End of the Greenspan error

HOW THE MASTER OF THE UNIVERSE STRIPPED HIMSELF At least he was sincere about it and that is the only In saying he was "absolutely" wrong about how markets behave, Alan Greenspan has admitted his own ignorance There was a time when investors and members of Congress hung on Alan Greenspan's every nuanced word. Now and then some may have politely suggested that perhaps he should ease up on interest rates, but they would never have dared to think that his encyclopedic view of the economy was in any way flawed or mistaken. Yesterday Greenspan broke that bubble by admitting that he may have been wrong in an appearance before the House oversight and government reform committee: I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms," Mr. Greenspan said. The mistake was fundamental. "You found that your view of the world, your ideology was not right, it was not working?" said California congressman Henry A Waxman, the committee chairman. "Absolutely, precisely," Greenspan said. "You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well." To hear Alan Greenspan admit that his way of seeing the world was "absolutely, precisely" wrong is to mark the end of an era. There was a time when Greenspan conferred his blessing on the proliferation of derivatives. He opposed regulating derivatives because they spread the risk and made cheap credit more widely available. The trouble is that the prices of this cheap credit began to lose any connection to reality as derivatives proliferated. As mortgages - which themselves were based on a real estate bubble - were dismembered and repackaged, the resulting derivatives became detached from the value of the underlying assets. Collateralised Debt Obligations, or CDOs, were given triple-A credit ratings and traded by bankers who never saw the properties or looked at the credit profiles of the borrowers. The risk may have been spread, but the price of the risk was badly underestimated. Two weeks ago, Nell Minow of the Corporate Library proposed the Paul Volcker rule (named after the former Federal Reserve chairman) in an appearance before the same House committee: "If Paul Volcker can't understand it, it shouldn't be on the market." Greenspan admitted that he and some other really smart folks didn't understand the derivatives market they had allowed to flourish, despite the "best insights of mathematicians and finance experts," sophisticated computer modeling and at least one Nobel prize in economics: The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. We have seen it over and over again in the Age of Greenspan: hedge funds got their name by hedging risks, but derivatives can be used to double down on risk just as easily. New financial instruments were declared to be so diabolically clever that they couldn't possibly fail. Sophisticated equations allowed bankers and hedge fund managers to price risk to within an inch of their lives, or so they thought; they were actually living far beyond any rational capital requirements. When Long-Term Capital Management, which hired some of those Nobel laureates, failed 10 years ago, Greenspan had to orchestrate a rescue using investment bank funds. LTCM was wound up, but its techniques spread quickly through Wall Street. Investment banks, which before the Age of Greenspan made money by managing money for clients, began trading for their own account. Managers were rewarded for taking on ever larger and more exotic risks that bore little resemblance to the underlying economic reality. One doesn't need a Nobel prize to know what brought about the collapse of this intellectual edifice. Humorist Roy Blount summed it up in a talk before an audience in Philadelphia earlier this week: "Money got too abstract, and that's why it went away"

A NEW ARCHITECTURE WITHOUT THE MAJORITY

THE LEADERS SHOULD WEAR SACKCLOTH AND ASHES AND GO THERE WITH A HEAVY HEART.........Maynard Keynes before the first Bretton Woods

IT IS tempting to dismiss the upcoming G20 meeting as a piece of political theatre. Presidents and prime ministers from a score of rich and emerging economies will descend on Washington, DC, ostensibly to remake the rules of global finance. Several have talked grandly of a sequel to the 1944 Bretton Woods conference, which created the post-war system of fixed exchange rates and established the International Monetary Fund and World Bank. That is nonsense. The original Bretton Woods lasted three weeks and was preceded by more than two years of technical preparation. Today’s crisis may be the gravest since the Depression, but global finance will not be remade in a five-hour powwow hosted by a lame-duck president after less preparation than many corporate board meetings. Yet for three reasons it is still a meeting worth having.

The first is that this could mark the beginning of a better multilateral economic system. The G20, created after the emerging-market crises a decade ago, is not perfect for today’s problems. It excludes a big economy with an admired system of financial regulation (Spain) but includes a mid-sized country that has become irrelevant to global finance because of its own mismanagement (Argentina). Still, the G20 includes most of the key parts of the rich and emerging world, making it a better forum for global economic co-operation than the G7 group of rich countries, which has until now held the stage.

