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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 RietzAsbury 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

June 24-26, 2009St. Hugh’s College, Oxford University, Oxford, UK

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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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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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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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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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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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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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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.


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Per Capita GDP in Nations Open and Closed to World Trade

Always Open 2006 Always Closed 2006Nation Per Capita GDP Nation Per Capita GDP

Barbados $17,610 Algeria $7,189Cyprus $21,177 Angola $2,813Hong Kong $33,479 Bangladesh $2,011Mauritius $12,895 Burkina Faso $1,285Singapore $28,368 Burundi $700Thailand $8,368 Central African Rep. $1,128Yemen $751 Chad $1,519

China $2,001Congo $1,369Cote d’Ivoire $1,600Dominican Republic $7,627Egypt $4,317Ethiopia $823Gabon $7,055Haiti $1,791Iran $7,980Iraq $2,900Madagascar $900Malawi $596Mauritania $2,535Mozambique $1,379Myanmar $1,693Niger $872Nigeria $1,188Pakistan $2,653Papua New Guinea $2,418Rwanda $1,380Senegal $1,759Sierra Leone $903Somalia $600Syria $3,847Tanzania $723Togo $1,675Zaire $774Zimbabwe $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


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across nations, what has been happening to inequality and poverty or the concept of

convergence among nations.

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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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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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 {(x1, y1), (x2, y2), . . ., (xk, yk)} where the xi 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 n-dimensional vectors even if the y-value

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 y-value of +1; if it is negative, the algorithm predicts a y-value 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


22


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 45 Factors 10 factorsAlbania -0.9999 -1.0479Angola -1.5701 -1.3473Bolivia -1.0987 -1.2265Ethiopia -1.6106 -1.4777Georgia -1.2053 -1.1505Ghana -1.4369 -1.2124Guatemala -1.1876 -1.0855Indonesia -1.2804 -1.2320Kazakhstan -1.0000 -0.8798Kenya -1.4301 -1.3824Lebanon -1.0003 -1.0088Morocco -1.1062 -1.0533Nigeria -1.4359 -1.3758Peru -1.0963 -1.0486Philippines -1.1356 -1.1535Thailand -0.9608 -0.8136Venezuela -1.0001 -1.0002Argentina -0.6834 -0.7224Botswana -0.4742 -0.5624Brazil -0.7782 -0.9008Chile -0.4801 -0.3891China -0.1282 -0.6589Czech Republic 0.4781 0.0827Egypt -1.1327 -1.1795India -1.1646 -1.1560Iran -1.1666 -1.0534Malaysia -0.2523 -0.4184Mexico -0.8208 -0.7842Poland -0.4681 -0.4366Romania -0.8441 -0.7429Russia 0.0256 -0.6292South Africa -0.5709 -0.5240Turkey 0.5125 0.8718Ukraine -0.5202 -0.7147Australia 0.9445 1.0000Canada 1.0754 1.0976France 1.2936 1.0998Germany 1.4943 1.5142Japan 1.5026 1.0235Republic of Korea 0.1209 -0.0290Singapore 0.9340 0.9998Sweden 1.0516 1.2535United Kingdom 0.6674 1.0005USA 1.4181 1.5219

Table 1


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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 Coefficient

Paved roads in km per capita 0.2416

Number of cell phones per capita 0.3675

Amount spent on healthcare per capita 0.7636

Literacy rate 0.05407

Private sector credit as a percent of GDP 0.1571

GDP (PPP) per capita 0.9074

Corruption index 0.8518

Exports (billions USD) 0.4490

Imports per capita 0.3133

Foreign reserves per capita 0.2819

Table 2

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


26


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.


27


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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