What Happens If You Save for College

A recent Op-Ed article in The New York Times argued that the cost of college could easily be lowered by cutting what’s called the “expected family contribution.” That is the amount, based on a complicated formula laid out by Congress many decades ago, that parents and students are expected to pay for college.

Colleges typically subtract it from their sticker price and then figure out a student’s aid package (though many private colleges use a different formula that takes into accounts assets like the amount of equity you have in your home).

The writer of the Op-Ed, Steve Cohen, explained: “Consider a family of four, earning $100,000 in income and having $50,000 in savings. The E.F.C. says that this family will contribute $17,375 each year to a child’s college expenses.” To do so, they would have to cut their after-tax expenses by 25 percent.

“Alternatively,” Mr. Cohen continues, “the family could use its savings. But that would deplete their $50,000 before the start of the child’s senior year, leaving nothing for the proverbial rainy day, or for the second child’s education.” The formula doesn’t care if you live in an area with a high cost of living, or if you’re underwater on your mortgage.

This had me wanting more details. What about retirement savings â€" would those be counted? What about older parents nearing retirement â€" would they be expected to draw down their savings as the same rate? Does the formula actually discourage saving?

A look at the formula guide for parents with dependent students was only a little help, but the Department of Education cleared up a few questions.

First, the formula for a family’s contribution is based on two things: income and liquid savings.

Let’s take income first. From your income, you get to deduct a number of expenses like taxes, employment expenses and what the federal government calls an “income protection allowance” â€" that is, an amount that is shielded from being sucked into the gaping maw of college costs. The size of the allowance is based on the household size and the number of college students in the house, and ranges from $14,460 for a two-person household where both are in school, to a high of $37,020 for a six-person household with one student.

Parents are then expected to contribute a percentage of what’s left over (the more that’s left over, the higher the marginal percentage, just like with income tax rates â€" except the rate here goes up to 47 percent).

Next comes savings. This does not include IRAs, 401(k)s or other retirement savings, so lard up on those at will. It does not include a primary residence, but it does include the value of a business or a farm that the parents don’t live on. It also includes custodial accounts for minors, and college savings accounts known as 529s. These accounts are listed as parental assets, not student assets, if the parent is the account owner.  (If a grandparent is the account owner, the 529 need not be listed.)

It’s actually better for the applicant if the 529 is a parental asset. The student’s own savings are assumed to be for college, and are drawn down at a much faster rate (20 percent a year) than parents’ savings, which are assumed to be needed for more than just college and are drawn down at a slower rate (12 percent a year).  But this also means that parents cannot quarantine savings for another child. Any 529 the parents own, no matter who is named as the beneficiary, must be included.

As with income, there is an “asset protection allowance” for parents. It does takes age into account â€" a little. A two-parent family in which the older parent is 30 has $9,100 that can’t be touched. If the older parent is 60, the allowance is $45,500.

Now, here’s the weirdest part of the formula: Single parents are allowed a far, far smaller allowance than married parents. A 60-year-old single parent can cordon off only $10,200. This is apparently because the formula is based on very outdated assumptions.

Nowadays, it’s well known that a two-person household does not cost twice as much as a single-person household, so it’s doubtful that two people would need to save twice as much as one â€" much less four times more. Or put another way, a single person nearing retirement needs to save almost as much as a couple. But the formula forces single parents to cough up more for tuition.

What about discouraging saving? The more you’ve saved, the more you are expected to pay â€" so why save at all? The answer is that the oversaver is expected to pay more, but not terribly much more. And unless you want to cut your expenses drastically, you will need the extra savings to cover the enormous bills.

Using the Education Department’s FAFSA4caster, I played around with various scenarios, assuming my hypothetical student had 60-year-old parents with an adjusted gross income of $100,000. With $50,000 in savings, the expected yearly contribution was $16,977. With $100,000 in savings, it went up to $19,797 â€" over four years, that’s $11,280 more. A whopping $150,000 in savings generated a yearly contribution of $22,617 â€" an extra $22,560 over four years.

It’s worth noting that the break for aging parents is not that great. When I ran the same models for 40-year-old parents, their E.F.C. was only $1,027 a year more than it would have been if they were 60.

Who the Job Creators Really Are

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

If you want to protect someone in Washington, call them a “job creator.” Such wonderful, rare creatures must be insulated from taxes, regulation, and especially unfriendly rhetoric.

But it’s not clear who the job creators really are. Of course they’re employers who hire people, and bless ‘em for it. We want them brimming with confidence and animal spirits. But they’re not hiring people to save America. They’re doing so because if they didn’t, they wouldn’t be able to meet the demand for the goods or services they produce, and they’d be leaving profit on the table to be scooped up by a competitor.

In this framing, as venture capitalist Nick Hanauer stresses, the job creator is the consumer or investor. They are the ones, by dint of their extra spending, who incentivize the employer to hire someone. 

What about when many consumers are temporarily out of the picture, as in a sharp recession? Then the government and the Federal Reserve need to step in and boost consumer demand with fiscal and monetary stimulus, making them the job creators.

One can continue to peel the onion in revealing ways here. You know what’s been the biggest job creator over the last few decades? Financial bubbles. The labor demand created by the dot-com bubble in the 1990s and the housing bubble of the 2000s created millions of jobs and sent the unemployment rate below 5 percent in both cases. (Speaking of onions, readers of that fine economic journal are well aware of this dynamic.)

Moreover, the standard Washington line is belied by recent statistics on profits, wages and jobs, which show a distinct lack of correlation between profitability and employment. The data in the table below start with compensation and after-tax profits, both as a share of national income, and figure out how much, in percentage points, those shares have changed over every post-war economic expansion that has lasted at least as long as this one â€" by now almost five years old. For example, the 3 percent in the upper left hand cell is the difference between the after-tax profit share in the second quarter of 2009 (8.8 percent) and the share in the third quarter of 2013 (11.8 percent). The last row of the table shows the percent growth in jobs for each expansion.

Source: BEA, NIPA table 1.12 and BLS

Over the last two expansions, after-tax (and before tax) profits did better â€" meaning they claimed more of the nation’s income â€" than in any of the prior four expansions of comparable length. Yet both compensation and job growth did the worst. What’s going on? Why isn’t profitability creating jobs? Where art thou, job creators?

One response is that profits typically recover before wages or jobs. True, but this far into the expansion â€" which is now about the average length of all post-war expansions â€" that shouldn’t assuage anyone’s fears. Another response is to note that the compensation share of national income has been flat or falling for a long time.

Actually, that’s not quite the case, as the figure below reveals. The table leaves out shorter cycles but the figure gives the full picture for the life of this data series, which begins in 1947. I’ve plotted a smooth trend though the series, and you can see it’s a) pretty cyclical, as you’d expect, and b) broadly grows through the mid-1980s and then trends down. The actual share in the most recent quarter, 60.7 percent, is the lowest compensation share since 1951.

Source: BEA, NIPA table 1.12

Clearly, globalization is in play: Multinationals don’t depend on healthy American consumers. Productivity is often cited as a factor in play here, as well, suggesting that firms are squeezing more work out of fewer workers, while automation is increasingly displacing more jobs. But while productivity has increased in this expansion, it hasn’t accelerated in ways that would support this explanation; in fact, it has decelerated (Dean Baker recently noted this point regarding the automation claim).