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Don’t just stand there

In the short term that co-operation, and this weekend’s meeting, should focus on the second good reason for the Washington summit: crisis management. Although the panic in the credit markets shows signs of abating, the economic news gets ever grimmer. Global demand is slumping as rich economies plunge into what, collectively, could be their deepest recession since the 1930s. Pernicious deflation, though still unlikely, is no longer an idle risk. Emerging economies are being hit hard by weakening exports and the collapse of private capital flows. The G20 summiteers cannot prevent this, but they can stave off a slump with zealous and co-ordinated action to prop up domestic demand and provide resources to cash-strapped emerging economies.

Some countries understand the urgency. China’s stimulus plan, even if it is a little less dramatic than first trumpeted, is an important step . Others, such as Germany, are being woefully timid. A collective commitment by those who can afford it will pack more punch than individual initiatives. Useful too, would be a pledge to cushion the slump in private capital flows to emerging economies, through both central-bank swap lines and the IMF. Countries with ample reserves, particularly China, Japan and the oil exporters, should promise now, and without preconditions, that they will lend to the IMF if it needs cash in the coming months. The G20 should also pledge its unequivocal support for free trade—a pledge that would gain credence if the leaders made a commitment to complete the Doha round of trade talks.

But what of the larger ambitions of “fixing” global finance? Here the temptation for hollow promises is greatest of all. The summiteers can make progress, but only if they temper their hyperbole with realism and humility.

International finance cannot just be “fixed”, because the system is a tug-of-war between the global capital markets and national sovereignty. As cross-border financial flows have expanded and big financial institutions have far outgrown their domestic markets, finance has become one of the most globalised parts of the world economy. At the same time, finance is inherently unstable, so the state has to play a big role in making it safer by lending in a crisis in return for regulation and oversight. Governments broadly welcome the benefits of global finance, yet they are not prepared to set up either a global financial regulator, which would interfere deep inside their markets, or a global lender of last resort. Instead, regulated financial firms are overseen by disparate national supervisors (in America they are sometimes state-based). The IMF helps cash-strapped countries, but the fund was conceived in an era when capital flows were restrained. It is puny relative to the size of global markets today.

This tug-of-war helped create today’s mess. Disparate rules led to loopholes and “regulatory arbitrage”. Many emerging economies sought to protect themselves against sudden outflows of foreign capital by building up vast foreign-exchange reserves. That fuelled the global credit bubble. Given today’s crisis, the incentives to amass reserves have only grown.

The contradictory desires for national sovereignty and global capital markets limit the room for an overhaul. For all the grand rhetoric, no politician is proposing to cede sovereignty to a global regulator, let alone create a true global lender of last resort. Nor is anyone proposing a wholesale effort to curb capital flows (which is just as well). With no great design on the drawing board, it is better to concentrate on the more modest goal of improving the current muddled contraption through a series of politically feasible enhancements that together could amount to a third justification for this meeting.

Refit the existing engine

One example is Gordon Brown’s idea of a “college of supervisors” to oversee the biggest financial firms. Another is a global set of norms on what should be regulated and how: from hedge funds to leverage limits, national regulators would do a better job if they acted in concert. By all means start to look at schemes to revamp the IMF by scaling back Europe’s presence and enhancing emerging economies’ clout. But it would be a mistake to rely only on the IMF. The Fed’s new swap lines with other central banks are an important reassurance for countries that face a liquidity squeeze; those swap lines deserve to be systematised and broadened.

Modest as they sound, such repairs will be difficult and time-consuming. This summit should get them off to a start. It won’t earn anyone a place in the history books alongside John Maynard Keynes and Harry Dexter White. But it would be a lot more useful than more gusts of grandiose rhetoric.

ANOTHER BRETTON WOODS

..... More winners this time?

AFRICA WILL NOT BE THERE BUT WE WILL BEAR THE BRUNT

This weekend President Bush will host an economic summit of the G-20 nations. This summit has been compared to the conference at Bretton Woods, NH that convened in 1944 to rebuild the global financial system after WWII. Unfortunately, the most important reform to come out of that conference so long ago does not appear to be on the agenda of this latest version.

The original Bretton Woods conference was convened primarily to structure the monetary system that would prevail after the war. The desire for a stable monetary system grew out of the experience of the 1930s competitive devaluations and high trade tariffs. Many at the time rightly came to associate these devaluations and high tariffs with war. Freer trade and a stable monetary system were associated with peace.

