Regional Economist - April 2016

7/25/2019 Regional Economist - April 2016

1/24

CommoditiesFalling Prices Hurt

Emerging Markets

ImmigrationWhich Populations

Are Growing, Shrinking?

From Backward Agrarian Societyto Industrial Powerhouse

in Just 35 Years

Chinas Rapid Rise

A Quarterly Reviewof Business andEconomic Conditions

Vol. 24, No. 2

April 2016

THE FEDERAL RESERVE BANK OF ST. LOUIS

CENTRAL TO AMERICAS ECONOMY


2/24

C O N T E N T S

Chinas Rapid Rise as an Industrial PowerhouseBy Yi Wen

Chinas industrial revolution over the past 35 years is probably one o themost important economic and geopolitical phenomena since the originalIndustrial Revolution in the 18th century. Te rapid growth has puzzledmany, in part because China tried and ailed at this transormation beore.What was the secret this t ime?

8

THE REGIONAL

ECONOMISTAPRIL 2016|VOL. 24, NO. 2

The Regional Economistis published

quarterly by the Research and Public Affairs

divisions of the Federal Reserve Bank

of St. Louis. It addresses the national, interna-

tional and regional economic issues of

the day, particularly as they apply to states

in the Eighth Federal Reserve District. Views

expressed are not necessarily those of the

St. Louis Fed or of the Federal Reserve System.

Director of Research

Christopher J. Waller

Chief of Staff to the President

Cletus C. Coughlin

Deputy Director of Research

David C. Wheelock

Director of Public Affairs

Karen Branding

Editor

Subhayu Bandyopadhyay

Managing Editor

Al Stamborski

Art Director

Joni Williams

The Eighth Federal Reserve Districtincludes

all of Arkansas, eastern Missouri, southern

Illinois and Indiana, western Kentucky and

Tennessee, and northern Mississippi. The

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Louisville, Memphis and St. Louis.

Please direct your commentsto Subhayu Bandyopadhyay

at 314-444-7425 or by email at

[email protected].

You can also write to him at the

address below. Submission of a

letter to the editor gives us the right

to post it to our website and/or

publish it in The Regional Economist

unless the writer states otherwise.

We reserve the right to edit letters

for clarity and length.

Single-copy subscriptions are free

but available only to those with

U.S. addresses. To subscribe, go to

www.stlouisfed.org/publications.

You can also write to The Regional

Economist, Public Affairs Office,

Federal Reserve Bank of St. Louis,

P.O. Box 442, St. Louis, MO 63166-0442.

3 PRE S I D E N T S M E S S A G E

4 Measuring Trends

in Income Inequality

By Michael . Owyang

and Hannah G. Shell

Beore there is discussion on what

can and should be done about

income inequality, interested

parties should understand the di-

erent methods that can be used to

measure the gap. Knowing when

the gap has been particularly wide

or narrow over the past 50 or so

years would also be helpul.

6 Commodities Importance

to Emerging Economies

By Alexander Monge-Naranjo

and Faisal Sohail

Te ups and downs o commodityprices can have a huge impact on

the economies o the produc-

ing nations (emerging, as well as

developed). Increasingly, these

economies are susceptible to the

needs o a single buyer: China.

15 Interest Rate Control

Not a Simple Process

By Stephen Williamson

Setting the ed unds rate is just

one step. Te Fed also has to deal

with the discount rate and the

interest rate paid on reserves.

Trow in a floor system (with a

subfloor) and overnight reverse

repos, and youve got a process

that is anyt hing but simple.

17 E C O N O M Y A T A G L A N C E

18 D I S T R I CT O VE RV I E W

Immigration Patterns

Yield Some Surprises

By Subhayu Bandyopadhyay

and Rodrigo Guerrero

Te percentage o oreign-born

in the our major metro areas o

the District is smaller than or the

nation as a whole. However, some

o the metro areas are showing

aster growth in their Asian, Ari-

can and Latin American popula-

tions than is the nation overall.

20 M E T RO PRO F I L E

Cape Girardeau, Mo.:

Ahead, Yet Behind

By Charles S. Gascon

and Joseph . McGillicuddy

Tis small MSA scores well oeducational attainment, cost

o living, employment in hea

care services and in ot her cat

ries. Still, output and job gro

are relatively slow.

23 N A T I O N A L O VE RV I E W

GDP and Inflation

Expected To Improve

By Kevin L. Kliesen

Strong job growth, consume

spending and housing activit

bode well or the economy th

year.

ComFallin

Emer

ImmigrationWhichPopulations

AreGrowing,Shrinking?

From Backward Agrarian Societyto Industrial Powerhouse

in Just 35 Years

Chinas Rapid Rise

AQuarterlyReviewofBusinessandEconomicConditions

Vol.24,No.2

April2016

THE FEDERAL RESERVE BANK OF ST.LOUISCENTRAL TO AMERICAS ECONOMY

ONLINEEXTRA

Read more at www.stlouisfed.org/publications/re.

Tracking the U.S. Economy with NowcastsBy Kevin L. Kliesen and Michael W. McCracken

Te Federal Open Market Committee wants its interest-rate deci-

sions to be data-dependent. But until the past several years, much

o the statistical inormation availablenot just to the FOMC, but

anyonehad come rom reports that looked backward at conditions

rom the previous month or even quarter. New models developed by

economists allow or orecasting o conditions in the current quarter

as reports arrive on a day-to-day basisas in now. Hence, nowcasts.

COVER IMAGE: THINKSTOCK/ISTOCK

7

6

5

4

3

2

1

0

Percent

Real GDP

1.9 2.1 2.0 2.0

2015 (Actual) 2016

The FOMCs March 2016 Econ

: r i r i r i r r r r r

r l i i r ir r r i i . l r r

r r i r li .

2.2

2 The Regional Economist|April 2016


3/24

Modern economic theory says that infla-tion expectations are an importantdeterminant o actual inflation. How does

expected inflation affect actual inflation?

Firms and households take into account

the expected rate o inflation when making

economic decisions, such as wage contract

negotiations or firms pricing decisions. All o

these decisions, in turn, eed into the actual

rate o increase in prices. Given that central

banks are concerned with price stability, poli-

cymakers pay attention to inflation expecta-

tions in addition to actual inflation.

Te two main ways to gauge inflation

expectations are survey-based measures and

market-based measures. An example o theormer is the inflation expectations rom the

University o Michigans survey o consum-

ers. As a predictor o inflation, this measure

tends to overstate inflation. Over the past 10

years, or example, expected inflation one

year ahead averaged more than 3 percent,

while actual inflation ended up averaging

less than 2 percent. Te Michigan surveys

results also tend to bounce around quite a bit

with the price o gasoline. Because consum-

ers usually go to the gas station, as well as

the grocery store, on a weekly basis, changesin those prices strongly shape their inflation

expectations. However, many other prices

exist in the economy, perhaps making this

particular way o looking at inflation expec-

tations less useul.1

Another example o a survey-based mea-

sure comes rom the Survey o Proessional

Forecasters (SPF), a group that tracks the

economy extremely closely. Te SPF provides

orecasts o inflation based on the consumer

price index (CPI) and on the personal con-

sumption expenditures price index (PCE).Te groups expectations o PCE inflation,

which is the inflation measure that the Fed

targets, are consistently around the Feds tar-

get o 2 percent. One interpretation o these

orecasts is that these proessional orecasters

have confidence that the Fed will make sure

inflation is 2 percent no matter what is going

on in the economy. Tis could be good rom

the central banks perspective because the

orecasts are signaling Fed credibility with

respect to its stated inflation target. On the

other hand, the orecasts might not be very

useul because they do not provide much

guidance on what the central bank would

have to do to steer inflation to 2 percent.

Although many people ocus on survey-

based measures, I tend to put more weight on

market-based measures o inflation expecta-

tions. Tese are tied to the market or rea-

sury Inflation-Protected Securities (IPS)

and are based on CPI inflation. Te basic idea

is that a nominal security, such as a rea-

sury note, and a real (or inflation-adjusted)

security with the same maturity both trade

in the market. Te price difference between

the two could be interpreted as the marketparticipants expectation o inflation over

the horizon o the security; this difference

is also called the breakeven inflation rate.

IPS-based measures o inflation expecta-

tions are available, or instance, at five-year

and 10-year horizons, as well as a five-year,

five-year orward horizon, which reflects

expectations o inflation not in the next five

years but in the five years afer that.

