Larry Summers: ‘I’m concerned that what is being done is substantially excessive’

Former treasury secretary criticises the scale of Biden’s fiscal policy and warns it could lead to overheating and wasted resources

Martin Wolf

           © Leonie Woods

The world economy is struggling to escape the economic shock of Covid-19. 

During the worst of this pandemic, high-income countries provided a scale of fiscal and monetary largesse previously only seen in world wars.

No, however, after the election of Joe Biden as president, the US is proposing to do more than double down on already generous support. 

Is what the US administration doing well judged or excessively risky?

For its proponents, the idea of “going big” is designed, among other things, to rectify the mistakes, as they see it, of the Obama administration of 2009. 

They want this to be seen as a transformative political moment. But Lawrence (Larry) Summers of Harvard has criticised the approach as the “least responsible” in 40 years.

Summers is an influential economist and policymaker on the US centre left. 

He won the John Bates Clark medal in 1993 and has been chief economist at the World Bank, Treasury secretary under Bill Clinton and head of Barack Obama’s National Economic Council.

Summers has never been reluctant to court controversy as a thinker and policymaker. 

Notably, in 2013, he reintroduced into macroeconomic discussions the idea of “secular stagnation”, first used by the Keynesian Alvin Hansen in the 1930s.

He used the label to explain the combination of a long period of easy, or ultra-easy monetary policy, with weak demand and disappointing growth. 

He then became the leading economist arguing in favour of less reliance on monetary policy and more on active fiscal policy.

Now, however, Summers — a Democrat with his party back in power — is criticising both the scale and direction of the administration’s fiscal policies. 

Instead of applauding its boldness, he fears they will lead to significant overheating and waste of resources.

In discussion with Martin Wolf, the FT’s chief economics commentator, Summers explains why the new approach might go disastrously wrong. 

He agrees there is a strong case for a more aggressive approach to fiscal policy. 

But policy still needs to be grounded in economic realities and priorities — and these ones, he insists, are not.

If Summers is wrong, it will matter little. 

If he is right, the hopes for a transformative presidency are likely to end in catastrophic economic and political disappointment. 

It is an immensely important argument.

Martin Wolf: Let’s start with the current macroeconomic situation and, particularly, the legacy of Covid-19 and the arrival of Biden. 

His administration has already passed an enormous new fiscal stimulus of $1.9tn and is talking about a longer-term investment package of $3tn. 

Together, this is close to a quarter of gross domestic product.

You have been critical of these policies. 

Could you explain your criticisms? And how does this fit with your views on secular stagnation?

Larry Summers: I’m going to focus on the American policy path and not talk about where responsibility lies for that path. 

I think, in important respects, it lies with the Republicans and with those on the more extreme left of the Democratic party.

If you look at the economy at the beginning of this year, prevailing forecasts were that Covid would reduce wages and salaries to American households by $20bn-$30bn a month, with that figure declining over the year. 

So, that would be a $250bn-$300bn hole in wages and salaries over the course of the year.

So, I look at this hole and then I see $900bn of stimulus in the December package, $1.9tn of stimulus in the recently passed package and $2tn in the savings overhang, which is also likely to be spent. 

I see the Fed with its foot on the accelerator as hard as any Fed has ever done.

I see serious discussion of trillions of dollars more in fiscal stimulus, along with the explanation that this latest package is not temporary Covid relief, but a harbinger of a major transformation in social policy, which suggests that at least some of it will be continued indefinitely.

So, I look at that dwindling hole. 

Then I look at expenditures that aren’t hard to add into the multiple trillions, and I see substantial risk that the amount of water being poured in vastly exceeds the size of the bathtub.

That could manifest itself, as a much smaller period of excess did during the Vietnam war, in rising inflation and a ratcheting-up of inflation expectations. 

It could, as has often happened, manifest itself in the Federal Reserve feeling a need for a sharp and surprising increase in interest rates, and the subsequent deceleration of the economy into recession.

It could manifest itself in a period of euphoric boom and optimism that leads to unsustainable bubbles, or it could all work out well. 

But, it doesn’t seem to me that the preponderant probability is that it will work out well. 

So I’m concerned that what is being done is substantially excessive.

How does this square with my earlier views on secular stagnation? 

I looked at the global economy and, indeed, at the US economy during the pre-Covid period and what I saw was that, at near-zero real interest rates, there was a quite substantial gap between private savings and investment, driven by demography, cheap capital goods, inequality and technology.

That substantial gap meant a deflationary tendency, one towards sluggishness and for savings to flow into existing assets and create asset bubbles. 

So, I felt that savings absorption was a central macroeconomic problem and the order of the problem was 3 or 4 per cent of GDP at very low interest rates that themselves carry substantial risks.

Now, when we’re talking about fiscal stimulus totalling 14 per cent of GDP in its first round, when we’re also talking about extraordinary monetary measures, structural effects of Covid — notably a large savings overhang — it seems to me that we are way overdoing the requisite response.

I always thought of economics as a quantitative field and when I hear people talk about why this is the right thing to do, they say things like “we really need to go big”, or “the 2009 stimulus was too small”.

It seems to me one needs to link the scale of the problem with the magnitude of the response. 

I look at the response and I look at the scale of the problem and I can’t see how it adds up.

There’s not much argument that the 2009 stimulus, in retrospect, was too small. 

It was 4 to 5 per cent of GDP over a couple of years, so it was 2.5 per cent of GDP in the first year, against a gap that was 6 or 7 per cent of GDP and growing, so it was perhaps a third or half of that gap.

Today’s stimulus is above 10 per cent of GDP in the face of a gap that is 3 or 4 per cent of GDP. 

Relative to the gap, this stimulus is already of the order of five or six times as large as in 2009. 

Not even the most extravagant critics of the 2009 stimulus have suggested it should have been six times as large.

I would say one other thing. 

In 2009 there was an important argument in which the people who were, in general, more progressive in their beliefs stressed that — in addition to responding to the macroeconomic situation — it was essential, in Rahm Emanuel’s phrase, “not to let a crisis go to waste” and take advantage of this opportunity to do deep structural things.

That’s why, in the 2009 stimulus, there were important investments in electronic medical records, new green venture capital and research-type measures, extending broadband and infrastructure repair and investment. 

What’s striking about today is that all of the trillions of dollars — all of it — does not include a penny directed at building back better.

I could have been comfortable with a headline figure well in excess of $1.9tn if it had been a large-scale, multiyear programme of public investment responding to our deepest societal concerns. 

But that’s not what this is.

It transfers to state and local governments that don’t have any new budget problem, according to the latest figures. 

It’s paying people, who have been unemployed, more in unemployment insurance than they earned when they were working. 

It’s giving cheques to families in the 90th percentile of income distribution.

It doesn’t seem prudent on resource allocation grounds, as well as being problematic on macroeconomic grounds.

MW: Assume you are correct. So we get huge excess demand in the US. 

One plausible consequence is a widening of the current account deficit, possibly associated with a large rise in the dollar as monetary policy is driven to tighten. 

