# Policy Tensor

## McGill TAs Strike Again: A Simple Proposal

In Thinking on April 15, 2015 at 6:24 pm

McGill teaching assistants have voted to strike on the first day of exams. The administration has its horns locked with the AGSEM, the teaching assistants’ union, primarily over pay; although there are other issues at stake. This is not the first time that graduate students are striking on McGill campus. The last one, a two-month strike in 2008, was particularly grueling. Nor are collective bargaining impasses all that uncommon between the two protagonists. Since its founding in 1993, the AGSEM has struck four collective agreements with the university. All of them sans one involved protracted bargaining.

In what follows, I will make the case for inflation-indexing future pay increases for McGill TAs. This will not solve the problem of bargaining over pay completely. The university and the union will still need to agree on the current fair wage rate. However, once they have done so, inflation-indexing will ensure that they will never need to revisit the question ever again. I will argue that because industrial actions are especially costly on campus and collective bargaining impasses are mostly about pay increases, McGill would benefit greatly from making future pay increases transparent, automatic, and depoliticized. I will show that not only is my proposal beneficial for undergraduates, it is also in the interest of the university and graduate students themselves. Finally, I will demonstrate that inflation-indexing is straightforward and easy-to-implement.

Once solid labor standards are already in place, the most serious concerns of workers are invariably related to pay. McGill graduate students have negotiated hard for equal pay (1998), working hours (2007), and pay increases (1998, 2007, 2008, 2011). This time around, the TAs’ demands include a cap on TA-to-student ratios. However, the principal demand is for significant yearly wage increases. Resolving the bargaining over pay is thus not going to remove the need for all bargaining. But it will take the thorniest issue off the bargaining table.

Since college students have a very tight calendar, industrial actions which would be hardly disruptive in other settings can be quite costly on campus. For instance, even though it is not unfair to think of the planned one-day strike on the first day of exams as symbolic, the disruption would nevertheless be significant. Students trekking up to sit through a major exam will be confronted by picket lines and the general disruption caused by striking invigilators. Were there to be an unlimited strike, classes would be cancelled and exams would go ungraded. In general, the rigidity of the academic cycle makes industrial actions on campus extraordinarily costly.

What should teaching assistants be paid? Since the university does not engage in price-competition when it hires graduate students, the fair wage cannot be set by the market. Obviously, they must be paid enough so as to maintain a basic standard of living. Beyond that, it is hard to make the case for a specific number. Let us say that the union and the administration agree on $x per hour. If there is no inflation, then neither the union nor the administration would ever need to revisit the bargain ever again. If inflation is nonzero, the bargain would need to be revisited again and again with the attendant risk of disruption on campus. For instance, suppose they were to agree on a 2 percent increase for the next three years. Then the union and the university will be back at the table in 2018, fighting over the exact same issue all over again. With inflation-indexing, we are back to the zero inflation case: Once you agree on a fair wage rate, you need never reopen that Pandora’s box again. Here is how inflation indexing would work. The university and the union would agree on a fair hourly wage rate, a published inflation rate to calculate the adjustment, and the frequency of the adjustment. For instance, the two could agree on a baseline wage rate of$30 an hour; the preceding 12-month consumer price inflation figure published by Statistics Canada; and an annual adjustment to the base rate effected on May 1st of every year. Future pay rises would thus be transparent, automatic, and depoliticized.

If inflation-indexing is so reasonable, why then is it so uncommon in industry? It is uncommon for a simple reason. Industrial workers bargain both for restoring living standards (which indexing would fix), and a share of gains in productivity (which indexing cannot fix). The second does not apply to graduate students who are promised no more than decent living standards. Indeed, graduate study is best regarded as an apprenticeship: The real monetary rewards lie in the future. Inflation-indexing is thus particularly well-suited for the TAs’ collective bargaining problem.