Te IPS-based measures may be viewed

as more inormative than survey-based mea-

sures because the ormer tend to react moreto incoming inormation about the economy

than do the latter. In this sense, the IPS-

based measures o inflation expectations give

a better sense o shifing inflation expecta-

tions than do other measures. One caveat

to this view is that IPS spreads also reflect

differences in the liquidity and risk charac-

teristics o nominal and real securities, and

that it may be premia associated with liquid-

ity and risk that are responding to incoming

data, as opposed to inflation expectations

themselves.2

I do not find those analyses verycompelling. Consequently, I think market-

based IPS spreads provide the best measure

o inflation expectations.3

Ideally, all o these measures o inflation

expectations would be close to the Feds

target o 2 percentor 2.3 percent or those

that reer to CPI inflation, which tends to

run about 30 basis points higher than PCE

inflation. However, inflation expectations in

major inflation-targeting economies have not

Inflation Expectations Are Important

to Central Bankers, Too

P R E S I D E N T S M E S S A G E

been running close to target o late. Europe

is a prime example where inflation expecta-

tions ell dramatically in recent years. Te

European Central Bank subsequently took

extraordinary action to try to return inflation

to target by implementing a quantitativeeasing program. In the U.S., IPS-based

measures o inflation expectations have allen

since the summer o 2014 and are somewhat

below levels that would be consistent with a

PCE inflation rate o 2 percent.4Whether the

Feds policies will be sufficient to return these

expectations to more normal levels remains

to be seen.

James Bullard,President and CEO

Federal Reserve Bank of St. Louis

E N D N O E S

1 The New York Feds Survey of Consumer Expecta-

tions also provides a measure of consumers

expectations for ination. See www.newyorkfed.org/

microeconomics/sceindex.

2 For instance, see Gospodi nov, Nikolay; Tkac, Paula;

and Wei, Bin. Are Long-Term Ination Expecta-

tions Declining? Not So Fast, Says Atlanta Fed,

Macroblog,Jan. 15, 2016. Also see Bauer, Michael

D.; and McCarthy, Erin. Can We Rely on Market-

Based Ination Forecasts? FRBSF Economic Letter

2015-30, Sept. 21, 2015.

3 Another market-based measure of ination expecta-

tions is so-called ination swaps. For a discussion of

TIPS breakeven rates and ination swaps, see Lucca,

David; and Schaumburg, Ernst. What to Make of

Market Measures of Ination Expectations?Liberty

Street Economics, New York Fed, Aug. 15, 2011.

4 The drop since 2014 has been highly correlated with

oil prices. For more on this topic, see my presentation

on Feb. 24, 2016, More on the Changing Impera -

tives for U.S. Monetary Policy Normalization.

The Regional Economist | www.stlouisfed.org 3


4/24

Acentral issue in economics concerns howoutput (equivalent to income) is distrib-uted across economic agents (e.g., workers,

entrepreneurs). A first step in addressing

this issue is understanding how output (or

income) is distributed in the United States

and understanding how the distribution haschanged over time.

Measuring income inequality, however,

is not a trivial endeavor. Multiple sources

o incomesalary, capital gains income,

employer-provided health insurance and

other non-salaried compensation, etc.make

simply measuring income itsel problematic.

Nonetheless, using a number o different

definitions o income and employing various

metrics, researchers have attempted to quan-

tiy income inequality in the U.S.

Economists have identified two broad peri-ods in income inequality over the post-World

War II periodfirst in the 1970s and then,

more recently, prior to the Great Recession.

In the sections that ollow, we describe how

income inequality is measured and then how

it changed over these two periods.

Income Inequality

and How Its Measured

Assessing income inequality boils down in

effect to measuring the income gaps between

high and low earners. Income inequality impliesthat the lower-income population receives

disproportionately less income than the higher-

income population: Te larger the disparity, the

greater the degree o income inequality.

o measure inequality, economists ofen

sort the population by income percentiles and

measure the difference across these percen-

tiles. For example, the top 10 percent o earn-

ers would be the 90th percentile. A related

way o dividing the population is quintiles,

which split the distribution into five even

buckets (the bottom quintile is the 20th per-

centile); quintiles are commonly used percen-

tiles or studying inequality except at the top

o the income distribution, where the income

difference between 98th and 99th percentiles

is large. o summarize inequality across theentire distribution, economists use the Gini

coefficient. Te Gini coefficient measures

income concentration at each percentile o

the population and ranges rom 0 (perectly

equal) to 1 (perectly unequal).

In order to study income inequality, one

needs income at an individual level. While

gross domestic product is the usual aggregate

indicator or income, there are many defini-

tions o income and many data sources avail-

able at the individual level. Economists ofen

use the Internal Revenue Services Statisticso Income program (SOI) or the Census

Bureaus Current Population Survey (CPS).

Studies using different data sources reach

various conclusions on income inequality,

depending on the definition used or income.

For example, economists Tomas Piketty

and Emmanuel Saez compiled a dataset using

SOI data back to 1913. Tey ocused on the

share o income earned by the top percen-

tiles to avoid poor data quality in the lower

percentiles.1Te SOI definition o income is

market income, the cash income reportedon tax orms.2Te SOI data more accurately

measure the top o the income distribution,

but less accurately measure low-income

statistics because low-income households are

not always required to file income taxes.3

Another source o individual income

data is the CPS. Every March, the CPSa

monthly survey o 75,000 householdspro-

vides the inormation used in the Annual

Social and Economic Supplement, which is

the primary source or census data on

income and poverty. Te CPS data are

reported in money incomemarket income

plus other cash income, excluding noncash

benefits, such as employer-provided health

insurance. While the CPS provides quality

low- and middle-income data, incomesabove a certain threshold are not reported to

protect individual privacy. Tis makes it less

ideal or high-income estimates.

Te Congressional Budget Office (CBO)

also constructed a dataset that merges the

CPS and SOI and draws on each sources

strengthsthe CPS or low income and the

SOI or high income. Te CBO reports mar-

ket income, both beore-tax (market income

plus government transers) and afer-tax

income (beore-tax income less ederal taxes)

Most studies find that more equality is seenin afer-tax income, ollowed by beore-tax

income and then market income.4Moreover,

it is generally accepted that the U.S. economy

is similar to other developed nations in

terms o pretax and transer income inequal-

ity. In other words, U.S. income inequality is

not intrinsically different rom what is seen

in other countries, and any differences are

mainly driven by the lack o income-

redistributing fiscal policies in the U.S.

Trends in Income Inequality

From the end o World War II to the early

1970s, income inequality in the U.S. was rela-

tively low. Te graph shows that rom 1947 to

1970, the Gini coefficient was flat or declin-

ing.5Piketty and Saez, using SOI data with a

longer history, ound that income inequality

peaked in the 1920s, then decreased afer the

Great Depression, when top capital incomes

ell and were unable to recover. Although

the U.S. economy rebounded during World

Measuring Trends

in Income Inequality

E C O N O M I C S

By Michael . Owyang and Hannah G. Shell

THIN



5/24

E N D N O E S

1 Piketty and Saez also estimate the portion o lower

income tax units that are excluded in the SOI data

and add these estimated values into their measure

o total income.2 Market income consists o beore-tax income rom

wages and salaries; profits rom businesses; capital

income, such as dividends, interest and rents; real-

ized capital gains; and income rom past services.

Other orms o income include cash and in-kind

payments rom programs like Social Security, ood

stamps and private benefits (e.g., health insurance).3 Te SOI data also exclude noncash benefits like

health insurance, which a re a growing portion o

middle-class income.4 Te differences in inequality by income concept

are largely due to a progressive tax struct ure and

social saet y nets, such as ood stamps, that benefit

individuals at the bottom o the distribution.5 Family income is defined as that o two or more

related persons living i n a household. It may

exclude single-person households and households

with multiple residents who are all not related.

Family income is available in the CPS rom 1947

to 2011, while household income was not collected

until 1967.

R E F E R E N C E S

DeNavas-Walt, Carmen; and Proctor, Bernadette D.

Income and Poverty in the United States: 2014.

Current Population Reports.September 2015. See

www.census.gov/content/dam/Census/library/

publications/2015/demo/p60-252.pd.

Te Distribution o Household Income and Federal

axes, 2011. Congress o the United States:

Congressional Budget Office. November 2014.

See www.cbo.gov/sites/deault/files/113th-con-

gress-2013-2014/reports/49440-Distribution-o-

Income-and-axes.pd.

Piketty, Tomas; and Saez, Emmanuel. Income

Inequality i n the United States, 1913-1998. Te

Quarterly Journal of Economics,Vol. 118, No. 1,

2003, pp. 1-39. See http://eml.berkeley.edu/~saez/

pikettyqje.pd.

Saez, Emmanuel. Stri king It Richer: Te Evolution

o op Incomes in the United States, updated

with 2014 preliminary estimates. University o

Caliornia, Berkeley. June 2015. See http://eml.

berkeley.edu/~saez/saez-UStopincomes-2014.pd.

Stone, Chad; risi, Danilo; Sherman, Arloc; a nd

DeBot, Brandon. A Guide to Statistics on His-

torical rends in I ncome Inequality. Center on

Budget and Policy Priorities. October 2015.

See www.cbpp.org/sites/deault/files/atoms/

files/11-28-11pov_0.pd.

