T HE URBA N I MP E RAT I VE Towards Compet i t i ve C i t i es EDITED BY EDWARD GLAESER ABHA JOSHI-GHANI The Urban Imperative The Urban Imperative Towards Competitive Cities Edited by Edward Glaeser and Abha Joshi-Ghani 1 1 Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trademark of Oxford University Press in the UK and in certain other countries Published in India by Oxford University Press YMCA Library Building, 1 Jai Singh Road, New Delhi 110 001, India © The International Bank for Reconstruction and Development / The World Bank 2015 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, NW Washington, DC 20433 The moral rights of the authors have been asserted First Edition published in 2015 All rights reserved. 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The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Contents List of Tables, Figures, Boxes, and Maps vii Preface xi Acknowledgments xiii Rethinking Cities xv Edward Glaeser and Abha Joshi-Ghani 1 Urbanization as Opportunity 1 Brandon Fuller and Paul Romer 2 The Shifting Urban Economic Landscape: What Does It Mean for Cities? 18 Richard Dobbs and Jaana Remes 3 Urbanization and the Geography of Development 51 J. Vernon Henderson 4 Analyzing Urban Systems: Have Megacities Become Too Large? 89 Klaus Desmet and Esteban Rossi-Hansberg 5 Are Cities the New Growth Escalator? 116 Enrico Moretti 6 Entrepreneurship, Public Policy, and Cities 149 Joshua Lerner 7 Urbanization and (In)Formalization 173 Ejaz Ghani and Ravi Kanbur vi Contents 8 Bridging Divides: Enabling Urban Capabilities 210 Saskia Sassen 9 The Great Migration: Urban Aspirations 234 Michael Keith 10 Infrastructure: Doing More with Less 261 Jonathan Woetzel and Herbert Pohl 11 Urban Transport: Can Public-Private Partnerships Work? 290 Eduardo Engel and Alexander Galetovic 12 Sustainable and Smart Cities 309 Matthew E. Kahn 13 Housing Matters 336 Sonia Hammam 14 Converting Land into Affordable Housing Floor Space 378 Alain Bertaud 15 Housing and Urbanization in Africa: Unleashing a Formal Market Process 413 Paul Collier and Anthony J. Venables Index 437 About the Editors and Contributors 457 Tables, Figures, Boxes, and Maps Tables 1.1 Urban residents and population, 1910, 2010, 2110, and 2210 9 4.1 Variables and sources 95 4.2 Urban policies in China 104 4.3 Urban policies in China for constant population- weighted characteristics 106 4.4 Urban policies in Mexico 110 4.5 Urban policies in Mexico for constant population- weighted characteristics 111 5.1 Metropolitan areas with the largest percentage of college graduates 119 5.2 Metropolitan areas with the smallest percentage of college graduates 120 7.1 Harnessing entrepreneurship and job creation in cities—formal manufacturing 189 7.2 Harnessing entrepreneurship and job creation in cities—informal manufacturing 191 Figures 1.1 Observed and projected normalized population for more developed and less developed regions, 1700–2200 6 1.2 Observed and projected urban share of the population in more developed and less developed regions, 1700–2200 7 1.3 Observed and projected number of new urban residents in more developed and less developed regions, 1900–2200 8 viii Tables, Figures, Boxes, and Maps 2.1 Per capita GDP has risen in tandem with increases in urbanization 19 2.2 The relative economic weight of large cities varies across regions 24 2.3 The Emerging 440 is expected to generate 47 percent of global GDP growth to 2025 30 2.4 Household income pools are poised to grow at twice the rate of the number of households in the Emerging 440 33 3.1 Urban-rural divergence and then convergence as urbanization proceeds 54 3.2 Urbanization, income, technology, and sector change 56 3.3 The spatial Gini and political structures 73 3.4 The world size distribution of cities 81 4.1 Counterfactuals without differences in one city characteristic (United States) 97 4.2 Counterfactuals changing dispersion in characteristics to U.S. levels (China) 101 4.3 Counterfactuals different urban policies (China) 107 4.4 Counterfactuals changing dispersion in characteristics to U.S. levels (Mexico) 108 5.1 Fraction of college-educated workers and salary of high school graduates in the United States, by metropolitan area 128 7.1 Jobs in developing countries are concentrated in the informal sectors 179 7.2 Informal sectors are exceptionally persistent (share of population in informal employment, earliest and latest data points available) 180 7.3 Spatial location of economic activity in India 186 7.4 Large informal sectors are associated with high poverty rates 194 7.5 Convergence in productivity in India’s unorganized manufacturing, 1989–2005 197 7.6 Convergence in productivity in India’s organized manufacturing, 1989–2005 197 9.1 The indicators of integration framework 245 Tables, Figures, Boxes, and Maps ix 10.1 All regions contribute to growth in urban demand, but China’s share is highest in key categories 267 10.2 Deliver infrastructure productively—lean construction reduced construction costs 10 percent and completion times 40 percent 278 11.1 Contracting under public-private partnerships and conventional provision 293 13.1 Incidence of renters by income quintile in selected Latin American countries, 2006 346 14.1 Commuting trip travel time in Gauteng, 2009 385 14.2 Land supply corresponding to one hour commuting time for three spatial arrangements for jobs and amenities 386 14.3 The potential supply of land depends on the speed of different transport modes 391 14.4 Ahmedabad’s land supply within 30 kilometers of the city center 393 14.5 The land allocation process in new areas in Ahmedabad over 2000–10 398 14.6 Typical low-cost housing layout according to Gujarat Development Control Regulations 401 14.7 Ahmedabad—typical slum layout: Sankar Bhuvan Shapur 406 Boxes 2.1 The McKinsey Global Institute’s Cityscope 21 2.2 The rising consumer class 32 3.1 Urbanization fostered by agricultural booms in Sub-Saharan Africa 58 3.2 New York City’s transformation 63 3.3 Industrial decentralization in India 66 3.4 Hinterland income and the cost of transport in Sub-Saharan Africa 70 3.5 Essentials for timely city formation and expansion 78 8.1 Foreign domestic worker rights, Hong Kong SAR, China 217 8.2 Female Youth Employment Initiative, Afghanistan 218 x Tables, Figures, Boxes, and Maps 8.3 Childcare for factory workers, Bangladesh 219 8.4 Juntos program: conditional cash transfers targeting women in Peru 220 8.5 Mother Centers International Network for Empowerment 221 9.1 Plural migrations and welfare externalities: social housing eligibility in east London 238 9.2 Shenzhen Speed: city growth and migrant integration 242 9.3 Migration settlement dynamics in the city: inclusive exceptionalism 248 9.4 Geographic scale jumping and urban migration 251 9.5 From basic principles to policy instruments in cities of migration 257 14.1 The five-hour commuting burden in Gauteng, South Africa 389 14.2 Door-to-door speed of public transport 392 Maps 2.1 The globe’s shifting economic center of gravity 28 11.1 Urban Highways in Chile 305 Preface Cities can be understood as the product of a triad of forces. First, and most obvious, cities are physical entities—streets, buildings, and subways. Visitors see these realities first, and while they are only part of the city, they shape everything else that occurs in an urban area. The physical bones of the city help determine the cost of housing, the integration of rich and poor, the ease of getting around, the quality of air and water. The second force is the public sector, which defines the borders of the city and has the responsibility for providing clean water and public safety. Public regulations shape private entrepreneurship and the buildings that give any city its skyline. Close proximity increases human connections, for good and bad. And the public sector helps manage those interactions, allowing the benevolent ones to flourish and limiting the more damaging consequences of urban interaction. Third is the magic of human interaction. Certainly, cities are physical entities and governmental units, but the real heart of the city is its people. Shiny buildings do not mean urban success—true success means that ordinary humans are finding success, by finding each other, within dense urban enclaves. These interactions gener- ate innovations in art and technology, and religion and politics, as they have for thousands of years since Pericles’ Athens and Kautilya’s Taxila. The goal here is to explore how these forces come together and shape cities, and how the public sector can play a more positive role in enabling the cities of the developing world to flourish. Too many cities in Sub-Saharan Africa continue to suffer from the oldest urban scourge—unclean water. In Uganda, only a fifth of the urban xii Preface population has access to piped water. Crime and murder turn many Latin American neighborhoods into places of terror rather than opportunity. Limited transport options can turn daily commutes in Asia’s megacities into arduous treks. Shantytowns are a regular sight in many of the world’s burgeoning cities. There are no easy solutions. The cities of the West acquired clean water only through massive expenditures on infrastructure. In America’s cities the battle against crime seemed unwinnable just two decades ago. Long commutes and expensive housing infect almost every thriving city. But even if the great problems of urban life cannot be simply solved, there are better—and worse—policy approaches to these problems. Human history provides hard-won knowledge about how to make cities more livable. No discipline has a monopoly on wisdom. We have brought together leading thinkers from several fields to bring their insights to urban issues. Collectively, their message is that the public sector must play a significant role, but that there is a danger for overreaching. Governments can over-regulate and build the wrong infrastructure. Without better decision making, the world’s cities will be unable to realize their true potential. The chapters in this book are intended not to prescribe ways forward but rather to incite debate and further research. And while exploring many key issues in rethinking cities, they are by no means exhaustive. We do not address several issues, among them urban governance and municipal finance since any meaningful discussion on these would require taking into account the huge diversity of approaches and constructs. We hope that you will find this collection of essays informative and thought-provoking. Edward Glaeser and Abha Joshi-Ghani Acknowledgments This volume benefitted from the contributions, support, and advice of many. The chapters in this volume were commissioned under the Urbanization Knowledge Platform launched by the World Bank in 2011 to strengthen its links with research institutes, the private sector, policy makers, and non-governmental organizations. We are most grateful to the Urbanization Knowledge Platform and the World Bank’s research committee for their strong support. First and foremost, we wish to thank the individual con- tributors to the volume for their contributions and also for their immense patience: Paul Romer and Brandon Fuller, New York University, Stern School of Business; Richard Dobbs and Jaana Remes, McKinsey Global Institute; Enrico Moretti, University of California, Berkeley; Joshua Lerner, Harvard Business School; Saskia Sassen, Columbia University; Michael Keith, COMPAS, University of Oxford; Ejaz Ghani, The World Bank; Ravi Kanbur, Cornell University; Jonathan Woetzel and Herbert Pohl, McKinsey & Co.; Eduardo Engel, Yale University; Alexander Galetovic, Universidad de los Andes; Alain Bertaud, Urban Planner; Sonia Hammam, The World Bank; Paul Collier and Tony Venables, University of Oxford; Matthew E. Kahn, University of California, Los Angeles; Esteban Rossi-Hansberg, Princeton University; Klaus Desmet, Universidad Carlos III de Madrid; and Vernon Henderson, Brown University. We benefitted immensely from the suggestions of the peer reviewer, Henry Overman, London School of Economics; David Dowall, xiv Acknowledgments UC Berkeley; and Uwe Deichmann and Jean-Jacques Dethier, The World Bank. We would also like to thank the following for their insights, sug- gestions and contributions: Sameh Al Wahba, Marianne Fay, Daniel Hoornweg, Abhas Jha, Hyoung Gun Wang, Austin Kilroy, Dennis Linders, Greg Clark, and Miguel Luiz Bucalem. A special thanks to Somik Lall for his help and contribution during the earlier phase of the book. Paola Colla, Berenice Sanchez, Fernando Armaderis, Punam Prakash, and Vivien Cherian provided critical administrative support. Bruce Ross-Larson and his team from CDI edited the manuscript and were generous with their time and attention, the Office of the External Publisher at the World Bank provided very useful sugges- tions. James Yang did the original illustration for the cover and he and his team were gracious in their accommodation of the iterations. A very heartfelt thanks to Sanjay Pradhan, Vice President, Learning, Leadership, and Innovation, The World Bank, and Kaushik Basu, Chief Economist, The World Bank, for their advice, guidance and incredible support. Finally, a special thanks to Mark Hirschboeck, The World Bank, for patiently, humorously and steadily tracking the edits, collating the chapters, following up with all the contributors, and keeping a keen eye on the various iterations. Rethinking Cities Edward Glaeser and Abha Joshi-Ghani Some three billion people will move into cities by 2030. The vast majority of this demographic shift will take place in developing countries. Urbanization is undoubtedly a key driver of development— cities provide the national platform for shared prosperity. But urbanization also poses enormous challenges—congestion, air pollution, social and economic divisions, crime and violence, the breakdown of public services, and creation of the slums that 1 billion urban residents call home. It is clear that cities have not performed as well as can be expected in their transformative role. But they have enormous potential to lift millions out of poverty and become hubs of knowledge, innovation, and entrepreneurship. How do we empower city leaders to harness the unprecedented urbanization taking place today and address the vast inequalities of access and opportunity that cities present? How do we avoid the mistakes of the past to ensure that the aspiring cities of the developing world grow in a way that is inclusive, equitable, and sustainable. Business as usual is not an option. So, what should be done—and why do we need to get it right? Why Rethink Cities? In 1899, Adna Weber began his magisterial survey of urban growth by observing that “the most remarkable social phenomenon of the xvi Rethinking Cities present century is the concentration of people in cities” (Weber 1899). Yet when Weber wrote, populations remained predominantly rural, even in wealthy countries, and poorer nations were overwhelming rural, as they had been for millennia. At the end of the 20th century, the developed world was overwhelmingly urban, but more than 60 percent of the populations of Africa and Asia were still rural (United Nations 2001). The 21st century has already witnessed the halfway point where more than 50 percent of the world’s population is now urban, and in this century, almost every nation is likely to become predominantly urban. The great transition from farm to city is filled with economic, social, and political promise. Few countries have transitioned from poverty to prosperity without urbanizing. The concentration of people in cities can offer both economic opportunity and the chance for social change toward a more open, innovative, inclusive, and democratic society. The easy spread of knowledge within dense areas does not just enable computer programmers to enter the global economy, it also enables the spread of new ideas about equality and opportunity and gives voice to multiple and diverse stakeholders, who are the lifeblood of political reform. While urbanization can mean economic dynamism, inclusion, and democracy, it also creates enormous challenges, and the diffi- culties of urban life are magnified when the public sector is weak. Urban proximity enables the exchange of bacteria just as easily as the exchange of new thoughts. It took centuries for the cities of the West to become places of good health, rather than contagious disease, but congestion and high housing prices continue to bedevil the world’s more prosperous urban places. The cities of poorer nations, especially those with more problematic public sectors, remain beset by enor- mous challenges. Despite these difficulties, urbanization will, and should, continue. Widespread prosperity seems much more likely to emerge from new cities than from the farms of the less developed world. The right response to the challenges of urban life is not to try to confine aspiring urbanites to rural poverty, but to defeat the demons that come with density. There are no easy solutions. The cities in developed coun- tries acquired clean water only through massive expenditures on Edward Glaeser and Abha Joshi-Ghani xvii infrastructure. In American cities, the battle against crime seemed unwinnable just two decades ago. Long commutes and expensive housing infect almost every thriving city. But even if the great prob- lems of urban life cannot be simply solved, there are better—and worse—policy approaches to these problems. Human history pro- vides hard-won knowledge on how to make cities more livable. There are many different plausible approaches to understanding urban solutions. One approach emphasizes clearly defined public sectors—such as transportation, police, and public health—and focuses on solutions in each sectoral silo. Yet some problems—such as economic vitality and quality of life—span sectors and require solutions outside any one area of public intervention. Therefore, a second approach might start with clearly defined objectives, such as longevity and economic prosperity, but these can be too broad, and different fields often differ in their approaches. This chapter presents a hybrid approach traversing both. Rethinking city strategies Policy makers and city mayors need to tackle a wide range of prob- lems, from debilitating conditions in urban slums to the lack of basic services such as clean water and sanitation, inadequate housing, the exclusion of the poor from the city’s socioeconomic fabric, and the management of natural hazards and pollution. If these problems are left unaddressed, cities can become a source of social and political instability. But cities can instead become the engines of transformative change toward inclusive, people-centered, and sus- tainable development. The key questions examined here center on cities and economic growth and the changing dynamics of world economic geography. Should we expect the economic success of cities like Bangalore and Shenzhen to trickle down to the less fortunate? What policies can ensure that the economic benefits of urbanization help a broad swath of the population? From the economy, pivot to the physical city: the market failures that lead to sprawling congested cities also cause environmental dam- age, increase greenhouse gas emissions, and inflict deleterious impacts on the most vulnerable citizens, the urban poor. How do cities xviii Rethinking Cities manage urban land, housing, and transportation to become sus- tainable and livable? No one doubts that cities need infrastructure, including sewage facilities, roads, and power generation. Yet while the need for infrastructure is clear, the best means of providing it are less obvious. Should it be provided by the public or private sectors? How can limited financing be used more effectively? National poli- cies matter for cities, and national policy makers can no longer afford to ignore this if they want to harness urbanization for economic growth, job creation, inclusion, and sustainability. The urban imperative: unleashing economic change Few cities expand without economic success. Just a handful of cities have had such powerful non-economic attractions that they have grown without a core economic comparative advantage. In the United States, early Boston attracted religious migrants, and Los Angeles drew in Midwestern farmers interested in a more Mediterranean climate. But even in these cases, urban pioneers wanted to earn a living, and later urbanites were attracted by the economic potential unleashed by the first residents. A more common historical pattern is that a city forms around a political nucleus. But even if political power is the primary source of the city’s external revenues, people cluster around that power searching for economic advantage. Every large city that is also a capital—from Washington, DC, to Kinshasa and Ankara—has grown in part because of the economic activity generated by the central authority. Yet even those cities are usually eager to see more non-political sources of prosperity. In commercial cities, the fight for economic success is even more critical. What do we know about urban productivity? The first, and most central, fact about the prosperity of cities is that productivity and incomes typically increase with city size and density. Glaeser and Gottlieb (2009) provide evidence for the economies of agglomera- tions in the United States, and there are many studies document- ing similar patterns in other wealthy nations (for example, Combes et al. 2008). If anything, the connection between urban density and prosperity seems to be even stronger in the developing world. Wages Edward Glaeser and Abha Joshi-Ghani xix typically rise by 6 percent as density doubles in the United States. The connection between density and incomes appears to double in India and triple in China (Chauvin et al. 2014). These facts just con- firm what seems obvious to the naked eye—economic growth in the developing world is uneven and highly concentrated in cities. Economists since Adam Smith have sought to understand why prosperity is higher in large population centers. One hypothesis is that some areas have innate productivity advantages as a result of natural factors, such as access to waterways or mines, and people come to cities to be near those productivity advantages. A related view is that some cities have manmade advantages, including the presence of national government, which attracts people. According to this view, the link between density and prosperity reflects largely reverse causality—productivity causes density, not the reverse. There surely was much truth to this view historically. The ports of Liverpool, New York, and Shanghai were major geographic advan- tages that helped those cities grow. Bleakley and Lin (2012) docu- ment how U.S. cities grew at fault lines, the natural stopping point of inland navigation. Coal mines were critical to Essen and Pittsburgh. The perceived political advantages of British control during the colo- nial era were surely part of the appeal of Singapore and Hong Kong Special Administrative Region (SAR), China. The economies of agglomeration Few scholars see natural resources as the cause of most urban productivity today. Commodities, like coal, can be easily shipped and the natural harbors of many cities have become irrelevant. Soil quality may explain historical density levels (Combes et al. 2008), but it is hard to imagine that soil quality has any direct impact on productivity today. Even in Africa, where urbanization is often associated with commodities, there is increasing evidence of agglomeration economies. Instead, most scholars believe that the agglomeration produces its own productivity, perhaps abetted by governmental factors and connections to the outside world. The benefits of being around other people are typically labeled agglomeration economies, the starting point for understanding xx Rethinking Cities the sources of urban success. Since agglomeration economies are so basic, and so ubiquitous, it is useful to review them, for they underlie everything else that follows. At their core, agglomeration economies occur because density increases the ease of moving goods, people, and ideas. Cities remove the physical spaces between people and firms, and proximity is valuable precisely because it makes con- nections easier. The most basic agglomeration economy is the reduction of trans- port costs for goods, which is emphasized by Krugman (1991) and others: if a supplier locates near customers, the costs of shipping decline. Ellison et al. (2007) show that manufacturing industries that buy and sell to each other also locate near one another. This agglomeration economy is closely linked to economies of scale at the firm level, because if factories were infinitely indivisible, they would just spread out to be located near every conceivable customer. Cities enable scale economies and proximity for trading partners. The decline in transport costs has made this agglomeration force less important in the developed cities of the West. For example, cities such as New York and London were once manufacturing power- houses, places where factories located to be close to customers and transport infrastructure. As it became easier to ship goods, manu- facturing left older, wealthier cities for cheaper locales in suburbs or lower-cost regions or lower-cost countries. In the 1960s and 1970s, many older cities had to struggle with the challenges created by this deindustrialization. A similar trend can be observed in some develop- ing countries today, where manufacturing is gradually moving out of cities in search of cheaper locales. But even if manufacturing is now far less important to San Francisco and Milan, it remains a mainstay for urban areas in the developing world. Developing countries are at an earlier stage of development, and lower labor costs give them an advantage in pro- ducing manufactured goods. Moreover, transportation networks are far less reliable in the developing world, which give a greater edge to urban areas, especially if they are also well-functioning ports. It is far easier to ship from rural Ohio than from rural Maharashtra, so new manufacturing is far more likely to locate in Mumbai than in Cleveland. Edward Glaeser and Abha Joshi-Ghani xxi Specialized business services Adam Smith focused on the benefits of the division of labor, which he connected with urban densities, noting that in “the Highlands of Scotland, every farmer must be butcher, baker, and brewer for his own family” (Smith 1776). During Smith’s era, factory production was strongly associated with specialized labor, so Smith’s observation can be interpreted as suggesting that benefits of factories were easier to exploit in cities with large home markets. His exact words, howev- er, refer to the service industry, which is particularly targeted toward local customers, and the benefits of specialization in urban service industries continue even in cities that have largely deindustrialized. At its most tangible level, Smith’s observation can be seen in the abundance of specialized shops, salons, and restaurants in large cit- ies. Yet in most cities, specialized business services are even more important. Kolko (2010) documents how business services have largely replaced manufacturing as the heart of urban economies in the developed world, and that they are becoming an important source of employment in developing countries too. These sectors have a natural affinity for high density locales, because they typi- cally involve a lot of face-to-face contact. One advantage of locating in London is proximity to an abundance of legal, accounting, and financial expertise, and that expertise can be extremely specialized, an added benefit to local customers. The urban edge in providing business services essentially reflects the fact that cities reduce transportation costs for people, but there are other ways for that edge to make cities economically dynamic— by creating thick urban labor markets (Marshall 1890). In a city with a panoply of diverse employers, the economic difficulties of a single firm may not cause much hardship for those firms’ employees who can readily work somewhere else. In a company town, however, the travails of that company will lead to far more distress. The abundance of local employers also eases the job search pro- cess, part of connecting labor and capital. Young workers may not know what sector or employer is a good match for their talents and inclinations. A city filled with different workplaces allows workers to try things out, to experiment with acting before entering into a career xxii Rethinking Cities in accounting. The fallbacks may also support more risk taking by urban workers, who can try something uncertain, knowing that there will be other opportunities if things do not pan out. The ease of connecting with other people also produces non- pecuniary benefits of urban living. Young people come to cities, in part, to be near other young people and because cities are marriage markets (Costa and Kahn 2000). The diversity of urban pleasures helps to make cities even more attractive than urban wages on their own. Speeding the flow of ideas Perhaps the most important urban advantage, however, comes from speeding the flow of ideas. Jane Jacobs (1970) considered cities the well-spring of innovation because they enable old ideas to be trans- formed into new ideas. There is an abundance of examples, from the creation of the skyscraper in 1880s Chicago to the development of modern finance in post-1970 New York, of how personal connections among innovators helped create a collaborative chain of brilliance. There are at least two distinct ways for workers to benefit from the free flow of ideas in cities. First, when ideas generate entrepre- neurship and jobs, the extra labor demand increases wages. Second, when the workers learn from the people around them, their human capital increases, and that makes them more productive. Both forces tend to raise wages in urban areas. One piece of evidence supporting the second hypothesis is that workers who come to cities typically see their wages rise slowly with their experience in the city, rather than instantly increasing to the average in the area (Glaeser and Mare 2001). This pattern is perhaps most compatible with the view that cities are drivers of human capital, where workers become skilled by being around other skilled people. General agglomeration economies should occur everywhere, but policy makers should seek to understand what forces are most power- ful in their community. The more critical question for policy makers is how to harness related forces that explain differences across space. Empirical work has documented two major factors that determine the success of cities: education and entrepreneurship. In India, the quality of infrastructure and the education of the local labor force are Edward Glaeser and Abha Joshi-Ghani xxiii the strongest predictors of city competitiveness for new firms (Ghani et al. 2012). Spillovers of knowledge In the 1980s, the new growth theory, led by scholars such as Paul Romer and Robert Lucas, focused on knowledge spillovers as the source of increasing returns economy-wide that enabled long-run economic growth. The focus on the flow of knowledge pointed toward both education and cities. In the United States, workers who live in more educated cities typically earn more, even holding their years of schooling constant (Rauch 1993). And the connection between an area’s education level and earnings appears to be even stronger in China and India than it is in the United States (Chauvin et al. 2014). Policy makers now focus on job creation in cities in addition to increasing productivity and raising incomes. Moretti (Chapter 5) sifts through the evidence on education as a source of local economic success and urban productivity. Productivity differences and economic disparities between geographical areas are not a consequence of exogenous factors like natural resources alone. Much of it is driven by forces of agglomeration economies such as thick labor and marriage markets, specialized service providers, and knowledge spillovers. The location of workers and firms shape the futures of entire communities. Moretti’s (2004) earlier work has shown how educational insti- tutions appear to be particularly powerful predictors of urban pro- ductivity. U.S. cities that had land grant colleges before 1940 have experienced higher wages and faster population growth in recent decades. These facts lend support to Senator Moynihan’s claim, “If you want to build a world class city build a great university and wait 200 years.” But most public officials have neither the ability to build a world- class university nor the patience to wait 200 years. So, the impor- tance of education must lead to a different set of policy levers. The education of an area reflects both selection, the in-migration of the skilled, and treatment—the education of the citizenry. Education strengthens a nation as a whole; therefore, attracting more skilled xxiv Rethinking Cities migrants means strengthening one community at the expense of another. In many cases, better local school systems will do double duty both by building a more educated workforce and by attracting skilled parents interested in better education for their children. What policies will attract more skilled workers? The literature on this question is limited, but it seems to call for investing in amenities that are particularly relevant to the more skilled. One line of thought emphasizes core urban amenities such as safe streets, good schools, and swift commutes, which should be valued by everyone. A second view focuses on urban attributes, like the arts and a thriving nightlife, which may be particularly attractive to more educated workers. The threat of inducing an exodus of the most skilled remains a major argument against attempts at local redistribution. The literature on education is far larger, but there remains rela- tively little consensus on the determinants of a first-rate education system. High-quality teachers appear to be a primary ingredient in educational success (for example, Chetty et al. 2011), but better management and governance are also important. In the develop- ing world, the problem of teacher absenteeism remains particularly acute. In some countries, like the United States, charter schools have achieved remarkable success, especially where public school systems are underperforming (Angrist et al. 2010). Similarly, the mush- rooming of private schools in India is meeting the gap created by underperforming and low-quality public education in many of the country’s urban areas. Nurturing entrepreneurs While the skills learned in school are surely important, the skills acquired out of school are likely to have an even greater impact. While many different skills are assuredly important to urban success, one particularly important knowledge base concerns entrepreneur- ship. The most traditional forms of economics tend to assume that the supply of entrepreneurship is constant across space, but since Chinitz (1961), economists have been aware of at least the possibility that the supply of entrepreneurs differs across space. In Chinitz’s (1961) comparison of New York and Pittsburgh, New York appeared to be more resilient even in the 1950s—in part thanks Edward Glaeser and Abha Joshi-Ghani xxv to the supply of entrepreneurship, a legacy of the city’s industrial past. New York’s largest industry had been garment production, which had few barriers to entry and provided a starting point for thousands of would-be entrepreneurs. Those entrepreneurs gained experience not just in making clothes, but also in starting a business—and they often took those skills into different industries, including banking and real estate. They also appear to have passed along some of those skills to their children. Pittsburgh, by contrast, was dominated by large firms, such as U.S. Steel. These companies may have been extremely efficient, but they tended to train middle managers rather than entre- preneurs. According to Chinitz (1961), the absence of entrepreneurs in Pittsburgh thus contributed to making the city less effective at reinventing itself. Typically, area-level entrepreneurship has been measured either using average firm size, controlling for industry, or the share of employment in newer establishments. Both measures are strongly correlated with subsequent employment growth, both across and within metropolitan areas (Glaeser et al. 2009). Chinitz’s hypothesis that natural resources, such as coal mines, led to heavy industries with fewer entrepreneurs and less capacity for urban regeneration also seems to be supported by the data (Chatterji et al. 2013). While the statistical work on entrepreneurship is at an early stage, the important role of entrepreneurship in generating local success is also supported by abundant urban history. Henry Ford played an outsized role in Detroit’s history, and the resurgence of Seattle since the 1970s seems linked to an abundance of start-ups, including Microsoft, Amazon, and Starbucks. Entrepreneurs, like most people, are not perfectly mobile, and they often locate their businesses where they have spent their early adult lives. These businesses can often become mainstays of local employment, often for decades. But even if the value of entrepreneurs is widely accepted, it is less clear what that implies for local policies (Lerner, Chapter 6). One activist school sees a role for large-scale government leadership in funding entrepreneurship and establishing a spatial cluster. Public support did play some role in creating Silicon Valley and the Bangalore Cluster. An alternative school argues that entrepreneurship is far too complicated for the public sector to effectively micromanage and instead argues for a more laissez-faire approach, emphasizing limited xxvi Rethinking Cities regulations and low taxes. A middle position focuses on improving the local business environment, improving physical infrastructure, attracting skilled workers, funding basic research, and provid- ing an appropriate legal infrastructure to allow that research to be commercialized. Toward a more inclusive city Successful urban entrepreneurs can earn billions, but urban success requires that prosperity comes to more than just a few. Inequality is a long-standing feature of urban life. Plato wrote, “Any city, however small, is in fact divided into two, one the city of the poor, the other of the rich” (Plato 363 bce [reprinted 2012]). In a highly unequal world, we should not be surprised that cities are also unequal, especially when poorer people can choose to come to cities. Urban poverty reflects, in part, the enduring attraction that cities have for poorer people, because cities provide economic opportunities and often a more robust safety net. Yet we should still worry about whether cities are doing enough to provide economic opportunity for everyone. The great-growing cities of the developing world are attracting millions of people from poor, rural areas. This migration process makes urban poverty inevitable. When those cities succeed, the flow of poorer people only increases, as it does when cities help poor people become more prosperous. So, successful cities cannot eradi- cate poverty, but they do provide opportunities to reduce the number of poor people within their borders. Wealthy countries often have communities without poverty, like the United States’ Greenwich, Connecticut, but such places are uniformly prosperous because they are unaffordable and have no space for the poor. That certainly is not success. A more inclusive city is not without slums and poverty, but it does manage to regularly enable poor people to escape poverty. It creates jobs and provides ladders of wealth and occupations that provide a means of moving toward prosperity. There are many causes of exclusion within metropolitan areas. Neighborhoods differ in core amenities, including access to public transport, employment, or parks and safe public spaces. The rich are often willing to pay more for such local assets, and that leads to clusters of wealth in a city’s Edward Glaeser and Abha Joshi-Ghani xxvii most desirable neighborhoods, and clusters of poverty where prices are lowest. If the rich are also willing to pay more for the privilege of living around other rich people, possibly because of better local schools or less crime, this will also lead to segregation by income. As natural as some sorting by income within an urban area might be, the isolation of the poor in specific neighborhoods works against the ideal of the inclusive city. After all, isolated pockets of poverty can seem very far from the thriving heart of a city. Children raised in segregated slums would seem to lose the benefits of being part of a connected city. Unsurprisingly, social reforms have long desired to build cities with more social and economic integration. The segregation of the poor should be a concern—divided cit- ies are neither productive nor sustainable. At the least, governments should worry about public policies that might contribute to segrega- tion, such as artificial differences in the levels of public services across space or land-use controls that make it difficult to build affordable housing in more expensive neighborhoods. Public policies must address the unnecessary segregation resulting from significant differ- ences in the availability of public services over space. The returns to education Historically, education has been a primary tool for creating inclusion at the level of the city and the country. The returns to education are typically high in the developing world, and education provides a far more sustainable path toward social mobility. Despite the extremely high motivation of many students, education in developing cities is often beset by significant difficulties, including limited resources, teacher absenteeism, and extreme heterogeneity in student prepara- tion. These problems can be even more extreme in the rural areas of the developing world. However, this note is not an education policy primer, and does not take any stand on the appropriate path for education reform. This is a golden age of education research, where randomized trials and other statistical methods are enabling us to learn much more about how to make teaching effective. In some cases, private pro- viders, such as charter schools in the United States, have achieved remarkable results. Other work shows that teacher quality is of xxviii Rethinking Cities enormous importance and teacher incentives can make a great differ- ence. There are clearly different paths toward educational quality, and local circumstances may dictate which path will be more effective within any country. The point is that improving education, particu- larly for the poorest in society, is likely to be the most effective way of ensuring more inclusive cities. The mix of industries Sassen (Chapter 8) approaches inclusiveness by contemplating the industrial mix of an area, and specifically discusses the connection between services and manufacturing. There are two important ways the industrial mix relates to earnings for the less advantaged. First, some industries may simply have more demand for less-skilled work- ers than others, and this will tend to increase earnings for the less skilled. Indeed, one cause of the rise in inequality in the West since the 1970s has been a relative decline in industries and occupations, especially in manufacturing, which disproportionately employed those with less education. The rise of urban manufacturing in the developing world, by contrast, increases the demand for less-skilled workers. Wage differences alone do not tell much about the quality of the jobs on offer. One reason that service sector jobs traditionally offered lower wages than manufacturing jobs, for comparably skilled workers, is that the service jobs had less physical discomfort than traditional manufacturing or mining. And an increase in demand for less-skilled workers in the city will also tend to attract less-skilled workers, limiting the local wage effects of the increase in demand. From a national perspective, there is nothing bad about the fact that rural migrants come to take up urban jobs seeking better eco- nomic opportunities and a better life for their families. However, as Keith (Chapter 9) reminds us, current urbanites will often oppose their migration. Antipathy toward urban growth is then reflected in overly draconian land-use policies or other rules favoring insid- ers over outsiders. In some cases, as in China, internal migration is limited by rules, and the migrants that do arrive are often given far fewer privileges than the insiders. Managing the conflict between Edward Glaeser and Abha Joshi-Ghani xxix current insiders and future migrants will be a major political task for developing world cities for decades. But the industrial mix affects worker productivity in a second and perhaps a more important way. A job is not just a paycheck; it is also an opportunity to learn. The disadvantaged benefit most from jobs that give them skills to help them move up. One plausible interpreta- tion of the apparent success of industrial policy in Singapore is that, as workers moved from textiles to electronics and then up the qual- ity ladder, they acquired human capital as they went. In this view, industrial policy is really human capital policy. Despite Singapore’s success, there are good reasons to suspect that industrial policy will more often produce cronyism than concrete benefits. Economists for centuries have urged a more laissez-faire approach to managing firm growth. But even if a government wants to avoid picking winners, choices regarding infrastructure and invest- ment will inevitably favor one industry or another. The overwhelmingly large informal economy One major feature of developing world cities is that the poorer labor- ers often work in an informal sector that is free from regulations and taxes, but where workers lack access to public services and some parts of the safety net. The scale of the informal economy is overwhelming, reflecting a state that engages in ambitious regulations, but lacks the ability to enforce them (Ghani and Kanbur, Chapter 7). While we may wish that every government had the inclination to engage in only limited, sensible regulations and the ability to enforce them, this is not the case in much of the developing world. In the world’s poorer cities, the informal sector is an escape valve, enabling entrepreneurs to succeed and employ less-advantaged workers despite significant regulatory barriers. In Indian cities, the informal sector is increasing in size relative to the formal sector. One interpretation of this increase is that density is even more valuable in the informal sector than in the formal sector. Since informal firms may rely more on tacit agreements between sup- pliers and customers, the benefits of easy face-to-face communication may be greater. Alternatively, informality may be more prevalent in xxx Rethinking Cities smaller firms that disproportionately locate in cities because of their need to partner with other firms. A third force pulling informality into cities is that large-scale manufacturing, which tends to be for- mal, is typically more land intensive and thus more suburban. Small service firms that prize informality are more naturally urban. Millions of less-advantaged workers benefit from the employment the informal sector provides, but informality is far from a perfect solution. In the “gray” market, there are no rules protecting worker safety and often little legal recourse for workers who have been mal- treated. Informality may be a reasonable response to a bad situation, and it may foster entrepreneurship and create jobs, but that does not mean there are no significant costs in having millions of workers without social safety nets. Rethinking city interventions Cities are people and political units, but they are also physical enti- ties, filled with vast amounts of housing and infrastructure and deeply shaped by public policies. Barriers to building can produce a flat city that sprawls and a proliferation of slums. New transport infrastructure can pull a city outward, as new settlements occur along the highway or subway line. The physical challenges facing develop- ing world cities can be daunting, and historically many of these cities have made decisions with severe adverse consequences. Housing, land, and transportation are at the nexus of how a city develops and how livable and inclusive it is for those who come attracted by new opportunities. The provision of core urban services To be inclusive, a city needs to provide more than just decent wages to its poorer workers, it needs to provide core urban services as well, such as clean water and sanitation. Workers need safety and decent com- mutes too, and they need decent housing. These issues are discussed by Woetzel and Pohl (Chapter 10), who observe that basic services are often concentrated in the city core, and access to clean water and sanitation drops rapidly as one moves out of the core. The disparities between core and periphery are most acute for megacities. The benefits Edward Glaeser and Abha Joshi-Ghani xxxi of urbanization do not seem to extend beyond the core. While density makes it more cost-effective to provide basic infrastructure services to urban residents, city governments often do not collect enough revenues to extend these services to the expanding urban population, or even to maintain existing services for current residents. Housing Take a panoramic look at the physical problems of African cities, especially their housing challenge (Collier and Venables, Chapter 15). Shantytowns have always existed in cities, though colder climates have tended to limit people’s willingness to urbanize in completely substandard dwellings. In warmer locations, where rural settings have become perilous due to conflict or crop failures, migrants are willing to come to cities even if housing is wildly inadequate. The challenge of providing decent housing involves a number of constraints—the limited supply of urban land, the lack of property rights, outdated and unpractical regulations on minimum lot sizes and floor area ratios, as well as weak construction sectors and a lack of suitable housing finance mechanisms for the poor and the middle class. Housing is really a combination of two attributes—a physical home and a location (Hammam, Chapter 13). Housing values differ so much within and across cities precisely because locations differ so much in their value. Housing markets are essentially local, so inter- ventions that provide more public housing in a far-flung suburb do little to ease the cost of living within a dense city. The key to solving the urban housing problem is not just to deliver more cheap hous- ing—it is also to make sure that housing is in places that provide plenty of value for residents. Understanding the constraints on sup- ply of adequate housing and the rising demand for affordable and adequate housing is important. Shaping the demand for housing is the demand for structures and particular locations, but housing policy often does more to influence housing supply than housing demand. Supply is shaped by build- ing technology, land availability, and the rules that influence con- struction. In some cases, those rules are widely flouted, so cities can develop an ocean of substandard housing despite having extremely tight building rules—Mumbai is one such example. Similarly, the xxxii Rethinking Cities provision of public subsidized housing in far-flung places, away from jobs and adequate transport, fails to generate complementary private investments in housing maintenance or upgrading and creates inef- ficient and divided cities The supply of housing is built up over time, and understanding supply means understanding both the stock of homes and the flow. The flow of homes is determined by the combination of supply and demand, and then the stock represents the history of past flows. Typically, the flows are positive and the stock gradually increases, but there are times when the stock can be radically reduced either through planned demolitions or natural disasters. A radical reduction in the stock of housing due to a calamity can represent one of the greatest urban challenges. Both rules and building technology determine the speed of the flow of housing supply. Complex multistory dwellings can take many months or years to build. A Byzantine permitting process can double or triple the construction time. Conversely, simple self-made or prefabricated homes can be put up in days, especially if there is no effective regulation. The speed of building can be considerably faster if residents are doing the building, avoiding the need to bring in outsiders to build more formal structures. Housing in many developing countries is often marked by physical and legal inadequacies (Collier and Venables, Chapter 15). Physically, the housing can be unsafe and lacking in core amenities, including running water and electricity. Legally, many residents lack clear title to their property, usually because homes were built without the permission of the land’s owner. Developing world cities have an enormous informal housing market, just as they have an enormous informal labor market, and the results are similar. The informal housing market provides usable space for poorer people who could not otherwise live in the city, but the residents of this housing have few of the protections of a more legal market. As we contemplate solutions to the housing problems of the developing world, we should be cautious about applying wealthy world standards to poorer nations. Housing that would be torn down in New York or London would often be seen as luxurious by the poorer residents of Addis Ababa. If housing is kept to standards that Edward Glaeser and Abha Joshi-Ghani xxxiii seem adequate to the wealthy world, the price will be prohibitive for poorer urbanites if they must pay for it themselves. If the housing is provided by the government, the public sector both risks crowding out other potentially more valuable forms of social spending, like education, and creates powerful, artificial incentives encouraging the poor to migrate to cities. The gulf in wealth between developing world and developed world cities also suggests the value of planning for obsolescence. Any housing that is appropriate for Africa or India today will (it is hoped) be inadequate 40 years down the road, when both areas are far wealthier. So, any housing policy needs to be self-consciously temporary and adaptable to the rapidly changing nature of developing world economies. Land use The public approach to housing in developing world cities always includes land-use regulations, although they may be only sporadi- cally enforced. Those regulations can have many purposes, but one typical goal is to ensure a minimum standard of living. Yet the impact of those requirements often increases the cost of housing precisely for people the rules are trying to help. This limits the ability of land-use regulations to ensure better housing standards. It is perhaps possible to accept that poorer urbanites will live in very small, very simple homes. It is harder to accept that these homes will be unsafe because of unsound building, have sanitary issues related to lack of sewage and other infrastructure, or be in precarious areas prone to natural disasters like flooding or landslides. These safety challenges are particularly hard to solve, because poorer residents often take on considerable risks in urban labor markets and disregard rules against living in dangerous locales. For the developing world, slums are often built ignoring both land-use restrictions and indeed property ownership itself. Many favelas and shantytowns were built on government land that was not intended to provide space for housing. In some cases, settlements grow up on private land that was being kept vacant for another purpose. There are difficult tradeoffs among the rule of law: the xxxiv Rethinking Cities preservation of space for alternative uses, or the very real housing needs of the urban poor. Housing involves structures as well as land, and the quest for better housing also involves innovative means of delivering inexpen- sive structures. A number of private companies have been experi- menting with smaller, prefabricated homes, often using inexpensive recycled materials. These strategies hark back to the days when Sears Roebuck sold thousands of cheap, do-it-yourself home-building kits throughout America, and private innovation helped create cheaper housing. But it is hard to imagine that cheap housing structures will solve the problem of affordable urban housing unless the legal infrastruc- ture is also effective and sensible. Ideally, land-use planning should aim at providing safe, affordable housing in a connected city, with functional transport corridors and easy connections between jobs and housing (Bertaud, Chapter 14). Yet, too often land-use systems produce sclerotic cities that provide insufficient legal, dense hous- ing and too many extremely arduous commutes. The focus on static urban design plans has resulted in massive urban sprawl and the development of new towns with little market demand. Land use is closely tied to transportation planning. Housing may be the combination of structures and location, but the value of location is determined by the ease of access to other locations. The core model of urban housing prices, first articulated by William Alonso almost 50 years ago, describes how density and price reflect the ease of access to jobs at the center of the city. The importance of transportation has not diminished since Alonso’s day (Alonso 1964). Transportation and land-use planning should be seen as a single topic (Bertaud, Chapter 14). For example, the impact of an urban height limitation will be determined in part by the ability to get to urban jobs from more distant locales. When a city with abundant public transportation limits the urban core, development for rich and poor will move away from the core, people will still be able to reach jobs, and the city will continue to grow. If only car transportation is possible, the poor are more likely to try to remain at the center, leading to overcrowd- ing, but the rich will suburbanize. If all travel links are poor, either the city’s growth will stop or it will still sprawl outward, but at an Edward Glaeser and Abha Joshi-Ghani xxxv enormous cost of time and comfort as the new populations engage in long, difficult commutes. Approaches to affordability Many affordability measures are foolish. The ratio of income to housing costs is one measure, but it is essentially arbitrary and often misleading. Consider a city and a rural area: in the city, workers can earn $5,000 a year, but must pay $2,000 in housing. In the rural area, housing costs only $500 a year, but earnings are only $2,500. The housing cost to income ratio is much higher in the city, suggesting an affordability problem, but earnings after paying for housing costs are 50 percent higher in the city, suggesting that the urban residents have a good deal. Indeed, the logic of spatial equilibrium would sug- gest that if there were no other particularly urban problems, housing costs should rise to $3,000 a year, so that after-housing earnings were equalized between the two locales (Bertaud, Chapter 14). Another approach to housing affordability is the physical cost of delivering housing and whether housing prices substantially exceed physical costs. This process does not reveal whether poorer urban- ites can afford the houses, but it does give some information about whether the housing market is functioning well. If the physical costs are relatively high, this suggests a problem in building technology. If prices are much higher than physical construction costs, this implies either high land values or regulatory barriers to construction. The other side of land-use planning involves commercial struc- tures, and comes with many of the same concerns: affordability is still desirable and safety remains a concern. Land-use regulations also affect the physical landscape. There has, however, been something of a sea change in the thinking on zoning for non-residential uses. A century ago, planners were very concerned with separating industrial and commercial from residential uses of land. They saw negative impacts of industry on residential neighborhoods. Today, mixed-use planning is far more popular, because planners now recognize the environmental and social costs of artificially separating people from their work. Jane Jacobs (1970) was one of the great advocates of mixed-use cities. There may still be cases where particularly noxious xxxvi Rethinking Cities factories need to be isolated, but in many cases, mixing rather than separating seems the more sensible policy. The challenge of financing environmentally sound infrastructure The environment, particularly the impact of climate change, is an important reason to focus on minimizing travel distances. Shorter commutes mean less energy use, which is of even more consequence if developing world cities develop automobile habits similar to the developed world. Cities are full of instances where individuals impose costs on third parties—externalities in the language of economics. The costs potentially related to carbon emissions provide an example of one such externality. This volume does not methodically consider the externalities inherent in urban congestion and contagious disease, although these provide a major motivation for spending on urban infrastructure. There is both a local and a global side to urban environmentalism (Kahn, Chapter 12). The global side focuses on city-level activities that may affect the entire planet, particularly through climate change. Cities do have higher carbon emissions than many traditional rural areas, but that is true of all more prosperous lifestyles. The relevant comparison is not between city living and rural poverty, but between city living and less dense, but still affluent, lifestyles, like sprawling suburbia. In that comparison, city living looks pretty green, because people drive less at higher densities and typically inhabit smaller liv- ing spaces, even holding family size and income constant (Glaeser and Kahn 2010). Recent literature also offers evidence of this rela- tionship between urban form and per capita emissions and, specifi- cally, the association of urban density with lower per capita emissions (Hoornweg et al. 2011). If India and China see their per capita carbon emissions rise to the level in the sprawling United States, global carbon emissions will increase by more than 125 percent. But if they rise only to the level seen in wealthy but hyper-dense Hong Kong SAR, China, global carbon emissions will rise by less than 30 percent. The environmental advantages of dense living provide one reason to rethink land-use policies that artificially limit building within the city center. Policies Edward Glaeser and Abha Joshi-Ghani xxxvii that limit driving, such as Singapore’s electronic road pricing, were implemented mainly to limit congestion for economic and social reasons, yet they also support global environmental concerns. Air quality, water pollution, and green spaces are three primary local concerns that help determine the local quality of life (Kahn, Chapter 12). In each case, private individuals tend to ignore the local impacts of their actions, such as when they deposit waste in common land areas, contaminating it, or drive polluting cars. For cities to be pleasant as well as productive, they must pursue policies that counter these costs of dense living. Developing world cities are likely to pay more attention to envi- ronmental concerns as they become wealthier and better educated (Kahn, Chapter 12). A pleasant environment is a luxury good, and richer people are willing to pay more for a pleasant location. The poorer residents of developing world cities are more likely to put basic necessities ahead of parks and clean air. Education also matters, because a more educated population is likely to be more effective at lobbying for local concerns, including the environment. Even if developing world cities do not get wealthier, many of them may still have to grapple with the challenges of climate change. If greenhouses gases lead to rising sea levels, or more extreme weather events, developing country cities are likely to face the consequences. Nearly two-thirds of urban settlements with more than 5 million people are located partly in low elevation coastal zones, which con- tain 13 percent of the world’s population (McGranahan et al. 2007). Many of them lack the infrastructure needed to cope with extreme weather events, so the possibility of major disasters is a looming chal- lenge for the developing world. Alternative approaches to environmental issues Economics and engineering offer alternative approaches to these environmental issues. Economics emphasizes using incentives to change individual behavior. A carbon tax that makes energy users pay for the social costs of their actions is a classic example of a tax aimed at reducing socially costly behavior. Congestion charging is another example. Engineering focuses on changing the physical environment to reduce the negative consequences of dense living. If congestion xxxviii Rethinking Cities charging is the economists’ approach to traffic congestion, the engineering approach is to build more highway lanes or to provide more public transit options. For highways and driving, the economic approach seems quite sensible: vehicle miles traveled increase roughly one-for-one with highway miles built (Duranton and Turner 2011). If this continues to hold in the developing world, just building more roads will not solve the traffic, since this will just induce more people to drive. It is hard to imagine that people will start limiting their driving unless they are charged for the social costs of driving and a viable alternative (such as reliable public transport) is available. But in other cases, the engineering approach is far more feasible than using economics. It is difficult to imagine relying on private provision and taxes for clean water and sewage. How could such a system be enforced in the informal communities of the developing world? The engineering approach to clean water and sewage, which involves massive public investment in infrastructure, seems the only feasible solution. Building the right infrastructure But providing infrastructure in the developing world is also daunt- ing. The infrastructure need is enormous, but so is the possibility of building the wrong infrastructure. Moreover, the building process is extraordinarily difficult, with plenty of opportunities for corruption and mismanagement. The public sector is often ill-suited to man- age such projects, because of both a lack of technical expertise and because of the short time horizons that often influence political lead- ers (Woetzel and Pohl, Chapter 10). Infrastructure challenges start with project selection. For decades economists have promoted cost-benefit analysis, and for centuries they have argued that infrastructure is best financed by user fees. Adam Smith argued that funding infrastructure with tolls can ensure that the projects built are also those that deliver sufficient social value added (Smith 1776). User fee financing may be politically difficult in some cases, and just plainly infeasible in others. Occasionally, the externalities that justified the infrastructure to begin with push against charging too much for the infrastructure’s use. For example, Edward Glaeser and Abha Joshi-Ghani xxxix if the goal is to eliminate contagious disease, then charging too much for potable water may push people to continue using unsafe sources. Paying for infrastructure When user fees cannot pay for the infrastructure, the push is toward conventional cost-benefit analysis and the use of more general tax funds. Even in this case, however, it is probably sensible to pay for infrastructure with local taxes paid by the people who use the infra- structure. Tax increment financing, which pays for infrastructure by taxing the increases in value of neighboring properties, provides an alternative way of making sure that the costs of infrastructure are paid for by people who actually benefit from it. While the basic tools for cost-benefit analysis are well understood, there are numerous problems with implementation. Often project supporters will try to significantly overstate benefits by overestimat- ing future use. In other cases, costs may be underestimated. When infrastructure creates significant benefits for the local community, it may be hard to estimate these benefits, especially if they are diffuse. For example, it is hard to determine the value of a project meant to make a neighborhood more attractive. This unpredictability leaves plenty of room for manipulating estimates for political ends. Too often governments invest too much in new infrastructure and too little in maintaining the existing infrastructure stock. Getting the most out of existing infrastructure can include policies such as congestion pricing, which efficiently rations access, but politics tends to resist such charges (Woetzel and Pohl, Chapter 10). Public-private partnerships Greater technical expertise in local governments is crucial if the government is managing the project, but it is also necessary if infra- structure provision has been farmed out to the private sector. But public-private partnerships (PPPs) are not a panacea (Engel and Galetovic, Chapter 11). There is plenty of room for failure in PPPs, especially if the government ends up expropriating the private firm or if the private firm ends up subverting the government. At their xl Rethinking Cities best, PPPs enable private expertise and incentives to accomplish a socially desirable task, like building a new bridge or highway. The basic structure is that the private builder receives the right to build the project and agrees to a time path of user fees. Those fees then provide incentives for the private sector to maintain the project, since it can cover its costs only if it continues to attract users. In cases where user fees do not cover the costs, the government will need to supplement these fees with a direct subsidy. PPPs offer tremendous promise, but there are many paths toward disaster as well. One possibility is that the private entity will convince the government to give them far too generous a subsidy. Any time the government is giving cash to a private entity, there is potential for corruption, since side payments to public officials can bring huge profits. Technical expertise is helpful in evaluating the project, but it will do little good if the official is on the payroll of the private com- pany. A second problem is if the government decides not to honor its contract. Once the infrastructure is in place, the government has an incentive to lean on the private entity to reduce its user charges. If firms anticipate such expropriation, they will be unwilling to make investments in the first place. A third problem is that firms may skimp on investments that could prevent low probability disasters. The advocates of PPPs correctly emphasize that a private firm will not let the project deteriorate to the level where users disappear, but they may take risks, betting that disaster will not materialize. If there is a catastrophe, the company may trust that its liability will be limited. These fears have materialized in many PPP projects throughout the world. Weaker public sectors are less likely to deliver projects efficiently on their own, but they are also less effective at monitor- ing private providers. PPPs are well worth investigating, but their downsides must also be anticipated. The infrastructure needs of developing world cities are among the greatest challenges of the developing world. Vast sums will be spent, and there is sure to be corresponding waste. Fuller and Romer (Chapter 1) emphasizes the role of government, new rules, the importance of local capacity, and the critical role of strong institutions and governance. Good governance is most important in areas where the government and the private sector can be most productive. Further, the capacity to enforce rules should be complementary to and Edward Glaeser and Abha Joshi-Ghani xli not a substitute for market activity. The hope is that an increasingly sophisticated local public sector will be able to manage the process so that the lives of ordinary citizens are truly transformed with clean water, reliable electricity, and faster commutes. But this is predicated on investing in and bolstering local capacity, as Romer makes clear. Cities in a national system: the spatial dynamics Apart from Singapore, cities are part of a nation-wide economic sys- tem that contains other cities and rural areas. The remarkable urban success of the Republic of Korea was driven mainly by the national government’s comprehensive planning and investment policies. National governments make policies that will influence the growth of the city, including investments in nation-wide transport systems and more location-specific interventions. In many countries, subnational political units, such as states or provinces, exert a fair amount of con- trol over individual cities. How should higher levels of government react to urban growth? Should national governments favor large cities, or should they push populations into more medium-sized cities? As cities grow, they generate agglomeration economies, but there are also externalities associated with greater population densities. Optimal policies toward medium and large cities need to not only recognize the existence of these effects, but also to understand how these effects differ by city size (Desmet and Rossi-Hansberg, Chapter 4). The existence of agglomeration economies on their own does not imply favoring big cities. When people and businesses are pushed from medium to large cities, the large cities become more productive, but the smaller cities become less productive. Those effects need to be weighed against each other. If there were no negative effects of big city density, then even with these losses, there would be a good reason to channel people toward the largest metropolitan areas. Yet because density has downsides, the benefits must be weighed against the costs. Desmet and Rossi-Hansberg (Chapter 4) present a tool for calibrating the relative size of the benefits and costs of city big- ness. There is an associated online tool, which national leaders can use to actually determine whether their country might use more or less urban concentration. The tool attempts to measure these positive xlii Rethinking Cities and negative effects using commonly available data and then use this measurement to predict optimal public policy. Agricultural productivity is often a precondition for urban growth: a nation rarely moves to urban living until its farms can feed its citizens. But big factories often leave urban areas, leaving services in the urban core. This is because in the long term, the largest cities are expensive places for industry, and with further development, modern industry tends to decentralize from the biggest cities, first to their peri-urban areas, and then to smaller cities and rural areas (Henderson, Chapter 3). Gradually, there emerges a geography of production in the urban hierarchy, whereby smaller cities tend to specialize in standardized manufacturing or certain services, while the largest cities tend have a diverse set of business and financial services, dependent on an information-rich, dense local environment. However, the link between industrialization and urbanization is not always as clear cut and as we would like to believe. National policies should therefore be directed towards creating a level playing field and creating strong institutions rather and favoring specific cities (Henderson, Chapter 3). In practice, national leaders will rarely consider explicit policies that favor one locale over another, except if a particular place is economically disadvantaged relative to the rest of the country. Still, in many cases, national governments do make choices that implicitly favor one area over another and these can be justified on grounds of either efficiency or equity. The location of highways and rail networks leads to choices between cities. Understanding when government interventions make sense and when they do not is important in setting sound development policies. It is also important to understand who benefits from place-based policies, for often the beneficiaries of these polices are not those targeted by national or regional governments (Moretti, Chapter 5). Areas for future research The challenges facing the world’s developing cities also call for more research on economic development, social mobility, and the impacts of government policies. Development research has experienced a revolution over the last 15 years, as increasingly sophisticated Edward Glaeser and Abha Joshi-Ghani xliii methods, especially randomized trials, have begun to emerge. In many situations these new methods have proved crucial, but other contexts require different approaches. While there is widespread agreement that entrepreneurship can be an important ingredient for economic success, there is less agreement about what drives entrepreneurship or what government policies encourage and incubate new economic enterprises. Most of the research on entrepreneurship has been in the developed world, but even that is just beginning to focus on the causes of entrepreneurial differences across space. An important new branch of research in the developing world would be to document the connections between entrepreneurship and growth, but more work is also needed that recognizes that entrepreneurship and growth may be the result of deeper forces. Further research is needed on government policies, including regulation, that may affect entrepreneurship. The World Bank’s ground-breaking work on measuring regulations can inform this research. Randomization is most likely to occur in this area around policies that target aid to individual entrepreneurs, rather than in regulations or other more widespread economic policies. It is critical that more research be conducted on the impact of infrastructure on economic, social, and health outcomes. There has been a considerable amount of water and sanitation-related work on health outcomes, on private provision and on targeted subsidies, but even more is needed. There may be scope for randomized trials, but large-scale infrastructure cannot be randomly allocated. In these cases, the best option may be to hope for natural experiments that allow estimations of full-range impacts of particular forms of development. Human capital and skills are at the center of urban success, and there are already a large number of researchers examining the determinants of educational outcomes. This is an area where randomized trials are particularly useful. There are numerous examples of settings where classrooms have been randomly selected to use different techniques or to offer varying incentives to students. The main failing of this research is that outcomes are typically test scores, and we are primarily interested in adult outcomes. Some research in the United States has documented the connection between teacher quality and adult earnings, but more work in this area is needed in the developing world. xliv Rethinking Cities The phenomenon of growing informality in the face of rapid urbanization is relatively new to the research and policy-making arena. Further research is needed to identify the causes underlying this trend, such as the nature of agglomeration externalities and how they play out in the formal and informal sectors; the precise reasons why productivity in the informal sector is lower than in the formal sector, especially if agglomeration benefits seem to accrue equally, if not more so, to informal enterprises. Why does informality persist in the face of rapid growth and continued deregulation in many countries; how to bring informal enterprises into the fiscal net so that they can contribute to the services needed for them to flourish; and what policy measures can be undertaken to support job creation, considering that job creation in the formal sector has not been or is unlikely to be sufficiently vigorous to meet the employment and poverty challenges of the next two decades. Other areas for research are on how regulations restrict and constrain the provision of affordable housing and on what can be done on both the supply and demand side for housing, including stimulating the private sector’s provision of affordable housing. More research and city-based analyses of the impact of specific regulations on housing costs, housing supply, and housing affordability are needed. Most knowledge on resilience today is based on rates of urban and economic growth and infrastructure typology of the last 50 years. But the pace and magnitude of urbanization are currently such that the built-up area will triple in the next 30 years. One of the biggest challenges today is resilience in the face of much greater uncertainty; a more rapidly changing climate; significantly increased variability in political stability and commodities pricing; more demands on food and water; and the rapidly changing geopolitical landscape. Research on resilience in an integrated context—resilient systems design—is a critical aspect of urban system design. While many relevant policy decisions are made and implemented locally, most statistical data are collected at the national level. A lack of globally comparable data on cities has fragmented urban research agendas and limited the growth of cumulative knowledge generation across countries, regions, and disciplines. This in turn has limited the capacity to get fact-based understanding of the patterns of city Edward Glaeser and Abha Joshi-Ghani xlv performance across the globe. That is why it is so important to collect verifiable and comparable city-level data. Finally, there also is need for research on the institutions that shape urban politics. We know relatively little about how institutions and politics affect the economic life of the city—case studies and more historically grounded work can provide more data in this area. *** Perhaps the most hopeful aspect of urban life is that cities tend to create their own solutions. London spread cholera, but also gave John Snow the information he needed to understand the sources of the disease. Urban connections are empowering communities through- out the world to press for urban improvements. There is hope in the future of cities, because cities have so often done miraculous things. The cities of the West were once places of suffering, crime, and grime, but now they are thriving centers of innovation, culture, and entre- preneurship, and are far more pleasant and safe. Why? Because urban leaders effected change, and that change will continue only with better governance and stronger institutions. For most of human history, people lived on the edge of survival. In the past two centuries, we have miraculously moved toward far greater prosperity through transformations, above all, in cities. Urbanization now has the potential of transforming the developing world, and that’s why getting urban policies right is so important. There is no future in rural poverty—the path to prosperity inevitably runs through cities. The right approach is not to accept the urban failures that often exist now, but to rethink cities and try to imagine how to get to a brighter urban future. Bibliography Alonso, William. 1964. Location and Land Use: Toward a General Theory of Land Rent. 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Smith, Adam. 1776. An Inquiry into the Nature and Cause of the Wealth of Nations. London: W. Strahan and T. Cadell. United Nations. 2001. “Urban Millennium: Urbanization Facts and Figures.” Special Session of the General Assembly for an Overall Review and Appraisal of the Implementation of the Habitat Agenda. http:// www.un.org/ga/Istanbul+5/booklet4.pdf. Weber, Adna. 1899. The Growth of Cities in Nineteenth Century America. New York: Macmillan. 