Collateralization Of Assets, Over-Extension Of Credit, And Free Trade

2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1

Collateralization of Assets, Over-Extension of Credit, and Free Trade: An

Empirical Analysis in Search of Justice and an Expanding Middle Class

John Charalambakis; David Coulliette, Ken Rietz

Asbury College

Introduction

In Plato’s

Republic we find Socrates asking the fundamental question that has been with us for centuries, “What is justice?” It seems that for Plato, as well as for Aristotle who followed him, justice is the essential virtue of a society. Socrates taught his disciples that justice is giving and getting one’s due. Plato describes that justice must be counted as desirable for its own sake (Plato, trans. Grube, 1982.) Justice, in other words, is harmony in the soul and harmony in the state. Furthermore, Plato tells us that responsibility should be delegated in accordance to one’s ability and place.

We believe that the latter could become the foundation for viewing international trade as an instrument of justice, because what is produced, where it is produced, and by whom is produced, depends upon the ability to produce in an efficient manner. In such a case, everyone can gain from the transaction, a concept that was taken to the next step by

Aristotle.

In this framework of thought, justice is viewed as fairness, power is restrained, the disadvantaged are empowered, and the interests of the society as a whole are being advanced. If that is the case then, sectors in the economy would work together in harmony (nowadays that would apply to the production and financial sectors), while convergence would be observed across nations.

This paper discusses first international trade as a venue and instrument of justice from a theoretical perspective, then adds a theological dimension to the theoretical framework where justice issues are viewed from a wholistic perspective and where international trade is viewed as the main venue of capital formation, which in association with social, physical, and financial infrastructures creates and sustains a middle class, without which democracy cannot function (Zakaria, 2003). Finally, the paper tests the above hypothesis by employing a vast number of factors and data from forty-four countries (categorized as

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St. Hugh’s College, Oxford University, Oxford, UK

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 frontier, emerging, and developed) and by using the support vector machine (SVM) algorithm.

The empirical results verify the hypothesis that trade is a source of creating a middle class, and thus serves as a venue of distributive and commutative justice. The paper concludes with a thesis (which still needs to be tested) that when the financial interests of collateralization and securitazation, are separated from production interests at a global level, then Pandora’s box is being opened, financial crises take place, and the reverse route starts i.e. the destruction of the middle class and injustice prevails.

From Plato to Rawls and Nozick

In the Republic , Socrates refuses and rejects the argument of Thrasymachus who argued that justice always serves the interests of the rulers of the society, the interests of the stronger in our midst. Moreover, Socrates rejects Glaucon’s argument which suggested a more modest approach, that justice is ultimately a matter of self interest and that people observe justice to avoid punishment. Both of these negative views about justice were rejected by Socrates who insisted that justice is the ultimate responsibility of the person, and should be delegated according to ability and place. Justice cannot be viewed as punishment, retribution or revenge. In ancient times, in Platonic terms, justice is a matter of social harmony and in Christian ethics, it is a matter of mercy. In economic terms we can talk about just wages, just distribution of rewards and of income. Issues of justice come at the forefront when there are exchanges. In his famous 1971 book, The Theory of

Justice, John Rawls takes the liberal approach to find the proper balance between liberty and equality, with a particular concern for the least advantaged. A few years later his colleague, Robert Nozick takes a more libertarian approach to justice defending a strong notion of entitlement where everyone gets what he or she is entitled to, based on endowments, without any reference to needs or inequalities.

We have the impression that any reference to justice by neglecting the concept of community (ecclesia in theological terms) would have horrified Plato, Socrates, Aristotle and their followers. Cicero long argued that the leading virtue in a society is justice and that the definitive ingredient of justice is merit. Therefore, meritocracy in society is a

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 necessary condition for justice to be administered. Meritocracy at the same time requires the observance of the rule of law, because the rule of law distributes rights and a just law advances fairness. (In the theoretical framework below, this will be titled the legal infrastructure.)

If production responsibilities are designated according to merit and ability (Plato and

Cicero) then, the responsibility of justice is to enable the individuals across nations to produce according to their natural and enhanced capabilities and endowments. If we take the concept of justice a step further, we would probably understand that justice is inseparable from righteousness (in the form of dikaiosyni as proclaimed in the New

Testament), at least in the Platonic and Aristotelian paradigms. In that sense, Plato’s central claim of righteousness is “performing the functions for which one’s nature is best fitted.” It is also interesting to note that both Plato and Aristotle defend non-egalitarian views of justice.

In The Ethics , Aristotle gives us a complex concept of justice. He divides justice in two broad categories as the lawful (he does not necessarily mean obedience to the laws of any particular state) and the concept of fair and equal. It is the latter that is advanced in

Aristotelian ethics (Aristotle, transl. Irwin, 1985.) The literal meaning of the word justice in Aristotelian ethics is the meaning of righteousness, which is the form of justice that represents complete virtue of the soul which cannot be understood unless it is comprehended within the framework of community, i.e.

, in relationships. There is no doubt then, that this Aristotelian understanding of justice fits well into the ecclesiastical paradigm of koinonia. Aristotle divides this kind of justice into distributive and rectificatory. For Aristotle, the student of Plato, justice should be viewed as fairness.