With an escalating contract tied to inflation, graduate students would not have to worry about the risk of falling living standards. They would be ceding that risk to the university. The university, with its billion-dollar balance sheet, is in a considerably better position to stomach that risk than poor graduate students. Graduate students thus stand to gain more than merely decent living wages; with inflation-indexing, they also get insurance against higher than anticipated inflation.

The university will also gain from inflation-indexing. Since its wage bill will track inflation, the university could easily hedge against the risk of higher than anticipated inflation. The university would, in effect, pocket the savings on the cost of insuring against uncertainty in its financial outflows. Indeed, getting rid of real wage uncertainty increases the real economic pie in absolute terms; gains which can be shared between graduate students and the university.

Inflation-indexing is sustainable. Super-inflationary pay increases would bankrupt the university. Sub-inflationary pay increases would steadily erode graduate students’ living standards. Neither is sustainable. On the other hand, McGill can afford to increase pay at the rate of inflation since the university’s receipts from tuition, endowments, and investment income can outperform inflation relatively easily.

McGill undergraduates deserve a campus free of disruption and TAs who are not overworked and underpaid. Graduate students deserve decent wages and freedom from fear of falling living standards. The university needs an affordable and sustainable financial commitment. Inflation-indexing ensures all of the above in perpetuity.

## War Strategies in Asia

In Geopolitics on April 9, 2015 at 10:33 pm

A variety of political developments could lead to a military confrontation between the United States and China. What would a war between the two colossi look like? The intensity, duration, and course of a war in Asia depend on the war strategies pursued by both adversaries. Talking about the war strategy of only one combatant is only half the story: the enemy gets a vote. In particular, prospects for escalation and intrawar deterrence require consistency between the war strategies of the combatants.

American and Chinese strategists are choosing from a small menu of three or four basic strategies. For the US: ‘distant blockade’, ‘maritime denial’, and ‘deep strike’; for China: ‘near-seas defense’, ‘regional bid’, and ‘hegemonic bid’. All of these terms are cartographic. We shall now make them more precise.

US war strategies

The US war strategy distant blockade means that once China demonstrates its resolve to hold US military assets in the Western Pacific at risk in a confrontation, US forces withdraw west of Malacca and impose a blockade. The cumulative economic pressure applied on China would be harsh but slow and steady thus greatly limiting the potential for escalation.

Maritime denial is a more aggressive war strategy that seeks to deny China access to Asian waters. With the Chinese navy locked up in the near seas, the US and its allies would be able use the maritime zone outside the first island chain for communication and shipping. China’s marginal seas would become a ‘zone-of-fire’, where access is denied to both by the adversary’s ability sink all surface assets at will.

Archipelagic defense is a variant of maritime denial which relies on placing US ground forces on islands off the Chinese mainland to bolster the US navy’s efforts to deny China access to Asian waters. In either variant, the punishment would be severe whilst still limiting the risk of escalation since China’s second-strike capability would not be undermined.

Deep strike is the most aggressive of the three war strategies being considered by US planners. It evolved from strategic concepts developed in the eighties by Pentagon planners concerned with thwarting a Russian land invasion of Europe under conditions of mutual nuclear deterrence and an American monopoly on precision strike. Known as the concept of AirLand battle in the late eighties, it was reformulated as AirSea battle for the defense of maritime Asia, especially Taiwan, against Chinese aggression.

Deep strike seeks to cripple adversary’s ability to project its power. Deep strike calls for a wholesale destruction of China’s ‘reconnaissance-strike complex’. The US would seek to destroy targets deep in mainland China in a bid to cripple China’s anti-access, area denial capabilities. Mainland targets would include command and control facilities, air and anti-air installations, space and anti-satellite equipment, radars and surveillance infrastructure, and missile launch platforms. But deafening and blinding China and destroying its ability to launch missiles undermines China’s second-strike capability. China’s government may then face a ‘use it or lose it’ situation. Deep strike thus poses significant risks of escalation.

Chinese war strategies

Now consider the military strategies available to China. For the sake of brevity, although the US would likely be fighting shoulder to shoulder with regional allies, we will refer to China’s adversaries in such a contest in the singular; simply as the US.