1 Urbanization as Opportunity Brandon Fuller and Paul Romer Some 10,000 years ago, humans started reorganizing their social and physical worlds, beginning what Shlomo Angel (2012) calls the urbanization project. Like any project, it reflects human intention. Building dense settlements was something we decided to do. Like any project, it also has a beginning and an end. An almost incom- prehensible amount of work remains; nevertheless, the end is near. Urbanization deserves urgent attention from policy makers, aca- demics, entrepreneurs, and social reformers of all stripes. Nothing else will create as many opportunities for rapid social and economic progress. And although it is hard to comprehend how much work remains, comprehending how quickly the work is now being done is even harder. The unique opportunities created by rapid growth in the urban population will soon pass. Human history seems to suggest that we have a lot of time. The urbanization project got started in the 1,000 years after the transi- tion from the Pleistocene to the milder and more stable Holocene interglacial (Richerson et al. 2001). As the climate began to favor sedentary agriculture, humans started building dense settlements. It took until 2010 for the urban share of the world’s population to reach 50 percent (3.5 billion people). 2 Urbanization as Opportunity Looking forward, the global population is likely to stabilize between 10 billion and 11 billion. The limiting value of the urban population is likely to exceed 8.5 billion. If it took 100 centuries to get to 3.5 billion urban residents, is it not safe to assume that it will take many centuries to make room for another 5 billion? Actually, no. The urban population is increasing at a pace that has reached 60 million people a year and is still increasing. The calculations that follow show that we could add more than 5 billion new urban residents in the next 100 years. In all the centuries that follow, we may add at most another billion. It is not just today’s incredible growth that challenges the imagi- nation; it is also the rapid slowdown that is soon to follow. In our lifetimes, we have to build urban accommodation faster than ever before. We also have to prepare for near future with a stable urban population in which it will be much more difficult to undertake reform or change the configuration of the transit corridors and other public spaces that define urban life. In developed countries, the urbanization project is basically com- plete. The remaining urban growth will play out almost entirely in developing countries. In 2010, the urban population in the regions that the United Nations (UN) classifies as less developed stood at 2.6 billion. In 100 years, it is likely to be three times larger. Moreover, as Angel (2012) shows, the historical pattern of urban growth suggests that over this time horizon, urban population density in developing cities could easily fall by half. The developing world can accommodate this urban population growth and declining urban density in many ways. One is to have a threefold increase in the average population of its existing cities and a six-fold increase in their average built area. Another, which would leave the built area of existing cities unchanged, would be to develop 625 new cities of 10 million people—500 new cities to accommodate the net increase in the urban population and another 125 to accom- modate the 1.25 billion people who would have to leave existing cities as average density falls by half. These bracketing extremes, and all the intermediate alternatives they suggest, have strikingly different implications for the size distribution of cities and the possibilities for social innovation and reform. Brandon Fuller and Paul Romer 3 We know that a city can expand its built-up area dramatically and successfully. During the 19th century, the built-up area of Manhattan expanded sevenfold along a street grid established in 1811 (Angel 2012). We also know that new cities can grow dramatically and suc- cessfully. Shenzhen, China, has grown from a tiny fishing village in 1980 to a metropolis of more than 10 million today. If it were a city-state, it would show the fastest rate of growth of gross domestic product (GDP) ever recorded (Zeng 2010). Because it was a new city that started with new rules, Shenzhen pioneered a model based on exports, market incentives, entry-level jobs in manufacturing, and incoming direct foreign investment. After Shenzhen’s success, this model spread across the country. These two large-scale projects show how influential human inten- tion can be. In each case, a few people looked decades ahead and made a plan. No invisible hand guided Manhattan toward rectangu- lar blocks of private property embedded in a public grid of avenues and streets. A real hand did—that of John Randel Jr., the engineer hired by a state commission to survey the island (Ballon 2012). Nor did an invisible hand bring foreign firms into China. Deng Xiaoping carried out a clear plan for reform designed to make it socially acceptable for workers raised on Mao’s Little Red Book to be hired by foreign “running dog capitalists.” The representatives of official multilateral agencies that brought the Washington Consensus to China still criticize his deviation from their orthodoxy. They were certain that the best path for reform was to implement it uniformly across the entire nation. Deng had a different, and arguably more realistic model of how to undertake durable social reform in a society that had just emerged from the convulsions of the Cultural Revolution: In the beginning opinions were divided about the reform and the open policy. That was normal… In carrying out the line, principles and policies adopted since the Third Plenary Session of the Eleventh Central Committee, we did not resort to compulsion or mass move- ments. People were allowed to follow the line on a voluntary basis, doing as much or as little as they wished. In this way, others gradually followed suit. It was my idea to discourage contention, so as to have 4 Urbanization as Opportunity more time for action. Once disputes begin, they complicate matters and waste a lot of time. As a result, nothing is accomplished. Don’t argue; try bold experiments and blaze new trails. That’s the way it was with rural reform, and that’s the way it should be with urban reform. (Deng 1992, 244) In creating an entirely new city, Deng’s strategy harnessed the same start-up dynamic that brings new technology into many industries. Of the four initial special economic zones in China, Shenzhen was the only overwhelming success. For some reason, a 1-in-4-success rate is viewed as a total failure for policy-startups but would be an astounding success compared to the 1-in-10-success rate claimed for business startups. The low success rate for start-up firms clearly does not imply that it is a mistake to allow start-ups. No one claims that because most startup firms fail, the only reliable way to raise produc- tivity in industry is to aim only for across-the-board improvement at all incumbent firms. As Deng showed with his famous southern tour (which was the occasion for the speech quoted here), one very visible success in Shenzhen was all it took to sustain the momentum of reform after reactionaries counterattacked and the future of the market reform process hung in the balance (Zhao 1993). The prospect of creating large new cities in coming decades pres- ents the world with unprecedented opportunities for reforms of all types. To cite just one example, at the new lower prices for natural gas made possible by new techniques for oil and gas extraction, it would be cost effective to use existing technology for gas-powered vehicles and power generation to build new cities that use neither liquid fossil fuels nor coal. For existing cities, switching costs would make this strategy for reducing the enormous health costs imposed by air pollu- tion more expensive. A switch will also be contentious because of the inevitable disputes that will arise about who should bear the much smaller cost of reducing existing levels of pollution. People living in existing cities may be doomed to endure the long wait for local governments to develop both a political consensus around reductions in air pollution and the sophisticated capacity needed to regulate emissions from plants that burn coal and large numbers of vehicles that burn gasoline or diesel oil. In a new city, a government with little administrative capacity could impose a limit on the allowed types Brandon Fuller and Paul Romer 5 of fuel before people move there and enforce this limit after they arrive. By demonstrating the feasibility and benefits of clean air, a few such cities might speed the development of a consensus for change in existing cities much as success in Shenzhen spurred reform in the rest of China. Many other policies such as transit and pricing systems that enhance mobility without generating congestion will be less costly and less contentious if they are implemented in the expansion area for a growing city rather than in its existing core. When New York City planned for expansion in 1811, it was already too late to fix the street grid in lower Manhattan. It remains as it was then. It was, nevertheless, entirely possible, at very low cost, to avoid the extension of a dysfunctional grid to the rest of the island. We live in a time when humans can make realistic plans for urban expansion that are as big and bold as the commissioners’ plan for Manhattan in 1811 or for new cities that could be as influential as Shenzhen. Hundreds of cities could expand as New York did or emerge out of nowhere as Shenzhen did. But the window of oppor- tunity will not stay open forever. In 100 years, it will be too late. And because the spatial patterns in cities are so durable, the choices we make through intention or inattention will have lasting conse- quences. Countless generations will live with the layouts and policy defaults that we leave for them in 2110. The next 100 years To estimate how long it will take to complete the urbanization proj- ect, it makes no sense to base projections on the type of exponential curve that we use for such measures as income per capita. To estimate the dynamics of growth in the face of an upper bound, the logistic is the natural alternative. A variable x that follows a logistic is con- strained to lie between 0 and 1 and grows at the rate g*(1 − x). One advantage of the logistic is that for two curves with similar initial growth rates g, it is a simple matter to calculate the number of years by which one lags behind the other. The UN publishes data on the total population and the urban population for 1950–2010 (UNDESA 2012). It also groups the data into two broad aggregates: more developed regions (MDRs) and 6 Urbanization as Opportunity less developed regions (LDRs). For population, Figure 1.1 shows the observed data as hollow points and a fitted logistic as a solid or dashed line. The observation for a given year is the population in each region as a fraction of the estimated terminal population for that region. The logistic curves fitted here imply a terminal population of 1.35 billion (standard error 0.023 billion) for MDRs and 9.91 billion (standard error 0.37 billion) for LDRs, roughly in line with the medium fertility variant of the UN’s world population projections to 2100. Appearances notwithstanding, there is nothing especially impres- sive about the fit here. Many functional forms for distributions, including a standard normal, could generate a good-looking fit. The advantage of the logistic is that its three key parameters—the terminal population, initial rate of growth, and lag between two curves—have a natural interpretation. At conventional significance levels, the data easily accept the restriction that the initial growth rate is the same for the two regions, 3.17 percent per year (standard error 0.08). The curve for the LDRs lags by 63.5 years (standard error 3.3). This is consistent with other Figure 1.1 Observed and projected normalized population for more developed and less developed regions, 1700–2200 Source: Authors’ calculations based on UNDESA 2012. Brandon Fuller and Paul Romer 7 more granular data on health and demographics. For example, today’s life expectancy in the low- and middle-income countries that correspond to the LDRs is about the same as in 1960 in the high- income countries that correspond to the MDRs (World Bank 2012). Figure 1.2 shows two pairs of logistic curves for the urban share of the population in each region. For each pair, the model forces the terminal share to be the same in the two regions. The data for the LDRs alone do not pin down a precise value for the terminal share so the constraint that the terminal shares are the same in the two regions is easily accepted. Our preferred model also forces the initial growth rate to be the same in the two regions. A less restrictive model lets the two growth rates differ. If we assumed that the errors are i.i.d. (independent and identically distributed) draws from a normal dis- tribution, the data would reject the restriction that the growth rates are the same, but Figure 1.3 suggests that the errors for the MRDs are not i.i.d. Instead, they show an oscillation around the underlying trend predicted by the logistic. Figure 1.2 Observed and projected urban share of the population in more developed and less developed regions, 1700–2200 Source: Authors’ calculations based on UNDESA 2012. 8 Urbanization as Opportunity Figure 1.3 Observed and projected number of new urban residents in more developed and less developed regions, 1900–2200 (million per year) Source: Authors’ calculations based on UNDESA 2012. One should not put too much faith in any estimate of a limiting value derived solely from a procedure that relies heavily on an ad hoc functional form assumption. We prefer the estimates from the restricted model, with its higher limiting share parameter of 0.87 (standard error, 0.01), mainly because the urban share continues to increase in almost all countries and already exceeds this value in a diverse group of countries that includes Argentina, Australia, Belgium, Chile, Israel, Japan, and Lebanon. Also, for the period when they overlap, its projections for the total urban population are somewhat closer to the ones that result from the detailed country- by-country forecasting procedure that the UN follows than the projections from the unrestricted model. For 2050, the last year for which the UN provides projections, our preferred model suggests a slightly higher share for the LDRs (65.1 percent) than does the UN projection (64.1 percent). The unconstrained estimate (62.6 percent) undershoots to a larger extent. With the restriction that the growth rate g is the same in the two regions, its estimated value is 2.46 percent per year (standard Brandon Fuller and Paul Romer 9 error 0.08). The urban share in the LDRs lags farther behind the MDRs (80.0 years, standard error 1.6) than does the curve for total population (63.5 years, standard error 3.3). The estimates for the two logistic curves imply values for the total urban population in each region as well as annual increases. Figure 1.3 plots the annual increase in millions of new urban residents per year. If Figures 1.1 and 1.2 are like plots of a fitted probability distribution function, Figure 1.3 is like a plot of an implied probability density function. As always, the deviations from the fitted curve, including the oscillation they induce for the MDRs, are more evident using the density than the distribution. By putting the two curves on a single axis, Figure 1.3 shows the extent to which the remaining process of urbanization is overwhelm- ingly a phenomenon of the LDRs, and overwhelmingly a phenom- enon of this century. These projections based on the logistic imply that the annual increase in the number of urban residents in the LDRs must soon peak and begin to fall. We are already well past the peak in the MDRs. Table 1.1 shows the effect of the cumulative influx of new urban residents over 100-year time intervals marked by three years defined relative to the milestone year of 2010: 1910, 2110, and 2210. In each reference year, the table shows the urban population and total population for each region. In the 100 years leading up to 2010, the total worldwide urban population increased by 3.4 billion people. In the next 100 years, the projected increase is 5.2 billion in the LDRs and 0.2 billion in the MDRs. In the 100 years that follow, the projected increase is a mere 800 million, all of it in the LDRs. Table 1.1 Urban residents and population, 1910, 2010, 2110, and 2210 Billions Year Urban residents Population Less developed More developed World world 1910 0.04 0.14 0.18 0.93 2010 2.60 0.96 3.60 6.90 2110 7.80 1.20 9.00 11.00 2210 8.60 1.20 9.80 11.30 Source: Authors’ calculations based on UNDESA 2012. 10 Urbanization as Opportunity Interpreting the lags The persistent lag in the dynamics of population growth and urban- ization are a reflection of the puzzling result first noted in the empiri- cal growth literature on growth in GDP per capita—an absence of unconditional convergence between the MDRs and the LDRs (see Barro 2012, for a recent overview of the evidence on conver- gence.) For measures that are bounded, it makes more sense to base any inference about unconditional convergence on estimates of logistic curves than on the trend in the ratio of the values in the two regions. This ratio can diminish even when the gap between the two curves remains constant. For example, the ratio of life expectancy in LDRs relative to the MDRs has been increasing (Bourguignon and Morrison 2002), but this is precisely what we would expect to observe for two variables that follow the same logistic and are separated by a fixed time lag. Here, the ratio of the urbanization rate in the LDRs relative to the MDRs increases from 0.32 to 0.59 yet the estimated lag either remains constant (for the constrained estimates) or increases (for the unconstrained estimates). These persistent lags are puzzling because LDRs today can use technologies that already exist in the MDRs, so growth in the LDRs is catch-up growth rather than growth at the technological frontier. All else equal, the LDRs should grow faster at any stage of develop- ment than the MDRs did at the same level of development, and the lags associated with development should shrink. This has hap- pened in many notable countries, but averaging across countries, the lag for the LDRs shows no sign of falling. This is what one might expect if the advantages presented by the potential for catch-up growth based on MDR technology are offset by a limited capac- ity for providing the government services that complement these technologies. Under this interpretation, the relative magnitudes of these lags are suggestive. If development were a one-factor process, we would expect the lag in the behavior of demographics, urbanization, and income per capita between the LDRs and the MDRs to all be the same. Instead, we see that population in the LDRs lags by 63.5 years (standard error 3.3) and remains constant. Under the preferred model, urbanization lags by 80.2 years (standard error 1.6) and Brandon Fuller and Paul Romer 11 remains constant. (Under the unconstrained model, the lag starts at 70 and grows.) A rough calculation based on Angus Maddison’s (2012) data sug- gests that the lag in GDP per capita is longer still. To approximate the UN definition of the MDRs, we created an aggregate consisting of Western Europe, Western offshoots, and Japan. In 1870, GDP per capita in our MDR aggregate was about $1,900 (measured in Maddison’s unit, 1990 International Geary-Khamis dollars). In the rest of the world, which corresponds roughly to the LDRs, GDP per capita did not reach $1,900 until 1970—a lag of 100 years. In 1900, GDP per capita in the MDR aggregate was $2,950. The LDR aggregate reached this level in 1995—a lag of 95 years. So, GDP per capita lags even farther behind the demographic measures than does urbanization. Assuming then that government capacity is the limiting factor in the LDRs, the variation in the lags suggests that complementarity with government services is strongest for the private activities that generate rapid GDP growth through technological inflows, weaker for the private activities that drive urbanization, and weakest for the health technologies that influence demographics. People can still urbanize, albeit less efficiently in slums and favelas, even if few government services are available. When it comes to the spread of health technologies that lengthen lives and reduce fertility, govern- ment services may be even less relevant. This suggests that at the same level of urbanization, the LDRs will have more access to technology but fewer government services than did the MDRs. Peak urbanization, weak capacity These arguments suggest that urbanization is peaking in the developing world at a time when the capacity to govern is still in short supply. Despite all the lip service to capacity building in the LDRs, there is little indication that government capacity will be able to increase in time to manage urban life in anything like the way it is managed in rich countries now. A quip attributed to Gordon Brown suggests how far off the time scales might be: “In establishing the rule of law, the first five centuries are always the hardest.” 12 Urbanization as Opportunity If governance is indeed the scarce factor, one response would be to find ways to let more people move from places with weaker governance to places with better governance (Clemens et al. 2008). A parallel strategy would be to export government services from places where the capacity for governance is well developed, to places where it is not. The potential gains from either strategy are much larger than those from further reducing trade barriers to flows of only privately provided goods and services (Clemens 2011). Much of the finance and expertise needed to develop new cities in the LDRs could come from the private sector in the MDRs, but these private services depend on complementary government ser- vices. For example, new cities might opt to outsource the provision of utility regulation to jurisdictions with more experience in this area. Both the private firms that could provide municipal water and the consumers who could consume it might be better able to agree to an arrangement that benefits both if an independent regulator can prevent the dual risks of ex post monopoly pricing by the water com- pany and the pressure for expropriation that unregulated monopoly pricing can foment. A policy of outsourcing utility regulation might be controversial if it were forced on the residents of an existing city, but might not be a deterrent to migrants who consider moving to a new city committed from the beginning to such an arrangement. After all, if large numbers of migrants are willing to move to a city in a developed country where the voters from the developed country control utility regulation and the migrants have no say, it is possible that large numbers of migrants might also be willing to move to a city located somewhere else where voters from the same developed coun- try control utility regulation. To be sure, it would be complicated to set up this kind of arrangement, but perhaps no more complicated than setting up yet another free trade area, and arguably with much larger benefits. Building new cities ought therefore to be an important goal alongside the inescapable need to expand existing cities because new cities may offer the best opportunity for experimenting with new solutions to the problem that holds back the potential implicit in catch-up growth, insufficient capacity of local government. Yet even with many new cities, most existing cities in the LDRs will also need to expand by a very large factor. With even the most optimistic Brandon Fuller and Paul Romer 13 increase in international trade in government services, severe capacity constraints will force the developing countries that are urbanizing rapidly to prioritize as they manage this expansion. Governments will therefore have to be narrow in the sense of not trying to do too many things, but strong in the sense of doing those few things well. For most rapidly urbanizing cities, Manhattan’s 1811 plan is a good starting point for a feasible model of strong but narrow urban planning. The plan was narrow in that it did not designate densi- ties, land uses, or locations for specific types of cultural, social, and economic development—tasks that even high-capacity governments have trouble getting right. It was also narrow in that it built and financed the streets on a just-in-time basis that took nearly one hun- dred years to complete. The plan was strong because the government used eminent domain to take, from the beginning, the land that would eventually be needed for those streets. It was strong because it forced landowners to cover the costs of the road construction adjacent to their proper- ties, road construction that increased the value of their land by much more than the levies they paid. Crucially, it was strong in the sense that public land designated for streets was protected for decades from squatting and informal settlement. As Angel (2008) points out, governments in rapidly urbanizing areas today have the capacity to do what Manhattan did in 1811. These governments can focus first on setting aside the public space for parklands and an arterial grid of dirt roads. Angel refers explicitly to “dirt roads” to emphasize that public space can be taken and pro- tected without the high spending necessary for building all the infra- structure that this public space will eventually support. This spending can take place as the city expands and new residents begin to demand the many services that are delivered by the trunk infrastructure that the arterial road network supports. Pilot programs for undertaking this kind of planning in Ethiopia have already shown that planning for this type of arterial grid is a manageable task for existing local governments (Angel et al. 2013). An approach to planning that is strong in this sense could also be narrow in the sense that it does not place any constraints on what private developers can do inside a superblock defined by the arterial grid. As long as there is some diversity in the private developers 14 Urbanization as Opportunity working on superblocks, bad development practices in any one block need not limit the city’s overall development. As land becomes more valuable, any mistakes in the superblocks will eventually be torn down and redeveloped. In contrast, because any adjustment to the arterial grid would require coordinated change on a much larger scale, it is unlikely that the grid itself will ever change. As a result, setting aside the public space for the logistic and utility corridors that can sew a city into a single market for labor and goods is a much higher priority than enforcing building codes on structures, imposing limits on density, or dictating the details of what private actors can do with the superblocks. A development goal for this century Humans have done something unique in the animal kingdom. We have shifted from one type of social structure—mobile bands with at most a few hundred members—to a radically different social struc- ture based on stationary urban nests of a complexity and scale that not even the social insects can match. More striking still, these nests have developed into a system of hubs linked by high-volume logis- tic spokes. The urbanization project is building an integrated social system in which 10 billion or 11 billion people, spread all across the globe, can cooperate. In this system, cities are both locations that facilitate local cooperation and nodes that channel the flows of goods and people that facilitate global cooperation. Humans have made progress by discovering new technologies that are non-rival, and hence can be shared with anyone else on the planet. The potential for discovering new non-rival goods lies at the heart of technological progress. It also explains why the gains that come from increases in the extent of the market will continue until everyone is part of a single cooperative network of the sort that we are now building. Because cities are essential to development of this network, it is critically important that people adopt the new social rules that are required to structure the dense interactions of city life. Moreover, it is not enough to strive for rules that are reasonably efficient now. We must also create a dynamic that lets the rules evolve to keep up with changes in our social and technological environment. In a Brandon Fuller and Paul Romer 15 small town, “go on green” is an efficient rule for managing traffic in an intersection controlled by a stoplight. As the population in the town increases, “go on green” can become very inefficient. It must be supplemented with a new rule, “don’t block the box.” In this broad dynamic of new technologies and ever denser and broader interactions structured by evolving sets of rules, it is typically the rules hold us back. Rules that may once have been efficient can become wildly inefficient yet still be frighteningly persistent. Because an unprecedented amount of urban area will be built dur- ing the 21st century, we have two main ways to establish cities that can work reasonably well for the foreseeable future. First, whenever possible, as urbanization takes place, people should delineate the public space of the logistics network, utility corridors, and parklands before the surrounding private space is occupied. Because the social rules for converting valuable private land into public space are so inefficient after people have occupied the land, it pays to establish the public space before large numbers of private claimants show up. A government that protects a grid of public space in an area that can accommodate large-scale urban expansion can then use the power of the individual incentives to build the urban structures that people will live in and work in. Even if the government does not, in its early decades, have the capacity either to build out such basics as a munici- pal water and sewage system or even to encourage private investors to build such systems, these can be retrofitted later if the arteries are available as utility corridors. Second, at least in this century, developing countries can develop new cities that let people can opt into new systems of rules. A new city like Shenzhen can help a society escape from rules that hold it back. Using new cities to implement reform makes it easier to strike the right balance between protecting the interests of the commu- nity, which often requires changes in rules, and allowing individual freedom, which can ensure that few people are forced to follow new rules that they think are illegitimate. New cities that compete for residents make it possible for a nation, a region, or the entire world to let new political entities try different types of rules and subject them to a market test based on the decision to opt in. This additional dynamic in the space of rules, one based on entry and exit, can oper- ate alongside the more familiar dynamic based on voice. Moreover, 16 Urbanization as Opportunity exit and entry are as likely to reinforce the power of voice as they are to undermine it. To be sure, some new cities will be disappointments, perhaps even failures, just as some new firms are disappointments or failures. Nevertheless, start-ups of both types still create value because the cost of the failures is so small compared to the benefit of even one roaring success. Together, New York and Shenzhen are models that show how humans can achieve an increase in supply on the required scale, but the market alone cannot replicate their success. Even in the early stages of development, a city requires a local government that is strong enough to protect the public space required for free mobility of goods and people. Instead of hobbling governments out of a fear that they might use even a modicum of strength in some counterpro- ductive way, it would be far better to increase competition between cities. If we take full advantage of the opportunity we now face and plan both for new cities and dramatic expansions of existing cities, we can break free from the admission of failure implicit in the Millennium Development Goals—from the sad belief that the only hope for the world’s poor is to shame governments into providing more services out of a sense of charitable obligation. The best hope for achieving the intention behind those goals is to shift focus to a single overarching goal: Every family in the world should be able to choose between several cities that compete to attract its members as permanent residents. Bibliography Angel, Shlomo. 2008. “An Arterial Grid of Dirt Roads.” Cities 25: 146–62. ——–—. 2012. Planet of Cities. Cambridge, MA: Lincoln Institute of Land Policy. Angel, Sholmo, David de Groot, Richard Martin, Yohannes Fisseha, Tsigereda Taffese, and Patrick Lamson-Hall. 2013. “The Ethiopia Urban Expansion Initiative: Interim Report 2.” NYU-Stern Urban Expansion Project Working Paper. http://urbanizationproject.org/uploads/blog/ Ethiopia_Interim_Report.pdf. Ballon, Hilary, ed. 2012. The Greatest Grid: The Master Plan of Manhattan, 1811–2011. New York: Columbia University Press. Brandon Fuller and Paul Romer 17 Barro, Robert J. 2012. “Convergence and Modernization Revisited.” Working Paper 18295, NBER. Bourguignon, Francois, and Christian Morrison. 2002. “Inequality among World Citizens: 1920–1992.”American Economic Review 92 (4): 727–44. Clemens, Michael A. 2011. “Economics and Emigration: Trillion Dollar Bills on the Sidewalk?” The Journal of Economic Perspectives 25 (3): 83–106. Clemens, Michael A., Claudio E. Montenegro, and Lant Pritchett. 2008. “The Place Premium: Wage Differences for Identical Workers across the US Border.” Policy Research Working Paper 4671, World Bank, Washington, DC. Deng, Xiaoping. 1992. “Excerpts from Talks Given in Wuchang, Shenzhen, and Shanghai.” The Selected Works of Deng Xiaoping, Vol. 3. http://www. archive.org/details/SelectedWorksOfDengXiaopingVol.3. Maddison, Angus. 2012. “Statistics on World Population, GDP, and GDP per Capita.” http://www.ggdc.net/maddison/oriindex.htm. Richerson, Peter J., Robert Boyd, and Robert L. Bettinger. 2001. “Was Agriculture Impossible during the Pleistocene but Mandatory during the Holocene? A Climate Change Hypothesis.” American Antiquity 66 (3): 387–411. United Nations Department of Economic and Social Affairs (UNDESA). 2012. “World Population Prospects: The 2011 Revision.” http://esa. un.org/unpd/wpp/index.htm. World Bank. 2012. World Development Indicators (database), Washington, DC. http://data.worldbank.org/data-catalog/world-development- indicators. Zeng, Douglas Zhihua, ed. 2010. Building Engines for Growth and Competitiveness in China: Experience with Special Economic Zones and Industrial Clusters. Washington, DC: World Bank, International Bank for Reconstruction and Development. Zhao, Suisheng. 1993. “Deng Xiaoping’s Southern Tour: Elite Politics in Post-Tiananmen China.” Asian Survey 33 (8): 739–56. 2 The Shifting Urban Economic Landscape What Does It Mean for Cities? Richard Dobbs and Jaana Remes Cities are the driving force of economic growth. According to the United Nations, more than half the world’s people now live in urban areas—in towns and in cities of all sizes. By 2025, the urban popula- tion is expected to have grown by another billion people, a huge majority of them in developing countries. At that point, 2.5 billion people—more than half the world’s urban population—will likely live in the burgeoning cities of Asia. China is expected to have more than triple, and India double, the number of urbanites in the United States today. Urbanization is not new. For centuries, people have packed up and moved from their rural homes in search of better-paid urban livelihoods. But today’s urban shift is unprecedented in scale and speed. It is no hyperbole to say that we are amid the most significant economic transformation the world has ever seen.1 Richard Dobbs and Jaana Remes 19 The productivity advantage of cities Densely populated centers—cities—enjoy powerful economies of scale, and for centuries urbanization and per capita gross domestic product (GDP) have moved in tandem (Figure 2.1).2 One reason for cities’ economic advantage is their often disproportionate numbers of skilled workers. Many cities have better education and training systems that feed the talent pool and attract students from elsewhere, many of whom stay. In India, higher education attainment is increas- ing five times faster in urban households than in rural households. And in China, many high school graduates come to Shanghai every year to further their education. The city’s 60 institutions produce at least 100,000 graduates every year, and more than a quarter of the city’s labor force has had a college education. Figure 2.1 Per capita GDP has risen in tandem with increases in urbanization Source: Population Division of the United Nations; Angus Maddison via Timetrics; Global Insight; Census reports of England and Wales; Honda in Steckel and Floud 1997; Bairoch 1975. Notes: a. Definition of urbanization varies by country; pre-1950 figures for the United Kingdom are estimated. b. Historical per capita GDP series expresses in 1990 Geary-Khamis dollars, which reflect purchasing power parity (PPP). 20 The Shifting Urban Economic Landscape In large cities, businesses can access more customers and employees and benefit from a broader supplier and service base. With a large number of customers at their doorsteps, cities are instant markets for many kinds of businesses—professional and personal services and shops, restaurants, and entertainment venues. One example is financial services. Just 24 cities account for nearly 95 percent of global equity market capitalization (World Federation of Exchanges n.d.). In Brazil, almost half of all deposits are in São Paulo and Rio de Janeiro. And the world’s 27 megacities—with populations of 10 million or more today—generated 25 percent of worldwide deposits in 2007 (Box 2.1). In emerging markets, large, well-known cities are on the strategic radars of international companies far sooner than smaller, less known cities. And the presence of companies reinforces a city’s popularity. The more jobs available in an urban center, the more people flock there in search of opportunity. As one university graduate told the McKinsey Global Institute, “All of China’s graduates want to go to Beijing or Shanghai for jobs. That is why there is such an oversupply in these cities” (Woetzel et al. 2009). Cities also offer the developed infrastructure that companies need to function—and that workers need to be productive. Access to reliable utilities and telecommunications matter for nearly all businesses today. And mass transit systems ferry throngs of workers to their workplaces each day—at speed. Once a critical mass of companies collects in a major metropolis, more companies tend to cluster around them. Large cities often become the center of a group of satellite cities with strong business and transport links—creating powerful network effects. New York and Los Angeles, the United States’ two megacities, are each at the heart of a cluster of nearby cities that benefit from their large neighbor. Bridgeport-Stamford, for instance, has built a successful niche business in finance, leveraging its proximity to New York City. Together, the “mother city” and its satellites benefit enormously from agglomeration effects. This clustering is happening all over the world. In China, for instance, the cluster around Shanghai on the Yangtze River Delta is now a world-famous economic dynamo. Less well known is the cluster of Guanzhou in the south, a rapidly growing export-driven business center. In India, 14 urban clusters are home to Richard Dobbs and Jaana Remes 21 Box 2.1 The McKinsey Global Institute’s Cityscope The McKinsey Global Institute Cityscope, a database of more than 2,600 urban regions, makes it possible to understand the evolving shape of global urban economies and extract city rankings and group- ings by region, variable, and type of city. The cities in the database are defined by integrated metropolitan areas rather than specific city jurisdictions, aggregating neighboring cities into a single urban center where appropriate. Examples include Rhein-Ruhr in Germany; Los Angeles, Long Beach, and Santa Ana in California; and Mumbai and Thane in India. In this fairly broad definition, which considers where people live and work regardless of distance, the city center is a small fraction of the city—in both area and population. Included in Cityscope are all metropolitan areas with a 2010 population of at least 150,000 in developed countries and all cities with a 2010 population of at least 200,000 in emerging regions. Demographic and economic variables are estimated by city for 2010 and 2025: total population; population from birth to age 14, ages 15–64, and ages 65 or older; total number of house- holds and average household size; number of households in four income brackets; and city GDP and per capita GDP in U.S. dol- lars measured with three different exchange rates (market, real, and PPP). Available economic data by city are limited and fragmented, and no single source can provide data on all Cityscope cities for any of the variables. For the base year 2010, we drew from a wide range of sources to collect existing city-level data, assessed the data for con- sistency across sources and variables before finalizing the metrics, and used the data to identify patterns for estimating variables for cities where data are not available. Despite best efforts, there remains room to improve and sharpen the available data. For 2010 GDP, our data sources were the McKinsey Global Institute’s India and China models for city-level GDP, national statistical offices, and C-GIDD (Figure B2.1.1). We estimated city-specific GDP growth rates from 2010 to 2025 using approaches that reflected whether the city had past GDP growth data available. To estimate households and household size in 2010, we used the McKinsey Global Institute’s India and China models, national statistical offices, and C-GIDD. For 2025 we used our household size (contd.) 22 The Shifting Urban Economic Landscape Box 2.1 (contd.) Figure B2.1.1 The McKinsey Global Institute used four sources to gather city GDP figures for 2010 Source: McKinsey Global Institute Cityscope 2.0. Note: a. The City 600 is a subset of the Cityscope database with the top 600 cities ranked by absolute GDP growth for 2010–25. econometric model with birth rates, death rates, and regional dummies as drivers. We used the model to forecast the decline in cities’ household size, reflecting convergence to a regional minimum. Sources for estimates of the number of household by income bracket in 2010 were the McKinsey Global Institute’s China model, national statistical offices, and C-GIDD. For 2025, we used our income distribution model and adjusted past patterns of changes with expected growth in per capita GDP. Richard Dobbs and Jaana Remes 23 approximately 17 percent of the country’s population but will likely account for 40 percent of urban GDP in 2030 (Atsmon et al. 2011). The final element of urban economies of scale is the delivery of services, including water, power, and telecommunications. Because cities have so many customers in a confined area, service delivery is cheaper. Delivering a liter of water to a city can cost as little as half that of delivering the same liter to a small village, because in cities suppliers can use common depots. McKinsey research found that in large cities, delivering several other services can similarly cost up to 50 percent less than in small villages. Some types of infrastructure, like international airports, are economically viable only when they serve large cities. Indeed, according to McKinsey estimates, a city of 5 million people needs about $5 million of investment per daily flight. But for a city of 1 million, the necessary investment rises to nearly $13 million. And once a city has an international airport, it becomes more attractive to both people and businesses. With their many productivity benefits, cities have historically offered two to three times the countryside’s average standard of living (see, for example, Maddison 1995; Morris 2010; Scheidel and Friesen 2009). Regions vary in the maturity of their urbanization Some regions are urbanizing faster than others. To understand the economic weight of cities across the globe, we focus on the world’s 2,600 large cities, defined in developing regions as metropolitan areas with at least 150,000 people and in developing regions as those with at least 200,000 (see Box 2.1). Collectively, the 2,600 are home to 38 percent of the world’s population but 72 percent of global GDP. Yet the role of large cities in the economy varies by country and region (Figure 2.2). A major reason is that some regions urbanized centuries ago while others still have a long way to go (Cadena et al. 2012). Europe—with Britain in the vanguard—and the United States shifted from rural to urban living in the 18th and 19th centuries, as industrial revolutions transformed their economies and vaulted them to global economic and political power. Europe industrialized and urbanized about 100 years before the United States, but today the latter is the world’s most urban region. Around 80 percent of the U.S. population lives in large metropolitan areas, which in 2010 24 The Shifting Urban Economic Landscape Figure 2.2 The relative economic weight of large cities varies across regions Source: McKinsey Global Institute Cityscope 2.0; McKinsey Global Institute analysis. Notes: a. Cityscope cities defined as having populations of at least 150,000 in 2010 in the United States and Western Europe. In China, Latin America, India, and Africa, only cities with at least 200,000 inhabitants in 2010 are included. GDP figures are in PPP dollars. b. The rest of the economy includes cities with fewer than 150,000 inhabitants, as well as rural areas. generated almost 85 percent of the nation’s GDP and nearly 20 per- cent of world GDP.3 Between now and 2025, large U.S. cities are expected to contribute more to global economic growth than the 355 large cities in all developed countries combined. The economic clout of U.S. cities is largely due not to its megacities (New York and Los Angeles) but to its broad swath of 257 middleweights—among them Chicago, Dallas-Fort Worth, and San Francisco-Oakland— home to 30 percent of the U.S. population and generating 37 per- cent of U.S. GDP. Richard Dobbs and Jaana Remes 25 Europe, despite its early start, is less urban than the United States, with only about 55 percent of its population in large cities, accounting for less than 65 percent of GDP. Traditionally, Europeans have been less inclined to move within their home nations and to neighboring countries than have the highly mobile U.S. population. One reason Europeans tended to stay put in the past is that European authorities provided generous unemployment benefits and other social transfers, allowing people more time to look for a job locally rather than move to where a suitable position is available.4 Whether this mobility gap will remain, however, is an open question. While mobility in the United States has been falling since 1990 and now stands at a 50-year low, a likely decline in regional investment and employment support in the European Union, together with more flexible cross-border labor regulations, may lead to increasing mobility there. Latin America is also relatively mature in its urbanization, having had large-scale urban growth in the second half of the 20th century. Today, 289 cities in the Cityscope database are home to 55 percent of the Latin American population and generate more than 75 percent of the region’s GDP. As in the mature urban economy of the United States, middleweight cities are taking up the baton of growth. During Latin America’s rapid growth over 1950–70, its megacities may have been the unintended by-product of import-substitution policies.5 Yet many of the region’s large cities were unable to provide the infrastructure and services to keep up with their rapid expansion. The urban scale benefits have been gradually turning into disecono- mies. Today, many large cities struggle with traffic gridlock, urban sprawl, slum housing, crime, and pollution—making them not only less pleasant but also less productive. Long traffic jams on the daily commute are sure to compromise a worker’s productivity. As a result, most of the region’s top 10 cities have had slower GDP growth over the past two decades than their middleweight peers, and we expect this trend to continue. Latin America’s middleweights are expected to generate more than 65 percent of the region’s growth over 2010–25. Growth in the populations and per capita GDPs of these middleweights is likely to outpace that of the region’s four megacities. China is right in the middle of its large-scale urban shift. Over the past 10 years alone, the share of the population in towns and 26 The Shifting Urban Economic Landscape cities has increased from 36 percent to 50 percent, and according to the United Nations its urban population could expand from around 555 million in 2005 to 910 million in 2025 (UNDESA 2012). That increase is larger than today’s entire U.S. population. Policies enabling large-scale urban migration are part of why China’s share of urbanites has expanded so rapidly,6 and large cities are now the cornerstone of China’s economy. In 2010, more than 700 metropolitan areas with 200,000 or more inhabitants collectively accounted for 78 percent of the nation’s GDP. Cities of all sizes continue to grow faster than smaller towns and rural areas, and we expect large cities to generate more than 90 percent of China’s GDP growth to 2025. India, while also urbanizing on a monumental scale, is still fairly early in its transition to an urban economy. Only 30 percent of Indians live in cities of all sizes. And fewer than one in five Indians live in the country’s roughly 230 large cities—about a third the number in China. State borders appear to limit mobility, and economic policies favoring small-scale local production have encouraged people to stay closer to home. Yet the number of people in India’s towns and cities increased from 290 million in 2001 to an estimated 340 million in 2008—and could hit 590 million by 2030 (Sankhe et al. 2010). This process is now accelerating. Indeed, the country took nearly 40 years (1971–2008) to add 230 million people to its urban population but could take only half that time to add the next 250 million. By 2030, urban areas of all sizes could generate 70 percent of net new jobs in India, contribute more than 70 percent of GDP, and drive a near quadrupling of per capita income. Even this expansion is likely to increase the share of urbanites from around 30 percent today to only 40 percent in 2030. Africa, the second-fastest growing region over the past decade, is also still early in its urbanization, with 213 large cities generating around $0.8 trillion in GDP, almost half the regional total. By 2025, the GDP of these cities should almost triple to more than $2 trillion, approaching a 60 percent share, and middleweight cities are expected to outperform the region’s largest city, Lagos. Urbanization, along with a young and growing labor force and an expanding consumer class, will continue to propel the region’s rapid economic growth (see Fine et al. 2012; Roxburgh et al. 2010). Richard Dobbs and Jaana Remes 27 Mass urbanization is shifting the global economic balance The world economy’s center of gravity is shifting from the advanced economies of the West to the emerging powerhouses of the East and South—at a speed and scale like never before. Mass urbanization in China, India, and other emerging nations is an enormous part of this movement. This shifting of the globe’s economic tectonic plates has profound economic consequences. In the short term, urbaniza- tion is propelling incomes in the developing world, a bright spot in an otherwise still fragile global economy; in the long term, it has the potential to reshape the world for governments and businesses alike. Rapidly expanding consumer classes with income for discretion- ary goods and services—previously devoted mainly to such basics as food, shelter, and clothing—will create vibrant new markets. And they have already triggered an investment boom. As cities try to keep pace with their expansion and the demands of their armies of new consumers, they will have to continue investing in buildings and the infrastructure to deliver housing, water, and power and to transport goods and people. The additional consumption and investment that will have to accompany the new urban consumer classes has the potential to inject an estimated $30 trillion of spending a year into the world economy by 2025. Today’s mass urbanization is unprecedented in speed and scale China is urbanizing on 100 times the scale of Britain in the 18th cen- tury and at more than 10 times the speed. As a result, the global balance—measured by the Earth’s economic center of gravity—is shifting back to Asia at a speed never before seen (Map 2.1).7 For centuries, most people lived on close to subsistence incomes, population grew slowly, migration was limited, and the Earth’s economic center of gravity was fairly stable. But industrialization and urbanization, first in Europe and the United States and then in developing countries, have driven rapid shifts in that center. Japan’s post-war economic renaissance began the swing back to the East in the 1980s, but the most recent decade has seen the fastest shift ever 28 The Shifting Urban Economic Landscape Evalution of the earth’s economic center of gravitya AD 1 to 2025 Map 2.1 The globe’s shifting economic center of gravity Source: McKinsey Global Institute analysis. Note: a. Economic center of gravity is calculated by weighting locations by GDP in three dimensions and projecting to the nearest point on the Earth’s surface. The surface projection of the center of gravity shifts north after 1950 as Japan industrial- ized rapidly, reflecting the fact that in three-dimensional space North America and Asia are not only “next” to each other but also “across from each other”. in the world’s economic balance. Over 2000–10, the center of gravity shifted about 140 kilometers a year—to the South and particularly to the East. That is about a third faster than the post–World War II movement away from Europe toward North America. In a short span of three years from 2007 to 2010, the swing in economic balance away from the United States and toward China was remarkable. Over that period, the GDP of large Chinese cities rose from 20 percent of that of large U.S. cities to 37 percent. These were unusual economic times. The United States was in recession or growing only slowly, while China was continuing to grow rapidly. In those three years alone, three more Chinese cities became mega- cities—one new megacity a year. In more mature economies, where urbanization is reaching a plateau, only Chicago is expected to hit 10 million people by 2025. The shift in economic balance is not bilateral between the United States and China, or even from West to East. The balance is shifting Richard Dobbs and Jaana Remes 29 to the South, too. In 2007, the GDP of Latin America’s cities was 26 percent that of their European counterparts, but by 2010 that share had risen to 37 percent. Just 600 cities could generate two-thirds of global GDP growth—and half that growth could come from 443 cities in emerging economies Urbanization is a global phenomenon with the broadest possible impact on the way we live and on the balance of world economic power. But the economic clout of cities is highly concentrated and likely to remain so. The top 600 metropolises measured by their contribution to global GDP growth—the “City 600”—are today home to just over one in five of the world’s people, but their economic power far outweighs their collective size. Together, they generated $34 trillion of GDP in 2010—or more than half the world total. We see them continuing to be hugely important for the global economy—, between them con- tributing an estimated $30 trillion of additional GDP (in expected real exchange rates), or nearly 65 percent of world growth.8 However, an even more important group within the City 600 will likely be the most powerful driver of the world economy—the “Emerging 440,” or 443 cities that we expect to generate 47 percent of global GDP growth over 2010–25 (Figure 2.3). Only 20 cities in the Emerging 440 are megacities, including São Paulo, Moscow, Mexico City, Istanbul, Lagos, and Dhaka.9 These 20 are set to gen- erate almost $6 trillion in GDP growth by 2025—a 7.6 percent compound annual growth rate, nearly twice the world economy’s 4 percent. The rest of the Emerging 440 comprises middleweights, which are expected to grow even faster, at an 8 percent annual rate, and to account for almost $18 trillion of GDP growth by 2025, or 35 percent of the total. The middleweights in the Emerging 440 are in 57 countries and every continent except Oceania. China has 236 of them. One is Haerbin in the northeast, whose growth took off early in the 20th cen- tury when the Chinese Eastern Railway, a spur of the Trans-Siberian Railroad, opened and ran through the town, and which has built a strong industrial base leveraging its excellent transport connections. Figure 2.3 The Emerging 440 is expected to generate 47 percent of global GDP growth to 2025 Source: McKinsey Global Institute Cityscope 2.0. Notes: Numbers may not sum due to rounding. a. Small cities and rural areas. b. Other large cities not included in the City 600. c. Includes cities from China (Hong Kong SAR, China, and Macau SAR, China) and Taiwan, China. d. Includes cities from Afghanistan, Bangladesh, India, Pakistan, and Sri Lanka. e. Includes cities from Cambodia, Indonesia, the Lao People’s Democratic Republic, Malaysia, Myanmar, Papua New Guinea, the Philippines, Singapore, Thailand, and Vietnam. Richard Dobbs and Jaana Remes 31 Today, Haerbin is an up-and-coming middleweight city of nearly 6 million people and the headquarters of Haerbin Electric Corporation, which generates half of China’s hydro and thermal power. Haerbin is also home to the world-famous International Ice and Snow Sculpture Festival. Other Chinese cities in the Emerging 440 are the inland transportation hub of Lanzhou, with 2.6 million people, and China’s largest coal port of Qinhuangdao, with 1.2 million. Latin America is home to 53 middleweights in the Emerging 440. Brazil’s third largest city of Belo Horizonte, the capital of Minas Gerais state, has rich mining and agriculture resources. And the car manufacturing city of Puebla is Mexico’s fourth largest urban center, with more than 2.6 million inhabitants. India boasts 28 cities in the group, including Bangalore, with 8 million inhabitants and globally known as the center of the country’s information and technology industry, and Pune, which specializes in the automotive and pharma- ceutical industries. Africa and the Middle East together contribute 37 middleweights to the Emerging 440, including Angola’s capital Luanda, the world’s third largest Portuguese-speaking city, Kumasi, which produces almost half of Ghana’s timber, and Port Harcourt, the center of Nigeria’s oil refining industry. The increasing power of the emerging urban world is compelling, but it would be a mistake to write off the cities of developed econo- mies as unimportant. Today, the GDPs of Tokyo, New York, and London would at market exchange rates rank them the world’s 9th-, 14th-, and 17th-largest economies. And even after accounting for expected changes in real exchange rates, Tokyo is on course to remain the world’s largest city by GDP in 2025, followed by New York in second place, Los Angeles fourth, and London sixth. Shanghai and Beijing are set to be the only two emerging cities among the top six in GDP. In fact, one of every five City 600 cities is in North America or Western Europe, and we expect them to account for about 14 percent of global growth to 2025. Cities will be home to 1 billion new consumers Urbanization and industrialization have hauled millions of people out of rural poverty, but the world still faces a challenge to ensure that urbanites do not now fall into the poverty trap.10 The urban shift 32 The Shifting Urban Economic Landscape has been the decisive force behind a global rise in the consuming classes—segments of the population with enough income to buy not only basic necessities but also discretionary goods and services—that will be a significant new force in the world economy (Box 2.2). The size of the world’s consuming class is on course to more than triple between 1990 and 2025—to more than 4 billion people. Nearly 2 billion of the new consumers will be in emerging market cities, and 1 billion of these urban consumers will enter the ranks of the consuming classes between now and 2025. More than 600 million of the new consumers will live in Emerging 440 cities. In 2010, nearly 55 percent of the Emerging 440 population had incomes high Box 2.2 The rising consumer class We define the consuming class as individuals with disposable income of more than $10 a day—or $3,600 a year—using constant 2005 PPP dollars. Our purpose is to focus on the population segment with enough income for discretionary spending on a range of consumer products. The threshold of $10 a day corresponds to the income at which the consumption of many consumer goods begins to grow rapidly. This definition is consistent with work by others, including Surjit Bhalla and Homi Kharas.11 Others have proposed different definitions for measuring the rise of living standards in emerging markets, com- monly characterized as the growing “middle class.” There are many ways to define the boundaries of the middle class. Martin Ravallion of the World Bank defines it as individuals earning between $2 and $13 a day at 2005 PPP, highlighting the changing share of the segment of the population just above the poverty line. The Asian Development Bank uses consumption of PPP $2–20 a day (Asian Development Bank 2010). Others, including William Easterly of New York University, define the middle class as the population between the first and fifth income quintiles in a country. This approach defines the middle class relative to each nation’s income distribution rather than using an abso- lute level of income or consumption. Note: The right solution depends on the purpose of the analysis. Our method reflects a focus on understanding rising consumer markets in emerging economies. Richard Dobbs and Jaana Remes 33 enough to make discretionary purchases; by 2025, we expect that share to be 80 percent. In emerging cities, incomes are rising faster than ever—and at twice the rate of growth in the number of households and individuals in consuming classes (Figure 2.4). We estimate that incomes will grow especially fast in households with disposable incomes of $20,000 or more in PPP terms. Such households within the Emerging 440 could see their incomes rise at a compound annual rate of 7.6 percent a year, and by 2025 they are likely to account for more than 55 percent of all Figure 2.4 Household income pools are poised to grow at twice the rate of the number of households in the Emerging 440 Source: McKinsey Global Institute Cityscope 2.0. Note: Numbers may not sum due to rounding. a. Total household income is the estimated average income in an income category multiplied by that category’s households. Average incomes of categories are esti- mated using an income distribution from a segment of 10 income brackets in 2010 and 2025. 34 The Shifting Urban Economic Landscape households in this income bracket, up from 35 percent today. There also will be more high-income consumers in the cities of emerging markets, likely to be home to 60 percent of all urban households with an income of more than PPP $70,000. Today, the Emerging 440 is home to just under 20 million such households, a tally likely to triple by 2025. China could account for one in five new high- income households, but other economies will have their share of the new prosperous—India with 6 percent, Brazil with 4 percent, and Mexico with 3 percent. These four economies alone will be home to an additional 30 million high-income households. These new consuming classes will fuel rapid growth in demand for a range of products and services. We expect that urban households could be responsible for around $20 trillion of additional spending in the period to 2025, more than $14 trillion of it in the large cities of developing economies. In the cities of the Emerging 440 alone, the rise in consumption is poised at about $10 trillion.12 In fact, growth in demand for many products will be even faster than the expansion of the consuming class—for two reasons. The first is the one we have mentioned—that incomes are rising faster than the number of consuming individuals and households, a testament to the economic power that living in a city confers. Second, so many people in the cities of emerging economies—particularly in China and India—are moving into the income brackets where spending on many goods and services tends to take off (Benshimol Severin et al. 2011). In India, discretionary spending—say, on packaged food and drinks, durable goods such as televisions or refrigerators, or din- ing out in restaurants—rose from 35 percent of average household spending in 1985 to 52 percent in 2005 and is expected to jump to about 70 percent by 2025 (Ablett et al. 2007). The economic shift is not happening at a consistent speed or with an identical pattern across regions because not all products see spending accelerate at the same level of income. The first types of products that tend to take off at fairly modest incomes are snack foods and bottled soft drinks—items that have low unit costs. Beauty products are slightly more expensive, and their consumption starts to speed up at higher incomes. Then, for luxury products such as fine wine or up-market fashion, the income threshold has to be higher still. Demand for deposit services tends to take off at higher Richard Dobbs and Jaana Remes 35 incomes than many consumer goods—they start to rise at around PPP $18,000 per capita income and continue to be concentrated in the leading cities of each nation.13 But spending patterns are about more than just income. Consumer tastes vary from region to region—or from city to city—in the same country. Cultural and religious preferences also play a part in what products grow fastest, and where. Obvious examples include the fact that alcohol sales are low in countries with a high share of Muslims, and meat consumption in India, where many people are vegetarian, is low by global standards. Demographic trends can also make a big difference. One-third of the population of Nigerian cities is below age 16, and sales of baby food are currently more than double the global average (at similar incomes). Growing cities in emerging markets need investment, capital, and resources Rising prosperity and integration into global markets means that cities will need more connections to other urban centers. As ris- ing prosperity translates into greater demand for many products, demand for transportation services that get products to consumers rises rapidly. Most consumer goods will be shipped in containers, and supply-chain logistics are creating further demand for container capacity. We estimate that by 2025 the urban world will need two- and-a-half times today’s container capacity in ports. Substantial investment is needed for the required expansion in capacity—likely more than a cumulative $200 billion by 2025 according to our rough estimates.14 Many emerging cities, as they seek to absorb and serve their expanding and ever more prosperous citizens, have already enjoyed a boom in residential and commercial building and infrastructure. To get a broad sense of the scale of the investment challenge, we estimate that, to cater to future demand, cities might need to more than double their physical capital investment—from nearly $10 trillion a year today to more than $20 trillion a year by 2025.15 Demand for housing and offices is soaring, and we estimate that cities will need to construct new floor space equal to around 85 percent of today’s stock of residential and commercial buildings 36 The Shifting Urban Economic Landscape (including stock needed to replace aging buildings) to keep up— that’s more than 80,000 square kilometers, or about the size of Austria. China is likely to account for almost 40 percent of these new buildings. For commercial buildings, North American cities will be important sources of growth. The United States and China are likely to contribute 60 percent of global construction of commercial floor space. Globally, this urban building boom is likely to require cumulative investment, including in replacement buildings, of close to $80 trillion to 2025.16 By 2025, urban residential demand for municipal water will be an estimated 40 percent higher than it is today—an increase of nearly 80 billion cubic meters, or more than 20 times the consumption of New York City.17 China will likely account for one-quarter of growth in demand for municipal water. Africa and the Middle East will be responsible for almost 14 percent of the global rise in municipal water demand in large cities. Meeting demand not only for water but also for the treatment of wastewater could require cumulative investment in the range of $480 billion by 2025. This rising urban demand is already straining the world’s available natural resources—energy, water, and metals such as steel includ- ed—and available capital. The global investment rate jumped from 20.8 percent of world GDP in 2002 to 23.7 percent in 2008 (before falling back somewhat during the global recession of 2009) (Dobbs et  al. 2010). On the resource front, prices of energy, land, food, and water have soared as strong demand—notably from developing countries—coincided with a period in which many resources became more expensive and less accessible. Indeed, due to waves of techno- logical innovation that made using these resources more efficient, the price rises over 2000–10 wiped out the price declines over the previous 100 years.18 With their dense populations, cities tend to use their resources more productively than do sparsely populated areas. McKinsey Global Institute research on China’s urbanization found that a concentrated pattern of urbanization could have almost 10 percent higher energy efficiency than a more dispersed pattern (Woetzel et al. 2009). The reason is that the industries in large cities, including services and electronics, tend to use less energy. Moreover, people tend to live and work in smaller spaces, so there is less need for heating and lighting. Richard Dobbs and Jaana Remes 37 Insulation, too, is easier and less costly to install in larger buildings. And mass public transportation—planned well—is more cost effec- tive in large cities than across a number of smaller urban centers. The higher the residential density of a city, the more the driving declines, cutting petrol use (Farrell et al. 2008). How cities try to accommodate their rising populations is not just relevant in the near term—cities need to plan and develop local economies that can produce sustained productivity gains long after exhausting the—arguably easy—gains of rural-to-urban migration. For cities investing in new capacity, there is a golden opportunity to lock in higher energy and resource efficiency for decades to come, setting the groundwork for sustainable economic vigor beyond their demographic growth spurt. The shifting economic balance poses a range of challenges for cities Cities now underpin the world economy, and how they manage their affairs will have a profound impact on the lives of more than half the world’s people. How cities handle themselves could not be more vital. As the world’s economic center of gravity shifts at speed from the advanced economies of North America and Europe toward the developing economies of the South and East, their challenges will differ sharply. For leaders of cities in mature economies that have already reaped most of the economic benefits of their urbanization, the challenge is to sustain growth and manage shifting demands on city services in a tighter fiscal environment. In the near term, U.S. and Western European cities are struggling to emerge from recession and over- come the dampening impact on growth of high unemployment and deleveraging (Dobbs et al. 2012a; Manyika et al. 2012a, 2012b). Looking further ahead, most of them will face the pressures of slower population growth, including aging, and of intensifying global competition. Some cities will see the impact sooner. In Italy, the city of Trieste will in 2025 need to grapple with the strain of having more than 30 percent of its population ages 65 or older, while in Naples the same share is expected to be below 20 percent. A city’s first step 38 The Shifting Urban Economic Landscape toward setting priorities for the years ahead is to understand its main economic strengths and challenges and how demographic and other trends are likely to shape its economy. Chicago, on course to become a megacity but grappling with slowing growth in recent years, has compiled a fact base as the platform for a new growth strategy. If cities in mature economies are to sustain and improve their service delivery, they will need to bake into their planning the principle of “doing more with less.” Productivity and smart planning will be the name of the game. The task for many city leaders in the developing world is just the opposite: how to keep up with the needs of an influx of 4 million people each month in search of work and higher standards of living. To both manage periods of rapid expansion and establish a solid base for sustained growth in the longer term, these cities must execute a complex managerial task of planning for housing, infrastructure, and transportation systems—ensuring that the city has the finance to meet operational and capital spending needs, to build capabili- ties to manage effectively the broad range of public services and city operations, and, through smart regulation, to create a favorable environment for businesses.19 The many facets of urban management are explored in the rest of this book (see also World Bank 2012). Yet the patterns of the changing urban world suggest that cities, wherever they are, also have much in common—and share similar imperatives. Govern smartly Cities are becoming more important to the economic fates of their nations, placing more responsibility on those who govern them. Getting governance right is not easy, and no single model works in all contexts. Many of the world’s leading cities, in both the developed and developing worlds, have chosen to put a powerful, politically appointed mayor in charge—China’s major cities and New York are examples—often supported by corporatized agencies that specialize in managing the myriad services that cities are obliged to deliver and reviewed rigorously against the results they achieve. In the city of Wuhan in China, the party secretary sets targets for economic growth and evaluates all city departments against them. South Africa con- Richard Dobbs and Jaana Remes 39 solidated the previously independent municipalities of Johannesburg into a single metropolitan government under a mayor supported by a non-political, professional city manager. Rio de Janeiro has a “deliv- ery unit”—a small team that has developed and coached a group of cross-functional staff charged with delivering on the city’s goals. A focused mandate and strong political backing are helping the unit break through the silos that prevent government departments from collaborating. Many other cities have a fragmented governance structure that splits responsibilities among city, county, state, and federal govern- ments and among siloed authorities in charge of such services as housing and transportation. In the Los Angeles metropolitan area, about 40 agencies oversee transport decisions and operations. And the San Francisco Bay Area consists of nine counties and more than 100 cities, making regional planning and coordination challenging. Consolidating and sharing services among cities and between cities and counties can free up funds, while a lack of coordination can be a recipe for inefficiency and wasted resources.20 New technologies can ease the urban managerial task. City man- agers can, for instance, encourage the installation of broadband in new housing developments, which costs much less than retrofitting existing housing. The increasing use of sensors and digital devices in physical objects and machinery is enabling the birth of “smart” urban infrastructure (Chui et al. 2010). For example, smart grids and sensors in water and sewage systems can help avoid system break- downs, halving the number of leaks. Smart transport systems can use sensors to monitor transportation flows to avoid congestion and traffic delays. In Mumbai, traffic control that adapts to traffic condi- tions has cut average travel time 12 percent. London’s congestion pricing scheme has reduced bus delays 50 percent and increased the average speed of all traffic 31 percent. Nurture the middleweights The middleweights’ increasing prominence, a pattern of the evolving world, has already proven to be the cornerstone of U.S. economic power and is now palpably changing the emerging urban landscapes from China to Latin America (Manyika et al. 2012b). These up-and- 40 The Shifting Urban Economic Landscape coming medium-size cities are likely to be home to the lion’s share of economic growth—not only globally but in most large countries. Countries can foster an environment for the middleweights to learn from experience and preempt the strains that have slowed the growth of many of their very large urban cousins. There is no single blueprint for cities to follow—indeed, it is precisely their diversity that makes middleweight cities powerful. In Latin America, successful middleweight cities range broadly— from entrepreneurial metropolises such as Monterrey in Northern Mexico, home to a technology cluster around the Tecnológico de Monterrey system that has stored a deeply rooted entrepreneurial culture—to Belo Horizonte in Brazil, a center of information tech- nology and biotechnology—to Medellin, with the first Colombian business cluster, PPPs fostering growth in electricity generation, textiles, fashion design, construction, and tourism—to resource-rich cities such as oil-producing Campeche and Villahermosa in Mexico or agroindustrial Rosario in Argentina—to manufacturing centers such as Puebla, home to the Volkswagen and Hylsa plants in Central Mexico—and to the cluster of machinery and equipment companies in the Santa Catalina region of southeastern Brazil. In India, between 70 and 100 medium-size “specialist” cities have grown on the back of an anchor sector—such as manufactur- ing, resources, transportation, and tourism—or as destinations for pilgrims, creating many more jobs and attracting more private investment than other cities of similar size. Examples include Agra, a magnet for tourism, and Bhilai, with its world-class steel facilities (Sankhe et al. 2010). Some middleweight cities will fare better than others—history shows that the growth of individual cities varies widely. Yet we expect half of global GDP growth to come from emerging market middle- weights, making their success critical for sustaining the growth of the global economy. Compete for people and investment Cities already compete for people and investment on a local and global stage. This competition is likely to intensify as more middle- weight cities are integrated into the global economy. The capacity to Richard Dobbs and Jaana Remes 41 attract people has determined the growth of cities in the past and will continue to do so in the future—and not only in rapidly urbanizing developing regions. Among the U.S. cities, differences in population growth explain most of the differences in GDP growth. Fast-growing cities—those with GDP growth at least 25 percent higher than the national average over 1978–2010—saw their populations grow two and a half times the national average despite having nearly identical per capita GDP growth (Manyika et al. 2012b). The same holds true in Western Europe. Most cities that outperform their national peers do so because of faster growth in population, not in per capita GDP.21 Aging will only intensify the race for attracting migrants, par- ticularly the young and educated. China has committed to gradually extending social services to migrants to attract the labor its cities need. Pittsburgh in the United States, in its post-industrial phase, diversi- fied its economic base and attracted new, more educated migrants, reinforcing its rebirth. Most leaders of large cities already are acutely aware of the compe- tition for hosting growing businesses. Attracting investment has been a central plank of government policy in Singapore and Ireland. Both have dedicated agencies—the Singapore Economic Development Board and the Irish Industrial Development Agency—that have built high-performing sales forces with skilled staff equipped with best practices from the private sector. And both identify prospec- tive investors, tailor offerings to the specific needs of not only each industry but also individual companies, and have the power “to make things happen for multinational corporations,” as the Economic Development Board’s motto proclaims (Alfaro et al. 2005). Seize the power of networks Clusters of cities with close economic and business relationships— and transportation links—enjoy powerful network effects. Instead of competing with each other, individual cities in a cluster can forge relationships to create an economy greater than the sum of its parts. But cities need to network on a global scale, too. Industry value chains, increasingly complex and global, require business and logistic connections between suppliers and customers in many countries or cities. For cities in developed economies whose population and GDP 42 The Shifting Urban Economic Landscape growth might be slowing, one route to revival is to build connections with the fast-growing cities of emerging markets, whether through air and port links or through business and personal relationships. For most nations, another area for change is foreign service. Many countries are seeing commercial diplomacy and trade missions as increasing priorities for their foreign-service corps, yet their person- nel allocation across the globe has largely failed to catch up with the growing importance of medium-size cities in emerging econo- mies. For instance, Wuhan, China, is likely to deliver more than 10 times the GDP growth of Auckland, New Zealand, over the next 15 years—yet most countries will post many more diplomats to Auckland than to Wuhan, if they have any diplomatic presence at all. India’s Hyderabad will likely post five times the GDP growth of Krakow in Poland, but the United States has about the same num- ber of foreign-service staff in each. In short, commercial diplomacy designed in the late 20th century now needs to take full note of the cities shaping the 21st. Being connected also enables cities to learn from each other. Cities the world over are experimenting with innovations in policy and operations—rethinking the way they work. In transportation, for instance, Curitiba in Brazil has introduced pioneering innovations in its public transport system, including a network of bus-only lanes. Colombia’s Bogotá now boasts its extensive TransMilenio bus rapid transit system. And Mexico City has its Metrobus system. Also in Colombia, Medellin has a gondola cable transportation system that connects some of the lowest income neighborhoods in the hills on the city’s outskirts with the metro network, a solution since adopted in nearby Manizales and in Caracas, Rio de Janeiro, and other cities. Food security is another area for new approaches. In the early 1990s, Belo Horizonte made the right to food a policy priority and created an agency that has subsidized food distribution through pop- ular restaurants and food baskets, through farmers markets and direct supply links to rural producers, and through nutrition assistance to schools and food banks. These measures have had a significant impact not only on urban nutrition but also on rural agriculture— with spending less than 2 percent of the city budget.22 Local government can make an enormous difference by adopting smart regulation. Lima in Peru suffered from a paralyzing amount Richard Dobbs and Jaana Remes 43 of red tape. A decade ago, it took more than 100 days to register a property. Today, the wait is just a week, the shortest of any capi- tal city in Latin America. This illustrates how dramatic change can occur through clever policies. Lima deliberately removed unnecessary officialdom (such as by reducing the number of certified copies of required documents) and sped up processes by allowing electronic cross-checking of information across agencies. Instead of making 10 visits to municipal offices, applicants could obtain a license in just 2. In 2006, the first lean process year, more than twice as many operating licenses were issued than in the four previous years com- bined (Sislen et al. 2007). Compiling a detailed fact base on cities, the economic environ- ment in which they operate, and the lessons of success and failure in their management are all vital if local policy makers are to meet the urbanization challenge. And they can benefit from learning from each other about both what works and what does not. The world’s cities already boast inspirational examples of how to overcome challenges that may seem insurmountable—and how to head off the problems that some of the globe’s largest metropolises struggle with today. How cities, the center of gravity of the world economy, cope with their expansion will shape the world for decades to come. So, rethinking cities is a vital task for our age. Notes 1. The McKinsey Global Institute, McKinsey & Company’s business and economics research arm, has published extensively on urbanization. See Woetzel et al. (2009); Sankhe et al. (2010); Dobbs et al. (2011b); Cadena et al. (2011); Manyika et al. (2012b); and Dobbs et al. (2012b). All McKinsey Global Institute reports can be downloaded at www. mckinsey.com/mgi. Unless otherwise noted, the findings in this chapter are based on McKinsey Global Institute research. 