Distributive justice for Aristotle is primarily concerned with what people deserve. We also need to keep in mind that Aristotle is particularly concerned with the justice of transactions. When Aristotle talks about justice in transactions, he refers to commutative justice in voluntary exchanges such as buying, selling and lending, or involuntary matters where we have victims of insults, thefts or assassinations. When Aristotle talks about equality and justice he refers to proportional, or what he calls geometrical proportion in

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 distributive justice. Through the centuries since then, we understand that in Aristotelian ethics we need to treat equals equally, while unequals deserve unequal treatment in proportion to their merit, in proportion to their abilities, and in proportion to their enhanced capabilities.

Therefore, according to Vlastos (Vlastos, 1962) – a leading scholar for Plato and

Aristotle – a distribution to be just is almost always an unequal one. Vlastos writes, “the meritarian view of justice paid reluctant homage to the equalitarian one by using the vocabulary of equality to assert the justice of inequality.”

We believe that central to Aristotle’s overall argument is the concept of justice as a state of attitudes, habits, customs and cultivated policies that advance and enhance the capabilities of persons, groups and nations. The enhancement of that capability leads to the development of character and to the development of a nation. When individuals are deprived from their potential, their nations cannot prosper. This kind of justice according to Aristotle is complete virtue, not complete virtue unconditionally, but complete virtue in relation to another (koinonia). Aristotle writes, “Moreover justice is complete virtue to the highest degree because it is the complete exercise of complete virtue and it is the complete exercise because the person who has justice is able to exercise virtue in relation to another not only in what concerns himself for many are able to exercise virtue in their own concerns but unable in what relates to another… and for the same reason justice is the only virtue that seems to be another person’s good because it is related to another for it does what benefits another, either the ruler or the fellow member of the community… and the best person is not the one who exercises virtue only toward himself but the one who also exercises it in relation to another since this is a difficult task… for virtue is the same as justice, but what it is to be virtue is not the same as what it is to be justice.”

A few sections later, Aristotle would argue, “what is just then is what is proportionate and what is unjust is what is counter proportionate, hence in an unjust action one term becomes more and the other less and this is indeed how it turns out in practice since the one doing injustice has more of the good and the victim less.” This proportionality in

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 distributive justice is in accordance with merit, ability, and - in economic terms - efficiency. Therefore, in Aristotelian ethics justice in order to be just has to have unequal proportions.

It should not be a surprise that Christian teachings from the first few centuries

(Chrysostom, Basil, Gregory of Nyssa among others) as well as from the Middle Ages to the Wesleyan renewal movements emphasized the uplifting of the poor as a natural outcome of Christian conversion. The lack of social uplifting and social holiness portrays betrayal of the Christian–kingdom principles. St. Thomas Aquinas synthesized the

Christianity of the Church with Aristotelian ethics and came up with some articles relating to justice that can be summarized as follows (Solomon and Murphy, 1990):

First, justice is a habit whereby a man renders to each one his due by a constant and perpetual will. Second, justice is always towards another, and third, justice is a virtue and actually it’s the chief of all the moral virtues.

Aquinas concludes his thesis on justice by echoing St. Augustine and Cicero by suggesting that charity, generosity and liberality is an essential part of justice, especially to the ones who are the least among us.

Other Philosophical and Historical Dimensions

Now, if we go further back and examine the ancient Chinese and far Eastern philosophies, we will discover that there are two concepts that summarize the moral elements of the mind and of the soul. Those two elements are the concept of li and ren.

The idea of li, is what is known in Confucian thought as the rules of conduct. The second concept is the idea of ren or what we would call today agape, the benevolent love toward others exhibited by rulers as well as the average person. In the far eastern thought when the soul loses its sense of justice it loses its moral compass and as Confucius said it’s like a mountain that has lost its trees (Mencius, 1970.)

In the midst of the seventeenth century Thomas Hobbes in his classic work (Hobbes,

1926), The Leviathan, describes the state of nature and a state of affairs as one

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 underlined by fear and insecurity. It’s a state of affairs where there is no right or wrong, no right to property, no mine or thine, no law and justice or injustice, only force and fraud. It is in this state of affairs and in this climate of uncertainty where all members in the society feel the need for a mutual social compass, a social contract that becomes a matter of rational necessity. The need for this kind of social compass forms the basis of

Hobbes’ argument that people have a basic ability to do damage to one another and in the absence of any sense of duty towards one another, in the absence of any power over the people, people become competitive, insecure, and mutually defensive. From a trade perspective Hobbes views international exchanges as a zero sum game where life on earth and exchanges are nothing but unhappy transactions of a life where there is no justice. Obviously Hobbes portrays a horrifying picture of relationships.

On the other hand, John Locke’s thesis gives us a more optimistic picture of how a social contract implements the natural law more fully and formally (Locke, 1983.) The primary purpose, according to John Locke, of this kind of social contract is to unify individuals into mutual transactions for the benefit of the community and it is a looser association and affiliation of individuals - who have freely chosen this kind of arrangement - than

Hobbes would have allowed.