Here’s what I think is happening.  Profits equal revenues minus costs, and labor is a cost. Maximizing profits means minimizing costs, and when labor’s bargaining power is as weak as it’s been in recent years, that’s not hard to do. Revenues, or companies’ earnings, haven’t been particularly strong, and this too implies that squeezing labor costs has been the key factor driving profitability (this line of thinking implies that stock prices and earnings ratios are elevated right now, which they are in historical terms).

That very simple profit equation, by the way, explains a lot of Washington’s behavior. Why should the restaurant lobby fight so hard against a minimum wage increase, allegedly on behalf of low-wage workers, when their clients are restaurant owners? To minimize labor costs and thus boost profits, of course.

The implications of the above are as follows.  First, we must think broadly about job creators and discount simple links between profits and jobs. If booming share prices and corporate profits lifted the poor and middle class, believe me, we’d know it by now. Second, we should be equally skeptical of arguments about the job-killing impact of taxing and regulating. Such measures should not be taken lightly, of course, but neither should we beggar our fiscal accounts or our environment to protect phantom job creators.

Third, we must pursue policies that increase the bargaining power of those who depend on paychecks as opposed to portfolios. Full employment is the best medicine, as that is associated with both robust profits and paychecks. But in the meantime, a higher minimum wage and the proposed new overtime rules could help slice national income up a bit more evenly.

There is of course nothing wrong, and a lot right, with robust profits. It’s when that is all there is that we have a big problem.

The Dollar Value of an Extra Year of Life

Uwe E. Reinhardt is an economics professor at Princeton. He has some financial interests in the health care field.

A recent article on Kaiser Health News reported on a new drug for the treatment of hepatitis C for which the manufacturer charges $1,000 a pill, or $84,000 for a 12-week course of treatment. Chronic hepatitis C is a leading cause of serious liver disease, including cancer.

It has been estimated that providing the drug to all patients known to have hepatitis C would substantially drive up budgets for public insurance programs and premiums for private insurance, though over the longer run there would be offsets to these upfront costs by obviating the need for alternative treatments, including liver transplants (see Pages 69-71 of the meeting summary from the California Technology Assessment Forum, linked to above).

The high price charged for the drug has led to street protests in San Francisco and calls for congressional hearings. It also provoked from The New York Times a stern editorial, “How Much Should Hepatitis C Treatment Cost?”

These reports brought to mind my post in November 2012. In that, I presented the following heuristic visual.

The horizontal line in this graph represents additional quality-adjusted life years (widely known in the research community as QALYs) wrestled from nature by a nation’s health system, arrayed in the increasing incremental costs per QALY gained. The vertical axis represents the incremental cost per additional QALY the health care system bestows on some patient.

I had called the solid line in the graph the QALY supply curve that the nation’s health system presents to society - the health system’s “offer curve,” in commercial parlance. A point on the line (e.g., Z) represents the most cost-effective (lowest cost) treatment capable of yielding the associated QALY. The treatment represented by point X would not be an efficient way to gain that QALY, because treatment Z is more cost-effective.

With this offer curve, a health system confronts the rest of the nation with two morally challenging questions:

1. Is there a maximum price above which society no longer wishes to purchase added QALYs from its health system, even with the most cost-effective treatments (e.g., Point C)?

2. Should that maximum price be the same for everyone, or could there be differentials - for example, a lower maximum price for patients covered by taxpayer-financed health programs (e.g., Medicaid, Tricare, the Veterans Administration health system and perhaps Medicare), a wide range of higher prices for premium-financed commercial insurance, depending on the generosity of the benefit package that the premium covers, and yet higher prices for wealthy people able to pay out of their own resources very high prices to purchases added QALYs for the family?

I tell my students that their parents and grandparents in the United States have always avoided confronting these morally taxing questions. They simply paid whatever was charged for whatever new medical technology came down the pike, letting per-capita health care spending grow annually at a long-term growth rate 2 to 2.5 percentage points above the growth in per-capita gross domestic product. The result has been spending far above the level of spending one observes in any other industrialized society (although we may implicitly have imposed a maximum price on QALYs for some Americans without health insurance).

But I also tell my students that they most likely will not be able to kick that particular can down the road much farther. Slower overall economic growth, rising income inequality and the stream of ever more expensive new medical technology that their classmates in biochemistry, molecular biology and bioengineering are likely to develop and offer to society at stiff prices will make that harder to do. As seasoned adults, my students will have to debate the two questions I raise explicitly

That debate seems to be closer at hand in this country than I had thought. An article titled “California medical experts question value of Gilead’s $1,000-per-pill hepatitis C drug” in US News Health notes:

An innovative hepatitis C drug that was only recently hailed as a breakthrough treatment is facing skepticism from some health care providers, as they consider whether it is worth the $1,000-a-pill price set by manufacturer Gilead Sciences Inc. A panel of California medical experts voted Monday that Gilead’s Sovaldi represents a “low value” treatment, considering its cost compared with older drugs for the blood-borne virus.

In effect, the panel seems to have concluded that while the drug was clinically effective and offered added clinical benefits beyond current treatments, its cost exceeded the price society should be willing to pay for those added clinical benefits. The panel in this case did not use QALYs as a measure of clinical outcome, but a metric called “sustained virologic response rate” (Page ES1).

Although other nations routinely undertake such studies and reject some therapies as too expensive - notably Britain’s National Institute for Clinical Excellence - for the United States it is quite a remarkable statement.

The panel of experts cited in the story was constituted by the California Technology Assessment Forum. The forum is part of the Boston-based Institute for Clinical and Economic Review, dedicated to evaluating the evidence and value of new medical technology. The institute also includes the New England Comparative Effectiveness Public Advisory Council.

A laudable policy of the California Technology Assessment Forum - and presumably of the institute â€" is to make its proceedings fully transparent through public meetings. All the documents surrounding the evaluation of this particular drug, including videos of the panel’s review of the evidence on clinical effectiveness and costs, are available on the web. So are a summary of the voting questions and responses thereto and a draft of the full assessment.

Evidently, the panel’s work meshes with what I framed two years ago with the chart above.

In a critical comment on that earlier blog post, Dean Baker of the Center for Economic and Policy Research called my framing of the issue “unfortunate.”

Mr. Baker would prefer to do away with patent protection of new drugs altogether, by expanding government funding of research and development, then licensing discoveries to manufacturers that would sell drugs competitively at prices near their low production costs, more like generics.

Alternatively, following a proposal by the Nobel laureate Joseph Stiglitz, Mr. Baker would use a public prize fund that would buy patents gained through privately funded research and development. Those patents would then be licensed to manufacturers that would similarly sell drugs at prices near production costs. These and other proposals are explored further in Mr. Baker’s earlier paper.

There is nothing wrong with and, indeed, much to be said for exploring alternatives to our current system based on patents and the idea of financing all private R.&D. for new drugs through prices paid by afflicted patients or their insurers.

Every economist would agree that it is inefficient, at any point in time, to sell a product at a price far above incremental manufacturing costs â€" what the economist Joseph Newhouse has called “static inefficiency” in drug pricing. The tricky task under any approach is to find the socially optimal time path of R.&D. for new medical technology - what Professor Newhouse has called attaining “dynamic efficiency.”

The alternatives to pricing new medical technology proposed by Mr. Baker and others whom he cites face huge political hurdles not likely to be overcome soon, if ever. I believe that for the system we have and will have for some time to come, I have framed properly the moral choices we face as a society.

China’s Shadow Banking Malaise

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a nonresident senior fellow at the Peterson Institute for International Economics. Simon Johnson is a professor at the M.I.T. Sloan School of Management and former chief economist at the International Monetary Fund.