The result of the first Bretton Woods conference was a system that pegged the US dollar to gold with the other major currencies pegged to the dollar. This system, while having many flaws, was a source of economic stability for 26 years. Other periods of fixed exchange rates (primarily fixed to gold) also produced more stable economic systems than floating rate regimes. This stability can be observed in the low volatility of commodity prices during the fixed periods. During the period of the pure gold standard from 1880-1913 (when the Federal Reserve was established) the standard deviation of commodity prices was roughly 4.5. During the free float period from 1914-1926 the standard deviation at least doubled (there are differences depending on which commodity index is used). During the Bretton Woods era from 1945 to 1971 commodity price volatility was reduced again to a standard deviation of about 8. Since 1971 volatility has again risen to about 15.

If the goal is more stability in the economic system, this new conference must begin to address the exchange rate system. Reducing the volatility of exchange rates and therefore commodity prices is essential to reducing the risk associated with international trade. Billions of dollars have been lost over the last few months alone by companies attempting, unsuccessfully, to hedge exchange rate and commodity price risk. UAL reported a $544 million loss from fuel hedges gone wrong. Citic Pacific Ltd. Lost $1.9 billion from hedging activities related to the Australian dollar. Northwest Airlines took a $410 million write down from losses on fuel hedges. Verasun lost $100 million from hedging the price of corn and ultimately filed bankruptcy. Sadia, Brazil’s second largest food company posted a $410 million loss from currency hedging activities and had their credit rating downgraded. While some of these losses were due to actions outside company hedging policies, they wouldn’t have happened if the need to hedge were eliminated or reduced.

Expectations for the conference are being downplayed and the goals minimized with the strengthening of the IMF seemingly the only concrete expectation. Most of the participant countries seem more interested in regulatory reform and that is certainly necessary and desirable. Even during the stable periods previously mentioned, there were banking crises here in the US. Even in a stable monetary environment, fractional reserve banking has the potential to destabilize. Based on recent experience with leverage, one would think that increasing bank capital requirements is one item that could be agreed upon. Other ideas, such as closer supervision of hedge funds and credit rating agencies, may not be necessary if monetary reform and banking reform are properly addressed.

The global imbalances much discussed over the last few years are exactly what the IMF was designed to address. When the IMF was founded along with the World Bank, the first Bretton Woods conference placed them in the context of a stable monetary system. Reforming the IMF without reforming the monetary system will not yield a more stable system. We would have to depend on the IMF not only to anticipate problems but also to act on them in a politically charged environment. The performance of the IMF since the fall of the first Bretton Woods agreement suggests that is too much to ask.

Monetary reform will not be easy. China and most of the emerging Asian economies will fight hard to maintain a currency advantage that they see as vital to the growth of exports that have fueled their past growth. The US will be reluctant to agree to a system that weakens the role of the dollar as the world’s reserve currency. The Europeans will press for a greater role for the Euro in international trade. These three currency blocs will all have their own agendas but the current global economic slowdown may be the perfect opportunity to address the issue of monetary reform. Global economic cooperation is no longer optional; this crisis has affected every region of the world.

Over the last 60 years we have witnessed a movement toward freer trade, freer markets and freer movement of capital that has raised living standards around the world. That movement accelerated over the last 30 years and the reduction in world wide poverty during that period is nothing short of astounding. It is critical that we construct a global monetary system that provides a stable structure within which we can extend this record and realize the full benefits of the free market.

WHY NOT LET THEM FAIL

THE MORAL OF THE MIGHTY BAIL-OUT

As we goggle at the fluttering financial figures, a different set of numbers passes us by. On Friday, Pavan Sukhdev, the Deutsche Bank economist leading a European study on ecosystems, reported that we are losing natural capital worth between $2 trillion and $5 trillion every year, as a result of deforestation alone(1). The losses incurred so far by the financial sector amount to between $1 trillion and $1.5 trillion. Sukhdev arrived at his figure by estimating the value of the services - such as locking up carbon and providing freshwater - that forests perform, and calculating the cost of either replacing them or living without them. The credit crunch is petty when compared to the nature crunch.

The two crises have the same cause. In both cases, those who exploit the resource have demanded impossible rates of return and invoked debts that can never be repaid. In both cases we denied the likely consequences. I used to believe that collective denial was peculiar to climate change. Now I know that it’s the first response to every impending dislocation.