Following John Locke in the midst of the eighteenth century, Jean-Jacuqes Rousseau contemplates a society where individuals, in contrast to the vision Hobbes has, will wander the face of the earth picking up food, sleeping comfortably and getting what they need from the naturally abundance around them. So they are happy creatures who are not compelled to enter into a social contract because of their meager provisions. However,

Rousseau believes that the foundational institution that perpetuates inequalities is the invention is private property, and that all inequalities have resulted from that. For him our competitiveness and unhappiness arises from the institution of private property and from the struggle between those in power and those without power. However, Rousseau wants to look to the future and to the foundations of better society and therefore he offers his own version of the social contract not as an instrument and a vehicle for controlling each other or protecting ourselves or our property, but as a way of giving the law to ourselves, and therefore elevating people to become citizens in a community of mutual

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 respect and mutual advancement. From a libertarian standpoint Friedrich Hayek (Hayek,

1976) and Robert Nozick (Nozick, 1974) would have emphasized the idea of commutative justice whose purpose would be to enforce contracts, to advance the liberty of persons, the protection of property, and the advancement of individualism in a society that doesn’t have a common scale of values because there is no wide agreement on values, therefore in such a society justice in those terms does not reward merit in some moral sense.

However, we believe that we need to move beyond commutative justice and even beyond distributive justice as envisioned by John Rawls in his veil of ignorance (Rawls, 1971.) If justice relates to relationships with others, and if a person does not live only by bread, then justice as fairness, where equals and treated equally and unequals are treated unequally, should become a venue and an instrument to advance society to a better place and could also become an instrument of empowerment for the person himself.

Free Trade vs. the Philistines at the Gate

The pursuit of aesthetic, cultural and intellectual goals is part of the process of rediscovering the image of God in our lives. However, it presupposes that people are fed, clothed and have achieved the necessities of life. If we echo Mathew Arnold’s call to be careful of the Philistines in our society - whose goal is to convert means to ends and social beings into material amoral existences – then, we have to identify the venues and the instruments where people are freed from the fear of lacking the necessities of life

(Honan, 1983.)

The pursuit of higher ideals as well as intellectual achievements could only take place when the fear of starvation and the fear of lacking the necessities of life disappear. For the latter to take place - which might be equivalent to the disappearance of the philistinism mentality - in our culture, we have to reach a point of creating a middle class that is sustainable. Justice in such a society, where middle class can be created and be sustained, is not achieved overnight, but over time, and its achievement is determined by institutional arrangements.

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This is exactly where free trade fits. Even if it is not the purpose of the paper to exemplify the advantages of free trade it would be proper to review that according to both theoretical and empirical evidence, free trade could become an instrument of convergence, of uplifting the poor from their misery, of restraining monopoly and oligopolistic powers, of advancing opportunities to the least in the society, of offering new horizons for the disadvantaged, and certainly of bringing better understanding and dialogue among rivals. However, any instrument that is not being taken care of, loses its appeal, especially when it neglects those who are left behind. Free trade has the potential of becoming an instrument of justice, and therefore of social equality where equals are treated equally. However like any double-faced sword, when it neglects the disadvantaged and allows inequalities to get out of hand (especially when the latter are coupled with over-extension of credit via over-collateralization means), then social and political instabilities feed the capital formation process, and ultimately lead to economic stagnation.

Speaking of the intellectual and moral consequences and benefits of international trade, we would do great injustice if we fail to look at the writings of Charles Montesquieu

(Montesquieu, 1989), especially book twenty of his The Spirit of Laws where he clearly declares that, “commerce is a cure for the most destructive prejudices.” Later in the same book Montesquieu will declare “peace is the natural effect of trade. Two nations who traffic with each other become reciprocally dependent for, if one has an interest in buying, the other has an interest in selling and thus their union is founded on their mutual necessities.” Furthermore, Montesquieu will declare and articulate that trade among nations produces a sense of justice among them, as the latter has been understood by

Aristotle. We believe that when people exchange goods or services they start understanding each other better, there is a dialogue that is being established, and therefore uncivilized notions are being eliminated through communication. Moreover, they discover that there are mutual benefits and advancements of efficiencies in their economies and organizations, and through this mutual advancement peaceful resolutions could heal particular disputes, while creating an environment of better understanding among peoples and nations.

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It was easily understood even before the time of Adam Smith - and according to

Montesquieu’s arguments - that international exchanges will bring specialization and that specialization will lead, as Montesquieu explains, from small to grand enterprises which implies greater productivity and efficiency, and an ability to produce at a lower cost. The latter will lead to lower prices, especially for the poor who previously could not get particular goods or services. The standards of living then increase because of greater efficiencies, lower costs, and the ability that is given to poor persons to not only purchase goods but also to be actively involved in the production of goods.

From that perspective international exchanges and international trade becomes and instrument of enhancing the capabilities of persons and especially of the least advantaged. Montesquieu continues and shows through historical examples, how harbor cities and nearby communities to the port thrived by immigrants who came to those cities to find jobs. The poor found good fortune where international exchanges were taking place, whether it was at Tyre, Venice or the cities of Holland. The ability of the port cities to attract immigrants signifies the concept of mobility, because we all know that without mobility there cannot be social progress.

However, if we read carefully Montesquieu’s arguments we will clearly see the underpinning theory which advocates that capital formation is the essence of establishing the framework of prosperity for the average person. Capital formation then, could become the alpha and omega of having a peaceful society that cares for the least advantaged, for the sustainment of a middle class, and for higher values and ideals.