With the United States economy still struggling to regain full employment, the European economy becalmed in the aftermath of a serious sovereign debt crisis and many emerging markets looking increasingly vulnerable, global macroeconomic attention has become increasingly focused on China. Will China’s economy slow down, and would such a development carry serious financial fallout, even some sort of crisis?

Some commentators have suggested that China could be facing a Lehman moment (or even a Greece or Spain moment) with some particularly Chinese characteristics. None of this sounds good, and some of it sounds downright scary.

But much of the speculation also seems like a stretch, if not an exaggeration of the negative implications for both China and the global economy.

There is a serious issue in China. Starting in 2009, to offset the potential effects of the global financial crisis, the government encouraged a huge credit boom. This credit was largely used to finance real estate construction and infrastructure, helping China grow 45 percent from the end of 2008 to 2013 (our data are from China’s official bureau of statistics). The numbers are staggering. Over the same period, the International Monetary Fund reports total financial sector financing outstanding (i.e., credit of all kind) rose to nearly 200 percent of gross domestic product at the end of the first quarter of 2013, from 125 percent of G.D.P. That is a $13 trillion increase in bank loans, bonds and various nonbank financing (this is how we read what is known as the monetary fund’s Article IV report on China for 2013). This sum is three-quarters of annual United States G.D.P.

The vast bulk of this increase, more than two-thirds of the total, was in nonbank financing â€" meaning credit that flowed through a financial institution other than a regulated bank.

When credit booms end, there is often some kind of bust. The Lehman crisis in September 2008 was one of the worst busts you can get; the failure of Lehman made people fear that many other banks and corporations could fail, and there was a sudden rush of funds from money markets, investment banks and bank deposits to safe United States Treasuries.

Corporations were no longer able to roll over loans and their other sources of financing, such as commercial paper. As a result, the economy contracted rapidly and people were fired. Were it not for huge Federal Reserve interventions, the banking system could have crashed from a loss of liquidity, i.e., lack of short-term funding.

China is not going to experience a Lehman sort of crisis, at least not now. The most serious problem in China is that nonbank “shadow” banking, especially trust securities and various types of bonds, grew rapidly with insufficient oversight. For the most part, this represented an attempt to circumvent the interest-rate controls that made bank deposits unattractive.

Savers moved funds from banks to buy these instruments. Now, just as was the case with subprime loans in the United States, some of these high-risk borrowers are failing to repay.

Savers will lose some money on those investments, so now savers will be returning to banks, not fleeing from them.

The current battle is over who will bear the losses. During China’s last financial crisis in the late 1990s, the losses were on the banks’ balance sheets, and the government eventually bore the brunt by recapitalizing banks. Until recently, there was some degree of confidence that the government would bail out both banks and nonbanks this time â€" in part because the regulated banks also sell some of the most dubious unregulated financial products.

In the jargon of financial markets, the shadow banks were therefore, in part, a moral hazard trade, very much akin to what we saw in the United States and in Europe in the period leading up to 2008.

However, now the Chinese government is making it clear that the nonbank financing instruments will not be bailed out, while the big banks are still obviously supported by the government. Just as in America and Europe, China’s biggest banks will live for another day, but the shadow banking sector is set to shrink.

So instead of facing a Lehman crisis, China’s financial system is facing a more standard credit bust, driven by the drying-up of the nonbank markets and some losses on bank loans. The eventual solutions to such problems are well understood.

Again to make a comparison, the Chinese strategy for dealing with the lurking problems of banks will be very similar to what we just saw in Europe and the United States: Let the banks slowly recognize their losses, and support the banks with credit from the central bank as needed.

While no one knows how large those bank losses are, China luckily has substantial scope for absorbing losses. For example, the Industrial and Commercial Bank of China, one of China’s largest banks, reported $59 billion of operating profit (before loan loss provisions) over the last 12 reporting months, according to data compiled by Bloomberg. It can use that profit to offset losses on its $1.5 trillion loan book (over and above the $38 billion that it has already provisioned).

Even if 10 percent of loans were to eventually default, with 50 percent recovery on those loans, the losses to equity capital could be offset with just two years of profits. Share issuance (already priced into equity markets) could raise further capital if needed.

This high profitability of Chinese banks makes them far more resilient than American and European banks. For example, Washington Mutual, which eventually was taken over by the Federal Deposit Insurance Corporation, reported roughly half the profitability of the Chinese banks in the boom years before it collapsed.

The other buffer in China is a very high national savings rate, running at nearly half of G.D.P. These savings ensure banks’ deposit base will keep growing, and banks will be flush with funds to lend. The labor force is still growing, and investment in equipment and capital will remain high. All these factors buttress growth.

However, do not misunderstand us. A slowdown in Chinese credit growth seems unavoidable, and true G.D.P. growth could easily turn out far below the 7.5 percent target of the Chinese authorities for many years.

So if China avoids a Lehman crisis but does face a serious growth slowdown, how worried should Europe and the United States be for their own economic growth? The answer is, not much at all.

China is still only a small fraction of the world economy. World G.D.P., calculated by the International Monetary Fund, was $73.5 trillion at the end of 2013, while China’s G.D.P. was about $9 trillion, or 12 percent of the total. The United States at $16.7 trillion and the European Union at $17 trillion are each nearly double the size of China (using market prices and actual exchange rates).

China’s main link with the rest of the world is through trade. According to the latest available data from the World Trade Organization, for 2012, China’s merchandise imports accounted for nearly 10 percent of the world’s imports. Exports to China in 2013 were $1.95 trillion.

Even if Chinese imports fell by, say, 15 percent in a very bad recession (they fell 11 percent in the global financial crisis from 2008 to 2009), the direct impact on everyone else in the world would be a loss of approximately $300 billion of demand, or less than 0.5 percent of world G.D.P. excluding China.

While this would be painful if Europe and the United States were also in recessions, it is a small figure when growth is picking up in those larger economies.

As the United States and Europe export relatively little to China (see the W.T.O. numbers linked above for details), the direct impact on them would be very small. Naturally, Asia would be hurt more.

Perhaps the largest effect of a deep Chinese recession would be felt through sharply reduced demand for the raw materials used in construction and infrastructure investment, which means that base metals, energy, commodities and other goods would become cheaper.

But here there is an element of a zero-sum game. Raw material exporters would be hurt â€" Vladimir Putin take note â€" but Europe and the United States would gain as the prices fall for commodities they import.

On net, the total effect of a China slowdown could be small for growth in the United States or Europe, but it would definitely be more negative for raw material exporters and countries that produce manufactured goods imported by China. The fears that the world may be facing another “Lehman crisis” emanating from China seem very far-fetched.

Q&A: Why the Dollar Remains the Reserve Currency

Economists called it the “dollar trap.”

The world is trapped into buying dollars because the United States market is big, liquid and reliable as a safe haven. And America is trapped in an addiction to cheap credit, with foreign demand for the dollar allowing the nation to spend well beyond its means.

In his latest book, “The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance,” Eswar S. Prasad, the former head of the International Monetary Fund’s China division and now a professor of trade policy at Cornell University, explains how the dollar’s “exorbitant privilege” came into being, why it’s unlikely to face a challenge anytime soon from the euro or China’s renminbi, and why this is so troubling for the future of the global economy.

He answered questions from David Barboza, the Shanghai bureau chief of The New York Times.

Q.

One of the surprising findings of your book is that things didn’t quite work out the way economists like you expected after the global financial crisis begin to hit in late 2008. What happened?

A.