2. There is a large body of literature assessing the nature and size of urban economies of scale. See, for example, Glaeser and Gottlieb (2009); World Bank (2009); and Gill and Goh (2010). 3. The 259 large U.S. metropolitan areas include the two megacities of Los Angeles and New York, each with 10 million or more people, and 257 middleweight cities, each with between 150,000 and 10 million. See Manyika et al. (2012b). 44 The Shifting Urban Economic Landscape 4. See Molloy et al. (2011). The authors find that U.S. mobility is about twice as large as mobility in most European countries outside of Northern Europe, based on a 2005 Eurobarometer survey that allows for comparisons with U.S. data (European Commission 2005). Data from the European Union Labor Force Survey generally confirm lower mobility rates in Europe than in the United States. Note that it is dif- ficult to compare mobility rates across countries because of conceptual difficulties in forming a common definition of internal mobility. 5. For more on the link between Latin American industrial policies and the emergence of megacities, see Elizondo and Krugman (1992) and Cadena et al. (2011). 6. China’s hukou, or household registration system, identifies a person as a resident of a particular area. Before 1980, this system was strictly enforced—people were required to stay in the neighborhood where they were born, and though they could travel the system did not permit them to move to seek employment, education opportunities, or better public services. After 1980, however, when China embarked on eco- nomic reform, hukou restrictions were relaxed. 7. The McKinsey Global Institute’s center of gravity analysis is based on country-level historical estimates from Maddison (2008) and country- level growth rates from Cityscope 2.0 until 2025. We allocated each country’s GDP to its approximate center of landmass. The same center of each country was used throughout the entire timeframe. To calculate the global center of gravity, landmass radian coordinates were trans- formed into Cartesian coordinates with a tool from the UK Ordnance Survey that uses ED50/UTM data and projection (see www.ordnance- survey.co.uk/oswebsite/gps). We then transformed these coordinates into momentums and averaged them to a true economic center of gravity for each year, located within the sphere of the Earth. Last, we drew a line from the center of the Earth through this center of gravity to the surface; see Maddison (1995). Previous approaches to assessing the world’s shifting economic center of gravity include Grether and Mathys (2010); Kharas (2010); and Quah (2011). 8. The GDP growth projections are based on the McKinsey Global Institute Cityscope 2.0 assumption that global GDP to 2025 will expand at an average compound annual rate of 4 percent. While projections for individual cities are subject to uncertainty, the broad patterns across types of cities or regions are directionally robust across a reasonable range of key assumptions. For more detail on the assumptions behind our forecasts and their sensitivity to changes in assumptions, see the methodology appendix of Dobbs et al. (2012b). Richard Dobbs and Jaana Remes 45 9. The 20 megacities in the Emerging 440 are, from highest to lowest population, Shanghai, Mexico City, São Paulo, Beijing, Mumbai, Delhi, Chongqing, Dhaka, Kolkata, Karachi, Buenos Aires, Manila, Rio de Janeiro, Moscow, Tianjin, Guangzhou, Cairo, Istanbul, Lagos, and Shenzhen. 10. There is broad recognition that, despite rising poverty in many urban areas, urbanization has helped reduce the world’s absolute number of poor people, defined as people living on $1 or less a day. According to the World Bank, the number of poor in the world fell 100 million over 1993–2002. But while the number of rural inhabitants below the poverty line fell 150 million, the number of urban poor rose 50 million (Ravallion et al. 2007). So, despite lower absolute poverty numbers, there is much to do. The United Nations’ Millennium Declaration rec- ognized that addressing the needs of the rising numbers of urban poor would be necessary to halve the proportion of people living in extreme poverty by 2015 (UNFPA 2007). 11. Surjit Bhalla defined the threshold for entering the middle class as income of $10 per day, as cited in The Economist (2009). The $10 per day consumption figure was also used as the lower bound of middle class in Kharas (2010). 12. We estimate total household consumption across cities by applying the private consumption share of GDP per country, using the GDP composition in 2010, to our GDP estimates for 2010 and 2025. Our approach implicitly assumes that the private consumption share of GDP will remain constant through 2025. Given past evidence from developed economies, the share of private consumption may increase with income, leading to higher projected growth in consumption. 13. Our estimates of the concentration of deposits in 2007 draw from a large number of fragmented national and international statistical sources and use predicted values for deposits in cities with missing data. The McKinsey Global Institute relied on data on total national deposits from the International Monetary Fund, McKinsey’s Capital Markets database, and McKinsey’s Global Banking Pools database. We collected city-level data on deposits for 771 cities worldwide using publications from national central banks. To estimate missing data, we used a regres- sion model on the pooled city-level data with four components, each with functional form and coefficients estimated using pooled city-level data: population and GDP by city from Cityscope 2.0; a fixed factor indicating the largest city in each country; a fixed factor for cities with absolute per capita GDP above PPP $18,000; and a factor for adjusting the national deposit to reflect regulation and consumption preferences 46 The Shifting Urban Economic Landscape at the country level. For full details of our methodology on deposits, containers, residential and commercial buildings, and municipal water, see the appendix of Dobbs et al. (2012b). 14. For our estimates on container shipping, we used data from the Containerization International database, Drewry Shipping Consultants, Global Insight, and Cityscope 2.0. To estimate the regional invest- ment required to meet expected demand growth, we first accounted for the use of current container capacity to ascertain how much more traffic could be absorbed by increasing efficiency (without building new capacity). We applied a global benchmark cost per twenty-foot- equivalent unit—the size of a standard container—of around $290 to the additional capacity required to meet demand by 2025. We did not make an assumption on the specific characteristics of newly built capac- ity (for example, greenfield or brownfield) or recognize that the actual cost may vary substantially across individual projects, driven by factors beyond the scope of our models. 15. This rough estimate of investment need applies the fixed capital invest- ment share of GDP per country in 2010 to our city GDP estimates for 2010 and 2025 (see Chapter 5). 16. No global benchmark data are available for residential and commercial floor space. We therefore relied on a variety of sources, including the International Energy Agency, Global Insight, the Lawrence Berkeley National Laboratory, SEMPLA-DIPRO, Embraesp, Seade, the Brazilian Institute of Geography and Statistics, the United Nations Human Settlements Programme, and the Economist Intelligence Unit, to produce a region-specific floor-space consumption demand as a function of per capita GDP for residential buildings and of service industry value added per capita GDP for commercial buildings. We then estimated the growth rate of per capita floor-space demand to 2025, using fitted 2010 values and expected per capita GDP and per capita services GDP in 2025. Finally, we estimated an aggregate range of investment needs across regions using data from Turner & Townsend and Riders Digest. 17. To estimate future municipal demand by city, we used available city- level per capita municipal water consumption for 595 cities with data—from national statistical offices, McKinsey’s China Urban Sustainability Index, the World Bank’s International Benchmarking Network of Water and Sanitation Utilities database, the Growing Blue database, and Eurostat. For cities with no available data on per capita water consumption, we used two approaches: For the 1,260 cities for which we had partial city coverage within the same nation, we esti- Richard Dobbs and Jaana Remes 47 mated their water consumption based on data for similar cities in the country; for the 802 cities with no data available, we predicted their per capita consumption using a regression model with per capita GDP as the independent variable. To project water demand in 2025, we pre- dicted the rise in per capita consumption based on the functional form identified for missing city data. 18. Dobbs et al. 2011a; McKinsey & Company’s Sustainability and Resource Productivity Practice. 19. McKinsey developed the Urban Performance Index, a benchmark- ing tool designed to provide a fact-based look at a city’s performance against its international counterparts on four critical criteria: economic performance, social conditions, sustainable resource use, and finance and governance. For the results of the Urban Performance Index bench- marking of Latin American cities, see Cadena et al. (2011). 20. In the San Francisco Bay Area, the Bay Area Council Economic Institute estimates that most shared services result in average savings of 5–10 percent. If finance and government and public safety and justice functions could be shared, as much as $600 million could be saved on a budget of $6.3 billion. See Bay Area Council Economic Institute (2012). Also see Cadena et al. (2011). 21. The McKinsey Global Institute will detail its analysis on large European cities in a forthcoming report. 22. 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Woetzel, Jonathan, Lenny Mendonca, Janamitra Devan, Stefano Negri, Yangmel Hu, Luke Jordan, Xiujun Li, Alexander Maasry, Geoff Tsen, and Flora Yu. 2009. Preparing for China’s Urban Billion. McKinsey Global Institute, New York. World Bank. 2009. World Development Report 2009: Reshaping Economic Geography. Washington, DC. ——–—. 2012. Planning, Connecting, and Financing Cities—Now. Washington, DC. World Federation of Exchanges. n.d. WFE Database. http://www.world- exchanges.org/statistics/. 3 Urbanization and the Geography of Development J. Vernon Henderson This chapter focuses on several interrelated key questions on the geography of development. Although we herald cities with their industrial bases as “engines of growth,” does industrialization in fact drive urbanization? (World Bank 2009). What economic activities do cities of different sizes undertake? Does this change as countries develop? If so, what are the policy implications? Do development policies have a big-city bias? If so, what does this imply for growth and inequality, and what are appropriate place-based policies? Should countries have policies concerning optimal city sizes or city-size distributions? Urbanization is central to the development process. Employment shifts out of agriculture into industry, and industrial production pro- ceeds most effectively in cities, with their agglomeration economies. Cities are thus viewed as engines of growth. While such relationships appear in the data, the process is not straightforward. Among devel- oping countries, changes in income or industrialization correlate only weakly with changes in urbanization. This suggests that policy 52 Urbanization and the Geography of Development and institutional factors may also influence the urbanization process, weakening the link between industrialization and urbanization. The relationship between industrialization and urbanization is absent in Sub-Saharan Africa (SSA). Urban development involves a hierarchy: production patterns vary across cities by specialization and differences between bigger and smaller cities in manufacturing and service composition. What cities of different sizes produce differs over the development process. Two items are important. First, production patterns churn as cities change the goods they specialize in and produce for export, implying that cities need to be nimble in formulating policies that affect local industry competitiveness. Second, as development proceeds, indus- try decentralizes out of the biggest cities. Transport investment plays a key role in industrial relocation and big-city transformation, as well as in trade volumes and incomes of hinterland regions. In many developing countries, especially pre-democratization, policy makers exhibit a big-city bias. Picking “winners” is part of intelligent public infrastructure investment. Given limited resources, policy makers need to decide, for example, where to place highways, which will offer a competitive edge to at least nodal cities. One hopes that such choices are based on market indicators, such as where industry is starting to agglomerate and where there are clear needs. Still, however, deciding which places to link and where to run high- ways involves picking winners. Here we focus on more explicit biases. These include offering some cities favorable access to and cost of credit in capital markets, favor- able access to export licenses, better public schools, and the like. Such favoritism seems focused on the biggest cities—national capitals or homes of political elites. Favoritism tends to draw firms and migrants to these cities. To try to avoid excessive in-migration and oversized, congested cities, favored cities might adopt policies that make living conditions for migrants more unpleasant. This can result in increased inequality and social tension. Finally, we will look at city sizes and city-size distributions. Factors determining both aspects are complex and poorly understood. It is hard to be proscriptive about either individual city sizes or overall city-size distributions. The best policies strengthen institutions in the relevant markets so that market forces can move the economy toward J. Vernon Henderson 53 better outcomes. That said, the role of public-private interaction and the details of what institutional reforms different situations require are controversial. Spatial transformation and cities as engines of growth Urbanization is associated with economic growth and industrial- ization. According to the classic two-sector models of Harris and Todaro (1970) and Williamson (1986) and their more recent incar- nations (Brueckner and Zenou 1999, for example), industrializa- tion, perhaps export led, drives development. Such industrialization requires urbanization, drawing labor out of a passive rural sector. And such spatial reorganization of the population seems efficient: both manufacturing and services benefit with increased productiv- ity from agglomeration economies and dense urban environments.1 In an endogenous growth context, human capital accumulation and rising effective technology levels can underlie this process as coun- tries develop, releasing labor from agriculture into industry in cities (Henderson and Wang 2005; Lucas 2004). Learning and knowledge accumulation may also be more productive in cities (Baum-Snow and Pavan 2012; Moretti 2004). This move of people out of agriculture into cities engaged in industry and service production has played out historically. There are no major developed, non-urbanized countries. And the dynamics of development seem consistent with the ideas behind the two-sector model. As urbanization proceeds, we expect countries to start with a strong divergence between the urban and rural sectors. No matter what triggers the industrialization process nationally, industrializing cities with more modern technologies and better access to foreign markets offer higher incomes than rural areas. This income gap starts to draw migrants to cities, and countries go through an intergenera- tional adjustment phase of young people moving from rural to urban areas. Urbanization eventually improves conditions in rural areas through better labor-to-land ratios and the agricultural moderniza- tion that occurs with improved education and national exposure to modern technologies and business methods. Urban-rural incomes then start to converge. Urban-rural consumption differences start high, but as urbanization proceeds, they disappear (Figure 3.1). At 54 Urbanization and the Geography of Development Figure 3.1 Urban-rural divergence and then convergence as urbanization proceeds Source: World Bank 2009. low levels of urbanization, the urban sector’s share of income can be 2–3 times its share of national population, while at high levels of urbanization, the two shares are equal. Asia and SSA are the two major world regions yet to fully urban- ize. Urbanization in Asia is following the traditional pattern discussed above, but SSA differs. It has experienced substantial urbanization in the face of modest income growth (Barrios et al. 2006; Collier and Venables 2007; Fay and Opal 2000; World Bank 1999), with limited industrialization (Johnson et al. 2009) and little technological prog- ress in agriculture (Figure 3.2) (Binswanger and Townsend 2000). The graphs in Figure 3.2, for developing countries defined as hav- ing less than the mean real income per capita in 1970, distinguish SSA from the rest of the world (NSSA). Part (a) concerns a measure of effective technology: the average years of high school and college of the adult population. There, the urbanization level in 2010 strongly correlates with effective technology, and SSA follows the same pattern as the rest of the world. Part (b) reveals a strong relationship between urbanization and income per capita for the rest of the world but not a. Effective technology and urbanization level b. Income and urbanization level (contd.) Figure 3.2 (contd.) c. Changes in technology and changes in urbanization d. Urbanization level and sector composition Figure 3.2 Urbanization, income, technology, and sector change Source: Work in progress by J. Vernon Henderson, Mark Roberts, and Adam Storeygard. Note: SSA = Sub-Saharan Africa; NSSA = Non-SSA Developing. J. Vernon Henderson 57 for SSA. Part (c) shows the long difference from 1970 and 2010 for changes in effective technology and urbanization. The change rela- tionships are positive but weaker, and for income changes not shown, they are insignificant. These three graphs together suggest two things. First, effective technology levels correlate better with and potentially lead urbanization. Second, while changes over time corroborate that urbanization relates to development, many other factors influence changes in urbanization. We will discuss some of these later. The biggest surprise concerns part (d). For the rest of the world, urbanization is associated with a reduced role of agriculture and increased role of industry (not shown). But for SSA, that is not the case. Some African countries are 40–45 percent urban (about China’s level of urbanization), with small shares in agriculture, and others are at the same level of urbanization, with large shares. Most of SSA has yet to develop modern industry. Cities are based on natural resource development—in particular, agriculture. Pre-industry urbanization seems associated with consumer cities rather than producer cities. Cities provide retail, wholesale, and personal services, where resource rents are spent. Box 3.1 offers evidence. The emergent urban hierarchy In this section, we cover three topics. First is the urban hierarchy that emerges in fully urbanized economies and how and why the hierarchy differs somewhat in developing countries. Second is the role of a country’s largest cities. In developed countries, this role has changed with time, and in developing countries today, that evolution is playing out much faster. Third is the effect of transport infrastruc- ture investments on the production patterns of the biggest cities and on regional development. Product and functional specialization A number of studies of the United States covering 1950–70 note a high degree of sector specialization (or product specialization) in metropolitan areas, especially smaller and medium-size ones.2 In a city, about 60–75 percent of employment is in non-traded good activities (personal, trade, restaurant, housing, construction, and 58 Urbanization and the Geography of Development Box 3.1 Urbanization fostered by agricultural booms in Sub-Saharan Africa Can growth in agriculture foster urban growth absent the development of manufacturing and tradable business and financial services? Can urbanization be driven by consumer cities rather than producer cities? Jedwab (2012) examines the relationship between cocoa booms in Ghana and Côte d’Ivoire and the development of cities. Sub-Saharan Africa (SSA) has yet to undergo a green revolution; fertilizer and irrigation use are low, and yields are low compared with other developing regions. Cocoa farmers in Ghana and Côte d’Ivoire operate on a 25-year cycle. New cocoa production areas arise in recently deforested areas and last for about 25 years before depletion. Then farmers move production to the next forested frontier. In both countries, production has moved successively from east to west. Jedwab uses this staged movement with district-level data for Ghana (1891–2000) and Côte d’Ivoire (1948–98) to show at the frontier how cash-crop production accounts for 60–75 percent of urbanization. This urbanization is not accompanied by increased production of manufacturing and tradable services in the frontier areas. Urban growth comes from farmers spending their incomes in local towns, trading with each other, and spending on products imported from outside the region. Towns become wholesale and retail centers, as well as producers of personal and farm services. Surprisingly, prior urbanization in earlier frontier areas is maintained even after cocoa production moves on, and these areas face income losses. In an unpublished work, Henderson and Storeygard provide cor- roborating evidence suggesting the effects of increased agricultural incomes on nearby cities. For 541 cities in 18 SSA countries, they show that positive rainfall shocks in a city’s hinterland raise city income. The idea is that rainfall increases agricultural yields and leads to enhanced urban incomes as farmers spend their incomes in cities. A one standard deviation increase in rainfall increases the intensity of “night lights” 14 percent. City lights are night lights measured daily for all points on the globe by U.S. satellites in the late evening (on the dark half of the lunar cycle for days without cloud cover). Henderson et al. (2012) show that changes in lights are a reasonable proxy for changes in income in places with weak or no income measures, and a 14 percent increase in lights suggests about a 4 percent increase in local gross domestic product (GDP). J. Vernon Henderson 59 utility services), and 25–40 percent is in the production of goods for export (sold outside the city). Historically, exports were mostly manufactured products. For example, using cluster analysis of simi- larity in production patterns based on 299 industries and 243 metro areas for the United States in 1970, Black and Henderson (2003) grouped cities into 15 types. A typical cluster type is automobiles, with 12 metropolitan areas in 1970 heavily engaged in producing automobiles and their parts and components. The median city in the group had 13 percent of its employment in automobile production, with the highest (Flint, Michigan) having 36 percent. The analysis also included cities engaged in textiles, apparel, aircraft, communica- tion, pulp and paper, shipbuilding, steel, petrochemicals, industrial machinery, and leather products. There were some specialized service cities, though in 1970 they were mostly state-college and state- capital cities (for example, Champaign-Urbana or Austin). Larger cities, such as Chicago and Dallas, were still classified as “diverse manufacturing.” These studies demonstrate that automobile and textile manufac- turing have few colocation benefits: they do not learn from each other or trade in intermediate inputs. So, to exploit within industry-scale externalities and limit city sizes to reduce urban congestion and other size disamenities, workers and firms partition into different types of cities specializing in production, with city sizes tailored to the degree of agglomeration benefits in their respective production types. Why then do we have big, diverse manufacturing cities? These could be centers of experimentation in an urban product-cycle model. According to Duranton and Puga (2001), while there are specialized cities, there are also diversified cities where potential manufacturers experiment with different technologies and products until they find what they are best suited to produce. Then, they decentralize to a specialized city. More generally, bigger cities are centers of research and development and higher technology development, where diver- sity and cross-sector fertilization in a Jacobs (1969) framework aids innovation and new product development. Fujita et al. (2004), on Japanese electronics firms, show an innovation and production hier- archy. Branches of electronics firms doing research and development and trial production are found in larger metropolitan areas, while mass production of standard items is found in non-metropolitan 60 Urbanization and the Geography of Development areas or offshore in developing countries. This pattern coincides with the higher return to learning in larger cities observed in the United States, even after accounting for the sorting of high-skill and high-ability workers into larger cities (Baum-Snow and Pavan 2012; Wang 2012). There are many complications to this paradigm. First are changes in developed countries, such as the United States since 1970. In a study based on 2000 data rather than 1970 data, Black and Henderson (2003) show that U.S. deindustrialization has reduced the share of manufacturing cities and resulted in the development of many more service cities. These include health, entertainment, transport services, insurance, and finance cities, in addition to the traditional state-college and state-capital cities. A number of cities are transitioning out of manufacturing, and former large, diverse manu- facturing cities are now more market and service oriented. Duranton and Puga (2005) show that, as cities have deindustrialized in recent years, sector specialization has declined. And as Kolko (1999) shows, the most industrialized parts of the United States are now rural (really non-urbanized) areas and smaller cities. To some extent, larger cities now display what Duranton and Puga (2005) call “functional specialization.” Larger firms now separate production from administrative and service functions, including the widespread development of sales office networks (Holmes 2005). Firms now have multiple “headquarters,” mostly administrative offic- es working in law, advertising, marketing, or finance. The authors show that functional specialization, or concentration in cities, has increased dramatically. This increased concentration of functions occurs only in cities with more than 1.5 million people, and espe- cially in the key market centers with more than 5 million. As Kolko (1999) shows, tradable business and financial services in the United States concentrate in the largest metropolitan areas, and their roles decline sharply going down the urban hierarchy. Another feature is churning—the turnover of export production activities of cities. As established in Eaton and Eckstein (1997) for France and Japan and by Black and Henderson (1999) and Duranton (2007) for the United States, there is little turbulence in city-size rank- ing over periods of 100 years or more. Big cities stay big, even if their economic bases change. This might be due partly to their immobile J. Vernon Henderson 61 housing capital stocks, which help retain employment even in the face of large negative economic shocks. Lower house prices keep people in depressed locations (Glaeser and Gyourko 2005). Contributing to the stability of city-size rankings may be the accumulated stock of location-specific general knowledge (Rauch 1993). However, there is enormous churning in cities’ industrial bases, as documented in Black and Henderson (1999) and Duranton (2007). As an example, Beardsell and Henderson (1999) examine the computer industry in the United States, where, with the invention of the personal com- puter, computer industry employment doubled over 1977–85. But by 1992, the offshoring of production had caused employment to fall back to 1977 levels. Apart from the dominant producer, San Jose, there was widespread change in dominant cities, with big declines in cities like Los Angeles, Minneapolis, and Poughkeepsie, New York (IBM), and big gains in new producers like Austin and San Diego. More generally, over a period of 30 years or so, many cities change industrial bases. Over 1963–92, the dominant U.S. cities in comput- ers, aircraft, instruments, and electronic components all changed. Duranton (2007) argues that churning is critical to innovation and urban growth. With national and regional cross-fertilization of ideas, a city producing an electronic auto component may invent a process relevant to a different industry—say, communications equip- ment. As that development takes hold and producers move to that city to learn the new process, the city transforms from an auto com- ponent city to a communications equipment city. For developing countries, there is a critical lesson, based on related literature on firms (Duranton 2012). Churning among firms whereby less productive, stale producers go out of business and are replaced by higher produc- tivity start-ups is key to an industry maintaining a competitive edge (Foster et al. 2008). Policies that prop up stagnant state-owned firms and industries retard growth, as do those that try to force or induce non-competitive private firms to stay in business. The analogy to cities is clear. While cities need to be aware of their industrial bases to properly serve them, policies that prop up or subsidize growth of declining or stagnant local industries spell future unemployment. Rather, cities need to be nimble, ready to change public service and infrastructure provision to match the needs of new producers, especially in countries with export-led growth. A 62 Urbanization and the Geography of Development city specializing in the production of certain apparel items might find that another, lower cost country is more competitive, that tastes change, or that buyers experience economic downturns, reducing demand. The city will lose its business, and its entrepreneurs will need to focus on another set of products. The city may thus need to alter the composition and level of services it provides to meet the needs of the new producers. Cities in developing countries, even ones that are industrializing, experience less product and functional specialization (Duranton 2012). The basis can be history, such as Maoist planning in China, whereby major cities and provinces operated almost in autarky and, by plan, produced all products. One can also apply the Duranton and Puga (2001) product-cycle model to argue that a country’s early industrialization stages of experimentation with products and imported technologies proceed most effectively in diverse environ- ments, especially larger cities. Also, as Donaldson (2010) points out, high transport costs lead cities to produce some consumer products inefficiently with backward technology rather than import them. As developing countries invest in transport infrastructure, the decline in transport costs makes trade cheaper. Cities can then specialize more in products for which they have a comparative advantage and import and stop producing items for which they have less advantage. Specialization will thus increase with transport investments. In the Republic of Korea, industry decentralized from the three largest cit- ies to smaller cities and hinterland areas following massive transport and communications infrastructure investments in the early 1980s (Henderson et al. 2001). Specialization or spatial concentration of employment across cities increased overall for manufacturing—and especially in such key sectors as heavy industry and machinery. The evolving role of the largest cities The biggest cities in a developing country tend to start off as manu- facturing centers. Box 3.2 traces New York City’s development as a major manufacturing center in the 19th and early 20th centuries to its role today as a deindustrialized major service producer and exporter. Calcutta, Jakarta, Shanghai, and Seoul all started as major manufacturing centers for their nations. Even in the mid-1990s, J. Vernon Henderson 63 Box 3.2 New York City’s transformation New York is and has been throughout U.S. history America’s dominant city. As detailed by Glaeser (2005), New York historically had consider- able natural advantages over competitor cities. It has a superb natural deepwater harbor better than Boston’s and is directly on the coast unlike Philadelphia. It is centrally located along the Eastern seaboard and historically was the center of a hub-and-spoke system including water links to the Great Lakes. Its hinterland had fairly rich agricultural land. New York grew initially as a shipping center, especially for cot- ton and textiles and as part of trade with the West Indies. With its harbor and central location, New York was also a main entry point for European immigrants. Many of these immigrants settled in New York’s ethnic neighborhoods, where people of like origin traded job and hous- ing information in common cultural and linguistic neighborhoods. In the latter half of the 19th century, a rapidly growing New York emerged as a manufacturing center. Its history of trade in textiles made it natural for developing a garment industry. Its ties to the West Indies, its natural harbor, and its central location made it the point for refining and distributing that region’s unrefined sugar. Finally, New York was the central importer of books from the United Kingdom and produced pirated versions for distribution in the United States. Such focus on manufacturing was not unique to New York. Kolko (1995) shows that, in 1910, the four largest U.S. cities had 35 percent of their employment in manufacturing, with shares moving down the urban hierarchy to the rural sector (at 25 percent). Big cities were manufacturing engines of growth. During this period, before rail commuting and cars and continu- ous process production (on a single floor), New York’s manufacturing developed in dense, five- and six-story buildings, and its population lived in similarly dense neighborhoods. Over the last 60–70 years, New York has deindustrialized and transformed into a service center. In 2002, 24 percent of employment in Manhattan was in profes- sional, scientific, or technical services or in security and commodity contracts (Glaeser 2005). From a different perspective, in 1997, while Manhattan had 1.8 percent of the nation’s total employment, it had 12 percent of national employment in financial headquarters, 12 percent in financial services, and 8 percent in business services, with 15 percent (contd.) 64 Urbanization and the Geography of Development Box 3.2 (contd.) of advertising. Manhattan’s historical high density has been central to its role as a service center. Arzaghi and Henderson (2008) estimate the high productivity benefits of very close spatial proximity, or density, of producers trading information. Close spatial proximity seems to most benefit services like advertising, which then out-compete manufacturers for these locations with their expensive land and high-priced labor. Shanghai remained a key heavy manufacturer in China. As noted above, this might have occurred because these megacities are key centers for importation and adaptation of knowledge, which are best carried out in a large, diverse environment. But also, as we will dis- cuss, public services, capital markets, and allocation of licenses may be biased toward these major centers. As development proceeds, manufacturing decentralizes from these large cities in two stages (as in the United States). First is decen- tralization to peri-urban or suburban areas of these cities. Second is decentralization from these metropolitan regions to hinterland areas, small cities, and rural areas. Henderson (2010) presents this process for Korea and Japan. World Bank (2012a) also looks at the Korean example and links decentralization to the widespread transport and communications infrastructure investments that Korea made in the early 1980s. As another example here, I consider 108 Chinese metropolitan areas for which there are good 1990 GDP data. For the first stage, in 1990, the nine largest metropolitan areas had about 85 percent of industrial GDP produced in their center cities as opposed to peri- urban areas (the rest of the prefecture); by 2005, this share had fallen to just over 60 percent, in a period during which the population share of these center cities actually increased modestly. For the sec- ond, now emerging stage, in 1990 the ratio of the share of industrial GDP of the nine largest cities in all 108 cities to the share of total GDP of the nine largest in all 108 was 1.05. By 2005, this figure had fallen to about 0.87. That is, the nine largest are changing from being more industrial than other cities to being substantially less industrial. J. Vernon Henderson 65 Box 3.3 considers recent decentralization in India and conse- quently raises another issue. We have painted decentralization here as a positive development. However, there may be premature decen- tralization in India and a loss of agglomeration benefits. Firms are driven from cities because of poor environments: poorly allocated infrastructure investments, a lack of public utilities, and inappropri- ate land market regulations. Bertaud and Brueckner (2005) discuss how land market regulations (limiting floor-area ratios) in Mumbai have led to sprawl and inefficiently low densities near the city center. This may result in a costly lessening of agglomeration benefits (World Bank 2012b). What drives this change in major cities from manufacturing lead- ers to service leaders? Several forces are at work. First, imported and adapted technologies learned in big cities become standardized, and producers benefit less from big-city knowledge spillovers. They then want to move production to less congested locations, with lower land and labor costs, especially if big cities have costly land market regulations and are poorly managed. Second, national production of traded business and financial services grows more than other sectors, as economies mature with more developed legal, financial, and marketing sectors and with more functional specialization. Big cities are more competitive for producing services and facilitating functional specialization. Third, whether rationally (conservation of resources) or due to big-city bias, big cities tend to start with bet- ter public infrastructure provision, important for firms. When such investments become more widespread nationally, decentralization becomes possible. We illustrate next with the key investment—trans- port infrastructure—and discuss location issues more generally. Role of transport investments Transport investments play two key roles in developing countries. First, they reduce commuting costs and the costs of moving goods within cities. That reduces the need to cluster activities in and around the city center, allows city populations to spread out, and enables industry to move out of the central business district. The second is the role of intercity, interregional, and hinterland investment in transport links. Since transport infrastructure investments are costly 66 Urbanization and the Geography of Development Box 3.3 Industrial decentralization in India Two studies look at recent patterns of production in Indian cities and how the patterns differ between the urban and rural sectors (Figure B3.3.1). Desmet et al. (2012) study manufacturing employment growth in districts where it is concentrated and in districts where it is not. They do the same for services. The time period is short, 2000–05, but the patterns are striking. The authors fit locally a trend with error bands, and as the data move to higher intensity districts with fewer observations, the error bands widen. For manufacturing, there is strong mean reversion, whereby districts with high concentrations in 2000 grow much more slowly over 2000–05 than districts with low concentration in 2000. In fact, on average, high-concentration districts have negative growth rates and lose employment. The pattern for services is quite different. High-concentration districts have higher average growth rates than at least the middle-concentration districts. At the upper end, growth rises with concentration. Overall, this suggests decentralization of manufacturing, which we explore below, with services concentrating even more in high-intensity districts, found in the biggest cities. Figure B3.3.1 Indian manufacturing density, 2000–05, and Indian ser- vices density, 2001–06 Source: Desmet et al. 2012. Note: Lighter shades represent error bands. Ghani et al. (2012) look more specifically at manufacturing and document the move away from cities to the rural sector. In Figure B3.3.2, the first part shows the urban sector’s decline in share of industrial output over 1989–2005, though its share of employment stabilized after 1995. The second part shows data just for the organized sector, as opposed to the informal sector. For bigger firms that dominate J. Vernon Henderson 67 national output, the urban shares of plants, employment, and output of the organized sector all declined after 1995. The authors argue that the organized sector is ruralizing. But as World Bank (2012a) points out, a lot of this movement is really suburbanization—the first stage of decentralization in which firms move to rural areas on the outskirts of major metropolitan areas, with vastly cheaper land and somewhat cheaper labor. While the urban share of employment in the organized sector declined, the urban share of informal sector employment rose. The informal sector may contain smaller experimental firms, for which city location is important, as well as traditional parts suppliers, which may now face spatial mismatch as their buyers in the organized sector move away. Figure B3.3.2 India’s urban shares and urban shares in the organized sec- tor, 1989–2005 Source: Ghani et al. 2012. Note: Figure plots urban shares of plants, employment and output for each year using survey data of plants from organized and unorganized sectors. and make up a large portion of national budgets, understanding their consequences is important for making better investment decisions. Baum-Snow et al. (2012) look at the effects of intracity transport investment in China on the move of industry and population to peri-urban areas. The authors econometrically estimate the impact on decentralization of having more highway rays (radial rays going out from the city center), more ring roads, and more railway rays. They examine the growth of activities in the 1990 city center (urban 68 Urbanization and the Geography of Development districts as of 1990) from 1990 to either 2005 or 2010 and find that each additional highway ray causally displaced 4 percent of the city center population to the suburbs over 1990–2010. They also find that, in China, where until very recently there was little long-distance highway shipping, rail rays play a central role in production decen- tralization. Each additional rail ray leads to a 26 percent reduction in city center industrial production, because suburban firms then have better access to rail nodes and sidings. More speculatively, they find that ring roads lead to major decentralization of both population and industry. Ring roads for industry link to suburban rail sidings and terminals and provide support for trucking as well. Clearly, transport investments within cities cause them to spread out, perhaps leading to urban sprawl and a large ecological footprint (Kahn 2006). This reflects market-reoriented spatial redistribution of activities, generated by people’s demand for space and firms’ demand for cheaper land and labor on the urban fringe. But sprawl can be inefficient, especially if fuel is subsidized, encouraging more com- muting, or if land is taken on the urban fringe at below-market prices (as in China), encouraging excessive taking. The role of intercity transport investments is key but still poorly understood. It helps to provide some context. Where does economic activity—urban or rural—locate in a country? As Rappaport and Sachs (2003) indicate, most economic activity occurs on a coast or on navigable waterways, due to the important role of water trans- port and water’s amenity value. However, many countries (India and China, for example) developed with centers far from the coast and huge interior hinterland populations. In countries with huge interior populations, per capita income clearly declines moving away from the coast (Naughton 2007). As Bosker et al. (2012) argue for China, countries with large interior populations can sustain huge hinterland cities not really served by a waterway. Still, access to domestic and international markets has a big impact on the location of economic activity and income produced by hinterland regions. Transport access raises incomes and induces in-migration in the areas it serves. Thus, there is a tradeoff of cost for maintenance of hinterland populations. If a country wishes to maintain large hinterland populations, it must invest in expensive transport infrastructure to keep these locations competitive and connected to international and coastal markets. J. Vernon Henderson 69 Over the last few years, economists have produced several studies that document the role of transport in these situations. Duranton and Turner (2012) show that transport investments increase city populations in the United States. Duranton et al. (2011) show that, for the United States, improved transport networks facilitate trade: cities today that are better connected to the national highway system have larger trade flows and tend to produce heavier items. In an impressive paper, Donaldson (2010) argues that improved transport from British investment in railways in the 19th and early 20th centuries enabled Indian districts to stop producing the goods they produced inefficiently and to import them instead. These districts could then focus production on goods for which they had a comparative advantage. Donaldson estimates that the advent of a rail passing through a district raised its real income per unit of land about 17 percent. In a differently conceived paper, Banerjee et al. (2012) argue that better rail transport connections in China after the mid-19th-century advent of treaty ports have had output effects on counties that got rails similar to the output effects on those farther off the grid. Rather than try to make inferences based on historical rails in India or China, Box 3.4 looks at trucking costs in SSA. Urban and big-city bias Does bias exist? Literature on urban bias argues that developing countries tend to favor the urban sector with improved terms of trade and better access to capital markets (Renaud 1981). However, the urban sector includes a diverse set of large cities and small towns. A more refined argument holds that the biggest cities—national capitals especially—receive the most favoritism (Ades and Glaeser 1995). As noted, infrastructure investments in transportation and communications are necessarily spatially targeted, based as much as possible on evolving private mar- ket demand for such investments. Placement of such investments may or may not involve bias. Here we focus on bias from public intervention in capital and export markets that favor certain loca- tions—particularly the politically connected or very biggest cities. Bias can also involve the quality of public services, such as schooling. 70 Urbanization and the Geography of Development Box 3.4 Hinterland income and the cost of transport in Sub-Saharan Africa Storeygard (2012) examines SSA countries where the primary city is on the coast (Tanzania, Mozambique, Angola, Gabon, Nigeria, Cameroon, Benin, Togo, Ghana, Cote d’Ivoire, Liberia, Sierra Leone, Guinea, Senegal, and Mauritania). He traces the distance along the best road network connecting 287 interior cities to their respec- tive primary cities. Because data are not available to trace the time development of roads, he examines another dimension, the travel costs on those roads, inspired by two considerations. First, per-mile vehicle trucking costs have a high fuel component; the elasticity of vehicle travel costs per unit of distance with respect to fuel prices is 0.35. Second, over 2002–08, the price of oil nearly quadrupled, from $25 a barrel to $97, with a commensurate rise in local diesel fuel prices. What is the impact of the rise in fuel prices on city incomes, as differentiated by distance? We expect places far from the coast to experience greater income losses, since their shipping costs per unit rise more. Unfortunately, we do not have measures of city income for SSA countries for any point in time, let alone as they vary over time. Storeygard measures income changes by changes in the intensity of city lights over 1992–2007. What does he find? As Table B3.4.1 shows, cities with greater road distance from the coastal primary city suffered greater income losses than those closer to the coast, with substantial effects. To interpret the magnitude of the estimated coefficients, we give an example. For maximum oil price change in the time period (from $25 a barrel to $97), a one standard deviation increase in distance from the primary city lowers city lights by 23 percent. That translates roughly into a 6 percent lower GDP. Storeygard shows that the effect on connections to the primary city is greater for cities (endogenously) served more by paved roads. Paving occurred for cities more likely to be better connected to international markets, so these cities are most sensitive to changes in cost of access to the coast. For cities served more by unpaved roads, access to a local regional center is more important. J. Vernon Henderson 71 Table B3.4.1 Log (night lights per city) annually, 1992–2008 Coefficient: Road −0.683*** −0.520** distance to primary city X oil price Estimation method Tobit; year and ordinary least squares; and controls city fixed effects, year and city fixed linear city specific effects, city-specific time trend splines on growth n 263 263 ***significant at 1 percent or better; ** significant at 5 percent or better. Here, if intervention is based on correcting market failures, there is little rationale for favoring big cities, as failure in the relevant markets may be more pronounced in the rural sector than in big cities. This section presumes bias is economically inefficient and focuses on the unintended consequences of such bias for both effi- ciency and equity. First, is there evidence of bias? Evidence is usually indirect, restrict- ing lending or access to export licenses in hinterland areas, as argued for Indonesia by Henderson and Kuncoro (1996). More tellingly, Jefferson and Singh (1999) and Au and Henderson (2006a) estimate that in China in the 1990s, the rate of return to capital in the rural sector exceeded that in the urban sector (especially in bigger cities) by at least 25 percent. Of course, some government capital market programs may be geared toward the rural sector,3 so the assessment is difficult. While Brazil had subsidized agricultural lending programs, it likely strongly favored the biggest cities in capital markets in the non-democratic era under state capitalism. Another issue is the degree to which public service provision is slanted toward the biggest cities, whether in showcase investments in Beijing and Shanghai or in the gap in quality of education facilities between rural and urban areas in Brazil or China. Favoritism may result from policies based on economic beliefs that the biggest cities are the engines of economic growth, incorrectly sug- 72 Urbanization and the Geography of Development gesting that government-influenced investments should be directed to the biggest cities. Or it may have an element of nepotism and corruption, whereby national leaders favor the city where they live and where their family and friends have businesses. Davis and Henderson (2003) make two important points about factors that can help offset bias. First is the role of transport invest- ments in helping hinterland development. The authors show that the degree of primacy—the share of the urban population in a country’s largest city—is influenced by transport investments. They argue that, conditional on population and land area, a larger national road net- work and a larger waterway system lead to reduced primacy, as hinter- land cities have better access to markets. Second, and very critically, the ability to favor the biggest cities is constrained by institutions as they develop. Conditional on population and land area, countries that have a federal constitution show less primacy—a smaller share of the urban population in the largest city of a country. Federalism helps level the playing field across cities, giving smaller hinterland cities greater freedom to finance and provide their own public ser- vices and to have regional banks. Similarly, improvements in the democratic environment lead to decreased primacy. Democratization allows elected candidates to represent hinterland region interests in a national legislature. Figure 3.3 shows how a more general measure of urban concentra- tion is lower in more democratized states and declines as democra- tization proceeds. Of course, institutions are endogenous, so causal inference is tough. Shocks that affect urbanization may also affect democratization. For example, Bruckner and Ciccone (2011) argue that rainfall shocks in SSA affect trade and income, which in turn affect the opportunity costs of conflict and hence democratization. But rainfall directly affects urban-rural incomes and urbanization. Why do we care about big-city bias? Favoring big cities in national markets and public service provision makes them attractive for firms—and hence for workers looking for jobs. Favored cities thus face increased in-migration, potentially leading to excessive city sizes, as in Bangkok, Jakarta, and Mexico City. This relates to the aforementioned idea that favoritism leads to (a) 1970 degree of democracy versus 2000 Gini (b) Changes in democratization and the Gini, 1970–2000 Figure 3.3 The spatial Gini and political structures Source: Henderson and Wang 2007. Note: The graphs look at the partial relationship between democratization and a measure of urban concentration, the spatial Gini, after factoring out national population, national income, and planned economic and federal structure influences. The spatial Gini is like an income Gini. Rank all cities in a country from smallest to largest. The spatial Lorenz curve is the cumulative share of the national urban population as we move from the smallest city to the largest. The Gini is the area between the Lorenz curve and the 45-degree line. On the 45-degree line, all cities would be of equal size in a graph of size rank against cumulative share. Democratization is measured by the polity index. Graph (a) shows the relationship between 1970 democratization and 2000 spatial concentration. Graph (b) shows the relationship between changes in democracy and changes in spatial concentration. 74 Urbanization and the Geography of Development increased primacy and urban concentration and raises two questions. First, should we be concerned about excessive city sizes? Second, because excessive size increases congestion and lowers the quality of city life, residents and elites of favored cities may try to limit in- migration. Collectively, they would like to keep the favors without the added population; of course, individual firms may want to hire cheap migrant labor. What policies could residents or elites follow to restrain in-migration? In urban models, modest increases in city size beyond an “optimal level” do not necessarily lead to substantial decreases in resident welfare. While there are increases in diseconomies, there are still scale benefits, and the net losses may be quite low. However, Henderson’s (2003) panel productivity study, the only study to look at this issue closely, implements an econometric model whereby one can calculate the best primacy level for each country (varying by country size). Best primacy maximizes productivity growth, as reflected in growth in real GDP per capita. A one standard deviation in primacy above its best level reduces a country’s annual growth 1.4 percentage points, a very large effect. Excessive size leads to wasted resources and reduced growth. Cai’s (2006) description of Chinese policy on urbanization addresses whether residents and local policy makers resist in- migration. China had strong formal migration restrictions enforced through the household registration (hukou) system, but they were lifted in 2001. The Chinese were concerned that cities like Beijing and Shanghai would be flooded with rural immigrants. Beijing and Shanghai are certainly favored with massive infrastructure invest- ments and in capital markets, as the role of state-owned enterprises has increased over the past decade. The articulated policy for the largest cities relative to the free-migration policy for small cities is to “raise the doorsill” to stem in-migration. “Raise the doorsill” means to provide migrants with poor living conditions and restricted access to public services. Migrants live either in dorms or, in Beijing, in about 300 urban villages scattered throughout the city and on the urban fringe, with little or no access to the formal housing market. Urban villages are still under rural governance, where the local rural residents “farm the housing”—provide essentially slum housing for migrants. These are units in which 4–6 migrants live in a single room J. Vernon Henderson 75 with all cooking, washing, and toilet facilities outside. Access to state schools, despite many policy initiatives, remains severely restricted for migrants. Most either leave their children back home or send them to quasi-legal private schools that face repeated attempts to close them and have unqualified teachers and very limited facilities (Kwong 2004). Migrants are not part of social security systems in cities and have no access to local health insurance. The policy debates about the resulting increases in inequality between residents and migrants are muted by the recognition that improving conditions would only attract more migrants. Inspired by this articulated policy for China, Feler and Henderson (2011) look at Brazil in the 1980s, before democratic reforms. National zoning regulations on formal sector housing created sizes potentially larger than what lower income residents wanted. The result was the development of illegal (favelas) and quasi-legal (lotea- mentos) settlements. Loteamentos were “illegal” developments built on private land, violating national zoning laws. Cities were thus not required to service them—in particular, with piped water—forcing households to buy from expensive private vendors. Some cities were more willing and had a lower cost for servicing these migrants than others. City districts (the units largely responsible for providing public piped water) that provided services had more growth in small houses that migrants live in than did districts that denied services. A one standard deviation reduction in small houses served in the 1980s led to a 15 percentage point decline in growth in numbers of households in a district over 1991–2000, where average growth was 40 percentage points. The data suggest that higher income and already more populated districts are more likely to underservice small houses. All this presents a dilemma. If national policy makers favor the largest cities with subsidized access to capital markets and ineffi- ciently high comparative public investments, these cities draw more migrants, resulting in excessively large and crowded cities. But acting to stem in-migration by either making living conditions very poor or acquiescing to poor conditions increases inequality and potentially social tension. Of course, favoritism is the heart of the problem: lack of a level playing field across cities as they compete for resources. Leveling the 76 Urbanization and the Geography of Development playing field means providing equal access to capital markets, fiscal resources, and export permissions and other licenses. But interpreting what equal access means is more difficult, as big cities have levels of development and degrees of sophistication different from rural areas. But markets can provide effective equal access. Banks may employ different screening mechanisms, information requirements, and repayment inducements in different areas. The issue is whether in the end lending across areas is geared so that rates of return on investments are equal. City sizes and the city-size distribution This section turns to two topics. First is the extent to which we expect individual cities, given what they produce and where they are located, to be of reasonably efficient size—and what policies that depends on. Second is the overall size distribution of cities in their respective countries and the relevant policy issues, if any. City sizes We have yet to talk about city-size determination, other than to suggest there may be a big-city bias that tends to draw migrants to favored cities. What institutions and market forces determine city sizes in general, regardless of where cities are in the hierarchy? The urban economic literature identifies two traditional settings, both based on how new cities are likely to form. One is self-organization, whereby individual firms and people mill about and cluster into set- tlements in an undirected and uncoordinated fashion—no real estate developers, no local governments investing to attract residents or subsidize businesses, and no company towns. The other is a national market in city land development, with the entrepreneurs being large real estate developers or local governments. For example, town or village governments may decide that they want to become a more major urban center. As formulated in Henderson (1974), Helsley and Strange (2012) detail how formation of cities by self-organization of residents and firms without large-scale developers and institutions leads to cities of very inefficient sizes. They also show that industrial compositions may be very inefficient. Similarly, Behrens et al. (2012) J. Vernon Henderson 77 model significantly oversized cities under self-organization, though Henderson and Venables (2009) show that with sophisticated contracting and capital markets, in a dynamic context, cities will tend to be efficient sizes under self-organization. Henderson and Becker (2000), building on Henderson (1974), argue that the potential poor outcomes under self-organization can be largely avoided with “free market” formation of new cities or with conversion of towns to cities led by private developers that can finance large-scale settlements. If existing cities become over- sized or operate inefficiently, the threat of new, better-sized, more efficient settlements maintains market discipline. To establish new cities, small town governments must have the fiscal autonomy and ability to finance expansionary public infrastructure, and large land developers, in conjunction with private employers and hous- ing providers, can effectively start new, large-scale settlements as demand requires. Garreau’s (1991) book on the U.S. development of “edge cities” details a large variety of partnerships between the public and private sectors, as well as purely private sector develop- ments. Behind all these mechanisms lies the need for good local institutions—well-defined and enforceable private property rights (without risk of expropriation) and disciplined access to capital markets. Box 3.5 discusses aspects of the requirements as argued in World Bank (2012a, 2012b). For developing countries, the issue is whether market formation of new cities works well enough to ensure reasonable outcomes and, if not, whether the national or regional governments can fill the gap by planning new cities. In this context, there is the need not just for existing cities to grow but for towns to expand into major urban centers. Over 1960–2000, new city formation accounted for more than 30 percent of urban population growth in developing countries (Henderson and Wang 2007). National governments do not have a great record in economic planning (hence the collapse of planned economies), and the scant evidence on new planned cities suggests that they do no better in planning city formation. World Bank (2012b) illustrates the Arab Republic of Egypt’s poor performance in new city planning. For market formation of cities, two issues emerge. First is the national government’s willingness to allow local hinterland towns working with the private sector to 78 Urbanization and the Geography of Development Box 3.5 Essentials for timely city formation and expansion World Bank (2012a, 2012b) analyzes issues of new city formation and city expansion and discuss the history of “planned cities.” Two general issues are important for a reasonable process: how cities can finance urban infrastructure, and how real estate markets should be structured to encourage private real estate development of urban land for residen- tial or commercial use. When cities borrow, they offer no collateral for loans: private banks or bondholders cannot seize public property. Ensuring repayment requires a strongly regulatory and sophisticated credit rating system whereby each city borrower is subject to regulation that requires transparency and full accounting and assurance of repayment. For example, if a local government is failing to pay its debts, a higher level of government may be able to intercept monies coming into the local government and force repayment of the debts. In many countries, capital markets and regula- tory systems are not mature enough for the widespread issuance of local public debt. Instead, the national government can create substitutes. World Bank (2012b, spotlight 4) discusses the FINDETER initia- tive in Colombia. FINDETER is a quasi-public financial institution that intermediates between commercial banks and borrowing locali- ties. It offers subsidized loans to banks as an inducement to lend to localities and monitors and approves applications with an eye to the proposed venture’s quality. When the bank lends, it absorbs all the risk but has the right to intercept certain city revenues (in this case, inter- governmental transfers) in event of non-repayment. FINDETER has a AAA local credit rating from Duff & Phelps. Also discussed is an initia- tive in Tamil Nadu, India, through which a public-private financial intermediary issues its own bonds and lends to localities with creative ways to limit risk, involve the private sector, and ensure that projects are producing revenue to help repay loans. Its loan recovery rate is 98 percent. Of course, in some countries like China, the national government intervenes to fund local city development directly. While people point to the creation of Shenzhen as a success, there are also spectacular failures, like Ordos. World Bank (2012a) analyzes property rights problems in India that inhibit large-scale developers. The country has limits on private assembly of land, and public taking (through eminent domain) is an opaque system tainted by years of corruption. More gener- ally, it has poorly defined property rights and a judiciary system that J. Vernon Henderson 79 operates too slowly to effectively enforce rights and decide disputes. This creates insecurity in tenure rights and increased risk to develop- ment projects. For eminent domain to work and for the local public sector to use property tax revenues, a proper system for land evaluation is needed. That requires trained appraisers, public assessments (to deter corruption), and transparency and consistency in evaluation (to get public acceptance). For large-scale developers and city land markets to work, India needs comprehensive reforms focused on well-defined and enforceable property rights and local governments that offer transpar- ency, expertise, and limited corruption. develop, and thus compete with, say, the primary city. Henderson and Wang (2007) suggest that this could be linked to democratiza- tion. They show that a one standard deviation increase in the polity measure of democracy noted above increases the growth in numbers of cities in a country 37 percent more than the typical increase. The effects are robust, linking growth in numbers of cities to democrati- zation and implied regional representation. Second, even if national governments are willing to encourage the development of hinterland cities, there is the needed timely devel- opment of local fiscal autonomy and access to capital markets for small towns ripe for expansion and development. Perhaps as critical, land markets in developing countries are often largely informal and with limited property rights, discouraging the evolution of large-scale real estate developers. We know property rights are important on a micro scale in house and labor markets (Field 2007; Galiani and Schargrodsky 2010), but on a larger scale, there is no research on their effects on timely city formation and the achievement of desir- able sizes. Aspects of property rights issues are also noted in Box 3.5. To be clear, we have little idea what the optimal size of any type of city should be. Not knowing optimal sizes, we also do not know corresponding optimal numbers. Au and Henderson (2006b), using a unique dataset and unusual context, look at the sizes of cities that maximize GDP per employee in China in 1997, where this so-called efficient size depends on place in the urban hierarchy. Why can we not use investigations like this to plan? First, it is not clear nationally that all cities should be at the size that maximizes 80 Urbanization and the Geography of Development GDP per worker. For example, at the sizes that maximize welfare per worker, cities with better amenities can offer higher welfare per worker than cities with poorer amenities. Basic welfare analysis tells us that more attractive cities should expand beyond the size that maximizes welfare per worker to accommodate more people than their sister cities with poorer amenities. Second, the best sizes are measured statistically with considerable error. Third, we believe that these efficient sizes are increasing with technological advances, mean- ing that what is efficient in 1997 is too small in 2007. In hybrid outcomes of market and planned sizes, world city sizes more than doubled over 1960–2000 (Henderson and Wang 2007). One wants not to proscribe sizes but to provide environments for the market to drive sizes toward efficient levels. City-size distributions In 2009, McKinsey issued a report on urbanization in China call- ing for the development of an urban network housing up to 500 million people in cities with 20–40 million people each. That would effectively mean placing most of the urban population in megacities, as opposed to the typical worldwide fraction of well under 10 percent for metropolitan areas of more than 12 million people. Our discus- sion of the urban hierarchy suggests that the McKinsey report is mis- guided. Most production is carried out efficiently in smaller, fairly specialized cities, and the role for megacities is strictly limited, as they specialize in high-profile items with limited national demand, such as high-end advertising; theater; high-fashion apparel; and financial, legal, and other business services. For example, the United States, an already heavily service-oriented country, has only two megacities, New York and Los Angeles. But there is a fascination with city-size distribution. Part of this focuses on two empirical regularities. First, the city-size distribution seems to closely follow a Pareto distribution; second, the relative size distribution is remarkably stable over time. Black and Henderson (2003) document this for the United States for 1910–2000. For the world, Figure 3.4 illustrates both the Pareto shape and the stability for 1960–2000 of the relative size distribution of metropolitan areas. Given the radical changes in production patterns and the structure J. Vernon Henderson 81 Figure 3.4 The world size distribution of cities Source: Henderson and Wang 2007. Note: There are 20 cells on the horizontal axis, each spaced apart by the same per- centage increase in size. The vertical axis shows the share of each cell in the number of world cities for the respective year. Sizes are normalized (as is the cutoff point) by the mean size in each year to obtain a relative size distribution. The absolute size dis- tribution is continually shifting right with technological improvements. The intent of normalizing is to compare shapes of the relative size distributions over time. The shapes are consistent with a Pareto distribution. Inspection reveals that the relative size distribution in 1960 is the same as in 2000. of the urban hierarchy in the United States over 1910–2000 or in the world since 1960, how can the relative size distribution remain the same? According to our notions of urban hierarchy, changes in economic structure should bring changes in the size distribution; indeed, as Henderson and Wang (2007) show, they do at the margin. But we rarely see massive shifts in relative urban size structure within countries over time. Why? A controversial paper by Gabaix (1999) sparked a round of papers by Eeckhout (2004), Rossi-Hansberg and Wright (2007), and Duranton (2007), among others. Gabaix formulates a stochas- tic process whereby cities receive repeated draws (uncorrelated with size) on overall productivity or quality of life. Cities that get repeated 82 Urbanization and the Geography of Development good draws by luck emerge as big, others are more middling, and the unlucky cities are small. Under certain conditions, a Pareto size distribution theoretically emerges (“Zipf ’s Law”), at least in the upper tail of the distribution. Rossi-Hansberg and Wright (2007) show that this formulation can be applied to a specialized hierarchy model, and Duranton (2007) shows it is consistent with ongoing urban innova- tion and churning. One disconcerting feature is that these models require cities to also churn in the long term, with cities moving up and down the hierarchy of sizes, something we do not observe in the data, at least among bigger cities. One can also formulate a simple, non-stochastic model whereby city productivity depends on a per- manent draw of a production amenity (like quality of access to water transport). If those amenities are Pareto distributed, the city-size dis- tribution will approximate a Pareto distribution as well (Henderson and Venables 2009). All these exercises focus on a single dimension, a one-time or repeated draw of a productivity parameter. Recent work by Desmet and Rossi-Hansberg (2012) and Albouy (2008) emphasizes the com- plex nature of the process. Cities get differential long-term draws on production amenities (like access to natural resources) and consumer amenities (like weather and natural recreation). They also get draws on their “culture” or how well, at least in the medium term, their public sector and institutions operate. Desmet and Rossi-Hansberg (2012) argue that these differences in the draws across cities in China profoundly influence productivity and population distribution, while in the United States their impacts are more muted. What is the bottom line for policy? First is not to proscribe. We simply do not know enough about what is most efficient and how costly market inefficiency is compared with a bad policy error. Instead, countries need to provide the institutions and decentralized government structure to allow new cities to form in a timely manner and to allow city industries to decline and emerge. They need to facilitate local public investment to provide needed infrastructure (World Bank 2009, 2012b). The size distribution that emerges will reflect underlying market forces and more likely approximate a reasonably efficient outcome than a proscriptive one. *** J. Vernon Henderson 83 Urbanization is complex. The link in developing countries between urbanization and income growth or industrialization is weaker than might be expected, suggesting that many other factors influence a country’s industrialization. In the urban hierarchy, there is ongo- ing churning whereby cities gain and lose comparative advantage in producing different items, perhaps because of innovation. Over time, the biggest cities deindustrialize and become service centers. Manufacturing moves to hinterland areas and smaller cities. It is dif- ficult to evaluate whether individual cities are oversized or have the right industrial composition—or whether the city-size distribution in a country is relatively efficient. Theory provides limited direction, and solid empirics with good verification are mostly absent. It seems that the best a country can do is create a level playing field in capital and export markets and provide institutions to foster com- petition and promote better outcomes. Creating a level playing field means eliminating spatial biases in policies and not targeting specific cities with favorable lending and market conditions. Providing insti- tutions to foster competition and promote better outcomes requires well-defined property rights for developers and reasonable and structured access to capital markets for public infrastructure invest- ments by local governments. But the development of institutions is endogenous, promoted by human capital accumulation and political events. As with firm technical efficiency, institutions advance and mature as human capital accumulates. Market-determined urban outcomes will thus improve with development. Notes 1. See Rosenthal and Strange (2004) and Puga (2010) for reviews of magnitudes. 2. 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Urbanization Review Flagship Report, Washington, DC. 4 Analyzing Urban Systems Have Megacities Become Too Large?* Klaus Desmet and Esteban Rossi-Hansberg The trend toward ever greater urbanization continues unabated across the globe. According to the United Nations, by 2025 close to 5 billion people will live in urban areas. Many cities, especially in the developing world, are set to explode in size. Over the next decade and a half, Lagos is expected to increase its population 50 percent, to nearly 16 million (UN-Habitat 2010). Naturally, there is an active debate on whether restricting the growth of megacities is desirable and whether doing so can make residents of those cities and their countries better off. This debate is not so much about urbanization per se—whether people should move to cities or stay in the countryside—but about whether (some of the world’s) megacities are creating megaproblems that could be avoided with suitable policies. People flock to cities in search of higher paying jobs and better amenities. Many of the * We acknowledge the support of the International Growth Centre at LSE (Grant RA-2009-11-015). 90 Analyzing Urban Systems world’s large metropolises, such as Los Angeles and Mumbai, are highly productive and located on large bodies of water. As cities grow, however, they start suffering from congestion, higher crime rates, and air pollution. How fast the benefits of efficiency and amenities erode with increasing congestion depends on the quality of governance, responsible for providing road infrastructure, sewerage systems, clean water, and security. Cities differ in their efficiency, amenities, and quality of governance, so they have no single optimal size. We need analytical tools that can help us evaluate the desirability of policies that hinder or promote the growth of cities of different sizes. This will allow us to assess urban policies that depend on the size of the cities where they are implemented (scale-dependent policies). When analyzing whether megacities have become too large, policy makers often analyze a single city in depth. But no city is an island:1 improving urban infrastructure in one city might attract migrants, and a negative shock in one location can be mitigated because people can move to another. Considering the general equilibrium effects of any such urban policy is thus key. That is, when deciding whether to make medium-size cities more attractive, policy makers need to understand how cities of all sizes will be affected.2 There is thus a need for quantitative models of systems of cities that are complex enough to account for the general equilibrium but simple enough in structure and data requirements to make them usable for policy makers. In Desmet and Rossi-Hansberg (2012), we develop such a framework. And in this chapter, we start by briefly sketching the main forces in that model and later discuss which data are needed for policy analysis. (For the interested policy maker, an online technical appendix provides a more detailed, step-by-step, practical guide on how to implement the methodology.)3 It then shows how the framework can be used to quantitatively analyze some important questions. Would there be any welfare gains from shrink- ing megacities and expanding medium-size cities? Is there any sense to implementing policies that make cities more equal in efficiency and amenities? How will growth in developing countries affect their city-size distributions? Are cities in developing countries really too large? Should policy favor smaller cities or medium–large cities? The answers to these questions will be country-specific. Countries are at different levels of development and have different geographies and Klaus Desmet and Esteban Rossi-Hansberg 91 histories. We will therefore compare the urban systems of three coun- tries: the United States, which as the world’s most advanced economy will serve as a benchmark; China, Asia’s largest economy and one of the world’s fastest growing; and Mexico, one of Latin America’s most important middle-income economies. A first policy question is how reducing spatial differences in city characteristics affects the city-size distribution. Many countries favor balanced spatial growth and try to reduce uneven development. Spatial concentration is often viewed with suspicious eyes, and many countries implement policies aimed at mitigating spatial differ- ences, with the goal of creating a less dispersed city-size distribution. When reducing productivity differences across cities, our quantitative analysis shows that responses vary by country. In the United States, the city-size distribution would become slightly less dispersed, with the larger cities shrinking and the smaller cities growing. In Mexico, something similar happens: Mexico City declines, but no city takes its place. By contrast, China’s city-size distribution becomes more dispersed, implying larger megacities. Although one would intuit that reducing spatial differences would lead to a less dispersed city-size distribution, the opposite result in China illustrates the importance of model-based analysis. Without this analysis, policies might have unintended consequences: a policy aimed at reducing the dispersion in city sizes might actually increase it. When mitigating spatial differences in city characteristics, we find limited welfare effects in Mexico and the United States but very large effects in China. Reflecting China’s important spatial disparities in productivity and the mobility restrictions under the hukou system, this suggests that as China develops further, it will reap huge benefits from the spatial reallocation of people and economic activity. We do not find the same effects in Mexico, probably because it has much more history as a developing market economy and thus suffers from fewer spatial distortions. A second policy question is whether policies that target lagging cities are more effective than policies that target cities of different sizes. Governments may choose to improve road infrastructure in remote areas or give firms incentives to move to particular locations. The United States federal policy of the 1960s to assist the declining Appalachia region is a good example (Glaeser and Gottlieb 2008). 