Montesquieu writes, “when the Dutch were almost the only nation that carried on the trade from the South to the North of Europe, the French wines which they imported to the

North were in some measure only a capital or stock for conducting their commerce in that part of the world.” Capital formation and the ability to generate stock of capital is the essence of economic activity and commerce in a society that generates jobs, incomes and the ability to consume the necessities of life. Montesquieu will continue by saying that even a losing trade will be beneficial for the society due to the kind of jobs that will be created and the social environment that will be advanced. He writes, “Further it may

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 happen so that, not only a commerce which brings in something is useful, but even a losing trade shall be beneficial.”

The Theoretical Framework

We are very fortunate to have the latest work published by William Bernstein entitled, A

Splendid Exchange, How trade shaped the world , (Bernstein, 2008), who in a fascinating and elaborate way reminds us that from Mesopotamia in 3000 B.C. to the globalization debates in the Seattle battles, trade is the foundation of capital foundation. Bernstein in his study reminds us how the early traders floated ivory, copper and barley through the

Tigris and Euphrates and he reminds us how the Greeks fought wars in order to advance the concept of trade. He also tells us the story of the Chinese and how they carried silk from China to Rome, and how the Portuguese traded spices in the sixteenth century.

When he reviews for his readers how the British came to Jamaica and how American trade policies in the late nineteenth and early part of the twentieth century became the key elements of economic growth, then we could concur with him and Montesquieu that trade is the foundational cornerstone of capital formation.

To that of course, we should add that it was the ability that the U.S. extended to

Europeans to reconstruct themselves and buy American products, that helped not only the

American producers but also the local communities in Europe for their reconstruction efforts, for employment, for income, for capital formation, and for growth. So unless there is international trade, unless there is the liberty to move things, to buy imported goods, to move capital, to move technology, to move people across nations and communities, unless there is freedom to move financial capital across oceans, there could not be a case of capital formation. The latter is the seed that is necessary for any kind of infrastructure to be produced whether that infrastructure is in the social sector (hospitals or schools), in a physical form (highways, roads, bridges and water systems), or in the financial field (banks, exchanges, brokerages). The buildup of these kind of infrastructures will create jobs and by creating jobs there will be savings and that savings will become the seed for loans and for credit extension which is necessary for business formation. Now, all the above could be represented in the following diagram.

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The spirit of the Philistines could only be defeated in a society which is able to explore, which is open to new ideas, open to other cultures, which is open to other forms of capital formation, which in turn lead to a better and more prosperous society. In such a society free trade is advanced for the sake of justice. Therefore, free trade is not an end in itself, it is a means to a higher end and that higher end is to treat equals equally.

The defeat of the Philistinian spirit is part of the process of growth, and it is a stimulated intellectual process which presupposes the understanding that the benefits which come from international trade may not be possible to be quantified in terms of econometric models and in terms of successes, but it certainly brings stability in a society, peace among nations, and certainly justice in commercial transactions, because as Montesquieu would remind us competition is the instrument by which a just value is achieved when exchanges take place. Furthermore, he explains that nations will eventually be enslaved into poverty and misery unless they undertake international transactions and exchanges. I believe the following table, taken from Bernstein’s book would demonstrate that exact point.

Per Capita GDP in Nations Open and Closed to World Trade

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Always Open

Nation

2006 Always Closed

Per Capita GDP Nation

2006

Per Capita GDP

Barbados

Cyprus

Hong Kong

Mauritius

$17,610

$21,177

$33,479

$12,895

Algeria

Angola

Bangladesh

Burkina Faso

$7,189

$2,813

$2,011

$1,285

Singapore

Thailand

Yemen

$28,368

$8,368

$751

Burundi $700

Central African Rep. $1,128

Chad $1,519

China

Congo

Cote d’Ivoire

$2,001

$1,369

$1,600

Dominican Republic $7,627

Egypt $4,317

Ethiopia

Gabon

Haiti

Iran

Iraq

Madagascar

Malawi

Mauritania

Mozambique

$823

$7,055

$1,791

$7,980

$2,900

$900

$596

$2,535

$1,379

Myanmar

Niger

Nigeria

Pakistan

$1,693

$872

$1,188

$2,653

Papua New Guinea $2,418

Rwanda $1,380

Senegal

Sierra Leone

Somalia

Syria

Tanzania

Togo

Zaire

Zimbabwe

$1,759

$903

$600

$3,847

$723

$1,675

$774

$2,607

When we contemplate on this last thought, two hundred and fifty years after those words were drafted, we will wonder what has been happening to the distribution of income across nations, what has been happening to inequality and poverty or the concept of convergence among nations.

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Just a couple of years ago, Xavier Sala-i-Martin (Sala-i-Martin, 2006) published a well- documented survey of the world distribution of income, and he concluded that we have been experiencing falling poverty and convergence around the globe, primarily in continents and nations that were characterized prior to the 1970s by extreme poverty and divergence. His chief examples are the nations of China and India along with the whole region of Southeast Asia. It would have been great if the survey had discussed the role that free trade has played in uplifting those countries and those continents out of poverty.

However, before we explore in greater detail Sala-i-Martin’s arguments regarding the reduction of poverty and convergence of global income, as well as discuss this paper’s findings regarding the role that international trade plays in the formulation of capital, the forming of infrastructures, and the establishment of the middle class, we would like us to review briefly what the classic arguments of John Stuart Mill (Mill, 1910) were in the midst of the nineteenth century when he was writing on international trade.