I expected the dollar to weaken because the crisis exposed problems in the U.S. financial system. Moreover, the U.S. racked up a lot of government debt and the Fed began flooding the global financial system with dollars. The more dollars there are out there, the less value they should have. But the exact opposite happened. The dollar, if anything, gained slightly in value.

Contrary to all expectations, the U.S. dollar’s position as the world’s dominant reserve currency has been strengthened by the crisis. The world became even more dependent on the dollar than it had been before the crisis.

Q.

What made the dollar attractive?

A.

It’s simple: there are no good alternatives to the dollar. Any time you think of the dollar losing its dominance, you have to ask yourself: if not the dollar, then what? And there’s no good answer. Emerging markets need foreign exchange reserves to protect themselves from volatile capital flows. And private investors and financial institutions want safe and liquid assets - assets expected to at least hold their principal value and that are easy to trade. These are typically government bonds.

But the supply of safe assets in the world has shrunk. The euro zone doesn’t look quite as safe anymore. Japan and Switzerland don’t want money flowing into their markets, as that would drive up the value of their currencies and hurt their exports. So that leaves the United States as the main provider of safe financial assets in the form of U.S. Treasury securities.

Q.

What are the implications of this so-called “Dollar Trap”?

A.

The dollar’s prominence is a mixed blessing for the U.S. A strong dollar and low interest rates mean the U.S. gets cheap goods from the rest of the world and cheap financing. But a strong dollar hurts U.S. exports and job growth. A more fundamental problem is that this reduces U.S. fiscal discipline. Any other country would have to pay a higher price for racking up big deficits.

Emerging market economies find it frustrating that they have to buy U.S. Treasury securities to protect themselves from capital flow volatility that is in part due to U.S. fiscal and monetary policies! They are trying to diversify into other currencies and other assets such as gold and real estate. But the reality is that there are no other financial markets that give them both safety and liquidity to the extent the U.S. can.

Q.

We know the euro has not challenged the dollar as a reserve currency. What about the prospects for China’s currency, the renminbi, becoming a global reserve currency?

A.

If China moves ahead with financial market reforms and liberalizes capital flows so foreign investors can acquire RMB-denominated assets, China’s renminbi could become a major reserve currency. But that wouldn’t be enough to make the renminbi a safe haven currency that would challenge the dollar. For that to happen, China would have to undertake significant reforms to its political, institutional and legal frameworks. That is needed for foreign investors to invest with confidence in China’s markets, for safety rather than just high yield.

Q.

The dollar is being bolstered by purchases made by the central banks of emerging market economies - economies where the average resident has one-sixth, one-seventh or one-eighth the financial resources as those living in advanced economies. Why are relatively poor countries financing the debts of wealthier countries, like the U.S.?

A.

  Emerging markets such as Brazil and India could use money more effectively domestically rather then buying U.S. bonds. But they want to protect themselves with large stockpiles of reserves. A second motive is to keep their currency from appreciating, which would hurt their exports. That’s why net flows are going uphill, as they say, from poor to rich countries. This began to happen after the Asian Financial Crisis of 1997-98. Memories of that and other painful crises that beset emerging market economies in the 1980s and 1990s are seared into the minds of their policy makers. So emerging markets are eager to increase their “self-insurance” against economic disasters by stockpiling reserves, even knowing the yields of U.S. government bonds are low and the dollar could depreciate over time, eroding the value of their holdings. This is a signal of how much the rest of the world is willing to pay for protection.

Q.

Isn’t there a better way to manage exchange rates?

A.

There are costs to managing or manipulating exchange rates. It’s expensive to sterilize as governments have to pay high interest rates on bonds they issue to soak up money they print to cheapen their currencies. And currency intervention creates all sorts of other problems. You end up distorting the financial system and subsidizing exports. What’s needed is a better mix of domestic policies in both advanced and emerging market economies, with less reliance on monetary policy to do all the heavy lifting. We also need international governance reforms that give emerging markets more voting power at institutions like the I.M.F., which is seen as beholden to its advanced economy shareholders and less responsive to the needs of emerging markets. Domestic and international reforms are necessary for a freer, market-oriented exchange rate system to work well.

Q.

Could we ever see a return to the gold standard?

A.

One thing we learned from the Great Depression and subsequent crises is that the gold standard severely constrains central banks from providing liquidity. Financial markets often need massive infusions of liquidity or cash, as happened during the global financial crisis. The gold standard inherently limits liquidity. I don’t think there is any going back. The supply of gold is limited. If you’re anchored to gold, you can’t print money at will. Financial assets that can be created freely turn out to be most useful in a crisis. Without an institution like the Fed that could produce money in unlimited quantities when the crisis hit, we’d be in much worse shape.

Q.

The U.S., like many advanced economies, has an aging population, a declining work force, growing debts and forecasts that suggest the dollar will weaken over time against the currencies of emerging market economies â€" which could raise interest rates. That would raise the cost of capital for the U.S., dealing a strong blow to the economy. Is this inevitable?

A.

The dollar is likely to depreciate, partly because the U.S. still has a sizable trade deficit. From this perspective, a dollar adjustment would be good for the U.S. and the rest of the world.

But it’s not clear interest rates will rise significantly any time soon. The world still clamors for dollars and there is no sign this will end. The world is so eager for protection against financial market mayhem, and there’s such a dearth of safe assets, so people may be willing to pay a high price for safety. It is plausible that there could come a tipping point when foreign and domestic investors lose confidence in the dollar. But this would create turmoil in financial markets worldwide. And that would cause investors to run for coverâ€"right back into the arms of the dollar! So, till a better alternative comes along, for the foreseeable future the world is stuck in the dollar trap.

Cellphone Bans May Not Prevent Accidents

Casey B. Mulligan is an economics professor at the University of Chicago. He is the author of “The Redistribution Recession: How Labor Market Distortions Contracted the Economy.”

A new study has found that cellphone bans have little effect on accident rates, even though they do affect driving habits.

Every year people are killed in car crashes, and in many of those accidents a driver was using a cellphone. For this reason, many states prohibit drivers from texting while driving or from holding cellphones in their hands.

The National Highway Traffic Safety Administration’s National Occupant Protection Use Survey has been measuring driving habits for a couple of decades. The agency puts hidden observers at various stop signs and stoplights to watch the vehicles that drive by and record whether drivers are visibly using cellphones.

A recent study by Cheng Cheng, a graduate student in economics at Texas A&M University, uses the agency data to estimate the effect of cellphone bans on driver behavior. Because states adopt their laws at different times and some states have not yet adopted bans, Mr. Cheng is able to compare driver behavior trends across states in order to estimate effects of the new laws. He finds that visible cellphone use drops about 50 percent when a state begins its ban.

Simply put, driving habits change when states ban cellphone use, which means that drivers perceive that the new laws will be enforced and fines levied.

But it’s less clear whether their transformed behavior prevents accidents.

Using a separate quarterly data source on automobile accidents by state, Mr. Cheng investigates accident trends and their relationship to the cellphone bans. He finds no evidence that bans on texting affect accidents, and that his data “suggests that handheld bans might not reduce accidents.”

Mr. Cheng suggests that part of the population may drive more safely when the cellphone bans are in place, but that their safety records are offset by more dangerous driving by people who try to keep their cellphone use concealed from observers (especially, police officers). Or possibly drivers using cellphones drive more slowly because they know that they’re distracted, and the slower speeds offset the extra danger of driving while distracted.

Or perhaps lawmakers overestimated the benefits of regulating this sort of driver behavior.