War II, wage controls prevented growth in

top incomes. Once the war ended, a progres-

sive tax structure and reorms such as Social

Security and unionization kept low- and

middle-income growth strong.

Starting in the 1970s, wage growth at the

top o the income distribution outpaced the

rest o the distribution, and inequality began

to rise. Te Gini coefficient grew rom 0.394 in

1970 to 0.482 in 2013. Te CBO estimates that

between 1979 and 2011 market income grew

56 percent in the 81st through 99th percen-

tiles and 174 percent in the 99th percentile.

In contrast, market income growth averaged

16 percent in the bottom our quintiles.

Government transers and ederal taxes

did have a redistributive effect during this

period, but income inequality in afer-

tax income grew substantially. Te 1970s

increase in inequality was different rom the

increase during the 1920s. During the periodrom 1940 to 1970, top-income composition

shifed rom capital income to wage income.

In the top 0.01 percent, the total income share

rom capital income ell rom 70 percent in

1929 to just above 20 percent in 1998. Wage

income rose over the same period, rom

10 percent to about 45 percent. High growth

in top wages is partly explained by the ax

Reorm Act o 1986, which lowered the top

marginal-income tax rates. Te short-term

impact o tax reorm is circled in red on the

graph. Longer-lasting wage growth camerom the reporting o stock options and other

orms o income as wages on tax returns.

Afer the increase in the 1970s, inequality

continued to rise. In the 2001 and 2007-09

recessions, top incomes ell sharply as stock

market crashes decreased the value o capital

gains and stock options. However, losses to top

incomes were temporary. During the recovery

period rom 2002 through 2007, or example,

the top 1 percent captured about two-thirds

o overall income growth, Piketty and Saez

estimated. Further, even though top incomes

ell 36.3 percent in the 2007-09 recession,

the incomes o the bottom 99 percent also

decreased 11.6 percent. Tis decrease is the

largest two-year all in the incomes o the bot-

tom 99 percent since the Great Depression.

So ar, the top 1 percent has captured

58 percent o income gains rom 2009 to

2014. Te newest data on income show that

growth rom 2013 to 2014 was more equal.

Te incomes o the bottom 99 percent grew

3.3 percent, the best rate in more than

10 years, and the Gini coefficient on house-

hold income decreased slightly, marking the

first nonrecession decrease since 1998.

Conclusion

Economists use Gini coefficients, percen-

tiles and detailed survey data to study trends

in income inequality. Tey find that inequality

has been rising in the U.S. since World War

II, reaching its highest level in 2013 since the

1920s. Tis result is robust or the definition o

income and the chosen measure o inequality.

Understanding the acts about inequal-

ity is the first step in assessing what can and

should be done. While there is a general

consensus that some reallocative transers

rom the top o the income distribution to the

bottom are desirable, the optimal amount othese redistributions is stil l up in the air.

Michael . Owyang is an economist , and Han-nah G. Shell is a senior research associate, bothat the Federal Reserve Bank of St. Louis. Formore on Owyangs work, see https://research.stlouisfed.org/econ/owyang.

SOURCES: Gini coefficients calculated by the Bureau of Labor

Statistics using Current Population Survey data, accessed via

Haver Analytics.

NOTE: The figure to the left shows Gini coefficients calculated

from Current Population Survey data for family and household

income. Only family income is available from 1947 to 1967, but

this measure is less ideal than household income because the

census defines a family as two or more related individuals living

in the same house. Roommates or single-person households are

excluded. The red circles mark the temporary increase in income

inequality from the Tax Reform Act of 1986, which lowered the

top marginal tax rate. Gray bars indicate recessions.

Gini Coefficient for Family and Household Income

1947

1949

1951

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

0.50

0.48

0.46

0.44

0.42

0.40

0.38

0.36

0.34

0.32

0.30

Gini Coefficient, Family Income

Gini Coefficient, Household Income



6/24

Many Countries Sink or Swimon Commodity Prices

and on Orders from China

T R A D E

Many emerging economiesand alsothose o some developed countries,such as Australia, Canada and Norwayrely

heavily on the production o commodities

and their sale to global markets. For

example, more than 10 percent o Canadas

and Chiles output in 2013 could be attrib-uted to the export o commodities, as can

be seen in Figure 1. Te equivalent share

is much higher or Venezuela and other

oil-producing countries. Te figure also

Commodity Prices

and the Business Cycle

Figure 2 shows the deviations rom

trend o a weighted index o commodity

prices and log output or Argentina, Brazil,

Canada, Colombia and Russia or all quar-

ters between 2000 and 2016. Tis cyclicalcomponent o prices and output is obtained

by estimating and removing the trend

component o each variable.1Te red line

shows the cyclical behavior o global com-

modity prices (lef axis). Te figure shows

that commodity prices exhibited significant

volatility over the past 16 years. In particu-

lar, between 2000 and 2006, commodity

prices were trending upward (not shown in

figure) with requent fluctuations around

this trend. Te year leading up to the Great

Recession saw a dramatic increase in the

price o all commodities, led largely by

increases in energy prices and in the prices

or ood and beverages. Te global reces-

sion saw a sharp decline in all prices, onlyto display an equally sharp recovery by early

2009. Te causes o the dramatic recovery in

commodity prices are debatable, but by 2011

they had recovered or exceeded prerecession

levels.2Between 2011 and 2014, commodity

prices remained relatively stable in trend

with small deviations.

Since the summer o 2014, there has been

a sustained drop in commodity prices, most

noticeably in energy. Some o the decline in

energy prices can be attributed to supply-

side actors. In particular, the newound

abundance o energy in the U.S. and result-

ing fight or market share by the Organiza-

tion o the Petroleum Exporting Countries

have led to plentiul supply and alling

prices. Tere is no such obvious supply-sideactor that can explain the drop in all other

commodity prices, which has attracted

much less attention.

Te right axis o Figure 2 displays the

deviations o output, measured as GDP,

rom its trend or our emerging market

economies and Canada. Te figure shows

that the cyclical components o output and

commodity prices are highly correlated

with each other.3Indeed, the dramatic,

ast and sustained recovery in commodity

prices must be credited as a major source othe relatively stronger, aster and sustained

recovery o emerging markets ollowing

the recession, relative to the recoveries in

the U.S., Europe, Japan and other major

economies.4Both Figures 1 and 2 make

a compelling case or the interlinkages

between emerging markets and the prices

o commodities: One or two years afer the

collapse in 2009, a tidal wave in rising com-

modities prices pushed emerging economies

to quickly recover and grow. Nowadays, the

tidal wave has receded, and many emergingmarkets are in danger o capsizing.

The Impact of China

From colonial times a ew centuries ago,

commodity prices have been driving fluctu-

ations o commodity-exporting economies.

What is interesting in this last cycle is the

emerging role o China, an emerging economy

itsel. Strikingly, Chinaand to a lesser extent

Indiahas surged as an importer o commo-

THINKSTOCK/

By Alexander Monge-Naranjo and Faisal Sohail

Some of the rise of China as the top importer of commodities

is due to a global shift in manufacturing, which also has

manifested in a decline in energy imports into the U.S. and

slow growth in Japan.

shows the diversity in the mix o commodi-

ties produced and exported, as well as

some diversity in the ratio o commodities

exported as a percentage o gross domestic

product (GDP) across these countries.

In this art icle, we examine the extent to

which the business cycles in emerging coun-

tries are highly dependent on fluctuations in

the global prices o commodities. As a corol-

lary, we show that the prospects o expan-

sions and contractions or emerging countries

are closely linked with the outlook or thecountries importing commodities. Addition-

ally, we show how the changing composition

o buyers o commodities has made emerg-

ing markets increasingly susceptible to the

whims o a single buyer: China. Indeed, the

recent decline in commodity prices and the

slowdown o growth in China go a long way

in explaining the recent recessions in Brazil

and Canada and may portend urther turmoil

in many emerging markets.



7/24

E N D N O E S

1 Tese deviations are computed using the Hodrick-

Prescott filter, the most common method to separate

business cycle components rom long-run trends. 2 See Fawley and Juvenal. 3 Te values or the coefficient o correlat ion o

output and prices or all the emerging economies

are positive and above 0.50, ranging rom 0.51 or

Argentina to 0.80 or Brazil. 4 See Helbling.

R E F E R E N C E S

Fawley, Brett; and Juvenal, Luciana. Commodity

Price Gains: Speculation vs. Fundamentals. Te

Federal Reserve Bank o St. Louis Te Regional

Economist,July 2011, Vol. 19, No. 3, pp. 4 -9.