This could, given the scale of borrowing around the world denominated in dollars, be followed by the sort of debt crisis we saw in the early 80s.

Should we be thinking about such international ramifications of the programme you’re discussing?

LS: I very much share your apprehensions. 

The reason I haven’t articulated a fuller set of views is that I find myself ambivalent between two adverse scenarios.

One is what I would call the Reagan deficits scenarios — a temporary boom, rising current account deficit, increased protectionism, a strong dollar and magnification of the debts of others.

The other risk is what I would call the pre-Bretton Woods scenario or the Carter administration scenario, in which the sense that a country is printing its currency indiscriminately, in conjunction with the substantial accumulation of debt, leads people to be more reluctant to hold it.

I guess if I can see a plausible scenario for a very strong dollar and for a very weak dollar, it’s logically possible that the forces will balance themselves, at least over time. 

Of course, Latin America’s experience would suggest that the pursuit of reckless policy could lead to a scenario like yours, followed by a currency collapse.

There’s a term I coined when I was in the Treasury, iatrogenic volatility. 

Iatrogenic illness is when you go into a hospital and you catch an infection there. 

Iatrogenic volatility is when policymakers, whose role is to stabilise markets, destabilise them with their actions.

I think there is a risk of that taking place. 

But I don’t have the conviction to predict in what direction and with what timing it will happen.

MW: Let’s suppose I were [Treasury secretary] Janet Yellen. 

Her argument might be that this stimulus might create some excesses in the short-run. 

But that will be a temporary shock.

We believe — she might say — that the elasticity of labour supply in the US is actually much greater than you and most other economists believe. 

We will pull a large number of workers into the labour force. 

This will pull up wages. 

That will squeeze profits, which will be fine, because profits are very high.

Yes, maybe, inflation will get up to 3-3.5 per cent but the Fed will look through that and expect a return to lower inflation. 

And, our future spending plans — this $3tn, or whatever — are going to be covered by taxes. 

You are far too worried about something we need to do to give confidence back to Americans, jolt us out of the Covid-19 recession and improve the conditions for many workers who have given up.

Why would you say this is wrong?

LS: I’d make these points.

First, no one was advocating a programme of this magnitude last December. 

This was not anyone’s economic analysis. 

So, the argument might be right — but it was not an argument anyone had come to before it became politically expedient.

Second, there’s much discussion that suggests you can’t measure the GDP gap but, gosh, employment is 10m people lower than it might otherwise have been, so there’s got to be enormous slack.

Covid-19 has wrought colossal changes in the global economy. 

In this monthly series, leading FT commentators hold in-depth, solutions-focused conversations with the world’s top economists about what the recovery will look like

As a rough calculation, if employment is 10m people short, that’s about 6 per cent of the labour force and, it appears, those who are not employed have wages of perhaps 60 per cent of the average worker. 

In terms of the shortfall in effective labour input, you’re at 60 per cent of 6 per cent, which is about 3.6 per cent.

So, in employment terms that gets you to just about the same gap that you come to in terms of more traditional estimates. 

You also don’t see the Fed or others substantially revising upwards their estimates of potential GDP.

Third, the view that this is only temporary expenditure sits uneasily with two other things that the proponents like to say. 

One is that this is a new era in progressive policy, with a different attitude towards government and public policy, and that there’s a lasting legacy of structural improvement.

That would suggest that the spending was going to continue over some very substantial interval, in which case relying on its transience may not be such a good idea, even before you get to the question of future spending and investment.

The other thing that Paul Krugman and others who have defended this programme argue is that households are going to save part of the money that’s provided to them. 

I, too, think it’s likely that half this money will be spent this year and a quarter of it will be spent next year and the year after.

Yet, you still have to ask what is the magnitude of the fiscal stimulus and what is the magnitude of the cumulative gap over the next several years? 

It is hard to make that arithmetic work out even over that period.

There is a serenity that, yes, inflation may rise for a time but it will return and expectations will not become unanchored. 

Of course, when it’s explained that the Fed has an entirely new paradigm, that this is an entirely new paradigm of fiscal and social policy, it’s a bit hard to understand why expectations should remain anchored.

So, we’re seeing an episode that I think differs both quantitatively and qualitatively from anything since Paul Volcker’s days at the Fed, and it stands to reason that would lead to significant changes in expectations.

Let me put it in a different way and it’s sort of ironic. 

The bet that we can do this is a bet on secular stagnation being even more true than I had supposed. 

For this to be right, the long-term demand gap has to be far larger than I had imagined.

I don’t think that, until recently, the principal criticism of my views on secular stagnation was that I was very much underestimating its force. 

So I find it not a preponderant probability.

MW: The implication of your view of the macroeconomics would seem to be that taxes have to be raised permanently because the administration’s ambitions are for permanent increases in spending, some of it on investment but quite a bit on current spending. 

If you were asked how should we raise the taxes to pay for this, what would you advise them to do?

LS: I have written for years in favour of increased public investment. 

An additional point that I think is under-appreciated is that whatever values you have, the reality is that a larger fraction of our population is going to be aged in the future and the relative price of things, like education and healthcare, has also increased very dramatically relative to the price of things like television sets. 

This means the public sector has to be bigger, to deliver on the same values.

The fact that we have more inequality, that support for opportunity and redistribution are central fiscal responsibilities and that we’re moving into an increasingly dangerous world with more international obligations, mean that whatever you thought the right share of government was 20 years ago, you should favour a substantially larger one today, unless your values have changed. And I do.

So, yes, the US would definitely be better off with a larger government and that is going to require larger taxes. 

I think the administration is entirely correct in its view that the place to begin looking for higher taxes is with those who have been most fortunate over the last decades.

The measures that I would favour would be, first, a very substantial increase in the tax-enforcement effort.

Second, there were very substantial and inappropriate excesses in the Trump tax cuts. 

Even the business community didn’t ask for a reduction in corporate rates to 21 per cent. 

A serious programme of corporate tax reform could surely raise over $1tn over the next decade.

Third, a variety of changes associated with capital gains tax would raise $0.5-1tn.

In all, I think one could raise close to $4tn over the next 10 years with measures that would be desirable in terms of having a more just and more level tax system, and that’s where the conversation should start.

Ultimately, I think society is going to require larger revenues and it is going to be necessary and appropriate to raise taxes, not just on the top 1 per cent of the population but more broadly.

And I think that would be the right thing to do, even if there were not macroeconomic concerns over overheating.

MW: Finally, a long time ago, we used to associate the Republican party with a “balanced budget” view. 

That has clearly gone out of the window. 

Is the same thing now happening to the Democrats? 

Is the implication of your analysis that no political force in America nowadays wants to offer fiscal rectitude?

LS: Imputing a tradition of serious fiscal concern to Republicans has been wrong for 40 years. 

Republicans have been deficit hawks whenever Democrats have wanted to spend money on helping people who are disadvantaged. 

And then going back to the Reagan tax cuts, through the Bush tax cuts and the Trump tax cuts, whenever there was an opportunity to cut taxes for high-income people.