92 Analyzing Urban Systems The European Union structural funds that subsidize investments in infrastructure and human capital in regions with an income per capita below a certain threshold are another. Other policies favor cities of particular sizes. For example, China’s urbanization policies in the 1980s and 1990s had a strong small-city bias based on “controlling the big cities, moderating the development of medium-size cities, and encouraging growth of small cities” (Kamal-Chaoui et al. 2009, 9). Our results suggest that policies targeting small cities are less effective than those targeting lagging cities. Encouraging the growth of small cities, as China once did, might thus be unwarranted. Of course, to target lagging cities, a methodology is needed to rank cities by different characteristics. Our model provides a framework to do so. We also analyze the spatial impact of country-wide shocks. As an example, we evaluate the effect of Mexico’s 1994 economic crisis. Our results show that productivity differences across cities increased during this episode, suggesting that the country’s largest cities, like Mexico City, suffered less than smaller cities. So, larger cities seem better at absorbing economy-wide shocks. The next section briefly summarizes the theoretical framework and discusses which data are needed. The third section implements the methodology for the benchmark case of the United States. The fourth section does the same for China and Mexico and compares the findings. And the last section concludes. A technical online appendix guides the reader through a practical, step-by-step discussion of how to do the analysis.4 A simple framework for a system of cities To analyze how policies affect a country’s city-size distribution, we need a framework recognizing that each city is part of a system— and that a shock to one city will affect the others. For example, a national policy that improves the amenities in medium-size cities will not only make those cities more attractive but also affect its larger cities. The framework should capture that a city’s size depends on multiple determinants, such as efficiency, amenities, and governance. These determinants are interrelated, so improving one might not have the expected effect if the others are ignored. In Desmet and Klaus Desmet and Esteban Rossi-Hansberg 93 Rossi-Hansberg (2012), we develop such a model of a system of cities. In what follows, we provide a brief overview of the forces at work in the model. In Desmet and Rossi-Hansberg’s (2012) framework, a country has a given number of cities. So the model is not suited to study city creation or destruction. Each city has three characteristics that affect its size: • Efficiency . Productivity is the efficiency with which a city can produce. One can consider a city’s productivity to be exogenous or can assume that it depends, at least partly, on its size, because of agglomeration economies. In other words, larger cities may be larger because they are more productive, but they may also be more productive because they are larger. • Amenities. Amenities are anything (positive or negative) that affects a city’s attractiveness as a place to reside, without directly affect- ing its productivity or distorting its labor market. This includes weather, geography (being close to water), pollution, crime, cul- tural and sports activities, and anything else that influences a city’s quality of life. • Excessive frictions. Excessive frictions are the distortions over and above what we would expect given the city’s actual size. As cities become larger, they become more congested, limiting a city’s population. But even among cities of the same size, not all are equal. Some cities are less efficient than others in dealing with congestion, perhaps reflecting that some city governments do not provide congestion-alleviating infrastructure as well as others. This would translate into higher local tax rates or other distortions. Cities will be larger if they are more efficient, provide better ame- nities, or have lower excessive frictions. Of course, what matters for an individual city is not just its own characteristics; it is also how its characteristics compare with those of other cities. A highly produc- tive city will have a smaller population if there are many others like it. A system of cities is in equilibrium if no one wants to (or can) move. This is not to suggest that wages should be equal across cities. Even if people can move at no cost, an individual might be willing to accept a lower wage in a city with better amenities. Many countries, 94 Analyzing Urban Systems like China, have internal migration restrictions. In our model, a city that restricts entry will be seen as having worse amenities. We will return to the mobility question when we discuss our findings for China. An important advantage of the Desmet and Rossi-Hansberg (2012) framework is that it can be implemented and used for policy analysis with few data requirements. To identify efficiency, we use information on income, hours worked, and possibly (but not neces- sarily) capital. By using data on income, consumption, and hours worked, we can estimate a city’s distortions. By comparing a city’s actual distortions with those it would be expected to have given its size, we can identify a city’s excessive frictions. Finally, by using data on population and matching a city’s actual size to the one generated by the model, we can identify a city’s amenities. The bottom line is that having data on population, income, consumption, hours worked, and possibly capital at the city level is enough to identify the determinants of the city-size distribution. Collecting such data is fairly straightforward. Table 4.1 briefly sum- marizes how we did this for the United States, China, and Mexico. Some metropolitan data, such as gross domestic product (GDP) for the United States and population for China and Mexico, are pro- vided directly by national statistical offices. Other metropolitan data, such as hours worked in the United States and Mexico, need to be constructed from microdata. Even when not using microsurveys, we often need to aggregate data up to the metropolitan level. In the United States, for example, a large amount of data are provided at the county level (metropolitan statistical areas are a collection of coun- ties), and in Mexico most variables are available at the municipal level (metropolitan areas are a collection of municipalities). To make reasonable cross-country comparisons, another relevant point is to use comparable geographic units. In the United States, metropolitan statistical areas should capture meaningful economic geographies, making them preferable to using counties or other localities. In China, prefecture-level cities cover the entire country and should thus be understood as metropolitan areas with their rural hinterlands, making them hard to compare with metropolitan statistical areas in the United States. That is why we rely instead on the districts under prefecture-level cities, which capture the urban Klaus Desmet and Esteban Rossi-Hansberg 95 Table 4.1 Variables and sources Variable Source United States Unit of observations Metropolitan statistical areas, 2005–08 Population Bureau of Economic Analysis Income Bureau of Economic Analysis Consumption Bureau of Economic Analysis, American Community Survey (constructed, Desmet and Rossi-Hansberg 2012) Hours worked Current Population Survey (constructed, Desmet and Rossi-Hansberg 2012) Capital Bureau of Economic Analysis, American Community Survey (constructed, Desmet and Rossi-Hansberg 2012) China Unit of observations Districts under prefecture-level cities 2005 Population China city statistics Income China city statistics Consumption China city statistics (constructed, Desmet and Rossi-Hansberg 2012) Hours worked 2005 One Percent Population Survey (constructed, Desmet and Rossi-Hansberg 2012) Mexico Unit of observations Metropolitan areas, 1989, 1994, 2000, and 2005 Population Mexican census Income Encuesta Nacional de Ingresos y Gastos de los Hogares (microdata, constructed) Consumption Encuesta Nacional de Ingresos y Gastos de los Hogares (microdata, constructed) Hours worked Encuesta Nacional de Ingresos y Gastos de los Hogares (microdata, constructed) Source: Authors. part of the country and thus make them comparable to metropolitan statistical areas. In Mexico, we also use metropolitan areas, as defined by the country’s national statistical institute. Once we have measures of these three determinants for each city in a country, we can do counterfactual policy exercises. For example, we 96 Analyzing Urban Systems ask what would happen if efficiency differences across Chinese cities fell to the U.S. level. Would this shrink China’s megacities or expand them? Would this improve the well-being of Chinese citizens? Which cities would gain and which would lose? Given that technology diffusion is likely to mitigate spatial differences in China’s productivity over the next decades, these are relevant questions for policy makers. The United States as benchmark Large cities must be highly productive, have attractive amenities, or be governed well. Otherwise, they would never have grown as large as they are. But because congestion costs accompany city growth, policy often aims to reduce heterogeneity across cities by revamping backward locations. Backward locations can be revamped by making productive investments (increasing efficiency), improving attractive- ness as a place to live (improving amenities), or strengthening local governance (lowering excessive frictions). Like business cycle poli- cies, which aim to smooth shocks over time, regional policies aim to smooth differences across space. To analyze the impacts of regional policies, we start by presenting results for the United States. This example will also provide a useful benchmark for comparing against China and Mexico. To present an upper bound of the potential effects of spatial smoothing, our counterfactual policy analysis consists of completely shutting down spatial differences in the city characteristics (efficiency, amenities, and excessive frictions) by setting their values to the population- weighted average. That is, we want to see what happens to the city- size distribution, to the fate of individual cities, and to overall welfare when we completely eliminate spatial differences in each dimension. While it is unlikely that any policy can completely smooth differences across space, this analysis provides a useful upper bound to what policy could actually achieve. Figure 4.1 shows the results. The upper-left panel shows the actual city-size distribution. Each of the other three panels presents the actual and the counterfactual distributions of city sizes when we shut down the spatial variation in one of the city characteristics. In each panel, the horizontal axis shows the log of population size and the Klaus Desmet and Esteban Rossi-Hansberg 97 vertical axis the log of the probability of cities being larger than that size. For a given city size on the horizontal axis, the vertical axis shows the share of cities that are larger than that size. A steeper slope implies a less-dispersed city-size distribution, with the smaller cities being larger and the larger cities being smaller. This is a common way of depicting city-size distributions, because it emphasizes the upper tail of the distribution and, perhaps more important, because a distribu- tion exhibiting Zipf ’s law would show up as a straight line with a Figure 4.1 Counterfactuals without differences in one city characteristic (United States) Source: Authors. 98 Analyzing Urban Systems slope of –1 (similar to the one for the United States in the upper-left corner of Figure 4.1). By comparing the actual distribution with the counterfactual distributions, we notice that efficiency and amenity differences have a limited effect on the city-size distribution, whereas differences in excessive frictions play a much larger role. Indeed, the counterfactual distributions when differences in efficiency or amenities are elimi- nated hardly change the city-size distribution. That is, if all cities had the same level of efficiency or amenities, the city-size distribution would not change much (except for some cities becoming extremely small). By contrast, if all cities had the same level of excessive fric- tions, the dispersion in city sizes would become much smaller, making cities much more similar in size than in reality. In the same way that growth accounting decomposes the relative role played by different growth determinants, this exercise of urban accounting can be interpreted as decomposing the relative role played by differ- ent city characteristics. This decomposition shows that the United States city-size distribution is due mostly to differences in excessive frictions. Eliminating differences in city characteristics amounts to smooth- ing differences across space. In the same way that the business cycle literature analyzes the welfare benefits of smoothing temporal shocks, we can analyze the welfare effects of smoothing spatial shocks. As the numbers at the top of the panels in Figure 4.1 indicate, the welfare effects are modest, with increases of 1.2 percent if all cities had the same efficiency, 0.2 percent if all cities had the same amenities, and 0.9 percent if all cities had the same excessive frictions. In terms of consumption equivalence, the corresponding figures would be 12 percent, 2 percent, and 9 percent. Finding positive welfare effects, though modest, is not surprising. Eliminating spatial differences tends to spread people more equally across locations. Congestion costs rise with size in a convex way, leading to welfare gains. As mentioned, the modest welfare gains are, if anything, upper bounds. Indeed, completely eliminating differences is probably impossible, given that some of a city’s characteristics might be given by nature or geography and thus difficult to change. In addition, our coun- terfactual exercises assume that people can move across locations at no cost. Klaus Desmet and Esteban Rossi-Hansberg 99 Because city characteristics can be correlated with size, spatial smoothing can often be reinterpreted as a size-dependent policy, affecting megacities differently from small and medium-size cities. For example, Figure 4.1 shows that equalizing efficiency makes the city-size distribution slightly less dispersed: the larger cities become smaller and the smaller cities larger. Los Angeles would lose 29 percent of its population, Chicago would lose 46 percent, and New York 77 percent. In this sense, a policy that smooths efficiency differences amounts to a size-dependent policy that favors smaller cities over larger cities. The same size-dependency is present when equalizing differences in excessive frictions. But, by contrast, amenities are correlated less strongly with size. When equalizing amenities across locations, some larger cities would lose some of their populations—for example, Los Angeles (8 percent) and San Diego (42 percent)—whereas others would add to their populations—for example, New York (44 percent) and Philadelphia (39 percent). Although smoothing differences in efficiency and amenities has a limited effect on the city-size distribution—the counterfactual distri- bution and the actual distribution do not look all that different—the individual cities mentioned above illustrate that the ordering of cities changes substantially. For instance, when equalizing efficiency across all cities, New York is no longer the country’s largest city, overtaken by Riverside (California), Los Angeles, Chicago, and Phoenix. The country’s largest city would be Riverside, with a population simi- lar to New York’s actual population. This reordering implies that behind the veil of an apparently stable city-size distribution, there would be a substantial reallocation of population. When calculating reallocation following the methodology of Davis and Haltiwanger (1992)—adding the number of new workers in expanding cities as a proportion of total population—we find reallocations of 37 percent when eliminating differences in efficiency, 20 percent when elimi- nating differences in amenities, and 44 percent when eliminating differences in excessive frictions. Once again, the welfare differences from smoothing are computed under the assumption of free mobility. If one were to consider the costs of moving and the magnitude of reallocation, any modest posi- tive welfare gain from smoothing would likely vanish and become negative. Indeed, many cities would undergo large shocks, giving 100 Analyzing Urban Systems people an incentive to move, despite the costs. This could easily turn the small welfare gains into large welfare losses. From that point of view, regional policies aimed at reducing spatial differences might be counterproductive. They would force many people to move, perhaps with important welfare costs. Comparing with China and Mexico China Reducing spatial dispersion to the United States level. In the United States, we found that even if we were able to eliminate all spatial differences in efficiency (or any other determinant of city sizes), the gains in well-being would be limited. We now turn to China, a country rapidly urbanizing over the last couple of decades. China has much larger spatial differences than the United States. In China, city productivity at the 80th percentile is 71 percent higher than at the 20th percentile; for the United States, that figure drops to 32 percent. As China continues to grow and develop, these spatial differences will likely converge to those in more mature economies, such as the United States. For policy makers that need to make long-term decisions about, for instance, how much to invest in infra- structure and where, understanding how China’s future growth will affect the spatial distribution of its people and economy is essential. Therefore, instead of analyzing what would happen if we completely smoothed China’s spatial differences, it might be more relevant to ask how the Chinese city-size distribution would change if it had the same dispersion in the city characteristics as the United States. Figure 4.2 shows the results. In the top-right panel, we lower the dispersion in efficiency across Chinese cities to the United States level without changing the population-weighted average efficiency. In the bottom panels, we follow the same procedure for amenities and excessive frictions. The welfare effects from reducing spatial differences are huge. If the dispersion in efficiency across Chinese cities were reduced to that in the United States, welfare would increase 17.7 percent, and similarly, if the dispersion in amenities dropped to that in the United States, welfare would increase 22.6 percent of the numbers would be large for consumption equivalence. Klaus Desmet and Esteban Rossi-Hansberg 101 Figure 4.2 Counterfactuals changing dispersion in characteristics to United States levels (China) Source: Authors. In contrast with the United States, these figures suggest that reducing spatial differences could have enormous positive effects on China’s well-being. This is all the more striking given that for the United States we completely eliminated spatial differences, whereas for China we only reduced spatial differences to the United States level. If we had completely smoothed spatial differences in China, as we did in our counterfactual exercise for the United States, the welfare 102 Analyzing Urban Systems effects would have been even larger. In the case of efficiency, for example, welfare would increase an astounding 55 percent in China but a meager 1.2 percent in the United States. Looking at how reducing spatial differences in efficiency to the United States level affects China’s largest cities, we find that Beijing would lose 87 percent of its population and Shanghai a similar 88 percent. Most of China’s other large cities would also lose people, except for Chongqing, whose population would grow 46 percent. Does this imply that the future will bring the demise of China’s megacities as technology spreads more equally across the country? Not necessarily. In fact, Figure 4.2 suggests the contrary: reducing differences in efficiency would make the city-size distribution more dispersed, implying that China’s largest cities would become larger and China’s smallest cities would become smaller. Hence, in contrast with the United States, where smoothing efficiency made cities more equal in size, the opposite happened in China. This unexpected result illustrates the need to analyze policies in a model of a system of cities with multiple determinants of city sizes. Not doing so could lead to unintended consequences: a policy aimed at reducing dispersion across cities might actually increase it. Given the huge decline in Beijing and Shanghai, an increasing dispersion in city size seems counter-intuitive. Some of the medium- size cities with attractive amenities and low efficiency now become the new megacities, and they become larger than Beijing and Shanghai today. The country’s three largest cities become Liuan in Anhui Province (predicted population 16 million) and Chongqing (15 million) and Bazhong (13 million) in Sichuan Province. Chongqing is already a megacity, and Liuan and Bazhong are medium-large cities with populations of 1–2 million. But because they have above-average amenities and below-average productivity, improving their efficiency transforms them into huge cities. Reducing the spatial differences in amenities to the United States level also leads to greater dispersion in China’s city-size distribution, because many larger cities in China have poor amenities. Formal and informal mobility restrictions are one possible reason for this. Indeed, if large cities are kept artificially small through mobility restrictions, our model will show them as having low amenities. Consider a highly efficient city with a predicted city size larger than in reality. In that Klaus Desmet and Esteban Rossi-Hansberg 103 case, some other force in our model must keep it from reaching that larger size. That counteracting force will be poorer amenities. As a result, many of the highly efficient eastern coastal cities have low amenities. Giving them better amenities would grow them tremen- dously. This is the case, for example, of several cities in Guangdong Province, which included some of the first special economic zones under Deng Xiaoping’s Open Door Policy. Shenzhen would grow to a population of 27 million, and Guangzhou would increase its popula- tion 64 percent. This finding is in line with Au and Henderson (2006), who argue that China’s megacities are too small. Mobility restrictions are not applied always and everywhere in China. Chongqing and Chengdu are pursuing “an unabashedly urbanization-based growth strategy” (World Bank 2009, 221). If those cities are benefitting from government policies promoting rural-urban migration, it should be reflected in our model as high amenities. Consistent with this, reducing the dispersion in amenities across cities would reduce Chongqing’s population 83 percent and Chengdu a more modest but still high 46 percent. Although mobility restrictions often stem from government policy through the hukou system, not all such restrictions are based on policy. Cities need time to grow, and housing and other urban infrastructure needs to be built. This “time to build” implies that Chinese cities can converge only gradually to their steady-state population level. Shenzhen is telling in this context. While the model predicts that it might be too small, it is unclear which part is due to policy restrictions and which part to the “time to build” constraint. As Shenzhen has been China’s fastest growing city since 1979 (World Bank 2009), it probably could not have grown much faster, even if people had been free to move. Other urban problems that afflict megacities, but more so in China than in the United States, include severe air pollution. Again, in our model air pollution will show up as a negative amenity, making cities like Beijing less desirable. In that sense, the low amenities of the larger Chinese cities might also be due to environmental problems. Overall, we find that lowering the spatial dispersion of amenities or efficiency would lead to larger cities and huge welfare gains. Greater mobility would surely narrow the dispersion in amenities, allowing the larger cities to grow even more. Differences in efficiency are also 104 Analyzing Urban Systems bound to narrow over time, as technology and efficient management practices diffuse spatially. Therefore, as China continues to develop and mature, it will likely see larger megacities—and more of them. Urban policies. While the previous section focused on the likely spatial evolution of the Chinese economy as it further matures, we now analyze the effects of specific urban policies. One common policy is to improve lagging locations. Cities are selected by their low productivity, bad amenities, or poor governance. Examples include the European Union’s structural funds, which subsidize local infra- structure and human capital formation in regions with an income per capita below a certain threshold, and China’s attempts to spread development from the highly productive coast to the less produc- tive inland. Another common policy is to favor growth in cities of certain sizes. In that case, cities get selected by their size. For example, China’s urbanization policy in the 1980s and 1990s was based on “controlling the big cities, moderating the development of medium- size cities, and encouraging growth of small cities,” though in more recent years this policy has gradually been phased out (Kamal-Chaoui et al. 2009). In what follows, we analyze the effects of the two types of policies mentioned above—those that benefit lagging cities and those that benefit cities of different sizes. Table 4.2 reports the results. The first row estimates the effect of a policy that improves conditions in backward cities. If we increase efficiency 20 percent in the bottom quartile of cities ranked by efficiency, the model predicts a 4.9 percent Table 4.2 Urban policies in China Urban policies Welfare differences (percent) Efficiency Amenities Excessive frictions Improve in worst cities by 20 percent 4.9 13.7 0.2 Improve in smallest cities by 2.0 4.5 0.1 20 percent Improve in medium-large cities by 5.2 8.9 0.1 20 percent Improve in largest cities by 20 percent 12.1 22.0 0.4 Source: Authors. Klaus Desmet and Esteban Rossi-Hansberg 105 increase in welfare. Corresponding policies that increase amenities and lower excessive frictions would also have positive welfare effects, of 13.7 percent and 0.2 percent, respectively. The next rows estimate the effects of size-based policies that improve conditions in the smallest cities (bottom quartile), the medium–large cities (second quartile), and the largest cities (top quartile). Two results stand out. First, targeting the worst cities is more effective than targeting the smallest cities. For example, improving amenities 20 percent in the smallest cities increases welfare 4.5 percent, less than a third the 13.7 percent if the policy focuses on the cities with worst amenities. Second, when comparing the size-based policies, the welfare effects are greater, the larger the cities that are targeted. This is of course not surprising. Improving efficiency (or any of the other characteristics) in the largest cities benefits many more people than the same policy applied to the smallest cities. For example, when increasing efficiency 20 percent in the largest cities, with populations above 1.4 million, welfare rises 12.1 percent, more than six times the 2.0 percent when applying the same policy in the smallest cities (populations of less than 500,000). From the point of view of expected benefits, this suggests that policy makers should concentrate their efforts on the country’s larg- est cities. But there is of course also a cost of implementing these policies, and this cost may well differ by city. Therefore, only with a cost constant across cities can we conclude that targeting the largest cities is better. For example, if we had to choose one of two isolated cities to connect by highway to the rest of the country, we would connect the larger one. But many other policies will likely have a cost increasing in the number of people. For example, building urban infrastructure or improving local schools will cost more the larger a city’s population. Enhancing efficiency in the largest cities will there- fore require more resources than in the smallest cities. To remove the effect that certain policies benefit more people than others (and are therefore likely to cost more than others to implement), Table 4.3 analyzes the same urban policies as before, but now keeps the ex-ante population-weighted characteristics constant. In other words, we leave ex-ante aggregate efficiency unchanged but change the distribution of efficiency across cities, benefiting some cities at the cost of others.5 We apply the same methodology to 106 Analyzing Urban Systems Table 4.3 Urban policies in China for constant population-weighted characteristics Urban policies Welfare differences (percent) Efficiency Amenities Excessive frictions Improve in worst cities by 20 percent 2.7 8.2 0.0 Improve in smallest cities by 0.8 2.2 0.0 20 percent Improve in medium-large cities by 1.9 1.3 0.0 20 percent Improve in largest cities by 20 percent 0.0 2.0 0.1 Source: Authors. amenities and excessive frictions. Policies that target cities by their characteristics rather than their size seem much more effective. Implementing such policies requires a methodology to rank cities by their characteristics. Our model provides a framework to do so. Note that within the class of size-based policies, no clear picture emerges of which size should be targeted. For example, focusing on the smallest cities is more effective for amenities, whereas improving conditions in medium-size cities has a greater impact for efficiency. Which type of city benefits the most depends on the distribution of the different characteristics across cities of different sizes. Beyond their effects on welfare, these policies also affect city-size distributions. Figure 4.3 shows the counterfactual city-size distribu- tions when improving efficiency. These correspond to the urban policies in Table 4.2. All policies, except for the one that targets the largest cities, tend to shrink the largest cities. For example, when increasing efficiency 20 percent in the bottom quartile of efficient cit- ies (top-right panel), the country’s largest city remains Shanghai, but its population drops 21 percent. The next two largest cities, Beijing and Chongqing, would also see their populations fall, by 22 percent and 6 percent, respectively. Mexico Reducing spatial dispersion to the United States level. After analyzing the United States and China, we now look at Mexico, Latin America’s Klaus Desmet and Esteban Rossi-Hansberg 107 Figure 4.3 Counterfactuals different urban policies (China) Source: Authors. second-largest economy. How would Mexico’s city-size distribution look like if it had the same dispersion in city characteristics as the United States? Figure 4.4 shows the results. The welfare effects for Mexico are far smaller than for China. If the dispersion in efficiency across Mexican cities were the same as in the United States, welfare would increase a mere 0.1 percent, compared with 17.7 percent in China. For amenities, the effect would be a larger 0.8 percent but still much smaller than China’s 22.6 percent. 108 Analyzing Urban Systems Figure 4.4 Counterfactuals changing dispersion in characteristics to United States levels (Mexico) Source: Authors. The main reason for the smaller effect is that Mexico looks more like the United States than China, especially in efficiency. In Mexico, the productivity of the city at the 80th percentile is 43 percent higher than the city at the 20th percentile. For China, that figure is 71 percent; for the United States, 32 percent. This suggests that the diffusion of technology has been greater in Mexico, reducing spatial differences. For amenities, the smaller welfare effects suggest Klaus Desmet and Esteban Rossi-Hansberg 109 that Mexico suffers less from mobility restrictions than China. The finding that Mexico’s spatial structure is closer to the United States’ than to China’s is further reinforced when we compare the effects of completely smoothing spatial differences in the city characteristics. In efficiency, for example, this would lead to a welfare increase of 0.7 percent in Mexico, 1.2 percent in the United States, and 55 per- cent in China. Another relevant question is how reducing spatial differences affects megacities relative to medium-size and smaller cities. In effi- ciency, we found that reducing differences to the United States level made the city-size distribution in China more disperse. This is not the case in Mexico: the country’s megacity, Mexico City, loses 17 per- cent of its population, dropping from 19.2 million to 16.0 million. The situation is similar in the United States, where spatial smooth- ing also reduced the size of the country’s largest city, New York. However, despite some of the country’s medium-size cities becom- ing much larger, none reaches the dimensions of Mexico City. In Leon, for example, the population increases from 1.4 million to 2.3 million. Other cases of medium-size cities gaining population include Puebla (16.5 percent), Aguascalientes (34.2 percent), and Acapulco (115.6 percent). Acapulco’s staggering growth can be explained by its having one of the country’s highest levels of ameni- ties, so that once it improves its efficiency, it grows tremendously. When reducing the dispersion in amenities across cities, the effect is quite different. Many of the larger cities lose population, such as Guadalajara (56 percent), but Mexico City, which grows from 19.2 million to 27.4 million, and Tijuana, which grows from 1.5 million to 6.3 million, do not. This reflects Mexico City and Tijuana having bad amenities. Once again, what we call amenities should be interpreted broadly. Any feature that holds back city growth but that does not distort the labor supply is a bad amenity in our model. For example, if pollution and a complex geography stunt Mexico City’s growth, our model will show it as a negative amenity. Urban policies. As in China, we now analyze the effect of two types of policies—those that benefit lagging cities and those that benefit cities of different sizes. Table 4.4 shows the results. If we improve efficiency 20 percent in the bottom quartile of efficient cities, the model predicts that welfare in Mexico will increase 0.4 percent. 110 Analyzing Urban Systems Similar policies that improve amenities would have a positive welfare effect of 0.7 percent, whereas policies that lower excessive frictions would have no noticeable effect. As for the scale-dependent policies, improving conditions 20 percent in the smallest cities would have a very small effect, in no case improving welfare more than 0.1 percent. Doing the same in larger cities has, as expected, a greater effect. One important difference with China is that the welfare effects of any of these policies are much smaller. Table 4.4 Urban policies in Mexico Urban policies Welfare differences (percent) Efficiency Amenities Excessive frictions Improve in worst cities by 20 percent 0.4 0.7 0.0 Improve in smallest cities by 0.1 0.1 0.0 20 percent Improve in medium-large cities by 0.5 0.3 0.1 20 percent Improve in largest cities by 20 percent 2.1 1.1 0.5 Source: Authors. Once again, the finding that targeting the largest cities has a greater impact is not surprising. As in China, if we were to control for the fact that improving conditions in larger cities benefits more people, we would find that the best policy targets the most lagging cities. Table 4.5 reports the results. Improving efficiency in the most backward cities improves welfare 0.2 percent, compared with 0.1 percent or less when targeting cities of different sizes. Mexico’s changing city-size distribution. Until now we have com- pared urban systems across countries, but our methodology can also compare urban systems over time. When reducing spatial efficiency differences to the United States level, welfare gains in Mexico rise, from 0.2 percent in 1989 to 0.6 percent in 1994, and then drop again, to 0.3 percent in 2000 and 0.0 percent in 2005.6 We now interpret this finding in light of the severe economic crisis that hit Mexico in 1994, which had profound effects on efficiency (Meza and Quintin 2007). As argued, equalizing efficiency across Klaus Desmet and Esteban Rossi-Hansberg 111 Table 4.5 Urban policies in Mexico for constant population-weighted characteristics Urban policies Welfare differences (percent) Efficiency Amenities Excessive frictions Improve in worst cities by 20 percent 0.2 0.1 0.0 Improve in smallest cities by 0.0 0.0 0.0 20 percent Improve in medium-large cities by 0.1 0.1 0.1 20 percent Improve in largest cities by 20 percent 0.1 0.1 0.2 Source: Authors. locations tends to help medium-size cities at the expense of larger once. We would therefore expect the positive effect on welfare to be larger, the greater the dispersion in efficiency. If so, the temporal pattern suggests that the dispersion in efficiency must have widened during the economic crisis—that is, the smaller cities are likely to have been hit harder than the larger ones. The data bear out these intuitions. The standard deviation of the log of efficiency increased from 0.27 in 1989 to 0.32 in 1994 and then declined to 0.23 in 2000 and 0.16 in 2005. Further, the correlation between changes in efficiency over time and city size in Mexico is always negative, except for 1989–94 when it was positive, indicating that larger cities suffered less than smaller cities. This is reflected by the counterfactual predic- tions for Mexico City. We know that reducing spatial differences in efficiency to the United States level will have a negative effect on the country’s capital, but the effect was much larger in 1994. While the predicted change in Mexico City’s population is –11 percent in 1989 and 4 percent in 2005, the predicted change is a much larger –53 percent in 1994, the crisis year. In addition to analyzing the spatial impact of the crisis, our results shed light on the long-run spatial development of Mexico’s urban system. The drop in the dispersion of efficiency suggests a tendency toward the spatial convergence of efficiency over time. In fact, by 2005 Mexico’s spatial dispersion of efficiency had converged to the United States’. Another long-term trend is the worsening in Mexico 112 Analyzing Urban Systems City’s amenities. If the country’s capital had the country’s average level of amenities, its population would have dropped 41.7 percent in 1989. By 2005, the situation was completely reversed: with average amenities, the city’s population would rise 40.0 percent. Some policy conclusions We have applied a simple model of a system of cities to do policy analysis. Our focus has been on the United States and two large emerging economies, China and Mexico. Our findings allow us to state six relevant policy conclusions: • Reducing spatial differences across cities does not necessarily imply larger cities becoming smaller. If efficiency were spread more equally across space, megacities would lose people in Mexico but gain in China. The finding that megacity populations may not always decline has to do with the multiple determinants of the city-size distribution and how they relate to each other. Many medium-size cities in China have great amenities but low efficiency. Improving their efficiency gives them a huge boost, allowing them to become larger than the country’s megacities today. In other words, Shanghai and Beijing would lose people, but other cities would take their place and outpace them. By contrast, Mexico City would lose people but remain Mexico’s largest city. • In a mature economy like the United States, the welfare effects of completely smoothing out spatial differences are small. Because policy is unlikely to completely eliminate differences across cities, these already-small effects should be interpreted as upper bounds. If, in addition, one were to account for the reallocation costs of people implied by policies that reduce spatial differences, these small positive welfare effects would likely become negative, suggesting there is little room for policies that focus on lowering differences across United States cities. • Emerging economies are typically characterized by larger spatial differ- ences than are developed economies, so the welfare effects of smoothing out spatial differences are likely to be larger. As China and Mexico continue to grow and develop, their spatial differences will likely converge to those in more mature economies, such as the United Klaus Desmet and Esteban Rossi-Hansberg 113 States. Reducing spatial differences in efficiency to the United States level would improve China’s welfare 17.7 percent and Mexico’s a much smaller 0.1 percent. The huge welfare effects in China can be explained by the large spatial dispersion in efficiency across its cities, a situation virtually absent in Mexico. A similar policy that lowers spatial differences in amenities would increase China’s welfare 22.6 percent and Mexico’s 0.8 percent. China’s much larger effect is likely related to its mobility restrictions under the hukou system. Taken together, our findings suggest that China stands much to gain from the spatial reallocation of people and economic activity, as technologies diffuse across space and mobility restric- tions are lifted. The effects in Mexico are substantially lower, prob- ably reflecting the country’s longer history as a developing market economy and its lack of formal mobility restrictions. • Urban policies that target lagging cities are more effective than those that target cities of different sizes. Urban policies often focus on either improving conditions in lagging cities or favoring cities of particular sizes. Our results suggest that targeting lagging cities tends to be more effective, except when the cost of implementing such policies does not increase with city size. In that case, target- ing the largest cities is better, because the benefits are shared by more people. The often observed policy in developing countries of favoring smaller cities is in general unwarranted. To implement policies based on city characteristics, a methodology is needed to rank cities by their different characteristics. Our model provides a framework to do so. • Country-wide shocks are likely to have important spatial effects. We find that Mexico’s 1994 economic crisis increased the dispersion of efficiency across cities. This implies that the country’s largest cities, such as Mexico City, were spared more than the country’s smaller cities. It suggests that large cities are more resilient to country-wide shocks than small cities. • From a methodological point of view, there is much to learn from a quantitative analysis of urban systems. Analyzing policy interven- tions for just one city, without accounting for its effects on others, is likely to be misleading. Given that the data requirements to implement this framework are minimal, we hope that policy mak- ers in many countries will find it useful. 114 Analyzing Urban Systems Notes 1. As in John Donne: No man is an island entire of itself; every man is a piece of the continent, a part of the main. 2. The literature on firm dynamics and industrial policy has also focused on this problem. For example, is it more desirable to subsidize small firms or large firms? See Restuccia and Rogerson (2008). 3. The online appendix is available at www.princeton.edu/~erossi/ RethinkingCitiesCh14Appendix.pdf. 4. See www.princeton.edu/~erossi/RethinkingCitiesCh14Appendix.pdf. 5. Of course, given that people will move as a result of the policy, the ex post aggregate efficiency may be different. 6. The numbers for 2005 are slightly different than those for Figure 4.3. Because we want to use a constant sample of cities across all years, the number of cities analyzed here is a bit lower. Bibliography Au, Chun-Chung, and J. Vernon Henderson. 2006. “Are Chinese Cities Too Small?” Review of Economic Studies 73: 549–76. Bai, Chong-En, Hsieh, Chang-Tai, and Ying Yi Qian. 2006. “The Return to Capital in China.” Brookings Papers on Economic Activity 37 (2): 61–102. Davis, Steve J., and John Haltiwanger. 1992. “Gross Job Creation, Gross Job Destruction, and Employment Reallocation.” Quarterly Journal of Economics 107 (3): 819–63. Desmet, Klaus, and Esteban Rossi-Hansberg. 2012. “Urban Accounting and Welfare,” Unpublished. Glaeser, Edward L., and Joshua D. Gottlieb. 2008. “The Economics of Place-Making Policies.” Brookings Papers on Economic Activity 39 (1): 155–253. Kamal-Chaoui, Lamia, Edward Leman, and Zhang Rufei. 2009. “Urban Trends and Policy in China.” Regional Development Working Paper 2009/1, Organisation for Economic Co-operation and Development, Paris. Kehoe, Timothy, and Kim J. Ruhl. 2010. “Why Have Economic Reforms in Mexico Not Generated Growth?” Journal of Economic Literature 48 (4): 1005–27. McGrattan, Ellen, and Edward Prescott. 2009. Unmeasured Investment and the Puzzling United States Boom in the 1990s. Research Department Staff Report 369, Federal Reserve Bank of Minneapolis, Minneapolis, MN. Klaus Desmet and Esteban Rossi-Hansberg 115 Meza, Felipe, and Erwan Quintin. 2007. “Factor Utilization and the Real Impact of Financial Crises.” The B.E. Journal of Macroeconomics 7 (1): Article 33. Restuccia, Diego, and Richard Rogerson. 2008. “Policy Distortions and Aggregate Productivity with Heterogeneous Plants.” Review of Economic Dynamics 11 (4): 707–20. UN-Habitat. 2010. The State of African Cities 2010: Governance, Inequality and Urban Land Markets. Nairobi. World Bank. 2009. World Development Report 2009: Reshaping Economic Geography. Washington, DC. 5 Are Cities the New Growth Escalator? Enrico Moretti In most countries, the geographical distribution of economic activity is highly uneven. Urban areas tend to have much more productive labor and higher salaries than rural areas, and there are vast differences across urban areas. In the United States, the hourly wage of workers in metropolitan areas with the highest average labor productivity is more than twice the hourly wage of workers with similar skills and experience in metropolitan areas with the lowest. In other words, the same worker can earn vastly different nominal salaries depending on where she locates. Even larger differences exist in many developing countries. Employers also differ across metropolitan areas. Areas with high salaries and high productivity tend to have employers that invest in much more research and development than areas with low salaries and low productivity. This chapter addresses two questions. First, it discusses the causes of these vast geographical differences in wages, human capital, and innovation. What makes some cities more economically successful than others in productivity and salaries? The question is important because the appropriate role of economic policy needs first to be based on what is driving spatial economic differences in the first place. Enrico Moretti 117 Most productivity differences within a country are unlikely to be explained by exogenous factors, like natural resources endowments. Instead, a part of these productivity differences reflects endogenous factors: three forces of agglomeration economies, which ultimately determine the location of workers and companies and thus shape the futures of entire communities. The forces are thick labor, thick markets for specialized service providers, and knowledge spillovers. Understanding them is critical, because they are responsible for the vast economic differences across cities and regions in most countries. Understanding them also holds the key to designing policies that can make struggling areas more economically successful. In a world with vast disparities in incomes across locales and with significant agglomeration externalities, what is the proper role of economic policy? Should national or local governments seek to redis- tribute economic activity from rich areas to poor? The second part of the chapter discusses regional economic development policies. In the United States alone, states and the federal government spend about $40–60 billion annually on these policies—more than is spent on unemployment compensation in a normal year. The European Union has an even more ambitious program transferring its develop- ment funds to regions with below average incomes. Asian countries, especially China, have a variety of special economic zones, designed to attract foreign investment to specific areas.1 Such regional development policies, often called place-based eco- nomic policies, are effectively a form of welfare, targeting cities or regions, not individuals. While such policies are widespread, the eco- nomic logic behind them is rarely discussed and even less frequently understood. This chapter clarifies when these policies are wasteful, when they are efficient, and who the expected winners and losers are. Understanding when government intervention makes sense—and when it does not—is a crucial first step in setting sound economic development policies. What makes some cities more economically successful than others? Good salaries, high productivity, and vibrant innovation are highly concentrated, not uniformly distributed over space.2 To get a more 118 Are Cities the New Growth Escalator? precise sense of how large the geographical differences in the level of economic activity can be within a country, consider Table 5.1. The table shows average salary levels among U.S. metropolitan areas with the highest percentage of local workers with a college degree.3 The list includes such large metropolitan areas as Austin, Boston, Minneapolis-St. Paul, Raleigh-Durham, San Francisco, San Jose, Seattle, and Washington, DC—as well as smaller cities with large universities, such as Ann Arbor, Fort Collins-Loveland, Iowa City, Lincoln, and Madison. In these cities, almost half the labor force is college educated, and a significant fraction has a postgraduate degree. Table 5.2 shows the metropolitan areas with the smallest percent- age of workers with a college degree. It includes Flint, Michigan; Vineland-Millville-Bridgeton, New Jersey; Visalia, California; and Yuma, Arizona. In these cities, only 1 in 10 workers has a college degree, and there is virtually no high-tech presence. These two tables have several noteworthy features. First, the sheer size of the geographical differences is staggering, often exceeding the differences between countries. Stamford, Connecticut, the city with the highest percentage of college-educated workers in the United States, has five times the number of college graduates per capita as Merced, California, the city with the lowest. This difference is much larger than the difference in schooling between the United States as a whole and many developing countries, such as India (three times), Peru (three times), and South Africa (four times). Second, differences in education are associated with huge differ- ences in average nominal salary. College graduates in the top group make $70,000–80,000 a year, or about 50 percent more than college graduates in the bottom group. Compare San Jose, fifth from the top, with Merced, at the very bottom. Both cities are in California, less than 100 miles apart, but their labor markets belong to different universes. San Jose, in the heart of Silicon Valley, has more than four times as many college graduates per capita as Merced—and salaries 40 percent higher for college graduates and 130 percent higher for workers with a high school diploma. The geographical differences are so large that high school graduates in the top group often make more than college graduates in the bottom. The average worker with a high school education in Boston makes $62,423, or 44 percent more than a college graduate in Flint. Table 5.1 Metropolitan areas with the largest percentage of college graduates Top metro areas Rank Percentage with Salary of college Salary of high college degree graduates ($) school graduates ($) Stamford, CT 1 56 133,479 107,301 Washington, DC/MD/VA 2 49 80,872 67,140 Boston, MA-NH 3 47 75,173 62,423 Madison, WI 4 47 61,888 52,542 San Jose, CA 5 47 87,033 68,009 Ann Arbor, MI 6 46 65,452 55,456 Raleigh-Durham, NC 7 44 63,745 50,853 San Francisco-Oakland, CA 8 44 77,381 60,546 Fort Collins-Loveland, CO 9 44 57,391 47,007 Seattle-Everett, WA 10 42 68,025 55,001 Trenton, NJ 11 42 81,914 64,299 Lexington-Fayette, KY 12 41 55,238 44,915 Austin, TX 13 41 62,289 48,809 Portland, ME 14 40 57,366 48,080 Minneapolis-St. Paul, MN 15 40 69,955 57,187 Denver-Boulder, CO 16 39 64,488 50,097 New York-Northeastern NJ 17 38 79,757 59,797 Lincoln, NE 18 38 50,401 41,837 Santa Cruz, CA 19 38 64,801 48,186 Tallahassee, FL 20 38 59,380 46,715 Worcester, MA 21 37 60,723 48,465 Source: Author’s calculations based on U.S. Census Bureau (2008). Table 5.2 Metropolitan areas with the smallest percentage of college graduates Bottom metro areas Rank Percentage with Salary of college Salary of high college degree graduates ($) school graduates ($) Mansfield, OH 286 17 53,047 35,815 Beaumont-Port Arthur-Orange, TX 287 17 58,234 38,352 Rocky Mount, NC 288 16 52,330 34,329 Stockton, CA 289 16 59,651 37,928 Fort Smith, AR/OK 290 16 50,937 33,187 Ocala, FL 291 16 47,361 32,725 Yuba City, CA 292 16 56,403 34,999 Modesto, CA 293 15 60,563 36,126 Waterbury, CT 294 15 54,651 37,280 Brownsville-Harlingen-San Benito, TX 295 15 43,800 22,450 McAllen-Edinburg-Pharr-Mission, TX 296 15 44,605 22,845 Anniston, AL 297 15 48,928 33,031 Yakima, WA 298 15 50,160 29,084 Bakersfield, CA 299 14 65,775 34,807 Danville, VA 300 14 42,665 28,868 Houma-Thibodaux, LA 301 14 56,044 37,395 Vineland-Millville-Bridgeton, NJ 302 13 57,668 35,375 Flint, MI 303 12 43,866 28,797 Visalia-Tulare-Porterville, CA 304 12 55,848 29,335 Yuma, AZ 305 11 52,800 28,049 Merced, CA 306 11 62,411 29,451 Source: Author’s calculations based on U.S. Census Bureau (2008). Enrico Moretti 121 A high school graduate in San Jose earns an average of $68,009, thousands more than college-educated workers in Merced, Yuma, Danville, and all the other cities at the bottom. In other words, the economic disparity between cities is so vast that it can dominate the disparity between levels of education. These differences are not specific to the United States; they exist in countries the world over, including developing countries. For exam- ple, China exhibits significant spatial differences in schooling, labor productivity, and salaries across regions. Average salaries in Beijing and Shanghai are several times higher than those in Lhasa, Golmud, and Yumen because workers in Beijing and Shanghai are much more productive. Average schooling achievement also differs significantly across cities, with the labor markets of highly developed coastal cities having a higher share of college graduates and the labor markets of less developed western cities having a lower share. The gap in average salary and average schooling between Beijing and Shanghai and rural areas in western China is even larger. Regional differences in India are equally striking. Metropolitan areas in poorer parts of India—like Patna in Bihar—tend to have average incomes four to five times lower than metropolitan areas in richer parts of India, like Delhi and Bangalore (now Bengaluru). In European countries, spatial differences tend to be more contained, as in Italy, where salary differences between highly productive northern cities like Milano, Trento, and Verona and less productive southern cities like Agrigento and Cosenza are only 60–70 percent. The share of college graduates in the labor force is 50–70 percent higher in the northern group than in the southern group. France exhibits similar spatial differences in productivity, salaries, and human capital. Throughout the world, the presence of many college-educated residents changes the local economy in profound ways, affecting both the kinds of jobs available to residents and the productivity of workers. Cities with many college-educated residents tend to have a local economy with a great deal of innovation. Table 5.1 includes some of the world’s most important innovation clusters, including Austin, Raleigh-Durham (Research Triangle), San Francisco, San Jose (Silicon Valley), and Seattle. Compare Boston, third from the top, with Flint, fourth from the bottom. Both have a proud industrial past, but their economies are now at opposite ends of the spectrum. 122 Are Cities the New Growth Escalator? Boston, with four times the number of college graduates, depends heavily on innovation and finance. Flint, with one of the country’s lowest concentrations of human capital, still focuses on traditional manufacturing, primarily of automobiles. A college graduate in Boston makes on average $75,173, or 75 percent more than the salary of a similar worker in Flint.4 This is no accident. Forty years ago, the rich areas in the United States and Europe were manufacturing hubs with abundant physical capital. Today, human capital is one of the best predictors of high salaries, both for individuals and for communities, and this is becoming increasingly true for developing economies. The cost of living in cities listed in Table 5.1 is higher than in cities listed in Table 5.2, so salary differences adjusted for local prices are smaller than nominal differences. While this explains why people still live in Flint and Merced and why everyone has not moved to Austin, Raleigh-Durham, and San Jose, it does not explain why there are still employers in Austin, Raleigh-Durham, and San Jose. Why should employers, especially those who compete nationally and internation- ally, put up with such high labor costs to be in these locations? A crucial question, because it holds the key to understanding why some cities are more economically successful than others. If you visit these cities, you will not find many visual clues to why salaries should be so high there. Take San Jose. Most of the iconic Silicon Valley companies are in anonymous office buildings or office parks. Like many other U.S. metropolitan areas, San Jose is made up mostly of parking lots, corporate campuses, and a few sterile-looking glass towers surrounded by an ocean of single-family homes. There is nothing distinctive about its urban form: freeways crisscross its vast expanse, and people drive everywhere. Local companies like eBay and Adobe must pay a skilled worker with a college education $87,033 a year in San Jose, but a similar company in Merced would need to pay only $62,411. In fact, if eBay and Adobe moved to Merced, they would end up paying less to hire a college graduate than they are paying now to hire a high school graduate, which is $68,009. The same puzzle arises in other countries. A large fraction of the Indian high-tech sector is in Bangalore, where real estate costs and salaries are higher than in other Indian cities. France, Japan, and the Enrico Moretti 123 Republic of Korea exhibit even more geographical concentration, as cities like Paris, Tokyo, and Seoul absorb the lion’s share of their nations’ most innovative activities and talent. The same is true in China, where Beijing and Shanghai have become magnets for the country’s highest achievers. With high wages and office rents, these cities are among the costliest places in China to operate a business. One would expect these cities to be unattractive for firms, espe- cially those that compete globally. A comprehensive study by the Organisation for Economic Co-operation and Development finds that 57 percent of all patents in developed countries are generated by 10 percent of metropolitan areas, and this concentration has been increasing over time. What is so special about cities like Bangalore, San Jose, Seoul, and Shanghai? In the past, firms established themselves near their customers because transportation costs were high. For example, during the Industrial Revolution, London companies could deliver their products at a cost advantage because most of their customers were in London. But today, transportation costs are low, and they do not explain a big part of the geographical distribution of economic activity. For high tech, the transportation costs are essentially zero, since one can ship software code instantly and cheaply through any modem. If all Bangalore software companies moved to the state of Bihar, where real estate and wages are much lower, no user would notice. The answer to the puzzle is that workers in cities in Table 5.1— together with their counterparts in other countries—are more productive. Employers are willing to pay higher wages because they get more in return for each hour worked. If workers were not more productive, firms in the traded sector would, in the long run, relocate away from high-cost locations. This higher labor productivity does not reflect better endowments of natural resources. After all, there is no silicon in Bangalore or Silicon Valley. Nor is there oil in Shanghai. The higher labor produc- tivity is due mostly to three important competitive advantages, which economists refer to collectively as the forces of agglomeration: thick labor, thick markets for specialized service providers, and knowledge spillovers. 124 Are Cities the New Growth Escalator? Thick labor A major advantage of cities for workers and firms is that urban labor markets are thicker. Economists have long understood that thick markets—those with many sellers and many buyers—are particu- larly attractive because they make it easier to match demand with supply. This matters more for highly skilled workers than unskilled ones, and it is a key reason for the existence of industrial clusters. If you are a software engineer specializing in a particular type of soft- ware design, it is really important to find the one biotech firm that uses that specific technology. If you move to a city like Bangalore, where many software firms are concentrated, you are more likely to find the firm that really wants—and will pay for—your unique skill set. If you move to a city like Calcutta (now Kolkata), with fewer software firms, you might have to settle for a less ideal match and thus a lower salary. You will have a vastly different career tra- jectory depending on where you move. The advantages of a better match also accrue to employers. By locating in Bangalore, a software startup enjoys higher productivity and produces more patents, because it can find exactly the kind of molecular biologist that fits its needs. A thick market appears to be a win-win for workers and firms alike. For workers in professional occupations, the economic return of being in a thick labor market, as measured by increased earn- ings, has been rising for the past 30 years. In the United States, the average wage in labor markets with more than a million workers is a third higher than the average wage in those with $250,000 or fewer. This remains true even after worker seniority, occupation, and demographics are held constant. Remarkably, this difference is now 50 percent larger than it was in the 1970s. Market size is especially important for workers with highly specialized skills, such as high-tech engineers, scientists, mathematicians, designers, and doctors. Among doctors, specialists in large cities perform a narrower set of activities than those in small ones (Baumgardner 1988). But market size does not matter very much for unskilled workers; manual laborers and carpenters perform similar tasks in large cities and small. The size of labor markets also affects how frequently people change jobs. One study that followed 12,000 workers over a 20-year period Enrico Moretti 125 revealed that early in a career, when a worker is shopping around for a good match, she will change jobs more often in a large, diverse local market than in a smaller, specialized one. Later in a career, however, when stability presumably becomes more appealing, people change jobs less often in large markets, because they are more satisfied with their matches (Bleakley and Lin 2010). In addition, market thickness provides a form of partial insurance against unemployment. When a layoff is caused not by a recession but by problems specific to a firm, market thickness reduces the probability that the worker will remain unemployed, because there are more potential employers. And thick labor markets reduce the likelihood that a firm cannot fill a vacancy. Market size is not just a curiosity. It has critical implications for the future of cities. The thick-market effect is one of the main reasons that the high-tech sector is concentrated in a small number of cities worldwide. Because thick labor markets are better at matching work- ers and employers, high-tech clusters have an enormous advantage in attracting even more high-tech employers and workers. The flip side, however, is that cities currently without a high-tech cluster find it hard to create one. This eventually adds to the economic differences across cities. Size also matters for the marriage market, which in many countries is segregated along education lines, with well-educated professionals increasingly marrying other well-educated professionals. Economists call this assortative mating: people tend to marry people with similar socioeconomic characteristics. It is nothing new. Even in the 1980s, well-educated women were more likely to marry well-educated men than less-educated men. This tendency has strengthened over the past 30 years, however, with a significant increase in the probability that a man with a master’s degree will marry a woman with a master’s degree, a man with a college degree will marry a woman with a col- lege degree, and so on. This applies not just to education but also to job type, salary, and many other factors. As assortative mating increases, the need for a large marriage market also increases. If you are looking for a partner with very specific characteristics, a thick dating scene is better. Even for married couples, the need for thick cities is increasing, because large labor markets are especially important for families in 126 Are Cities the New Growth Escalator? which both husband and wife have a professional career. This kind of “power couple” represents a small but growing number of households. In a study of changing family structure, Costa and Kahn (2000) found that in 1940, among U.S. couples in which both husband and wife had a college education, only 18 percent of wives worked. By 1970, that figure had more than doubled to 39 percent, but most of the women had majored in fields such as education and nursing and had been tracked into traditionally female jobs. Their experience was one of “first family, then jobs,” and they often left the labor force when their first child was born. By 1990, college-educated wives of college-educated men had begun to resemble men in their professional choices and aspired to “career, then family” or “career and family.” By 2010, 74 percent of college-educated wives were in the labor force, with jobs in virtu- ally all fields and sectors. As more married couples have two careers, more of them face a location problem, since wives are increasingly unwilling to be the ones who give up their careers to accommodate their spouses’ job changes. Today, half of companies list a spouse’s employment as the biggest reason that employees turn down a job relocation offer. Thick labor markets—markets large enough to offer good professional matches for both partners—are the best way to solve this problem. This matters tremendously for the future of cities. Costa and Kahn find that well-educated professionals are increasingly gathering in large cities and that more than half this increased agglomeration is due to the growing severity of the location problem of power couples. This is bad news for small cities, because it means that they are becoming less competitive, especially in the eyes of highly educated professional couples. In the long run, smaller cities are destined to experience a reduced inflow of well-educated professionals and will therefore miss out on economic growth, thus becoming poorer over time (Costa and Kahn 2000). Thick markets for specialized service providers A second advantage of large metropolitan areas, especially those that develop large industrial clusters, is the presence of highly specialized intermediate service providers. These vendors supply specialized Enrico Moretti 127 services important to companies, such as advertising, legal support, technical and management consulting, shipping and repair, and engi- neering support. These services enable firms to focus on what they are good at, without having to worry about secondary functions. By the mere act of moving into a large cluster of similar firms, a company in effect becomes larger overnight, because it can draw on specialized local expertise. The larger the cluster, the more specialized the service providers can be. As a result, firms within a large cluster become more productive and more successful. A small software developer in Seattle does not need an in-house lawyer, because there are already plenty of local law firms specializing in intellectual property, licens- ing, and incorporation of startups. A pharmaceutical company in Mumbai can buy specialized services for its labs from local vendors, and a hardware company can find specialized shipping services. Many of these services are non-tradable, which means that geo- graphical proximity to clients is required to deliver the service (legal services, for example, require a lot of face-to-face interaction between client and attorney). And even when they are tradable, geographical proximity to clients helps deliver successful products, as providers often need to be close to potential clients to assess their needs and show how they can help. This matters less for mature products but is critical when a product is new. This is one important factor that keeps industrial clusters geo- graphically together. Service providers are there because the clients are; the clients are there in part because the service providers are. This affects cities in two important ways. First, it increases the number of local jobs created by local companies: if a city attracts an IBM office, it gains not just the IBM jobs but also the jobs in the service sector. Second, it further strengthens the attractiveness of cities that have successful clusters at the expense of cities that do not: it makes IBM more likely to open an office in Silicon Valley.5 Knowledge spillovers More educated countries tend to be richer. More important, countries whose citizens’ education grows faster tend to see faster economic progress. The link between country education and economic growth is quantitatively strong. Krueger and Lindhal (2001) find that each 128 Are Cities the New Growth Escalator? additional year in the average education of a country results in a gross domestic product (GDP) increase of 5–14 percent, a substan- tial income gain. Of course, the direction of causality is not always clear. Economists have long recognized that “education is both the seed and the flower of economic development” (Harbison and Myers 1965, xi). For example, countries that improve their education sys- tems could at once change other policies that enhance growth, thus complicating the causal interpretation of the relationship between education growth and economic growth. The same correlation between education and economic growth across countries exists within countries across regions. Indian states with the highest level of literacy and highest level of college graduation also have the highest incomes. The same is true in countries as diverse as Brazil, Germany, and Indonesia. Figure 5.1 shows the relationship between the average salaries of high school graduates in each U.S. metropolitan area and the fraction of workers with a college education in those areas. Tables 5.1 and 5.2 hinted at a positive relationship between local human capital and salaries across U.S. metropolitan areas. The figure shows that this link is robust, and it holds true for most U.S. cities. There appears to be a clear positive association, indicating that the more college gradu- ates, the higher the salaries for high school graduates.6 The economic Figure 5.1 Fraction of college-educated workers and salary of high school graduates in the United States, by metropolitan area Source: Moretti 2012. Enrico Moretti 129 effect is quite large. The earnings of a worker with a high school education rise about 7 percent as the share of college graduates in his city increases 10 percent. One may be concerned that the figure is comparing apples and oranges—that workers who pick cities with many college graduates, like Boston, might differ fundamentally from workers who pick cities with fewer college graduates, like Flint. If Boston attracts high school graduates who are smarter or more ambitious than those in Flint, it should be no surprise that they earn more. To account for this possibility, I relied on 14 years of data from the National Longitudinal Survey of Youth, which has tracked the lives of 12,000 people since 1979. This dataset is particularly useful because it ensures an apples-to-apples comparison by tracking how the salary of a given person changes over time as the number of college graduates in a city changes. The finding? Workers who live in cities where the number of college graduates increases experience faster salary gains than workers who live in cities where the number of college graduates stagnates. The same individual’s salary can thus depend on how many skilled workers are nearby. This relationship holds for all sectors, but it is especially strong for workers with high-tech jobs (Moretti 2004b). Three reasons explain the relationship between the number of skilled workers in a city and the wages of their unskilled neigh- bors. First, skilled and unskilled workers complement each other: an increase in the former raises the productivity of the latter. In the same way that working with better machines increases a worker’s productivity, working with better educated colleagues increases the productivity of an unskilled worker. Second, a better educated labor force facilitates local employers’ adoption of newer and better tech- nologies. Third, an increase in a city’s overall human capital gener- ates human capital spillovers. This concept is at the heart of modern economic growth theory, the study of what determines a country’s economic success. Researchers have built sophisticated mathematical models show- ing that sharing knowledge and skills through formal and informal interaction generates significant knowledge spillovers. These spillovers are thought to be an important engine of economic growth for both cities and nations. Robert Lucas (1988), arguing that these spillovers may be large enough to explain long-run differences between rich 130 Are Cities the New Growth Escalator? and poor countries, showed that people learn from each other when they interact and that this process makes those who interact with better educated peers ultimately more productive and creative. More recent research has extended and articulated the concept (see, for example, Gaspar and Glaeser 1998; Glaeser 1994a, 1994b, 1999). New ideas are rarely born in a vacuum. Social interactions among workers tend to generate learning opportunities that enhance inno- vation and productivity. So the fact that workers earn more in highly educated cities is not an accident but a reflection of the higher labor productivity that comes from working alongside highly educated colleagues and neighbors. Jaffe et al. (1993) used patent citations to understand how knowl- edge diffuses within a circle of friends, colleagues, or scientists in a city. When filing for a patent, inventors are required to list all the inventions that their invention builds on. These links offered the economists an innovative way to track the flow of knowledge among inventors. They found that knowledge is subject to a significant degree of “home bias,” in the sense that inventors are significantly more likely to cite inventors living nearby than those living farther away. Because patents are freely available, citations should not neces- sarily display geographical favoritism. An inventor in, say, Raleigh- Durham, should have the same awareness of products or ideas generated elsewhere as of those generated locally. And yet an inventor in Raleigh-Durham is much more likely to cite a previous invention patented by someone else in Raleigh-Durham than one patented in another city. The home bias is substantial. Excluding citations that come from the same company, citations are twice as likely to come from the city of their citing patent than from other places. This means that scientists and inventors are more familiar with knowledge produced by those who work near them, presumably because they share ideas and information through informal conversations and interactions. These interactions take place both inside and outside the workplace, including casual settings like local cafés and social events. Thus, geography matters for spreading knowledge, and knowledge quickly dies with distance. Citations are highest when the citing inventor is located 0–25 miles from the cited inventor. Citations are far lower when the citing inventor is more than 25 miles from Enrico Moretti 131 the cited inventor, and the effect completely disappears beyond 100 miles. Geographical distance seems to impede the flow of ideas, even within a firm. This alone should discourage companies from out- sourcing any part of the innovation phase to low-cost countries. Take the high-tech company Cadence, with about 2,000 employees in San Jose, 1,000 in India, and another 1,000 scattered around the world. An Indian software engineer at level T4 makes about a third of what a similarly qualified software engineer in San Jose makes. When I asked Cadence’s executive senior vice president, Nimish Modi, why the company does not move more research and development to India, given the potential savings, he told me that proximity and personal interaction matter to the creativity of its engineers. “We have sophisticated videoconferencing facilities, and we use them all the time to communicate with India,” he said. “But it is not the same as face-to-face interaction. Nothing replaces a group of engineers sitting together and arguing in front of the whiteboard.” Being around smart people tends to make us smarter, more cre- ative, and ultimately more productive. And the smarter the people, the stronger the effect. Azoulay et al. (2010) focus on what happens to medical researchers when they work with an academic superstar. It is difficult to establish the causal relationship here because of self- selection: superstars tend to work with strong researchers, so the fact that their collaborators are especially prolific may just happen because they are better, not because they are benefiting from knowl- edge spillovers. To control for this, the three economists focused on what happens to the productivity of a superstar’s collaborators when the superstar dies unexpectedly (they identified 112 such deaths). Although nothing changed in the collaborators’ own circumstances following the superstars’ deaths, they experienced “a lasting 5 to 8 percent decline in their quality-adjusted publication rates” (Azoulay et al. 2010, 2). It is not just that people publish more when they are close, the quality of their research is better. When a team of Harvard Medical School doctors analyzed all medical research articles published at Harvard and correlated their data with the distance between the authors’ offices, they found that being less than one kilometer away raised the quality of research, as defined by how many other 132 Are Cities the New Growth Escalator? researchers cited the article. The effect was even larger if the authors were in the same building. Innovative firms thus have an incentive to locate near other inno- vative firms. In the same way that having a good colleague next door affects my creativity, having good neighbors—even competitors— improves the creativity of companies and workers. This in turn helps explain why workers in cities with many well-educated residents earn higher salaries than identical workers in other areas. By clus- tering near each other, innovators foster each other’s creative spirit and become more successful. These effects have not faded over time. While many people think that e-mail, cell phones, and the Internet have made physical proximity less important to the creative process, in reality the opposite is true. Location is more important than ever, in part because knowledge spillovers are more important than ever. A large number of highly educated workers in a city is also associ- ated with more creativity and a better ability to invent new ways of working. One way to see this is to look at what Jane Jacobs called “new work,” novel occupations that did not exist before. The econo- mist Jeffrey Lin (2011) has studied which cities are the most creative, in the sense that they generate the most new work as measured by jobs that did not exist 10 years earlier. Between 5 percent and 8 percent of workers are engaged in new work at any time in the United States, but this number is much higher in cities that have a high density of college graduates—the ones in Table 5.1—and a diverse set of industries. Lin also found that creativity pays off: for the first few years after a new kind of job is created, workers in those positions earn significantly higher wages than identical workers in old jobs. Implications for regional economic development policies The discussion here has important implications for the future of cities and for the policy makers interested in shaping it. There is something phenomenal about the forces of agglomeration just uncovered. They are responsible for turning a collection of indi- vidual workers and firms into something much larger than the sum of its parts. This generates what economists call localized economies of scale. The term economies of scale usually refers to the ability of companies to become more efficient as they grow. For example, large Enrico Moretti 133 car manufacturers are more efficient than small ones. But instead of applying to a single company, these economies of scale apply to all the companies in a geographical area. Larger cities, and cities with larger industrial clusters, tend to be more efficient because they have a thicker labor market, a more specialized supply of business services, and more opportunities for knowledge spillovers. While individual companies in a cluster do not necessarily become more efficient as they grow, all companies taken together become more efficient as the cluster grows. A surprising implication is that countries are more productive—and thus richer—when a significant fraction of their economic activity is concentrated in some cities, rather than spread out evenly across space. Another implication is that cities that are initially similar can grow apart economically over time (Moretti 2012). These differences are no accident—they are the