Helbling, Tomas. Commodities in Boom. Interna-

tional Monetary Funds Finance and Development

June 2012, Vol. 49, No. 2, pp. 30-31.

dities over the past two decades. In 1990,

China accounted or only 2 percent o all

commodities traded, while the U.S. and Japanaccounted or about 15 percent each. By 2013,

China was the leading commodity importer, at

15 percent o global trade, while the U.S. and

Japan had allen to 10 percent each. A similar

trend holds i we consider only the market or

energy commodities, e.g., oil, natural gas and

coal. (India displays similar trends, although

starting much later: In 2005, India accounted

or 1 percent o all global imports o commod-

ities; in 2013, it accounted or 5 percent.)

Some o the rise o China as the top

importer o commodities is due to a globalshif in manuacturing, which also has

maniested in a decline in energy imports

into the U.S. and slow growth in Japan.

Moreover, since the early 2000s, the U.S.

has increasingly relied on domestic energy

sources, lowering its need or energy imports,

while Japans lost decade led to a decline in

trade. However, Chinas annual GDP growth

rate averaged about 10 percent between 1990

and 2013, and this high growth rate was

accompanied by an ever-growing demand or

industrial inputs. Indeed, Chinas growth wasshared by many emerging economies as they

provided the exports to sustain Chinas surge.

But these same economies must also share

in Chinas slow-growth periods. Recently,

Chinas growth rate has allen to about 6 or 7

percent (still high compared with that o the

U.S. and other developed countries today),

and the uncertainty around Chinese growth

has increased. All o these actors are behind

the recent collapse in commodities prices.

FIGURE 1

Agriculture Food and Beverage Agriculture Raw Material Metals Energy

Argentina

Brazil

Canada

Chile

Colombia

Indonesia

Mexico

Russia

South Africa

Venezuela

As a Percentage of GDP

Commodity Exports as a Percentage of GDP in 2013

SOURCES: Massachusetts Institute of Technology Observatory of Economic Complexity, Haver Analytics.

NOTE: The figure shows the share of export in commodities as a percentage of real GDP as of 2013.

Commodities are grouped following the Standard International Trade Classification, rev. 3.

0 2 4 6 8 10 12 14 16 18 20

FIGURE 2

All Commodities (left axis)

Quarter

Argentina Brazil

Canada Colombia Russia

Cyclical Component of Prices and Output

SOURCES: International Monetary Fund, Haver Analytics.

NOTE: The figure plots the cyclical component of commodity prices (left axis) and output (right axis). The underlying commodity price data are

normalized to 1 in the first quarter of 2000. The Hodrick-Prescott (HP) filter with smoothing parameter of 1600 was applied to quarterly data on

prices and the natural logarithm of output (measured as real GDP) to obtain the cyclical component. The final data point is 2015:Q4 for prices

data and is 2015:Q2 for output data.

2000:Q

1

2001:Q

1

2002:Q

1

2003:Q

1

2004:Q

1

2005:Q

1

2006:Q

1

2007:Q

1

2008:Q

1

2009:Q

1

2010:Q

1

2011:Q

1

2012:Q

1

2013:Q

1

2014:Q

1

2015:Q

1

1.0

0.8

0.6

0.4

0.2

0.0

0.2

0.4

0.6

0.8

1.0

CyclicalComponentofPrices

0.02

0.01

0.00

0.01

0.02

C

yclicalComponentofOutput

Conclusion

It is striking how strongly commodities

prices drive the overall economic fluctua-

tions o emerging countries despite remark-

able differences in their composition o

commodities or export and their total

export shares as a percentage o their GDP.

Yet, or these countries a salient common

actor emerges: the importance o China

and its growth prospects.

Alexander Monge-Naranjo is an economist andFaisal Sohail is a technical research associate,both at the Federal Reserve Bank of St. Louis.For more on Monge-Naranjos work, see https://research.stlouisfed.org/econ/monge-naranjo.



8/24

By Yi Wen

Chinas Rapid RiseFrom Backward Agrarian Society

to Industrial Powerhousein Just 35 Years

Chinas industrial revolution, which started 35 years ago, is perhapsone o the most important economic and geopolitical phenomenasince the original Industrial Revolution 250 years ago. Te reason is sim-

ple: Less than 10 percent o the worlds population is ully industrialized;

i China can successully finish its industrialization, an additional 20 per-

cent o the worlds population will be entering modern times. Along the

way, China is igniting new growth across Asia, Latin America, Arica andeven the industrial West, thanks to the countrys colossal demand or raw

materials, energy, trade and capital flows.

Chinas rapid growth has puzzled many people, including economists.

THINKSTOC

I N T E R N A T I O N A L



9/24

The Regional Economist|www.stlouisfed.org 9

How could a nation with 1.4 billion

people transorm itsel relatively suddenly

rom a vastly impoverished agricultural

land into a ormidable industrial power-

house when so many tiny nations have been

unable to do so despite their more avorable

social-economic conditions? Among the

many conflicting views that have emerged tointerpret Chinas rise, two stand out as the

most popular and provocative. Te first sees

Chinas hypergrowth as a gigantic govern-

ment-engineered bubble. It is not sustain-

able and will collapse because China has no

democracy, no human rights, no reedom

o speech, no rule o law, no Western-style

legal system, no well-unctioning markets,

no private banking sector, no protection

o intellectual properties, no ability to

innovate (other than copying and stealing

Western technologies and business secrets),nor a host o many other things that the

West has possessed or centuries and have

proved essential or Western prosperity and

technological dominance.1According to this

view, the bubble will burst at the expense o

Chinas people and environment.

Te second view sees Chinas dramatic rise

simply as destiny. It is returning to its histori-

cal position: China had been one o the richest

nations and greatest civilizations (alongside

India) rom at least 200 B.C. to 1800, the dawn

o the Industrial Revolution in England. (SeeFigure 1.) It was only a matter o time or

China to reclaim its historical glory and domi-

nate the world once again. (As Napoleon once

said, Let China sleep, or when the dragon

awakes, she will shake the world. 2)

But neither view is backed by serious

economic analysis, instead being based either

on prejudice or nave extrapolation o human

history. How could a nation with all those

adverse elements or business and innovation

be able to grow at a double-digit annual rate

or several decades and transorm itsel in

such a short time rom an impoverished agri-

cultural economy into a ormidable manu-

acturing powerhouse? I culture or ancient

civilization is the explanation, then why

arent Egyptian, Greek or Ottoman empires

bursting onto the world stage?

Tis article provides a different view o

Chinas rise, one based on undamental

economic analysis. It hopeully will lead to

a better understanding o Chinas miracle

growth but also will shed light on the ail-

ures and successes o many other nations

attempts at industrialization, including the

original Industrial Revolution itsel.

Admittedly, many people think Chinas

economic miracle has come to an end. Te

growth o its economy has declined sharplyrom the double digits to 7 percent or lower.

Its stock market is in turmoil, and its cur-

rency is under attack. But keep in mind that

the United States experienced 15 financial

crises and a our-year civil war as it rose to

global prominence. It was on the verge o

collapse in 1907 afer taking on the mantle

o the worlds superpower rom the United

Kingdom. Te U.S. also weathered the Great

Depression in the 1930s and the global

financial crisis in 2007. Does all o this mean

it is no longer an economic star?

Some Facts about Chinas Rise

Tirty-five years ago, Chinas per capita

income was only one-third o that o sub-

Sahara Arica. oday, China is the worlds

largest manuacturing powerhouse: It

produces nearly 50 percent o the worlds

major industrial goods, including crude steel

(800 percent o the U.S. level and 50 percent

o global supply), cement (60 percent o the

worlds production), coal (50 percent o the

worlds production), vehicles (more than25 percent o global supply) and industrial

patent applications (about 150 percent o the

U.S. level). China is also the worlds largest

producer o ships, high-speed trains, robots,

tunnels, bridges, highways, chemical fibers,

machine tools, computers, cellphones, etc.

Figure 2 shows the manuacturing out-

put o the top five countries in the world

between 1970 and 2013. In the early 1970s,

when President Richard Nixon visited

China, it produced very ew manuactured

goodsa tiny raction o the U.S. level.

About 1980, Chinas manuacturing started

to take off, surpassing the industrial powers

one by one, overtaking the U.S. in 2010 to

become the No. 1 industrial powerhouse.

The Secret Recipe

How did China achieve this in 35 years?

Te short answer is that China has redis-

covered the secret recipe o the Industrial

Among the many conflicting

views that have emerged to

interpret Chinas rise, two

stand out as the most popu-

lar and provocative. The first

sees Chinas hypergrowth

as a gigantic government-

engineered bubble. The

second view sees Chinas

dramatic rise simply as

destiny. But neither

view is backed by serious

economic analysis, instead

being based either on preju-

dice or nave extrapolation

of human history.


10/24

Revolution. But what is the secret recipe,

and why didnt China find it sooner?Te British Industrial Revolution was one

o the most important socioeconomic events

in human historyperhaps as significant as

the discovery o fire and agriculture. Beore

this revolution, humanity across all conti-

nents had lived essentially at a subsistence

level, stagnating in the so-called Malthusian

trap.3But the Industrial Revolution changed

it all: Starting about 1760, the living standard

in the United Kingdom began to increase

dramatically, leading to an era o permanent

growth in per capita income. Because o thealmost magical increases in living standards

and national income, among other things,

almost every nation has tried to emulate the

British Industrial Revolution.