In the 1990s, substantial amounts of business investment were being inhibited by high costs of capital. 

So I pushed the idea that bringing deficits down and crowding in private investment was an attractive growth strategy.

In the context we’ve had for the last decade, when cost of capital was not a meaningful constraint on investment, one needs to think quite differently about deficits. 

So, I don’t think anybody should believe the things that were believed in 1993, because the world has changed in important ways.

But, in many ways, today’s situation is a bit like the 1960s. 

It was then hoped that the laws of economic arithmetic could be suspended and that it would all work out. 

That experiment didn’t work out well for Lyndon Johnson, economically, and it didn’t work out well for the Democratic party, politically. 

I think there is a significant risk that something of the same kind will happen today.

Biden’s Cradle-to-Grave Government

His latest $1.8 trillion plan rejects the old social contract of work for benefits.

By The Editorial Board

President Joe Biden speaks on the North Lawn of the White House on April 27. PHOTO: STEFANI REYNOLDS/POOL/ZUMA PRESS

The progressive hits keep coming from the Biden Administration, and the latest is the $1.8 trillion American Families Plan introduced in broad strokes on Wednesday. 

It’s more accurate to call this the plan to make the middle class dependent on government from cradle to grave. 

The government will tell you sometime later, after you’re hooked to the state, how it will force you to pay for it.


We’d call the price tag breathtaking, but by now what’s another $2 trillion? 

Add $2 trillion or so each for the Covid and green energy (“infrastructure”) bills, and that’s $6 trillion of new spending in 100 days. 

That doesn’t include the regular federal budget of more than $4 trillion a year. 

No worries, mate, the Federal Reserve will monetize the debt.

But the cost, while staggering, isn’t the only or even the biggest problem. 

The destructive part is the way the plan seeks to insinuate government cash and the rules that go with it into all of the major decisions of family life. 

The goal is to expand the entitlement state to make Americans rely on government and the political class for everything they don’t already provide.

The White House talking points pitch this in the smothering love of the welfare state: “making care affordable”; free medical and family leave; “free education”; two years of “universal pre-school”; “invest in the care workforce.” 

Subsidies and millions of new care givers, all licensed and unionized, will nurture you through the challenge of earning a living and raising a family.

One question to ask is: Haven’t we tried this before? 

What is Head Start if not government pre-school education and child care? 

Weren’t school lunches and the Women, Infants and Children program supposed to prevent child hunger? 

Food stamps, welfare checks, child-care subsidies and a supplement to earned-income, plus public housing. 

Weren’t all of these programs and more from previous decades supposed to end poverty?

Why did the trillions of dollars spent on those programs fail? 

And if they didn’t work, why do we need more?

For the candid answer, listen to Rahm Emanuel, the Chicago Democrat who explained the political calculation this week to the Washington Post: “Once everyone’s in, all the parents want in. 

Then it’s not a poor person’s program or a poverty program. 

It’s an education program. . . . That to me, that is essential. 

It changes the center of gravity once it’s for everybody.”

So much for the “safety net” to prevent poverty. 

This is now about mainlining benefits to middle-class families so they become addicted to government—and to the Democratic Party that has become the promoting agent of government.

Democrats are enamored of this principle of “universality” because it has worked to sustain the popularity of Social Security and Medicare, despite their failing finances. 

But those programs promise benefits in return for work across a lifetime. 

The Biden New Deal isn’t a deal at all. 

Most of its programs are free handouts on the model of the 1960s Great Society.

The new pre-school entitlement will go to all families, as would free community college. 

The tax-credit expansion to $3,600 per child in the Covid bill, which Mr. Biden wants to make permanent, is on top of the other welfare subsidies. 

The Biden plan also makes permanent an expansion of ObamaCare subsidies for more affluent adults, eliminating the subsidy cap that was 400% of poverty. 

A new paid family leave entitlement will be an incentive for companies to drop leave benefits that already cover most workers.

All of this adds up to healthy guaranteed annual income largely untied to the social contract that requires work, which is the real path to independence and self-respect.


The White House is also less than honest about how it will pay for all this. 

Its short answer is that more taxes on the wealthy and more IRS audits are enough. 

But that doesn’t come close.

The permanent child-tax credit expansion would cost $1.6 trillion over 10 years, according to our friends at Cornerstone Macro. 

The White House says it only costs $420 billion, but that’s because it only includes four years through 2025. 

The new entitlements ramp up slowly but explode in the later years, while the tax increases are immediate and won’t raise the revenue they expect.

That’s especially true of the increase in the top tax rate on capital gains to 43.4%, which would lose money by all historical experience. 

The White House tries to get around this by eliminating the step-up basis for paying capital gains at death, meaning an heir would pay the tax based on accrued value over a lifetime. 

This is a back door addition to the current death tax rate of 40%.

The White House also predicts that unleashing thousands of new IRS agents will find $700 billion in unpaid tax bills. 

But this prediction is based in part on old IRS data, before the 2017 tax reform that removed many tax loopholes, especially in the corporate tax code. 

The only benefit of the IRS audit army is that its $700 billion bogey replaces what would be another tax increase.

The new taxes are destructive, but their impact will take time to be felt as the post-pandemic economy soars. 

The GOP shouldn’t ignore the taxes and spending. 

But a more potent political target may be the bill’s tripling down on a welfare state that disdains the dignity of work and seeks to make Americans the wards of government.

Biden’s Infrastructure Plan: Who Are the Winners and Losers?

The American Jobs Plan (AJP) proposed by President Biden on March 31 would spend $2.7 trillion and raise $2.1 trillion dollars over the 10-year budget window of 2022–2031, according to the Penn Wharton Budget Model (PWBM), a nonpartisan initiative that analyzes the economic impact of public policy proposals.

The AJP’s tax and spending provisions would increase government debt by 1.7% and reduce GDP by a quarter percentage point by 2031, the study projected. By 2050, however, government debt would fall by 6.4% and GDP would decrease by 0.8%, according to its estimates.

“The decline in GDP isn’t necessarily going to mean that we are worse off as a society,” Alex Arnon, associate director of policy analysis at PWBM, said in an interview on the Wharton Business Daily radio show on SiriusXM. (Listen to the podcast at the top of this page). Much of the spending is to keep existing infrastructure in running condition and to provide insurance against unforeseen setbacks, he added.

“A lot of the investments [will be] in resilience, and as a form of insurance against, say, catastrophic climate change or a future pandemic,” Arnon continued. “Those investments in the most likely outcome don’t pay out in full [if] things go okay. But if we get unlucky and things turn out much worse than we expect, we’ll be glad we have that insurance.” Some benefits of those investments are not captured in GDP measurements, such as “better roads, safer and faster trains, or more regular bus services,” he added.

Taking the Long View

While the AJP does not specify any spending plans beyond 2029, PWBM has assumed that the proposal would not increase federal outlays in 2030 and beyond, and that its business tax provisions continue past the budget window.