predictable result of the three forces of agglomeration. Cities with the right sectors and with workers who have the right skills are likely to strengthen their position over time, while others, trapped by their pasts, are likely to keep losing ground. It is a tipping-point dynamic: once a city attracts some innovative workers and companies, its economy changes in ways that make it even more attractive to other innovative workers and companies. This tends to generate a self-sustaining equilibrium, with many skilled individuals looking for innovative jobs and innovative companies looking for skilled workers.7 This is a case where the future of a city depends on its past. Social scientists call it path dependency. This presents a significant challenge for policy makers, as it means that cities without a strong local economy might find it difficult to start one. It is a classic chicken- and-egg problem. Specialized workers will not move to a city that does not have a cluster because it will be hard to find an employer that values their unique skills. Innovative companies will not move there because finding specialized labor will be difficult. This presents a terrible challenge for communities that have fallen on hard times and are struggling to reinvent themselves. The economics of big pushes A successful city’s economy is based on a remarkable equilibrium between labor supply and demand: innovative companies (the labor 134 Are Cities the New Growth Escalator? demand) want to be there because they know they will find workers with the skills they need, and skilled workers (the labor supply) want to be there because they know they will find the jobs they are looking for.8 The economy of a struggling city is the opposite. Even if real estate is dirt cheap, skilled workers do not want to be there, because they know there are no jobs; innovative companies do not want to be there either, because they know there are no skilled workers. It would be in the interest of one group to move if the other did, but neither wants to go first. It is a catch-22 (Moretti 2012). One way to move a city from a bad equilibrium to a good one is with a big push: a coordinated policy that breaks the impasse and simultaneously brings skilled workers, employers, and specialized business services to a new location. Only the government can initiate these big-push policies, because only the government has the ability to coordinate the individual actors—the workers and employers—to get the agglomeration process going. The idea is to provide public subsidies for those willing to move first but then stop the subsidies after the process becomes self-sustaining. The first and most important big push in U.S. history was the Tennessee Valley Authority (TVA), created amid the Great Depression to lift a desperately poor region out of poverty. In practice, this meant investing in large infrastructure programs, particularly electricity- generating dams, whose power was used to electrify the region and boost local productivity; an extensive network of new roads; a 650-mile navigation canal; schools; and flood control systems. A smaller portion of the funds was devoted to malaria prevention, reforestation, education programs, and health clinics. The program’s enormous scale went far beyond anything attempted before or since. Over 1933–58, $30 billion from U.S. taxpayers poured into the region. At the program’s peak, in 1950, the annual federal subsidy to the region was $625 per household. After 1958, the federal government began to scale back its investment, and the TVA became a largely self-sustaining entity. This program is not unlike regional economic development poli- cies that many developing countries currently adopt. This approach to economic development is based on the intuitive notion that public monies can jump-start a local economy trapped in poverty. But crit- ics on both the right and the left have lambasted such initiatives, Enrico Moretti 135 either as big government overreach or top-down control of local communities. In an influential 1984 article in the New York Review of Books, the progressive urban thinker Jane Jacobs wrote a scathing critique of big-push policies, including the TVA, arguing that it is an unnatural way to foster local economies and concluding that they work miserably in practice. How can we rigorously assess these place-based policies? The real test is not whether they create jobs during the push. The fact that an inflow of money temporarily increases economic activity in an area is hardly a sign that the money was well spent. We need to look instead at whether the publicly financed seed can eventually generate a privately supported cluster large enough to sustain itself. The idea is that government investment carries the local economy past the tipping point but no further. At that point, the forces of agglomera- tion take over, continuing to attract businesses and workers well after the subsidies end. A recent study of the TVA found that the program succeeded in generating an industrial revolution in an area that had to that point been largely rural (Kline and Moretti 2012). During the big-push years of 1933–58, manufacturing jobs in the region grew much faster than they did in the rest of the country—companies found the cheap electricity and easy transportation attractive—and manufacturing jobs kept growing faster after the federal subsidies dried up. Even in 2000, more than 40 years after the end of the federal transfers, manufacturing jobs in the region were growing faster than those in comparable parts of the south, though the effect is now slowing and will probably soon disappear. While the program succeeded in moving the region from a low-productivity sector (agriculture) to a high-productivity sector (manufacturing), it did not succeed in rais- ing local wages in any significant way. The reason is simple: as more and more jobs were created, more and more workers moved there from the rest of the south to take advantage of improved economic conditions. This increase in the supply of labor effectively offset the increase in demand. The fundamental challenge with this type of place-based policies is that for them to be successful, local policy makers must be able to pick promising companies to invest in. They need to be a little like venture capitalists. In this sense, President Franklin Roosevelt 136 Are Cities the New Growth Escalator? had it easy. When manufacturing was the engine of job growth and prosperity depended on infrastructure and cheap energy, the recipe for development was obvious. The level of industrial development in the Tennessee Valley was so low that it hardly mattered whether an aluminum smelter, a steel factory, or a chemical factory opened its doors. But today, the most important determinant of success for local communities is human capital, and making the right call is much harder. Should a county spend all its money attracting a new nanotech lab, or should it go for Amazon’s latest computer farm? A solar-panel research and development facility or a biotech lab? Even professional venture capitalists have a hard time predicting which industries and companies will succeed. For mayors of struggling municipalities, this challenge can prove insurmountable. Overall, the track record on industrial public subsidies in the United States and Europe is not great. It is simply too difficult for policy makers, even the brightest and best intentioned, to identify winning industries before they become winners. Even if it were clear which industries would drive future growth, it would still be difficult to pick winning companies within those industries. Indeed, looking at the United States’ most successful industrial clusters, it is hard to find one spawned by a big push. No local poli- tician set out to create Silicon Valley. In Austin, San Diego, and Seattle, the success of an original anchor company was typically the seed that grew into a high-tech or life-science cluster. The same is true for smaller, more specialized clusters, arguably a more realistic goal for struggling communities. Consider Boise, Idaho; Kansas City, Kansas-Missouri; and Portland, Oregon, three small high-tech hubs anchored by semiconductors, general high tech, and animal health and nutrition sciences, respectively. Although small, these centers are dynamic: Boise and Portland produce almost as many patents per capita as Boston. None of these hubs was planned. The opening of Intel’s semiconductor facility in 1976 jump-started Portland’s high- tech sector. The seed for Boise was planted in 1973, when Hewlett- Packard moved its printer division there. Life science research and development in Kansas City can be traced back to the 1950s, when Ewing Marion Kauffman started his pharmaceutical lab. Little of the high-tech presence in these cities resulted from aggressive recruit- ment of companies by local governments (Moretti 2012). Enrico Moretti 137 Other parts of the world have seen some success. Ireland used a deliberate big-push policy to build up new human capital–intensive sectors. Through aggressive tax incentives and other enticements, it created clusters in high tech and finance, though the country’s recent financial crisis throws the sustainability of such policies into question. Israel’s high-tech cluster, one of the world’s most dynamic, depends highly on the country’s military. Although the Israeli government did not set out to create a local high-tech sector, its need for innovative defense technologies and specialized human capital indirectly fostered a private sector that later became globally competitive. Perhaps the best example of big-push success is Taiwan, China, which in the 1960s and 1970s transformed its rural economy into an advanced one with a dynamic innovation sector through a large-scale policy of government-sponsored research. The program brought top Chinese scientists back from the United States and established a clus- ter of publicly supported research and development that eventually became thick enough to sustain private companies. This is one of the rare instances in which policy makers turned out to be good venture capitalists. While they did bet on several failed technologies, they also bet on semiconductors very early on. Semiconductors quickly became the core of Taiwan, China’s, high-tech sector and arguably one of its engines of prosperity. More recently, Taiwan, China’s, high- tech cluster has embraced newer technologies, including life sciences. But Taiwan, China, might just be the exception that proves the rule. Cluster building Ever since Harvard scholar Michael Porter popularized the catchy concept of cluster building in the early 1990s, cities and states have been trying to engineer economic clusters through a variety of public policy measures.9 A widespread example of place-based industrial policies is the use of economic subsidies to attract large companies to struggling communities in order to seed a cluster. Virtually every time a company announces plans for a new headquarters, a lab, or a large production facility somewhere in the United States, the bid- ding begins. States compete aggressively by offering larger and larger enticements in the form of tax breaks, subsidized loans, local infra- structure, export assistance and financing, workforce training, and 138 Are Cities the New Growth Escalator? area marketing. These subsidies can be incredibly large. Panasonic recently received more than $100 million ($125,000 per job) to move its North American headquarters to Newark, New Jersey, while Electrolux was given $180 million ($150,000 per job) in tax abate- ments for its new establishment in Memphis, Tennessee. Mercedes received a $250 million incentive package ($165,000 per job) for locating in Vance, Alabama. Total state spending on local economic development amounts to $40 billion a year, far more than the cumu- lative federal spending for the TVA over its 30 years of government subsidies. While politicians and the companies they subsidize usually extol the benefits of these deals, critics complain that they are a huge waste of public money. Is spending $150,000 per job really the best way to help the residents of Memphis? What if we just wrote checks to those residents instead? Greenstone et al. (2010) have studied what hap- pens to local communities when their bid to attract a large employer by offering subsidies succeeds. When firms are considering where to open a large plant, they typically begin by looking at dozens of loca- tions. They narrow the list to roughly 10 sites, from which two or three finalists are selected. The study compared the experience of the counties that the company ultimately chose (the winner) with the runner-up counties (the losers). For example, when BMW decided to open a new plant in the United States in the 1990s, the decision of where to locate it came down to two finalists: Greenville-Spartanburg, South Carolina, and Omaha, Nebraska. BMW choose Greenville- Spartanburg, partly because of an incentives package worth $115 million. In this case and others, the losers were counties that had survived a long selection process but narrowly lost the competition. These cases can therefore tell us how the winner county would have fared if it had decided not to bid. The study finds that in the years leading up to such a bidding war, winners and losers were similar in terms of employment, salaries, and productivity. But after, the winners’ productivity surged. These productivity gains, which appeared to reflect knowledge spillovers, were particularly large for existing plants that shared similar labor and technology pools with the new plant. Thus, by making exist- ing producers more productive, a new plant generated an important benefit—a positive externality—for the rest of the country’s establish- Enrico Moretti 139 ments. This higher productivity led to more jobs and higher wages. So, the provision of subsidies might be seen as a way to internalize this externality. To be efficient, however, the provision of the subsidy should be commensurate with the magnitude of the social benefit. When dozens of similar counties are desperate to attract outside investment, their bids sometimes become so generous that they exceed the social benefits to the community. Mayors and governors have an incentive to bring the new company to town, no matter what the cost. When they succeed, front-page stories in local newspapers tend to focus on the hundreds of future local jobs, not on the fine print of the financial packages offered. When they do not succeed, local politicians are lambasted for not doing enough for the local economy. All this can lead local governments to overbid. In such a case, the only winners are the owners of the company being courted, because state and local governments end up stuck with the bill. At a more fundamental level, one has to wonder about the aggre- gate impact of place-based policies for the entire country. Even when these subsidies make economic sense for a particular community, they do not always make sense for the country as a whole, as com- petition among municipalities for a given company can turn out to be a zero-sum game for the nation (Glaeser and Gottlieb 2008). It is even possible that these policies have a negative impact on aggregate economic activity. Just like any other example of government inter- vention, place-based policies redistribute economic activity from one part of the economy to another. If the economic cost to communi- ties that pay for the transfer is larger than the economic benefit to communities that receive it, these policies may end up hurting the country as a whole. More economic research is needed to establish whether this possibility is empirically relevant. Universities and local jobs Given the importance of human capital for local economic develop- ment, many local governments seek to raise the education of their residents by supporting local colleges and universities. But do univer- sities really change a community’s economy? The role of colleges and universities in local development is complex. As seen, the number of 140 Are Cities the New Growth Escalator? college-educated workers is the key factor driving cities’ economic success. But college graduates are a very mobile group, and they do not necessarily stay in the city where they went to school unless market conditions are attractive. Research shows that the presence of a college or university in a city increases both the supply of college graduates, by educating some and attracting others from outside, and the demand for col- lege graduates, by making them more productive (Moretti 2004a). The demand effect comes through three channels. First, some busi- nesses are created directly as a result of academic research. Recent research indicates that the passing of the Bayh-Dole Act in 1980, which encouraged universities to exploit their innovations com- mercially, resulted in job growth for communities near universities. Since 1980, the Massachusetts Institute of Technology has generated 3,673 patents; companies started by graduates and faculty generate $2 trillion in sales each year. Stanford University and the University of California (Berkeley) can make similar claims. A second important benefit of universities is that academic research generates the kind of knowledge spillovers discussed earlier, and this further fosters a local innovation sector. Jaffe (1989) found that this spillover effect is particularly relevant in pharmaceuticals, medical technology, electronics, optics, and nuclear technology. While some of the spillover accrues to companies everywhere, a significant part is local. A third channel is through a university’s medical school and its associated hospital. Because hospitals are open 24 hours a day and provide one of the most labor-intensive and skill-intensive prod- ucts, they generate hundreds or even thousands of high-paid local jobs. Much health care is a local service, following local prosperity rather than causing it. But sometimes hospitals become regional or national providers. Rochester, Minnesota (home to the Mayo Clinic), Pittsburgh, and Houston attract patients from all over the country and beyond. These hospitals are effectively producing a trad- able service that is exported outside the local economy—not unlike Microsoft and Apple—and therefore their presence is an important driver of local wealth. Overall, research suggests that the presence of a university is on average associated with a better educated labor force and higher Enrico Moretti 141 local wages (Moretti 2004a). But mayors and local policy makers should realize that a university—even a good one—is no guarantee of economic success. While most large cities have universities, only a small fraction of metropolitan areas have large concentrations of innovative industries. Washington University in St. Louis is a better academic institution than the University of Washington in Seattle, but St. Louis has few high-tech jobs to show for it. In fact, its popula- tion has been declining for 50 years, while Seattle is now one of the world’s most dynamic innovation hubs. Arizona State University and the University of Florida are among the largest U.S. institutions of higher education, but Phoenix and Gainesville rank low on the list of innovation hubs. Cornell and Yale dominate global academic rank- ings, but other than employers directly connected to these universi- ties, there is little in Ithaca and New Haven to suggest a world-class high-tech cluster. So, proximity to a research university is important, but it alone is not enough to form a sustainable cluster of innovative companies. This is a key distinction, one ignored by countless local governments— from Las Vegas to Detroit, from Italy to China—that invest scarce resources in creating research centers. Universities are most effective at shaping a local economy when they are part of a larger ecosystem of innovative activity, one that includes a thick market for specialized labor and specialized intermediate services. Once a cluster is established, colleges and universities play an important role in fostering its growth, often becoming a key part of the ecosystem that supports it and makes it successful. Who really benefits from place-based policies? Government policies can be justified on grounds of either efficiency or equity. This chapter has discussed under what conditions place- based policies are an efficient use of taxpayer money. It now turns to the question of who benefits from these policies. This is not easy to answer in practice, because the beneficiaries of place-based industrial policies are not necessarily those directly targeted by policy makers. This has to do with the tight link between a city’s labor market and its housing market. 142 Are Cities the New Growth Escalator? An increase in a city’s labor demand has two effects. It raises employment and local wages. And the increase in employment raises the local cost of housing. Cities where labor demand is strong tend to have higher housing costs than those where it is weak, so that differences in salaries adjusted for cost of living (real salaries) are smaller than differences in unadjusted salaries (nominal salaries). An interesting implication is that a significant part of the wealth created by the dynamism of cities with a strong labor market accrues not just to workers through the labor market but to homeowners through the housing market, in the form of capital gains. These capital gains are an important channel for some residents of an area to benefit from the strength of their local economy. For renters, however, the effect of a strong labor market is tempered by the increase in their monthly housing costs. The economic benefit created by regional development policies designed to increase a city’s employment is ultimately split between local workers (in higher wages) and local homeowners (in higher housing values). The change in real estate prices effectively redistrib- utes the wealth created by job growth from one group to another. The split depends on how accommodating the supply of housing is and how mobile workers are (Moretti 2011). It is important to recognize that local governments can affect the split. Policies that allow for increases in local housing stock following increases in local employment tend to keep housing prices in check, thus favoring workers who do not own a house. By contrast, policies that limit growth in the housing stock tend to result in housing cost increases, thus favoring homeowners (Glaeser et al. 2005). Land-use regula- tions, then, are an important mechanism that local governments can use to redistribute the wealth created by job growth from home- owners to renters. *** Despite all the hype about exploding connectivity and the death of distance, location matters now more than ever. Our best ideas still reflect the daily, unpredictable stimuli that we receive from the people we come across and from our immediate social environment. Most of our crucial interactions are still face to face, and most of Enrico Moretti 143 what we learn that is valuable comes from the people we know, not from Wikipedia. The number of telecommuters as a fraction of the total labor force is still incredibly small. Video conferencing, e-mail, and Skype have not made a dent in the need for innovative people to work side by side. In fact, that need is more important than ever. Even as goods and information travel faster and faster to all corners of the globe, there is an inverse gravitational pull toward key urban centers. Globalization and localization seem to be two sides of the same coin (Moretti 2012). It was not supposed to be this way. At the peak of the dot-com frenzy in 2000, observers of all stripes almost unanimously concluded that “the new economy gives both companies and workers more locational freedom.” In The World Is Flat, one of the most influential books about globalization, Thomas Friedman famously argued that cell phones, e-mail, and the Internet lowered communication barriers so much that location was irrelevant. Distance was dead. Geography did not matter. This argument continues to resonate. The idea is that no matter where people live, they can share knowledge and move products at virtually no cost. According to this view, the good jobs, now concentrated in high- cost locations such as Bangalore and Silicon Valley, will quickly disperse to low-cost locations. This process of dispersion, the argu- ment goes, will be faster than the dispersion of manufacturing jobs, because moving software codes over the internet (using DSL technol- ogy) is easier than moving bulky goods across borders. In this vision of the future, the great innovation hubs of the globe will disappear, and innovation jobs will disperse evenly across the country. The key prediction is economic convergence. Low-cost areas will attract more and more of the new, high-paying jobs. Cities that have been lagging—the Clevelands, the Mobiles, the Topekas—will grow much faster. Bogged down by their high costs, New York, San Francisco, Seattle, and similar cities will decline. But the data do not support this view. In fact, the opposite has been happening. For innovation, a company’s success depends on more than just the quality of its workers—it also depends on the sur- rounding ecosystem. This is important, because it makes innovation harder to delocalize than traditional manufacturing. A textile factory 144 Are Cities the New Growth Escalator? is a standalone entity that can be put pretty much anywhere labor is abundant. By contrast, a biotech lab is harder to export, because you would have to move not just one company but an entire ecosystem. A growing body of research suggests that cities are not just a col- lection of individuals but are complex, interrelated environments that foster the generation of new ideas and new ways of doing business. For example, social interactions among workers tend to generate learning opportunities that enhance innovation and pro- ductivity. Being around smart people makes us smarter and more innovative. By clustering near each other, innovators foster each other’s creative spirit and become more successful. Thus, once a city attracts some innovative workers and innovative companies, its economy becomes even more attractive to other innovators. In the end, this is what is causing an increased concentration of good jobs, talent, and investment. This does not mean there is no merit to the view that low-cost areas are destined to catch up. At a global level, the most important eco- nomic development of the past decade is the incredible improvement in the living standards of low- and middle-income countries, such as Brazil, China, India, and Turkey, and even some African countries. Their strong economic performance has greatly narrowed their gap with rich countries, thus contributing to a marked convergence in incomes. The catch-up experienced by the southern United States over the past 50 years is another example of convergence. Many southern states were much poorer than the rest of the country in the 1960s but grew more rapidly in the following decades. Yet in both cases, the process of catching up was geographically uneven. Some southern cities—Atlanta, Austin, Dallas, Houston, and Raleigh-Durham, for example—grew much faster than others, thus increasing the disparity among communities in the south. Developing countries exhibit similar regional differences. In China, Shanghai has reached a per capita income close to that of a rich nation. Its students outperform American and European students in standardized tests by a wide margin. Its public infrastructure is better than that of most U.S. cities. But agricultural communities in western China have made much less progress. The regional differences in China have clearly grown, even if the difference between China and richer countries has shrunk. Enrico Moretti 145 The implications for economic policy are complex. Visionaries have been trying to build thriving cities from the time people started living in them. Utopian communities have always ignited imagina- tions, with their promise of curing social ills through enlightened planning and strong values. In most cases, these communities have not lasted. People often have unrealistic expectations of their governments. The role that local governments can play in revitalizing struggling communities is less extensive than most voters realize and most mayors would like to admit. The reality is that a city’s economic fate is determined largely by historical factors. Path dependency and strong forces of agglomeration present serious challenges for com- munities without a well-educated labor force and an established innovation sector. Local governments can certainly lay a foundation for economic development and create all the conditions necessary for a city’s rebirth, including a business climate friendly to job creation, but there is no magic formula for redevelopment. Like politics, all innovation is local: each community has its own comparative advantage. Local governments must build on their existing capabilities by leveraging local strengths and expertise. The use of public funds to create jobs must be reserved for when there are important market failures and a community has a credible chance of building a self-sustaining eco- nomic cluster. Ultimately, though, local policy makers should realize that when it comes to local development, there is no free lunch. Notes 1. A recent version of special economic zones is represented by “charter cities,” an idea originally promoted by economist Paul Romer. Honduras is seeking to develop a new major economic cluster from scratch. The idea of a charter city is an extension of the idea of special economic zones. But unlike the typical special economic zone, the political and legal institutions in Romer’s charter cities are not those of the host country, which is often corrupt and inefficient. They are instead the institutions of some external, well-functioning country. 2. This section is based largely on Moretti (2012). 3. To obtain a precise measure of the differences among metropolitan areas, I used data on 15.4 million workers ages 25–60 living in 306 metropolitan areas from the American Community Survey, collected 146 Are Cities the New Growth Escalator? every year by the U.S. Census Bureau The Census Bureau defines met- ropolitan areas to include not just the political boundaries of a city but also its neighboring communities, to the extent that commuting patterns suggest that they are part of the same local labor market. Metropolitan areas are thus economically integrated regions that include places where people live and work. The New York metro area, for example, includes New York City and its suburbs in Long Island, New Jersey, Connecticut, and Westchester County. I focus on metro areas with employment of greater than 200,000. (In this chapter, I use the terms city and metropolitan area interchangeably.) 4. Of course, the relationship with innovation is not perfect. Stamford has a thriving financial sector but not many high-tech startups. 5. An important example of specialized service providers for innovative companies is venture capital. People have remarked for decades that one of the secrets of Silicon Valley’s success is its deep and articulated venture capital base. But what does proximity have to do with funding? Why, in a world of fast communication and cheap plane tickets, should venture capitalists on Sand Hill Road favor startups near them? The answer is that venture capitalists do not simply write a check and then disappear. An increasingly important part of their job involves monitor- ing, nurturing, and mentoring new businesses. This is why location matters. Nurturing and monitoring are clearly easier if the startup is nearby. In the end, geographical proximity to venture capitalists still matters. Skype and cell phones have not changed this simple fact. This is one reason that the world of high tech is and will remain geographi- cally concentrated. 6. The outlier in the top right corner is Stamford. Because 305 other cities are in the graph, the relationship is not driven by this outlier. 7. None of this should be an argument for complacency for successful cities. The forces of agglomeration are no guarantee that cities will keep their lead in innovation forever. Detroit was the Silicon Valley of its day, and its successful industrial cluster has largely disappeared. 8. This section is based largely on Moretti (2012). 9. This section is based largely on Moretti (2012). Bibliography Azoulay, Pierre, Joshua S. G. Zivin, and Jialan Wang. 1988. “Physicians’ Services and the Division of Labor across Local Markets.” Journal of Political Economy 96 (5): 948–82. ——–—. 2010. “Superstar Extinction.” The Quarterly Journal of Economics 125(2): 549–89. 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Moretti, Enrico. 2004a. “Estimating the Social Return to Higher Education: Evidence from Longitudinal and Repeated Cross-Sectional Data.” Journal of Econometrics 121 (1–2): 175–212. ——–—. 2004b. “Workers’ Education, Spillovers and Productivity: Evidence from Plant-Level Production Functions.” American Economic Review 94 (3): 656–90. ——–—. 2011. “Local Labor Markets.” In Handbook of Labor Economics, vol. 4B, edited by Orley Ashenfelter and David Card, 1237–313. London: Elsevier. ——–—. 2012. The New Geography of Jobs. New York: Houghton Mifflin Harcourt. U.S. Census Bureau. 2008. American Community Survey 2008. Washington, DC. 6 Entrepreneurship, Public Policy, and Cities Joshua Lerner Since the 2008–09 global financial crisis, interest among policy mak- ers in promoting innovative, high-potential ventures has exploded. The emerging great hubs of entrepreneurial activity—like Bangalore, Dubai, Shanghai, Silicon Valley, Singapore, and Tel Aviv—bear the unmistakable stamp of the public sector. Enlightened government intervention played a key role in each region’s emergence. But for each effective government intervention, dozens, even hundreds, dis- appointed, with substantial public spending bearing no fruit. This scenario might lead one to conclude that the public sector’s pursuit of entrepreneurial growth is a massive casino where bets are made with few guarantees of good returns. Perhaps there are no les- sons to learn from the success or failure of programs to stimulate entrepreneurial activity. The truth, however, is that the disappoint- ing outcomes of many government efforts to promote venture and entrepreneurial activity were all too predictable. These efforts shared flaws that doomed them virtually from the start. The same flaws have 150 Entrepreneurship, Public Policy, and Cities appeared the world over—from Europe and the United States to the newly emerging economies. Fast-growing entrepreneurs—and the investors who fund them— have attracted more attention both in the popular press and from policy makers, who see them as having played a large role in creat- ing new industries and revitalizing economies. Many countries have launched efforts to encourage entrepreneurial activity. This attention will likely intensify as countries seek to overcome the deleterious effects of the credit crunch and its recessionary effects. This chapter sheds light on how governments can avoid mistakes in stimulating entrepreneurship. In recent decades, efforts have increased to provide the world’s poorest with financing and other assistance to facilitate their entry into entrepreneurship or the growth of their small ventures. These are typically subsistence businesses offering services like snack preparation or clothing repair. Such busi- nesses typically allow business owners and their families to get by, but little else. The public policy literature—along with academic studies of new ventures—often does not distinguish among the types of businesses being studied. We will focus here exclusively on high-potential new ventures and the policies that enhance them. This choice, not intended to dimin- ish the importance of efforts to boost microenterprises, reflects the complexity of the field: the dynamics and issues involving microfirms are quite different from those of their high-potential counterparts.1 A substantial literature suggests that promising entrepreneurial firms can have a powerful effect in transforming industries and promoting innovation. The importance of entrepreneurial innovation The world has an enormous appetite for growth. And the need for growth leads inexorably to a hunger for innovation. The United States and other developed countries are confronting a grim eco- nomic calculus: huge unfunded liabilities, plus a lack of economic growth, portend a much bleaker future. In the United States today, public spending and ongoing deficits push the limits of sustainability. And the official balance sheets, if anything, understate the problem: unfunded liabilities, not reflected Joshua Lerner 151 on the government’s official balance sheet, for the two main health- care entitlement programs alone, Medicare and Medicaid, are an estimated $58 trillion (Meeker 2011). Nor do these problems show any signs of easing: recent Congressional Budget Office estimates show the U.S. govern- ment running a deficit until at least 2080 (U.S. Congress 2011). Meanwhile, persistently high unemployment drains the limited resources for social services and shrinks the tax base. The situation in other advanced economies might be worse: Japan, the United Kingdom, and the Eurozone face a toxic mixture of low growth, huge debts, and high unemployment. The quick fix, of course, is to simply cut costs—whether wasteful public programs or excessive entitlements. But this strategy—however necessary in some cases—is not as effective as some would have you believe. As in a number of countries, excessive spending cuts may actually perpetuate the downturns that caused the financial crisis, depressing growth and sapping consumer confidence. This dilemma is not confined to the developed world. Emerging economies have come under enormous stresses and face social unrest and outright revolution. In many cases, uneven economic progress has been a key driver of discontent—as growth has not been substan- tial or widely distributed. Economic growth leads to more working people and fewer unem- ployed, more tax revenue, and a great easing of pressures. And there are essentially two ways to achieve such growth, at least in advanced economies that cannot simply imitate breakthroughs elsewhere. One is simply to add more inputs: having workers, for instance, retire later or run plants for longer hours. But this strategy is a game of diminishing returns: countries can only push people so far to work longer and harder. Nor, in a world of diminishing resources, is it clear that producing more is always desirable. The alternative route is much more appealing: to get more out of existing inputs through innovation. Such innovation can take many forms, from new goods and services to new production processes to improved organization and management. The pioneering work of Moses Abramowitz and Robert Solow in the 1950s (Abramowitz 1956; Solow 1957) finds that technological change is critical to eco- nomic growth: innovation has not just made our lives longer and 152 Entrepreneurship, Public Policy, and Cities more comfortable but has made us richer as well. Many studies have documented the strong connection between technological discover- ies and economic prosperity across countries and over time. This relationship is strongest in advanced countries—that is, those that cannot rely on copying others or on a rapidly increasing population to spur growth. Technological innovation is also critical for tackling the many challenges the world will likely face over the next decades: envi- ronmental degradation, global warming, proliferating pandemics, and terrorism, just to name a few. Our responses—many requiring advances in science and engineering—will shape our future and that of our children. Moreover, there appears to be a strong relationship between entrepreneurship and innovation. The role of start-ups in emerging industries has been highlighted in both case studies and system- atic research. Acs and Audretsch (1988) found that new, small firms developed more than half the 20th century’s most important inno- vations. But the contribution of small firms was not central in all industries. Rather, their role was a function of industry conditions— greatest in immature industries in which market power was relatively unconcentrated. What explains the apparent advantage of smaller firms? Much of it stems from the difficulty of large firms in fomenting innovation. Using extensive case study evidence, Jewkes et al. (1958) note that: It is erroneous to suppose that those techniques of large-scale operation and administration, which have produced such remarkable results in some branches of industrial manufacture, can be applied with equal success to efforts to foster new ideas. The two kinds of organization are subject to quite different laws. In the one case the aim is to achieve smooth, routine, and faultless repetition, in the other to break through the bonds of routine and of accepted ideas. So that large research organizations can perhaps more easily become self-stultifying than any other type of large organization, since in a measure they are trying to organize what is least organizable. But this observation still begs a question. What explains the diffi- culties of larger firms in creating true innovations? Answers explored Joshua Lerner 153 in recent work include at least three reasons entrepreneurial ventures are more innovative. The first has to do with incentives. Normally, firms provide incen- tives to many types of employees, from salespeople to waiters. Yet large firms are notorious for offering employees little more than a gold watch for major discoveries. Why would the design of incentive systems for innovative tasks differ from that for mundane tasks? The weak incentives in large firms may reflect the inherent riskiness and unpredictability of innovative projects, their length and complexity, and the number of parties that could make crucial contributions. Whatever the reason, there is a striking contrast between the very limited incentives at large corporate labs and the stock-option-heavy compensation packages at start-ups. Second, large firms may simply become ineffective at innovating. Incumbent firms frequently have blind spots that stem from their single-minded focus on existing customers.2 As a result, new entrants can identify and exploit market opportunities that the established leaders fail to see. Finally, new firms may choose riskier projects. New firms are more likely to pursue high-risk strategies, while established firms rationally choose more conventional approaches (see, for instance, Aron and Lazear 1990). So while small firms fail more frequently, they are more likely to introduce more innovative products. New firms are better at creating new software categories, while established firms have a comparative advantage in extending existing product lines (Prusa and Schmitz Jr. 1994). So it might be clear why governments would want to promote entrepreneurship, but why the frequent emphasis on venture funds? The answer lies in the challenges facing many start-ups, which often require substantial capital. A firm’s founder may not have the funds to finance these projects alone, and so must seek outside financing. Entrepreneurial firms with significant intangible assets expect years of negative earnings, have uncertain prospects, and are unlikely to receive bank loans or other debt financing. Venture capital—as inde- pendently managed, dedicated pools of capital that focus on equity or equity-linked investments in private, high-growth companies—can help alleviate these problems. 154 Entrepreneurship, Public Policy, and Cities Typically, these investors do not primarily invest their own capi- tal. They usually raise the bulk of their funds from institutions and individuals. Large institutional investors, such as pension funds and university endowments, are likely to want investments in their port- folio that have the potential to generate high yields, such as venture capital, and typically do not mind placing a substantial amount of capital in investments that cannot be liquidated for extended peri- ods. Often, these groups have neither the staff nor the expertise to make such investments themselves, so they invest in partnerships sponsored by venture capital funds, which in turn provide the funds to young firms. We will explore efforts to promote the growth of high-potential entrepreneurial ventures, as well as the venture capitalists that fund them. While the public sector is important in stimulating these activities, far too often public programs have not met their goals. Many of these disappointments could have been avoided, however, if the leaders had taken some simple steps in designing and implement- ing these efforts. The role of the public sector If we have heard too many pronouncements of Silicon Valley leaders, we might begin with the view that the government has nothing to contribute to new ventures (see, for instance, Rodgers 2000). Is this not the realm of heroic entrepreneurs and investors, as far removed from government bureaucrats as imaginable? The history of Silicon Valley and several of the pioneering venture capital groups suggests that reality is far more complex than some of our more libertarian entrepreneur friends might have us believe. In each case, the government’s catalyzing role was critical in stimulating the growth of the region, sector, or firm. This is not to minimize the miscues along the way. There were many challenges with these efforts: Silicon Valley’s pioneers labored with a stop-and-start pattern of government funding: wartimes would see a surge in funding for research and procurement that would just as soon disappear when hostilities ended (see Leslie and Kargon 1996; Saxenien 1994; and especially Sturgeon 2000). And in their early years, the founders of pioneering venture groups, such as American Joshua Lerner 155 Research and Development and 3i, did not clearly distinguish social goals from financial objectives, leading to a muddled mission and confused investors (Ante 2008; Liles 1978). Despite these caveats, it seems clear that the role of the public sector—or, in the case of American Research and Development, individuals operating with a broader social framework in mind—has proven critical for catalyzing growth. To be sure, entrepreneurial markets allow us to make a credible intellectual case for a natural government role in encouraging their evolution. Entrepreneurship is a business with increasing returns. Put another way, establishing a start-up is far easier with 10 other entre- preneurs nearby. Firm founders and venture capitalists benefit from their peers. For instance, if entrepreneurs are active in the market, investors, employees, lawyers, data providers, and the wider capital markets are likely to know about the venturing process and what it takes in terms of strategy, financing, support, and exit mechanisms. In entrepreneurship and venture capital, the actions of any one group are likely to have positive spillovers—or “externalities”—for their peers. Examples abound of government intervention triggering the growth of a venture capital sector. For instance, the U.S. Small Business Investment Company (SBIC) led to the formation of the infrastructure for much of the modern venture capital industry (Bean 2001; Liles 1978; Noone and Rubel 1970). Many of the early ven- ture capital funds and leading intermediaries—such as lawyers and data providers—began as organizations oriented to SBIC funds and then gradually shifted their focus to independent venture capitalists. Similarly, public programs played an important role in triggering the explosive growth of virtually every other major venture market around the globe. But at least two well-documented problems can derail govern- ment intervention programs. First, the programs can simply get it wrong, allocating funds and support in an inept or, even worse, a counterproductive manner. Competent programs are more common in wealthier countries with more heterogeneous populations and an English legal tradition. A second problem, delineated in the theory of regulatory capture,3 is that private and public sector entities will line up to capture direct 156 Entrepreneurship, Public Policy, and Cities and indirect subsidies that the public sector hands out. For instance, programs geared toward boosting nascent entrepreneurs might instead end up boosting cronies of the country’s rulers or legislators. There is no shortage of examples of both problems in the history of public venturing programs: • In its haste to roll out the SBIC program in the early 1960s, the U.S. Small Business Administration chartered—and financed— hundreds of funds whose managers were incompetent or crooked. • The incubators taking part in Australia’s 1999 Building on Information Technology and Strengths program frequently cap- tured the lion’s share of the subsidies meant for entrepreneurs by forcing the young firms to purchase their own overpriced services. • Malaysia opened a massive BioValley complex in 2005 with little forethought as to whether there would be any demand for it. The facility soon became known as the “Valley of the Bio-Ghosts.” • In the 1980s, the British Labor and Conservative governments subsidized and gave exclusive rights to publicly funded biotech- nologies to the firm Celltech, whose management team was inca- pable of exploiting those resources. • Norway squandered much of its oil wealth in the 1970s and 1980s propping up failing ventures and funding ill-conceived new busi- nesses begun by relatives of parliamentarians and bureaucrats. Strategies and their limitations Policies that governments employ to encourage venture capital and entrepreneurial activities take two forms: those that ensure an eco- nomic environment conducive to entrepreneurial activity and ven- ture capital investments; and those that invest directly in companies and funds. First, it is necessary to ensure that entrepreneurship is attractive. Often, in their eagerness to get to the “fun stuff” of handing out money, public leaders neglect to set the table—to create a favorable environment. Making entrepreneurship attractive will likely have several dimen- sions. Ensuring that creative ideas can move easily from universities and government laboratories is critical. But many entrepreneurs Joshua Lerner 157 come not from academia but from corporate positions, and studies have documented that the attractiveness of entrepreneurial activ- ity for these individuals is very sensitive to tax policy. Also impor- tant is ensuring that the law allows firms to enter into the needed contracts—for instance, with a potential financier or a source of technology—and that these contracts can be enforced. Finally, education will likely be critical. Ensuring that business and technol- ogy students are exposed to entrepreneurship classes will allow them to make more informed decisions, and creating training opportuni- ties in entrepreneurship for mid-career professionals will also likely pay dividends. Second, it is important to ensure that international investors find the country or province attractive for investment. In most entre- preneurial hubs emerging in the past two decades, international investors, not domestic institutions, have made the critical early investments. These investors are likely to have the depth of knowl- edge and experience that enables them to make large bets on the most promising organizations. But these players are likely to be reluctant to take part if regulatory conditions are not up to global standards, or if there are substantial concerns about the ability of investors to exit investments. Reaching out to interested and skilled individuals overseas—most often, expatriate entrepreneurs—can also provide a source of capital and expertise. A final important—though very challenging—role for govern- ment is to intervene directly in the entrepreneurial process. As noted, government programs must be designed thoughtfully to be sensitive to the private sector’s needs and the market’s dictates. Because of the “increasing returns” nature of entrepreneurship, these efforts can play an important role in an industry’s early days. At the same time, governments must avoid the common pitfalls of public venture initiatives. I divide these pitfalls into two categories: conceptual issues, which doom a program from its very start, and implementation issues, which create problems as the programs enter operation. One common conceptual problem is to ignore the realities of the entrepreneurial process. For instance, many public venture capital initiatives are abandoned after a few years: the programs’ designers apparently did not understand that these initiatives take 158 Entrepreneurship, Public Policy, and Cities many years to bear fruit. Others have added requirements—such as the stipulation that portfolio companies focus only on explicitly “precommercial” research—that, while seemingly reasonable from a public policy perspective, run counter to the entrepreneurial process. In other cases, reasonable programs have been created that are too tiny to have any impact or so large that they swamp already existing funds. A second common conceptual problem is to ignore the market’s dictates. Far too often, government officials have sought to encour- age funding in industries or geographic regions with a lack of private interest. Whether driven by political considerations or hubris, these efforts have wasted resources. Effective programs address this problem by demanding that credible private sector players provide matching funds. These broad conceptual problems can doom a program even before it starts. But there are also plenty of pitfalls once programs begin. One common implementation problem is not worrying about incentives. Participants in public schemes to promote entrepreneur- ship can do well regardless of whether the program meets the public sector’s objectives. In many instances, they do well even if the com- panies go belly up. The contrast with the best practices among private investors, in which incentives are commonly given scrupulous atten- tion, could not be more striking. Public initiative managers should pay more attention to what will happen in various scenarios and how incentives can lead to problematic behavior. Another implementation pitfall is the absence of appropriate eval- uation mechanisms. Ideally, programs will undergo careful scrutiny at two levels. First, each program will be carefully analyzed. While recognizing that any initiative will take time to bear fruit, it is impor- tant to periodically take stock of what appears to be working and what is not. Second, fund managers and firms participating in the programs should also be scrutinized. It is important to ensure that the groups benefiting from these programs show the most promising market performance and have the most potential to benefit, rather than simply being most adept at garnering public funds. A final common implementation issue is to ignore the inter- national nature of the entrepreneurial process. In today’s global venture industry, limited partners’ capital commitments, venture Joshua Lerner 159 capitalists’ investments, and entrepreneurial firms’ spending increas- ingly flow across borders and continents. To attempt to build a local entrepreneurial sector and venture capital industry without strong global ties is a recipe for an irrelevant sector without much economic impact. Yet in many instances, international participation is actively discouraged. Research and case study findings on program outcomes Many policy makers suggest that they are interested primarily in enhancing the growth and dynamism of entrepreneurial companies in their region as a lever for overall regional or national economic performance. A few policy levers are consistent with achieving that objective. Remember that entrepreneurial activity does not exist in a vacuum Entrepreneurs depend heavily on their partners. Without lawyers to negotiate agreements, marketing gurus and engineers to work for low wages and a handful of stock options, and customers to take a chance on young firms, new ventures are unlikely to grow. But despite the importance of the entrepreneurial environment, government officials often hand out money without considering the other barriers entrepreneurs face. This behavior is unlikely to address the problems of young firms. In some cases, crucial aspects of the entrepreneurial environment may initially seem tangential, such as robust public markets for young firms to spur venture investment. Singapore took a broader view, addressing not just a lack of capital but also the many other barriers impeding the creation of a productive arena in which entrepreneurs can operate. Leverage the local academic scientific and research base more effectively One precondition of entrepreneurship deserves special mention: in many regions, the low level of entrepreneurial activity and venture capital financing does not match the strength of the scientific and 160 Entrepreneurship, Public Policy, and Cities research base. The role of technology transfer offices is critical here. Effective offices do far more than simply license technologies; they also work closely to educate nascent academic entrepreneurs and facilitate introductions to venture investors. It is crucial to build the capabilities of local technology transfer offices and ensure that both potential academic entrepreneurs and technology transfer personnel have opportunities to train in the nature and mechanics of forming a new firm. All too often, technology transfer offices are encouraged to maximize the short-term returns from licensing transactions. This leads to more transactions with established corporations that can make substantial upfront payments, even though considerable evi- dence suggests that licensing new technologies to start-ups can yield substantial returns in the long run, both to the institution and to the region as a whole. If policy makers are serious about developing an entrepreneurial sector, they must think seriously about how technol- ogy is transferred, the incentives offered, and their consequences. Respect the need for conforming to global standards It is natural to want to hold onto long-standing approaches in such matters as securities regulation and taxes. These approaches have evolved to address specific problems and have proven effective. Despite the reluctance to change, there is a strong case for adopting the de facto global standards if a country is serious about promoting entrepreneurship and venture capital. Global institutional investors and venture funds will likely be discouraged if the customary part- nership and preferred stock structures cannot be employed in a given country. Even if a perfectly good alternative exists, they might be unwilling to devote the time and resources to explore it. Unless one is in a country like China—where global investors will feel compelled to master the system, no matter how complex, because of the size of the market opportunity—there is much to be said for allowing trans- actions that conform to the models widely accepted as best practice. Let the market direct where subsidies should go to stimulate entrepreneurial and venture activity Two efforts that have largely met their goals (at least so far) are Israel’s Yozma program and New Zealand’s Seed Investment Fund. While Joshua Lerner 161 these programs differed in their details—the first was geared toward attracting foreign venture investors while the second encouraged local, early-stage funds—each used matching funds to determine where public subsidies should go. In undertaking these efforts, the following should be kept in mind: • The right firms or funds will not likely be identified overnight. Rather than funding dozens of groups immediately, it makes more sense to first fund a handful of entities. As feedback is received from the early participants, it may be appropriate to launch a second and third batch, or instead to supplement the capital of the pioneering firms and funds. • These initiatives should not compete with independent venture funds or engage in the protracted financing of substandard firms that cannot raise private financing. It would thus help if these efforts, emulating initiatives that have succeeded in the past, required a large amount of funds to be raised from non-public sources. • In selecting which venture funds to provide with capital, it may be a challenge to interest top-tier venture groups. Rather, the expectation should be that a region can attract solid groups with a particular interest in industries where there is already real local strength. • In the same spirit, policy makers might cast their net broadly in terms of the types of firms and funds they seek to attract. In addition to conventional standalone start-up venture funds, they might also consider encouraging corporate spin-offs and venture funds. • In encouraging seed companies and groups, extensive interven- tion might be needed before these groups should get funding. This could entail working closely with the groups to refine strategies, recruit more partners (perhaps even from other regions), and identify potential investors. Moreover, the firms and groups must retain enough “dry powder” not to go belly up once the govern- ment subsidies run out. Having the right leader is critical for these interventions to be effective. • Policy makers can encourage success by publicizing in advance their evaluation criteria for prospective firms and funds and if the criteria are close to those in the private sector. 162 Entrepreneurship, Public Policy, and Cities Resist “overengineering” entrepreneurship and venture capital initiatives Government requirements that limit the flexibility of entrepreneurs and venture investors can be very detrimental. It is tempting for policy makers to restrict where firms can operate, the types of securi- ties that venture investors can use, or the evolution of the firms going forward (for example, restrictions on acquisitions or secondary sales of stock). The government should eschew such efforts to microman- age the entrepreneurial process. While it is natural for firms and groups receiving subsidies to retain a local presence or to continue targeting the local region for investments, it can help to minimize these requirements. Recognize the long lead times of public venture initiatives Impatience is one of the common challenges of public entrepreneur- ship and venture capital initiatives. Building an entrepreneurial sector is a long-term endeavor. Promising programs must have enough time to grow. Far too often, promising initiatives have been abandoned on the basis of incomplete (and often, not the most critical) indicators, such as low interim rates of return of initial program participants. Moreover, many politicians have unrealistic expectations about the likelihood of job growth from these efforts in the short and medium terms. Young, high-impact firms are no doubt an engine of job cre- ation, particularly at the regional level.4 But even substantial innova- tion-driven entrepreneurship might be unable to quickly overcome a jobs problem. As the last few years have shown, massive layoffs in automobile manufacturing and construction cannot be solved with even an extremely well-run biotech incubator. Unrealistic expecta- tions and little patience—and consequently the creation of rules that force program participants to focus on short-term returns—are a recipe for disappointment. Find the right size for initiatives Policy makers must walk a fine line in finding the right size for ven- ture initiatives. Too small a program will probably have little impact Joshua Lerner 163 on the challenging environment facing pioneering entrepreneurs and venture funds. Moreover, inflated expectations might create a backlash that will make future efforts difficult. But too large a program risks swamping the local markets. The imbalance between plentiful capital and limited opportunities could introduce patholo- gies. Consider the Canadian labor fund program. It not only backed mostly incompetent groups that did little to spur entrepreneur- ship but also crowded out some of the most knowledgeable local investors. Understand global connections Entrepreneurship and venture capital are increasingly emerging as global enterprises. This evolution has two important consequences. First, no matter how eager policy makers are to encourage activity in their own backyard, they must realize that to meet their goals, firms must have a greater international presence. Restricting firms to local hiring and manufacturing are likely to be profoundly self-defeating. Second, to promote successful firms, it can help to involve foreign investors as much as possible. Substantial benefits can come to local companies in relationships with funds that are based elsewhere but that invest capital locally. Moreover, initial investments that do well will attract more foreign capital. In addition, local affiliates of a fund based elsewhere—having developed an attractive track record—will gain the credibility they need to raise their own funds. That said, when using public funds to subsidize activities by overseas parties, these entrepreneurs and groups should commit to recruiting local personnel and reveal the extent to which the partners based elsewhere will manage the local groups. Institutionalize careful evaluations of these initiatives In the rush to succeed, many policy makers make no provision for evaluating their efforts. The future of these initiatives should be determined by the extent to which they meet their goals, rather than other considerations (such as the vehemence with which pro- gram supporters argue for their continuation). Careful program 164 Entrepreneurship, Public Policy, and Cities evaluations will lead to better decisions. These evaluations should consider not just the participating funds and companies but also the broader context, including: • Gathering and publicizing accurate data on the extent of high- potential entrepreneurship and formal and informal venture capital activity. Some of this information can be collected immediately; other information can be gathered only after some activity. These data will be important not only for program evaluations but also to publicize the growing size and dynamism of the local venture market to prospective investors. • Comparing publicly supported firms and venture groups with their peers to determine the difference the program has made. • Tracking the performance of the companies that are and are not participating in the program, including not just financial returns but also such elements as sales and employment growth. The evaluators might also consider whether it would be feasible to randomize at least some awards, or explore the use of regression discontinuity analysis in the evaluations. Realize that the programs to promote entrepreneurship and innovation need creativity and flexibility Many public venture initiatives are like the villain in a horror film—as much as one tries, they cannot be killed off. Their seeming immortality reflects the capture problem discussed above: powerful vested interests soon coalesce behind these initiatives, making them impossible to get rid of. The countries that have had the public programs with the greatest impacts, on the other hand, have been willing to substitute new incentives for programs not doing well. They have also been willing to end programs because they are too successful—they have met their goals and thus no longer need public funding. Moreover, program rules may have to evolve, even if it means eliminating important classes of participants. If government is going to be promoting entrepreneurship, it needs some of the same qualities itself. Joshua Lerner 165 Recognize that “agency problems” are universal, and take steps to minimize their danger The temptations of directing public subsidies in problematic ways are not confined to any region, political system, or ethnicity. While we might wish that humanity would commit to maximizing the public welfare, more selfish interests are all too common. In designing public programs to promote venture capital and entre- preneurship, limiting the possibilities for such behavior is clearly essential. Defining and adhering to clear strategies and procedures for venture initiatives, creating a “firewall” between elected officials and program administrators, and carefully assessing the programs can help limit these interests. Make education a greater part of the mix It helps if there is an emphasis on education, with at least three dimensions: • The first is building outsiders’ understanding of the local market’s potential. A lack of information is one of the critical barriers to venture investment in a country. Visiting a racetrack for the first time, it is nice to know whether the track favors front-runners or late closers and who the hot local jockeys are. In the same way, institutions often feel much more comfortable investing if they can access information about the level of entrepreneurial activity in local markets, the outcomes of the investments, and so forth. An important role for government is to gather this information directly or to encourage (and perhaps fund) a local trade associa- tion to do so. • Second, in many emerging venture markets, some entrepreneurs have a great deal of confidence but little understanding of the expectations of top-tier private investors, potential strategic part- ners, and investment bankers. The more that can be done to fill these knowledge gaps, the better. • Finally, a broad understanding in the public sector of the chal- lenges of entrepreneurial and venture capital development is very 166 Entrepreneurship, Public Policy, and Cities helpful. In many instances, policy makers have made expensive errors in promoting these activities out of a lack of understanding of how markets really work. Less-consistent approaches Not all suggestions are good. Some are heard frequently—indeed, touted by consultants and intermediaries—but do not align with the global evidence on the right steps to build an entrepreneurial sector or venture capital industry. Local entrepreneurs and venture investors frequently demand that local pools of government funds—whether sovereign funds owned by the states or pension funds for public employees—be allocated largely to domestic entrepreneurs or venture funds. This suggestion, while initially plausible, is problematic for several reasons: • The creation of dynamic markets appears to be driven largely by global private equity limited partners, not local players. Early- stage venture funds—assuming that they can develop a good track record—are likely to attract considerable interest from institu- tional investors. By directing funds to local groups that cannot raise money, governments are likely to be rewarding precisely the groups that do not deserve funds. • As highlighted above, public programs are in real danger of flood- ing the market with far more capital than they can reasonably deploy. Such well-intentioned steps can actually end up hurting entrepreneurs and venture capitalists. • It flies in the face of the principle that public venture capital funds should rely on the market to identify attractive opportunities, rather than mandating activity. While it is hoped that local pen- sion and investment funds will eventually play an important role here, it should be at a pace comfortable for them. A second, less-helpful suggestion is the common demand for pro- visions that would give investors an immediate tax deduction when a venture capital investment is made. A frequently cited model is the CAPCO program, pioneered in Louisiana and adopted by a number of other states. Unfortunately, these efforts have met few of their Joshua Lerner 167 goals. This suggestion, while initially appealing, raises concerns for two reasons: • The evidence suggests that tax policy encourages venture capital primarily through the demand side: the incentive that entrepre- neurs have to (typically) quit their salaried jobs and begin a new firm instead. Little evidence suggests that tax policy can dramati- cally affect the supply of venture capital by the types of sophis- ticated institutional investors that provide capital to the world’s leading venture industries. Indeed, many dominant venture capital investors—such as pension funds and endowments—are tax-exempt in most countries. • One of the powerful features of the venture capital process is the alignment of incentives. No one—whether limited partner, ven- ture capitalist, or entrepreneur—achieves substantial gains until the company is sold or goes public. Economists argue that such an alignment keeps everyone focused and minimizes the danger of strategic behavior that benefits one party but hurts the firm.5 Giving substantial tax incentives at the time of the investment could distort this alignment of incentives. A third suggestion that raises concerns is relying on an outside investment firm to manage a fund-of-funds for that locale. It has been tried in a number of American states but is problematic for several reasons: • The fees charged by these intermediaries are often substantial. These services, while they might appear small (only 1 percent of capital under management), often end up eating a huge fraction of the returns. • The investments by the intermediary might not be driven primar- ily by the local government’s priorities. Intermediary fees can also create incentives to do deals for the intermediary’s own sake, rather than taking the steps that advance the mission of the fund. Thus, a financial institution may be tempted to put the money to work quickly so it can raise another fund (and generate more fees). • There may be funds that the intermediary has a “special relation- ship” with (for example, an investment bank’s fundraising group 168 Entrepreneurship, Public Policy, and Cities may be gathering capital for that group). In these instances, divided loyalties will come into play, and the government’s best interests might not be served. It is thus no surprise that U.S. states that have tried such efforts have seen only very limited growth in their venture industries. Another persistent theme—perhaps the hardest to resist—is the desirability of blindly duplicating programs and incentives provided elsewhere. For instance, many Persian Gulf states have borrowed concepts from Dubai, even if the very fact that the strategies worked for Dubai means that they are less likely to work elsewhere (such as the creation of a major air travel hub). Moreover, there has been a strong temptation to emulate even ill-considered programs. For instance, despite having been widely emulated, incentive schemes in other regions that gave large tax benefits to those investing in entrepreneurial firms have typically not met policy makers’ goals in promoting entrepreneurship. Similarly, we have seen that the widely adopted strategy of instructing local pension fund managers to make economically targeted investments with employees’ funds has had mixed results. Ill-considered steps to promote entrepreneurship and venture capital can be profoundly distorting, attracting inexperienced opera- tors and leading to ill-fated investments. The resulting poisonous legacy can discourage legitimate investors from entering the market for years to come and set back the creation of a healthy industry. So, tempting as it is to match these investment incentives offered by others, if a strategy appears ill considered, it is best avoided. Final thoughts The quest to encourage venture activity can seem like a sideshow among governments’ many responsibilities, from waging war to ensuring the stability of major financial institutions. Certainly, the annual spending on public venture capital programs—while substan- tial in absolute terms—pales in comparison to defense and health care spending. But the picture changes when looking at the long-term consequences of policies that facilitate or hinder the development of a venture sector—that is, a vital entrepreneurial climate’s impact on Joshua Lerner 169 national prosperity. In the long run, the significance of these policies looms much larger. In many cases, there is likely to be a government role in stimulat- ing a vibrant entrepreneurial sector, given the early stage of maturity of these activities in most countries. But it is easy for the govern- ment to overstep and squander its investments in this arena. Only by designing a program that reflects an understanding of, and a willing- ness to listen to, the entrepreneurial process can government efforts be effective. There is also a great need for more academic research in this area. The paucity of research reflects in part the fact that these programs are difficult to evaluate. In undertaking these assessments, one has to ask what would have happened without the subsidies. This may seem pretty daunting: we need to look inside a crystal ball and figure out what would have happened in the parallel universe in which the program did not exist. Of course, a lack of research is a problem in many fields, whether evaluating new pedagogical approaches or testing new pharmaceu- ticals. By conducting randomized trials, in which some otherwise undeserving entities are selected for awards while some otherwise deserving entities are passed over, the impact of the program can be understood. The entrepreneurs who receive awards but are below the cut-off score, and those who are above the line but do not receive awards, are compared with their peers to get a sense of the program’s impacts. In this way, any unobserved differences between the entre- preneurs who received awards and the controls are eliminated. That the entrepreneurs who take part in a government program do better than their peers does not mean the program has made a difference. Rather, the applicants could have been disproportionately the best and the brightest entrepreneurs, smart enough to learn about the program and find the time to fill out the application. Moreover, if there is a competition for the awards, the screening process should pick out the better groups. Yet such trials—however widely adopted in other areas—remain quite rare when assessing public efforts to promote entrepreneurship. A frequent objection to randomization is that it is wrong to know- ingly give public money to an inferior entrepreneur. While we have long been comfortable with the use of randomized trials in medical 170 Entrepreneurship, Public Policy, and Cities research, in which one set of cancer patients gets the experimental drug and another gets the traditional treatment, the introduction of random choices in economic settings makes many leaders nervous. Whatever the merits of their reluctance, it has blocked attempts to use randomization while assessing public venturing programs. Fortunately, there is an alternative: regression discontinuity analy- ses. This type of analysis accounts for the fact that when program managers assess potential participants, there will always be some applications that fall just above the cut-off or just below. By compar- ing these entrepreneurs or venture funds, which are likely to be very similar except that some were chosen for the program and others not, one can get a good sense of the program’s impact without a random- ization procedure. As Adam Jaffe, one of the most vocal advocates of better evaluation approaches, has observed: “I and others have previously harped on randomization as the ‘gold standard’ for pro- gram evaluation. I now believe that [regression discontinuity] design represents a better tradeoff between statistical benefits and resistance to implementation” (Jaffe 2002). But even getting access to data on rejected applicants can be a sensitive process. Getting better research will require that policy makers be more open to policy experiments; it will also take academics willing to work with government officials to address their concerns. While these critical issues can seem arcane and technical, well- considered—or misguided—policies are likely to profoundly influence our opportunities, as well as those of our children and grandchildren. However challenging the encouragement of entrepreneurship might seem, it is too important to be left entirely to policy specialists. Notes 1. For a discussion of these issues, see Schoar (2010). 2. The first example of arguments along these lines I am aware of is Foster (1986). 3. The articulation of this model in the economics literature is frequently attributed to Olson (1965) and Stigler (1971), and its formal modeling to Peltzman (1976) and Becker (1983). 4. See earlier papers in this series, most recently Haltiwanger (2012). 5. For a detailed review of the academic literature, see Gompers and Lerner (2004). Joshua Lerner 171 Bibliography Abramowitz, Morris. 1956. “Resource and Output Trends in the United States since 1870.” American Economic Review 46: 5–23. Acs, Zoltan J., and David B. Audretsch. 1988. “Innovation in Large and Small Firms: An Empirical Analysis.” American Economic Review 78: 678–90. Ante, Spencer. 2008. Creative Capital: Georges Doriot and the Birth of Venture Capital. Boston, MA: Harvard Business School Press. Aron, Debra J., and Edward P. Lazear. 1990. “The Introduction of New Products.” American Economic Review Papers and Proceedings 80: 421–26. Bean, Jonathan J. 2001. Big Government and Affirmative Action: The Scandalous History of the Small Business Administration. Lexington, KY: University Press of Kentucky. Becker, Gary S. 1983. “A Theory of Competition among Pressure Groups for Political Influence.” Quarterly Journal of Economics 98: 371–400. Foster, Richard N. 1986. Innovation: The Attackers’ Advantage. London: Macmillan. Gompers, Paul, and Joshua Lerner. 2004. The Venture Capital Cycle. 2nd ed. Cambridge, MA: MIT Press. Haltiwanger, John. 2012. “Job Creation and Firm Dynamics in the U.S.” Innovation Policy and the Economy 12: 17–38. Jaffe, Adam B. 2002. “Building Program Evaluation into the Design of Public Research Support Programs.” Oxford Review of Economic Policy 18: 22–34. Jewkes, John, David Sawers, and Richard Stillerman. 1958. The Sources of Invention. New York: St. Martin’s Press. Leslie, Stuart W., and Robert H. Kargon. 1996. “Selling Silicon Valley: Frederick Terman’s Model for Regional Advantage.” Business History Review 70: 435–72. Liles, Patrick R. 1978. Sustaining the Venture Capital Firm. Cambridge, MA: Management Analysis Center. Meeker, Mary. 2011. USA Inc. A Basic Summary of America’s Financial Statements. Menlo Park, CA: Kleiner, Perkins, Caufield, & Byers. Noone, Charles M., and Stanley M. Rubel. 1970. SBICs: Pioneers in Organized Venture Capital. Chicago: Capital Publishing. Olson, Mancur. 1965. The Logic of Collective Action. Cambridge, MA: Harvard University Press. Peltzman, Sam. 1976. “Towards a More General Theory of Regulation.” Journal of Law and Economics 19: 211–40. 172 Entrepreneurship, Public Policy, and Cities Prusa, Thomas J., and James A. Schmitz Jr. 1994. “Can Companies Maintain Their Initial Innovation Thrust? A Study of the PC Software Industry.” Review of Economics and Statistics 76: 523–40. Rodgers, T. J. 2000. Why Silicon Valley Should Not Normalize Relations with Washington D.C. Washington, DC: Cato Institute. Saxenien, Annalee. 1994. Regional Advantage: Culture and Competition in Silicon Valley and Route 128. Cambridge, MA: Harvard University Press. Schoar, Antoinette. 2010. “The Divide between Subsistence and Trans- formational Entrepreneurship.” Innovation Policy and the Economy 10: 57–81. Solow, Robert M. 1957. “Technical Change and the Aggregate Production Function.” Review of Economics and Statistics 39: 312–20. Stigler, George. 1971. “The Economic Theory of Regulation.” Bell Journal of Economics 2: 3–21. Sturgeon, Timothy J. 2000. “How Silicon Valley Came to Be.” In Understanding the Silicon Valley: Anatomy of an Entrepreneurial Region, edited by Martin Kenney. Stanford, CA: Stanford University Press. U.S. Congress. 