Unortunately, only a ew places have suc-

ceeded: Northern and Western Europe, the

United States, Japan and the Asian igers,

among others. Although the Asian igers

(South Korea, aiwan, Hong Kong and Sin-

gapore) industrialized rather quickly afer

WWII, some o them (such as aiwan) so

ar have reached a per capita income o only

about hal the U.S. level.

Why have only a ew nations succeeded?

Political institutions are the key, according

to the institutional theory. Inclusive institu-

tions (e.g., democracy) put restrictions on

the elite class, allowing the ree market, ree

trade, private property rights and the rule o

law to flourish. Tis implies private incen-

tives or wealth accumulation, innovation

and growth. On the other hand, extractive

institutions (such as dictatorship) imply the

lack o not only reedom o choice but o

protection o private-property rights and

the rule o law, all o which leads to the lack

o private incentives to work hard, accumu-

late capital and innovate. Te end result is

poverty. Tereore, the solution or endingpoverty is simple: democracy.4

Or is it?

Such theories are difficult to square with

the acts. First, there are ample democracies

with pervasive economic stagnation and

continuous political turmoil: Aghanistan,

Egypt, Iraq, Libya, Pakistan, Tailand,

unisia and Ukraine, to name a ew. Second

there are ample extractive institutions that

have been economically strong, such as

Germany (1850-WWII) and Russia (1860-

WWII). Te institutional theory also cantexplain the dismal ailure o todays Russia

at economic reorm under democracy and

shock therapy, Japans rapid industrializa-

tion during the Meiji Restoration, South

Koreas economic takeoff in the 1960s-1980s

under dictatorship or Singapores post-inde-

pendence economic miracle. Nor can the

theory explain why under identical political

institutions, property rights and the rule o

law, there exist pockets o both extreme pov-

erty and extreme wealth, as well as o violent

crime and obedience to law. Such dichoto-mies exist in many U.S. cities, or example.

Italy is another example, with its poverty in

the south and wealth in the north.

Chinas Past Failures

What is happening in China is not its first

attempt at industrialization but the ourth

over the past 120 years.

Te first attempt was made between 1861

and 1911. It came on the heels o Chinas deeat

in 1860 by the British in the Second Opium

War. Deeply humiliated by unequal trea-

ties imposed by Western industrial powers,

the Qing monarchy that was then in control

in China embarked on a series o ambitious

programs to modernize its backward agrarian

economy, including establishing a modern

navy and industrial system. Tis attempt

started eight years earlier than the Meiji

Restoration that triggered Japans successul

industrialization. Fify years later, the effort in

Economic History of China and Other Major Powers

Non-Asian Ancient Civilizations

(Greece, Egypt, Turkey, Iran)

China

Germany

United States

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

ShareofCu

mulativeGDP

India

Japan

Russia

Italy

Spain

United Kingdom

France

1

1000

1500

1600

1700

1820

1850

1870

1900

1913

1940

1950

1960

1970

1980

1990

2000

2010

2014

SOURCE: The Maddison-Project, http://

www.ggdc.net/maddison/maddison-

project/home.htm, 2013 version.

NOTE: The cumulative gross domestic

product is for all the countries listed and

represents at least 70 percent of the total

for the world at any given time, with the

rest provided by smaller countries.

FIGURE 1



11/24

China turned out to be a gigantic ailure: Te

government was deep in debt, and the hoped-

or industrial base was nowhere in sight.

A nationwide demand or political

reorms, ollowed by social turmoil, ulti-

mately led to the 1911 Xinhai Revolution. It

overthrew the extractive Qing monarchy

and established the Republic o China,the first inclusive government in China

based on Western-style constitutions. Te

new republic tried to industrialize China

by a wholesale mimicking o U.S. political

institutions, including democracy and the

separation o powers (legislative, executive

and judicial branches o government).

At that time, a amous slogan among the

Chinese was Only science and democracy

can save China. Te revolutionaries o the

educated elite believed that the monarchys

ailure to industrialize and Chinas overallbackwardness were due to its lack o democ-

racy, political inclusiveness and pluralism

(exactly as the modern institutionalism theory

has argued). But 40 years passed, and China

remained one o the poorest nations on earth.

In 1949, the republic was deeated by

the Communist peasant army. Te new

government initiated the third ambitious

attempt to industrialize Chinathis time by

mimicking the Soviet Unions central plan-

ning model. Tirty years passed, and the

effort ailed again: In 1978, China remainedessentially in the same Malthusian poverty

trap, with per capita income not signifi-

cantly different rom what it was around the

Second Opium War.

Hence, the reason or Chinas three

ailures was clearly not the lack o ree

market and private-property rightsthe

Qing dynasty had probably a better market

system and better private-property rights

than did England and the rest o Europe in

the 17th and 18th centuries. Nor was it the

lack o democracythe government o the

Republic o China was so inclusive that even

members o the Communist Party were

allowed in the government.

What Was Different This Time?

Chinas ourth attempt started in 1978 under

leader Deng Xiaoping. Te country reused to

take advice rom Western economists (unlike

what Russia did in the 1990s) and instead

took a very humble, gradualist, experimental

approach with its economic reorms. Te keys

to this approach have been to:

1. maintain political stability at all costs;

2. ocus on the grassroots, bottom-up

reorms (starting in agriculture instead oin the financial sector);

3. promote rural industries despite their

primitive technologies;

4. use manuactured goods (instead o

only natural resources) to exchange or

machinery;

5. provide enormous government support

or inrastructure buildup;

6. ollow a dual-track system o government/

private ownership instead o wholesale

privatization; and

7. move up the industrial ladder, rom lightto heavy industries, rom labor- to capital-

intensive production, rom manuactur-

ing to financial capitalism, and rom

a high-saving state to a consumeristic

welare state.

Chinas ourth attempt mimics the

historical sequence o the British Industrial

Revolution, despite dramatic differences in

political institutions. (Afer all, China is still

an authoritarian state.) Te British Indus-

trial Revolution ollowed five key stages:

1. the proto-industrialization stage, which

developed rural industries or long-

distance trade;

2. the first industrial revolution, which ea-

tured labor-intensive mass production or

the mass market;

3. the industrial trinity boom, which

involved the mass supply o energy,

locomotive power and inrastructure to

acilitate mass distribution;5

1970 1975 1980 1985 1990 1995 2000 2005 2010

3,500

3,000

2,500

2,000

1,500

1,000

500

0

U.

S.d

ollars,

billions

Manufacturing Output for Top Five Countries in 2013

SOURCE: United Nations.

China

United States

Japan

Germany

Russia

FIGURE 2

The Regional Economist| www.stlouisfed.org11


12/24

4. the second industrial revolution, eaturing

the mass production o the means o mass

production, such as steel and machine

tools (including agricultural machinery),

as well as the creation o a large credit

system; and

5. the welare state stage, which incorporates

economic welare (such as the modernservice economy, unemployment insurance,

equal access to health care and education,

and a ull-fledged social saety net) and

political welare (such as democracy, human

rights, the end o the death penalty, legaliza-

tion o gay marriage).

Along such a development path, democ-

racy is the consequence instead o the cause

o industrialization. Democracy reinorces

stability only in industrialized societies.

Almost all successully industrialized econ-

omies have gone through these key stages inhistory, as the ollowing examples show:

U.K. path to industrialization: 6

1. 1600-1760: Proto-industria lization in

rural areas, organized and financed by

rich merchants (e.g., via the putting-out

system7);

2. 1760-1830: first industrial revolution

in textile industries, relying on wood-

ramed and water-powered textile

machines or mass production;

3. 1830-1850: boom in industrial trinity:energy (such as coal), transportation

(such as railroad) and locomotive (such

as steam engine);

4. 1850-1900: second industrial revolution,

involving the mass production o the

means o mass production, such as iron,

steel, chemicals and machinery; and

5. Afer 1900: entering the welare state

(e.g., universal suffrage in 1928).

U.S. path to industrialization:

1. Beore 1820: rural industries mushroom-

ing in the countryside;

2. 1820-1860: first industrial revolution

mass production o textiles, based on

imported or stolen British technologies;

3. 1830-1870: boom in industrial trinity,

such as the 1828-1873 railroad mania;

4. 1870-1940: second industrial revolution,

eaturing mass production o steel, automo-

biles, telecommunications, chemicals and

mechanized agriculture in the 1940s; and

5. 1940s-present: entering the welare state

afer WWII with such key steps as the

civil rights movement in the 1960s, uni-

versal suffrage in 1965, Violence Against

Women Act o 1994 and legalization o

same-sex marriage in 2015.