The study assessed the impacts beyond the 10-year budget window, extending up to 2050, in order to remove the “big bias” that a shorter window would entail, PWBM faculty director Kent Smetters said at a press conference where he released the study’s findings. The estimates “would not look favorable” in a 10-year window, especially since public spending on infrastructure projects such as bridges would have “a longer-run path” before they begin to pay off, said Smetters, who is also a Wharton professor of business economics and public policy. “We want to give a fairer comparison by going more long-run.” Smetters is

In addition to Arnon, the PWBM team that conducted the analysis includes Marcos Dinerstein, economist; Jon Huntley, senior economist; and John Ricco, associate director of policy analysis, under the direction of Richard Prisinzano, director of policy analysis and Efraim Berkovich, director of computational dynamics.

“The fact that we are pulling resources out of the private sector in order to make these investments in public capital [will hurt] future outputs.”–Alex Arnon

Funding for the AJP is planned from higher business taxes, including an increase in the corporate tax rate to 28%; a minimum tax on corporate book income (income firms publicly report on financial statements); and a higher tax rate on foreign profits of U.S. companies. Other funding is planned by removing tax preferences for fossil fuels and tax deductions for certain types of foreign income.

The original Biden campaign proposal called for spending on public infrastructure, R&D, workforce training, affordable housing, and caregiving. It later added an additional $400 billion in clean energy tax credits.

The PWBM model treated individual components of those spending outlays as either public investments or as transfers. Public investments, totaling $2.1 trillion of the AJP, include new spending on transit infrastructure, R&D, and domestic manufacturing supply chains. Investments in such “public capital” enhance the productivity of private capital and labor. Transfers, totaling $600 billion, include spending on affordable housing access and on home- and community-based care.

Crowding out Private Investment

New spending on either public investments or transfers, if financed through increased federal deficits, has the indirect effect of crowding out private investment. “That crowding-out effect reduces growth in the capital stock and thus GDP,” the study noted.

According to PWBM, the tax provisions in the AJP have two direct economic effects: decreasing firms’ incentives to invest and disincentivizing saving by households. “The revenue raised by these tax provisions has the indirect effect of decreasing government deficits and thus crowding in private investment,” it stated.

“In isolation, raising the statutory corporate tax rate is expected to increase corporate investment in the near term. However, that positive effect is reversed when an increase to the corporate rate is combined with the AJP’s proposed minimum tax on book income, which reduces the value of depreciation deductions — in turn increasing the tax wedge on investment. The plan’s international tax provisions also increase the overall tax burden on corporate income.”

Those tax provisions have a cascading effect: The increase in corporate tax rates lowers the after-tax return on equity investment, the study noted. As a result, “households, facing lower after-tax returns, save less which in turn decreases investment and the capital stock.”

“The fact that we are pulling resources out of the private sector in order to make these investments in public capital [will hurt] future outputs,” Arnon said. “The tax increases fall [almost] entirely on corporations, and they are a significant negative for investment and therefore for economic growth over the long run.”

Although the plan’s public investments increase the productivity of capital and labor, that productivity boost is not enough to overcome additional crowding out of capital due to increased government deficits, PWBM stated. By 2031, the AJP’s spending provisions alone would increase government debt by 8.16%, and decrease capital stock by 1.17%, and GDP by 0.25%. By 2050, all of those would fall: government debt by 4.72%, capital stock by 1.46% GDP by 0.33%.

Those funding estimates are on the conservative side because PWBM did not measure the potential impact of other tax proposals in the AJP. They include increased tax enforcement against corporations, denial of expensing for offshoring jobs, and the creation of a tax credit for onshoring jobs. The Biden administration also plans to push other countries to increase their corporate taxes.

Backtracking on Minimum Corporate Tax

The AJP includes a new form of minimum tax based on book income, but with some modifications. That is in sharp contrast to the 2017 Tax Cuts and Jobs Act, which repealed the corporate alternative minimum tax.

Some of the motivation there for the Biden administration might be to target corporations that may over-report book income, or what they publicly report, to attract investors, while underreporting taxable income to lower their taxes, said Arnon. “It’s trying to balance those incentives. The thinking is it will encourage corporations to be more accurate in their reporting of both incomes.”

Compared to the corporate minimum tax requirements that existed prior to the Tax Cuts and Jobs Act, the AJP proposal “is even more complicated and creates even more strange incentives,” Arnon noted.

Treasury secretary Janet Yellen last week also called for a global minimum corporate tax rate to prevent corporations from fleeing to lower-tax or tax-free regimes. Such a global tax could help prevent the type of “race to the bottom” that has been underway, Yellen said in a speech to the Chicago Council on Global Affairs.

“[The AJP is] much more aggressive in terms of seeking out and making sure we tax every dollar of corporate profits, regardless of where it’s earned.”–Alex Arnon

Taxing Foreign Income

The AJP’s proposal to collect more taxes on the foreign profits of U.S. corporations represents “a huge change” from the existing tax regime, said Arnon. He noted that while the Tax Cuts and Jobs Act “massively overhauled the system of international taxation,” the Biden administration wants to scrap all of that and replace it with a new system. “[The AJP is] much more aggressive in terms of seeking out and making sure we tax every dollar of corporate profits, regardless of where it’s earned.”

Taxing foreign profits of U.S. corporations could backfire by prompting them to either relocate overseas, get acquired by a foreign company, or do inversions. “This is probably the single biggest uncertainty in what the plan would actually end up doing,” said Arnon. “The proposed new taxation of foreign profits increases the incentive [for a U.S. corporation] to complete an inversion [by getting] acquired by a foreign corporation [in a lower-tax country].” Taxing foreign profits would increase the value of an inversion for a corporation with substantial international operations, he added.

The Biden administration plans to prevent those inversions with penalties for corporations that go headquarters shopping overseas. “They will use regulatory means, essentially, to ensure that corporations cannot just ditch the U.S. purely for tax reasons,” said Arnon. He recalled that after “a wave of inversions in the mid-2000s,” new rules put in place by the Obama administration and the Tax Cuts and Jobs Act “dramatically reduced the incentives to invert, and we did see a significant slowdown in inversions.”

“Those inversions all but ended after 2017 as reform lowered the top corporate rate to 21% from 35% and moved the U.S. closer to a territorial tax system in which income is taxed where it is earned,” The Wall Street Journal said in an editorial, citing research by Dan Clifton of Strategas Research Partners. In the three years after the passage of the Tax Cuts and Jobs Act (2018–2020), companies repatriated $1.6 trillion from overseas to the U.S., a sharp increase from the $495 billion repatriated in the three years prior to the tax cuts, the data showed.

Those tax provisions have a cascading effect: The increase in corporate tax rates lowers the after-tax return on equity investment, the study noted. As a result, “households, facing lower after-tax returns, save less which in turn decreases investment and the capital stock,” the PWBM report noted.

“Despite the decline in government debt, the investment-disincentivizing effects of the AJP’s business tax provisions decrease the capital stock by 3% in 2031 and 2050,” the study stated. “The decline in capital makes workers less productive despite the increase in productivity due to more infrastructure, dragging hourly wages down by 0.7% in 2031 and 0.8% in 2050.”

