Democracy Lab

Why the Carrot Isn't Working, Either

The Chinese government thinks it can thwart unrest among ethnic minorities by raising their incomes. But prosperity doesn't buy loyalty.

On Oct. 28, a car crashed in Beijing's Tiananmen Square, killing two innocent bystanders and injuring about 40 others. The incident appears to have been an act of terrorism, albeit quite an unsophisticated one, perpetrated by ethnic Uighurs, a Turkic Muslim population mostly living in China's Xinjiang Uighur Autonomous Region (XUAR). This is the first time in recent history that Uighurs have engaged in political violence outside the XUAR. The incident seems to be a product of the substantially escalating tension between Uighurs and the Chinese state.

The Uighurs view the XUAR as their homeland, an assertion that has long fueled tensions between them and the Chinese state. This tension has been on the rise over the last twenty years as the People's Republic of China rolled out controversial policies that emphasize integrating Uighurs into the Chinese state. (In the photo above, Uighurs living in Turkey burn a Chinese flag to commemorate the July 5 incident.) The government has used heavy-handed measures to impose this integration (sticks), but it has placed its largest bets on the hope that rising prosperity will encourage loyalty among Uighurs (carrots). Unfortunately, China is guided by an outdated development strategy, and it's only generating more instability.

China's most controversial integration measures suppress the Uighur culture and violate the group's human rights. Since the mid-1990s, the Chinese state has pursued policies that limit the Uighurs' ability to freely practice Islam and prevent all forms of political organization and expression in the XUAR. This has led to hundreds of arrests on political charges of "illegal religious activity," "separatism," and "terrorism," scores of which have ended in executions. More recently, the Chinese government has adopted education policies that force all students to study in Mandarin Chinese while limiting access to education in the Uighur language and reducing the publication and broadcasting of materials in Uighur.

But these heavy-handed cultural transformation measures tell only part of the story. The Chinese government has also undertaken a gigantic economic development plan for the XUAR, and has targeted rural Uighurs to partake in education and industrial work projects at institutions and factories in China's interior. These "softer" efforts to integrate Uighurs have not only failed to ease tensions between Uighurs and the state, but indeed appear to have exacerbated them.

This has caused frustration among Chinese policymakers and citizens, who view these efforts as a benevolent program to provide Uighurs with new opportunities and better livelihoods. But the Uighurs' resistance should not be surprising. In fact, in the modern era, many states have attempted to pacify restive minority populations through economic development, only to bear similar results.

The idea of modernization as a way to unify nations goes back several centuries. The nation-states of Europe we know today -- Germany, England, France -- emerged as unified entities from their fragmented forbears through the advance of communication and transportation technology, along with concerted efforts by state leaders. Modern states not only began to collect taxes and raise armies, but also sponsored national systems of education that propagated state ideology and instructed pupils in a single national dialect. Economic development birthed loyalty to the state and fellow-feeling among citizens. As suggested by both Marxist and free market modernization theorists, economic stability and prosperity was thought to yield harmonious, unified states.

In the 20th century, would-be state builders sought to accomplish in a few decades what took centuries to take hold in Europe, using top-down planning and industrialization. This approach was effective in achieving rapid growth, but it was less successful in establishing a unified body politic. In Turkey, leaders attempted to use a strategy of economic development through education and infrastructure to integrate minority Kurds into the new state, even as they banned the Kurdish language and suppressed its culture. This strategy only generated a violent movement for secession. Today, the Turkish government has been pressed to accommodate the still-strong Kurdish identity through new reforms.

The Soviet Union also relied on development to integrate the many peoples of its far-flung empire. After the Russian Revolution, the Bolsheviks sought to eliminate national identity altogether -- and with it the threat of anti-Soviet nationalism -- by delivering material progress. Increased well-being would bind people to the Soviet regime, while macroeconomic growth would eliminate differences between nations, ultimately transforming Latvians and Uzbeks into exclusively Soviet subjects. As we now know, this did not work out as planned: 70 years of development led to remarkable improvements in living standards, but it did not stifle nationalism. It was the wealthiest inhabitants who were the most vehement in opposing the Soviet Union.

Why doesn't prosperity buy loyalty?