Gordon Brown, for example, was as much in denial about financial realities as any toxic debt trader. In June last year, during his Mansion House speech, he boasted that 40 per cent of the world’s foreign equities are now traded here. “I congratulate you Lord Mayor and the City of London on these remarkable achievements, an era that history will record as the beginning of a new golden age for the City of London.”(2) The financial sector’s success had come about, he said, partly because the government had taken “a risk-based regulatory approach”. In the same hall three years before, he pledged that “in budget after budget I want us to do even more to encourage the risk takers”(3). Can anyone, surveying this mess, now doubt the value of the precautionary principle?

Ecology and economy are both derived from the Greek word oikos - a house or dwelling. Our survival depends upon the rational management of this home: the space in which life can be sustained. The rules are the same in both cases. If you extract resources at a rate beyond the level of replenishment, your stock will collapse. That’s another noun which reminds us of the connection. The OED gives 69 definitions of stock. When it means a fund or store, the word evokes the trunk - or stock - of a tree, “from which the gains are an outgrowth”(4). Collapse occurs when you prune the tree so heavily that it dies. Ecology is the stock from which all wealth grows.

The two crises feed each other. As a result of Iceland’s financial collapse, it is now contemplating joining the European Union, which means surrendering its fishing grounds to the Common Fisheries Policy. Already the prime minister Geir Haarde has suggested that his countrymen concentrate on exploiting the ocean(5). The economic disaster will cause an ecological disaster.

Normally it’s the other way around. In his book Collapse, Jared Diamond shows how ecological crisis is often the prelude to social catatrosphe(6). The obvious example is Easter Island, where society disintegrated soon after the population reached its highest historical numbers, the last trees were cut down and the construction of stone monuments peaked. The island chiefs had competed to erect ever bigger statues. These required wood and rope (made from bark) for transport and extra food for the labourers. As the trees and soils on which the islanders depended disappeared, the population crashed and the survivors turned to cannibalism. (Let’s hope Iceland doesn’t go the same way.) Diamond wonders what the Easter islander who cut down the last palm tree might have thought. “Like modern loggers, did he shout ‘Jobs, not trees!’? Or: ‘Technology will solve our problems, never fear, we’ll find a substitute for wood.’? Or: ‘We don’t have proof that there aren’t palms somewhere else on Easter … your proposed ban on logging is premature and driven by fear-mongering’?”(7).

Ecological collapse, Diamond shows, is as likely to be the result of economic success as of economic failure. The Maya of Central America, for example, were among the most advanced and successful people of their time. But a combination of population growth, extravagant construction projects and poor land management wiped out between 90 and 99% of the population. The Mayan collapse was accelerated by “the competition among kings and nobles that led to a chronic emphasis on war and erecting monuments rather than on solving underlying problems”(8). Does any of this sound familiar?

Again, the largest monuments were erected just before the ecosystem crashed. Again, this extravagance was partly responsible for the collapse: trees were used for making plaster with which to decorate their temples. The plaster became thicker and thicker as the kings sought to outdo each other’s conspicuous consumption.

Here are some of the reasons why people fail to prevent ecological collapse. Their resources appear at first to be inexhaustible; a long-term trend of depletion is concealed by short-term fluctuations; small numbers of powerful people advance their interests by damaging those of everyone else; short-term profits trump long-term survival. The same, in all cases, can be said of the collapse of financial systems. Is this how human beings are destined to behave? If we cannot act until stocks - of either kind - start sliding towards oblivion, we’re knackered.

But one of the benefits of modernity is our ability to spot trends and predict results. If fish in a depleted ecosystem grow by 5% a year and the catch expands by 10% a year, the fishery will collapse. If the global economy keeps growing at 3% a year (or 1700% a century) it too will hit the wall.

I’m not going to suggest, as some scoundrel who shares a name with me did on these pages last year(9), that we should welcome a recession. But the financial crisis provides us with an opportunity to rethink this trajectory; an opportunity which is not available during periods of economic success. Governments restructuring their economies should read Herman Daly’s book Steady-State Economics(10).