We would like to emphasize that in his writings, while he articulates well the advantages of free trade in terms of lower prices, higher incomes, great efficiencies, reduction of costs, allocation of resources, inviting new investments and in terms of higher productivity, he makes a very good point when he says that international trade and foreign transactions become the cornerstone of surplus capital that can be used to produce other things. Therefore, it is the savings in capital which advances efficiency, prohibits misallocation of resources, and assists nations in the production of goods or in the consumption of imports, all of which lead to higher standards of living, higher levels of disposable income, and thus greater propensity for capital accumulation. However, all these benefits from free trade are not as important according to John Stuart Mill as the intellectual and moral advantages that free trade carries with it. Mill writes:

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Empirical studies throughout the world have documented that free trade of goods, capital, and technology not only reduce prices and enhance incomes, but also act as the conduit for transferring the technologies that enhance productivity, increase competition and therefore, stimulate industries to become more efficient. Moreover, the push for efficiency forces unproductive businesses to reform or go out of business. Competition stimulates efficiency, and over the years study-after-study has documented this phenomenon. Therefore, when we look at studies by Keller (Keller, Wolfgang, and

Yerple, 2003), Hay (Hay 2001), Edwards (Edwards, 1998), Crafts, (Crafts, 2000),

Harrison and Hanson (Harrison and Hanson, 1999), and Sachs and Warner (Sachs and

Warner, 1995), we can see that overall economic growth as well as productivity growth can double and sometimes triple when industries become less sheltered from foreign competition. Mexico is a classic case because it can be demonstrated that after its trade liberalization in 1985 its productivity increased dramatically. The same happened in

India as well as in South Korea. These productivity gains, which we clearly understand to be economic gains, take place due to the new allocation of resources within industries as well as across industries. Empirical studies have also shown that trade liberalization

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 over the past few decades in Spain, Chile and New Zealand have contributed to rapid growth in productivity as well as greater growth in their economy. While there might be a dispute as to whether trade is directly responsible for greater growth - studies actually diverge in their conclusions, see Franklen and Romer, 1999 or Rodriguez and Rodrik,

2001 - we do have however, a consensus which says that trade may not be directly correlated with growth, however it stimulates growth indirectly through investments, i.e. we have sufficient evidence of indirect relationship where growth increases in countries via the mechanism of international investments, which in our paradigm is the cornerstone of capital formation.

Therefore, the idea that the free movement of capital goods or of intermediate goods, is the cornerstone that promotes investments which in turn supports growth could be supported by empirical evidence and could be clearly seen in the three graphs that follow, and which have been adapted from Douglas Irwin’s book, Free Trade Under Fire , (Irwin,

2002.) In the next three graphs we can clearly see starting with the case of South Korea that the trade reforms that were initiated in 1964-65 have contributed to significant increases in GDP per capita. In the second graph we can see a similar trend in a totally different continent. Chile adopted trade reforms, both qualitative and quantitative restrictions were lifted in 1974-75, and again we see a significant and dramatic increase in the GDP per capita after trade liberalization took place. Again, I would like to emphasize that this became the cornerstone of capital formation. A more recent case which is related to the famous BRICs (Brazil, Russia, India, and China) has to do with the trade reforms that took place in India in 1991. Tariffs were reduced from an average of 85% to an average of 25%, and the complex system of import controls was eliminated, the Rupee was devalued and was also made convertible. It is interesting to observe the significant increase in GDP per capita that India has experienced to the point that several analyst has said that India lost several decades after its independence in 1947 because the trade restriction suppressed economic liberty for almost 40 years and destroyed growth for at least two generations. The truth of the matter is that India since 1991 has been formulating social capital, physical capital and infrastructure, and the proofs of financial infrastructure become more evident year-after-year, as millions of Indians have start taking part in the formation of a middle class.

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Source: Irwin, 2002, pp. 42-44.

Now, if we return for a moment to our previous intellectual benefits, the non-economic benefits from trade, we can still remember the perpetual peace advocated by Immanuel

Kant who suggested that a durable peace could be built upon a tripod of representative democracy, international organizations and economic interdependence. Of course, we cannot neglect the expanding political science literature which illustrates that indeed economic interdependence among nations reduces the risk of conflict, mitigates the risk of war and finds that there is a positive link between trade and peace. Even if we are tempted to question the plausibility of the relationship, we should not neglect the fact that study-after-study points to the apparent link between political reforms as an outcome of liberalization. So while trade may fail to generate movement towards democracy, there is ample evidence to point that domestic institutions perform better, and are less corrupt when there is open trade and competition and when nations are open to each other in an accountable manner (Irwin, 2002).

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Is it Convergence or Divergence?

Of course, there is plenty of literature that reviews the distributional effects of globalization. We could point out reviews by Harrison and Gordon (1999), Adrian Wood

(1999), Goldberg and Pavcnik (2007.) The latter, points out to the fact that countries that have experienced great forms of globalization either through more imports and exports or through the magnitude of capital flows, (FDIs, foreign exchange fluctuations, etc.) have experienced higher levels of inequality. Particularly on pp.48-49 of that review, the authors point out that countries from different continents have experienced either significant or slight increases in inequality, with the latter being measured either as skill premium between skilled and unskilled workers, or by the Gini coefficient, and sometimes by consumption or income patterns.