First, economic development, rather than causing political passivity, tends to result in greater political engagement. Scholars of modernization theory recognized decades ago that urbanization, literacy, and rising incomes gave people greater means to develop their own interests and to advocate for them. Rather than expressing gratitude to the state that made their political consciousness possible, newly empowered classes would demand more accountable governments and sometimes overthrow them. In simplified form, this is the story of democratization in Europe in the 19th century. It is also the story of anti-colonial liberation movements, whose leaders emerged from the middle classes that were educated under colonial systems of rule.

A second reason development fails to quell nationalism is that it occurs unevenly, especially when it is rapid and state-led. The benefits of centralized investment, even if nominally intended for the minority masses, often fail to reach their targets. Instead, state largesse tends to fall disproportionately into the hands of well-connected elites (who may be settlers in minority regions rather than minority representatives themselves) or to benefit certain (usually urban) areas over others, which can increase overall inequality between majority and minority ethnic groups and exacerbate resentments. Prosperity and development lead more citizens of the majority group to settle in minority regions, often marginalizing minority groups in areas where they were once the primary inhabitants. When people are marginalized both economically and culturally, their exclusion heightens their awareness of difference from the majority and provides a unifying cause around which they can rally.

A third reason for the failure of the modernization strategy is that human beings tend to value certain ideals in addition to, and often above, material well-being. Money is nice, but the desire for justice, fairness, self-determination, or dignity can be a stronger driver of human behavior. Although the protests of the Arab uprisings were partly about unemployment and frustration with elite corruption, the demonstrators' slogans appealed to more abstract virtues in pursuit of a better society. "Bread, freedom and dignity" became a rallying cry in Egypt's Tahrir Square. Expression of these values is usually even more pronounced in movements involving culturally marginalized groups, who react to official suppression by asserting their language, culture, and traditions.

This brings us back to the Uighurs. The Chinese government's intensive development plan has only inspired conflict in the XUAR as Uighurs become increasingly marginalized in their own homeland. Development has in many cases displaced traditional Uighur communities, the most well known example being the destruction of the culturally significant, medieval city of Kashgar. In other cases the government has forcibly relocated Uighurs to accommodate large development projects. Additionally, China's policies have encouraged an influx of Han Chinese migrants into the region in pursuit of economic opportunity, reducing the Uighur share of the population. Finally, Uighurs are increasingly discriminated against for employment in urban areas, as the economic benefits of the region's development flow mostly to Han Chinese.

China's development efforts in the XUAR utilize an outdated top-down model of development that betters the region's GDP, but not the lives of its average citizens. As a result, many Uighurs perceive China's development plan as an attack on their very existence.

The failure of state-led development to ease ethnic tensions in the XUAR should not be taken as evidence that development can never mitigate conflict and unrest. However, when the politics of identity are involved, development planning must include all ethnic groups and communities and promote a fair distribution of wealth. In the absence of these considerations, China will continue to be confronted by the perverse consequences of its development policies. Attacks like the one in Tiananmen Square may become all too common.



Paul Krugman's Blind Spot

Sorry, but the New York Times' star columnist just doesn’t understand Europe.

Few have written more about the European financial crisis since 2008 than the Nobel laureate, New York Times columnist, and Princeton economics professor Paul Krugman. After five years, it is clear that the eurozone has survived contrary to his predictions and the countries that pursued fiscal discipline, contrary to Krugman's advice, have done better -- both economically and politically -- than those that did not.

Since Krugman represents the mainstream of Anglo-American economic commentary and enjoys both popularity and an impact on policy, a post mortem of his positions in the European financial crisis are of broader relevance. The problem is not the odd flawed prediction -- everybody makes such mistakes -- but an unhelpful thinking about fiscal policy of which Krugman is the prime representative.

I was first struck by Krugman's misperception of the European financial crisis back in December 2008, when he wrote a blog post that baffled me. It was titled: "Latvia is the new Argentina." The comparison was bizarre. Argentina is a large, closed economy that has mostly pursued populist economic policies, while Latvia is a very small, open economy, a member of the European Union with small public debt and excellent business environment. The only similarities were financial crisis because of large current account deficits leading to an absence of market financing.