As usual I haven’t left enough space to discuss this, so the details will have to wait for another column. Or you can read the summary published by the Sustainable Development Commission(11). But what Daly suggests is that nations which are already rich should replace growth (”more of the same stuff”) with development (”the same amount of better stuff”). A steady state economy has a constant stock of capital maintained by a rate of throughput no higher than the ecosystem can absorb. The use of resources is capped and the right to exploit them is auctioned. Poverty is addressed through the redistribution of wealth. The banks can lend only as much money as they possess.

Alternatively, we can persist in the magical thinking whose results have just come crashing home. The financial crisis shows what happens when we try to make the facts fit our desires. Now we must learn to live in the real world.

TAG AND CONTROL

How the Global System use the Tag of Least Developed Country (LDC)to control many countries. Every three years, the Committee for Development Policy (CDP) of the United Nations designates a group of least developed countries (LDCs), which today form a group of fifty states (see table 1). In theory, these countries are the poorest of the poor, “highly disadvantaged in their development process . . . and facing more than other countries the risk of failing to come out of poverty.”[1] As such, the United Nations Conference on Trade and Development (UNCTAD), the lead agency charged by the UN to work with the LDCs, has sought to secure various forms of special treatment for them, in particular preferential market access to developed countries. Unfortunately, this experiment has not been successful. The number of LDCs has more than doubled since the concept was first adopted in 1971, and many of the original designees have lower per-capita income today than thirty-five years ago. Only one of them--Botswana--has graduated from the list; another, Cape Verde, is scheduled for graduation in 2007. Part of the problem is that the criteria by which the UN designates LDCs are intellectually flawed despite repeated efforts to refine them (in 1999, 2000, and 2003). As a result, the LDC category obscures far more than it reveals about the needs of the countries it encompasses. In fact, the LDCs represent neither a well-defined group of the poorest countries in the world, nor do they include a majority of the world’s poorest people. Rather, the LDCs are an incredibly diverse group of states--varying in their history, geography, and problems--that are poorly suited to UN’s one-size-fits-all approach. That approach, furthermore, has been at best ineffective and at worst detrimental to the economic development of the LDCs. UNCTAD, in effect, has tried to make the LDCs into its wards, contributing to the specious belief that these countries are simply too poor to reform. As a result, the LDCs have been abetted and encouraged by UNCTAD in their failure to address the misguided policies--in particular, domestic overregulation, weak property rights, skewed trade regimes, and lack of democracy--that have stunted their growth. It is telling that the CDP recently attempted to designate Zimbabwe as an LDC, despite the fact that the country’s devastation is almost entirely the product of its government’s own policy choices, not external structural factors. It is time to acknowledge that the thirty-five-year experiment in designating LDCs has failed to advance their interests and should be discontinued. In fact, the only entity that is served by the LDC concept at this point is the UNCTAD bureaucracy itself, which uses the process as one of the reasons to justify and perpetuate its existence. Neither the World Bank nor the International Monetary Fund nor any of the regional development banks formally recognize the LDC category or treat the LDCs differently from other developing countries. The best approach for the LDCs would be to dispense with the pretense that they form an intellectually justifiable category, to put an end to the UN’s triennial review process and the six-year graduation process, and to begin to address these countries’ individual needs on a case-by-case basis. Because it may be politically infeasible to terminate the LDC concept or wrench these countries from the UN bureaucracy entirely, however, responsible governments should at least push for a radical reform in the way LDCs are treated. The Designation and Graduation of LDCs The United Nations applies three criteria, every three years, to designate LDCs: gross national income, the Human Assets Index, and the Economic Vulnerability Index.[2] To qualify as an LDC, a country must satisfy all three criteria. To qualify for graduation, a country must pass two of the three thresholds in two consecutive triennial reviews.[3] During the latest triennial review in March 2006, a country had to have an average per-capita income from 2002-2004 that was below $745 to qualify as an LDC and over $900 to graduate. Additionally, a country with at least twice the threshold LDC income of $745 in the 2002-2004 period could graduate, even if it did not pass the other two metrics. Because income level is just one criterion, however, there are many countries with per-capita incomes of less than $745 that nonetheless are not considered LDCs. India, for instance, with its average per-capita income of $543, is not on the list, even though it has a quarter of the world’s poor, while Equatorial Guinea, with a per-capita income of $3,393, has been included. To make matters worse, the methodologies that the United Nations uses to estimate a country’s per-capita income, human resource assets, and economic vulnerability are problematic.