.
  • Communication technologies, especially the mobile internet, are a big deal and a force for good. They’re one of the major factors accelerating growth in Africa (i.e., easier to find out about prices in various markets). They’ll also inspire a lot of political reform, as people can now more easily see how other people live, become aware of injustices and other countries’ ways of doing things, etc. And heck, they just make life better and more convenient in the developed world — academics who spent most of their time in the past pinning down data sets can now get raw information with a few Google searches and give the rest of their time to actual analysis.

And here are some of the ideas that stood out as really really interesting:

  • Spence points out that, as your correspondent likes to belabor, the truth is a lot more complicated than the endlessly repeated claim that “The financial crisis showed just how screwed up markets can be, so we need more financial regulation now.” The basic problem with this is that crises are, pretty much by definition, risks that the market didn’t see coming. And the thing is, regulators use the exact same models to measure systemic risk as market participants do, because both employ the latest macroeconomics. So the logical extension of this point seems to be that the next crisis won’t be averted by changing the structure of our regulation — it has to come from better (truer) economics. (It also invites an avenue for future research: To see if the kinds of extra regulation being proposed in the 90s and 2000s/being removed in the 80s — if effected/if prevented from being removed — actually would have prevented the crisis, given that fact. There’s a strong possibility the answer is ‘no.’)
  • China faces the very real prospect of a “middle-income trap,” and it’s weird that people assume that China will just sort of cruise through it, because, historically, most quickly-developing nations did not escape that trap. A middle-income trap happens when a country can no longer rely on the low-hanging fruit of growth driven by the export of labor intensive products, as made possible by low labor costs. Once incomes rise sufficiently, this model obviously no longer works. To keep progressing, the country needs to transition into a modern, services-based economy, which involves political leaders making the difficult choice to allow some export industries to die, and getting domestic production and consumption to match up at a high level. It’s really, really hard to pull off — South Korea’s one of the only recent success stories, and its political leadership had a hell of a time making it happen. And there’s little telling what will happen when incomes rise in China sufficient to undermine the competitiveness of exports.
  • Spence does a fine job articulating the benefits versus costs of a managed exchange rate for emerging markets. The basic virtue of a manged exchange rate is that it allows an emerging market to partially insulate itself from panics and crises in the developed world’s financial markets: I.e., if Americans suddenly become more risk averse and suddenly withdraw capital from Emergistan, Emergistan can prevent its currency from being suddenly devalued (prompting a vicious cycle) by selling the dollars it acquired in the process of managing the exchange rate. So, when handled credibly, managed exchange rates can give fragile industries in emerging markets a lot more certainty, by eliminating currency risks that — due to the low sophistication of their financial markets — they have trouble otherwise hedging. That’s a big boon to growth.
  • But there’s a trade-off here that has to do with the middle-income trap: As long as countries manage their exchange rates, there will always be political pressure on the central bank to keep the currency weak enough to keep its export industries competitive. This can become a serious problem when it’s time for the country to move through and beyond the middle income zone.
  • Finally, international economics involves a lot of what Spence calls “adding-up problems” (i.e. prisoner’s dilemmas on an international scale)  some of which are, interestingly, exacerbated by globalization. The most interesting case of this is that, in the wake of the financial crisis, European countries weren’t generally able to enact a stimulus plan like those enacted in the U.S. and China. Why? Well, since Europe is so economically interlocked, any one country would benefit if all the other European countries around it enacted a stimulus that boosted demand for its products; and any one country would be hurt if it alone enacted stimulus, because most of this debt-funded, stimulus-driven demand would leak over into the surrounding countries. So each country had an incentive to ‘free ride’ on the stimulus of all the others and little stimulus happened. The U.S. and China, because they are fiscally sovereign, didn’t have this problem (this obviously is part of the reason Spence thinks the Eurozone needs more fiscal unity to match its monetary).

Are all of these ideas correct? Well, Spence is the Nobel laureate, so your correspondent defers to him for now.

Final judgment: The book is half-recommended for readers who want a catch-up on these basics. But be warned – it is poorly written, and poorly edited. English is surely Spence’s second language, behind mathematics. It may be the slowest non-technical reading you’ve ever done.

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2 thoughts on “Michael Spence’s The Next Convergence

  1. Matt, your blog is the econ education I never had. I swear I gave it a chance– three classes in HS and college. Unfortunately, each was among the most inane courses I’ve ever taken, and I had to give it a rest if I wanted to finish my engineering degree. All this is to say: I have a lot of questions. Here, look!

    * I don’t understand bullet 3 of “the basics”. What exactly is the problem you’re describing, and why is it a problem?