We need to point out that, as we mentioned earlier, the Xavier Sala-i-Martin (2006) article is very emphatic in demonstrating that worldwide poverty has been reduced and convergence has been achieved through globalization. Sala-i-Martin points out that

China has a lot to do with this kind of convergence, and he shows that if we use the $2 per day income line, then we could clearly see that poverty estimates have experienced a significant decrease in China between 1980 and the beginning of the twenty-first century, from about 48% to less than 15%. For China, Sala-i-Martin reports that more than 250 million people escaped poverty because of globalization. He further reports the same thing for countries such as Indonesia and Thailand with the only exception is Southeast

Asia being Papua New Guinea. Overall, and excluding China, more than 200 million people escaped poverty because of globalization in the last quarter of a century. He does point out that the big Asian success is dramatically different from the African experience.

In Africa, the total number of those living in poverty has jumped by more than 200 million persons. In all African countries poverty and inequality has increased, with the exception of Botswana and maybe some small countries like Mauritius. Sala-i-Martin composes what he calls the WDI (World Distribution of Income) and presents an impressive time-series table of the WDI from the 1970s to the beginning of this century.

In that table, we could clearly see that all measures of inequality have been declining,

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 whether we measure inequality using the Gini coefficient or the variance in the logs of income. Moreover, he shows that that ratio of income of the top twenty percentile to the bottom twenty percentile, as well as the ratio of income of the top ten percentile to the bottom ten percentile has been experiencing significant decreases by as much as 30%.

Therefore, the graph below summarizes the WDI from the 70s to the beginning of the twenty-first century.

Source: Xavier Sala-I- Martin, 2006

The argument of the paper is that the significant reduction in inequality which has been empirically demonstrated by Sala-i-Martin is the effect and the outcome of capital formation using the means of international trade. Now, this is a strong argument that needs further investigation and a lot more work, however from a theoretical standpoint as well as from a historical standpoint we can say that nations, empires and economic powers have built themselves up through savings and capital formation using the means of international trade. As Bernstein clearly explains in his book, A Splendid Exchange, whether we talk about the Sumerians, Chinese, Portuguese, Spanish, British or the

Americans, they all have built their capital by opening or financing (in the case of the

U.S.) international exchanges. So, in our theoretical framework there is always a need for a rule of law and the right to property, what we call the legal infrastructure.

However, this must always be accompanied by capital formation.

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If historical experience is teaching us anything, it is that capital formation is best done through international trade, trade liberalization and international exchanges. Eventually, trade liberalization becomes the venue or vessel of empowering people to experience upward economic mobility. It is like having many people at a port on the coast and some of them board a vessel, the vessel empowers them to get better acquainted with technologies, to have better access to capital and other resources, exposes them to ideas, to better education, because it takes them away from the port, to new places. The distance between those who are left behind at the port and those who are now sailing away from the port may be rising initially, but the ones who are on the vessel are the ones who are experiencing the phenomenon of being part of the middle class. In another analogy, we can think of a moving escalator, the international trade becomes the escalator of moving people up, being part of better educational opportunities (social infrastructure), better health care provisions (again, social infrastructure), being able to move around and experience upward mobility, get better jobs, save and invest i.e. take advantage of physical and financial infrastructures. The country as a whole in that case, is able to export and import, to experience growth through investments and FDIs, capital importation, better technologies and production techniques.

The country through export-led growth experiences physical and social infrastructure investments, which eventually empowers the people and the middle class to enjoy savings. Those savings will become the seed for a financial infrastructure, both local and foreign-owned. The emergence of the this kind of infrastructure will finance the formation of new vessels, which in turn will bring the people from the port/coast to the ocean, thus sustaining the creation of the middle class.

So while we may be taking a leap forward without enough evidence at this point, I think it would be normal to expect that globalization, as it is evolving may be showing some measures of higher inequality. However, if properly realized that is simply a means to create and sustain a middle class via capital formation, then over time liberalization and higher international trade will lead to the creation of the middle class, leading eventually to lower rates of inequality and poverty.

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If convergence is indeed achieved, then justice has been implemented, because justice relates to others and becomes reality when equals are treated equally.

The Empirical Results: Methodology, Selection of Variables, and of Countries

We need to emphasize in the beginning of this section that the results and analysis here is preliminary and research is already underway for better understanding of the ideas that have been developed in this paper. Since part of the research is to determine which factors in the four infrastructure areas would contribute to the emergence of a middle class (once capital formation has taken place via the means of international trade), the first (and admittedly most subjective) step was to develop an initial list of factors that describe the infrastructure for each country.

Data were collected from different sources, such as the World Bank, the IMF, different branches of the UN (UNDP, and UNCTAD), and the World Factbook for the 2005 year.

Note that the first step of the algorithm scaled the data by dividing by the maximum absolute value that occurred for each data variable, to prevent the larger-scale factors

(such as exports) from overwhelming the smaller-scale factors (such as student-teacher ratio) in the model. This allowed us to readily compare the effectiveness of the coefficients that we obtained.