[4] As a result, the entire LDC edifice rests on a shaky quantitative foundation. To determine a country’s per-capita income, the UN uses per-capita gross national income (GNI) as calculated by the World Bank’s Atlas method.[5] This measure suffers from a number of limitations: it ignores the presence of non- tradable goods in national income, differences in domestic and foreign inflation rates with specific trading partners (other than G8 countries like France, Germany, Japan, Great Britain, and the United States), and changes in the value of the domestic currency in relation to the U.S. dollar. For many LDCs, additionally, there are no reliable data on factor incomes such as foreign remittances--a critical variable in developing countries, which often have large diasporas that send money home from abroad. In 2003, for instance, worker remittances in Nepal amounted to 14 percent of GDP and 23 percent in Haiti. In light of these problems, a better methodology for estimating per-capita income would be the purchasing power parity (PPP) method, which does not suffer from many of the Atlas method’s weaknesses enumerated above. Ethiopia, which had an average per-capita income of $100 for 2002-2004 according to the Atlas method, had an average per-capita income of $701 in PPP terms for the same period (see table 2). To determine a country’s level of human development, the UN uses the Human Assets Index (HAI), which in turn comprises four subindexes that are aggregated, with equal weight given to each subindex. They are: (a) average calorie intake as a percentage of minimum calorie requirements, (b) the mortality rate of children at five years and under five, (c) the gross school enrollment ratio, and (d) the adult literacy rate. There are several problems related to the HAI and its use. First, the equal weight it assigns to each of its four indicators makes it an artificial measure of human resources. In effect, it presumes that societies count a dollar spent on literacy as the equivalent of a dollar spent on health care, despite the fact that preferences for these assets vary among different societies depending on their unique circumstances and needs. Second, each of the subindexes is treated independently by the HAI, while in real life they are highly dependent on each other. For example, a high mortality rate for children is often associated with a low adult literacy rate for women. Third and finally, in most of the poorest countries, data on these metrics are weak, if not altogether absent; consequently, the use of the HAI creates a sense of precision where none actually exists. The final criterion for LDCs--economic vulnerability--is measured by the Economic Vulnerability Index (EVI), which is even more troublesome than the HAI. The EVI is computed by aggregating two broad indexes, the exposure index and the shock index, with each assigned an equal weight. The exposure index has four components: population size; remoteness; merchandise export concentration; and the share of agriculture, forestry, and fisheries in GDP. The shock index has three sub-categories: homelessness due to natural disasters, the instability of agriculture production, and the instability of exports of goods and services. Like the HAI, the EVI mistakenly treats several indicators that are closely correlated, both negatively and positively, as though they were independent of each other. For example, the degree of exposure of an economy determines the nature of shock to the economy. Thus, shocks and exposures are highly correlated; one index could be used for both. More broadly, however, there is a problem with the very notion of an index that purports to measure “economic vulnerability.” Many economic activities are intrinsically uncertain, and there is a limited extent to which effective public policy can reduce this: for instance, a predominantly agricultural economy is more exposed to shock, particularly if its irrigated area is small. Given these methodological flaws, the resulting list of LDCs has little internal coherence, with wide diversity in size, location, and endowments. Thirty-three LDCs are in sub-Saharan Africa, sixteen in Asia, and one in the Americas. Bangladesh is the largest in population, with 141 million, while Tuvalu is the smallest, with only 11,000 persons.[6] Sixteen are landlocked, twelve are remote islands, and twenty-two are littoral (see table 1). None of this is to deny that the LDCs have some features in common. But, as we shall see below, these similarities tend to be broadly shared among all developing countries, rather than uniquely among the LDCs. Certainly, they offer an insufficient basis for the one-size-fits-all approach that the UN has adopted toward these countries. Poor Excuses for Poor People When pressed about the analytic weaknesses in the LDC framework, defenders of the category often fall back on a broader argument about these countries’ exceptionalism. The claim, in brief, is that LDCs constitute a group of countries that are simply too poor to reform on their own. In particular, the countries’ past colonial history, isolation, ethnic fractionalization, and weak human resources are all cited as reasons for assistance over and above what other developing states might receive. Putting aside the fact that neither geography nor history is an explicit part of the matrix for designating LDCs, there are several flaws with this argument. With respect to history, it is true that