    * Regarding basics bullet 4, what are “our theories” on what, besides affluence, causes geopolitical influence?

    * While the regulators may use the same models of risk as the market, is it not conceivable that political factors would prevent them from implementing safeguards in policy? IOW, were any regulators saying before the crash “hey guys, we’d like to have some more control over X” where X is something they didn’t have the legal authority to do?

    * Never heard of the middle-income trap, but it’s a fascinating idea. If I had to guess, I’d say we don’t understand it well enough to prescript our way through it. Getting to the far side is, in part, a happy accident. Thoughts?

    I thought the last point was really fascinating too. I think that as nations become more interconnected, we will see their problems fall into a few categories: prisoner’s dilemmas, tragedies of the commons, and acting-multilaterally-defaults-to-the-least-common-denominator. Arguably all of these have existed since WW1, but a.) these will only be on the rise and b.) I haven’t seen such a catalog before. I’d love to see this classification, complete with historical examples and potential issues in the future!

  2. Erik, much obliged:
    “* I don’t understand bullet 3 of “the basics”. What exactly is the problem you’re describing, and why is it a problem?”
    — Indeed, you caught me eliding quite a bit because this is the thing I find most difficult to explain/understand myself. So here goes. Here’s a thing we all know: China exports a lot to us, and we quite a lot less to them, right? That’s our trade deficit. This means that, somewhere along the line, the Chinese got a bunch of dollars from us — and they got more dollars from us than we got RMB from them in these trades. But dollars don’t buy you anything in China. So what do the Chinese do with these dollars they have accumulated? The answer is two things: (1) sometimes they sell them to their own central bank, which the Chinese central bank holds in huge reserves, which is what allows it to manage/manipulate the dollar-RMB exchange rate; and (2) they use them to buy dollar-denominated U.S. financial assets — i.e., our government’s bonds, shares in U.S. companies, etc. Indeed, though the U.S. has a famously huge trade deficit with China, we also have — necessarily — a huge “capital account” surplus — because those dollars the Chinese got from our import purchases have to go *somewhere* don’t they? In essence, Chinese banks and securities firms are putting a lot of capital back into the U.S. on behalf of their Chinese; and a necessary component of this is that the Chinese have tons of savings deposited (in RMB) in these banks, which expands the banks balance sheets and lets them do all that lending. So the saving nation vs. debtor nation, capital account deficit/surplus, and trade deficit/surplus problems, are all, as you can see, connected by the fact that the RMB need to go somewhere in China and the $’s need to go somewhere in the U.S. (or held by the central bank).

    The problem is, this means that there is a lot of “cheap capital” in the U.S. economy. There’s a lot of cash for investment that just wants to go somewhere — even to projects that might not really be worthy of the investment. So the U.S. was getting more and more cheap investment capital, even as U.S. businesses are becoming less and less competitive vis-a-vis China. And, this may have had something to do with that little bubble we had which popped in 2007-2008 and such. So, China’s savings glut plus our trade deficit with China inevitably causes a capital account surplus, which temporary papers over problems in our economy, and creates distortions that have bad effects over the long term. At the same time, it causes some problems for the Chinese economy too. Many people think the cheap capital in China itself is causing a real-estate bubble; and the country’s companies really should be moving toward attracting and meeting domestic demand. But why bother when we Americans will just keep buying everything? So it kind of postpones China’s transition to a fully developed economy.
    (Please don’t quote me as an authority on this — but writing this was a very good exercise in my own understanding.)

    ” Regarding basics bullet 4, what are “our theories” on what, besides affluence, causes geopolitical influence?”
    –I didn’t really have any specific academic theories in mind. I just mean what I think we all implicitly think: The U.S. is the richest country on earth and also the most powerful. So there’s some connection between total riches and total power (as we would expect logically, since most of the work that diplomats do has something to do with securing their countries economic interests). At the same time, France’s GDP is barely bigger than Brazil’s, and it won’t be for much longer, but it’s arguably way, way more geo-politically powerful than Brazil. Why? History. The French have just been around awhile and are just so damned civilized. So once China and India are both much economically larger than the U.S. and the EU will they be more powerful by virtue of that? Or will the U.S. and the EU be ‘locked in’ to geopolitical hegemony in the same way that France is, currently, locked into some influence.

    “IOW, were any regulators saying before the crash “hey guys, we’d like to have some more control over X” where X is something they didn’t have the legal authority to do?”
    — Right. That’s just the question I have. Because otherwise — at the risk of coming off as too political — there’s no good basis for the pro-regulation crowd to use the crisis as a ‘neener-neener’ moment.

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