Q&A: A Sociologist on Inequality

Lane Kenworthy, a sociologist at the University of Arizona.

Is income inequality truly the defining challenge of our time? Should it be the central issue for American liberalism? Lane Kenworthy, a professor of sociology and political science at the University of Arizona, has been thinking about this more deeply than most. Earlier this year, he published “Social Democratic America,” in which he outlined how a strengthened welfare state could deliver broadly shared prosperity. This year, he is writing another â€" tentatively entitled “Should We Worry About Inequality?” â€" in which he assesses the damage inflicted by America’s widening income gap.

My Economic Scene column this week discusses what we know about inequality’s consequences. Following is a transcript of an email interview with Mr. Kenworthy last week, lightly edited for length and clarity.

Q.

You are working on a book titled “Should We Worry About Inequality?” Should we?

A.

Yes, I think we should, though not for the reasons that have dominated recent debate.

Q.

Many thinkers seem convinced that income inequality is producing all sorts of social dysfunction. How bad, in your view, is the damage?

A.

I’ve looked at the experiences of the world’s rich countries since the late 1970s to see what they tell us about income inequality’s effects on an array of economic, social, and political outcomes. I conclude that inequality’s harm has been less pervasive and devastating than some claim, but that it has done significant harm.

The evidence supports a number of the most prominent hypotheses only weakly or not at all. As best I can tell from the available data, income inequality hasn’t reduced economic growth. It hasn’t hindered employment. It may or may not have played a role in fostering economic crises, including the Great Recession. It hasn’t reduced income growth for poor households. It may or may not have contributed to the weakening of household balance sheets by encouraging too much borrowing. It may or may not have reduced equality of opportunity. It hasn’t slowed the growth of college completion. It either hasn’t reduced the increase in life expectancy or the decrease in infant mortality or, if it has, the impact has been small. It looks unlikely to have contributed to the rise in obesity. It hasn’t slowed the fall in teen births or homicides since the early 1990s. It may or may not have weakened trust. It doesn’t appear to have affected average happiness. In the United States it ha had little or no impact on trust in political institutions, on voter turnout, or on party polarization. And while it may have boosted inequality of political influence, we lack solid evidence that it’s done so.

On the other hand, income inequality has reduced middle-class household income growth. It very likely has increased disparities in education, health, and happiness in the United States. And it has reduced residential mixing in the U.S.

Q.

Free-market economics is based on the premise that inequality is indispensable for growth: in an utterly equal world nobody would have an incentive to excel, launch the successful new business or invent the awesome new technology.  More recent research suggests, however, that more unequal economies may actually grow more slowly. What gives?

A.

In developing nations, the evidence does suggest that income inequality tends to be bad for economic growth. This is partly because inequality hampers educational attainment, as parents force their children to work instead of going to school, and partly because it fosters political instability. But in affluent democratic countries like the United States, few families keep their children out of K-12 schooling due to financial need and governments aren’t threatened or toppled by groups demanding less inequality.

In rich nations, income inequality is thought to reduce economic growth mainly because the rich spend a smaller portion of their income than the middle class and the poor, so higher inequality may mean less consumer demand.

What does the evidence tell us? When I compare across the rich countries, I don’t find compelling evidence that income inequality has been bad for economic growth. Other recent studies have reached a similar conclusion.

Income inequality might harm the economy in another way: by causing financial crises. Households with stagnant incomes could increase borrowing in order to sustain consumption growth, and their debt levels could eventually become unsustainable. As the rich got a larger and larger portion of the income, they could end up with excess savings, which fuels speculative investment and financial bubbles. Third, the rich could use their money and political influence to press policy makers to loosen regulations on finance.

Studies that have examined financial crises across countries and over time don’t, however, find a systematic link with high or rising income inequality.

Q.

What about the 2008 crisis in particular?

A.

It probably will be a while yet before the causes are fully sorted out, but there are grounds for skepticism about income inequality’s contribution. Growing demand for loans by middle- and low-income households may have been driven more by the rising cost of homes and college, along with relaxed lending standards and the availability of home equity loans, than by slow household income growth. Risky lending may have been spurred by the creation of new financial instruments that appeared to spread risk and by rising pressure for profits in publicly-owned investment firms. Finally, the Federal Reserve could have quashed the housing bubble, the proximate precipitant of the crisis, had it wanted to. That it chose not to do so arguably owed more to Fed Chair Alan Greenspan’s ideological predilections than to the political influence of America’s rich.

There surely is some point at which the top 1 percent’s income share would be high enough to impede economic growth. But the experience of the world’s rich countries suggests that that point probably hasn’t yet been reached.

Q.

A powerful critique of inequality is that it is incompatible with democracy - slicing society into powerless have-nots and plutocrats who can shape society to fit their interests. What do you make of this argument?

A.

Money clearly matters in American politics. With the richest getting a larger share of the country’s income, it’s sensible to hypothesize that they would have growing success in swaying policy makers. Still, the influence of money in American politics occurs mainly via lobbying rather than campaign contributions. While the amount of money spent on lobbying has increased exponentially in the past several decades, much of that increase might well have occurred even if income inequality hadn’t increased. After all, lobbying is funded primarily by companies and other organizations, not individuals. Moreover, the impact of money is likely to be smaller when there is already a lot being spent. American politics has been flush with private cash for a generation, so additional spending might no longer buy much additional influence.

The most relevant evidence comes from studies by political scientists Larry Bartels and Martin Gilens. They examined the relationship between votes in Congress on proposed policy changes and the opinions of Americans with different incomes. They found that voting correlated much more closely with the views of the rich.

We need to know whether this pattern of unequal influence increased as income inequality rose. According to Gilens, the correlation between income and influence on policy was weak during the Johnson presidency, strong during the presidencies of Reagan and Clinton, and relatively weak during the presidency of George W. Bush. This isn’t what the inequality hypothesis predicts.

Now, this is by no means a full and complete test of the inequality hypothesis. The well-to-do may exert their influence mainly by keeping proposed reforms from ever coming to a vote and via behind-the-scenes shaping of legislation, and their ability to use these kinds of levers might have increased as their share of income grew. But here too we lack supportive evidence.

Q.

Another common argument is that widening income inequality is hindering social mobility - making it more difficult for children born at the bottom of the income pile to rise through the ranks. Recent research has cast some doubt on this proposition, however. What do you find?

A.

Children who grow up in households with lower incomes are less likely to have good health care, low stress, learning-centered preschools, good elementary and secondary schools, extracurricular activities that promote cognitive and non-cognitive skills, and access to a strong university. We would thus expect a widening of the gap in parents’ income to reduce the likelihood that children from low-income families will succeed in moving up.

Yet parents’ income isn’t the only determinant of a person’s abilities and motivations when she reaches adulthood. Non-monetary influences such as genetics, in-utero developments, parents’ habits and behaviors, peers, and schooling matter too. In addition, there surely are diminishing returns to money; beyond a certain point, more parental income probably helps only a little, if at all.

Among the rich nations for which we have data, those with greater income inequality tend to have less mobility across generations, just as the inequality hypothesis predicts. The problem is that there are other factors that could explain this. The four Nordic nations â€" Denmark, Finland, Norway, and Sweden â€" have low inequality and high mobility. Maybe their low inequality causes their high mobility. But they’ve been providing affordable high-quality early education to a substantial portion of children age 1 to 5 for roughly a generation, and they also feature late tracking in K-12 schools and heavy subsidies to ensure that college is affordable for all. These public services, rather than low income inequality, could be the key to why the Nordic countries have such high intergenerational mobility. If we leave out the Nordic nations, the cross-country association between income inequality and mobility remains, but it is quite weak.