Near-seas defense seeks to deny the US military access to China’s marginal seas. An initial barrage of missiles and airstrikes would target all air, surface, and undersea assets of the US within the China seas. In particular, China would not attack US military bases in maritime Asia outside the near seas, such as those in Japan, the Philippines, and Guam. It would then establish a naval defense perimeter along the ‘first island chain’. This military strategy would leave China exposed to a local counterattack by US forces in the western Pacific, but sharply limit the probability of escalation.

A more aggressive variant of near-seas defense would have the initial barrage of strikes target all US military assets and bases in the western Pacific, whilst still maintaining China’s naval perimeter along the ‘first island chain’. Given US’ force posture of forward deploying only a fraction of its strength, even a ‘splendid first-strike’ on US assets in the western Pacific would not seriously cripple the US’ ability to mount a counterattack. And far from limiting the war, it would guarantee a prolonged campaign as the US seeks to regain its position in the region. A splendid first-strike on US military assets in the western Pacific is thus unlikely to accompany a near-seas defense. Note that the threat of a splendid first-strike is much more serious when mounted against an American strategy of archipelagic defense.

A regional bid would indeed begin with a massive first-strike on US positions in the western Pacific, including Guam and perhaps Japan; crippling America’s ability to mount a local defense. China would then repeat Japan’s World War II strategy of establishing a secure naval perimeter along the entire western Pacific. The United States would be forced to rebuild its supply lines; and in the meanwhile, rely on ineffective long range platforms to attack China.

Once China succeeds in kicking US forces out of Asia, it would still be exposed to a distant blockade. China would lose access to Western markets and gulf energy. There are only three ways out of the ‘Malacca dilemma’. First, growth in Asian markets coupled with a shale revolution in China could take the bite out of a potential blockade. Second, China could build up its maritime power enough to defeat the United States in open ocean combat. Third, a combination of secure land access to Caspian Sea energy and growth in Asian markets could make a blockade less painful.

Given that Asia is likely to grow into at least as big a market at Europe, the Malacca dilemma calls for a western-oriented strategy that leverages China’s land power. China could seek to deny the US military access to the Caspian Sea region to ensure its access to the region’s significant energy deposits. It would be extraordinarily difficult for the United States to project power in Central Asia, given that the region is far from the open ocean. At best, the US could use long-range cruise missiles to disrupt Chinese supply lines. But these missiles would have to be launched either from bases in the Middle East or from naval platforms in the gulf. Both would be vulnerable to counter-force strikes by the Chinese.

While access to energy supplies may be critical to China’s war effort, the western theater will be secondary to the maritime zone where the regional bid will play out. Rather than being an alternative, a western-oriented land strategy complements China’s regional bid.

Hegemonic bid is a war strategy suitable for a Chinese bid for the highest stakes. China would seek to engage and defeat US forces operating in the open ocean. The minimal goal of this war strategy would be for China to replace the United States as the dominant naval power in the Indo-Pacific: from Suez to Hawaii. More expansively, China could seek to replace the United States as the global maritime hegemon. Hegemonic bid will only become available to China once it has mastered open ocean warfare.

War in Asia

Since the 1996 Taiwan crisis, when the United States intimidated China by sending three aircraft carriers to the Taiwan Strait, China has sought to build what the Pentagon calls anti-access, area denial capabilities. The centerpiece of this strategy has been a reconnaissance-strike complex that allows China to credibly threaten US naval assets that approach China’s near seas. Twenty years of effort has borne fruit. China now enjoys the capability to hold US surface assets in the western Pacific at risk.

While it has managed to gain some mastery over precision strike, China has not yet developed significant power projection capabilities. The Chinese navy’s ability to operate in contested environments and on the high seas is still rudimentary; although growing rapidly. China’s economy is growing fast along with its military budget. There is no reason to believe that China will not be able to dramatically increase its naval power in the coming decades.