Put another way, that means “workers will have less capital to work with and less high technology because of the negative effect on investment,” said Arnon.

Not an Easy Passage

With its controversial proposals, the AJP is expected to face challenges as it makes its way through Congress. “We can already see different groups lining up to take aim at specific provisions,” Arnon noted. “I fully expect that if we do see any kind of final legislation, it’s not going to look exactly like this.”

The AJP is a work-in-progress, and its final shape would depend on the challenges it faces in Congress and modifications the Biden administration may incorporate. One big change came on April 8, when PWBM’s release of its study coincided with a report in The Wall Street Journal that the Biden administration plans to raise the income threshold for its proposed minimum corporate tax to $2 billion from its campaign proposal of $100 million. 

“The change will lose revenue and increase short-term deficits,” said Smetters. PWBM will assess the potential impact in future studies, he added. 

How to Stop the Poverty Pandemic

Experience shows that innovative and evidence-based approaches, when executed well, can dent poverty. With the COVID-19 pandemic threatening to reverse hard-won global gains, the need for policy-relevant research, and for scaling effective solutions, has never been more urgent.

Lindsay Coates, John Floretta

WASHINGTON, DC/CAMBRIDGE – Globally, extreme poverty is increasing for the first time in 20 years. 

Although some poor countries are now receiving COVID-19 vaccines, the pandemic is set to drive nearly 150 million people into extreme poverty by the end of 2021, reversing decades of progress.

Within the space of just weeks, the COVID-19 pandemic fundamentally altered how billions of people carry out their day-to-day lives. 

To understand the sheer scale of these effects, there is no better guide than a map.

But the world has a huge opportunity to help prevent this outcome, and not only through more generous aid and vaccine distribution. 

Lower-income countries also need assistance in adapting and scaling more robust social protection and livelihood programs. 

Such initiatives build resilience, enabling people to weather future economic crises. 

And collaborations between enterprising non-profits and researchers can help guide the way.

Careful, high-quality research to evaluate the effectiveness of specific social policies and programs in different contexts has increased markedly in the past two decades. 

A particularly rigorous approach known as randomized evaluation employs a methodology similar to that of medical trials to assess the real-life effects of promising innovations.

This research has identified a range of effective measures to reduce extreme poverty, including schemes to enroll more girls in school, help the unemployed find jobs, and support voters in making more informed election choices. 

The tremendous value of this research was recognized in 2019 when the Nobel Memorial Prize in Economic Sciences was awarded to three of its pioneers, Abhijit Banerjee and Esther Duflo of MIT and Michael Kremer of Harvard.

A vivid example of how social policy research-and-development collaborations can make a real difference to those whose livelihoods have been upended by the pandemic is the Graduation Approach, whose effectiveness Banerjee and Duflo have studied. 

Established and led by BRAC, the largest NGO based in the Global South, the Graduation Approach involves a holistic sequence of interventions that are evidence-based, highly adaptable to local contexts, and designed to meet the multidimensional needs of people in extreme poverty.

Graduation participants are provided with an income-generating asset such as a cow, a sewing machine, or a cash transfer. 

In addition, they receive wraparound support for the following 18-36 months, including training on how to generate income from the asset, life skills coaching, consumption support, access to a savings account, and links to government assistance.

BRAC previously collaborated with a team of economists from the London School of Economics on a randomized evaluation to study the Graduation program’s impact on poverty in rural Bangladesh. 

The results were impressive: the move to self-employment increased the poorest participants’ earnings by an average of 37% over four years. 

But could the approach be effective and scaled in other contexts?

To answer this question, nonprofits working in seven countries, from Pakistan to Peru, were trained to run the program while rigorous evaluation continued. 

Researchers from MIT’s Abdul Latif Jameel Poverty Action Lab (J-PAL) and Innovations for Poverty Action conducted six concurrent randomized evaluations in each country. 

These coordinated studies found the Graduation Approach to be one of the most effective of the evaluated programs for helping people propel themselves out of extreme poverty.

In nearly every country, Graduation program participants improved their economic outcomes. 

They successfully launched small businesses, and their increased income led them to explore other ways to make money. 

Participants also reported improved psychological well-being, including an increased sense of hope. 

A follow-up study published in November 2020 found that these positive effects persisted for up to ten years after the program ended.

To date, BRAC has reached more than 2.1 million households in Bangladesh, where the program originated, with a “graduation” rate of 95%. 

As of 2018, more than 100 organizations in nearly 50 countries have piloted or implemented Graduation programs.

The Graduation Approach’s worldwide expansion and proven ability to break the cycle of extreme poverty shows that designing innovative programs, collaborating with researchers to test them rigorously, and establishing trusted partnerships with governments can result in great strides toward scaling up the most effective schemes. 

High-quality research demonstrating the Graduation Approach’s effectiveness across contexts helped BRAC, J-PAL, and other partners convince donors and governments that the model can help vulnerable people create sustainable livelihoods and make social protection policies more inclusive and effective.

As BRAC scales Graduation globally through direct implementation and with partners, it has identified important lessons that can inform similar efforts. Above all, adherence to the key underlying principles driving a program’s impact is essential, while also adapting the model to each context. 

An ethos of learning and critical self-evaluation is central to program success, as Graduation’s 20-year evolution in Bangladesh has shown. 

And by examining a program’s effects on different population groups and continuing to tweak and test its components, like the size and type of livelihood packages provided, we can continue to leverage research to empower people in extreme poverty.

The scale of the Graduation Approach after years of iteration and evaluation points to areas where philanthropy and aid can be especially useful. 

These include investment in social policy innovations, rigorous evaluation of whether and how they work, and partnerships with governments to apply globally sourced knowledge to their own programs.

Our experience shows that innovative and evidence-based approaches, when executed well, can dent poverty. 

With the pandemic threatening to reverse hard-won global gains, the need for policy-relevant research, and for scaling effective solutions, has never been more urgent.

Lindsay Coates is Managing Director of BRAC’s Ultra-Poor Graduation Initiative.

John Floretta is Global Deputy Executive Director of MIT’s Abdul Latif Jameel Poverty Action Lab (J-PAL).

The world’s biggest economy

America’s boom has begun. Can it last?

High-frequency economic data suggest it’s full steam ahead

The latest monthly employment report, published on April 2nd, painted an impressive picture: over the previous month America created more than 900,000 jobs. 

That figure, the strongest since August, reflects the state of the economy in the first half of March, when the surveys took place. 

But a look at “high-frequency” economic data for more recent weeks, on everything from daily restaurant diners to Google-search behaviour, suggests that, since then, the recovery has if anything accelerated further. America’s post-lockdown boom has begun.

A rapid bounce-back would be welcome, because the world’s largest economy remains a long way off its pre-pandemic peak, and the damage has been severe. 

Even after the latest jobs numbers, over 8m fewer people are in work than before the pandemic. 

The job losses are concentrated among low-income groups (though it is no longer the case that women are more affected than men). 

One-third of small businesses remain closed. 

Poverty is higher than it was before covid-19 struck, especially among black families. 