2011. “CBO’s 2011 Long-Term Budget Outlook.” Congressional Budget Office, Washington, DC. http://www.cbo.gov/ ftpdocs/122xx/doc12212/06-21-Long-Term_Budget_Outlook.pdf. 7 Urbanization and (In)Formalization Ejaz Ghani and Ravi Kanbur Inexorable urbanization and formalization have been the expectations in development discourse. The two are expected to proceed hand in hand. Indeed, measures of urbanization and formalization have been proposed and used as indicators of development. But while urbaniza- tion has proceeded apace in developing countries, formalization has slowed significantly over the past quarter century. This disconnect raises questions for development analysis and development policy. Why did we expect urbanization and formalization to go together in the first place? Is the link between urbanization and formalization more complex than what we had once thought? What then explains the recent disconnect between urbanization and formalization? Is formalization a reasonable policy goal? Might urbanization policies and formalization policies conflict? If so, what can be done to resolve the conflicts? These are the questions this chapter addresses. The chapter has three core sections. The first section asks what exactly is meant by formality and informality. It argues that part of the policy confusion on urbanization and formalization arises from the many concepts of informality that abound—ranging from poverty itself, through the small scale of enterprise and a lack of maintained 174 Urbanization and (In)Formalization written accounts, to whether laws and regulations are complied with. Proposing a definition of formality that relates activity to state regulation, the chapter also asks why formalization may have stalled and why informal sectors are large. The second section turns to urbanization processes and asks how they intersect with and interact with the incentives to formalize. It argues that there are two standard mindsets in development discourse—one that expects urbanization to lead to formalization and one that expects urbanization to be associated with increased urban informality. It looks at the origins of these mindsets in the literature and traces their development to the modern literature. In particular, it examines how informality is treated in discussions of urbanization, structural transformation, and agglomeration externalities and finds that treatment to be somewhat lacking. The section also explores how countries might attempt to integrate agglomeration, urbanization, and formalization. The third section looks at policy. Each view of how urbanization feeds formalization has distinctive policy conclusions. Early views of industrialization—as leading to an inexorable pull of the rural population into formal employment—saw industrialization, urban- ization, and formalization as the same thing, to be encouraged by policy. Later views of rural-urban migration—as leading to a transla- tion of rural poverty into urban poverty in the informal sector— coincided with cautions about urbanization and greater support for rural development. We now find ourselves at a juncture where job creation and agglomeration benefits make a strong case for urbaniza- tion as an integral part of development strategy, but concerns about urban poverty in the informal sector are folded into general concerns about congestion costs that run counter to such a policy stance. The section then considers whether any policy packages can harvest the benefits of density that urbanization can offer, while managing the downside. The response to urban informality turns out to be an important part of such a policy package. Formality: concepts, measurement, and trends The terms formality and informality are very common in develop- ment discourse. Technical and policy discussions are replete with Ejaz Ghani and Ravi Kanbur 175 these terms, and their use dates back several decades, intersecting with other terms such as “dual economy” or dualism between a “modern/capitalist” sector and a “traditional” sector. And discussions of the rural-urban transition also overlap with debates on informality. Given this attention in the literature, one might expect the evolu- tion of a clear and consistent conceptualization and measurement of formality and informality. But as argued in Guha-Khasnobis et al. (2006) and in Kanbur (2009), we do not find this at all. On the contrary, a range of concepts and associated measurements emphasize different features and characteristics. We begin this sec- tion with a brief overview of how the discourse has evolved in its various strands. Concepts The earliest discussions of a “dual economy” and associated notions of formality and informality—though these terms were not used at the time—have elements still present in the mindsets of many analysts and policy makers. The Dutch anthropologist and colonial administrator Julius H. Boeke (1943) envisioned a dualism between activities that came under the jurisdiction of colonial law and the traditional sphere outside the ambit of these rules and regulations. The easiest way to capture this mindset is to think of a wall separating the two domains. On one side of the wall was a domain ordered by regulations, on the other, a domain that was not, implying disorder and disorganization. Nearly 50 years later, Elinor Ostrom (1990) would question vigorously the notion that there was indeed disorder on the “other side.” Looking more deeply into activities outside the realm of conventional state regulation, her research revealed carefully crafted management mechanisms. But the tension between these perspectives persists to this day. The Lewis (1954) model of dualistic development has surprisingly little to say about state regulations. Instead, the dualism is between the capitalist mode of production, where profits are maximized and factor payments are according to marginal product, and a traditional mode of production, where they are not. In the Lewis perspective, labor could not be paid its marginal product in the traditional mode of production because the marginal product of labor was zero—some 176 Urbanization and (In)Formalization other, “traditional” rules of output allocation applied. Although this traditional sector has typically been associated with the rural/ agriculture sector in later discussions, it is clear that such a simple dichotomy was not necessarily what Lewis had in mind. He wrote about “capitalist agriculture” on plantations and the like, but for him elements of the “reserve army of labor” could equally be found in urban settings: The phenomenon is not, however, by any means confined to the countryside. Another large sector to which it applies is the whole range of casual jobs—the workers on the docks, the young men who rush forward asking to carry your bag as you appear, the jobbing gardener, and the like. These occupations usually have a multiple of the number they need, each of them earning very small sums from occasional employment; frequently their number could be halved without reducing output in this sector. Petty retail trading is also exactly of this type. It is enormously expanded in overpopulated economies, and each trader makes only a few sales. Markets are crowded with stalls, and if the number of stalls were greatly reduced, the consumers would be no whit worse off. (Lewis 1954, 2) Although Lewis does not use the term “informal sector,” it seems clear that for him it would be a sector where the marginal product of labor was close to zero. The 1970s saw a flurry of analyses and publications. For econo- mists, Harris and Todaro (1970) is seminal from a conceptual point of view. Although it does not use the term formality, it starts by saying that a key feature of the model is a “politically determined urban minimum wage at levels substantially higher than agricultural earnings” (Harris and Todaro 1970, 126). Thus implicit is a sector that comes under the purview of state regulations, which underpin a statutory minimum wage. The point for Harris and Todaro (1970), however, is that this wage is not market clearing. Workers displaced then end up getting very low earnings in the urban sector—the “informal” sector. It is this sector that absorbs the excess, and it is this sector that adjusts. This mindset informs at least some of the policy discourse on regulations today. Of course, there is also rural-urban migration in the Harris-Todaro model (see next section). Ejaz Ghani and Ravi Kanbur 177 It is generally recognized that anthropologist Keith Hart (1973) introduced the term “informal sector” to the literature, describing economic activity in an urban slum in Accra, Ghana: The main message of the paper (Hart 1973) was that Accra’s poor were not “unemployed.” They worked, often casually, for erratic and generally low returns; but they were definitely working… Following Weber, I argued that the ability to stabilize economic activity within a bureaucratic form made returns more calculable and regular for the workers as well as their bosses. That stability was in turn guaranteed by the state’s laws, which only extended so far into the depths of Ghana’s economy. “Formal” incomes came from regulated economic activities, and “informal” incomes, both legal and illegal, lay beyond the scope of regulation. I did not identify the informal economy with a place or a class or even whole persons. Everyone in Accra, but especially the inhabitants of the slum where I lived, tried to combine the two sources of income. Informal opportunities ranged from market gardening and brewing through every kind of trade to gambling, theft, and political corruption. (Hart 2006, 25) Hart’s conceptualization echoed International Labour Organi- zation (ILO) (1972), and subsequent attempts to systematize the definition of informal activity for national statistical purposes followed closely the notion that entities recognized by the law were formal and those not so recognized were informal. ILO (1993, para. 5) provides the following definition: [Informal enterprises] are private unincorporated enterprises …, that is, enterprises owned by individuals or households that are not constituted as separate legal entities independent of their owners and for which no complete accounts are available that would permit a financial separation of the production activities of the enterprise from the other activities of its owner(s). Since the 1990s, some have moved to broaden the concept of informality, from an enterprise-based perspective as given above in ILO (1993) to a worker-based perspective focused on whether the worker receives certain mandated protections and benefits from the employer. The distinction is made between the informal sector and 178 Urbanization and (In)Formalization the informal economy, the former on an enterprise-based definition, the latter on a worker-based definition, so as to extend the focus to include not only enterprises that are not legally regulated but also employment relationships that are not legally regulated or protected. In brief, the new definition of the “informal economy” focuses on the nature of employment in addition to the characteristics of enterprises. (Chen 2006, 76) Measurement and trends With so many different concepts of informality and formality, it is no surprise that getting nationally comparable estimates of informality is difficult. Even if the basic concept is agreed—for example, registered enterprises—the detailed specification may vary across countries, because the registration requirements will vary, too. Estimates by national authorities may differ from those by international agencies because of differing definitions and data sources. Despite concerns about data and definitions, there is agreement that the informal sector is large in most developing countries and that it is the overwhelming employer of labor in the non-agricultural sector. For developing countries as a group, more than half of all jobs—more than 900 million workers—are in the informal sector (Jutting and de Laiglesia 2009). The sector is large not just in employment but also in number of enterprises. Many more new establishments are created in the informal sector than in the formal sector. Figure 7.1 plots the share of informal employment in total non-agricultural employment for 50 developing countries against their per capita incomes, using data from the International Labour Organization’s Key Indicators of the Labor Market, the Organisation for Economic Co-operation and Development (OECD), and the World Bank’s World Development Indicators. For these countries as a group, nearly half of non-agricultural jobs are generated in the informal sector. In India, the share is much higher, at more than 80 percent. Also high in Sub-Saharan Africa, it is slightly lower in Latin America, with Brazil at 42 percent and Mexico at more than 50 percent. The lowest share is in Central and Southeastern Europe, with the share in Poland and the Russian Federation in single digits. Ejaz Ghani and Ravi Kanbur 179 Figure 7.1 Jobs in developing countries are concentrated in the informal sectors Source: ILO 2011; OECD 2009; World Bank 2010. Note: Chart uses latest available data on informal share of employment for 52 coun- tries (1995–99 or 2000–07). GDP per capita is in 2005 purchasing power parity international dollars. The relationship between the size of informal sector and devel- opment in Figure 7.1 slopes down. This stylized cross-section relationship, established many times in the literature, informs the mindset that predicts a decline in informality with development. But notice first a huge dispersion in the cross-country relationship. Second, however, the cross-section relationship is not found in recent time series. Figure 7.2 compares the trend over time in the share of informal employment in total non-agricultural employment for a dozen developing countries. What is striking is that the size of informal sector has remained exceptionally persistent. It has not con- tracted over time. To the contrary, it seems to have increased, with few exceptions. This persistence of informality in the face of inexorable urbaniza- tion frames the analytical and policy questions in this chapter. The stubborn resistance to formalization is a challenge to analysts—why is it happening?—and to policy makers—what, if anything, can and should be done about it? We turn now to these questions in the next two sections. 180 Urbanization and (In)Formalization Figure 7.2 Informal sectors are exceptionally persistent (share of population in informal employment, earliest and latest data points available) Source: Government of India, various years; ILO 2011. Urbanization and the transition to formality Urbanization is proceeding inexorably in the world; formalization is not. Kanbur (2011) explores why informality might persist in many countries despite economic growth. Possible explanations include looser regulations, weaker enforcement of regulations, and techno- logical changes that have made it less inefficient to avoid regulations by operating at a smaller scale. An additional factor could be the changing gender composition of the labor force (Ghani et al. 2011c). The focus of this section, however, is on the connections and interac- tions between urbanization and formalization. Why might we expect the two to move together at all? Indeed, might there instead be a more intimate connection between urbanization and informality? And what does the literature on agglomeration externalities and con- gestion costs say about the incentives of enterprises to become formal or to stay informal? Ejaz Ghani and Ravi Kanbur 181 The traditional literature This section begins with the traditional literature on dualism and on the formal/informal divide reviewed in the last section, to see what different elements of it say about the connections between the rural-urban transition and the informal-formal transition. In Boeke’s (1943) view, to the extent that the urban comes under the ambit of colonial regulation while the rural does not, urbanization is associ- ated with increased formality. In the Lewis (1954) framework, the key distinction is between capitalist and non-capitalist modes of production. As investment takes place in the capitalist (or “modern”) sector, labor is drawn away from the traditional sector, the pool of surplus labor. Only if we identify the traditional sector with rural and the capitalist sector with urban do urbanization and formalization go together in the Lewis framework. The Hart (1973) framework focuses on the urban sector and identifies informality as activities outside the reach of state regulation. In this setting, urbanization would lead to an increase in informality if rural migrants went disproportionately into informal activities, as envisioned by Hart. Migration is under- explored in Hart (1973), though there are suggestions that recent migrants may be more likely to be in the informal sector. The Harris-Todaro framework (1970), in the original and as devel- oped by many later studies, comes closest to offering the possibility of a systematic link between rural-urban migration and informality. Recall that migration in this model takes place in response to the differential between rural income and expected urban income—the urban sector offers the probability of employment in the formal sector, where the wage is set at a high level, but also the one-minus- this probability of ending up with a very low income in the urban informal sector. Jobs in the formal sector are rationed, and getting one of these high-paying jobs is in effect winning a lottery. Losing the lottery is ending up in the informal sector. With this setting, consider first the addition of a new job in the formal sector. If all other employment in the economy (urban informal and rural) is classified as informal, the degree of informal- ity will fall. But the increased employment in the formal sector will increase the probability of getting a high-paying formal sector job 182 Urbanization and (In)Formalization and thus induce more migration, increasing the absolute size of the urban informal sector. In a full migration equilibrium, when expected urban income is equated to rural income, the relative size of the informal sector in the urban area will remain unchanged. In this scenario, then, informality will either fall or stay the same, depending on how it is measured. Now consider a scenario where the formal sector wage is increased, holding formal sector jobs constant. Raising the formal sector wage will induce more migration and, since total jobs in this sector are fixed, a higher proportion of the now larger urban population will end up in the urban informal sector. If informality means rural employment plus urban informal, of course the degree of informality will not change. But if informality means simply urban informality, and official definitions of informality focus mainly on the part of the non-agricultural labor force that is informal, the degree of informal- ity will increase with urbanization. The Harris-Todaro framework (1970) thus provides some insights into possible connections between urbanization and informality, but it is entirely worker-based—the location decision of enterprises is not considered. And yet these decisions are just as important for the overall pattern of urbanization. Considering enterprise behavior links the discussion to the recent literature on agglomeration benefit and congestion externalities. Enterprise size, geographical density, and formality Beall et al. (2010) identify the key features of the urban context as proximity, density, diversity, dynamics, and complexity. The origins of this discourse go back at least as far as Lewis Wirth (1938) who said that a city was a “relatively large, dense, and permanent settle- ment of socially heterogeneous individuals” (Wirth 1938, 1). For economists, starting at least with Marshall (1920), dense proximity of a diverse pool of skills has been the foundation of agglomeration benefits. But such disciplines as sociology and anthropology have emphasized the problems of differences in close proximity—for example, ethnic cleavages—and urban responses to these challenges. Of course, economists have also discussed the costs of agglomeration in the form of congestion costs. The recent literature has discussed Ejaz Ghani and Ravi Kanbur 183 the balance between agglomeration benefits and costs to arrive at optimal city concentration (Overman and Venables 2010; Desmet et al. 2012). This section focuses on the interactions among enterprise size, city traits, industry traits, and agglomeration economies in both the for- mal and informal sectors. It relies on a direct empirical link between enterprise size and formality. Larger enterprises are more likely to be formal, in the sense of coming within the ambit of state regulations and complying with these regulations (Levy 2007). Regulations in many countries (India, for example) are written to apply to enter- prises of at least certain size (for example, enterprises with 10 workers or more). Further, official statistical definitions of formality (India’s definition of the “organized sector,” for example) also relate to enter- prise size. With this background, consider the incentives for large and small enterprises to locate within or outside densely populated areas—and what affects these incentives. Larger manufacturing enterprises clearly need more land, which is more easily available in less densely popu- lated areas. One possible cost of moving to less dense areas is the loss of access to public goods like electricity. But technological advances mean that firms can have small generators without a substantial cost increase, and besides, own-generators can guarantee supply where the public electric supply is erratic, as in many urban settings. In addition, large enterprises that operate in industries with mature technology seem to benefit less from agglomeration economies. To the extent that smaller firms are less vertically integrated, it helps to be in a dense ecosystem with forward and backward supply chain links in inputs and outputs in close proximity. And to the extent that larger firms are more likely to be vertically integrated, moving to a less dense location is likely to cost less. Putting these arguments together, we can construct a rationale for why, all else equal, smaller firms are more likely than larger firms to benefit from agglomeration externalities. This is only a tendency, of course—location decisions will be influenced by many considerations. But the question arises—what may have changed in the last 20 years to increase the advantage of smaller firms locat- ing in more densely populated areas, and the reverse for larger enterprises? 184 Urbanization and (In)Formalization One straightforward reason is the ongoing urbanization, which is increasing density. This puts larger firms at a disadvantage because of their greater need for land. At the same time, problems in urban gov- ernance and infrastructure are well documented. And as suggested above, larger firms are more likely to be able to escape these problems by locating in less dense areas, where they can control power supply through private generators and are perhaps not as hemmed in by land-use regulations. Further, smaller enterprises are more likely to benefit from density because they are more likely to not be vertically integrated. Related to this is another possible reason for smaller (and thus more likely informal) enterprises to migrate to urban areas. If tech- nology is changing to make scale economies less important than in an earlier era, informal enterprises are more able to survive. All else held constant, if technological change or the emergence of a sup- ply chain makes production possible at a smaller and less vertically integrated scale, and especially if the coordination across elements of the previously integrated chain of production is made easier through the physical proximity that urban density makes possible, data on the persistence of informality should not be surprising. On this reason- ing, we would expect smaller enterprises to migrate to urban areas and larger enterprises to migrate from urban areas. But what is the evidence for this reasoning? Turn now to some remarkable recent trends in India. The location of formality in India As noted, India’s official definition of formality, from the enterprise perspective, turns essentially on enterprise size. In manufacturing, the “organized” sector includes establishments with 10 workers or more and that use electricity. If the establishment does not use elec- tricity, the threshold is 20 workers or more. These establishments are required to register under the India Factories Act of 1948. The “unorganized” manufacturing sector, by default, comprises establish- ments that fall outside the scope of the Act. India is the world’s second-fastest growing economy, but it also has a very large informal sector. In manufacturing, nearly 99 percent of enterprises—and 81 percent of employment—are in the unorganized Ejaz Ghani and Ravi Kanbur 185 sector. In services, the unorganized sector is an estimated 74–90 percent of employment, depending on the definition. The Indian economy has undergone amazing structural transformation over the last two decades, but the unorganized sector’s employment share has remained high (Ghani et al. 2011a, 2011b). For manufacturing, it was 81 percent in 2005, almost exactly the same as in 1989. So the unorganized sector is also exceptionally persistent. India provides a good case for examining how urbanization and formalization have interacted and evolved over time. Is the formal sector moving out of urban areas? Is the informal sector moving in? Do cities generate agglomeration economies in the informal sector? Has the spatial allocation of plants improved across urban and rural locations? Ghani et al. (2012) examine trends in the spatial location of organized and unorganized enterprises in India. They combine the enterprise data from the Annual Survey of Industries for the orga- nized (formal) sector and from the National Sample Survey for the unorganized (informal). The organized manufacturing sector is surveyed by the Central Statistical Organization every year through the Annual Survey of Industries, while unorganized manufactur- ing establishments are surveyed separately by the National Sample Survey Organization at roughly five-year intervals. These surveys identify whether each establishment is in an urban or rural loca- tion. Establishments are surveyed with state and four-digit National Industry Classification stratification. On the whole India’s manufacturing became more urbanized, with the share of workers in urban areas rising from 33 percent of employees in 1989 to 41 percent in 2005 (Figure 7.3a). Urbanization growth was most dramatic from 1989 to 1994, slowing to 2000. The urbanized employment share was basically flat from 2000 to 2005. This pattern was also present in manufacturing plant counts, but the opposite trend emerges for manufacturing output, which has moved increasingly toward rural areas. The differences in the relative movements of the organized and unorganized sectors are striking (Figures 7.3b and 7.3c). Over 1989–2005, the organized sector moved from urban to rural loca- tions, with its urban employment share declining from 69 percent to 57 percent. By contrast, the urban employment share for the unor- ganized sector increased from 25 percent to 37 percent. Because the a. Plants and employment are urbanizing—output deurbanizing b. The organized sector is deurbanizing c. The unorganized sector is urbanizing Figure 7.3 Spatial location of economic activity in India Source: Ghani et al. 2012. Note: The figures plot urban shares of plants, employment, and output for each year using survey data on plants from formal (organized) and informal (unorganized) manufacturing sectors in India. Ejaz Ghani and Ravi Kanbur 187 unorganized sector accounts for about 80 percent of employment in India’s manufacturing, total urbanization increased for employment. Likewise, the organized sector accounts for more than 80 percent of India’s output, such that aggregate output becomes more rural. Large firms in India with high capital and land intensity are more likely to locate in rural areas. There is evidence to support this from within- district and between-district movements, which both tend to work in the same direction for the urbanization of the unorganized sector and the deurbanization of the organized sector. Could these changing patterns in the urbanization of the infor- mal sector and the deurbanization of the formal sector be explained merely by changing the definition of urbanization? Probably not. India’s definition of an urban setting has been mostly stable since the 1961 census, and the country uses more demanding criteria than most countries. For example, substantial parts of U.S. metropolitan areas like Atlanta or Phoenix would be classified as rural in Indian statistical analyses because their population densities fall below 1,000 people per square mile (Ghani et al. 2012). What attracts new entrepreneurs and workers to cities? Ghani et al. (2011b) quantify the factors and traits of cities and industries that systematically predict greater entry of new establishments in the formal and informal sectors. They use cross-sectional establish- ment surveys in 630 districts in India across 35 states and union territories. They quantify entrepreneurship as firms younger than three years and define entry measures through employment in these new establishments. They examine the role of demographic traits in cities (age profiles, population, population density), structural traits of cities (education of the local labor force, quality of local physical infrastructure, connectivity to major cities), business climate traits (stringency of labor laws, household banking conditions), and the impact of agglomeration economies in formal and informal sectors. They develop metrics that unite the incumbent industrial structures of districts with the extent to which industries interact through the traditional agglomeration channels (Marshall 1920). This conceptual approach has also been used to describe location decisions and city structures in several advanced economies. The first agglomeration channel is proximity to customers and suppliers, which reduces transportation costs and thus increases productivity. The 188 Urbanization and (In)Formalization second is the Chinitz effect. Chinitz (1961) argued that Pittsburgh’s large, integrated steel firms depressed external supplier development. By contrast, New York City’s much smaller firms, organized around the decentralized garment industry that then dominated the city, were better suppliers to new firms. The third channel is labor pooling. Table 7.1 provides basic spatial results for the organized manufac- turing sector. Column 1 includes just district populations, district- industry employments, and industry fixed effects. Not surprisingly, existing district-industry employment strongly shapes the spatial location of entry in the organized sector: a 10 percent increase in incumbent employment raises entry employment into formal sectors by around 2 percent. In addition, a district’s population increases entry rates with an elasticity of 0.5. Higher-order population terms are not found to be statistically significant or economically important. Column 2 includes the district traits. Three factors stand out as discouraging the entry of new plants into the formal manufacturing sector in cities: high population density, strict labor regulations, and greater distance to one of India’s 10 largest cities. The first factor, observed in many spatial settings, is closely studied by Desmet et al. (2012) in India. The traded nature of manufacturing products allows more rural settings for firms, and manufacturers often seek environ- ments with lower wages and cheaper rents than those in high-density areas. The second connects with earlier studies of India arguing that strict labor laws reduce economic growth. These policies are associ- ated with reduced entry even after conditioning on district-industry size. The third highlights that while organized manufacturers avoid the high costs of urban areas, they also avoid the most remote areas in favor of settings nearer to large population centers, likely to access customers directly or to connect to road transport and shipping routes. By contrast, the education of a district’s workforce is strongly linked to higher entry rates. This is consistent with the findings for the United States. The elasticity for India is in fact stronger in eco- nomic magnitude, if not precision, than that in comparable studies of advanced economies. Table 7.2 computes these estimates for the unorganized manufac- turing sector. Several distinct differences exist. First, local population has a much greater connection with unit elasticity in column 1’s simplest estimate. This greater connection of entry to the overall size Table 7.1 Harnessing entrepreneurship and job creation in cities—formal manufacturing Base District Full Adding Using leg estimation traits estimation consumption entry count (1) (2) (3) (4) (5) DV is log entry employment by district-industry Log of incumbent employment in district-industry 0.229+++ 0.186+++ –0.028 –0.030 0.032+ (0.043) (0.040) (0.048) (0.047) (0.018) Log of district population 0.531+++ 0.483+++ 0.475+++ 0.482+++ 0.216+++ (0.179) (0.155) (0.156) (0.161) (0.056) District Traits: Log of district population density –0.569+++ –0.563+++ –0.562+++ –0.197+++ (0.088) (0.080) (0.079) (0.029) Share of population with graduate education 0.211+ 0.235++ 0.230++ 0.078+ (0.110) (0.107) (0.111) (0.042) Demographic dividend for district (age profiles) 0.605 0.567 0.535 0.271 (0.458) (0.446) (0.468) (0.177) Index of infrastructure quality for district 0.018 0.096 0.086 0.015 (0.100) (0.094) (0.097) (0.038) Strength of household banking environment 0.143 0.095 0.085 0.027 (0.104) (0.100) (0.106) (0.036) Stringency of labor laws in district’s state –0.210+++ –0.161++ –0.157++ –0.095+++ (0.070) (0.064) (0.065) (0.023) Log travel time to closest large city –0.275+++ –0.241+++ –0.237+++ –0.091+++ (Contd.) Table 7.1 (Contd.) Base District Full Adding Using leg estimation traits estimation consumption entry count (1) (2) (3) (4) (5) (0.090) (0.083) (0.083) (0.031) Log per capita consumption 0.152 (0.505) Local Industrial Conditions by Incumbent Firms: Labor market strength for district-industry 0.161 0.164 0.026 (0.102) (0.102) (0.041) Inputs/supplier strength for district-industry 0.485+++ 0.485+++ 0.154+++ (0.098) (0.098) (0.043) Outputs/customer strength for district-industry 0.388+++ 0.387+++ 0.167+++ (0.140) (0.140) (0.057) Chinitz small suppliers metric for district-industry 0.279 0.279 0.337+++ (0.213) (0.212) (0.129) Industry fixed effects Yes Yes Yes Yes Yes Observations 4,843 4,843 4,843 4,843 4,843 Adjusted R-squared 0.128 0.166 0.218 0.218 0.279 Source: Ghani et al. 2011b. Note: Estimations quantify the relationship between district-industry employment in new establishments and local district conditions. District-level traits are taken from the 2001 census. Industrial conditions are calculated from 2005–06 using incumbent establishments in the district-industry. Labor regulations are a composite of adjustment and disputes laws. Estimates weight observations by an interaction of district size and industry size, include industry fixed effects, and cluster standard errors by district. Non-logarithm variables are transformed to have unit standard deviation for interpretation. Table 7.2 Harnessing entrepreneurship and job creation in cities—informal manufacturing Base District Full Adding Using leg estimation traits estimation consumption entry count (1) (2) (3) (4) (5) DV is log entry employment by district-industry Log of incumbent employment in district-industry 0.163+++ 0.123+++ –0.075++ –0.078+++ –0.040 (0.031) (0.029) (0.029) (0.029) (0.026) Log of district population 1.051+++ 0.878+++ 1.010+++ 1.025+++ 0.866+++ (0.161) (0.157) (0.160) (0.153) (0.138) District Traits: Log of district population density –0.019 –0.044 –0.042 –0.044 (0.070) (0.068) (0.073) (0.057) Share of population with graduate education –0.002 –0.026 –0.079 –0.046 (0.080) (0.084) (0.087) (0.074) Demographic dividend for district (age profiles) 0.954+++ 1.053+++ 0.770++ 0.798+++ (0.326) (0.330) (0.326) (0.285) Index of infrastructure quality for district 0.386+++ 0.365+++ 0.259++ 0.325+++ (0.096) (0.097) (0.104) (0.086) Strength of household banking environment 0.222+++ 0.211+++ 0.152+ 0.193+++ (0.080) (0.080) (0.082) (0.071) Stringency of labor laws in district’s state –0.007 0.000 0.020 0.030 (0.069) (0.069) (0.066) (0.062) (Contd.) Table 7.2 (Contd.) Base District Full Adding Using leg estimation traits estimation consumption entry count (1) (2) (3) (4) (5) Log travel time to closest large city –0.004 0.009 0.029 0.017 (0.069) (0.074) (0.074) (0.065) Log per capita consumption 1.191+++ (0.365) Local Industrial Conditions by Incumbent Firms: Labor market strength for district-industry 0.263+++ 0.271+++ 0.028+++ (0.075) (0.075) (0.067) Inputs/supplier strength for district-industry 0.553+++ 0.542+++ 0.504+++ (0.107) (0.108) (0.096) Outputs/customer strength for district-industry 0.291+++ 0.292+++ 0.246+++ (0.050) (0.051) (0.044) Industry fixed effects Yes Yes Yes Yes Yes Observations 6,451 6,451 6,451 6,451 6,451 Adjusted R-squared 0.195 0.233 0.264 0.267 0.294 Source: Ghani et al. 2011b. Note: Estimations quantify the relationship between district-industry employment in new establishments and local district conditions. District-level traits are taken from the 2001 census. Industrial conditions are calculated from 2005–06 using incumbent establishments in the district-industry. Labor regulations are a composite of adjustment and disputes laws. Estimates weight observations by an interaction of district size and industry size, include industry fixed effects, and cluster standard errors by district. Non-logarithm variables are transformed to have unit standard deviation for interpretation. Ejaz Ghani and Ravi Kanbur 193 of local markets almost certainly reflects unorganized entry’s being proportionate to market size and servicing local needs. Unorganized manufacturing clearly conforms much more closely to the overall contours of India’s economic geography than does organized manu- facturing. The other two district traits associated with strong entry are the strength of local, within-district physical infrastructure and the strength of local household banking environments. This contrasts with organized manufacturing entry, where education stood out. An intui- tive explanation is that these patterns and their differences reflect the factors that each sector depends on most. Organized manufacturing establishments, for example, may have broader resources that reduce their dependence on local infrastructure and household finance. Likewise, it is reasonable to believe that the unorganized sector depends less on educated workers than the organized sector. Finally, measures of input/supplier strength and output/customer strength have a greater impact on employment growth for the unorganized sector than for the organized. Thus, while agglomeration benefits exist in both formal and informal manufacturing, they appear empirically to be stronger for the informal sector. Additionally, input-cost factors are more influential in the location choices of small startups, while output conditions and labor markets are more important for large entrants. So economic reasoning, and Indian evidence, would suggest that, from an enterprise-based perspective, the comovement of urbaniza- tion and informality should be no surprise. Similarly, a worker-based perspective can also produce, as in the Harris-Todaro framework, a comovement of urbanization and informality. What does this mean for policy? Turn to the next section. Policy implications We have argued that of the two great stylized predictions on the development process—increasing urbanization and increasing formalization—the first is proceeding apace while the second has stalled. We have investigated why informality is on the increase, and indeed how urbanization may itself be associated with increasing informality. But what are the policy implications of these trends 194 Urbanization and (In)Formalization and these causalities? The answer to this in turn depends on why we should worry about informality, what can be done about it, and in particular what cities can and should do about it. We turn now to these questions. Why worry about informality? There are (at least) three reasons for informality to be a concern in policy circles—it is associated with higher levels of poverty and vulnerability, lower levels of productivity, and lower contributions to fiscal revenue. Consider each in turn. Figure 7.4 plots the share of informal jobs against poverty rates across countries. The line slopes up, suggesting that a larger size of the informal sector is associated with higher poverty rates. The macro-level association is confirmed by almost every micro-level country-specific study that looks at the association between poverty and informality. Workers in the informal sector are predominantly poor in both income and non-income dimensions. The reason is that informal jobs have low productivity, and some groups, such as women and the young, are overrepresented in the informal sector (Jutting and de Laiglesia 2009). In India, workers in the unorganized Figure 7.4 Large informal sectors are associated with high poverty rates Source: ILO 2011; OECD 2009; World Bank 2010. Note: Chart uses latest available data on informal share of employment for 48 coun- tries (1995–99 or 2000–07). Ejaz Ghani and Ravi Kanbur 195 sector have nearly twice the incidence of poverty (20.5 percent) than their counterparts in the organized sector (11.3 percent) (NCEUS 2007). Studies also find lower levels of health, education, and other non-income achievements in the informal sector. Some caveats are in order. The links between working informally and being poor are not always straightforward. Recent empirical work has emphasized heterogeneity within the informal sector (Chen 2006). Not all jobs in the informal economy yield paltry incomes. Indeed, many in the informal economy, especially some self-employed, earn more than unskilled or low-skilled workers in the formal economy. There also is much innovation and many dynamic growth-oriented segments in the informal economy, requiring con- siderable knowledge and skills. One is the fast-growing information and communications technology sector in India’s large cities. And some evidence suggests that informal sectors have expanded in Indian districts where the formal sectors have expanded. Finally, in the spirit of the Harris-Todaro analysis (1970), informal sectors in cities attract the poor people. They do not make them poor. Despite these caveats, the strong association between informality and poverty is the driving concern of policy makers, and their chief worry is persistent informality in the face of rapid growth. In addition to the income, education, and health dimensions of poverty, there is also the exclusion of the informal sector from the city’s decision making and outright harassment by police and government agents. The experiences of the Self Employed Women’s Association (SEWA), a union of women who earn their living in the informal sector, are telling. As a recent publication notes: Delhi is a place where people migrate in search of work. But as each day passes, people become invisible among the crowd and glitter. The less educated migrants find a variety of work like labor work, ironing work, vending work, home-based work, domestic work, and driving rickshaws—and they earn well enough. With rapid development happening in all major cities of India, the poor are displaced ruthlessly. The situation for street vendors is no different. The street vendors are harassed by MCD [Municipal Corporation of Delhi], Police, Goons, and Mafias, in the process of beautification, modernization, and development… The Goons and Mafias, with support from Police and MCD, set up the markets at various places and illegally charge 196 Urbanization and (In)Formalization vendors for the space. In desperation, vendors pay Rs 500–1,000 to Goons or Mafias to make a living. Besides, MCD charges a penalty to vendors for setting up illegal spaces. Thus, vendors are exploited by both Mafias and MCD. (SEWA 2012, 1) Along with lower incomes, the lower productivity of enterprises in the informal sector is well documented (Jutting and de Laiglesia 2009). Most recently, Busso et al. argued that in Mexico total factor productivity is much higher in the formal sector than in the infor- mal—so much so that “one peso of capital and labor allocated to formal and legal firms is worth 28 percent more than if allocated to illegal and informal firms, and 50 percent more than if allocated to legal and informal firms” (Busso et al. 2012, 1). But other studies have pointed out strong evidence for manufacturing convergence. In a study of 100 countries using industry data for formal sectors, Rodrik (2011) finds that industries that start at lower levels of labor productivity grow faster. Figure 7.5 plots labor productivity in India’s unorganized indus- try at the district level. Each dot in the scatter plot reflects labor productivity in the unorganized industry in a district. A line sloping down suggests that districts that started with lower labor productivity in the initial period experienced faster productivity growth in later periods. But there is a lot of dispersion. No doubt, the pace of con- vergence will accelerate with better infrastructure, improved policies, and stronger institutions, as discussed earlier. The convergence in the unorganized manufacturing sector can have a huge impact on aggre- gate manufacturing convergence, given that more than 80 percent of India’s manufacturing employment is in the unorganized sector. The impact of formal manufacturing on aggregate manufacturing convergence is reduced by its small share of employment. Figure 7.6 shows manufacturing convergence in India’s organized sector at the district level. Districts that started with lower labor productivity in the initial period grew faster in later periods. Formal sectors can converge faster due to the tradable nature of the goods they produce, the benefits of scale economies, and the better connec- tivity through cities into global production networks. So, cities play a role in manufacturing convergence in both formal and informal sectors. Ejaz Ghani and Ravi Kanbur 197 Figure 7.5 Convergence in productivity in India’s unorganized manufacturing, 1989–2005 Note: The horizontal axis is the initial labor productivity of unorganized industry in a district in 1989. The vertical axis is the growth of labor productivity in unorganized industry in that district. Figure 7.6 Convergence in productivity in India’s organized manufacturing, 1989–2005 198 Urbanization and (In)Formalization What about the fiscal implications? Policy makers worry that the informal sector is largely outside the tax net. Indeed, in some coun- tries the statistical definition of enterprise informality is based on whether it is registered for tax purposes. Of course, if an exogenous shift in conditions brings more firms into the tax net, that is good fis- cally. But if informality increases, the tax net suffers. The important question from a policy perspective, however, is whether policy mea- sures could be taken to induce greater formality and greater revenue. The answer is not self-evident—and certainly not as simple as relaxing regulations to bring more firms into the formal sector. For example, on taxing profits, Auriol and Warlters (2005) argue that there is a tradeoff between restricting entry to the formal sector, which would raise taxable profits per firm, and increasing the number of formal sector firms by relaxing regulation. The argument is confirmed by their empirical analysis of regulation, taxation, and informality for a cross-section of 64 countries. In a similar vein but focusing on tax collection, Keen and Mintz (2004, 559) model tradeoffs in lowering the tax threshold to bring in more firms into the value added tax net: “Too high a threshold compromises the basic objective of raising revenue; too low a threshold may leave the authorities overwhelmed by the difficulties of implementation and impose excessive compli- ance costs on taxpayers.” What should be done about informality? The dominant policy perspective on informality can be illustrated by two quotations, the first from the World Bank (n.d.), and the second from The Economist (2010): There are various reasons why governments may be concerned about large informal sectors. These include potentially negative consequences for competitiveness and growth, incomplete coverage of formal social programs, undermined social cohesion and law and order, and fiscal losses due to undeclared economic activity. For most governments, these concerns outweigh any advantages that the informal sector offers as a source of job creation and as a safety net for the poor. Thanks largely to baroque regulation, half the labor force toils in the informal economy, unable to reap the productivity gains that come from technology and greater scale. Ejaz Ghani and Ravi Kanbur 199 It would seem that the informal sector is a problem because of low productivity, low contribution of fiscal resources, and high concen- tration of poverty, vulnerability, and exclusion. Further, the major causes of informality are to be found in “baroque regulations.” The conventional wisdom’s headline policy conclusion is thus clear—informality is a problem, it is caused by overly strict regulation of the formal sector, and it can be solved by deregulation. We wish, however, to sound a note of caution, especially given the stubborn persistence of informality across the world, and even in the face of historically high economic growth when regulations have not neces- sarily been tightened—if anything, they have been relaxed. Yet job creation in the formal sector has slowed, leaving the informal sector to pick up the slack. If these trends continue, the informal sector may need to be viewed not as a problem to be solved by “formalization” but as requiring support to enhance the productivity of the poorest members of society. Our focus here has not been informality per se—it has been infor- mality in the context of urbanization and the lack of formalization in the face of rapid urbanization. We have shown that the persistence of informality is to be expected as urban formal sector jobs expand, because the expectation of securing these jobs pulls in far more migrants from the rural sector than there are formal jobs, with the surplus ending up in the informal sector. We have also shown that from an enterprise-based perspective, it can be a perfectly rational response to stay small. This can be in response to regulations or to rising urban density and to changes in technology that make operat- ing at a smaller scale less inefficient than before. If this argument has some validity, informality caused by small scale is unlikely to disappear with urbanization. Indeed, it is likely to grow. The arguments here suggest that caution about the conventional policy perspective is particularly warranted, given that the increase in informality over the last two decades has happened alongside rapid urbanization. Research on interaction between urbanization and informality is still at an early stage, and empirical evidence on why some cities attract more informal activity than others is still sketchy. While the “cost of doing business” clearly is relevant (Levy 2007), other factors can also be important. Agglomeration economies may be more important for the informal sector than the formal, and 200 Urbanization and (In)Formalization changes in technology may explain persistent informality despite unprecedented rates of economic growth. The comovement of informalization and urbanization juxtaposes concerns about growing informality, because of its association with poverty, with the policy drive to urbanize in order to reap agglomera- tion benefits. Is there a conflict, then, between the growth gains of urbanization and the possible poverty costs of informalization? Our answer: not necessarily. Instead, a policy package is needed to make the best of urbanization’s growth potential while addressing issues of informality. Note that, alongside the benefits of agglomeration, the analyti- cal and policy literature has also highlighted various agglomeration (“congestion”) costs. There is already a discussion of how to manage and mitigate these costs—addressing such issues as transportation and infrastructure, residential zoning and land-use patterns more generally, and above all, urban governance (Ahluwalia et al. 2014). Among the urban governance issues is how to tax rising land values in order to provide urban services that could mitigate the conges- tion costs of agglomeration. As our enterprise-based discussion of informality makes clear, small firms in the informal sector benefit from agglomeration externalities as much, if not more, than larger firms in the formal sector. This is one reason for the migration of informal enterprises into dense urban settlements—and the rela- tive movement of formal enterprises out. Providing urban services to these enterprises is thus as important as the usual focus on the formal sector. As discussed, informal sectors play a bigger role in the job- enhancing effects of structural transformation. Formalization should not result in overly regulating it, lest the sector’s growth be slowed or the incentives to remain informal increase. But not formalizing reduces the informal sector’s access to service delivery, which is often linked to fiscal policies. So there are huge tradeoffs. That said, policy makers can consider reducing the cost of becoming formal and increase the cost of staying informal. To reduce the cost of becoming formal, tax structures and rates should be simplified, and tax exemp- tions and holidays should be reduced. Authorities could improve tax administration and implement a simple presumptive tax—linking payments to the availability of infrastructure services (for example, Ejaz Ghani and Ravi Kanbur 201 bulk electricity at an industrial or business tariff). Of course, to make such an offer effective, it should be costly to “steal” electricity. A value added tax needs to be implemented effectively, and tax credits for previous tax payments need to be made available to those ready to be formalized. Not giving tax credits for previous value added tax payments (especially for imported goods) can be costly to informal sector businesses (and a gift to the tax authority). Cities also need to reduce labor market rigidities that increase the cost of being formalized or becoming big. If governments do initiate some sort of wage or employment subsidies, they should be temporary, transpar- ent, and targeted—and of course available only if employers pay the basic taxes. The policy response from this perspective is not necessarily to view informality as a threat to productivity and growth and to move to deregulate—or to reduce the costs of regulations so as to reduce the incentives to avoid them. Regulations should be subject to tests of efficiency and equity. For example, if law says that all enterprises with 10 workers or more have to register, and if the cost consequences of registration are relatively high, many enterprises will stay below the critical threshold, and there will be a distortion away from optimal firm size. But if optimal firm size is declining in any case, and this is particularly so in urban areas because of the added benefits of density and agglomeration, then reforming regulations may not be as high a priority as ensuring that the benefits of density are indeed reaped by all enterprises. The focus then turns more to the provi- sion of urban services and to urban governance, which underpins the delivery of these services, rather than the narrow and specific weakening regulation or strengthening enforcement, though they have their place. An agenda for city mayors to address the challenge of growing informality It is important for policy makers to recognize that much urbanization in developing countries is thanks to the informal sector. Informality is not going away—it is growing. And the forces leading to its growth go beyond regulations on the formal sector. So deregulation is a tool with limited impact on informality. It is not a panacea—it cannot 202 Urbanization and (In)Formalization be the mantra. But the link between urbanization and informal- ization needs to be better managed. City mayors need to focus on three ‘I’s—integration, intervention, and institutions—and on one ‘E’—entrepreneurship: • Integration. Policy makers should take an inclusionary approach to the urban informal economy, not an exclusionary approach. City mayors need to promote better integration of urbanization with the informal sector. The interaction between urbanization and for- malization will improve the link between strategies for growth and jobs. City mayors should find ways to ensure that the informal sector is integrated into city planning, budgeting, and financing. The more that cities recognize the link between urbanization and formalization, and design appropriate policies and investments to support it, the more effective the policy interventions will be. • Intervention. Workers in the informal sector are predominantly poor—in both income and non-income dimensions. The reason is that informal jobs have low productivity, and certain groups, such as women and the young, are overrepresented in the informal sector. Informal sectors lack access to basic services (water, sanita- tion, electricity). City mayors should improve service delivery in informal sectors and slums. Workers in informal sectors will also benefit from social protection programs. • Institutions. To sustain development, many policy makers and business leaders want to encourage the informal-to-formal sector transition of workers through changes in property rights, business registration procedures, and financial access, often with specific application to whether entrepreneurs enter the formal economy. City mayors need to address these issues at the local level, with a focus on which policies can grow the overall size of the formal sector. What should city mayors do? Engage with organizations of informal workers as partners in development, and invite them to participate in city management. Understanding how the transi- tion to organized involvement occurs is important for city plan- ning and policy choices. • Entrepreneurship. If job creation is a priority, policy makers should focus on promoting entrepreneurship locally. Of course, many policy levers can promote entrepreneurial growth. To Ejaz Ghani and Ravi Kanbur 203 help this, mayors should invest in local education and physical infrastructure. Job growth is predicted by higher concentrations of new and young establishments. The two most consistent factors that predict overall entrepreneurship are the levels of local educa- tion and the quality of local physical infrastructure. High-quality goods and services cannot be produced without well-educated workers, and they cannot be delivered without roads, electricity, and telecommunication. And moving people is as important as moving goods, if not more important. The key point is that policy makers have to change their mindsets and bring small enterprises—their owners and their workers—into urban governance structures. They should be given greater voice in the design and management of urban policies. Today, large enter- prises have disproportionate influence on urban decisions. But the urban future appears to be with smaller informal enterprises. This disconnect needs to be addressed. *** Two of the great stylized predictions of development theory, and two of the great expectations of policy makers as indicators of progress in development, are inexorable urbanization and inexorable for- malization. Urbanization is indeed happening, beyond the tipping point where half the world’s population is now urban. Our main conclusions about trends in informality and the interactions between urbanization and formalization can be stated as follows: • Cities create the space for structural transformation, entrepreneurship, and jobs. The world’s urban population is expected to swell to more than 60 percent over the next two decades—and continue to rise after that. Almost 90 percent of that growth will happen in the developing world: an expansion of almost 2 billion people. Africa and South Asia, the only regions still mostly rural, will see their urban populations double in that time. Much of the transformation will be in the informal sectors and in small and intermediate cities, which often lack the skills, facilities, and services to cope with the human tide. 204 Urbanization and (In)Formalization • Informal sectors are large and persistent. Informal sectors in cities account for more than 50 percent of jobs, and in India, 80 percent of manufacturing employment. They also account for a majority of entrepreneurship—in India, more than 99 percent of establish- ments in the manufacturing sector. Nearly a billion people live in slums, and most of them work in the informal sector. While the formal sector has grown rapidly and propelled growth in devel- oping countries, the informal sector has kept pace. The informal sector’s persistence is not due to some industries becoming less formalized and others more so, though technologically advanced and capital-intensive industries tend to have lower informal sector shares. Persistence is more systematic and an integral part of urban- ization. Many more new enterprises that locate in cities are in the informal sectors, and many more people migrate to cities seeking better paying jobs and living conditions. Indeed, informal sectors seem to thrive in cities with dynamic formal sectors. Fast-growing state industries tend to experience increasing informal activity in India. All in all, informal sectors have become an integral part of urbanization and structural transformation. • Cities provide the ecosystem and generate agglomeration economies in the informal sector. Most empirical studies on cities and agglom- eration economies have focused on developed economies and formal sectors. But there is emerging evidence that agglomeration economies in developing countries also operate in the informal sector. Related to the agglomeration economies is the fact that entrepreneurs often find it difficult to work with large, vertically integrated suppliers, and small entrepreneurs work better with many more small entrepreneurs. A diverse and large number of entrepreneurs in New York City’s garment industry made it more competitive, while Pittsburgh, with one large and vertically inte- grated steel factory, has become a ghost town. • Formal firms are moving out of cities and informal firms are mov- ing in. Formal firms are moving out of more expensive cosmo- politan cities in search of lower land and labor costs, at an even earlier stage of development in developing countries. The traded nature of manufacturing products allows more rural settings for firms, and manufacturers often seek cheaper environments than the wages and rents associated with large and high-density Ejaz Ghani and Ravi Kanbur 205 areas. Indian industries with high capital and land intensity are more likely to locate in rural areas. By contrast, informal firms move into cities in search of better infrastructure and to benefit from externalities generated by thicker labor markets, access to inputs, and proximity to customers. Cities with better education and infrastructure not only attract many more entrepreneurs but also urbanize faster. Has the fast pace of urbanization shrunk informal sectors? Has persistence in informal sectors slowed urbanization? What can be done to integrate informal sectors with urbanization? • What can cities do to improve the link between formalization and urbanization? It is important for policy makers to recognize that much of the urbanization in developing countries is occurring through the informal sector. In conclusion, the growing informality in the face of rapid urban- ization is fairly new to the research and policy-making arena. Older findings, older assumptions, and older policy prescriptions will need to be reconsidered as further research identifies the causes underly- ing the trends. Some of the main topics for exploration include the nature of agglomeration externalities and how they play out in the formal and informal sectors; the precise reasons that productivity in the informal sector is lower than in the formal sector, especially if agglomeration benefits seem to accrue equally if not more to informal enterprises; the reasons that informality in many countries persists in the face of rapid growth and continued deregulation; how to bring informal enterprises into the tax net so that they can contribute to the services that enable them to flourish; and what policy measures can support the informal sector in creating jobs and addressing pov- erty, given that it does not look as though job creation in the formal sector has been, or is likely to be, sufficient to meet the employment and poverty challenges of the next two decades. We have begun to raise these questions and to provide preliminary answers. 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Oxford, UK: Oxford University Press. ——–—. 2011b. “Spatial Determinants of Entrepreneurship in India.” Working Paper 17514, National Bureau of Economic Research, Washington, DC. ——–—. 2011c. “Local Industrial Structures and Female Entrepreneurship in India.” Working Paper 17596, National Bureau of Economic Research, Washington, DC. Government of India. Various years. Annual Survey of Industries and National Sample Survey (manufacturing only). Ministry of Statistics and Programme Implementation, New Delhi. Guha‐Khasnobis, Basudeb, Ravi Kanbur, and Elinor Ostrom, eds. 2006. Linking the Formal and Informal Economy: Concepts and Policies. Oxford, UK: Oxford University Press. Gundogan, Naci, and Mustafa Kemal Bicerli. 2009. “Urbanization and Labor Market Informality in Developing Countries.” MPRA Paper 18247, Munich Personal RePEc Archive, Anadolu University, Eskişehir, Turkey. http://mpra.ub.uni-muenchen.de/18247. Harris, John, and Michael Todaro. 1970. “Migration, Unemployment and Development: A Two Sector Analysis.” American Economic Review 60 (1): 126–42. Hart, Keith. 1973. “Informal Income Opportunities and Urban Employment in Ghana.” Journal of Modern African Studies 11 (1): 61–89. ——–—. 2006. “Bureaucratic Form and the Informal Economy.” In Linking the Formal and Informal Economy: Concepts and Policies, edited by Basudeb Guha‐Khasnobis, Ravi Kanbur, and Elinor Ostrom. Oxford, UK: Oxford University Press. Henderson, J. Vernon. 2010. “Cities and Development.” Journal of Regional Science 50 (1): 515–40. 208 Urbanization and (In)Formalization International Labour Organization (ILO). 1972. Incomes, Employment and Equality in Kenya. Geneva. ——–—. 1993. Resolutions Concerning Statistics of Employment in the Informal Sector Adopted by the 15th International Conference of Labour Statisticians. Geneva. ——–—. 2011. Key Indicators of the Labor Market. 7th ed. Geneva: ILO. Jutting, Johannes P., and Juan R. de Laiglesia, eds. 2009. Is Informal Normal? Towards More and Better Jobs in Developing Countries. Paris: Organisation for Economic Co-operation and Development. Kanbur, Ravi. 2009. “Conceptualizing Informality: Regulation and Enforcement.” Indian Journal of Labour Economics 52 (1): 33–42. ——–—. 2011. “Avoiding Informality Traps.” In Reshaping Tomorrow: Is South Asia Ready for the Big Leap? edited by Ejaz Ghani. Oxford, UK: Oxford University Press. Keen, Michael, and Jack Mintz. 2004. “The Optimal Threshold for a Value Added Tax.” Journal of Public Economics 88 (3–4): 559–76. Levy, Santiago. 2007. Good Intentions, Bad Outcomes: Social Policy, Informality and Economic Growth in Mexico. Washington, DC: Brookings Institution. Lewis, W. Arthur. 1954. “Economic Development with Unlimited Supplied of Labour.” Manchester School of Economic and Social Studies 22: 139–91. Marshall, Alfred. 1920. Principles of Economics. 8th ed. London: Macmillan. National Commission for Enterprises in the Unorganised Sector (NCEUS). 2007. Report on Conditions of Work and Promotion of Livelihoods in the Unorganised Sector. New Delhi. http://nceuis.nic.in/Condition_of_ workers_sep_2007.pdf. Organisation for Economic Co-operation and Development (OECD). 2009. “Is Informal Normal? Towards More and Better Jobs in Developing Countries.” http://www.oecd.org/inclusive-growth/Is%20Informal%20 Normal%20Towards%20More%20and%20Better%20Jobs%20in%20 Developing%20Countries%20.pdf Ostrom, Elinor. 1990. Governing the Commons. New York: Cambridge University Press. Overman, Henry G., and Anthony J. Venables. 2010. “Evolving City Systems.” In Urbanization and Development: Multidisciplinary Perspectives, edited by Jo Beall, Basudeb Guha-Khasnobis, and Ravi Kanbur. Oxford, UK: Oxford University Press. Rodrik, Dani. 2011. “Unconditional Convergence.” Unpublished. Ejaz Ghani and Ravi Kanbur 209 Self Employed Women’s Association of India (SEWA). 2012. “Where Else are Vendors Harassed by Mafias Like Delhi?” SEWA Newsletter 39, Gujarat, India. http://www.sewa.org/Thirty_nine.asp. World Bank. 2010. World Development Indicators 2010. Washington, DC. ——–—. n.d. Workers in the Informal Economy. Washington, DC. http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/ EXTSOCIALPROTECTION/EXTLM/0,,contentMDK:20224904~m enuPK:584866~pagePK:148956~piPK:216618~theSitePK:390615,00. html Wirth, Lewis. 1938. “Urbanism as a Way of Life.” The American Journal of Sociology 44 (1): 1–24. 8 Bridging Divides Enabling Urban Capabilities Saskia Sassen Cities benefit from two key conditions, both with direct implications for social, cultural, and economic integration. One is a large middle class and a large sector of modest profit-making firms, distinct from a sharp concentration of incomes and profits. The other is a well- distributed urban economy: robust neighborhood sub-economies preventing excessive economic concentration in the center, and good transportation for people and goods—not only to the center but also transversally. Securing the conditions cannot solve racial and sexual violence, environmental destruction, and other problems. But the weakening of the middle sectors since the 1980s has not solved these problems either, bringing new economic negatives. Cities worldwide have seen growing inequality, devastated neighborhood sub-economies, and rising racial and sexual violence. These develop- ments signal that extreme inequality is not good for cities or most urban residents. The post–World War II decades into the 1980s best illustrate the growth of the middle sectors—from Europe to large swathes of Asia, Saskia Sassen 211 Africa, and Latin America. Cities were generally poorer than they are today, as measured by municipal gross domestic product (GDP) and municipal government budgets, and as a share of national wealth and income. But their economies were better distributed, with far more small firms and middle-class households. Despite some brutal excep- tions, such as apartheid in South Africa and racial segregation in the United States, cities in this era generally had less violence, crime, and religious conflict. Many cities with diverse religions that are today aflame saw peaceful coexistence, bordering on indifference, in that earlier period. We cannot go back to that era. Indeed, even the cities that con- tinue to benefit from such basic conditions today must confront rapid population growth and the associated challenges of integra- tion in labor markets, housing, and transport. The urban economy is marked by capture at the top, poorer middle classes, larger destitute populations, and more crime and conflict. These challenges, though present in cities the world over, play out differently in smaller, pros- perous cities in Europe and North America than in megacities in Asia, Africa, and Latin America. But cities today are also seeing a massive upgrading of infrastruc- ture in city centers and high-value neighborhoods. This is due partly to the expansion of high-end business districts and residential areas— and their associated expulsions of more modest firms and households. One outcome is widespread homelessness and destitution, even in cities where these problems had become rare by the mid- to late-20th century. The reasons for this juxtaposition vary enormously due to the differences among cities and among the national economies and societies in which they function. Some cities are sinking under the weight of the negatives, while others are, more recently, succeeding. When clashing visual orders obscure economic articulations Two aspects are often overlooked in discussions about urban econo- mies, whether small or large, global or local. One is that there are multiple articulations between backward and advanced sectors, no matter how different their urban spaces. The second, a critical instance of the first, is that a particular type of manufacturing is 212 Bridging Divides very much a part of today’s urban service economies, including the most advanced. How advanced economic sectors interact with backward sectors is a key indicator of a city’s economic health. Considered by some a relic from days passed, many backward sectors actually serve the advanced economic sectors and their high-income employees. Today’s cities have a type of urban manufacturing geared to design sectors of all sorts (from jewelry to furniture design, architecture, and interior dec- oration); cultural industries (theaters and opera houses need sets and costumes, and museums and galleries need display settings for their collections); building trades (customized woodwork and metalwork); and other sectors of advanced service-based economies (the staging in luxury shops and restaurants, displays in corporate headquarters).1 Because urban manufacturing is deeply networked and operates in contracting and subcontracting chains, it inverts the historical rela- tion between manufacturing and services. Moreover, because urban manufacturing is often fairly customized and hence needs to be near its customers and a diverse pool of top craftspeople, it should be seen as infrastructure for integration. But the visual orders and topographies of major cities do not help us see these articulations. The increasingly homogenized environ- ments of the glamour zone are visually disconnected from the infor- mal economy and urban manufacturing and, at their most extreme, with slums in global south cities. Making these articulations visible would help policy makers and urban civic organizations interested in more urban integration. Some types of material economies, including those I refer to as urban manufacturing, are critical even in advanced knowledge sec- tors. These kinds of urban material economies matter enormously for cities and vice versa. Urban manufacturing, both formal and infor- mal, thrives in cities and, if properly recognized, could contribute to a better distributed economy that produces more mid-level jobs and firms with mid-level profits rather than large profits. Urban manufacturing is often highly specialized—but just as often in ways that analyses of the knowledge economy overlook. Unlike mass manufacturing, it needs to be in cities or urban areas because it is networked, is based on multiple supplier and contractor links, and needs direct contact with customers. And it varies enormously across Saskia Sassen 213 cities, reflecting their differing economic histories. For instance, when major producers of fiber optics, light-emitting diodes, and other advanced glass components sought to expand, one potential site was Toledo, Ohio. This old industrial city beat out high-tech cities, such as Austin, Texas, for these factories (Fitzgerald 2009). The key was that Toledo had a long history of manufacturing traditional industrial glass products and a knowledgeable workforce that could be trusted with the new types of glass production. In cities with extreme inequalities, where the advanced economy captures most of the income and profits, urban manufacturing partly shifts to slums.2 This is evident in cities as diverse as Istanbul, Mumbai, and São Paulo. All three have long histories of manufactur- ing and have seen the emergence of a new type of urban manufactur- ing that services advanced sectors—from design to culture. Whether in cities or in slums, urban manufacturing often goes unrecognized by economic development experts and planners or is misunderstood as an impediment to an advanced urban economy. The spaces and visual orders of urban manufacturing do not fit the image of the advanced economy and are thus easily seen as backward leftovers. In cities where the advanced economy captures a disproportion- ate share of income and profits, initiatives that cut across the divide of the economic center and economic periphery can make an enor- mous social and economic difference for the city at large. A growing number of municipal governments have recognized this, instituting diverse strategies that incorporate marginal areas and groups into mainstream economic circuits. We see a significant effort to over- come barriers that keep the poor from realizing their work capacities simply because they cannot get to their workplaces. Much can be done through transport initiatives that recognize the importance of connecting workers and economies, city centers, and their peripher- ies. Examples can be found in many cities. More generally, today’s political economy clearly needs and gener- ates a growing number of global cities. Together, these cities form a multi-sited, advanced infrastructure for global actors—economic and cultural, professionals and immigrants. But far less recognized is the rise of global slums in major cities of the global south. Most slums are not global, just as most cities are not. Yet, despite the immobili- ties of their inhabitants, some slums are becoming actors with global 214 Bridging Divides projection. Dharavi in Mumbai, perhaps the best known of these slums, is one of the most developed, with its many informal enterprises catering to some of the city’s major economic sectors. São Paulo has several major slums, some quite international, with migrant workers and small entrepreneurs from Peru and other neighboring countries. And La Salada in Buenos Aires, drawing both locals and immigrants into its manufacturing and trading activities, is now South America’s largest informal market (Sassen 2011a). One way to capture these less-visible dynamics is to think of the urban economy as traversed by myriad specialized circuits connect- ing sectors to a far broader range of urban activities than is usually understood. Even finance, when disaggregated into these circuits, has been shown to be linked to urban manufacturing suppliers, often through the design and building trades. Many smaller cities have the skilled workers and potential for developing an urban manufacturing sector linked to somewhat rou- tine corporate services. This is due to the urbanization of a growing range of economic components of non-urban sectors; for example, mining and large-scale manufacturing firms buy many of their cor- porate services in cities. Firms in all economic sectors nowadays are buying more insurance, legal, and accounting services. The services needed by the more conventional economic sectors (heavy manu- facturing, mining, industrial agriculture, transportation) can be pro- duced in smaller cities. Further, the presence of a corporate services sector, along with the resulting growth of a high-income workforce that prefers urban living, in turn generates a demand for urban manufacturing. Such urban living entails a bundle of demands—for high-end restaurants and shops, for museums and cultural events, for customized furniture and metalwork, and for the renovation of older buildings, many of which create demand for urban manufacturing. A lack of support from policy makers, and even from analysts and researchers, can quash the potential for developing a healthy urban manufacturing sector. A network effect lies at the heart of urban economies. The sector connections described above is one reason to reject the widespread tendency among city governments to privilege the advanced ser- vices and neglect most other sectors. Such privileging is a profound Saskia Sassen 215 mistake. It means missing the opportunity to articulate the multiple components of urban economies more strongly and effectively. And to a city’s advantage, most firms, whatever their sector, cannot move out without losing this effect, and so are more likely to stay. A city that puts in the effort and resources necessary to develop most of its sectors can have a diversified urban economy, including the extremes of urban manufacturing and advanced services. This also means a diversified social structure and neighborhood sub-economies. Dynamic advanced services and cultural sectors can drive demand for urban manufacturing products. Indeed, that is a condition for having a dynamic urban manufacturing sector and, as I argue, speci- fies it (Sassen 2010). These types of economic articulations across sectors, which look as if they have nothing to do with each other, are a solid infrastructure for social integration policies, because they feed job growth across a broad range of jobs and incomes. This can help reduce the violence and anger growing in so many cities worldwide where elites grow richer and the rest see their earnings fall and their jobs disappear. Women in cities: obstacles and vectors to urban inclusion There are many ways that gendering promotes the types of inequality that can be an obstacle to making cities inclusive, some going well beyond hurting women themselves. But in urban space, the absence of a gendered perspective is the main obstacle to urban inclusion in gendered societies. It is the failure to recognize women’s needs for public space, transport routes, street safety, and more. Genderless urban planning in societies that are mostly still gendered works against many women, though not all. Women face challenges in access to essential services, housing security, livability, and mobility. The fear and insecurity women experience in many cities is often invisible to men, though young boys and children generally do expe- rience their own forms of fear. Cities, urban cultures, and the safety experienced by women, men, and children varies enormously across the world. Here I examine a few aspects of this vast subject. 