Based on this facile analogue, Krugman concluded that Latvia would then have to devalue as Argentina had, but of course that didn't happen. The Latvian government ignored his advice. It stuck to its peg to the euro and carried out a draconian fiscal adjustment, which quickly restored confidence and prompted plenty of structural reforms; it is now the fastest growing economy in Europe. Krugman's mistake was to look at only a couple of indicators and draw a simplistic analogue.

Krugman's most spectacular failure has been his prediction of the dissolution of the eurozone. As Niall Ferguson has noted, Krugman "wrote about the imminent break-up of the euro at least eleven times between April 2010 and July 2012." Well, that didn't happen. Not only did the eurozone remain intact but in 2009, Slovakia joined, as did Estonia in 2011; Latvia is set to join in January 2014.

While anyone can make a mistake, Krugman's error was more profound, indicating a lack of understanding. He treated the eurozone as primarily a system of fixed exchange rates, ignoring that it is a currency union with centralized clearing of payments. As the euro crisis evolved, uncleared payment balances piled up. The best way of dissolving these imbalances was by restoring confidence in the euro system, which the European Central Bank (ECB) has done, sensibly, since July 2012. A breakup of the eurozone, on the other hand, would have resulted in large debts and claims of the various members, leading to major financial destabilization.

In the last century, three multi-nation currency unions in Europe have endured disorderly breakups -- namely the Habsburg Empire, Yugoslavia, and the Soviet Union. In each case, the outcome was multiple hyperinflations from which several countries have still not recovered two decades later. To my knowledge, Krugman has never mentioned this aspect in print. Nor was it self-evident that the EU and its single market would survive if the euro system broke up. This was truly unchartered territory. However, ECB President Mario Draghi did understand the dangers, and in July 2012 he declared that ECB would "do what it takes" to save the euro. And while Krugman advised against saving the euro, he had (rightly) praised the "do what it takes" philosophy.

When it comes to fiscal policy, Krugman is single-minded in his focus on aggregate demand rather than supply, seemingly unaware of how constrained supply has been in the EU, not least because of overregulated labor and service markets. He has persistently favored fiscal "stimulus," larger budget deficits, and slower fiscal adjustment. Today, the record is clear. The countries that have followed his advice and increased their deficits (the South European crisis countries), have done far worse in terms of economic growth and employment than the North Europeans and particularly the Baltic countries that honored fiscal responsibility.

Luckily for European democracies, the ultimate verdict on crisis management belongs to the voters. During the five years from October 2008 until September 2013, eight EU governments -- in Estonia, Finland, Germany, Latvia, Luxembourg, the Netherlands, Poland, and Sweden -- have been reelected, hanging onto power even in the face of economic crisis. These governments were the ones that pursued responsible fiscal policies often called austerity, contrary to the policies Krugman prescribed. Apparently, large budget deficits are not very popular with voters. In 2012, the average budget deficit of these eight countries was 1.6 percent of GDP to compare with 4.8 percent of the 19 countries, where the governments have been ousted. The voters seem to have got it right. The economies of the eight virtuous countries grew by 1.4 percent, while the economies of the 19 others contracted by 0.8 percent.

If we examine the reasons for this outcome, it does not appear surprising. The only economic argument for a slow fiscal adjustment is that the fiscal multiplier, that is, the ratio of change in national income to the change in government spending, might be uncommonly large in the first year (as the International Monetary Fund [IMF] has claimed in one research paper, though, in the literature there's no clear-cut agreement that the fiscal multiplier is so great). Moreover, five years after the bankruptcy of Lehman Brothers, we are no longer talking about the short term of one year but the long term of five years.

Many more arguments favor an early fiscal adjustment -- namely that financing is often not available, that European countries needed to trim their public expenditures, and that Europe's key problem was structural. Krugman's problem is not his view on these issues but that he persistently ignores them, as if they did not matter. In his world of economics, little matters but aggregate demand.

For many countries in jeopardy, international financing is not available. Since the average public debt in the EU had risen to 91 percent of GDP in 2012, hardly any country but Luxembourg and Sweden had fiscal space to pursue fiscal stimulus. Among the 28 EU countries, no less than eight needed international financial assistance not available to them on the market -- Hungary, Latvia, Romania, Greece, Portugal, Ireland, Spain, and Cyprus. Therefore, fiscal stimulus was not an option because bond yields and interest rates had surged sharply and surprisingly.