And the impact of school closures on children’s education could last for decades.

High-frequency data, largely produced by the private sector, are useful in identifying economic turning-points before they get picked up in the government’s figures, which are slower to arrive. 

In March and April 2020, long before the publication of official numbers, these data showed that the economy was falling off a cliff. 

A year on, happily, they point to a rapidly strengthening economy.

Using mobility data from Google, The Economist has constructed an economic-activity index, which measures people’s visits to workplaces, stations, retail outlets and recreation sites. 

A month ago the index was 30% below its pre-pandemic baseline (see chart 1). 

In recent days the index has jumped to 20% below the baseline.

Other high-frequency data show similar trends. 

The number of passengers travelling through American airports is rising fast. 

Economists have also closely watched statistics from OpenTable, a booking platform. 

In February the number of restaurant diners was 48% lower than normal. 

So far in April it is 18% lower. 

Hotel occupancy is increasing rapidly. 

High-frequency indicators of manufacturing and services activity are surging, too.

People are venturing outside, and mixing, in greater numbers, in part because a successful vaccination campaign has allowed some easing of restrictions. 

And when people do leave the house, they have money to spend. 

On March 17th the Treasury deposited $250bn in stimulus cheques into people’s bank accounts, adding to the $1.5trn of extra personal savings (about 10% of annual consumer spending) that households had piled up by the end of 2020. 

A tracker by JPMorgan Chase, a bank, shows that payment-card spending is near its pre-pandemic level (see chart 2). 

In late March total spending was up by nearly 20% on the previous month, according to Cardify, a data-provider.

The upshot is that America is likely to register jumbo gdp-growth numbers in the second quarter of 2021. 

Research by Nicolas Woloszko of the oecd, a rich-country think-tank, gives a hint of what is to come. 

He uses another type of real-time data, Google-search trends, to construct weekly gdp measurements for the g20 economies. 

In the final week of March American gdp was about 4% below where it would have been in the absence of the pandemic. 

That is the strongest figure in over a year, and far better than most other rich countries.

Many forecasters are now expecting gdp growth of 6% or more in 2021. 

If that happens, then it will not come as a surprise if America notches up monthly jobs gains of 1m or more in future employment reports. 

The unemployment rate could be near its pre-pandemic rate fairly soon.

Yet two factors could spoil the party. 

One relates to economic “scarring”. 

Some economists worry that the pandemic has damaged America’s productive capacity. 

If lots of businesses have gone bankrupt, then even with buoyant demand many Americans will not have jobs to go back to.

So far there is no compelling evidence of a wave of insolvency. 

In 2020 total commercial bankruptcies were about 15% lower than the year before. 

Extensive fiscal support offered by the federal government has helped firms pay their bills, while many landlords have offered rent concessions. 

Bankruptcies have remained low so far in 2021, but no one really knows whether or not they will rise in the coming months, as fiscal support ends and landlords seek to make up for lost time.

The second factor relates to fears that infections could take off again, despite the momentum behind vaccination. 

There are particular concerns about coronavirus variants, such as one first found in Britain, which spread more easily (though the prevalence of the “British variant” has not stopped cases tumbling in Britain itself, where, as in America, vaccination has been proceeding apace). 

Cases of covid-19 in America are now rising again. 

Some places, such as Chicago and New Jersey, have paused reopening.

That is slowing the recovery, but not yet stopping it. 

Widespread vaccination has weakened the link between infection and hospitalisation. 

In Michigan and Florida, two states with high levels of the British variant, the Google-Economist economic-activity index has lost steam in recent days, though it is still stronger than it was in the first quarter of the year. 

There will be setbacks along the way, but expect the good economic news to start piling up.

Why manufacturing matters to economic superpowers

Reshoring makes sense for some industries as competition rises between the US and China

Rana Foroohar 

        © Matt Kenyon

Manufacturing matters. 

While it has become increasingly automated and globalised over the past several decades, it still holds a special place in the national psyche in the US and other big exporting nations, such as Germany, China and Japan.

Part of that is down to its disproportionate benefits to the economy. 

In the US, for example, although manufacturing represents just 11 per cent of gross domestic product and 8 per cent of direct employment, it drives 20 per cent of the country’s capital investment, 30 per cent of productivity growth, 60 per cent of exports and 70 per cent of business R&D, according to figures from the McKinsey Global Institute. 

Manufacturing’s share of the economy in many other developed countries is far higher.

No wonder the debate over where things are made is both emotional and political. 

This debate has come to the forefront in recent years, not only because of US-China tech and trade wars and supply chain shortages in the pandemic, but also because of human rights. 

Western brands including Nike, H&M, and European luxury producers find themselves in an increasingly difficult position for using cotton produced in Xinjiang, some of which may be harvested and spun by forced Uyghur labour.

US and European companies are under tremendous pressure to boycott Xinjiang cotton and use homegrown alternatives. 

Yet when they do, they risk a backlash from the Chinese, who seem to have added the Uyghurs to the list of “no-discussion” areas such as Tibet, Taiwan and Tiananmen. 

I suspect that the side brands take will depend largely on how important China is to their overall revenue and future growth.

But the textile industry has been becoming less globalised for some time now. 

In the US, sectors including textiles and furniture were among those hit hardest by the accession of China to the World Trade Organization, since they are both labour intensive and tradable.

However the calculus has shifted now that wages and domestic demand have risen in China. Well before the Xinjiang concerns, apparel supply chains were shifting. 

Chinese producers exported 71 per cent of finished apparel goods in 2005. By 2018, it was just 29 per cent. 

This change is coming at the same time as other tailwinds for the regionalisation of apparel. 

More brands are going directly to consumers, bypassing expensive bricks and mortar shops. 

This is also increasing investments in software, which will boost efficiency, shorten production cycles, and thus further shift the labour/transport cost/productivity arbitrage in favour of local production.

Whether such reshoring matters for national economies depends very much on the industry. 

A fascinating study by MGI, to be released on April 15, examines 30 main manufacturing sectors in the US. 

It finds that 16 of them stand out for their economic and strategic value, as measured by their contribution to national productivity and economic growth, job and income creation, innovation and national resilience. Apparel is not on the list. 

But semiconductors, medical devices, communications equipment, electronics, autos and auto parts, and precision tools are.

Of course, some of those industries are dividing along national lines, often more for political than economic reasons — witness the US-China chip wars. 

While the US still has the edge in chip design, domestic production capacity has fallen dramatically over the past three decades. 

That is one reason for the shutdowns in the US automotive industry that began in February, when post-pandemic production started to ramp back up. 

That same month, President Joe Biden called for a national review of supply chain vulnerabilities.

His administration has already made it clear that it would like to see more domestic production of semiconductors, medical supplies and other strategically important items. 

But, says MGI chair James Manyika, “size of demand for domestic production matters, especially in industries where there are scale and learning curve effects”, such as semiconductors, which are made far more cheaply in Asia. 

The US could create more demand for domestically fabricated chips, but only if the government underwrote investment via guaranteed federal procurement of supplies, as it did for semiconductors in the 1950s and 1960s.