Patterns in local communities in the United States suggest little if any correlation between income inequality and relative intergenerational mobility. Deirdre Bloome, a Ph.D. student at Harvard, also finds that states in which income inequality has increased the most haven’t been more likely to suffer a decline in intergenerational income mobility.

If income inequality impedes intergenerational mobility, we should observe a decline in mobility during the period of rising income inequality. But it’s too early to reach a definitive conclusion about this. We need to know whether mobility declined for Americans born after 1979, and they haven’t yet reached their peak earning years. Findings so far are mixed. Some recent studies find no indication of declining mobility, while others conclude that it probably has declined.

So the available evidence offers hints of support for the hypothesis that income inequality reduces intergenerational mobility, but only hints.

Q.

Given the weak evidence that inequality is leading to bad social outcomes, on what grounds should we oppose it? What is the case for policies to stop the widening of income inequality?

A.

I think there are three. First, the evidence suggests that income inequality does have some harmful effects. It reduces income growth for middle-class households. This is a big problem; slow income growth for ordinary Americans is in my view one of our country’s chief failures over the past generation. Income inequality probably also increases inequalities in health, education, and happiness, and it leads to greater residential segregation.

Second, although we don’t yet have conclusive evidence, there is a strong possibility that income inequality has enhanced the political influence of the rich. Not only is this problematic for democracy; it also could have bad spillover effects on other things we care about, from education to economic growth to climate change and beyond.

Third, the fairness objection to high income inequality remains, I believe, as compelling as ever. Much of what determines a person’s earnings and income â€" intelligence, creativity, physical and social skills, motivation, persistence, confidence, connections, inherited wealth, discrimination â€" is a product of genetics, parents’ assets and traits, and the quality of one’s childhood neighborhood and schools. These things aren’t chosen; they are a matter of luck. A nontrivial portion of income inequality is therefore, arguably, undeserved.

Q.

So what are the appropriate policies to address these shortcomings? Do we need to reduce income inequality?

A.

I think the smartest approach for most problems is to tackle them directly, rather than pursue an indirect route via lower income inequality. For instance, if we want to improve intergenerational mobility, our best bet might be universal early education rather than a reduction in the top 1 percent’s income share. If we want to boost college graduation, we could increase financial aid to students from low-income families. If we want to reduce inequality of political influence, we could expand public funding of election campaigns and enhance transparency rules for lobbying and private contributions.

On the other hand, addressing the problem of slow income growth for middle-class households probably does require reduced income inequality. Ideally, we could figure out a way to get both the employment rate and wages rising again, but an array of economic pressures â€" intense competition, shareholder demands for constant profit growth, computers and robots, the attraction of outsourcing and offshoring, and more â€" make this a very difficult task. We may need to turn to a public insurance mechanism. One possibility would be to expand the earned-income tax credit well into the middle class and index it to G.D.P. per capita. This could be funded by higher tax rates on those at the top of the income ladder.

Helping Low-Income Children Succeed

Nancy Folbre is professor emerita of economics at the University of Massachusetts, Amherst.

Diverging incomes among families lead to diverging destinies among children, undermining the promise of equal opportunity. Economic research helps explain why this happening and what we could do about it.

So contend Greg J. Duncan and Richard J. Murnane in “Restoring Opportunity: The Crisis of Inequality and the Challenge for American Education,” a book that deftly summarizes a new wave of research on educational reform and, in the process, breaks through some tough ideological logjams.

Parents today spend more money on “child enrichment expenditures,” like private schools, extracurricular activities and home-learning materials, than ever before. Low-income families simply can’t keep up. In 1972-73, the poorest quintile of families spent, on average, about 24 percent as much as the richest 20 percent in this category. By 2005-06, they spent only 15 percent as much.

Skeptics sometimes assert that poverty itself isn’t bad for children; rather, parents who aren’t very good at earning income are also not very good at helping their children learn. But money does matter. Professors Duncan and Murnane emphasize that several experimental studies that randomly assigned some poor families a significant income supplement revealed significant positive effects on the children’s academic achievement.

This finding defuses the claim that education reform alone can eliminate disparities. Vast differences in per capita student spending across school districts, and the institutional weaknesses of large bureaucracies, have greatly reduced the potentially equalizing impact of public education. These problems, the authors say, need to be addressed in unison.

Avoiding simplistic recommendations like “just spend more” or “just promote charter schools,” they point to three success stories that bridged the public and private sectors, increased spending in cost-effective ways and, most importantly, improved the quality of educational instruction for low-income students.

In 2004, the Boston Public Schools began a concerted effort to expand and enhance preschool education for 4-year-olds, applying additional resources, improved curriculums and new forms of accountability for teachers and schools. A recent evaluation by two Harvard researchers found especially positive effects for children from low-income families â€" sufficient to close more than half the gap at kindergarten entry between their academic skills and those of counterparts from relatively affluent families.

Institutional details matter more than institutional form. Most charter schools have proved no more effective than conventional public schools at improving outcomes for poor children. But one standout program, the University of Chicago Charter School network, has proved successful at improving the quality of instruction in its elementary schools, partly as a result of escaping bureaucratic rules that made it difficult to recruit and retain talented teachers for the students who need them most.

Similar themes emerge from consideration of a successful public high school initiative in New York City, the development of smaller “schools of choice” that students can opt into. Per-pupil expenditures went up, but provided a rich payoff. Allowing students some voice in their enrollment decisions, and fostering the stability and commitment of the teaching staff, has created a more sustainable social environment which, in turn, has increased the graduation rates of low-income students by seven percentage points.

Professors Duncan and Murnane provide clear and effective instruction to the nation’s education policy makers. One can only hope that these students are paying attention.

The Government Is No Drunken Sailor

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

You know that rap about runaway spending under Obama?  Well, if you actually look at the outlays on the books during the Obama administration, adjusting for inflation and population growth, you get the picture below.

The figure shows significant spending growth in only one year: 2009, as outlays rose to meet the deepest recession since the Depression, including automatic stabilizers and stimulus.  Since then, outlays have fallen, adjusting for inflation and population growth.  From 2009 to 2013, they’re down 12 percent; compared to 2008, they’re up 3 percent, not quite the spending spree that is often suggested in partisan debate.

Source: CBPP analysis of OMB and BLS data.

Second, new analysis by my CBPP colleagues Richard Kogan and William Chen shows that relative to projections that were made in 2010, spending reductions in various bills, including the Budget Control Act (2011), the American Taxpayer Relief Act (2012), the Bipartisan Budget Act (2013), and the recent farm bill generated deficit savings of $2.5 trillion over the current 10-year budget window (2015 to 2024).  Adding in the associated reduced interest payments of about $650 billion amounts to $3.2 trillion in deficit savings from spending cuts.

Revenue added about $950 billion and technical and economic changes added savings of about $840 billion. Thus, Mr. Kogan and Mr. Chen find $5 trillion in savings over the budget window relative to the 2010 baseline.

Moreover, as the figure below reveals, 77 percent of the savings that come from policy changes (i.e., excluding technical and economic changes) are from spending cuts to government programs; less than a quarter come from revenue.  Thus, to the extent that further deficit reduction is warranted â€" as it is decidedly not in the near term â€" this analysis strongly points toward the necessity of new revenue.