Since part of the purpose was to establish a proof of concept for using the Support Vector

Machine (SVM) and a broad scope of infrastructures, originally it was decided that limiting the number of countries would achieve the purpose. We selected small lists of countries under each of the three categories frontier, emerging, and developed. Frontier countries are ones that most economists would agree have very few people in the middle class, but have the potential, such as sufficient resources, to develop one. Emerging countries have a middle class that is growing. Developed countries have a mature and stable middle class. An initial run used a very small sample of countries in each category.

It was exceedingly successful, prompting an expansion of the lists. This paper details the results of the newer results.

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Discussion of Algorithm

The mathematical technique used to determine the significance of the factors was the

Support Vector Machine (SVM). This is a classification method from learning theory that uses a set of input training data {( x

1

, y

1

), ( x

2

, y

2

), . . ., ( x k

, y k

)} where the x i

represents vectors of dimension n and the y values are assigned a value of +1 or -1, depending on whether the point is inside a set or not. For the purposes of this study, the x vectors hold the list of factors that describe the state of a given country that may be characterized as having a middle class ( y = +1) or not ( y = -1).

In common with most learning algorithm, the SVM algorithm operates in two phases. In the training phase, the SVM model with a linear kernel takes the training data and produces a bias value b and a vector c (dimension n) of coefficients. The testing phase of

SVM is then run on all the data, using just the ndimensional vectors even if the yvalue is known. The algorithm will calculate the dot product of the coefficient vector with the data vector and then subtract off the bias value. If the resulting number is positive, the algorithm predicts a yvalue of +1; if it is negative, the algorithm predicts a yvalue of -1.

Running the algorithm on the training data verifies that the training phase worked well.

This particular implementation of the SVM algorithm uses what is termed a linear kernel.

It was chosen because of the limited number of countries in the data set, and because the linear kernel tends to be the worst performer. If this kernel works, then increased data and a non-linear kernel should work much better. A non-linear kernel has an additional step when the data is transformed non-linearly before the coefficients are determined.

A non-linear kernel will be important as this study proceeds. An example will illustrate the reason. One factor that is critical to the development of the middle class is the extension of credit. People in the lower classes do not have the capital with which to start a business and thereby move to a higher class. The marvelous success of microloans illustrates this point. Therefore, in a linear model, the amount of credit extended would certainly have a positive coefficient. That would imply that as more credit is extended, even greater benefits accrue. But at some point, credit may become overextended, and become detrimental to the middle class (see concluding note.) This is arguably a

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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 significant factor in what caused the collapse of the middle classes of Argentina and

Mexico in the recent past. That means that the extension of credit must, at that point, have a negative coefficient. Only a non-linear approach to modeling the middle class can accommodate both aspects of the extension of credit. Similar comments could be made about other data, such as inflation (CPI), which has a rather small range of values considered healthy, while values much outside that range are considered detrimental to a country’s economy.

Analysis of Data: Initial Run

First, we ran SVM on a collection of 44 countries using 45 factors for each country. The training set was the collection of 17 frontier countries and 10 developed countries. The testing phase consisted of finding the predictions for those as well as the 17 emerging countries. (The same process was used during the reduced factor run of SVM.) The results are summarized in Table 1 on the next page, giving the SVM output value, but not the prediction, which is easy to determine from the sign of the output.

The first 17 rows of the table list the frontier countries, the next 17 rows list the emerging countries, and the last 10 rows list the developed countries. There are also two columns.

The first numeric column gives the SVM output using all 45 factors for training and testing. The other numeric column will be explained below.

The results show very clearly that the SVM algorithm (even with the linear kernel) works very well. The frontier countries, except for Thailand, all fall into the SVM output range of -1.0 to -1.6; the emerging countries mostly fall in the range from -0.8 to 0.0; the developed countries, except for South Korea, fall in the range 0.6 to 1.5. These results, especially for the frontier and developed countries, form a primary validation of the SVM algorithm; it does seem to be doing what we want it to do. The separation between the ranges for the different categories of countries also seems remarkably large, providing further evidence that the algorithm is working.