Given the push towards “buy American” under Biden, as well as the use of the federal balance sheet to support union labour in government contracts and healthcare infrastructure, that’s not inconceivable. 

Indeed, some within the defence community (which needs high-end chips for military equipment) as well as the progressive left (which wants the US to lead on cutting-edge clean tech, which might also create semiconductor demand) would like the US and China to decouple supply chains for chips.

Where would this leave Europe? 

Sitting very uncomfortably between two economic superpowers. 

It does not matter much at a national competitiveness level what fast fashion purveyors and luxury retailers do about Xinjiang, though the moral questions involved may well have brand value implications.

But it does matter what governments do to support domestic demand or control supply chains. 

I suspect that those decisions will start to revolve less around simple cost and efficiency calculations, and more around a broad discussion of national competitiveness.

Biden Must Fix the Future, Not the Past

The US administration's proposed $2 trillion infrastructure package could transform the US and set an important example for other developed countries to follow. But to achieve its potential, the plan must avoid misleading state-versus-market dichotomies and outdated Cold War tropes.

Dani Rodrik

CAMBRIDGE – President Joe Biden’s $2 trillion infrastructure plan is likely to be a watershed moment for the American economy, clearly signaling that the neoliberal era, with its belief that markets work best and are best left alone, is behind us. 

But while neoliberalism may be dead, it is less clear what will replace it.

The challenges that the United States and other advanced economies face today are fundamentally different from those they faced in the early decades of the twentieth century. 

Those earlier challenges gave rise to the New Deal and the welfare state. 

Today’s problems – climate change, the disruption of labor markets due to new technologies, and hyper-globalization – require new solutions. 

We need a new economic vision, not nostalgia for a mythicized age of widely shared prosperity at home and global supremacy abroad.

On climate change, Biden’s plan falls short of the Green New Deal advocated by progressive Democrats such as Representative Alexandria Ocasio-Cortez. 

But it contains significant investments in a green economy, such as supporting markets for electric vehicles and other programs to cut carbon dioxide emissions, making it the largest federal effort ever to curb greenhouse-gases. 

On jobs, the plan aims to expand employment offering good pay and benefits, focusing, in addition to infrastructure, on manufacturing and the growing and essential care economy.

New ways of thinking about the role of government are as important as new priorities. 

Many commentators have framed Biden’s infrastructure plan as a return to big government. 

But the package is spread over eight years, will raise public spending by only one percentage point of GDP, and is projected to pay for itself eventually. 

A boost in public investment in infrastructure, the green transition, and job creation is long overdue. 

Even if the plan were nothing more than a big public investment push financed by taxes on large corporations, it would do a lot of good for the US economy.

But Biden’s plan can be much more. 

It could fundamentally reshape the government’s role in the economy and how that role is perceived. 

Traditional skepticism about government’s economic role is rooted in the belief that private markets, driven by the profit motive, are efficient, while governments are wasteful. 

But the excesses of private markets in recent decades – the rise of monopolies, the follies of private finance, extreme concentration of income, and rising economic insecurity – have taken the shine off the private sector.

At the same time, it is better understood today that in a complex economy characterized by so much uncertainty, top-down regulation is unlikely to work. 

Regardless of the specific domain – promoting green technologies, developing new institutional arrangements for home-care workers, deepening domestic supply chains for high-tech manufacturing, or building on successful workforce development programs – government collaboration with non-governmental actors will be essential.

In all these areas, the government will have to work with markets and private businesses, as well as other stakeholders such as unions and community groups. 

New models of governance will be required to ensure public objectives are pursued with the full participation of those actors who have the knowledge and capacity to achieve them. 

The government will have to become a trusted partner; and it will have to trust other social actors in turn.

In the past, each excessive swing in the state-market balance has eventually prompted an excessive swing in the opposite direction. 

The Biden plan can break this cycle. 

If it succeeds, the example it sets of markets and governments acting as complements, not substitutes – demonstrating that each works better when the other pulls its weight – could be its most important and enduring legacy.

In this regard, it is unhelpful to view the Biden plan as a way to restore America’s competitive position in the world, especially vis-à-vis China. 

Unfortunately, Biden himself is guilty of this framing. 

The package will “put us in a position to win the global competition with China in the upcoming years,” he recently argued.

It may be politically tempting to market the infrastructure plan in this fashion. 

In an earlier era, the prevailing fear that the US was losing its edge to the Soviet Union in ballistic missiles and in the space race helped catalyze a national technological mobilization.

But there is much less reason for fearmongering today. 

It is unlikely to buy much Republican support for the plan, given the intensity of partisan polarization. 

And it diverts attention from the real action: if the plan increases incomes and opportunities for ordinary Americans, as it should, it will have been worth doing, regardless of the effects on America’s geopolitical status.

Moreover, economics is different from an arms race. 

A strong US economy should not be a threat to China, just as Chinese economic growth need not threaten America. 

Biden’s framing is damaging insofar as it turns good economics at home into an instrument of aggressive, zero-sum policies abroad. 

Can we blame China if it tightens restrictions on US corporations as a defensive measure against the Biden plan?

The plan could transform the US and set an important example for other developed countries to follow. 

But to achieve its potential, it must avoid misleading state-versus-market dichotomies and outdated Cold War tropes. 

Only by leaving behind the models of the past can it chart a new vision for the future.

Dani Rodrik, Professor of International Political Economy at Harvard University’s John F. Kennedy School of Government, is the author of Straight Talk on Trade: Ideas for a Sane World Economy.

India’s Trump Card Against China

Moving into the spotlight is the strategically invaluable Andaman and Nicobar Islands.

By: Phillip Orchard

Despite its enormous potential, India is by no means an inevitable counterweight to Chinese ambitions in the Indian Ocean. 

The country's immense domestic needs and its preoccupation with land-based threats have prevented it from turning its attention fully to the maritime realm. 

And the more China races ahead with its breakneck military expansion, the harder it will be for India to catch up

But it's a mistake to look at Indian and Chinese maritime capabilities as an apples-to-apples comparison. 

India doesn't need to match China destroyer for destroyer or missile for missile because India has some extraordinary geographic advantages in its favor – ones that also happen to make it particularly attractive as a partner with other powers in the region. 

And the strategically invaluable Andaman and Nicobar Islands, India's great trump card in its intensifying competition with China, is moving into the spotlight.

India's Point of View

For a country with more than 4,500 miles (7,200 kilometers) of coastline, India has never been particularly ambitious in the maritime sphere. 

This is, in part, because for much of its history it didn’t have much reason to be. 

Geographically, India is protected by the near-impenetrable Himalayas to its north, harsh subtropical regions to its east and deserts to the west. 

Its long coastline makes it vulnerable to seaborne threats, sure, but few powers have ever been capable of exploiting this vulnerability. 

Buffered by the vast waters of the Arabian Sea, the Bay of Bengal and the open ocean, India is blessed with abundant strategic depth when it comes to naval threats. 