As intimated above, neither of these developments should be seen as anything like great achievements.  The stimulus response to the Great Recession was too short-lived, and many of the program cuts in that orange pie slice above have been thoughtless slash-and-burn (sequestration) that have and will continue to make life harder for economically vulnerable families.  And from the perspective of the macroeconomy, the decline in the budget deficit from 10 percent of G.D.P. in 2009 to 3 percent in 2013 is the sharpest fall in the budget deficit since 1950. It is the source of the fiscal headwinds that have consistently held back the recovery.

But one thing you can’t say, at least if you want to be factual, is that the federal government has been spending like a drunken sailor and we’re doomed to Grecian levels of insolvency.  Of course, if you don’t want to be factual, you can say anything you want.

Unemployed? You Might Never Work Again

The long-term unemployed “are an unlucky subset of the unemployed.” They tend to be a little older, a little more educated, a little less white - but really they’re not that different from the broader pool of people who have lost jobs in recent years. Except for one thing: There is a good chance they’ll never work again.

These are the sobering conclusions of a new paper by three Princeton University economists including Alan B. Krueger, the former chairman of President Obama’s Council of Economic Advisors.  The paper, presented Thursday at the Brookings Panel on Economic Activity, is part of a growing body of research showing that the prospects of people who lose jobs deteriorate rapidly unless they find new jobs quickly.

This has important, but opposite, implications for monetary and fiscal policymakers. It suggests the Federal Reserve has limited power to reduce long-term unemployment without tolerating higher inflation, which Professor Kreuger and his colleagues argue is affected primarily by the level of short-term unemployment. At the same time, it suggests that legislators acting with greater force and urgency could help people whose hopes are slipping away.

“Overcoming the obstacles that prevent many of the long-term unemployed from finding gainful employment, even in good times,” they wrote, “will likely require a concerted effort by policy makers, social organizations, communities and families, in addition to appropriate monetary policy.”

The idea that the long-term unemployed are on the margins of the labor market, exerting little pressure on wages or prices, is relatively new. On Wednesday I asked Janet L. Yellen, the Fed chairwoman, what she thought of papers that have reached the same conclusions as Mr. Krueger’s group.

“I think it would be tremendously premature to adopt any notion that says that that is an accurate read on either how inflation is determined or what constitutes slack in the labor market,” she responded. “I wouldn’t endorse â€" I certainly don’t think our committee would endorse the judgment of the research that you cited.”

The basic argument made by the new paper, and others like it, is that the long-standing relationship between movements in inflation and unemployment, which appeared to break down during the Great Recession and its aftermath, can be restored by writing off long-term unemployment. The Phillips curve, a description of this relationship, predicted a decline of one percentage point per year between 2009 and 2013. The actual average was just 0.2 percentage points.

Adjust for - which is to say, ignore - long-term unemployment and voila! The difference almost completely vanishes.

People are only counted among the long-term unemployed if they say they are still looking for jobs. As time passes, people tend to give up, and those who do are no longer counted as members of the labor force. So why do the people who persist in trying become less successful with time?

“Either because, on the supply side, they grow discouraged and search for a job less intensively or because, on the demand side, employers discriminate against the long-term unemployed, based on the (rational or irrational) expectation that there is a productivity-related reason that accounts for their long jobless spell,” the new paper says.  It adds that the two explanations are complementary, “as statistical discrimination against the long-term unemployed could lead to discouragement, and skill erosion that accompanies long-term unemployment could induce employers to discriminate against the long-term unemployed.”

But there is no necessity to this explanation, and the paper itself contains some countervailing findings. It notes that the long-term unemployed tend to be older and more highly educated, suggesting their labor is relatively more expensive, and their prospects may improve with the economy.

The paper also presents striking evidence that few people are finding jobs in new industries. Professor Krueger and his colleagues draw the conclusion that government may be able to help. The authors write, “These results suggest that assisting unemployed workers to transition to expanding sectors of the economy, such as health care, professional and business services, and management, is a major challenge.” But if long-term unemployment is more common in industries recovering more slowly, because would-be workers are trapped in those industries, this too suggests that the problem may be economic rather than personal.

There is a way to resolve the question. Fiscal and monetary policy makers could try to help, and we could all see what happens.

Instead, the debate seems increasingly likely to remain purely academic, and the long-term unemployed permanently lost.

The Economics of Limiting Russia’s Expansion

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a nonresident senior fellow at the Peterson Institute for International Economics. Simon Johnson is a professor at the M.I.T. Sloan School of Management and former chief economist at the International Monetary Fund.

In the United States and Western Europe, discussion is focused on stopping Vladimir Putin from further expanding Russia’s territory. On present course, the West’s strategy looks set for more failure; only a major shift in economic strategy by the Ukrainian government is likely to make a significant difference. Giving or lending lots of money to Ukraine is unlikely to help and may even be counterproductive.

Ukraine’s economic failure over the last two decades is astounding. When the Soviet Union broke up in 1991, Ukraine’s gross domestic product per capita was greater than Romania’s, slightly higher than Poland’s and about 30 percent less than Russia’s. Today, Poland and Romania enjoy more than twice Ukraine’s income per person and Russia nearly triple.

This dismal performance reflects partly a lack of natural resources, but also self-interested leaders who have lined their pockets rather than focus on growth. The Orange Revolution of 2004 brought Viktor Yanukovych to the presidency, after more than a decade of pervasive corruption, but this episode proved to be a great disappointment. The Yanukovych years that followed were even worse.

Ukraine’s economic situation has recently become more desperate. If Ukraine is to pay all of its bills, the amount needed over the next two years to make debt payments and cover the budget deficit on its current trajectory add up to nearly $40 billion. These bills are growing daily because of the severe disruptions caused by the loss of Crimea, the continuing instability in eastern Ukraine and the nonpayment for gas deliveries from Russia. Because of the West’s unbending support for the current Kiev government, many Ukrainians expect large and generous support to help the nation out of this mess.

Western diplomatic actions in recent months have created nothing short of a fiasco for Ukraine and some of its neighbors. Diplomats overtly welcomed the change to an anti-Russian government in Kiev, and they celebrated the flight of the pro-Russian President Viktor Yanukovych. We were all pleased to see some highly corrupt politicians toppled, yet, in the midst of all these intrigues, some news organizations and diplomats lost sight of the end game with Russia.

With no credible military threat and an unwillingness of politicians to inflict pain by applying sanctions against Russia similar to those imposed on Iran, Western politicians proved toothless. The Germans do not want to disrupt the supply of gas from Russia, the British do not want to undermine their status as a financial haven, and the Americans are concerned about reprisals against their companies with large exposures in Russia (e.g., PepsiCo, Exxon or Citigroup).

In a series of moves that appear to have been planned carefully, Mr. Putin has taken Crimea, won huge popular support in Russia and in much of Crimea and left the West holding financial responsibility for the rest of Ukraine.

There is no doubt that Russia may seek to annex more parts of Ukraine. Russian military intervention is possible, but the Crimean strategy has proven much easier. Time and momentum are on Russia’s side, so Mr. Putin can be patient. If Ukraine’s eastern and southern regions continue to flounder while Russia grows richer, it is only a matter of time before large separatist movements will develop in these areas.

Russia will make a success of Crimea as an example for others: pensions, government wages and other incomes can roughly double to meet Russian averages. The experience of debate and referendums in Quebec, Scotland, Catalonia and other regions all point to plausible democratic routes to exit that Russia can encourage.

A stable Ukraine, with an economy that catches up to its neighbors, is the best defense against disintegration. There is a chance to keep Ukraine united with its current borders (less Crimea), but it would require a striking change in Ukrainian economic strategy - something very hard to pull off with so many levers of power in the hands of the established political elite, who remain well entrenched.