216 Bridging Divides A solid body of research documents the ways that women are disadvantaged in the use of urban space—be it public parks, feeling safe, or access to transport. Thus, while there is good critical work on cities, much of it is based on neutral concepts as they relate to gendering: family, population, transport, business districts, and so on. There is urgent need to revisit urban planning from a gender perspective. Basic urban systems do not respond to women’s needs. Falu and Segovia observe an appropriation of women’s time through inconvenient distances to transport, shopping, schools, health services, and possibly jobs (Falu and Segovia 2007). For instance, men commute to and from their jobs, and traffic systems are geared mostly to this pattern, albeit with significant differences in quality and frequency by an area’s income level. Women, however, often combine work and family and need short, interconnected trajectories given their fragmented uses of time. These urban patterns point to an appropriation of women’s time and a devaluing of their economic contribution in both their homes and their paid jobs (Falu and Segovia 2007). Ana Falu (2009) takes this a step further and argues that the different values assigned to their activities are the central gender system for organizing urban space. For instance, the public sphere is marked mostly masculine, so it acquires economic and social value; the private sphere, marked mostly feminine, is given only symbolic value. Such gendering effects often take on specific forms within a female population through ethnic, race, status, and religious variables, with certain combinations producing the most devastating effects. In South America, being a poor indigenous woman produces the sharp- est negative outcomes. Indeed, they are likely to be the lowest paid but also the most threatened in public space. Another particularly vulnerable and growing population are immigrant women, who even if lawful residents face the threat of deportation if they should report abuse or mistreatment. Box 8.1 describes an initiative in Hong Kong Special Administrative Region (SAR), China, that helps immigrant household workers. Fear itself, even without actual violence or abuse, can become a deterrent for women to claim their rights or to use pub- lic space and public transport (Viswanath and Mehrotra 2008). Wars can bring some of the most acute needs for women. One initiative Saskia Sassen 217 Box 8.1 Foreign domestic worker rights, Hong Kong SAR, China Hong Kong SAR, China, relies heavily on migrants to meet the demands of the local labor market. In 2012, some 230,000 foreign women—mostly Filipino, Thai, and Indonesian—worked in the city as live-in cooks, nannies, and maids (Stanton 2012). Under Hong Kong’s immigrations law, foreign domestic workers (FDWs) are bound exclusively to their employers by two-year contracts. The contracts require FDWs to live in their employer’s home, and should they be fired, they have just two weeks to find new employment or be deported (Hong Kong Immigration Department 2012). The ever-present threat of deportation is a significant constraint on FDWs’ ability to report abuse or mistreatment, and many employers take advantage. Indeed, of Indonesian domestic workers in Hong Kong SAR, China, 42 percent were paid less than they agreed on with their employers (Varia 2007). In 2001, more than 25 percent of FDWs reported verbal or physical abuse, with a high prevalence of sexual abuse (Hong Kong Human Rights Monitor 2001). The Bethune House Migrant Women’s Refuge was founded in 1986 to help migrant women in need, especially those fired by their employers or who have fled their abuse. The refuge’s goal, beyond free- ing women from unsafe or abusive working conditions, is to develop their ability to advocate for themselves—both in society and in a court of law. The refuge provides legal aid and arranges for FDWs to observe legal proceedings so that they can become familiar with the process and empower themselves as self-advocates. Some former FDWs use the skills and knowledge they gained through the Bethune House to advocates for other migrant workers (Stanton 2012). addressed this in Afghanistan, a country racked by more than three decades of war. The damage to the country’s human capital, especially that of women and girls, has been devastating (Box 8.2). But women have organized in cities across the world to get men, communities, and governments to address their disadvantages. They have pushed or forced their governments and employers to provide needed facilities. For instance, a common issue is the long 218 Bridging Divides Box 8.2 Female Youth Employment Initiative, Afghanistan Afghanistan has been racked by more than three decades of war, and the damage to its human capital, especially of women and girls, has been devastating. In 2006, the United States Educational, Scientific and Cultural Organization estimated that the literacy rate among adolescents ages 15–24 was at most 20 percent (World Bank 2009). During the Taliban’s rule (1996–2001), women were excluded from the education system, and literacy for rural women fell to as low as 10 percent. In 2007, six years after the fall of the Taliban, women made up less than a third of students in school (World Bank 2009). With the U.S. military’s withdrawal on the horizon, along with the rollback of international aid, Afghanistan needs to maximize its human capital to integrate into the global economy. To help tackle this challenge, the World Bank, the Nike Foundation, and the Government of Denmark have partnered to fund the Afghanistan Female Youth Employment Initiative. The pilot program, launched in 2009, targets women ages 15–27 living in Mazar-e-Sharif, the capital of Balkh Province, and seeks to equip them with non- traditional skills so that they can participate in export opportunities made possible by the city’s proximity to Tajikistan, Turkmenistan, and Uzbekistan (World Bank 2009). Urban Afghanistan has received disproportionately little aid money for education; the pilot seeks to redress this imbalance and give Afghan women not just education but also marketable skills. As of 2012, the pilot project had created opportunities for some 1,300 young women to receive education and occupational training from private non-governmental organizations in Afghanistan (Afghanistan Ministry of Education 2012). work commutes for poor working women and their children. This is particularly acute for breastfeeding women in poor countries, who lack the options available to working women in the developed world (including sterile and refrigerated receptacles for storing milk). Breast milk should not be wasted given extreme food insecurity and malnutrition in poor countries. Box 8.3 describes an initiative that addresses this challenge. Another type of initiative that has benefitted women is cash transfers through diverse mechanisms. One targeted effort that has worked well is Peru’s Juntos project (Box 8.4). These cases illustrate initiatives that could work anywhere. Saskia Sassen 219 Box 8.3 Childcare for factory workers, Bangladesh Bangladesh’s booming export economy is built in part on the backs of working women. Discounting associated industries, garment factories produce 10 percent of the country’s GDP and employ 3 million work- ers, 80 percent of them women (German and Pyne 2010). Each year, roughly 500,000 Bangladeshis migrate from the countryside to Dhaka, the capital, to find work (Akter 2010). And even if they find work, their struggles are far from over. In 2010, 67 percent of people living in Mohammadpur slum, one of the city’s oldest and largest, earned less than 5,000 taka a month (roughly $60). The average household spent 3,232 taka a month on food and 933 taka a month on rent (Akter 2010). These low wages and high expenses make it nearly impossible for mothers to stay home with their children, even in families where fathers are the primary wage earners. Children are often left unattended in dangerous conditions while their mothers work to support the family. If possible, older children stay home to care for their younger siblings—but at the expense of their education (UNICEF 2002). In any case, poor women struggle to care for themselves and their families as they integrate into the urban workforce. Many humanitarian and international organizations have provided significant aid to Bangladesh. The non-governmental organization, Phulki, however, identified a key problem—breastfeeding is all but impossible for mothers working in factories (Schwab Foundation). Options available to working women in the developed world, such as expelling milk throughout the day and storing it in sterile, refrigerated containers, is not possible due to a lack of infrastructure and education. Given Bangladesh’s high food insecurity and malnutrition, the discom- fort that lactating women experience when they cannot discharge their milk, and breastfeeding’s many health benefits for both mothers and children, solving that problem alone would have been extremely valu- able. But Phulki’s solution has grown to address other struggles that working migrant mothers face. Working directly with factory owners and employees, Phulki established factory-based daycare centers for children of ages six weeks to two years. The organization establishes the centers, provides start-up support, and then turns their manage- ment over to factory owners. Factory employees gain access to afford- able childcare and can breastfeed nursing children (UNICEF 2002). Moreover, many of the factory owners take advantage of their relation- ship with Phulki to offer adult education classes on topics like family planning, literacy, and nutrition (The Global Fund for Women 2003). Over 20 such factory-based childcare centers have been established. 220 Bridging Divides Box 8.4 Juntos program: conditional cash transfers targeting women in Peru Poverty in Latin America remains highly influenced by gender. But inequality is not static across the region. As many countries narrowed their wage, poverty, and education gaps, Peru fell behind. Despite a constitution that provides for equal rights, women hold only about 25 percent of land titles (SIGI 2012). Also, the legal tradition of “infor- mal ownership” allows husbands to sell their wives’ property without permission, women earn about 46 percent less than men, and 38 per- cent of women report being victims of domestic violence (SIGI 2012). Juntos, a conditional cash transfer government aid program estab- lished in 2005, has made significant headway not only in reducing family poverty and malnutrition but also in empowering women. Like other conditional cash transfer programs, Juntos pays needy families a small monthly stipend (about $33) in exchange for participating in health and education programs and obtaining government identifica- tion documents (Holmes et al. 2010). Mothers of eligible families (women with children younger than 14 or pregnant women) are paid directly. Women who receive these payments are required to attend weekly training sessions that focus on basic reading and writing and are introduced to other programs that focus on empowerment, equal- ity, and legal aid (Holmes et al. 2010). A primary goal of these time- consuming training sessions is to hold Peruvian men responsible for household work and to change their attitudes toward the gendered division of labor. Women in the program have reported some success in this endeavor, with both men and women reporting that changes were taking hold. According to one man interviewed, “Before only men were the boss …. Now it is different, we are changing …. Previously, my wife did what I said, she didn’t give her opinion. Now she does, one can tell, and we reach a solution. Women’s opinions were less important. Now she gives her opinion regarding how to progress in life” (Holmes et al. 2010, 4). According to a woman, “We now have reached an agreement, we go alone to the bank. [Previously] men did not understand, they got annoyed even when we attended meetings. We were afraid and even had to miss meetings.” Another woman: “Out of jealousy, sometimes they asked us, ‘Why do you go? You leave your house unattended.’ … Now they don’t” (Holmes et al. 2010, 4). Juntos, with its strong impact on gender relations in Peru, is creating more links for women to integrate themselves into mainstream society. Saskia Sassen 221 And women themselves have fought to gain back the streets, develop safety audits, and fight for their rights to the city. Over the last two decades, movements have proliferated throughout the world—in Latin America, Africa, Asia-Pacific, Europe, and North America. We now have two decades of research and grassroots action on safer cities for women. One strong emergent approach is that of the rights to the city and a right to safety in the city (see, for example, Whitzman et al. 2012). Immigrant women in New York City have organized a domestic workers union, a first in the city and perhaps in the country (Fosado and Jackson 2009). Marta Fonseca and Sara Ortiz Escalante describe how women are making urban spaces inclu- sive by developing a series of urban diagnoses: gender audits of every- day life, walks through a city to reclaim women’s history in that city, and deploying women wearing shirts with the sign “public women” in places of vulnerability.3 Their key starting point: “Neutral and universal planning does not exist. What this neutrality does is ignore diversity in our society based on gender, origin, social class, ethnicity, religion, sexual orientation, etc.” Perhaps one of the most impressive grassroots initiatives is Mother Centers, which aim to build social infrastructure in communities that have suffered economic disloca- tion. The initiative started in a few localities and has now spread to the world, with more than 800 centers (Box 8.5). Box 8.5 Mother Centers International Network for Empowerment The Mother Centers International Network for Empowerment grew out of social research by the German Youth Institute in Munich in the early 1980s (Jaeckel et al. 2002). Staff members discovered that preventative policies that enabled families to access community assets were much more effective than intervening after families fail (MINE 2012). To facilitate this, they opened family-oriented, grassroots com- munity centers (Mother Centers) to recreate family and community networks that had been damaged by socioeconomic dislocation. The main tenet of the organization is participation: everyone has something to contribute to the community, and the centers exist to facilitate that interaction (Laux and Kolinska 2004, 5). Many social service (contd.) 222 Bridging Divides Box 8.5 (contd.) providers project the message that individuals seeking help have some kind of deficit (“You have a problem. Come to us, the experts, for help”), but at Mother Centers, everyone is a participant and a con- tributor, and the message is that they are needed (“You are good at at least one thing. Come to the Mother Center and contribute to the community”) (Laux and Kolinska 2004). The fall of totalitarian governments in Eastern Europe created a huge demand for community infrastructure and social services that had disappeared in a sea of unemployment, violence, upheaval, and decay. Mothers at home with children faced severe isolation—not just from goods and services but also from human contact and social networks. The Mother Center initiative spread quickly through peer visits and exchanges in the post-socialist world (MINE 2012) and helped restore the contact points that are the foundation of coherent society. The Mother Centers movement has continued to expand though grassroots peer exchanges and individual initiative. Today, there are more than 850 centers worldwide (not only in the United States, Germany, and the former socialist regimes of the European Union but also in countries like Rwanda and Cameroon) (Laux and Kolinska 2004). The centers are self-managed public spaces in neighborhoods that offer peer networks and drop-in childcare, facilitate access to community and employment resources, and expand children’s positive social space. They revolve around a drop-in coffee shop or other shared space where childcare is provided. And they offer adult education classes and services, such as hair cutting, secondhand shops, sewing classes, computer training, and job retraining. When possible, women are paid hourly for services, providing them with much-needed income and a sense of ownership and empowerment (MINE 2012). Centers usually reach between 50 and 1,000 families per neighborhood. They supplement the usual social safety net—and in some cases replace it (Jaeckel et al. 2002). Cities and political subjectivity: when powerlessness becomes complex Cities are key sites for making new norms and identities. Max Weber’s The City identifies a city’s ideal-typical features, the conditions that compel residents and leaders to craft innovative responses and Saskia Sassen 223 adaptations to challenges—in short, to push the urban population into action. For Weber, the cities of the Late Middle Ages had these conditions: ideally a set of social structures that encourage individuality and innovation and hence are an instrument for change. But Weber did not find these qualities in the industrial cities of his time; he found that large factories and corporate bureaucracies were dominating cities, robbing citizens of the ability to shape at least some of their cities’ features. Another key idea in Weber’s work is that these transformations could instill larger foundational transformations beyond the city, offering the possibility of understanding changes that could—under certain conditions—eventually encompass all of society. Weber shows us how, in many cities, these changes led to what today might be called governance systems and citizenship. Political, economic, legal, and cultural struggles centered in cities can become the catalysts for new trans-urban developments in many institutional domains— markets, participatory governance, rights for members of the urban community regardless of lineage, judicial recourse, and cultures of engagement and deliberation. Cities again emerged as strategic sites when the global era began, a trend counter-intuitive but now extensively documented (Sassen 2012). Global cities have sprung up across the world and emerged as strategic sites for innovation and transformation in multiple institu- tional domains. This process has not been painless. Key components of economic globalization and digitization concentrated in global cities produced dislocations and destabilizations of institutional orders in and beyond cities.4 Further, some of the key legal, regula- tory, and normative frames for handling urban conditions are now part of national framings—much of what is called urban develop- ment policy is also national economic policy. The high concentration of these new dynamics in global cities forces both the powerful and the disadvantaged to craft new responses and innovations, albeit for very different types of survival. By contrast, from the 1930s to the 1970s, when mass manufactur- ing dominated, cities had lost strategic functions and were not sites for creative institutional innovations. The large factory—at the heart of mass manufacturing and mass consumption—and the government were at the time the strategic sites of major institutional innovations. 224 Bridging Divides My own reading of the Fordist city corresponds to Weber’s in that the strategic scale under Fordism is the national scale—cities lose significance. But I part company with Weber in that the large Fordist factory and the mines became key sites for the making of a modern working class and a syndicalist project; it is not always the city that is the site for making new norms and identities. With globalization and digitization—and all that they entail— global cities do emerge as strategic sites for making norms and identi- ties. Some norms and identities, such as those of global managerial elites, project extreme power. Others, notably those of immigrant neighborhoods, project innovation under extreme duress. While the strategic transformations are concentrated sharply in global cities, many also develop (besides being diffused) in smaller or less- global cities. Weber’s observation about urban residents, rather than merely leading classes, is also pertinent for today’s global cities. Conditions in these cities are not only creating new power structures but also opening the door for new types of actors long without a political voice. The localization of strategic components of globalization in these cities allows the disadvantaged to develop new ways of contest- ing global corporate power. And the growing numbers and diversity of the disadvantaged affords them a greater presence in these cities, in a way they could not on a plantation, for instance. It is critical to uncover the differences between powerlessness and invisibility within this process of enabling the disadvantaged to contest global power and to gain presence in their engagement with power, indeed, also in their interactions with each other. Today, the localization of the most powerful global actors in global cities cre- ates objective conditions for engaging power at a local scale. This makes powerlessness complex, even if it does not necessarily generate empowerment. Highly localized struggles are actually a form of global engagement, a horizontal, multisited recurrence of similar demands in cities the world over (see Sassen 2008, ch. 6, 8). Examples include the struggles against gentrification’s encroachments on minority and disadvantaged neighborhoods, as well as modest middle-class neighborhoods; the related struggles for the rights of the homeless, whose numbers increased in many cities starting in the 1980s; and demonstrations against police violence, often connected to gentri- Saskia Sassen 225 fication and displacement. These struggles are different from the ghetto uprisings of the 1960s, which were short, intense eruptions damaging mostly the ghettos themselves. Two conditions make some of today’s cities strategic sites, and both capture major transformations that are destabilizing older systems of organizing territory and politics. One is the rescaling of strategic ter- ritories that articulate the new politico-economic system and hence at least some features of power. The other is the partial unbundling or at least weakening of the country as the container of social pro- cesses, due to the variety of dynamics encompassed in globalization and digitization. The consequences of these two conditions are many; what matters here is that cities emerge as strategic sites for major economic processes and for new types of political actors. Even poor immobile individuals and marginalized communities can become part of a global space for making demands for justice, recognition, and voice. The political practices in today’s global city differ from what might have arisen in Weber’s medieval city. In the medieval city, a set of practices allowed the burghers to set up systems for owning property and protecting it against more powerful actors, such as the king and the church, and to build defenses against despots. Today’s political practices, I would argue, have to do with the presence of those with- out power and with a politics that claims rights to the city rather than protection of property. What the two situations share is the notion that through these practices new forms of political subjectivity—that is, citizenship—are being established and that the city is a key site for this type of political work. The city is, in turn, partly built on these dynamics. Far more so than a peaceful and harmonious suburb, the contested city is where the civic is getting built. After centuries of the ascendance of the national state and the scaling of key economic dynamics at the national level, the city today is once again a scale for strategic economic and political dynamics. Cities as frontier spaces: the hard work of keeping them open One key condition for the city to survive as a space of complexity and diversity—and not merely as a high-density concrete jungle—is 226 Bridging Divides reducing conflict, whether originating in racism, government wars on terror, or the devastation of climate change (see, for example, Marcuse 2002). Can the urbanity of city residents and city spaces—rather than ethnicity, religion, or phenotype—mark a city? Bringing out the urban subject in city residents has historically been one force in thwarting urban conflicts. But that mark does not simply fall from the sky. It often stems from hard work and learning from failures. One question is whether it can also stem from the need for new solidarities in cities that confront major challenges, such as racism, sexual violence, and environmental crises. These challenges might force a critical mass of city residents into joint responses and, from there, into a stronger urban subject and identity rather than an individual or group (for example, ethnic or religious) subject and identity. One historical window into this type of urban capability is immi- gration. What must be emphasized here is the hard work of making open cities and of repositioning the immigrant and the citizen as urban subjects that mostly transcend nationality. In a city’s daily routines, the key ruling factors for both immigrants and citizens are work, family, school, public transportation, and so on. Perhaps the sharpest difference in a city is between the rich and the poor, both of which include immigrants and citizens alike (see, for example, Smith and Favell 2006). When the law and the police enter the picture, the differences between immigrant status and citizen status become key factors. But most of daily life in the city is not ruled by this distinction. Here I address this issue from the perspective of the capacity of urban space to make norms and subjects that can escape the con- straints of dominant power logics, such as nationality, the war on terror, and racism. Historical European immigrant integration through the making of the European open city is one window into this complex and historically variable question. In my reading, the history of Europe and the Western Hemisphere shows that the challenges of incorporating the outsider often became the push to develop a stronger civic and urban experience of mem- bership, rather than a civic based on religion, class, and ethnicity. At times, immigrant inclusion became the occasion for expanding Saskia Sassen 227 the rights of the already included, notably citizens. Responding to claims by the excluded has over time expanded the rights of citizens, a subject I develop at length elsewhere (Sassen 1999). And very often, restricting the rights of immigrants also restricted those of citizens; one recent example is the U.S. Illegal Immigration Reform and Immigrant Responsibility Act of 1996, an immigration law that took away rights from immigrants and, far less noticed, citizens.5 Anti-immigrant sentiment, long a critical dynamic in Europe, has until recently been mostly overlooked in most accounts of European history, given self-understanding as a continent of emigration.6 Anti-immigrant sentiment and attacks occurred in each major immi- gration wave in all major European countries. No labor-receiving country has a clean record—not Switzerland, with its long admirable history of international neutrality, and not France, the most open to immigration, refugees, and exiles. For instance, French workers killed Italian workers in the 1800s, accusing them of being the wrong type of Catholic. There have always been, as there are today, individuals, groups, organizations, and politicians who believe in making society more inclusive. History suggests that those fighting for immigrant inclu- sion have succeeded in the long run, even if only partially. The trans- formation from disdain for foreigners to acceptance is also the result of constraints in a large city; for instance, in a sound, reasonably fast public transport system, it is not feasible to check the status of all users. A basic rule needs to be met: pay your ticket and you’re on. That is the making of the civic as a material condition. Anyone who meets the basic rule—pay the ticket—can use public transport, regardless of whether they are citizens or immigrants, former prison- ers, tax evaders, or generally nice people. Europe has a little-known several-century history of internal cross- border labor migration. This history hovers in the shadows of official European history, dominated by the image of Europe as a conti- nent of emigration, never of immigration. Yet in the 1700s, when Amsterdam built its polders and cleared its bogs, it brought in north- ern Germans to help; when the French developed their vineyards, they brought in Spaniards. Workers from the Alps were brought in to help develop Milan and Turin, as were the Irish when London 228 Bridging Divides needed help building water and sewage infrastructure. In the 1800s, when Haussmann rebuilt central Paris, he brought in Germans and Belgians; when Sweden decided the monarchy needed some new palaces, it brought in Italian stoneworkers; when Switzerland built its Gothard Tunnel, it brought in Italians; and when Germany built its railroads and steel mills, it brought in Italians and Poles. During these flows of intra-European migration, immigrant workers were initially seen as outsiders—as undesirables, as threats to the community, as people who could never belong. The immigrants were mostly from the same broad cultural group, religious group, and phenotype as receiving societies. Yet they were considered impos- sible to assimilate. The French saw Belgian and Italian immigrant workers as the wrong type of Catholic; the Dutch saw German immigrant workers as the wrong type of Protestant. These telling facts suggest that it is incorrect to argue, as is so often done, that it is more difficult today to integrate immigrants because of their different religions, cultures, and phenotypes. When these features were similar, anti-immigrant sentiment was as strong as it is today, and it often led to violence. Yet after two or three generations, many immigrants found their way into the community fabric. They often maintained their distinc- tiveness, while still being members of the complex, highly heteroge- neous social order of any developed city.7 Today, the argument against immigration is focused on race, religion, and culture, and this focus might seem rational—cultural and religious distance is why integration is difficult. But in sifting through the evidence, we find only new contents for an old passion: the racializing of the outsider as the ‘Other’. Today, the Other is stereotyped by differences of race, religion, and culture. These arguments mirror those of the past, when migrants were broadly of the same religious, racial, and cultural group. Migration hinges on a move between two worlds, even if within a single region or country, such as that of East Germans moving to West Germany after 1989, where they were often viewed as a different ethnic group with undesirable traits. What is today’s equivalent challenge, one that can help us look beyond our differences and make what would correspond to that traditional European civic tradition built through incorporating at least a share of the foreigners in their midst? Saskia Sassen 229 Where we stand The major challenges that confront cities—and society in general— have increasingly strong feedback loops that disassemble the old civic urban order. But these challenges also have the potential to spur the development of new types of civic cultures—broad platforms for urban action and collaboration across groups. Fighting climate change might well force citizens and immigrants to work together, regardless of religion, culture, or phenotype. Similarly, fighting the abuses of state power in the war on terror can create coalitions that bring together residents who once would never have collaborated. Now that there are greater threats to civil rights—and even basic survival—amid sharp inequalities and climate change, we might well see novel solidarities emerge. Zooming into the city level, with the evidence I examined, includ- ing the cases described in this paper, one conclusion jumps out. Cities that succeed in their interventions show us that the old model of “integrating them” does not work; what seems to work best is a different starting point: “we are all in here—we all are the city. There is no ‘them.’” Integration policies that work begin with building on current integration efforts that have succeeded (even if integration has been limited). The work of integrating across divides in a city then becomes the work of improving existing integration nodes (schools, workplaces, neighborhood sub-economies, housing, cul- tural districts) and expanding the number of points of integration to achieve better distributed urban economies, housing, and transport. The aspiration is multi-nodal cities on all three vectors. Notes 1. See also Gratz’s (2010) chapter on manufacturing in New York City linked to top-level design sectors—for example, making classic style furniture replicas to be sold through the Museum of Modern Art. Another example is American Apparel, a fashion store that made a point of manufacturing in inner Los Angeles and became hugely successful, though it eventually suffered setbacks. 2. This usage of the term “slum” needs to be distinguished from the exclu- sively negative conventional understandings, whether in literature or in UN Habitat practice. The recovery of the term comes from leadership 230 Bridging Divides in some of the world’s major slums. “Slum” here is a knowing word choice. It is not the category of the observer, but the category of the actor inside the slum. I develop some of this in Sassen (2011a). See also Sassen (2011b). 3. Public Women: Gender Inclusive Planning Experiences in Catalonia (colectivopunto6@gmail.com). 4. Emphasis on this multiplication of partial assemblage contrasts with its treatment in much of the globalization literature, which tends to assume the binary of the global versus the national. In this literature, the national is understood as a unit. I emphasize that the global can also be inside the national—that is, the global city. The globalization litera- ture also tends to focus on the powerful global institutions that have played a critical role in implementing the global corporate economy and have reduced the power of the state. By contrast, I also emphasize that some components of the state have gained power because they have to implement policies necessary for a global corporate economy. This is another reason for valuing the more encompassing normative order that a city can (though does not necessarily) generate. 5. See Sassen (2008), ch. 6; see also chs. 4 and 5 for a diversity of other domains besides immigration. 6. This section is based on research in two previous works: Sassen (1999, 2007). 7. Elsewhere I have documented the acts of violence, the hatreds we Europeans felt against those whom we today consider “one of us.” See Sassen (1999); for a more general discussion, see Appadurai (2006). Bibliography Afghanistan Ministry of Education. 2012. Terms of Reference: Conducting Social Marketing Survey, Providing Job and Life Skills Trainings, and Job Placement Service. Islamic Republic of Afghanistan. http:// www.worldbank.org/projects/P116036/adolescent-girls-initiative- afghanistan?lang=en. Akter, Tahera. 2010. Migration and Living Conditions in Urban Slums Implications for Food Security. Unnayan Onneshan. http://www.unnayan. org/index.php?option=com_content%26view=category%26layout=blo g%26id=27%26Itemid=163. Appadurai, Arjun. 2006. Fear of Small Numbers. Durham: Duke University Press. 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It then lays out a framework for understanding the costs and benefits of new arrivals through migration’s externalities and the challenges and policy tradeoffs that confront city stakeholders. The chapter concludes by suggesting ways municipalities, by optimizing flexibility, can make migration more productive and less destructive in shaping the “good city” and the “smart city.” There are few paths to global economic growth that do not run through cities—and even fewer that do not depend on growing the city in population size, scale, and economic exchange. Historically, cities have grown by concentrating the economic advantages of number and density, the social potential of innovation, and the cultural possibilities of newness. By bringing together the factors of production—land, labor, capital, and enterprise—in ever more Michael Keith 235 recombinant forms, cities offer the possibility of securing new eco- nomic advantages and scaling them up. To realize these advantages—in 18th- and 19th-century indus- trial cities as much as in today’s megacities and medium-size cities— urban growth must integrate new populations into the metropolitan machine. Urban demographic change can come from population growth through longer life expectancies and from birth rates exceed- ing death rates, but it can also come from a city’s appeal to people who in turn drive further rounds of economic development. Journalist and commentator Doug Saunders (2010) projects a massive demo- graphic shift to urban areas: What will be remembered about the 21st century, more than any- thing else except perhaps the effects of a changing climate, is the great, and final, shift of human population out of rural, agricultural life and into cities. We will end this century as a wholly urban species. This movement engages an unprecedented number of people—2–3 billion humans, perhaps a third of the world’s population—and will affect almost everyone in tangible ways. It will be the last human movement of this size and scope; in fact, the changes it makes to family life, from large agrarian families to small urban ones, will put an end to the major theme of human history, continuous population growth. (p. 1) The world is only becoming more urban. While Europe has 35 cities of at least a million people, by 2025 China will have an estimated 225 cities and India’s number of cities will have grown from 42 to 68. By 2030, some 350 million more people will live in Chinese cities. And though growth in Indian cities is driven more by expanding urban populations and the reclassification of formerly rural land, the move to the city has already restructured traditional social and economic relations. But the migration challenge for 21st-century cities is complex. Alongside the urbanization of predominantly rural societies across the world, other flows reflect changing demographics, new labor market demands, family unification, and political upheaval. In Europe, long-term demographic trends have led to shrinking cities in some areas and a demand for migrant replacement populations and new labor markets in healthcare sectors due to an aging population. High-skilled labor migration has become one facet of 236 The Great Migration globalization, while increasing human connectivity has forged links across transnational family networks. Political upheavals generate major forced migrations in conflict zones, geopolitical realities create transit migrations, and countless people travel under the radar of formal measurement—irregular migrations of a scale that authorities can only estimate. Meanwhile, the old growth engines of cities in the global north attract the hopeful and the skilled. In exceptions, such as Japan and the Republic of Korea, states try to resist in-migration, but strengthening labor demand remains on the policy horizon for expanding economies. So the first challenge for 21st-century cities is to understand that, while migration into cities is a global phenomenon, both the causes and the consequences are complex and varied. What complicates the move to cities The move to cities is central to development and growth, but the arrival of migrants can trigger concerns about the impacts of migra- tion. Indeed, potential competition for resources and opportunities has frequently translated into populist sentiment. In February 2012, a national controversy erupted in China when professionals in Hong Kong SAR, China, took out a newspaper ad depicting incoming mainland Chinese as locusts and asking, “Are you willing to pay 1 million HK dollars every 18 minutes to take care of mainland children born in Hong Kong?” (China Daily 2012). In Mumbai in recent years, Raj Thackeray, founder of the Maharashtra Navnirman Sena, has used concerns about competing rural migrants—Biharis in particular—to drive populist campaigns and secure political power. In the United Kingdom, even after the 2008–09 global financial crisis, migration remains a top political concern, and in mainland Europe anti-migrant sentiment drove both the rise of extremist parties and at times mainstream debates. So why is this? Why do economies and cities demand further streams of migration while existing residents worry about incomers? The answer is straightforward but challenging for mayors and policy makers alike. The opposition to migration is not entirely irrational. Cities need migration: migrants grow the economy, and migrant niche economies frequently create innovation and dynamism. Some Michael Keith 237 40 percent of Fortune 500 companies were started by migrants or their children. But the costs and benefits of migration are not distributed evenly. This concept needs to inform policy development. The benefits of migration accrue in the labor market (whether defined by commuting distance or recruiting distance) and the tax base. The integration of migrants into labor markets displaces some people in competition for jobs; however, migrants themselves generate demand, spend their own money, and in turn create new employment opportunities. There is no “lump of labor” among which city jobs are shared. Most analysts contend that migration to the city will usually grow jobs and, consequently, the tax base and overall benefits for society. But these benefits can accrue unevenly. Migration’s unintended consequences—welfare externalities— become most visible in neighborhoods, where people live rather than work. In some areas, migration-related social change might lead to pressures on public goods—environmental amenities, primary schools, and subsidized housing (for rent or ownership). But importantly for policy makers, measuring these externali- ties involves both normative and analytical categories. Externalities generate policy tradeoffs for municipal governance in balancing the permeability of a city’s economy with the integration of its society. As cities strive to accommodate flows of people, different welfare systems ration scarce public goods in different ways. These rationing systems are frequently controlled nationally but managed locally. Pragmatic demands on city managers often involve demographic realities that do not align with national policy principles—as much in New York, London, or Los Angeles as in Mexico City, Johannesburg, Shenzhen, or Istanbul. New migrants’ access to health care is often regulated nationally, though the controversial 2012 flows from the mainland to Hong Kong SAR, China, for natal and perinatal care highlighted the uneven- ness of national categorization. At other times, city mayors and local governments determine access to public or semipublic goods like primary education or subsidized accommodation. Accommodation of migrants defines the permeability of residence in rental and pur- chase markets and at times in the extemporized development and settlement of unused metropolitan areas. And so rationing and regu- lation depend heavily on whether new migrants are full citizens— 238 The Great Migration whether they have the same rights as residents to public and private goods. The arrival of people in a city often accelerates the growth of informal settlements, overcrowded rental accommodations, and “slumlords,” or landlords that exploit new arrivals. The ways that new migrants access subsidized housing, dwell in regulated and inspected rental sectors, or receive accommodation after displacement by slum clearance or urban renewal schemes all nuance the absolute costs of migration externalities with the moral classifications of eligibility criteria (see Box 9.1). Some cases of migration’s welfare externalities challenge the con- ventional measurement of its fiscal impacts. Within a static model of the city, including new migrants in the rationing of public goods Box 9.1 Plural migrations and welfare externalities: social housing eligibility in east London London is a global city structured by generations of migration. Its East End in particular has paradoxically provided both extreme social conflict and ideal migrant integration. The conflict and the community building have frequently revolved around competing eligibility defini- tions of migrants and locals. The white East End has given us exemplary moments of cultural fusion. The quintessentially British fish and chips emerged here from Jewish methods of preparing fish and the Huguenot tradition of fry- ing Irish potatoes. But the East End has also witnessed violent clashes between Catholic and Jewish migrants, marked in turf wars like the Battle of Cable Street in 1936, when the British Union of Fascists marched on the Jewish quarter. Even contemporary “whiteness” crumbles under scrutiny, highlighting old conflicts between Irish migrants who built the docks in the 19th century; Irish crime families still living in 21st-century east London; Jewish migrants forced from the Pale in the late 19th century, some of whom followed Rudolph Rocker’s Jewish cosmopolitan anti-colonialism; and people displaced from across Europe after World War II. From the 1970s on, migration focused principally on the Sylhet region of Bangladesh, amplifying old lascar seafarer connections with London’s docks but concentrating new arrivals in the restaurant and rag trade sectors. Michael Keith 239 Legal residents in the 1980s, Bangladeshi families were dispropor- tionately offered the worst social housing, and the UK Commission for Racial Equality moved against the local authority for overt discrimina- tion. Bangladeshi rights to the city were also fought for rather than given, with popular uprisings following the deaths of high-profile victims of racist violence. But as rational allocation of social housing came to the fore in the 1990s, some challenged the moral calculus that privileged either those born locally or those with the greatest immediate needs. The neighborhood, the borough, and the country determine eligibility for subsidized rental housing in different ways. How to mediate the “proper” democratic demands of “local” people and the “rights” of those needing accommodation is an intractable problem. Many applicants for social housing were born in Bangladesh. So even after living in the United Kingdom for many decades, they are formally migrants. This raises one of the central questions in calculating migration’s welfare externalities: How do we regulate the welfare state in a world structured by global flows of people and resources? Migration’s social costs in housing shortages and ethnic competition focus on dense city neighborhoods, even where the economic benefits of Bangladeshi migration have been immense. Today, sink estates bought through right-to-buy take-ups of old council rentals (by old Jewish and Irish families and by Bangladeshi migrants) are let out to Lithuanians and Russians, and Roman Catholic school enrollment is rising again. Who has the right to demand welfare support in today’s globalized world? Whose communities should be provided welfare? Theoretically, this might make us think about a tension between com- munitarian belonging and sentimental transnationalism. Practically, the most effective integration depended on three strategies to diffuse eligibility-criteria conflict. First, strong policy planning increased the social housing supply by extracting at least 25 percent of all new private housing development for public amenity (and up to 50 percent where accompanied by state subsidy). Second, transparent allocation systems encouraged people to “choose” properties and see the results of their preference in their place on the allocation queue. Third, eligibility criteria explicitly addressed both social need and the queuing element of waiting for social housing. Such practices focus on the eligibility criteria of migrants to the city. They cannot eliminate social conflict but can enhance a sense of progressive urban change in all sections of the community. 240 The Great Migration increases objective welfare costs. But some policy makers, consider- ing a more dynamic model, might argue that excluding new migrants from the rationing of public goods decreases the long-term benefits of migration, as the new migrants’ potential contribution to the city economy is not fully realized. Yet allowing newcomers access to state- financed social inclusion (in schooling, health care, welfare services, and housing) potentially undermines the solidarities of existing city dwellers and may thus have social consequences. These dilemmas highlight two challenges for policy makers in the 21st-century city governments. First, the great movement into cities replicates a standard tradeoff in migration studies. Some scholars believe that there might be a tradeoff between restricting the numbers of migrants allowed into a country and extending rights to new migrants (Ruhs 2013). In other words, it might be easier for policy makers to increase the numbers of international migrants in a country that restricts migrant rights than in a country that immediately grants new migrants full citizenship. Second, the immediate impacts of new migrants may focus on current labor demand (a static model of the city economy), but the longer impact may reflect labor demand beyond a single economic cycle and social trends across several generations (a dynamic model). How well people sustain international connections also raises ana- lytical and moral challenges for policy makers. In today’s societies, where both mobility and international connection have increased exponentially, migrants may sustain links between locations; “home” may refer both to places where families arrive and to places where families are rooted. As the distinction between permanent and tem- porary migration potentially blurs as a result, maintaining longer term transnational links takes on more meaning. In the 21st century, we are already seeing countercyclical flows, as Brazilian and Colombian migrants to Madrid and London return to the more dynamic Latin American economies, and policy debates on marriage migration, as one demographic chooses spouses from countries of origin rather than country of arrival. Temporal dimensions further complicate the move into cities, which often have neighborhoods and districts where several trends operate simultaneously. In the early 20th century and after World War II, we considered mass migration to global north industrial cities Michael Keith 241 (for example, to the United States, Canada, and northern Europe) permanent, with declining social and family connections with the origin nation and assimilation into the new settlement site. But as the world has become more connected, global travel has become cheaper, easier, and faster, while Skype, Twitter, and Facebook can connect us 24 hours a day. In the 20th century, migration was considered generational, with the first-migration generation characterized by arrival, the second by settlement, and the third by assimilation. The 21st-century displacement of migration paradigms by mobility paradigms—describing new, less rooted connections of people to places—complicates these dynamics. And as origin nations’ econo- mies grow, migration networks reconfigure. In the late 20th century, Spain, Italy, and Greece hosted steady economic expansion that transformed Barcelona, Madrid, Rome, Naples, and Athens from origin nations to migrant destinations. As global economic dynamics shift even faster, migration networks will continue to evolve geopolitically. For example, Kumkapi, a small neighborhood in Istanbul, has hosted transnational trading networks linking the former Soviet Union to its Ottoman penumbra, transit migrants seeking access to European Union labor markets, and new international labor migrants contributing to the fast-growing Turkish economy. Migration consequently both exemplifies and reinforces urban dynamism, as transnational connections inform commerce flows, local economic innovation, and labor market flexibility. Policy makers must understand these distinctive trends, whose cumulative effects structure both causes and consequences of migration into cities. Migration externalities are both positive and negative, introducing new economic possibilities and challenging the ecological balance of the urban fabric. Compounding these dilemmas, variations in skills and affluence affect both adaptation and reception of new migrants. In economic theory and longer term social history, growing city economies need both unskilled and skilled migrants. When we calculate migration’s welfare externalities, we should remember that both skilled and unskilled migration in some senses “come cheap” to the host cities. Crudely put, people cost society mostly in the early and late years of their lives—when young, they need protection and education; when old, they need support and more health care. Most migrants 242 The Great Migration are adults and consequently arrive cost-free; their origin nations have borne the costs of their early years (see Box 9.2). Highly skilled, affluent migrants can provide for themselves in the short term and have the purchasing power to affect local markets. During the economic upturn of the NICE (non-inflationary consistently expan- sionary) decade, some 56,000 migrants arrived in London each year. But the new migration flows initially attracted little media attention, as most migrants were highly skilled, affluent workers associated with the booming financial sector, whose presence still largely deter- mines property prices in some parts of the city.1 Equally, in situations of political instability, the sheer scale of rapid change can displace the “rational” policy development of both migration flows and settlement integration. South Africa’s largest city, Johannesburg, has 3–3.5 million people and a greater area population at least twice that. By late 2011, it was home to an estimated 450,000 asylum seekers, predominantly from neighboring Zimbabwe, making it one of the world’s largest refugee camps, with migrant presence equally distorting both policy debate and metropolitan dynamics (Dailymotion 2011). Box 9.2 Shenzhen Speed: city growth and migrant integration “Shenzhen Speed” captures the pace of economic development in the city just north of Hong Kong SAR, China. In 1979, some 390,000 people held Shenzhen residential rights, or hukou. The municipal regions’ residential population are now an estimated 10–15 million. Liu Kaiming (2007) has delineated four phases of development of the city’s growth. In phase 1 (1979–85), large-scale urban infrastructure was built, driven by migrant workers from other parts of Guangdong Province. From 1983, the development of export-processing factories relied on the sanlai yibu system (three imports and one compensation). Affluence focused on a local synthesis of raw materials, components, labor, and land with a lump-sum compensation. The state led the model, but enterprises linked to (frequently Hong Kong SAR, China–focused) foreign direct investment, ever more flexible employment policies, and an increasingly female migrant labor force. In phase 2 (1986–92), more factories and enterprises appeared, developing a wider geographic focus but remaining largely within special economic zones. In phase 3 (1992–2000) and phase 4 (2000–present), the city has displayed rapid Michael Keith 243 restructuring—the factories and production systems have moved up the value chain, factories relocated, and migrants improved their skills. Although the pattern has become more complex in recent years, Shenzhen migrants live overwhelmingly in cheng zhong cun (villages in the city), where rural property rights remain. Old village clans retain much of their autonomy, negotiate with municipal government, and shape residential development, sometimes with notoriously poor- quality and poorly planned handshake apartments (wo shou fang) where migrants live in overcrowded conditions and sometimes targeting the skilled and affluent migrants in partnerships with real estate developers. A paradox rests at the heart of the Shenzhen integration machine: formalized informality. Rural property rights over development in the cheng zhong cun have sped reform-era urban growth since 1978 and state-regulated urban property rights in the “rational” and planned metropolis. The cheng zhong cun work as family-based limited stock investment companies that have effectively incorporated the massive migrant flows into the city, evolving rapidly as one wave of migrants succeeds another. But the villages are sites of informality and creativ- ity, as well as the means of selective incorporation and subordination. Some villages, such as Da Fen, where major arts and cultural industries linked to Hong Kong SAR, China, investment have clustered, have specialized economically, while others negotiate directly with foreign direct investment manufacturers from Japan. Yet others, such as Xia Sha, have transformed from unskilled labor sites to rental housing sites for skilled workers in local technology firms. Functionally, they serve the city’s interests. Economically, they mediate migration welfare externalities. Welfare net costs are borne by the hidden support systems in the rural regions where children are sent home to be educated, the partial and incomplete models of hukou-related “city-zenship” that proffer provisional and partial membership and limited access to city rights to new arrivals. In the parts of Shenzhen that have moved up the manufacturing value chain, the villages have evolved rapidly. In some villages, old handshake apartments have been renovated for more upmarket tenants (Shenzhen-style gentrification). In other villages, the development of commodity housing has created new leasehold arrangements. In parts of the city with urban property rights, new xiao qu residential complexes have created a different urbanism. The plurality of regimes of property rights has so far worked pragmatically as the municipality negotiates between the local government’s formal powers and the company structures of the (informally zoned) villages. 244 The Great Migration Policy makers must mediate short-term pressures and long-term gains and recognize the plural geographical scales of the metropolis. Successful urban migration depends on a city’s permeability—its ability to integrate new presence in an old fabric. Policy agendas, agenda setting, and tradeoffs in city governance What makes a city permeable to migration? The anonymity of cities like Lagos, New York, and Shanghai, with weak social bonds and indifference to strangers, helps make urban neighborhoods more flexible, suggesting that city freedoms sometimes self-regulate. But exuberant urban growth gone unchecked can lead to city sprawl that in its low densities rapidly becomes ecologically unsustainable. Managing longer and shorter term pressures calls for understanding the policy dilemmas of incremental but rapid urban change. This in turn demands a facility for making sense of how migration affects some parts of a city differently than others. This balancing of time scales and geographic scales informs the policy agendas and tradeoffs necessary for the 21st-century city. Rights and the rational city In November 2004, at the initiative of the Dutch Presidency, the EU Council adopted the Common Basic Principles on Integration. The principles were designed to promote a common European approach toward migrant integration and to serve as a reference for imple- menting and evaluating current and future integration policies. The extent to which member states of the European Union have adopted them is moot. But the framework could help city governments consider migrant integration in both a global and European context. The Council identifies economic, social, cultural, and political integration and a commitment from the European Union to manage migrant integration as a two-way process involving migrants themselves and the institutions and societies where they arrive. This moves policy practice away from an expectation that effective integration depends entirely on the new arrivals assimilating themselves. It Michael Keith 245 draws attention to the policies that successfully promote migrant integration—a British model developed by Ager and Strang (2004) to focus on policy interventions in employment, housing, education, and health that are facilitated by ensuring both “language and cultural knowledge” and the safety and stability of migrant settlement and networks (Figure 9.1). The model is as useful for cities of the global south as it is for cities of the global north—because it identifies a transition through which specific interventions can enhance urban permeability. It points policy formation toward the most effective integration interventions, most notably through considering human capital and language skills and protecting new arrivals’ safety and security (in criminal justice systems and civil society). The focus on evolving integration also suggests how urban policy making might prioritize dynamic social change within incremental policy intervention. City perspectives often differ from those of nation-states. Cities may reconcile the presence of illegal or irregular migrants with their contribution to the city’s social and economic fab- ric through migration amnesties or established paths to citizenship. North American and European mayors are often more sympathetic to such amnesties than central governments, keen on maximizing and formalizing the employment conditions and tax contributions of working migrants. Figure 9.1 The indicators of integration framework Source: Ager and Strang 2004. 246 The Great Migration Recognition and belonging To be inclusive, the changing city must continually build a sense of community. Also, sustained links between homeland (or “diasporic”) networks and the arrival cities can be mutually productive. The American sociologist Alejandro Portes has long argued that such networks enhance ethnic enclave and niche economies in the new arrival cities and the potential for growing ethnic enterprises that help upward mobility. This model is seen across the world—in migrants from Wenzhou Province to Beijing and Shanghai; in the successful social mobility of South Asian “twice migrants” expelled from Africa during the decolonization period and succeeding in British cities in the 1980s and 1990s; and in some “model minority” Korean and Cuban settlements in the United States. However, recognizing the identity politics of new migrations pres- ents policy makers with further dilemmas. Religious faith commonly creates powerful social networks but can also challenge religion’s place in the public square and its framing in social policy interventions. The geopolitics of the early 21st century promoted particularly intolerant debates about Islamic structures, institutions, and symbols serving new migrant communities. The controversies around the Ground Zero mosque in New York City, New York, United States the 1992 destruction of the Babri mosque in Ayodhya, Uttar Pradesh, India, and the 2009 ban on mosque minarets in Switzerland demonstrate how the urban landscape has become a contested arena of identity politics. City governments not only regulate and license the visible presence of new cultures but also structure their own institutions in ways that either welcome and include new cultural demands or ignore or exclude them. Self-help, grassroots welfare, and community organizations may use migrant identities to organize religious schooling, two-way flows of remittances, home and family support, and rural-urban links, entrenching social divisions (and sometimes political power bases) between migrant groups instead of bringing them together. The social and political landscape of cities like Karachi or Cape Town or (in different ways) London or Chicago demonstrate this patterning. Urbanism is both an inventive life form and one that regularly defies government prerogative and rational organization. Formally Michael Keith 247 suppressed articulations of culture, work, and life commonly find the city plastic enough to support informal expression. This in turn broaches two further arenas for migration policy consideration in 21st-century cities. The first considers the functionality of formally recognizing the migrant presence. The second considers the possibil- ity of planning and developing a flexible urbanism. Formality and informality States often try to control migration and then fail to suppress it. In Los Angeles and New York, Berlin and London, Istanbul and Cairo, Johannesburg and Nairobi, and Shenzhen and Beijing, national gov- ernments in recent decades have at times attempted to prevent in- migration. But some essential characteristics of the city—complexity, anonymity, weak governance—enable people to avoid detection for long periods of time (irregular migration). This can create tension between city government and national government. Nation states make policies that formalize the movement of people; municipalities have to manage and mediate the informal realities that do not always mirror the policies. Irregular migration is by definition hard to measure. But in many cities—from Istanbul to New York to Shenzhen—migration realities, rather than policy rhetoric, structure neighborhoods. Demonstrating the tension between the formal and the informal city, irregular migration informs the policy dilemmas for city stakeholders who work simultaneously at the local, the metropolitan, and the central government levels. Informal settlement challenges how we think about balancing the rights of the migrant (particularly the “right” to housing) with the proper regulation of the city. Particularly in the global south, some cities have settlements without clear property rights, where established tenure does not correspond with formal title and where informal occupation defies formal cadas- tration. Such situations demand clear thinking about the economic and moral calculus we use to develop the good city—reconciling the plausible with the ideal, demographic settlement pressures with rational organization of space, property rights with popular demands for redistribution, and formal principles with informal realities. 248 The Great Migration Policy practice and city experience are developing to address how migration affects more urban common pool resources, such as occupied or informally titled land, and how “urban land tools” affect the integration of a migrant community. Because migrants join com- munities that may already be tenure insecure, local groups “can be quick to abandon or change ways of tenure in the face of significant migrant arrival, because there can be little reason to continue with rules that others are not following” (Unruh 2004). Legitimacy, a crucial component of protection against eviction, is complicated as migrant groups shift, appropriate, and alter the premises for access to land-based resources (Box 9.3) (Unruh 2004). Extensive research has been conducted on strategies to formalize, integrate, and upgrade semi-permanent communities of poor rural- to-urban migrants through an emphasis on promoting rights of use, Box 9.3 Migration settlement dynamics in the city: inclusive exceptionalism Across the south, experiments are addressing the challenges of localized urban poverty through policy instruments that institutionalize territo- rial exceptionalisms from specific planning regulations. These strategies target regulatory conditions that may impede the growth and main- tenance of land tenure and livelihood arrangements, accommodating gradual growth through the incremental application of regulations over defined periods of time. Exceptional zoning, in some ways akin to special economic zones, can instead dampen the impacts of land speculation and planning codes to promote inclusive growth, protect- ing the fragile social capital on which much of the world’s urban poor and newly arrived depend. For example, in policy critiques of Texas’s colonias, low-wage migrant neighborhoods on the U.S.-Mexico border, researchers have noted a catch-22: urban infrastructure essential for upgrading a migrant’s home is often connected right up to the colonia’s edge but then withheld from most households due to rigid health and safety regulations (Ward 1999). Implementing a regulatory exceptionalism might help unblock this bind, to the mutual benefit of migrants and the existing community. As the colonia develops, utilities might be connected preemptively. Health and safety standards might then be gradually applied in parallel Michael Keith 249 with actual growth, affording the colonias a more stable tax base, better integration into the labor force, and the retroactive payment of original utility connections (Ward 1999). Ananya Roy similarly recounts how homeless communities in the United States have occupied fully disowned properties only to be evicted on health and safety grounds (Roy 2003). This policy stance seems to contradict its own regulatory logic, as homelessness itself presents a de facto health and safety risk for the homeless and their surroundings. Brazil’s Special Zones of Social Interest, established in the mid- 1980s in Belo Horizonte, provide a concrete precedent of regulatory exceptionalism over designated territories toward incremental urban growth. These zones are low-income urban areas with softer planning rules to promote legalization, legitimacy, and upgrading (Assies 1994). Participatory local governance policies applied to very low- income districts promote occupation rules that differ from those of the rest of the city, such as exemptions in land-use standards. But as anthropologist Teresa Caldeira notes, the fully inclusive participatory process may inadvertently reinforce acute social and class differences, as the powerful lobbying potential of richer citizens comes to the fore. This democratic imbalance may be described as a legalization of inequality, with poorer areas marked as illegal, rather than extralegal, by lower land-use standards (Nogueira Budny 2007). Many self-built areas of Belo Horizonte were not acknowledged until the zones were established. Integrating these areas in a planning regime lays the foundation for a longer trajectory of acknowledgment within planning practices (Nogueira Budny 2007). What are the possibilities for learning and applying strategic exceptionalism and regulatory incrementalism to city areas with a high density of migrants? Perhaps there are opportunities for addressing the challenges migrants face to facilitate the livelihood networks that prove so essential to new arrivals. Specific planning regulations and infrastructure, if temporarily suspended or preemptively connected, can complement more social aspects of the “city as integration machine,” and strategically exceptional zones can be reframed for the commons. Perhaps we can frame the needs and challenges migrants face as a negative balance of resources, or as a common pool deficit rather than a common pool resource. In this way, legislators and policy makers can use the language of community rules engagement and positive criteria for participation. 250 The Great Migration cooperative ownership, and customary land rights to protect critical livelihoods and social capital (Durand Lasserve 1998; Fernandes and Varley 1998; Fitzpatrick 2005). But when differences in national citizenship arise in urban land claims, and as tensions build between existing urban poor and new arrivals, questions around an occupa- tion’s legality invariably surface. Economically and ethically challenging new settlements occur commonly at the frontier of development, in marginal lands, where the state has not yet addressed land tenure, and where political instability or insecurity has undermined land tenure. These criteria fit neatly with many of the dense settings of the urban development frontier, whether in inner city slums, in land zoned for commercial or industrial use but now derelict through deindustrialization, or on the urban periphery. In regions where major forced migrations structure national con- texts (such as in many parts of Africa), international aid and service provision for internally displaced peoples or refugees further com- plicate rules of access and legitimacy. Unruh (2004) describes the variability in assistance migrants can receive across local, regional, national, and international institutional scales and the frequently contentious nature of this aid with regard to a resource (such as land) shared with local communities. Ostrom (1990) highlights legitimacy and rule shifts in the com- mons as important for city thinking. Facts on the ground confront city policy makers with options that demand pragmatic responses, exemplified in an emerging policy priority area collaboration by the United Nations High Commissioner for Refugees and the Cities Alliance to address the rapid rise of urban refugees and the still unde- fined need for urban protection spaces that foreground pressurized neighborhoods (Cities Alliance 2011). Policy thinking on urban protection spaces focuses on tenure arrangements for refugees and migrants in cities and highlights the need to think creatively about the relationship between the needs of the city as a whole and those of specific neighborhoods with high in-migration. As the city grows, the balance among tenure, title, and occupation can push city policy makers to trade the legal clarification of property rights for the need to address housing demands. The analytical fram- ing of the city commons can both clarify how policy makers might Michael Keith 251 approach such tradeoffs and link what appears exceptional in global south cities with sustainability in affluent metropolises. Ostrom’s focus on the legitimacy of questions that separate the eligible from the ineligible generates a theoretical reconsideration of mapping publics and commons in a city and practical possibilities for a strategic exceptionalism (Roy 2005), developing city gover- nance strategies that build on a community’s self-definition through conflict or exclusion from land and other forms of the commons (Box 9.4). Box 9.4 Geographic scale jumping and urban migration Across institutions, implementing urban upgrading in informal areas, with the subsequent possibility of eviction, has led to international cooperation on the right to fair resettlement that has jumped across local and global scales. Through the increased leverage afforded by broad shared-interest federations, groups of urban poor have managed to circumvent non-compliant city and national governments by lobbying international development organizations to withhold national infrastructure funding in response to rights violations. The most salient examples of institutional scale jumping toward accountability have come from international development organizations increasingly opening channels to federations advancing housing rights struggles, holding promise for the promotion of new channels to migrants’ rights federations. Since before 2005, the International Institute for the Environment and Development has recommended that development organizations promote the “creation of channels” to community-based organiza- tions and federations, built mostly around community savings groups and often managed by women, to ensure that investment is imple- mented most effectively and linked with rights-based accountabil- ity (Satterthwaite 2005). The institute argues that change comes not from physical improvements but from improvements in relationships between groups and agencies leading to physical improvements. In India, the National Slum Dwellers Federation, in combination with Mahila Milan and the Society for the Promotion of Area Resource (contd.) 252 The Great Migration Box 9.4 (contd.) Centers, has organized more than 2 million slum dwellers and settle- ment for some 20,000 households. These resettlement schemes have been directed partly by the World Bank as a condition for transporta- tion loans to the government of Mumbai (Jamdar 2003 in Roy 2005). More recently, in Phnom Penh, Cambodia, where the Solidarity for the Urban Poor Federation has been active since 1994, a new wave of evictions from Boeung Kak Lake in 2011 led the World Bank to with- hold its $50–70 million annual loan to the country (Tran 2011). This cooperation between local grassroots organizations and global international development organizations to lobby national and city governments builds on the advancement of channels by development agencies to dialogue with local organizers. However, some qualities linking groups in the form of federations and determining interac- tion between federations and the state seem more likely to accom- modate effective leveraging against local governments. According to the International Institute for the Environment and Development, factors conducive to cross-scale accountability and resource manage- ment include autonomous organizations, social pressure on the state (including protest toward partnership), avoidance of political affilia- tion, and direct engagement with the state on collective consumption in forums that do not involve social movements (Satterthwaite 2005). With proper social coordination and a clear, resource-based dialogue that avoids political categorization, the right to fair resettlement that comes with any upgrading can forge a new cooperation that might even hold non-compliant or negligent national and metropolitan governments accountable for their citizens’ rights to shelter and basic services. Given this non-aligned imperative and the transnational nature of so many federations, what are the organizational and material assets, or commons, for migrants in the city? We can postulate opportunities to consolidate autonomous, transnational federations for city migrants, explicitly benefiting from a break with the rural-urban/international categorization of migrant human rights, and thus politically non- aligned despite tangible connections to the state. Clearly articulating shared material and social goals, as well as membership criteria and rules for lobbying initiatives or social movements, helps create new channels between the international and the local for holding city governments accountable for violations of urban migrants’ rights. Michael Keith 253 While a community invariably constructs and enforces new rules of exclusion to avoid the tragedy of the commons (Ostrom 1990), “migrants can derive their own forms of land access in reaction to rules of exclusion from community, or … from institutions that facilitate an equitable place in the local land tenure system” (Unruh 2004, 113). As internal migrant communities in Zambia and refugee communities in Tanzania demonstrate, limited rights (and citizen- ship) can enable the development of local rules and collectivity to engage with urban land resources (Unruh 2004). This resonates with other studies on possibilities for promoting temporally scaled regula- tory exceptionalisms, as suggested by Peter Ward in the context of Texan colonias for Mexican laborers (Ward 1999), or as an epistemo- logical policy corollary to the exceptionalism of free enterprise zones across the global south (Assies 1994). To address the problems many urban governments in the south attribute (often unfairly) to migrants, we might consider a new form of zoning that recognizes that some neighborhoods have special pressures and need short-term and medium-term solutions to the challenges of migrant arrival. A sensitivity to broader pluralisms might forestall resource degradation in the city. To promote the idea of a “city as integration machine,” other controlled pluralisms might be exceptional, emphasized as possible strategies for building commu- nities across migrant groups for the mutual benefit of the commons. In cities of informal urbanisms, income exclusion and migrant mobility generate pragmatic and plural responses to the need to accommodate new populations. But this problem goes beyond the global south. Cities in the affluent north have long had to consider how their longer term ecological sustainability depends on integrat- ing their distinctive parts—a mix of function, form, and activity that precludes extreme polarization and that increases urban densification and reduces its ecological footprint. Migration dynamics again high- light some unexpected continuities between the cities of the south and those of the north. Trading off the rational city and the flex- ible city: smart cities and the creativity of urbanism. The rationally planned city can sit in tension with the flexible city, the smart city learns but the creativity or urbanism may be found in the cramped cities of the metropolis as much as in university laboratories and architectural charrettes. 254 The Great Migration The ecologically sustainable city reframes externalities because it questions how we define the commons in a rational, controlled, planned city. Urban transformation and restructuring happen simul- taneously with demographic change and migration. The flexible city of the 21st century will need to reconcile the new demograph- ics of change with the old instruments of shaping a city—through planning, architecture, and real estate markets. As major urban regeneration reshapes cities globally in the 21st century, the emerg- ing city incorporates, excludes, or displaces new arrivals and old communities. In the 21st century, city planners and designers need to consider how to integrate new populations with old residential areas and cal- culate what residential markets will provide and where state zoning principles should limit or ration new residential development in realizing sustainability, formalizing land rights, and alleviating exclu- sion. This in turn calls for considering how to reconcile development externalities and migration externalities through the metropolitan governance structure. As we try to make the city more ecologically sustainable, we must synthesize the new urban form and changing city demographics, reconciling long-term negative externalities with reasonable city growth. There are four ways to approach negative externalities, broadly associated with well-known economic thinkers: taxing at marginal cost (after Arthur Pigou), formalizing full property rights with costs set and allocated among those causing the externality and/or those affected (including future generations and migrants; after Ronald Coase), creating institutions that bring those causing the externality together with all those affected (after James Meade), and building command and control systems (most often witnessed in socialist or planned societies). These traditions inform the varying analytical approaches to externalities. The focus on experimental forms of tenure and regu- lation in the cities of the south is in part a return of the sorts of institutional innovation sought by Meade in the face of challenges to both Coasian orthodoxy and command economies. Recognition of social pressures on economic development systems (see Box 9.4) logically mirrors the increasing recognition in the global north that Michael Keith 255 the social costs of metropolitan polarization demand alternative ways of reconciling welfare externalities, such as new, flexible, and incre- mental institutions. When London confronted its early 21st-century challenges, it had to decide how to mediate the reinvention of its poorer former indus- trial districts with the demands for housing and urban growth. The British planning system, with an aspiration to generate high-density, urban renaissance–style growth, promoted both social mix and zon- ing patterns that synthesized housing-led urban regeneration and the “value capture” of substantial social housing and public amenities through private-led development. In some parts of east London, a quarter or more of all new private housing development was passed over at no subsidy for social use, a public amenity open to borough residents with housing rights (even if they were migrants) and closer to Meade than to Coase in its response to the welfare externalities of migration. But in a multicultural city like London, this raises diffi- cult questions about who is a migrant and about eligibility categories that prioritize either measurable social need for housing or welfare queuing for scarce rental resources (see Box 9.1). Similarly, New York City Mayor Michael Bloomberg has tried to use new forms of tax credit financing to build or preserve more than 100,000 units of affordable housing, developing such innovations as inclusionary zoning and extending the term of affordability to make sure there is housing for future generations and that taxpayer invest- ment is not squandered. New York affordability mechanisms rest on state assurance of calculable risk displacing the uncertainties of gentri- fication and neighborhood change. For the city’s common good, using new fiscal institutional mechanisms and land zoning internalizes the externalities of property price inflation. Along with experiments in land taxes, community land trusts, and migrant housing associations, potential institutional responses can affect the scale disjunctures of migration externalities—both spatially and temporally. Resistance to city change inevitably prompts responses from minorities (including migrants) who oppose transformation and play the system to optimize their own positions. Writing on a case in Phnom Penh, Cambodia, Simone (2008) described the complex forms of brokerage and mitigation that regulate commerce and 256 The Great Migration production in an occupied modernist building. Amid an awareness of the potentially unique efficacy of a “messy site” in a city that is increasingly formalizing, everyday negotiators meet city officials to protect their ad hoc community by framing it as a “culture and lei- sure center.” Arbitrage between forms of belonging takes a back seat to forward-looking collective negotiations to promote the site’s spon- taneity by framing it in the language of formal eligibility. Informed, complex, and strategic groups can therefore negotiate with the city government. Techniques of reframing settlements explicitly to intro- duce more uncertainty into the city through dominant regeneration and planning paradigms offer possibilities for the flexible inclusion of migration into global south cities. These examples of flexibility highlight the importance of city governments mediating the contrasting and frequently incommen- surable demands of new development, incoming migrant settlement, and existing neighborhoods that will frequently contest the city’s restructuring. The flexibilities involve a synthesis of different forms of expertise—the economic hope value of land, the moral calculus of city governance, the competing eligibility demands of new and incoming migrant residence and the technocratic disciplines of city-building land-use planning, development control densification, architectural master planning, and ecological impact measurement. They involve innovative and creative ways of working across the old divisions of architecture, planning, and real estate. And they point to a way of valorizing the interdisciplinary synthesis of city expertise in structuring the future cities of 21st-century migration (see Box 9.5). These tradeoffs will remain challenging, but there are some policy formulations that promote a city flexible enough to integrate the scale of future migration: • Establish creative links among architects, planners, and real estate professionals that avoid the default development of unsustainable urban sprawl. Cities need piece-by-piece consideration and interdisciplinary master planning of neighborhoods with high in-migration to stretch the limits of formal zoning and land-use legacies that make the city inflexible. New models of land-use regulation and the propensity for local actors to reinvent their own Michael Keith 257 Box 9.5 From basic principles to policy instruments in cities of migration In 2007, the British government’s Commission on Integration and Cohesion listed four principles through which locally structured policy frameworks might synthesize integration of new migrants and local development: • Shared future, which focuses policy makers on becoming over being: shared ways of looking forward that recognize diverse histories, identities, and trajectories by emphasizing the collaborative fabric of the future urban form. • Localized citizenship, which stresses that status and eligibility work at plural geographical scales and that rights and responsibilities play at the neighborhood, city, and national levels and work alongside transnational responsibilities. • Ethics of hospitality, which value the stranger and the newcomer within a framework of mutuality and civility. • Visible social justice, which appeals not only to equality of opportu- nity and outcome but also to transparency in decision making. The principles provide a useful framework for policy analysis. But for 21st-century development, we need to supplement them with flexible policy tools that reflect good urban management. City management works through the careful combination of incommensurable social goods, possible only when we see the city simultaneously at different geographic scales and through both static and dynamic models, synthesizing synchronic and diachronic models of social change. A neighborhood’s needs do not always align with the whole city’s, and today’s demands do not always align with tomorrow’s. Translating these principles into policies entails recognizing the pressures of urban migration. It calls for reconciling policy solutions for the world today (as people move to the city) with those for the world as we would want it tomorrow. The principles recognize tradeoffs— between formality and informality, rights and numbers, and quantity of policy making and quality. neighborhoods can be reconciled with more experimental collabo- rations of city professionals geared for ecological sustainability and land-use densification. 