Japans path to industrialization:

1. 1603-1868 (the Edo period): commercial

agriculture and rural artisan manuactur

ing flourished amid political stability;

2. 1868-1890 (early Meiji): ull-fledged

proto-industrialization;

3. 1890-1920 (including late Meiji): first

industrial revolution, based on mass pro-

duction o textiles, relying on imported

machinery and exports o labor-intensive

textile products;

4. 1900-1930: boom in industrial trinity(e.g., railroads);

5. 1920-1941: beginning o second industrial

revolution; and

6. 1945-1980: continuation o second indus-

trial revolution, democratic reorm under

U.S. occupation, entering welare state.

Chinas Path

China compressed the several centuries

o Western (and Japanese) development into

three decades. Its path to industrialization

has gone through three major phases:1. 1978-1988: proto-industrialization. Tis

phase eatured the sprouting o millions

o rural enterprises (collectively instead o

privately owned by armers) across Chinas

vast countryside and small towns; these

enterprises acted as the engine o national

economic growth during the first 10 years

o economic reorm. Te number o village

firms increased more than 12-old (rom

1.5 million to 18.9 million), village industrial

gross output increased more than 13.5-old

(rom 14 percent o gross domestic prod-

uct, or GDP, to 46 percent o GDP), village

peasant-workers grew to nearly 100

million by 1988, and armers aggregate

wage income increased 12-old. Because

o such phenomenal growth in the supply

o basic consumer goods, China ended its

shortage economy (a typical eature o all

centrally planned economies, character-

ized by the rationing o meat, other ood,

Along such a development

path, democracy is the conse-

quence instead of the cause

of industrialization. Democracy

reinforces stability only in

industrialized societies. Almostall successfully industrialized

economies have gone through

these key stages in history. ...



13/24

clothes and other basic consumer goods) in

the mid-1980s and simultaneously solved

its ood security problem. Te 800 million

armers were the biggest beneficiaries o

the economic reorm in this period.

2. 1988-1998: first industrial revolution. Tis

phase eatured mass production o labor-

intensive light consumer goods acrossChinas rural and urban areas, relying

first mainly on imported machinery. Dur-

ing this period, China became the worlds

largest producer and exporter o textiles,

the largest producer and importer o cot-

ton, and the largest producer and exporter

o urniture and toys. Rural enterprises

continued their hypergrowth, and their

workers reached 30 percent o Chinas

entire rural labor orce (not including

migrant workers). Village industrial out-

put grew by 28 percent per year, doublingevery three years (an astronomical 66-old

increase) between 1978 and 2000.

3. 1998-present: second industrial revo-

lution. Tis phase eatured the mass

production o the means o mass pro-

duction. Because o the rapidly and

enormously expanding domestic market

or intermediate goods, machinery and

transportation, there was a big surge in

the consumption and production o coal,

steel, cement, chemical fibers, machine

tools, highways, bridges, tunnels, ships,etc. In all, 2.6 million miles o public

roads were built, including more than

70,000 miles o express highways (46 per-

cent more than in the U.S.). wenty-eight

provinces (out o 30) have high-speed

trains (with total length exceeding 10,000

miles, 50 percent more than the total or

the rest o the world).

The Triumph of Marketism?

Is Chinas achievement the triumph o

marketism? Yes and no. Yes or obvious

reasons: Markets impose economic incen-

tives to compete, impose discipline on

management and on technology adoption,

and create Darwinian creative destruction

to eliminate losers.

But no or overlooked reasons: Its

extremely costly or independent, anarchic,

uneducated peasants to orm cooperatives

unless social trust and markets exist; its also

extremely costly to create a unified national

mass market and a global market to support

the division o labor and mass production;

and it is especially costly to create market

regulatory institutions to prevent cheating

and raud. Tese costs prevented the prior

ormation o industries and, thus, explain the

ailures o the Qing dynasty and the Repub-lic o China to kick-start Chinas industrial

revolution in the 19th and early part o the

20th centuries, despite their having private-

property rights and even democracy.

Te poverty o nations is caused by their

inability to mass-produce consumption goods.

But mass production requires mass markets

and mass distribution to render it profitable.

Where does the mass (world) market

come rom? Early European powers relied

on a mercantilist state government and

militarized merchants to create monopo-listic global markets through colonialism,

imperialism and slave trade. In particu-

lar, generations o British monarchs and

merchants (e.g., the British East India Co.)

helped create or England the worlds largest

textile market, cotton supply chains and

trading networks that kick-started the origi-

nal Industrial Revolution.

oday, developing nations no longer have

such privilege or the time to nurture such

a powerul merchant class to create markets.

Hence, governments play a bigger role inmarket creation.

Tereore, the ongoing industrial revolu-

tion in China has been driven not by

technology adoption per se, but instead by

continuous market creation led by a capable

mercantilist government; the market cre-

ation is based on mutually beneficial trade

instead o the gunboat diplomacy methods

o earlier Western powers.8

The Secret Is Sequencing

Democracy and laissez-aire do not

automatically create a global market. Mar-

ket creation requires state power, correct

developmental strategies and correct indus-

trial policies. Te ree market is actually

extremely costly to create.9

As weve already seen, the development

o an industrial market is a sequential

process (rom the agricultural and artisan

stage to the proto-industrial market and so

THINKSTOCK/TOP

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14/24

E N D N O E S

1See Chang. 2 See Jacques or http://wander ingchina.blogspot.

com/2008/08/napoleon-and-his-view-on-china.

html. 3 Te Malthusian trap, named afer the 19th cen-

tury British political economist Tomas Robert

Malthus, suggests that or most o human history,

income was largely stagnant because technological

advances and discoveries only resulted in more

people, rather than improvements in the standardo living. It is argued that many countries in tropical

Arica still find themselves in the Malthusian trap. 4 See Acemoglu and Robinson.5 Te specific components o the industrial trinity

evolve over time. In terms o energy, it was coal in

the 19th century, oil in the 20th century and solar

power in the 21st century. In terms o communi-

cation, it was the telegraph in the 19th century,

the telephone in the 20th century and electronic

mail in the 21st century. 6 Te demarcations o the stages are approxima-

tions and can never be exact, and they ofen tend

to overlap with each other or a substantial period

o time. But a higher stage always appears later

than a lower stage in history or the successul ly

industrialized nations, whereas the unsuccessullyindustrialized nations tend to directly jump i nto

higher stages by skipping earlier stages. 7 Te putting-out system was a system o ami ly-

based domestic manuacturing that was prevalent

in rural a reas o western Europe during the 17th

and 18th centuries. Domestic workers involved in

this system typically owned their own primitive

tools (such as looms and spinning wheels) but

depended on merchant capitalists to provide them

with the raw materials to ashion products, which

were deemed the property o the merchants. Semi

finished products would be passed on by the mer-

chant to another workplace or urther processing

while finished products would be taken direct ly to

market by the merchants. 8 In this regard, China contributed to and also ben-

efited rom the postwar peaceul world order cre-ated by the joint efforts o developing countries,

their independence movements and the industrial

world powers, especially the United States.9 See Wen or more detail ed analysis.

10 A theoretical ramework or why successul in-

dustrialization must go through stages is provided

in my orthcoming book, titled Te Making of an

Economic Superpower: Unlocking Chinas Secret

of Rapid Industrialization. See https://research.

stlouised.org/econ/wen/sel.

R E F E R E N C E S

Acemoglu, Daron; and Robinson, James A. Why

Nations Fail.New York: Crown Publishers, 2012.

Chang, Gordon G. Te Coming Collapse of China.

New York: Random House, 2001.

Jacques, Martin. When China Rules the World: Te

End of the Western World and the Birth of a New

Global Order.Second Edition. London: Penguin

Press, 2012, 2nd edition.

Wen, Yi. Te Making of an Economic Superpower:

Unlocking Chinas Secret of Rapid Industrializa-

tion.St. Louis Fed Working Paper 2015-006B,

2015. See https://research.stlouised.org/wp/

more/2015-006.

on). No matter how late a nation starts its

development, it must repeat earlier stages to

succeed.10It is like learning mathematics.

Trough thousands o years o development,

the human race discovered math knowledge

sequentially: rom numbers to arithmetic to

algebra to calculus, etc. Although calculus

is in todays first-year college textbooks,every generation o children must still

repeat humanitys evolutionary process to

learn math. Tey do not jump to calculus

at age 6; instead they start with learning

numbers (with the help o their fingers, just

like our ancestors did) and gradually move

up the ladder.

In contrast, modern economic theories

teach poor countries to leap orward, to

start industrialization by building advanced

capital-intensive industries (such as chemical,

steel and automobile industries), by settingup modern financial systems (such as a float-

ing exchange rate, ree international capital

flows, and ully fledged privatization o state-

owned properties and natural resources)

or by erecting modern political institutions

(such as democracy and universal suffrage).