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Country

Albania

Angola

Bolivia

Ethiopia

Georgia

Ghana

Guatemala

Indonesia

Kazakhstan

Kenya

Lebanon

Morocco

Nigeria

Peru

Philippines

Thailand

Venezuela

Argentina

Botswana

Brazil

Chile

China

Czech Republic

Egypt

India

Iran

Malaysia

Mexico

Poland

Romania

Russia

South Africa

Turkey

Ukraine

Australia

Canada

France

Germany

Japan

Republic of Korea

Singapore

Sweden

United Kingdom

USA

-0.6834

-0.4742

-0.7782

-0.4801

-0.1282

0.4781

-1.1327

-1.1646

-1.1666

-0.2523

-0.8208

-0.4681

-0.8441

0.0256

-0.5709

0.5125

-0.5202

45 Factors

-0.9999

-1.5701

-1.0987

-1.6106

-1.2053

-1.4369

-1.1876

-1.2804

-1.0000

-1.4301

-1.0003

-1.1062

-1.4359

-1.0963

-1.1356

-0.9608

-1.0001

0.9445

1.0754

1.2936

1.4943

1.5026

0.1209

0.9340

1.0516

0.6674

1.4181

2009 Oxford Business & Economics Conference Program

-0.7224

-0.5624

-0.9008

-0.3891

-0.6589

0.0827

-1.1795

-1.1560

-1.0534

-0.4184

-0.7842

-0.4366

-0.7429

-0.6292

-0.5240

0.8718

-0.7147

1.0000

1.0976

1.0998

1.5142

1.0235

-0.0290

0.9998

1.2535

1.0005

1.5219

-1.0479

-1.3473

-1.2265

-1.4777

-1.1505

-1.2124

-1.0855

-1.2320

-0.8798

-1.3824

-1.0088

-1.0533

-1.3758

-1.0486

-1.1535

-0.8136

-1.0002

10 factors

Table 1

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ISBN : 978-0-9742114-1-1

24


Reduction of Factors

It could easily be argued that with 45 factors and 44 countries, it is easy to expect results of this caliber. So, we attempted to reduce the number of factors used, still regarding the conceptual framework.

The factors used in the remainder of this discussion are as follows:

 For physical infrastructure:



Paved roads in kilometers per capita



Number of cell phones per capita



For social infrastructure:



Amount spent on healthcare per capita



Literacy Rate



For financial infrastructure:



Private sector credit as a percent of GDP



GDP (PPP) per capita



For legal infrastructure:



Corruption index (Transparency International)



For international trade (in dollars):



Exports



Imports per capita



Foreign reserves per capita

Table 1 above lists the output of the SVM algorithm using only these ten factors, in the second numeric column. Table 2 below lists these ten factors, and the coefficients that the

SVM algorithm generates for each. (It should also be noted that results equivalently good can be obtained with only six factors, showing that SVM is more than adequate for separating the categories of countries.)

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Factor

Paved roads in km per capita

Number of cell phones per capita

Amount spent on healthcare per capita

Literacy rate

Private sector credit as a percent of GDP

GDP (PPP) per capita

Corruption index

Exports (billions USD)

Imports per capita

Foreign reserves per capita

Table 2

Coefficient

0.2416

0.3675

0.7636

0.05407

0.1571

0.9074

0.8518

0.4490

0.3133

0.2819

The following comments are in order: First, all developed countries, with the exception of South Korea, show up with SVM output values in the appropriate range. This exception appears puzzling at first glance, but an examination of the data shows that it is almost entirely due to a value of the corruption index that is considerably lower than for other developed countries.

Second, this time only the Czech Republic shows with a positive prediction, although

Turkey is very nearly positive. This complies with the liberalization and openness that both countries have exhibited over the last two decades, both most likely the result of the incentive provided by the future possibility of membership in the European Union. We could then, make the claim that international openness and exchanges serve the purpose of forming capital and thus, advancing the formation of the needed infrastructures which in turn will lead to the creation of the middle class.

Third, the relatively weak positions of Egypt, India, and Iran need to be reviewed in a time series before any conclusion is reached.. However, it is also worth mentioning that just by trade alone China performs better in the SVM, a fact which by itself could help us

June 24-26, 2009


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2009 Oxford Business & Economics Conference Program ISBN : 978-0-9742114-1-1 understand a little better the value of international trade in forming the necessary cornerstones that a middle class needs.

Conclusion: A Word of Caution and Direction for Future Research

The empirical part of this paper should be viewed as a proof-of-concept attempt for using a multi-factor and linear approach to quantifying the extent to which international trade forms the basis of capital formation, which in turn advances the formation of infrastructures that create a middle class. These results seem to indicate that using international trade and the infrastructures as have been described above along with the

SVM algorithm, is a feasible methodology, and is worth continuing in broadly the same direction.

However, at this point I would like very briefly to introduce the idea of what happens when things go to the extreme, especially when the financial sector’s interests diverge from the trade sector’s interests i.e. from the production or real economy’s interests.

When efforts are being made to sustain prosperity and the middle class with paper means rather than real assets and real production, then we will see a divergence of the production and real sectors interests from the financial sector’s interests. The latter will tend to produce paper assets which will be over-collateralized, over-securitized, for the purpose of generating significant short-term profits. The table below shows the explosion of derivatives and other related instruments (CDOs, CLOs, etc.) in the last few years. It demonstrates the extent of irrational collateralization of “assets”, where the financial sector keeps pushing for more and more securitization of paper assets, which will be sliced into pieces and sold to individual and institutional investors.

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Source: Bank of International Settlements, 2008

Of course, it seems that we are just start learning the lesson that these paper-assets are nothing more than paper, i.e. there is nothing behind them. This is the phenomenon of extreme and irrational securitization and collateralization that is taking place in the U.S. and the EU, and which has been destroying the financial sector, because it can only create bubbles and bubbles usually burst. The bursting of the bubbles will create in turn instability not only in the economic sector but also in the political and social sectors, and therefore the whole economy’s cohesiveness may become unstable and questionable, which eventually may lead to significant destructions. As direction for future research, it would be interesting to identify the possibility for economies to establish a rule by which they collateralize and securitize assets in a way that will not destabilize the economies.

The proposal for future research would be to form an index of internationalization of the economy - whether this is imports and exports as a fraction of GDP, foreign reserves,

FDIs, currency swings, technology transfers, etc – and use this index as the compass/anchor of collateralization and securitization, so that the interest of the real economy (production) are not disassociated from the interests of financial capital, and thus do not jeopardize the sustainment of the middle class via misallocation of resources.

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