And at any rate, any invading power would confront India’s demographic immensity, which makes direct subjugation by force nearly impossible.

That outside powers have dominated the subcontinent in centuries past is a result mainly of its internal divisions. 

Its primary occupiers – various Muslim dynasties from the 11th century to the 18th century and the Europeans shortly thereafter – succeeded because they managed to turn India against itself, exploiting the competition among different factions and power centers to cultivate coalitions of collaborators who would support their largely commercial objections.

As a result, India has generally focused inward since it became independent. 

Its viability as a modern nation-state has depended on its governments’ ability to manage internal divisions. 

External geopolitics, with the exceptions of the periodic blowups with Pakistan and occasional border clashes with China, took a back seat to more immediate concerns. But the demands of this endeavor are changing, as is India’s broader strategic environment, forcing New Delhi to look increasingly to the far seas.

Its most vital lifelines flow from the west. To fuel growth and development, India’s economic interests have expanded far beyond the subcontinent. 

The country has well over a billion mouths to feed, and sustaining the level of economic growth and modernization necessary to support this population has given India a voracious appetite for commodity imports such as energy. 

In 2019, around 47 percent of the total energy India consumed came from imports, including more than 80 percent of its oil supplies. 

As a result, the country has been quickly expanding its naval presence around critical chokepoints near the Arabian Peninsula and Horn of Africa – waters known to be teeming with pirates, rebels and explosive risks rooted in Middle Eastern rivalries.

Indian interests in eastbound sea lanes are growing too as the country seeks to boost its status as a manufacturing and export power. 

Already, around 40 percent of India’s trade passes through the turbulent waters of the Strait of Malacca, which has plenty of pirates of its own – and, more concerning for India, Chinese ambition. 

As China moves to address its own strategic concerns to the east, secondary issues to its southwest are becoming more important, making India more of a potential threat, however unwittingly, and vice versa. 

China needs to find ways to bypass chokepoints in the East and South China seas, so it needs to build deep-water ports, pipelines and rail lines in India’s backyard. And to prepare for a potential conflict that blocks its maritime chokepoints, it also needs to develop naval forces to keep its backup outlets open and counter enemy forces coming from the west – an effort that will require a network of bases and logistics facilities on India’s periphery to support them.

Thus, India now has good reason to fear both Chinese encirclement and Chinese domination of more distant waters on which India increasingly relies. And this means India now has very good reason to invest considerably more in developing the capabilities to secure trade routes and sustain the regional balance of power with China.

But India has had a hard time shifting resources from its army and air force to the navy. While it’s been touting grand plans for a 200-ship navy by 2027 (up from 130 today) and quietly laying the groundwork for its own “string of pearls” in the Middle East and Southeast Asia, the navy still received just 15 percent of last year’s budget, compared with 23 percent for the air force and 56 percent for the army (the bulk of which goes to pensions). 

The navy’s share of the pie is actually down from 18 percent in 2012. India's struggle to shift focus to the maritime realm might be one motivator behind China's moves in the Himalayas and with Pakistan. 

The more India stays bogged down in conflicts on land, in other words, the less it can shift focus to the sea.

The Metal Chain

China has little reason to fear India as a major threat to its interests in, say, the South China Sea or around Taiwan. But India doesn't need to achieve military parity with China to become a problem. 

It simply needs to leverage its geographic advantages and the growing interest in cooperation from external powers like the U.S. 

This puts the spotlight squarely on the strategic godsend that are India's Andaman and Nicobar Islands.

The archipelago, featuring some 572 islands (just 38 of them inhabited) stretches from just 100 miles north of the northern tip of Indonesia's Sumatra island through the heart of the Andaman Sea toward Myanmar. 

The islands are, in effect, the gateway to the Strait of Malacca. In the view of Chinese defense planners, the more apt metaphor for the islands is a “metal chain.” 

For India, developing the capabilities needed to threaten Chinese access to Malacca from the Indian mainland would be difficult and expensive, requiring rapid leaps forward in its submarine, aircraft carrier, air force and missile programs, as well as in India’s military logistics and surveillance capabilities. 

Threatening Chinese access to Malacca from the Andaman and Nicobars is more straightforward. 

The archipelago is the proverbial “unsinkable aircraft carrier.” 

Indian bases there are ideally placed for conducting surveillance operations, deploying anti-ship missiles and radar stations, stationing supply depots, refueling fighter planes, and so forth.

The islands, moreover, make India immediately attractive as a partner for powers like the U.S that already have the capabilities to maximize their strategic value – something that could allow India to keep China at bay without breaking the bank by trying to match China’s spending on the People's Liberation Army. 

India’s growing ties with Australia are particularly notable in this regard, given how Australia's Cocos Islands could play a similar role in blocking Chinese egress through the Sunda and Lombok straits. 

The Andaman and Nicobars also could facilitate deeper military cooperation with Southeast Asian countries that historically are leery of provoking China without the ability to defend themselves. 

In 2018, India and Indonesia reached a tentative reciprocal access agreement giving India access to a port on the Indonesian island of Sabang, located just southeast of the southernmost Andaman and Nicobar island.

India, though, is still in the early stages of modernizing the military infrastructure enough to maximize their strategic value. 

At present, the islands are home to seven air and naval bases. 

But India began a series of much-needed improvements – for example, lengthening runways to be able to handle fighter jets or long-range reconnaissance aircraft and expanding port infrastructure to handle large warships – only over the past few years. 

India has also been somewhat reluctant to open up the islands to foreign partners. 

Reciprocal access agreements it signed with the U.S., France, Japan and Singapore in recent years, for example, reportedly did not include the Andaman and Nicobars.

But there's been a renewed sense of urgency in New Delhi to tap into the islands’ strategic potential more effectively. 

At the height of the crisis in the Himalayas last summer, there were several calls in Indian media to put the Andaman and Nicobars to work, and India subsequently held naval exercises around the islands to signal to China that aggression in the Himalayas could backfire in ways that could truly hurt China. 

In August, Indian Prime Minister Narendra Modi deemed the islands’ development a strategic priority and announced a new development plan. 

The same month, India announced the completion of a submarine optical fiber connectivity project in the area. 

In October, a U.S. long-range sub hunter became the first U.S. military aircraft to make a refueling pitstop. In December, India test-launched supersonic anti-ship Brahmos missiles from the islands. 

In March, Japan announced a $36 million grant for the development of energy storage systems on South Andaman.

Nothing will happen quickly. India's budgetary problems remain, and the pandemic isn't going to help. 

It's leery of giving China any more reason to try to militarize one of its Belt and Road ports on India's doorstep. 

There's some evidence that Indonesia and, in particular, Malaysia aren't exactly thrilled about the trajectory toward militarization of the Strait of Malacca, and India has an interest in handling Southeast Asian suspicions carefully. 

And India, in general, is still embracing the concept of strategic alignment with outside powers – something it historically has typically eschewed – only slowly.

Even so, on the question of whether and just how much India will emerge as a major player in the burgeoning competition over the Indo-Pacific, the Andaman and Nicobars are the center of gravity. 

Watch them closely.