Russia controls many of the levers for Ukraine’s success. It is Ukraine’s largest trading partner. Ukraine is heavily in debt to Russia and relies on Russia for most of its energy imports. Russia has been selling Ukraine natural gas at well below world prices. Russia also has substantial ability to promote riots, political intrigues and general instability. In short, unless Ukraine can normalize relations with Russia, it has little hope for growth.

In contrast with Russia’s influence, the West’s ability to affect Ukraine’s success is highly limited. The idea of providing Ukraine with a big loan from the International Monetary Fund and other forms of external financial assistance will not help much and may even make things worse. Given the financial state of Ukraine, such money could easily be wasted before Ukraine turns again, as it eventually must, toward better relations with Russia.

Greater integration of Ukraine into Europe, through the European Union, could set the institutional framework better placed for growth. Yet the potential for such an association agreement is one reason Russia has chosen to bring more pressure. However, a trade pact does not resolve Ukraine’s entrenched corruption, and any success still relies on Russia’s cooperation. The European Union needs to engage with Russia as much as possible, but events in Crimea make this hard.

One thing that Ukraine could do soon, to encourage growth and harness the goals of the Maidan revolution, would be to move quickly, and in a high-profile manner, against all forms of corruption. In 2004 Georgia fired all its traffic police, then hired new officers, with higher salaries, better equipment and less inclination to accept bribes (see this Princeton case study for more detail). Simplification of the tax system, changes in regulatory policy and changes to the judiciary can also reduce corruption.

But to take all these actions requires political legitimacy, and this can only be acquired through new presidential and parliamentary elections. The European Union pact, any kind of I.M.F. program and large-scale moves against corruption require a government that can make long-term commitments and demonstrate political strength.

The current government was selected after violent street demonstrations and early on revealed an anti-Russian stance that is at odds with keeping the nation unified and with harmonizing relations with Russia. Until there is political capacity to achieve significant reduction in corruption, Ukraine’s growth prospects and its ability to remain unified, remain limited.

The Economics of Limiting Russia’s Expansion

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a nonresident senior fellow at the Peterson Institute for International Economics. Simon Johnson is a professor at the M.I.T. Sloan School of Management and former chief economist at the International Monetary Fund.

In the United States and Western Europe, discussion is focused on stopping Vladimir Putin from further expanding Russia’s territory. On present course, the West’s strategy looks set for more failure; only a major shift in economic strategy by the Ukrainian government is likely to make a significant difference. Giving or lending lots of money to Ukraine is unlikely to help and may even be counterproductive.

Ukraine’s economic failure over the last two decades is astounding. When the Soviet Union broke up in 1991, Ukraine’s gross domestic product per capita was greater than Romania’s, slightly higher than Poland’s and about 30 percent less than Russia’s. Today, Poland and Romania enjoy more than twice Ukraine’s income per person and Russia nearly triple.

This dismal performance reflects partly a lack of natural resources, but also self-interested leaders who have lined their pockets rather than focus on growth. The Orange Revolution of 2004 brought Viktor Yanukovych to the presidency, after more than a decade of pervasive corruption, but this episode proved to be a great disappointment. The Yanukovych years that followed were even worse.

Ukraine’s economic situation has recently become more desperate. If Ukraine is to pay all of its bills, the amount needed over the next two years to make debt payments and cover the budget deficit on its current trajectory add up to nearly $40 billion. These bills are growing daily because of the severe disruptions caused by the loss of Crimea, the continuing instability in eastern Ukraine and the nonpayment for gas deliveries from Russia. Because of the West’s unbending support for the current Kiev government, many Ukrainians expect large and generous support to help the nation out of this mess.

Western diplomatic actions in recent months have created nothing short of a fiasco for Ukraine and some of its neighbors. Diplomats overtly welcomed the change to an anti-Russian government in Kiev, and they celebrated the flight of the pro-Russian President Viktor Yanukovych. We were all pleased to see some highly corrupt politicians toppled, yet, in the midst of all these intrigues, some news organizations and diplomats lost sight of the end game with Russia.

With no credible military threat and an unwillingness of politicians to inflict pain by applying sanctions against Russia similar to those imposed on Iran, Western politicians proved toothless. The Germans do not want to disrupt the supply of gas from Russia, the British do not want to undermine their status as a financial haven, and the Americans are concerned about reprisals against their companies with large exposures in Russia (e.g., PepsiCo, Exxon or Citigroup).

In a series of moves that appear to have been planned carefully, Mr. Putin has taken Crimea, won huge popular support in Russia and in much of Crimea and left the West holding financial responsibility for the rest of Ukraine.

There is no doubt that Russia may seek to annex more parts of Ukraine. Russian military intervention is possible, but the Crimean strategy has proven much easier. Time and momentum are on Russia’s side, so Mr. Putin can be patient. If Ukraine’s eastern and southern regions continue to flounder while Russia grows richer, it is only a matter of time before large separatist movements will develop in these areas.

Russia will make a success of Crimea as an example for others: pensions, government wages and other incomes can roughly double to meet Russian averages. The experience of debate and referendums in Quebec, Scotland, Catalonia and other regions all point to plausible democratic routes to exit that Russia can encourage.

A stable Ukraine, with an economy that catches up to its neighbors, is the best defense against disintegration. There is a chance to keep Ukraine united with its current borders (less Crimea), but it would require a striking change in Ukrainian economic strategy - something very hard to pull off with so many levers of power in the hands of the established political elite, who remain well entrenched.

Russia controls many of the levers for Ukraine’s success. It is Ukraine’s largest trading partner. Ukraine is heavily in debt to Russia and relies on Russia for most of its energy imports. Russia has been selling Ukraine natural gas at well below world prices. Russia also has substantial ability to promote riots, political intrigues and general instability. In short, unless Ukraine can normalize relations with Russia, it has little hope for growth.

In contrast with Russia’s influence, the West’s ability to affect Ukraine’s success is highly limited. The idea of providing Ukraine with a big loan from the International Monetary Fund and other forms of external financial assistance will not help much and may even make things worse. Given the financial state of Ukraine, such money could easily be wasted before Ukraine turns again, as it eventually must, toward better relations with Russia.

Greater integration of Ukraine into Europe, through the European Union, could set the institutional framework better placed for growth. Yet the potential for such an association agreement is one reason Russia has chosen to bring more pressure. However, a trade pact does not resolve Ukraine’s entrenched corruption, and any success still relies on Russia’s cooperation. The European Union needs to engage with Russia as much as possible, but events in Crimea make this hard.

One thing that Ukraine could do soon, to encourage growth and harness the goals of the Maidan revolution, would be to move quickly, and in a high-profile manner, against all forms of corruption. In 2004 Georgia fired all its traffic police, then hired new officers, with higher salaries, better equipment and less inclination to accept bribes (see this Princeton case study for more detail). Simplification of the tax system, changes in regulatory policy and changes to the judiciary can also reduce corruption.

But to take all these actions requires political legitimacy, and this can only be acquired through new presidential and parliamentary elections. The European Union pact, any kind of I.M.F. program and large-scale moves against corruption require a government that can make long-term commitments and demonstrate political strength.

The current government was selected after violent street demonstrations and early on revealed an anti-Russian stance that is at odds with keeping the nation unified and with harmonizing relations with Russia. Until there is political capacity to achieve significant reduction in corruption, Ukraine’s growth prospects and its ability to remain unified, remain limited.