But such top-down approaches violate the

historical sequence o the Industrial Revolu-

tion and have led to political chaos, develop-

mental disorders and deormed capitalism

in Arica, Latin America, Southeast Asia and

the Middle East.

Challenges Ahead

As China has industrialized, it has

picked up not only the posit ives o Western

development but the negatives, including

rampant corruption and organized crime,

unprecedented pollution and environmental

destruction, rising divorce and suicide rates,

widespread business raud and scandals,

markets ull o lemons and low-quality

goods, pervasive asset bubbles, rising

income inequality and class discrimina-

tion, requent industrial accidents, etc. And

there are other challenges, including build-

ing social saety nets, finishing social and

economic reorms in the health care and

education sectors, finishing rural urbaniza-

tion and agricultural modernization, estab-

lishing modern financial inrastructure and

regulatory institutions as in the U.K. and

U.S., and establishing a modern legal system

as in Hong Kong and Singapore.

However, as long as China ollows the

right sequence o economic development,

these problems should be merely growing

pains and not the same daunting structural

obstacles like the Malthusian poverty trap

or the middle-income trap aced by many

developing nations in Arica, Latin Amer-ica, the Middle East and Southeast Asia.

Conclusion

Ever since the 15th century, the spirit o

capitalism has been shake hands and do

business, regardless o ideology, religion,

culture and national boundary. It is pre-

cisely such a spirit that has created modern

industrial civilization and will continue to

change the world.

For a hal-century afer World War II, the

U.S. pursued one o historys most success-ul nation-building win-win strategies: It

nurtured the rebuilding o Europe and Japan

and the development o other poor coun-

tries and bonded them economically. China

today seems to be carrying the U.S. banner

orward: China is pursuing win-win develop-

ment strategies, too, that are ocused on eco-

nomics. It is doing so through global business

engagement and international inrastructure

buildup regardless o religion, culture, politi-

cal system and national boundary.

Chinas rise provides a golden opportunity

or developing nations to ride or ree on the

China train. But how much each individual

nation can benefit rom Chinas rise depends

entirely on its own worldview, development

strategies and industrial policies.

Meanwhile, the 21st century appears to be

shaping up as Chinas century.

Yi Wen, a native of China, is an economistat the Federal Reserve Bank of St. Louis. Tis

article is based on a lecture of his in November(see www.stlouisfed.org/dialogue-with-the-fed/chinas-industrial-revolution-past-present-future), which drew heavily from his forthcom-ing book, titled Te Making o an EconomicSuperpower: Unlocking Chinas Secret oRapid Industrialization.For the working paperversion of the book, see his website at https://research.stlouisfed.org/econ/wen. Wen wouldlike to thank William R. Emmons, also aneconomist at the St. Louis Fed, for commentsand Maria A. Arias, a senior research associateat the Bank, for research assistance.

14 The Regional Economist | April 2016


15/24

Most people are aware that decisionsby the Federal Reserve (Fed) affectmarket interest rates. Tese decisions have

consequences or the interest rates that con-

sumers pay on mortgage loans, credit cards

and auto loans, and or the interest rates

aced by businesses on bank loans, corpo-rate bonds and commercial paper.

But there is more than one interest rate

that the Fed sets, either as a target or by

administrative fiat. Many people are aware

o the target or the ederal unds rate, or ed

unds rate, that the Federal Open Market

Committee (FOMC) o the Fed sets at its

eight regular meetings a year. Te ed unds

rate is an interest rate on overnight credit

arrangements among financial institu-

tionsthat is, a very short-term interest

rate. Te Fed also sets the discount rate, orthe interest rate on primary credit, which

is an interest rate at which the Fed lends

to commercial banks in its role as a lender

o last resort. Still another rate is that on

interest paid by the Fed on reserves. Banks

hold reserve accounts with the Fed; these

accounts essentially play the role o checking

accounts or financial institutions. (A reserve

account is useul when a bank needs to make

large payments to other financial institu-

tions.) Tus, a reserve account is a loan to the

Fed rom a bank. Beore late 2008, reserveaccounts paid zero interest, as dictated by

Congress in the Federal Reserve Act.

Prior to the financial crisis (late 2007

through 2008), the Fed conducted monetary

policy within what economists call a chan-

nel system. Te Fed targeted the overnight

ed unds rate within a channel, with the

discount rate as the upper bound on the

channel and the interest rate on reserves

as the lower bound on the channel. For

Interest Rate ControlIs More Complicated

Than You Thought

F E D E R A L R E S E R V E S Y S T E M

By Stephen Williamson

FEDERAL RESERVE BOARD

example, in January 2007, the discount rate

was set at 6.25 percent, the ed unds rate was

targeted at 5.25 percent and the interest rate

on reserves was 0 percent. Te ed unds rate

could not, in principle, go above the discount

rate because no bank would choose to borrow

rom another bank at an interest rate higher

than the rate at which it could borrow romthe Fed (the discount rate). Similarly, no bank

would lend to another bank at an interest rate

lower than the interest rate it could receive

rom the Fed (the interest rate on reserves).

In 2007, the New York Fed would intervene

every day in financial marketsthrough open

market operations, which are the purchase

and sale o assets by the Fedto try to bring

the ed unds rate as close as possible

to the target set by the FOMC.

But between 2007 and now, the details

o how the Fed conducts monetary policy

have changed in important ways. First, since

late 2008, the reserves held at the Fed by

financial institutions have earned interest;

such interest payments are allowed under

an amendment to the Federal Reserve Actpassed by Congress. Further, and more

importantly, the interest rate on excess

reserves, or IOER, is set by the Fed and

can be changed over time.

Second, during the Great Recession (late

2007 to mid-2009) and its afermath, the Fed

engaged in some unconventional monetary

policy actions. For our purposes, the most

important o these was a program o large-

scale asset purchases, sometimes known as

quantitative easing. Tis program led to a

large increase in the stock o reserves at theFedeffectively, the Fed purchased a large

quantity o assets (U.S. reasury securities

and agency mortgage-backed securities) by

issuing more reserves.

For the Fed, the large stock o reserves

outstanding implies that monetary policy

works differently nowwithin afloor

system rather than a channel system. In a

floor system, the IOER plays a key role. In

principle, what should happen in a floor

system is that, with plenty o reserves in the

system, the Fed can achieve its target or theed unds rate by simply setting the IOER.

Why? I the ed unds rate were lower than

the IOER, then banks would be able to make

a profit rom borrowing on the ed unds

market and lending to the Fed at the IOER,

thus orcing up the ed unds rate. I the ed

unds rate were higher than the IOER, then

a bank wanting to lend would earn more

interest on the ed unds market than by

lending to the Fed at the IOER. Te large

Also by Stephen Williamson

The St. Louis Fed has just released its annual report.

The main essay, written by Williamson, is about the

Feds return to normal monetary policy after seven

years of abnormally low interest rates. St. Louis Fed

President and CEO James Bullard also addresses this

topic. Elsewhere in the annual report, the St. Louis

Feds work, people, mission and results are featured.

To read the report online, go to www.stlouisfed.org/

annual-report.

The Regional Economist |www.stlouisfed.org 15


16/24

demand or ed unds would then orce the

ed unds rate down.

According to this logic, controlling the

ed unds rate should be easy or the Fed

under a floor system. But theory and reality

sometimes do not agree. From late 2008 to

December 2015, the IOER was set at 0.25 per-

cent. However, contrary to what many people

might think, since early 2009 the ed unds

rate has generally been 5 to 20 basis points

(one basis point is equal to 0.01 percentage

points) lower than the IOER. Tis difference

between the IOER and the ed unds rate is

typically ascribed to costs or commercial

banks associated with borrowing on the ed

unds market.1

Te persistent difference between the

IOER and the ed unds rate was a concern

or the Fed as it anticipated the time when

lifoff would occur, where lifoff reers

to the date at which the Fed would departrom its long period (since late 2008) o

zero interest rate policy, or ZIRP. Could the

Fed expect that the ed unds rate would

increase along with the IOER i the Fed

attempted to control the ed unds rate only

through increases in the IOER?

Te solution adopted by the Fed is unique

in central bankinga floor system with a

subfloor. Te New York Fed, in intervening

in overnight financial markets, is now mak-

ing use o an overnight reverse repurchase

agreement (ON-RRP) acility. ON-RRPs areessentially reserves by another name. In ON-

RRP transactions, financial institutions lend

to the Fed, just as they do when they hold

reserve accounts with the Fed. Te difference

between reserves and ON-RRPs is that, in an

ON-RRP arrangement, the Fed posts securi-

ties in its portolio as collateral, just as in any

private repurchase agreement transaction.

A repurchase agreement is simply a special

kind o financial market loan that is secured

by collateral just as, or example, your mort-

gage is secured by your house, which can beseized i you deault on the mortgage.