former colonial status has been found to be an important determinant of future development. Former British colonies have typically enjoyed better property rights and legal systems, as well as greater political stability, while the former French colonies in sub-Saharan Africa have been characterized by greater political upheaval, authoritarian regimes, and corrupt governments. Some researchers have proposed a partial explanation for this in British common law, with its emphasis on precedent, adaptation, and bottom-up feedback, in contrast to French civil law, with its top-down, state-centric approach. Additionally, former colonies with a high degree of ethnic fractionalization tend to do worse today on a range of development outcomes, including literacy, infant mortality, corruption, and government service delivery. The problem, however, is that the colonial experience of the LDCs is not monolithic. Afghanistan, Ethiopia (except for a five-year period under Italy), and Bhutan, for instance, were never formally colonized by a foreign power. Some countries, such as Chad, Haiti, and Senegal, were French possessions; while others, including Zambia and Sudan, fell under the British sphere of influence. The Democratic Republic of Congo was Belgian, and Eritrea was briefly controlled by Italians. There is no clear pattern of colonial history that can be said to define the LDCs, any more than for the rest of the developing world. The same is true when it comes to ethnic fractionalization. Many of the LDCs, for instance, have Balkanized populations--Sudan, Congo, and Rwanda being three of the most obvious examples. But then, so do many other states that are not LDCs, such as India and Nigeria. Other LDCs, meanwhile, such as Cambodia, Tuvalu, and Vanuatu, are near-homogenous. Once again, it is difficult to see a constant at work here. As for geography, advocates of the LDCs typically point to several variables to justify their special status. LDCs, for instance, are predominantly in the tropics, increasing the incidence of disease and constraining economic growth. But several of the best performers among the developing countries are also located in the tropics, such as Singapore, Taiwan, and (as of late) India. Clearly, a tropical climate need not condemn a country to poor development. The same can be said of being landlocked, as sixteen of the fifty LDCs are. Although transportation costs for these countries may be higher compared to states with direct access to the sea, Botswana--one of the best performing countries in sub-Saharan Africa and the only LDC to graduate from the list--is landlocked. Another twelve of the LDCs are small islands, many in remote locations. Although these countries must confront high transportation costs and the inability to achieve economies of scale in the production of non-tradable goods, it is not clear that either factor is a real constraint. Singapore, Hong Kong, and several Caribbean islands--such as Trinidad and Tobago, Jamaica, St. Lucia, and Barbados--are small, yet they have developed rapidly. Similarly, countries in remote locations such as New Zealand, Fiji, and Tahiti have enjoyed high levels of income by turning their remoteness to their advantage and adopting sound economic policies to overcome the disadvantages of high transport costs. Rewarding Failure If neither history nor geography has prevented LDCs from joining the developed world, what factors are to blame? Unsurprisingly, LDCs suffer from many of the same problems that have inhibited growth across the developing world, including poor governance and bad economic policies. Consider, for instance, governance in the LDCs, which is characterized overwhelmingly by the absence of democracy (see table 3). Freedom House’s annual comparative survey, which ranks countries according to the political rights and civil liberties their citizens enjoy, finds that LDCs received median scores of 4.5 and 4.4 respectively from 1995 to 2005 (with 1 being the most free, and 7 the least).[7] By contrast, the world averages for advanced countries during this period were 1.2 and 1.5, and 3.6 and 3.7 for developing countries. It is no accident that the only LDC ever to graduate prior to 2006, Botswana, is also one of Africa’s few stable democracies. The restrictive nature of the economic policy regimes in LDCs is another important reason why they remain poor. Individual businesses are highly constrained by the absence of clear property rights and government over-regulation, which together inhibit private investment and overall economic efficiency. Instead of encouraging LDCs to overhaul their economic policies and embrace greater political freedom, however, the UNCTAD has downplayed these issues. Specifically, LDCs have been given differential treatment in international trade--a practice whose origins can be traced back to 1968, when UNCTAD recommended the creation of a Generalized System of Tariff Preferences (GSP) under which developed countries would grant preferential access to developing country exports. In 1979, the General Agreement on Tariffs and Trade (GATT)--the predecessor of the World Trade Organization--made GSP a permanent provision allowing preferential market access for developing countries, limited reciprocity in multilateral trade negotiations, and the use of trade policies as an instrument of development policy, implicitly accepting that multilateral free trade was not fully consistent with economic development.