In late 2008, for example, Latvia and Romania lost market access when their public debt was less than 20 percent of GDP, showing how minimal their fiscal space was. Yet, Krugman ignores that many small countries find it difficult to raise international financing in times of crisis.

Krugman's persistent pleas for more fiscal stimulus presumably contributed to the IMF pushing countries such as Spain, Slovenia, and Cyprus to increase their budget deficits impermissibly to about six percent of GDP, far more than they could finance, in 2009. After these countries had expanded their budget deficits, they could not cut them, which is not very surprising. This raised their bond yields and put them into financial hazard.

All European countries have excessive public expenditures that need to be trimmed because they harm economic growth, which Krugman refuses to acknowledge. To his horror, the Baltic countries carried out a fiscal adjustment that consisted of two-thirds expenditure cuts and one-third higher taxes. The southern Europeans, by contrast, mainly raised taxes, which Krugman was less opposed to. As a consequence, even in 2012 Greece had 55 percent of GDP in public expenditures, significantly more than Sweden (52 percent) and far too much to allow significant growth. Obviously, Greece should have cut expenditures faster so that their public debt as in the Baltics.

The key European problem, which Krugman persistently ignores, has long been constrained supply because of poorly functioning markets for labor and services, which led to low growth before the current crisis. Front-loaded fiscal adjustments made ample structural reforms necessary in the Baltic countries and Bulgaria and caused great economic growth in the Baltic countries, while Greece has only recently started undertaking significant structural reforms. Major structural changes are both necessary and appreciated. Latvia cut public wages by 26 percent in 2009 and sacked 30 percent of its civil servants in 2009 without any public protests, while public unrest was ample in Greece until the government started sacking civil servants. In the last year, it has been minimal.

What Krugman refuses to see is that front-loaded fiscal adjustment quickly restores confidence, brings down interest rates, and leads to an early return to growth. Thanks to greater structural adjustment, the growth trajectory is likely to be higher in countries that quickly and enthusiastically embrace these reforms than elsewhere. Accordingly, the three Baltic countries that suffered the largest output falls at the outset of the crisis because of a severe liquidity freeze returned to growth within two years and have, over the same period, enjoyed the highest growth in the EU. By contrast, Greece, with its back-loaded fiscal adjustment, as recommended by Krugman, has suffered from six years of recession.

Krugman also worried at length about the risk of a "competitive deflation" because of large wage cuts. But deflation has hardly occurred anywhere in Europe. Even in Latvia, where unit labor costs in the whole economy declined by 25 percent in 2008-2009, consumer prices fell by just 1 percent in 2009. Part of the explanation is that productivity in Latvian manufacturing rose by an extraordinary 50 percent in 2008-2011 thanks to an early and radical fiscal adjustment and impressive structural reforms. The evidence points to the success of these measures; Krugman just refuses to see it.

Throughout the European financial crisis, Krugman has provided poor advice on how to pursue fiscal policy. The successful EU countries recovered by doing the opposite of what he recommended -- while those governments that followed his advice on slow and back-loaded fiscal adjustment, or even fiscal stimulus, have failed miserably. During five years of extensive writing on the EU financial crises, Krugman advocated depreciation, but maintained that pegged exchange rates worked perfectly well.

Contrary to his predictions, the eurozone has survived. He advocated fiscal stimulus, but rapid fiscal adjustment turned out to be the best cure for both public finances and economic growth. He ignored that all EU countries had excessive public expenditures and needed structural reforms. Nor did he understand the general mood of Europeans, as clearly expressed by their electoral preferences, though that didn't stop him from expressing strong views to the contrary. And he has favored social democracy, which European voters have widely rejected to the benefit of the moderate center-right, which has never been stronger.

The reasons for his misperceptions of European economic policy are manifold. Krugman did not look upon the relevant variables and ignored all but a few facts. He adhered to a simplistic macroeconomic view that more fiscal stimulus is always better, which should make poor John Maynard Keynes turn in his grave. It's hard to overcome the suspicion that Krugman actually had the United States and its problems in mind when he was writing about Europe. The real problem is that these two parts of the world are quite different.