Without getting into all the details,2the

idea behind the floor-with-subfloor system

is that the Fed sets, along with the discount

rate and IOER, an ON-RRP rate, which is

the rate at which financial institutions can

lend to the Fed in the market or repurchase

agreements. Te ON-RRP rate is set below

the IOER, and then policy is announced as a

target range or the ed unds rate, with the

top o the range given by the IOER and the

bottom o the range determined by the ON-

RRP rate. Tus, the IOER sets the floor, and

the ON-RRP rate sets the subfloor.

But could this system work? On Dec. 16,

2015, the FOMC decided to increase the

target range or the ederal unds rate rom

0-0.25 percent to 0.25-0.50 percent,3

withthe discount rate at 1.0 percent, the IOER

at 0.50 percent and the ON-RRP rate set at

0.25 percent.

As shown in Figure 1, the value o

ON-RRPs outstanding increased rom

$105 bill ion on Dec. 17, 2015, to $475 bil lion

on Dec. 31, ollowing which the quantity

dropped back to the neighborhood o

$100 billion. In the ed unds market, as

shown in Figure 2, the average daily ed

FIGURE 1

FIGURE 2

12/17/15

12/19/15

12/21/15

12/23/15

12/25/15

12/27/15

12/29/15

12/31/15

01/02/16

01/04/16

01/06/16

01/08/16

01/10/16

01/12/16

01/14/16

01/16/16

01/18/16

0 1 / 2 0 / 1 6

0.6

0.5

0.4

0.3

0.2

0.1

0.0

PercentPerAnnum

A Floor and a Subfloor for the Federal Funds Rate

SOURCES: Federal Reserve Board/Haver Analytics.

IOER Federal Funds Rate ON-RRP Rate

NOTE: In principle, the large stock of reserves outstanding should result in the fed funds rate equaling the interest on excess

reserves (IOER), but economic factors have resulted in the former rate running below the latter. The rate for overnight reverserepurchase agreements (ON-RRP) should serve as a secondary floor for the fed funds rate, and it largely has. The only time

the fed funds rate has fallen below the ON-RRP rate since liftoff was Dec. 31, 2015, and this is likely explained, in part, by

the fact that financial reporting took place on that day and the fact that there are differences in the time frames of f ed funds

and ON-RRP transactions.

Dec. 31

12/17/15

12/20/15

12/23/15

12/26/15

12/29/15

01/01/16

01/04/16

01/07/16

01/10/16

01/13/16

01/16/16

01/19/16

01/22/16

500

400

300

200

100

0

Billi

ons

ofDollars

Value of ON-RRPs Outstanding

SOURCES: Federal Reserve Board/Haver Analytics. NOTE: ON-RRP stands for overnight reverse repurchase agreement.

Dec. 31

unds rate has typically been within a tight

range o 0.35-0.37 percent, except on Dec. 31,

2015, when the average rate was 0.20 per-

cent. Tus, in terms o results, the Fed has

been successul in controlling the ed unds

rate within the 0.25-0.50 percent range.

But why was the average ed unds rate

so low and the ON-RRP quantity so highon Dec. 31, 2015? Tis date was both the

quarter-end and year-end, which is impor-

tant because at this time financial reporting

takes place and financial institutions want to

have their balance sheets appear as avorable

as possible to their shareholders and regula-

tors. Lending on the ed unds market can be

a risky activity, as lending is unsecured, while

lending to the Fed in the orm o ON-RRPs

is essentially riskless. Tereore, we might

16 The Regional Economist | April 2016


17/24

On the web version of this issue, 11 more charts are available, with much of those charts data specific to the Eighth District.

Among the areas they cover are agriculture, commercial banking, housing permits, income and jobs. To see those charts, go to

www.stlouisfed.org/economyataglance.

U . S . A G R I C U L T U R A L T R A D E AVERAGE LAND VALUES ACROSS THE EIGHTH DISTRICT

15 1611 12 13 14

90

75

60

45

30

15

0

NOTE: Data are aggregated over the past 12 months.

Exports

Imports

FebruaryTrade Balance

BILLIONS

OFD

OLLARS

2014:Q4 2015:Q1 2015:Q2 2015:Q3 2015:Q4

6

4

2

0

2

4

6

YEAR-

OVER-

YEAR

PER

CENT

CHANGE

Quality Farmland

Ranchland or Pastureland

SOURCE: Agricultural Finance Monitor.

C I V I L I A N U N E M P L O Y M E N T R A T E I N T E R E S T R A T E S

11 12 13 14 15 16

10

9

8

7

6

5

4

3

PERCENT

March

11 12 13 14 15 16

4

3

2

1

0

10-Year Treasury

Fed Funds TargetFebruary

1-Year Treasury

PERCENT

NOTE: On Dec. 16, 2015, the FOMC set a target range for the

federal funds rate of 0.25 to 0.5 percent. The observations

plotted since then are the midpoint of the range (0.375 percent).

I N F L A T I O N - I N D E X E D T R E A S U R Y Y I E L D S P R E A D S R AT ES ON FE DE RA L F UN DS FU TU RE S O N S EL EC TE D D AT ES

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

NOTE: Weekly data.

5-Year

10-Year

20-Year

PERCENT

April 8, 2016

12 13 14 15 161st-Expiring

Contract3-Month 6-Month 12-Month

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0

CONTRACT SETTLEMENT MONTH

PERCENT

10/28/15

12 /1 6/ 15 3 /1 6/ 16

1/27/16

R E A L G D P G R O W T H C O N S U M E R P R I C E I N D E X ( C P I )

10 11 12 13 14 15

6

4

2

0

2

NOTE: Each bar is a one-quarter growth rate (annualized);

the red line is the 10-year growth rate.

PERCENT

Q4

11 12 13 14 15 16

4

2

0

2PERCENT

CHANGE

FROM

A

YEAR

EARLIER

March

CPIAll Items

All Items, Less Food and Energy

E C O N O M Y A T A G L A N C E

expect that, on Dec. 31, lenders in the over-

night market would shif their activity rom

the ed unds market to the ON-RRP market,

as this would reduce risk on their balance

sheets. Sure enough, we saw a large increase

in ON-RRP activity on Dec. 31.

Still, why were ed unds market lenders

accepting an average interest rate o 0.20

percent on Dec. 31, 2015, which is lower

than the ON-RRP rate on that date, and why

were some participants accepting interest

rates as low as 0.08 percent? A potential

explanation or this is that ed unds market

trades and ON-RRP trades are very differ-

ent in terms o the time o the day lending

occurs and when the loan is paid back the

next day. In particular, ON-RRP borrow-

ing by the Fed occurs between 12:45 and

1:15 p.m. E, and loans are paid back the

next day between 3:30 and 5:15 p.m. E.

However, a ed unds transaction can occuras late as 6:30 p.m., with unds potentially

returned early the next day.4So, while a ed

unds market transaction may be riskier

because lending is unsecured, it is also more

liquid, as lending can occur later in the day

and unds can be returned more quickly the

next day. Tus, lenders may be willing to pay

or liquidity with a lower overnight interest

rate, and this would have a larger effect at

the quarter-end, when trading on the ed

unds market is thin.

Stephen Williamson is an economist at theFederal Reserve Bank of St. Louis. For more onhis work, see https://research.stlouisfed.org/econ/williamson. Research assistance was providedby Jonas Crews, a research analyst at the Bank.

E N D N O E S

1See Williamson.2 See Williamson or more inormation.3 See Board o Governors.4 See Bartolini, Hilton and McAndrews or more

inormation on the timing o transactions.

R E F E R E N C E S

Bartolini, Leonardo; Hilton, Spence; and McAndrews,James. Settlement Delays in the Money Market.New York Federal Reserve Bank Staff Reports,2008,No. 319. See www.newyorked.org/medialibrary/media/research/staff_reports/sr319.pd.

Board o Governors o the Federal Reserve System. PressRelease,Dec. 16, 2015. See www.ederalreserve.gov/newsevents/press/monetary/20151216a.htm.

Williamson, Stephen D. Monetary Policy Normali-zation in the United States. Federal Reserve Banko St. Louis Review, 2015, Vol. 97, No. 2, pp. 87-108.See https://research.stlouised.org/publications/

review/2015/q2/Williamson.pd.

The Regional Economist |www.stlouisfed.org 17


18/24

D I S T R I C T O V E R V I E W

Immigration Patterns in the District

Differ in Some Ways from the NationsThe Eighth Federal Reserve Districtis composed of four zones, each of

which is centered around one of

the four main cities: Little Rock,

Louisville, Memphis and St. Louis.

By Subhayu Bandyopadhyay and Rodrigo Guerrero

Immigration has a variety o economiceffects on a nation. For example, immi-grants may provide employers with cheaper

or more-skilled labor than what the native

population provides, which makes the

host nation more competitive in its export

markets. Domestic consumers may benefitrom lower prices due to greater production

efficiencies. On the negative side, immigra

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