[8] Since then, UNCTAD has been the main advocate and sponsor of special and differential treatment for developing countries in general, and LDCs in particular. Because trade preferences under GSP were extended to all developing countries, it did not initially prove of any special value to LDCs. Later, however, some developed countries granted special access to LDCs at the behest of UNCTAD. Thus the QUAD group of countries (Canada, Japan, the European Union, and the United States) have extended duty-free and quota-free access to LDCs under different programs. The EU has also introduced a measure for LDCs, plus another twenty-seven countries, under its Economic Partnership Agreements. The net effect of UNCTAD’s advocacy is that LDCs have been encouraged to seek trade preferences rather than to pursue the internal policy reforms that they desperately need. The trade preferences that LDCs have been awarded, furthermore, are ineffective at best--a mere band-aid for the problems these countries face, with no benefits in the long run.[9] Trade preferences are problematic for several reasons. First, they operate on the demand side through market access, while the main problems in LDCs are on the supply side, related to such issues as weak policy and institutional environments and inadequate infrastructure. Second, preferences can only help countries with effective supply facilities and supply chains. Most LDCs, alas, lack the supply facilities needed to increase export volumes and take advantage of preferences. Third, preferences are a value-declining asset. As other exporters gain easier access with lower protection, as is likely to happen with international trade negotiations such as the Doha Development Agenda or with bilateral trade agreements with competing exporters, the value of access declines. Thus, trade preferences only provide a short-term respite over competitors, which could have a comparative advantage in the particular product but are disadvantaged in U.S. and EU markets due to high protection. Fourth, the largest part of the revenues from trade preferences (the difference between the domestic market price in the preference-giving developed country and the duty-free price for the export from the LDCs) is captured by developed country importers rather than LDC exporters.[10] Meanwhile, given domestic supply problems, the pass-through of the revenues from LDC exports to farmers and labor is restricted by weaknesses in trade facilitation, institutional arrangements, and the nature of the policy regimes in which competition within the LDCs is limited. There is even evidence to suggest that trade preferences can inflict harm. Many studies have shown that preferences delay and discourage domestic policy reforms such as the reduction of internal barriers that act as a tax against exports.[11] Moreover, valuable political capital is wasted when LDCs direct their national efforts to preserving preferences, rather than working to address supply-side issues such as poor infrastructure. Preferences can also be harmful by providing a temporary incentive for LDCs to produce goods in which they have no long-term comparative advantage. A New Approach Given the diversity of LDCs with respect to their endowments, history, geography, and infrastructure, it simply does not make sense to treat them all alike. Add to that the UN’s poor stewardship of them over the past thirty-five years, and there is a powerful case to be made in favor of abolishing the LDC designation altogether and instead dealing with these countries on the basis of their individual needs. Of course, such a draconian measure--no matter how intellectually justifiable--would no doubt prove unpalatable in many quarters. Therefore, it is perhaps more productive to consider how LDC methodologies might be reformed and improved. A good place to start would be to simplify the present muddled criteria, replacing them with a simple cap of $1,500 per-capita income, using the PPP method, as the sole criterion. This would reduce the current group of fifty countries by half (see table 2).[12] Rather than treating these newly designated LDCs as an undifferentiated mass, furthermore, developed country governments might put a new emphasis on evaluating their individual needs. Small countries subject to natural disasters, such as the South Pacific islands, for example, would receive a different set of prescriptions than large countries in sub-Saharan Africa that suffer from human resource problems, like HIV/AIDS. There should also be a newfound focus on policy reforms--especially those that liberalize LDC economies in trade, regulation, and their domestic financial sector. Once again, however, the precise approach would differ according to an individual country’s circumstances. There also needs to be greater attention in LDCs to the consistent relationship between economic development and democracy.[13] Most of the LDCs, particularly in sub-Saharan Africa, have been marked by authoritarianism, with devastating consequences for property rights, ethnic harmony, and internal stability. Without movement toward greater political freedom, LDCs are condemned to remain poor. The overarching point here, however, is that the problems faced by LDCs are overwhelmingly inside their own borders, not at the borders of the countries that are importing goods from them. Nonetheless, by virtue of being grouped into an artificial category, they have been encouraged to seek ineffective trade preferences, rather than to adopt the internal political and economic reforms they so badly need. Instead of perpetuating this flawed arrangement, it is time to reconsider the LDC concept--and put an end to the tyranny of a definition.