If war comes within the next decade, China will have no option but to rely on near-seas defense as the other two war strategies will be unavailable. By 2030, the growth in Chinese naval power should be sufficient to make regional bid a viable option. And by mid-century, China should be in a position to consider a hegemonic bid as well.

The United States enjoys a very strong geostrategic position. The US homeland is protected against all but the longest range platforms of its potential adversaries. Regional allies both add to US strength and provide stepping stones to bring its power to bear in the western Pacific. In the 2000s, deep strike was a viable war strategy for the United States. The rise of China’s precision-strike complex, together with uncertainty about its nuclear posture means that deep strike is no longer viable. At the present juncture, maritime denial is a viable war strategy for the United States.

The US is in a good position to deter China from seeking to forcibly upend the regional territorial status quo ante in the near future. As China continues to grow more powerful, at some point, perhaps within a decade, maritime denial would no longer be on the menu for the United States either. And in the more distant future, say by mid-century, the United States would lose the ability to mount a distant blockade as well.

The contours of a potential war in Asia thus depend critically on when it is fought in ‘system time’.

Potential for escalation to all-out war

 US/China Near-Seas defense Regional bid Hegemonic bid Deep strike High High High Maritime denial Medium High High Distant blockade Low Low High

War zones

 US/China Near-Seas defense Regional bid Hegemonic bid Deep strike Mainland China Mainland China/Western Pacific Indo-Pacific Maritime denial First island chain Western Pacific Indo-Pacific Distant blockade – – Open ocean

A splendid first-strike in the Western Pacific

 US/China Near-Seas defense Regional bid Hegemonic bid Deep strike Likely Very likely Very likely Maritime denial Unlikely Likely Very likely Distant blockade Unlikely Unlikely Likely

## Why the Rate of Return Exceeds the Growth Rate

In Markets on April 4, 2015 at 3:42 am

I have been scratching my head over the elementary inequality $r>g$  for some time. As you probably know, this inequality is central to the “actuarial” mechanism that drives stratification in Piketty’s work. Basically, if the rate of return (net of depreciation) outpaces the growth of the overall economy, the capital-to-output ratio, $\beta=K/Y$, or equivalently, the wealth-to-income ratio, increases. Since the upper tail of the wealth distribution obeys the Pareto law, this implies relentlessly increasing stratification under fairly normal conditions. In other words, in light of the demographic-actuarial logic, the only thing standing between patrimonial capitalism and us, is war and taxes.

But how can $r>g$ in perpetuity? This looks like an impossibility: If capital income grows at a faster rate than the economy, then the share of capital income in GDP, $a$, should rise until it is 100%, and then $r$ could not exceed $g$ anymore. I will show how this is a fallacy in the baseline model of economic growth. It is also true of generic models when we replace key exogenous variables in the Harrod-Domar-Solow-Cobb-Douglas model by their micro-theoretic, endogenously arrived at, equilibrium values. For instance, inter-temporal optimization in dynastic models yield the same results as the basic model. But I will not attempt to show that $r>g$ holds under very general conditions. Instead, I will show how this sheds light on global imbalances and the international economy.

In the baseline model, the output $Y_{t}$ given capital $K_{t}$ and effective labor $L_{t}$ is

$Y_{t}=K_{t}^aL_{t}^{1-a}$.

Assuming zero population growth, effective labor grows at the same rate as productivity, say $g$. Suppose that the savings rate is $s$, and the rate of return in global markets is $r$. Then, the Harrod-Domar-Solow-Cobb-Douglas model implies that in the steady-state,

$r\times s = a\times g$,

where $a$ is the capital share in national income, which is mathematically determined by the elasticity of substitution of capital and labor. (It is the exponent of capital if one assumes the Cobb-Douglas production function as we have.) Another immediate implication is that the capital-to-income ratio converges to the ratio of the savings rate and the growth rate of the economy. That is,

$\beta:=K/Y \longrightarrow s/g$,

which is why low growth regimes imply increasing stratification. Where is $r$ hiding? Well, $r$ must satisfy $r\times s =a\times g$. Under conditions of global capital mobility, it is $r$ is that given exogenously. At the global level,

$r= a\times g/s$,

in the steady-state. For commonly observed values of the parameters, the implied rate of return, $r$ is reasonable. For instance, for current global ballpark estimates, $a=32\%, g=3\%$, and $s=24\%$, which implies that $r=4\%$; a good ballpark for long-term interest rates. The only way for $r$ to fall below $g$ is if the share of capital in national income is less than the savings rate, i.e., $a. But this is almost never the case. The share of capital in national income hovers around a third, whereas the global savings rate stays close to a quarter. Also, if $r, agents’ inter-temporal optimization requires them to borrow as much money as possible; an implausible result. Under fairly normal conditions then, the rate of return exceeds the rate of growth of the economy.

So where did we go wrong in our apparent contradiction? We went wrong in assuming that $r>g$ implied an unbounded share of capital in income. This does not happen because the marginal return to capital falls as capital intensity rises. In the standard model, capital-to-output ratio stabilizes at $s/g$, and capital’s share in income, $a$, determines the rate of return of capital. (Capital’s share in income, $a$ is, in turn, determined by the elasticity of substitution between capital and labor). This implies that that the rate of return on capital may easily exceed the rate of growth of productivity, and hence the overall economy, even if capital’s share in national income is held constant!

——-

The thing to understand is this: The savings rates and growth rates of all countries are codetermined. We can take $a$ to be technologically determined outside the model. Also, under perfect capital mobility, the rate of return is the market-clearing price of capital that equates global savings and investment. Suppose that the capital share is constant across countries. Then the ratio of savings rate to growth rate must be equal across countries as well. Of course, the ratios may be different in the short run, but they will tend to their steady-state values over time. That is, savings-to-growth ratios are equal across national economies in equilibrium.

In the note on global imbalances, my claim was that the high-savings strategy of China, Japan, and Germany works through the capital account to suppress the US savings rate. One can use the straightforward model to understand that dynamic mathematically. In what follows, we will basically mine the steady-state equality $g/s=r/a$.

Consider a bipolar open international economy where both the poles are price-takers in the global capital market. Suppose that the capital share in every national economy is 30%. Let’s compare two scenarios.

For the reference scenario, suppose that the market clearing rate of return is 6%. Then the ratio of growth rate to the savings rate of every national economy must be 20%. (Which implies that all national economies must converge to the capital-income ratio of 500%). Let’s say in equilibrium we have one pole, say the United States, saving at the rate of 20% (and hence growing at 4%); and the other, say China, saving 30% (and thus growing at 6%).

For the second scenario suppose that China follows a high-savings strategy. By a combination of wage suppression and financial repression, it raises its savings rate to 50%. Let’s say this depresses the market-clearing global real interest rate to 4%. The ratio of growth rate to the savings rate of every national economy must now be 12.5%. So China grows at 6.25%. The United States has to lower its savings rate to say 16%. The US thus grows at 2%.

In light of the lowering of trend growth from 4% to 2% at the center, we may use the current account frame-of-reference and see the second, prevailing, scenario as one of secular stagnation. Equivalently, we may use the capital account frame-of-reference and see the second scenario as one of a global savings glut. This is basically what is going on in the world economy (see chart of American and Chinese savings rate below). Ben Bernanke has inaugurated his blog by arguing that global interest rates are low because of a global savings glut; pointing out that central banks cannot control long-term rates (see picture above of the yield curve courtesy of the Grey Lady). Summers responded by defending his secular stagnation thesis.

Guys, it’s the same thing. And it is the result of the high-savings strategies of US’ trade partners, especially China. Boosting demand in the United States, whether through fiscal or monetary means is not the answer. This is a US foreign economic policy issue. The right question to ask is this: How can the United States persuade China, Germany, and Japan to lower their savings rate? For unless these states pursue alternate strategies to secure their economic interests there is no hope for resolving global imbalances.

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