258 The Great Migration • Build innovative links between microfinance and big money for upgrading slums and improving neighborhoods. Cities need to harness the potential of individuals with the incentive to improve their neighborhoods and the innovations that increase the supply of affordable housing (for both residents and migrants). This involves thinking through institutional hybrids of state and private housing supply that engage in both neighborhood governance and housing development. • Develop experimental forms of multilevel governance that recognize, mediate, and link the priorities of neighborhoods and the metropo- lis. Cities need to mediate the costs and benefits of migration by developing innovative neighborhood governance and zoning policies (normally over limited periods of time) and mitigating the migration pressure points in specific neighborhoods. • Harness the dynamism of the informal city and the rational organiza- tion of the formal city. Cities need to recognize the significance of powerful family networks and gendered difference in promoting local resilience, human capital growth, community safety, and social mobility. Enhancing the positive impacts of migration to metropolises involves developing informality’s creativities and formalization’s structures, the planned state regulation of city professions and market freedoms, the pluralization of tenure and title models, and a strong sense of both the ethnographic present and the plausibility of a civic future shared by migrants and settled members alike. Note 1. 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Civil Society Movements in the Informal Housing Sector: Examining SPARC as a Case Study in Mumbai. Unpublished master’s thesis. University of California, Berkeley, CA. Liu, Kaiming. 2007. “Introduction: Eye on Migrant Workers.” The Chinese Economy 40 (3): 12–23. Nogueira Budny, Daniel. 2007. “Democracy and the City: Assessing Urban Policy in Brazil.” Woodrow Wilson International Center for Scholars, Washington, DC. http://www.wilsoncenter.org/publication/democracy- and-the-city-assessing-urban-policy-brazil. Ostrom, Elinor. 1990. Governing the Commons: The Evolution of Institutions for Collective Action. Cambridge, UK: Cambridge University Press. ——–—. 2009. “Gemeingütermanagement—eine Perspektive für bürger- schaftliches [Governing a Commons from a Citizen’s Perspective].” In Wem gehört die welt? Zur wiederentdeckung der gemeingüter, edited by, Silke Helfrich. Munich: Oekom Verlag. 260 The Great Migration Roy, Ananya. 2003. “Paradigms of Propertied Citizenship: Transnational Techniques of Analysis.” Urban Affairs Review 38 (4): 463–91. ——–—. 2005. “Urban Informality: Toward an Epistemology of Planning.” Journal of the American Planning Association 71 (2): 147–58. Ruhs, Martin. 2013. The Price of Rights: Labour Immigration Policy and the Rights of Migrant Workers in High Income Countries. Princeton, NJ: Princeton University Press. Satterthwaite, David. 2005. “Housing as an Asset and as an Arena for Developing Social Policy: The Role of Federations Formed by the Urban Poor.” Paper presented at the Arusha Conference, “New Frontiers of Social Policy,” Arusha, Tanzania, December 12–15. http://siteresources. worldbank.org/INTRANETSOCIALDEVELOPMENT/Resources/ housingasasset.pdf. Saunders, Doug. 2010. Arrival City: How the Largest Migration in History is Shaping Our World. London: William Heinemman. Simone, Maliq. 2008. “The Politics of the Possible: Making Urban Life in Phnom Penh.” Singapore Journal of Tropical Geography 29 (2): 186–204. Tran, Mark. 2011. “World Bank Suspends New Lending to Cambodia over Eviction of Landowners.” The Guardian, August 10. http:// www.guardian.co.uk/global-development/2011/aug/10/world-bank- suspends-cambodia-lending. Unruh, Jon D. 2004. “Migration Induced Legal Pluralism in Land Tenure: Implications for Environmental Change.” In Environmental Change and Its Implications for Population Migration, edited by, Jon Darrel Unruh, Maarten S. Krol, and Nurit Kliot. New York: Springer. Unruh, Jon D., Lisa Cligget, and Rod Hay. 2005. “Migrant Land Rights Reception and ‘Clearing to Claim’ in Sub-Saharan Africa: A Deforestation Example from Southern Zambia.” Natural Resources Forum 29 (3): 190–98. Ward, Peter M. 1999. Colonias and Public Policy in Texas and Mexico: Urbanization by Stealth. Austin, TX: University of Texas Press. 10 Infrastructure Doing More with Less Jonathan Woetzel and Herbert Pohl Adequate urban infrastructure can be expensive, but the costs of not delivering housing, transportation, water, sewage, public facilities, and other necessities are also high. Inadequate infrastructure slows and even reverses economic growth, driving unemployment, crime, and urban decay. It can fuel urban tensions by widening divisions among ethnic or income groups or between long-time residents and recent immigrants. And it can foster a general malaise that drains a city’s vitality and spirit. What are the benefits of delivering infrastructure? One study in Africa showed that the return on investment for infrastructure was about 50 percent, based on contributions to gross domestic product (GDP), and that if investments were optimized, the return would be closer to 150 percent. This value is delivered through increased productivity and job creation, among other channels. Social ben- efits from improved public services and living standards are also substantial. 262 Infrastructure: Doing More with Less All too often, funding shortfalls are cited for failures in delivering the needed infrastructure. But our experience and research around the world has shown that performance gaps in governance, institu- tions, processes, and capabilities are just as damaging. In addition, a systematic approach to key questions, such as whether existing infra- structure is being used effectively and whether new infrastructure can be delivered more efficiently, can compensate for much of the perceived funding shortfall. Without a doubt, financial gaps are a concern. In an era of tighter lending practices and austerity at all levels of government, public officials find it more difficult and, in some cases, more expensive to meet the needs of their constituents. The McKinsey Global Institute (MGI), the business and economic research arm of McKinsey & Company, estimates that the annual physical capital investment needed in cities globally will double from about $10 trillion today to more than $20 trillion by 2025. The bulk of this need will be in cities in emerging economies. The 440 or so emerging market cities with the most dynamic economies, for example, will need an estimated 44,000 square kilometers in new commercial and residen- tial floor space by 2025. They will also need to invest an estimated $190 billion to meet demand for container port capacity and about $200 billion for water supply and wastewater treatment systems. In emerging markets, inadequate infrastructure can be a substantial barrier to growth. In Latin America, where urbanization is progress- ing rapidly, many of the largest cities emerged from the 1980s debt crisis to establish solid fiscal positions. But infrastructure spending failed to keep up with growing needs. As a result, inadequate hous- ing, urban planning, and transportation networks became obstacles to growth. For the past two decades, economic growth rates for most of the region’s 10 largest cities have been below the national growth rate. Not a luxury, adequate infrastructure is a necessity for growth and many other municipal economic and social objectives. Adequate infrastructure reduces costs, supports economic activity, increases factor productivity in cities, and connects cities to domestic and international markets. It also creates jobs directly in construction and maintenance and indirectly by boosting economic activity generally. And it underpins social development and sustainability by increasing Jonathan Woetzel and Herbert Pohl 263 intra- and interregional trade and improving relationships, providing health, education, and housing, encouraging environmentally sound practices, such as switching from road to rail, and offering many other benefits. But funding is not the only obstacle to adequate infrastructure in the world’s growing cities. Funding committed to building infra- structure in Africa from all sources rose from $38.9 billion in 2009 to $55.9 billion in 2010, but over the same years the share of these funds actually dispersed dropped from 48 percent to 38 percent. Altogether in both years, about $55 billion was available for needed projects—but not used. Investors cited difficulty in identifying appropriate projects and shortages of technical capacity and other skills within governments among the reasons. Quite simply, with the staggering demand for infrastructure in emerging economies, officials will need to continue gathering as much funding as possible to meet their needs. They must also become smarter about how they approach infrastructure development. Some cities around the world have found ways to ensure that finite funding delivers the greatest possible impact. Whether creating new systems or upgrading existing capacity, urban leaders have considered four fundamental questions often overlooked in infrastructure development planning: • Are we building the right infrastructure? • Are we using existing infrastructure most effectively? • How can we deliver infrastructure more efficiently? • How can we benefit from working with private partners? Finding the right answers to these questions will help urban leaders meet their growing infrastructure needs more effectively, more effi- ciently, and more quickly. Ignoring these questions can lead to costly and wasteful mistakes. For example, during Japan’s “lost decade,” the 1990s, the country overbuilt infrastructure with no clear strategy, squandering billions of dollars with little impact. In one instance, 17 bridges were built for three expressways to connect the main island of Japan to Shikoku, an island with about 3 percent of the country’s population. The costs reached $29 billion. 264 Infrastructure: Doing More with Less By improving governance systems, institutions, processes, and internal capabilities, urban leaders can build reliable infrastructure for their populations and squeeze more value from their expendi- tures. They rarely have the time or expertise to evaluate the details of individual projects. Judging, for example, the effectiveness of a sewer system, the thoroughness of a bridge-building contract, or the estimates included in a transportation plan are usually beyond their abilities. But urban leaders can create the right set of governance structures, credible institutions, and robust processes—and develop local capabilities. By doing so, they can go far to compensate for funding shortfalls and move their infrastructure systems forward. The rest of this chapter looks closer at the infrastructure needs of cities in emerging markets, based on the most recent MGI analysis. Next, it offers practical suggestions on how to answer fun- damental questions facing any government trying to get the greatest impact from limited infrastructure funds. And before concluding, it examines how cities worldwide have improved governance, insti- tutions, processes, and capabilities to help close the infrastructure funding gap. Patterns of urban growth By 2025, the physical capital investment in the world’s cities is expected to have doubled, from about $10 trillion today to more than $20 trillion. This growth includes expenditures on buildings, infrastructure, machinery, and other equipment. The bulk of the new capacity is expected to be built in emerging market cities. This surge in urban development, particularly in emerging coun- tries, can be a mixed blessing. Densely populated urban areas tend to use resources more productively than rural areas or more sparsely settled cities. Bus systems enjoy heavier ridership, for instance, and rail becomes a reasonable option. Water and sewage systems serve more people per kilometer of pipeline and canal. But rapid urbaniza- tion also puts a heavy strain on global natural and capital resources, and unless infrastructure keeps pace with growth, many of the potential benefits of urbanization—economic, environmental, and social—could be reduced. Jonathan Woetzel and Herbert Pohl 265 The June 2012 MGI report on global urbanization, Urban World: Cities and the Rise of the Consuming Class, looked closely at three areas of infrastructure need in developed and developing cities: demand for commercial and residential floor space, municipal water systems, and container port capacity. These areas were chosen because of their diversity and because credible data were readily available at the municipal level. That allowed us to examine historical patterns and to estimate future demand—and to offer an illustrative overview of infrastructure demands triggered by rapid urbanization. We paid particular attention to a group we call the Emerging 440, which comprises the 443 cities in emerging markets included in the world’s top 600 in expected contribution to global GDP growth to 2025. The Emerging 440 will be a powerful force in the global economy. They will likely account for almost half the world’s eco- nomic growth over 2010–25, and more than 600 million people in these cities will gain access to discretionary spending and join the consumer class. Among the Emerging 440, 20 are megacities (populations of more than 10 million), while the remainder have populations of at least 200,000. And though 57 countries are represented in the Emerging 440, more than half the cities are in China, underscoring the country’s predominance in this era of rapid urbanization. As would be expected, patterns of estimated demand differed sharply. Global demand for container port capacity should show the most significant growth, driven by the sharp rise in the global consumer class. Most of the world’s consumer products, as well as intermediate manufacturing goods, are shipped in containers, and we expect demand for container capacity to grow at a compound annual rate of 7.2 percent over 2010–25, much faster than the 4.4 percent compound annual GDP growth estimated for cities during this period. Meeting this demand would almost triple today’s capacity at global container terminals. Demand for commercial and residential space and municipal water is also expected to grow significantly, if more slowly than global GDP. Many cities have already begun massive building programs to meet the growing needs, and these efforts are likely to continue as cities accommodate projected growth. Over 2010–25, cities around 266 Infrastructure: Doing More with Less the world will need to build more than 80,000 square kilometers of commercial and residential floor space, including replacement space. At a compound annual growth rate of 3.8 percent, available urban floor space will expand by more than 40 percent during this period. Of the three infrastructure components examined closely, demand for municipal water is expected to show the slowest growth over the next decade or so, but it will still outpace population growth almost twofold. We expect demand for urban water to rise at a compound annual growth rate of 1.8 percent over 2010–25, compared with 1.0 percent for population growth. The difference is partly a result of a trend toward smaller households. The number of urban households is estimated to grow at a compound annual rate of 1.7 percent, well above the population growth rate. We also found significant differences between cities in developed and developing countries (Figure 10.1). Following current trends, about 60 percent of the growth in these three categories will come from cities in emerging markets. And with the majority of the Emerging 440 in China, it comes as little surprise that a large portion of the growth across all categories will be centered there. China alone is expected to account for 38 percent of the global growth in demand for commercial and residential floor space, 28 percent for container port capacity, and 27 percent for municipal water. Other regions—India, Latin America, and the Middle East and Africa—will also account for a significant portion of this new demand. India and the Middle East and Africa, for example, will each account for a greater share of the new global demand for municipal water than North America, with Latin America not far behind. Each of these three emerging regions will need two to three times more new container port capacity than North America over 2010–25. Only for floor space will the demand in North America be greater than that individually in India, Latin America, and the Middle East. Population, income growth behind demand for floor space Demand for floor space in cities will soar in the coming years, with three-quarters likely to arise in the Emerging 440. Of the 80,000 square kilometers of floor space needed, we estimate that 77 percent must be built in developing countries, primarily for residential Jonathan Woetzel and Herbert Pohl 267 Contribution to urban growth, 2010–25 (percent) Figure 10.1 All regions contribute to growth in urban demand, but China’s share is highest in key categories Source: McKinsey Global Institute Cityscope 2.0. Note: Other developed and emerging regions account for 16.0 percent of growth in population, 17.4 percent of growth in GDP, 16.0 percent of growth in demand for floor space, 19.8 percent of growth in demand for municipal water, and 18.6 percent of growth in demand for containers. Growth in demand for floor space includes replacement floors. a. GDP measured at expected real exchange rate. use, and China—with about 40 percent of total demand—will be the center of activity. Our estimates comprise new construction, representing about 60 percent of the demand, and replacement floor space. The cumulative cost to meet this need through 2025 is about $80 trillion. Residential construction will make up roughly three-quarters of this demand, and the focus will be in developing countries. Already, a little more than half the world’s residential floor space is in develop- ing countries, and that proportion should increase significantly as new demand is met. Our study suggests that the increase in demand will equal about 90 percent of current stock. This estimate comprises new construction and replacement space needed to compensate for deteriorating buildings. 268 Infrastructure: Doing More with Less A critical factor in this growing demand is the rising number of households, especially in developing countries. Because average household size is shrinking in most emerging markets, the number of households is growing faster than the population. Demographics and behavioral shifts are the main reasons behind this trend. In some areas, young adults are moving alone to the cities, while in others the population is aging, and seniors tend to live in smaller households. In addition, the demand for floor space by individual households rises with incomes, and GDP per capita is growing fastest in developing countries. About 80 percent of the global demand for new or replacement housing over 2010–25 will occur in emerging cities. China and South Asia together will likely account for about 60 percent of the demand, or 34,000 square kilometers. The brunt of available commercial space will remain in developed markets, which today account for about two-thirds of global com- mercial floor space. Demand for services, a primary user of commer- cial space, is greatest at the highest incomes. But even in commercial space, demand for new and replacement construction will be high- est in emerging markets. About 60 percent of the demand for new space will be in cities in developing countries, led again by China. China will need about 5,700 square kilometers of new commercial space over 2010–25, or 30 percent of total new demand. Demand in China will be just higher than that in North America, whose need is an estimated 5,200 square kilometers in the coming years. All told, about $35 trillion of investment will be needed to satisfy demand for residential and commercial floor space in cities in emerging markets, with China alone needing $25 trillion. Ports, water illustrate need for a range of improvements Beyond residential and commercial floor space, cities will need to invest in a broad range of infrastructure projects to meet growing demand. From basic services such as water supply and wastewater treatment to the basics of growing economies such as transportation and communication networks, urban centers in developing countries will account for the vast majority of this demand. Jonathan Woetzel and Herbert Pohl 269 For example, the number of cars in use globally is expected to double to about 1.7 billion by 2030. By far, most of this new traffic will be in developing countries. Modern road networks will need to be built or improved to accommodate this massive fleet, even as urban density encourages a switch from cars to metro rail. Another estimate suggests that air traffic will increase 5 percent annually over 2010–25. The demand for new terminals will focus on cities in developing countries, which will see expanding passenger and cargo traffic as their economies and incomes continue to grow. China, for example, is expected to build about 100 civil airports over the next decade. Information technology networks, including connections to broadband, and electricity supplies are among the other areas likely see significant growth pressure. Our study focused on water supply and wastewater treatment and on container port capacity as two aspects of infrastructure develop- ment that illustrate the overall expected demand in diverse areas. The two areas were also selected because some data were available at the municipal level, allowing more accurate analysis. About $480 billion in urban infrastructure investment will be needed globally by 2025 to finance growing demands for water sup- ply and wastewater treatment. A potable water supply is the most basic responsibility of cities to their residents. Water supply is so fundamental to a developing country’s needs that it is included in the United Nations’ Millennium Development Goals, a blueprint for fighting poverty and improving health standards. Indeed, cities in developing countries will account for more than 80 percent of the growth in overall water services. Global demand for urban water supply should increase from about 190 billion cubic meters annually to about 270 billion. Growing urban populations and increasing incomes trigger a parallel rise in the demand for water. Of the total increase of 80 billion cubic meter, the Emerging 440 will account for about 67 billion, or more than 80 percent. The imbalance is largely because cities in developed markets have near-universal water availability, and their needed investments will focus primarily on system improvements and organic demand increases. In Sub-Saharan Africa, water and sanitation accounts for almost 25 percent of overall annual infrastructure investment need. 270 Infrastructure: Doing More with Less While cities in emerging markets will focus largely on meet- ing water supply needs, they will also face significant demand for improved wastewater treatment. Water supply investment in the Emerging 440 will represent about 80 percent of water infrastructure spending through 2025, with wastewater treatment accounting for the remaining 20 percent, while the split will be more even in cities in developed countries. Altogether, demand for increased wastewater treatment facilities will grow about 18 billion cubic meters in the Emerging 440, spread fairly evenly across regions. Container port capacity illustrates the growing demand for higher level infrastructure in cities in developing countries. A sharp rise in the number of households with discretionary income has lifted hundreds of millions of people into the consumer class, and because about 90 percent of consumer goods are shipped by ocean-going containers, demand for port capacity will increase in turn. Growth will also be pushed by increased demand for manufacturing inputs, which also are generally shipped in containers. Global container traffic—incoming and outgoing—will grow more than 2.5 times over 2010–25, the equivalent of 24 new ports the size of Shanghai’s facilities, the largest in the world today. More than 90 percent of this new capacity will be needed in cities in emerging markets. Investment to develop these facilities would amount to more than $200 billion during this period, with China alone accounting for about 30 percent. Along with the investment in physical assets, improvements will also be needed in port superstructure, intermodal systems, equip- ment, and information technology systems. And many existing facilities will need to be upgraded or replaced. Significant pressure on natural, capital resources The factors behind rapid urbanization present significant challenges to better managing natural and capital resources. Rising incomes and increased consumption are putting pressure on these resources, including those once considered abundant and unthreatened. The market stimulus brought by infrastructure projects world- wide will inject needed energy into the global economy, especially if Jonathan Woetzel and Herbert Pohl 271 augmented by the resulting growth in consumer spending in emerging markets. Beyond the immediate stimulus, these projects accelerate economic growth and in many ways represent deferred consumer spending. Roads are built with the expectation that con- sumers, among others, will travel them. Apartments will need to be furnished and filled with appliances. At the same time, the growing demands of an expanding con- sumer class will add considerable strain to global natural and capital resources, already stretched thin. The challenges facing municipal leaders in the Emerging 440 will be unlike those faced in cities that matured during the Industrial Revolution, when natural resources were fairly abundant. Fortunately, new technology and ideas can help cities in developing countries meet these challenges using attrac- tive and efficient solutions to deliver modern infrastructure to their residents. The surge in demand for natural resources signaled by the expected growth in the consumer class coincides with growing scarcities. Local shortages of resources once taken for granted, such as fresh water, are becoming more common in both developed and developing countries. Prices have risen dramatically since 2000, and, with markets increasingly interlinked, a surprise in one can send shockwaves through others. Throughout the 20th century, prices of basic resources—energy, materials, food, and water—trended down, falling on average about 0.7 percent a year and supporting global economic growth. Amazingly, the gains of those 100 years were wiped out by the unprecedented price increases of the past decade. Despite recent easing of some prices, volatility will likely continue. Because of higher incomes in cities, per capita consumption of energy and other resources tends to grow faster in cities than in over- all country populations. But the concentrated populations in urban centers also have efficiencies that conserve resources and enable technology-related options. For countries part of the Organisation for Economic Co-operation and Development (OECD), urbanites travel 20–30 percent less than suburbanites, substantially reduc- ing emissions and the demand for fuel. Urban environments allow technology-driven solutions that save energy, such as variable pricing for parking and congested areas, which reduce vehicle use. Urban 272 Infrastructure: Doing More with Less density also enables public transportation options, which create further savings. And because urbanites live in smaller homes, they consume 20–30 percent less energy than suburbanites. Indeed, some cities may find that by allowing higher densities they may avoid pressure for costly road improvements that ease greater use of private cars, bringing in turn increased fuel consumption and pollution. The savings can be used to expand urban rail systems, which higher densities also support. Such tradeoffs can be made only at the city level, where officials can more closely compare economic costs and benefits, as well as the likely impacts on economic development, society, and the environment. MGI research has shown that cities can slow the growth in energy demand by half and cut 20 percent from their projected energy needs by 2020 by employing current energy-efficient technologies effectively. These systems can quickly pay for themselves through energy savings that would benefit urban households and businesses. Deployed correctly, these solutions can cut the investment for energy- supply infrastructure and reduce public and private energy costs for decades. One study has shown that by 2030 greater energy efficiency in buildings—better insulation, modern lighting, and other measures— could reduce global energy demand by 31 quadrillion British thermal units, 20 percent greater than the energy used now by shipping and air transport combined. Improved energy efficiency in residential and commercial buildings could contribute about a fifth of the $2.9 trillion in potential savings identified from more productive use of natural resources, with the majority captured by cities. Similarly, demand for capital resources has been growing over the past decade, and needs have been exacerbated by the aftermath of the 2008/09 global economic and financial crisis, which left capital scarce. Before the crisis, global investment rates rose from 20.8 percent of global GDP in 2002 to 23.7 percent in 2008, boosted in part by growth in urban capital needs. Despite a sharp drop in 2009, MGI analysis suggests that investment rates should rise again, reaching about 25 percent of global GDP by 2025, with urban infrastructure needs fueling some of the growth. When the global recovery takes root, the increased demand for capital will likely lead to higher capital costs. This should further Jonathan Woetzel and Herbert Pohl 273 compel cities in developing countries to use available funds as effec- tively as possible, channeling them to the most productive projects. Countries can also contribute to the effort by implementing policies that create deep and stable domestic financial markets. Such mea- sures could, for instance, work to gather national savings and direct them toward rational investments. McKinsey estimates that globally 2.6 billion adults do not have a bank account, and, especially in emerging markets, financial institutions serve only a small portion the national market. The most recent MGI research has underscored the growing demand for infrastructure development and improvements in cities around the world, particularly in developing countries. Failure to meet these needs could dampen urban economic growth and contribute to an array of other problems. Financing infrastructure development will always be a priority for municipal officials, and whether starting from scratch or improving existing assets, more value can be squeezed from available resources by carefully considering the four crucial questions on each project. Optimizing existing and new infrastructure Infrastructure funding is finite, but value for money may not be. By optimizing value, officials can create greater capacity from their projects and deliver greater benefits to their constituents. This can be done by assuring that the right infrastructure is being built, existing infrastructure is used effectively, infrastructure projects are delivered efficiently and private partners are included. Spending time to examine these aspects of value creation, rather than relying on gut instinct or popular opinion, can help municipal officials deliver the greatest benefits from finite resources. With a less vigorous approach, officials may be tempted to overbuild infra- structure, wasting money and other resources on projects with more capacity than needed under reasonable predictions, erecting show- case pieces as political status symbols, or building redundant assets in the absence of interagency coordination. Underbuilding can also be a problem, perhaps associated with a lack of transparency and corrup- tion. An open, systematic approach to infrastructure investment can mitigate these problems. 274 Infrastructure: Doing More with Less In many cases, cities can cut 40–50 percent from infrastructure costs by exploring these questions vigorously, freeing funds for further improvements. Asking them can help avoid unnecessary projects that offer benefits to few compared with their cost and that deliver only marginal gains compared with other infrastructure options. By systematically considering these questions when drawing up infrastructure programs, governments can produce substantial returns on their investments. Well-delivered infrastructure can pro- duce returns on investment of up to 50 percent, measured as GDP gains against cost, and when optimized the return is much higher. We have often seen that in developing countries cities enjoy GDP per capita as much as six times higher than that of rural areas. Quality infrastructure is a primary factor behind the difference. Building the right infrastructure When making infrastructure decisions, government officials are often bombarded from all sides. They face piles of information on the technical minutiae of a project and competing—and occasionally petty—political factors. Projects can be windfalls for landowners and contractors, and lobbyists are quick to promote their views of a proj- ect’s importance. At the same time, city planners can deliver reports totaling hundreds of pages covering, for instance, traffic forecasts, financial and risk analyses, technical specifications, estimated envi- ronmental impacts, and potential social and economic impacts—all supported by arcane calculations beyond the understanding of most non-experts. Fact-based decisions are difficult when faced with a flood of unfil- tered data and opinion. But municipal officials in many developing countries have found solutions that allow them to focus efforts and resources on the right infrastructure for their situation, projects whose benefits justify their costs and that contribute to clear economic or social objectives. They have done this by embedding infrastructure development into their broader social and economic development strategy, creating portfolios of infrastructure options, and evaluating the options rigorously and objectively. Cities can segregate and categorize the information from their portfolio of options to get a clearer view of the true costs and benefits Jonathan Woetzel and Herbert Pohl 275 of major projects and make better decisions. In a Middle East city, we helped officials rank their infrastructure needs by looking at nine core aspects of each project, which covered about 90 percent of the task. The examination covered the financial health, economic impact, social welfare, and strategic fit of proposed infrastructure investments. For example, it asked what contributions to GDP were expected from the investment and what fundamental needs were addressed. The tool was so easy to use that it could be installed on tablet computers, giving officials online access to the analysis, even during cabinet meetings. Such tools cannot offer a “correct” answer to whether a project should be approved. Beyond the data analyzed, subjective consider- ations are always relevant. While stretching water or electric services to the areas of a city that are hardest to reach may cost more per household, health and other benefits could easily outweigh the costs. Such tools offer analyses consistent across projects and allow officials to set priorities more effectively. Projects that rank high are given a boost, and if projects that rank lower are approved, the tradeoffs needed are more transparent. In the Middle East effort, officials were struggling to rank numer- ous infrastructure proposals in areas ranging from roads and bridges to power generation and from schools to hospitals. Weighing the benefits of a new road against those of a new hospital, for example, can seem like comparing apples and oranges. As is often the case, officials were presented with volumes of data on projects and assump- tions that were commonly unclear or inflated. For example, potential GDP impact would be double- or triple-counted across projects to create stronger business cases. To clear the fog and help choose the right infrastructure invest- ments for their city, officials reclassified the projects from more than 20 different asset classes to just 3: those with expected financial returns, such as hotels; those with economic returns, such as roads; and those with social returns, such as schools and hospitals. They looked at each project’s financial health, economic health, social health, and contribution to the city’s strategic objectives and stan- dardized the assumptions and definitions across all project proposals. For example, impact on GDP was clearly delineated by such direct effects as employment gains and productivity improvements. The 276 Infrastructure: Doing More with Less process was meant not to deliver the correct technical answer but to support a debate based on crucial facts that clarified the implications of competing investment decisions. The results of the analysis gave officials comparisons that made it easier for them to make better decisions and move forward with the right infrastructure choices. A web-based tool provided officials with ready access to, for example, matrices that compared projects by their scores across various benefits, as well as key data on individual projects. The government also established an investment review unit to manage and maintain the transformation and build the necessary internal skills. The Republic of Korea pursued an approach that systemati- cally linked its infrastructure program to official social and economic development objectives. As part of the effort, the government established institutions that in 2005 became the Public and Private Infrastructure Management Center, which developed a standardized methodology and reviewed all major projects. The center has helped translate national economic and social objectives into a multiyear infrastructure program, saving an estimated $60 billion in infrastruc- ture costs. Using existing infrastructure effectively A robust infrastructure development program must also consider whether existing infrastructure is being used most effectively. Officials and planners often harbor biases toward new projects, which offer the chance to be creative, the challenge of building something from scratch, and the potential to deliver substantial improvements. By contrast, maintaining and improving operations for existing infra- structure is less captivating. But getting more use and benefits from existing infrastructure is essential as city leaders seek to invest infrastructure funds more effec- tively. In transportation, for example, measures should be considered to steer residents from road to rail, to optimize urban planning to balance traffic flows, and to adjust fees and other restrictions to bal- ance usage with social costs. London and Singapore, for instance, control private traffic in the city center to reduce congestion and encourage residents to use bus and rail systems. Jonathan Woetzel and Herbert Pohl 277 Windhoek, Namibia’s capital, has an exceedingly dry climate, and demand for water increased about 7 percent a year over 1992–99. To meet this challenge, city officials focused on a rehabilitation pro- gram that featured a variety of measures. They emphasized repairs to the current system, established regular leakage-detection proce- dures and water audits to identify inefficiencies, and increased use of underground storage capacity, an alternative to dam storage (where evaporation losses were high). In addition, they promoted the use of gray water and semi-treated water for industrial and agricultural purposes and brought usage fees closer to the true costs of collection and distribution. And they launched a community education pro- gram that included training local plumbers and gardeners how to use water efficiently. The result: a 40 percent reduction in the city’s water consumption per capita, accommodating significant urban growth and extending the city’s projected “run dry” date by six years. In an example from a developed country, California launched an electricity demand management program in response to the 1973–74 oil shock, which more than quadrupled global oil prices. Measures included adjusting electricity prices based on consumption, regulat- ing efficiency standards for appliances, and introducing a slate of programs to promote energy efficiency. The efforts were a success, and the state’s 2010 consumption per capita was about 40 percent below the national average, having been steady for more than three decades. Delivering infrastructure efficiently Delivering infrastructure more efficiently must focus on improving productivity in construction. For most major infrastructure projects, construction costs represent a substantial portion of investment. Yet globally, unlike almost every other commercial sector, the construc- tion industry has shown no substantial productivity improvements in recent decades, and in some markets, such as the United States, productivity has declined. Occasional improvements in the industry have been the result of new materials rather than significant changes in operations. A look at the drilling operations in a tunnel project illustrates the problem (Figure 10.2). Among the problems were work delays Figure 10.2 Deliver infrastructure productively—lean construction reduced construction costs 10 percent and completion times 40 percent Source: McKinsey & Company analysis. Jonathan Woetzel and Herbert Pohl 279 because of a series of minor stoppages, crew or materials that were not available when needed, equipment that was not available because of maintenance, and equipment that was simply idle. Many industries have adopted lean manufacturing approaches to their needs, and the construction sector would be wise to do the same. Lean emphasizes eliminating as much waste as possible in a process, say by shuffling the sequence of work, scheduling maintenance in a way that does not slow the process, and ensuring that equipment is used to full capacity. We estimate that introducing lean practices at the drilling operation could cut completion times 40 percent and costs 10 percent. As large consumers of construction services, governments—and ultimately taxpayers—are paying a heavy price for these continuing inefficiencies. Cities have substantial market power and can encourage their contractors to address the waste in their operations. Among the measures they can use are contractual terms that oblige companies to work with officials to streamline project delivery, initiatives to explore new sources of materials and other resources (from low-cost countries, for instance), and programs to introduce lean construction in all projects. McKinsey estimates that an average productivity increase of about 30 percent is possible in the medium term if these or similar measures are followed. Lean principles helped the Swedish Transport Administration cut production costs in its construction program 10–15 percent and increase productivity 2–3 percent a year. Lean measures, such as par- allel activities during construction and ample support to allow pavers to operate efficiently, were estimated to save as much as 40 percent of work time, depending on the operation. Careful planning allowed the administration to reduce the need for earth to be excavated and hauled, as well as the need for hot mix for road surfacing. Increasing the slope slightly in some sections of roadway reduced the need for excavation and asphalt surfacing almost 18 percent, with no expected impact on traffic or safety. Using prefabricated elements and sourcing from low-cost countries were other elements of their program. Getting value from public-private partnerships Public-private partnerships (PPPs) have become a growing trend in infrastructure development across the world. The potential of using 280 Infrastructure: Doing More with Less private investment to supplement public funding is very attractive. It is also risky, as governments and operators witnessed with the Eurotunnel between France and the United Kingdom, Melbourne’s CityLink toll road, and many other projects in both developed and developing countries. Business plans are easily undermined by hostile political pressure, overly optimistic traffic estimates, and even com- peting infrastructure projects. And when a PPP goes wrong, it leaves a trail of litigation and, more often than not, the public picking up the tab. Despite the risks, however, PPPs can be a valuable part of a city’s infrastructure development program. Private companies can bring many advantages to the partnership, including a clearer sense of the sturdiness of the business plan and experience squeezing costs out of capital projects and operations. Governments with little experience working with private partners should begin with smaller projects, such as design-and-build contracts, before attempting more elabo- rate, revenue-generating programs. Countries like Canada, with very successful PPP programs, have built their achievements on decades of experience. Our work and research has shown that four factors can contribute to the success of PPPs: • Consolidated organization. Many cities have combined all their PPP projects into a single unit, rather than leaving them under the control of various agencies. Centralization allows consistent processes that can lower transaction costs and builds experience and expertise within the PPP unit. Once a department approves a PPP project, it hands over responsibility to the PPP unit. • Critical mass. Cities have also driven PPP programs effectively by creating pipelines of similar projects. By focusing efforts on, say, road maintenance or power generation, the city builds a critical mass that can lower overall costs. One-off projects are generally more expensive than a collection of projects that can spread start- up costs among different efforts and gain economies of scale. • Defined process. A clearly defined process also contributes to the chances of success. Cities and their private partners write detailed process descriptions that include explicit milestones, documenta- tion requirements, and transparent contractual terms. This effort Jonathan Woetzel and Herbert Pohl 281 builds capabilities and experience within city agencies and creates trust with the private partners. • Start slow. Cities should also expect to move slowly up the learning curve. Initial PPP projects should follow reasonably simple busi- ness models that are easy to evaluate, monitor, and administer. As city administrators gain experience, they can pursue partnerships with more complicated structures and more sophisticated risk allocation mechanisms. Successful PPP projects can deliver extensive value to all sides of the partnership. Over 1993–2001, Chile awarded 21 toll-road con- cessions to private partners totaling about $5 billion. Starting with the simplest projects first, the country eventually improved more than 2,000 kilometers of highway, including urban routes ringing the capital of Santiago, which were tendered later in the program. Fees for driving on the Santiago ring are based on time of day, to manage congestion and electronic payment systems and ease entry and exit from the network. One estimate suggests that the government has captured about $150 million in revenues from the PPP system, while only one concession partner has filed a claim under the system’s minimum- use guarantees. In addition, one study of road users and local and national leaders gave the system a score of 6 on a 7-point scale. Following the success of the toll-road projects, the country expanded its PPP program to include prisons, hospitals, public buildings, and public transport infrastructure. Opportunities to close the infrastructure gap Addressing the four crucial questions will help officials craft an infra- structure program that better meets the needs of their community with the money available. To create even more value, officials must review the structure and character behind the delivery system. In many cases, opportunities to stretch limited resources can be realized by improving governance, processes, institutions, and capabilities. The gap between available funds and needed investment in infrastructure will not disappear, but beyond gathering the funds to finance infrastructure programs, municipalities must also improve 282 Infrastructure: Doing More with Less how they govern their programs, create appropriate institutions to manage and maintain their infrastructure, implement the right processes to increase productivity, and build capabilities in public services. Together, these efforts can help compensate for perceived funding gaps and ensure that projects are planned appropriately, completed efficiently, and maintained and operated effectively. Governance City leaders have neither the time nor the expertise to microman- age projects or even judge the details of individual proposals made by agencies and ministries that own infrastructure assets. For most, it is beyond their capabilities to evaluate the quality of technical engineering specifications, review the rigor of environmental impact statements, challenge assumptions behind demand and usage esti- mates, or scrutinize the details of an engineering, procurement, or construction contract. Infrastructure discussions often focus on outcomes once projects are completed. These postmortems either celebrate progress in eco- nomic and social development or lament cost overruns and delays that added years to the project’s schedule. While interesting, such discussions alone do little to help cities build infrastructure better. Instead, leaders should explore the factors behind the achieve- ments and failures and create the right conditions to make successes more likely. One promising approach is to create independent institutions that oversee infrastructure investment and provide clarity and bench- marks on overall spending. The unit can help top municipal officials match a city’s infrastructure development program with its strategic objectives. By creating a governance structure staffed by experts with the appropriate skills, city leaders create conditions that increase the probability of successful infrastructure development. Credibility, trust, and competence are critical components of a working gover- nance structure. Some cities, for example, have an investment review unit. From our experience, such units can offer independent assessments of planned and ongoing infrastructure projects because they operate outside the structure of agencies or ministries that own and manage Jonathan Woetzel and Herbert Pohl 283 individual assets. They also report directly to political leaders and decision makers, allowing them to offer unfiltered analyses and conclusions. Investment review units are commonly led by individuals with a keen understanding of infrastructure assets, an ability to discuss programs with a wide range of stakeholders, and the credibility to participate in high-level decision making. They are often supported by a small team comprising infrastructure specialists with expertise in specific asset classes, planners who can reconcile priorities with overall capital allocation concerns, and data analysts responsible for tools, databases, and other aspects of information technology support. Along with improvements in institutional efficiency, better gov- ernance can increase the effectiveness of infrastructure programs. In South Africa, officials created a competition regulatory authority, particularly to govern practices in the construction sector. The agency focused on eliminating anticompetitive behavior and helped achieve substantial cost savings in new, large capital projects. Institutions Strong national and municipal institutions are the foundation of a successful infrastructure program. They build capabilities to support programs even as individual experts come and go from the adminis- tration. As projects begin contributing noticeable and cost-effective improvements to city living, they gain valuable credibility among constituents, contractors, private partners, political leaders, and other public bodies. The Rwandan government established several administrative bodies, including the Ministry of Infrastructure, to rebuild infra- structure lost during its tragic civil war and to initiate new projects. The ministry, given the mandate to lead the national effort, had responsibility for implementing and coordinating the activities of other ministries and public agencies. It monitored quality and cost standards, launched programs to improve capabilities, and looked after the sustainability of the program, among other tasks. The ministry’s efforts contributed greatly to the country’s stellar achievements, which included a 40 percent increase in electricity generation over 2008–11 and a more than twofold increase in the 284 Infrastructure: Doing More with Less number of people with access to electricity over 2006–10. More than a third of the nation’s road network was also brought up to accept- able conditions, including a large majority of district roads. At the same time, GDP growth averaged 8.3 percent a year over 2005–10, compared with 4.3 percent just five years earlier. Sweden witnessed similar successes after creating the Swedish Transport Administration in 2010. The measure merged the for- mer road and rail administrations to save administrative costs, lower construction costs, and improve planning coordination among transportation networks—road, rail, sea, and air. Altogether, the 6,500 employees at the administration were charged with managing 100,000 kilometers of road and 12,000 kilometers of rail. Despite constrained public finances, the administration had to cope with rail and road traffic growing 1–2 percent annually, significant congestion, and maintenance backlogs. To meet these challenges, the administration focused on better planning and coordination across all modes of transport, improved productivity in investments and maintenance, and increased operational and administrative efficiencies. As the new administration gained traction, it identified potential savings, for example, by reducing the excavation needed for roadbeds, increasing recycling and the reuse of switches, and optimizing and standardizing road surface material selection. More use of design-build contracts and greater internal capabilities are expected to allow 800 full-time consultants to be replaced by 400 in-house professionals, with financial savings to match. Creating an effective institution to oversee Sweden’s transporta- tion network also helped officials implement productivity programs throughout the administration. The administration has begun applying measures expected to reduce internal costs for administra- tion, facilities, and information technology more than 20 percent. Potential savings in investments have been identified to reduce con- struction costs 10–15 percent. And more rigorous fact-based analysis is deciding whether to maintain or replace deteriorating assets and is presenting capacity-constraint forecasts and other vital information to government budget makers. With ambitious improvement targets, the administration is seeking to become much more effective—a catalyst for improving productivity in the Swedish construction sector. Jonathan Woetzel and Herbert Pohl 285 Processes Standardized processes are vital components of making infrastructure work harder. Uniform processes save time and allow economies of scale. They also make performance management easier by establish- ing clear metrics that can be compared across individuals, locations, and units. And the act of codifying these processes helps identify ways to save costs, time, and other resources. In addition, processes enable due consideration of a project, countering political pressure to move a project forward too quickly and potentially waste resources. Faced with serious problems, Tanzania’s Dar es Salaam Port applied process improvements focusing on operational equipment effectiveness practices to turn around a deteriorating situation. At the outset of the project, the port, which handled incoming and outgo- ing goods for seven countries, was operating at just 85–90 percent capacity. Unnecessarily long container clearances and ship turn- around times were causing the port to lose market share to others in the region. Among the process improvements were computerized customs services, dedicated inland container depots, and extended operating hours. Combined with global standards for operational equipment effectiveness, these new processes helped the port increase its number of ships berthed by 40 percent and its container traffic by 16 percent. In addition, container clearance time was cut from 24 days to 8 days, and ship turnaround time from 19 days to 4 days. The project was estimated to have saved $500 million in capital investments. The decision-making process is another area where changes can speed projects and lower costs. Instead of initially focusing on specific expenses, such as construction costs, decision makers should discuss in more detail the business plan of the project proposal under consideration, looking at such aspects as who will benefit and how. If approved, the project could be revisited following a detailed feasibility study and, after completion, initial assumptions should be compared against outcomes to increase confidence going into future projects. Decision makers at this level should approve or disapprove project plans or business plans, as well as the overall budget, but they should not necessarily become involved in preapproving specific expenditures within the project, even large outlays. 286 Infrastructure: Doing More with Less Adjusting the process can accelerate decision making by allowing leaders to focus on the bigger picture without becoming stuck in details that they might not be able to handle properly. At the same time, offering incentives, increased responsibilities, and accountabil- ity to experts within the projects encourages them to use resources more productively and find ways to minimize costs without affecting quality. Processes can be implemented fairly quickly, and once approved they can be in place within about two months. A “soft launch,” in which the new and old processes are run in parallel, can help isolate bugs that must be corrected and increase confidence in the new system. Capabilities Globally, most city administrations responsible for planning and managing infrastructure development are understaffed and lack the necessary expertise, especially in relation to the capital at risk and benchmarks in the private sector. As a result, budget overruns and missed deadlines are common, leading to increased frustration among city officials and residents. As pressure mounts to finish quickly, addi- tional costs can be massive, especially in a project’s later stages. Part of the solution is to build the capabilities of city staff handling infrastructure programs and to populate the administration with the right number of experts in various disciplines as quickly as budgets allow. Technical skills in such areas as project management, planning, design, maintenance, and operations are clearly necessary. Capability improvements are usually needed at all phases of infrastructure pro- grams, from project proposal through construction and into ongoing maintenance. Our experience helping cities build their capabilities suggests that several areas can support more efficient and effective infrastructure programs: • Project and performance management. Many cities, including London, New York, and Rio de Janeiro, have specific departments or offices with project management capabilities that are responsible for understanding the city’s goals, working with various agencies Jonathan Woetzel and Herbert Pohl 287 to reach those goals, and presenting their findings to top city lead- ers. These cities and others are putting greater emphasis on perfor- mance management—for example, by attaching key performance indicators to their strategic objectives. In some cases, as in Rio de Janeiro, responsibilities for project and performance management are allocated to separate departments. Together, these capabilities allow city leaders to monitor progress clearly. The capabilities needed go beyond gathering data to include understanding the dynamics behind the metrics and interpreting whether goals are on track. The result: better informed decisions. • Information technology. Some cities are elevating information tech- nology to an integral part of their development strategy, not just as an enabler that supports initiatives managed by various depart- ments. New York and Boston each have municipal chief infor- mation officers, who champion efforts to modernize their city’s information technology systems and use social media, geographic information system (GIS), open source platforms, and other new technologies to help accomplish their city’s objectives. This new approach requires investment in building internal capabilities but can unleash substantial returns in greater efficiencies. Traffic man- agement systems, such as electronic road pricing and smart traffic lights that optimize vehicle flow, can dampen the pressure on road expansion and reduce travel time, emissions, and energy use. • Communication. Cities are also building communications capa- bilities, often focusing on disseminating information to the public and within the administration more effectively. Hong Kong SAR, China; Paris; and Seoul have worked on improving how they visually present their ideas and plans. By making higher qual- ity maps, three-dimensional virtual models, and physical scale models of their plans, they have encouraged better informed and more focused public debate and internal policy discussions. As a result, decisions can take less time, and misunderstandings can be avoided. • Predictive modeling. As cities are under increasing pressure to justify investments and policy decisions, credible capabilities in predictive modeling have become more important. Infrastructure proposals are supported by a wide variety of estimates surrounding future events, such as population growth, transportation demand, 288 Infrastructure: Doing More with Less and economic growth. Reliable modeling is an essential founda- tion for these estimates. While many cities rely on outside expertise for these services, some, including Chicago, London, New York, and Paris, have built significant internal capabilities in this area. Capability building is often part of a program that introduces new tools and processes as well. In one example, a Middle East govern- ment was struggling to rank its infrastructure projects. Part of the problem was linked to internal capabilities. Project proposals and funding requests often included insufficient or poor quality data, especially on business plans and expected impacts. Public planners and analysts did not have the training or tools to provide the level and quality of information to make good decisions. As seen, part of the solution included developing a tool that automated some of the analysis and provided a fact base that helped officials rank poten- tial investments. Tailored formats for inputting the necessary data on each project improved the quality of information, and a scoring engine within the tool created a fact-based comparison of investment options. In addition, staff members went to workshops and other activities to improve their personal capabilities. South Africa also turned to capability building as part of a strate- gic performance improvement initiative centered on capital expendi- tures. A lack of skills among public servants planning and executing large capital projects was exacerbating capacity and capital shortages in the country’s power system. The country’s skill-building program emphasized lean construction techniques to reduce building costs, helping reduce capital costs for new construction 12 percent and creating more than 11,500 jobs. *** Around the world, roughly 2–6 percent of GDP is spent on infra- structure improvements, and developing countries in Africa, Asia, and Latin America are spending at the high end of the range. As urban populations continue to grow, so too will the demand for infrastructure. Mayors and other city leaders in developing countries face the daunting challenge of meeting these expanding needs with finite funding. Jonathan Woetzel and Herbert Pohl 289 But our work and research has shown that funding, while important, is not the only obstacle to developing strong urban infrastructure. Improvements in governance, institutions, processes, and internal capabilities are often neglected as officials bemoan their funding challenges. Focusing on these areas can close the funding gap considerably, allowing cities to deliver greater benefits from their investments. In addition, cities must be smarter about how they approach their infrastructure development programs. Officials must carefully consider whether they are building the right infrastructure, getting the most benefit for existing infrastructure, and delivering projects efficiently—and whether PPPs can deliver additional benefits. Cities that progress in their infrastructure programs despite the current challenges will be those with leaders who look beyond fund- ing to find ways to serve their citizens effectively with the resources available. 11 Urban Transport Can Public-Private Partnerships Work? Eduardo Engel and Alexander Galetovic Cities exist, grow, and prosper because they take advantage of scale economies and specialization wrought by agglomeration. But output growth inevitably stresses transport infrastructure because production requires space and mobility. Similarly, on the demand side, wealthier people use more space, buy more cars, and are more mobile. To prevent congestion from crowding out agglomeration benefits and to expand the supply of urban land, cities must invest in transport infrastructure. Yet balancing the growing demand for infrastructure with its supply is often difficult. Poor street and highway maintenance, excessive congestion, and slow capacity expansion are endemic in cities the world over. Many urban commentators find that slow capacity expansion is not the problem, blaming congestion instead on an irrational prefer- ence for car travel—a harmful part of urban life akin to excess noise or pollution. They argue that building more infrastructure, especially highways, just fosters sprawl and fails to reduce congestion—that people respond to more capacity by driving more and wasting even Eduardo Engel and Alexander Galetovic 291 more time (Mogridge 1997). In this view, a central task for policy makers and planners is to curb the preference for cars. Proponents of this view advocate subsidizing public transportation; enacting taxes and restrictions to raise the costs of owning and driving cars; and establishing zoning regulations to foster compact living, shrink the spatial distribution of activities, and reduce the number of vehicle trips. We assert, by contrast, that space and mobility are both factors of production and consumption goods with positive income elasticity and that the conventional provision of transport infrastructure suffers from three important shortcomings. Heggie and Vickers (1998, 19) describe one compellingly: [Roads] are not managed as part of the market economy with its formidable pricing dynamic. There is no clear price for roads, road expenditures are most often funded from general tax revenues, and the road agency is not subjected to any rigorous market discipline. This biases managerial incentives. Roads are managed like a social service with multiple goals. Road users pay taxes and user charges, but the proceeds are almost always treated as general tax revenues. Instead of being financed through user charges, roads are thus financed through budget allocations determined as part of the annual budget- ary process. These allocations bear little relationship to underlying needs … or to users’ willingness to pay. There is … no direct link between revenues and expenditures …, there is no price to ration demand …, and expenditures are not subjected to the rigorous tests of the marketplace …. Second, many cities lack the funding to maintain and expand streets and urban highways. And third, because streets and urban highways are interconnected networks, planning at the city level and coordination among jurisdictions (for example, among municipalities or between local and regional or national authorities), is lacking. Yet urban planners often lack formal and real authority to cut through the bureaucratic web of multiple authorities and jurisdictions. Can public-private partnerships (PPPs) deal with these problems better than conventional public provision and ensure proper maintenance, timely expansion, and less congestion? 292 Urban Transport Public-private partnerships: what they can do and what they need to work What is a public-private partnership? When delivering infrastructure, governments face three challenges: deciding what to build and when, building cost-effectively, and ensur- ing proper maintenance and service quality once the infrastructure is built. Until recently, highways were considered public goods and were thus built by governments, funded with budget appropriations, and managed by ministries or public agencies. But many countries have since introduced the PPP, a new contractual agreement used extensively around the world to build roads, bridges, and tunnels. A PPP bundles finance, construction, and operation into a long- term service contract between the government’s procurement authority and a standalone private firm—the special purpose vehicle (SPV; see Figure 11.1a). The SPV takes charge of building and operating a legally and economically self-contained project for 10–30 years. On the financing side, it pledges the cash generated by the project, which can come from tolls or government payments, to pay back both equity and debt financiers.1 The SPV’s narrow focus leaves little room to divert funds to other divisions, and PPP deals are usually highly leveraged. On the production side, the SPV hires a firm to build the facilities and then operates the project and maintains the infrastructure. When the contract ends, assets revert to the government. Compare PPPs with conventional provision, where the govern- ment deals directly with financiers, the builder, and the operator (Figure 11.1b). Under conventional provision, the project is financed with public debt and budget appropriations; a government agency hires the builder and then the operator. This basic structure has many variations, often influenced and sometimes determined by country, regional, and city laws and institutions. Sometimes the whole process is taken on by a single public institution (for example, a central gov- ernment ministry or a city authority), with tasks split among agencies, among layers of government, or even within the same government institution. PPPs normally enter the conventional provision structure inheriting many of its shortcomings—and cities are unlikely to adopt radical institutional reform to change that. Eduardo Engel and Alexander Galetovic 293 Figure 11.1 omits the source of funding—tolls or government transfers—because both PPPs and conventionally procured projects may rely on one or both. There are many public toll roads around the world; conversely, many PPPs are funded with budget appropriations. When? The appeal of PPPs stems from the glaring shortcomings of public provision. When PPPs began to spread around the world, many believed that private participation in infrastructure would by itself improve performance. To some extent, this prejudice is warranted. Figure 11.1 Contracting under public-private partnerships and conventional provision 294 Urban Transport Public agencies in charge of infrastructure projects (for example, ministries of public works, city governments, or municipalities) tend to have many objectives and are accountable to multiple principals, weakening incentives. Moreover, management practices in the public sector are more rigid, and public agencies are constrained by annual budgets—for good reasons. Public managers can neither use the earnings of their organization to reward employee’s performance nor freely allocate factors of production. Indeed, constraints imposed by the legislature and the administration limit hiring, purchasing, contracting, and organizational structures (see Wilson 1989, ch. 7). These constraints also imply that the design of institutions that manage infrastructure is seldom concerned with efficient scale and scope. Thus, while many projects are large enough to assign tasks to specialized service providers—such as construction companies or maintenance contractors—public agencies tend to manage all the infrastructure of a jurisdiction (sometimes the whole country), whose size far exceeds the efficient scale of operation. Poor street and highway maintenance is just one shortcoming stemming from the excessive scale of the institutions. PPPs, by contrast, are the opposite type of organization. Because each project is managed by an SPV, their focus is narrow and incen- tives naturally sharp. Moreover, because SPVs are private firms, management is not constrained by public sector rigidities, and their goal is private gain. Last, it is far easier to pitch each PPP to its efficient scale of operation. All in all, PPPs substitute private manage- ment practices, incentives, and focus for public sector rigidities, weak incentives, and excessive scale. In retrospect, however, it is easy to see that the view initially held by many that “privatization” through PPPs would work as liberaliza- tion of, say, international trade or goods markets, was naïve. Contrary to liberalization, PPPs do not relieve governments of most of their duties. Indeed, with single-project firms and temporary concessions, the government retains discretion to plan and coordinate network expansion as demand grows over time. Just as with public provision, performance depends heavily on the quality of project selection and appraisal. Moreover, public authorities must still manage externali- ties, ensure rights of way so that projects can be built, enforce project Eduardo Engel and Alexander Galetovic 295 delivery and monitor contract execution thereafter. Thus, while PPPs take some responsibilities off the government’s shoulders, at the same time they make the task of public authorities even harder because they have an additional agent to deal with. How? A central economic characteristic of transport infrastructure is the large, mainly exogenous demand risk: predicting initial use and growth rates is next to impossible. Demand forecasts depend on estimates of the macroeconomic cycle, which are tied to economic performance, and on estimates of microeconomic conditions, which reflect local demand fluctuations. Risk can also stem from uncertain- ties—about changes in the income elasticity of demand for motor vehicles and, when tolls are charged, about the toll elasticity. Either uncertainty can throw off demand forecasts, which are usually inac- curate in the short term (three to five years) and all but useless in the long term. Consider the Dulles Greenway, a 14-mile (22.5-kilometer) road joining Leesburg, Virginia, with Washington-Dulles International airport, near Washington, DC. When the contract was granted in the mid-1990s, two consulting companies independently forecast that, with a toll of $1.75, the Greenway would serve roughly 35,000 vehicles a day. Actual traffic turned out to be just 8,500 vehicles a day, because the public dislikes tolls and Virginia widened its non-tolled State Route 7, which serves the same users. In this case, demand risk was policy related, but it was also beyond the firm’s control and thus exogenous. High demand risk makes risk sharing essential in PPP contract design. Consider PPPs that can be funded with tolls. Despite high demand uncertainty, tolls often pay for the project eventually; the question is only how long it will take. Even though the initial demand for the Dulles Greenway was much lower than expected, toll revenue eventually will pay for capital and operating expenses. For projects that will eventually pay for themselves, a present-value-of-revenue (PVR) contract offers many attractive properties. Under the flexible PVR contract, the regulator sets the discount rate and toll schedule, 296 Urban Transport and firms bid the present value of toll revenue they desire. The firm with the lowest bid wins, and the contract lasts until the winning firm collects the toll revenue it demanded in its bid. A PVR contract reduces risk. When demand is lower than expected, the franchise period is longer; when higher than expected, the period is shorter. Assuming the project turns profits in the long run so that it will eventually be paid for, all demand-side risks are eliminated, reducing the risk premium to far lower than what the firm would demand with fixed-term concessions.2 This should attract investors at lower interest rates than those offered by fixed-term PPPs. Each franchise generates the same toll revenue per year, but the PVR contract offers a variable franchise term. If demand is low, the franchise holder of a fixed-term contract may default; by contrast, a PVR contract extends until user-fee revenue equals the bid, ruling out default. The PVR bondholders do not know when they will be repaid, but that is better than not being paid at all. Reducing demand risk also mitigates the winner’s curse and bids become more cost- oriented (Tirole 1997). The flexibility of PVR contracts works well for urban highways, because setting the right toll for highways is difficult. Unless traffic estimates are accurate—a rare event—the tolls will likely be either so low that they create congestion or so high that the highway is underused. In a PVR franchise, the regulator could set tolls effi- ciently to alleviate congestion without distorting the concessionaire’s incentives. When tolls are not an option, the government can pay a fixed periodic fee, contingent on the service quality standard being met— the availability contract. Availability contracts have become more popular in many countries, including France, the United Kingdom, and the United States. Under these contracts, the government selects an SPV to build public infrastructure. In exchange for the project services, the government remits the SPV a unitary payment, which covers principal and interest on the debt plus a return to the SPV’s shareholders, known as the sponsors or the private party. The SPV receives an amount to cover the costs of operations, maintenance, and service provision. The government guarantees the quality of service specified in the contract by making regular payments conditional on the contracted service being available. Eduardo Engel and Alexander Galetovic 297 Availability contracts, optimal if no tolls are charged, are often awarded to the firm requiring the lowest annual payment, so that demand risk is minimal. Availability payments cover the upfront investment, and the concessionaire profits on it regardless of actual demand. Availability contracts can also maintain a network. For example, in summer 2007, Missouri’s Department of Transportation selected a consortium to rebuild or replace 800 bridges and maintain them for at least 25 years. The costs were an estimated $400–600 million, with the state making annual payments once the work was done. The contract provides strong incentives for the consortium by finessing it if contract specifications are not met: $500 a day for each bridge for delays beyond the original construction deadline, $2,000 a day for closing, and $2,000 a day for each structure that fails to meet the quality standards set out in the contract. Similarly, cities could allocate street maintenance to a concessionaire in exchange for meet- ing service standards. The role of institutions PPPs cannot exist unless certain preconditions are met. Most important, property rights, including those arising from contracts with the government agency, must be protected. Otherwise, private firms will not commit large upfront investments to be paid by future revenue flows (tolls and availability payments); even if they do, they will demand a prohibitively high premium to bear the risk. A well-developed financial market helps PPPs because it allows firms to securitize the project locally after it is built without paying high premiums to compensate for exchange rate uncertainty and country risk. Where property rights are poorly protected, PPPs are not an option. Governments in those areas should thus strive to improve public infrastructure provision. Pitfalls of public-private partnerships Public finance PPPs, contrary to misconceptions, do not free up public funds. Indeed, they affect the inter-temporal government budget in 298 Urban Transport much the same way as public provision. With a PPP, the current government saves the initial investment outlay, but it then relin- quishes either future user-fee revenue (if the PPP is funded with tolls) or future tax revenue (if the PPP is funded with government payments). Confusion about the inter-temporal nature of PPPs underlies one of the most glaring and widespread defects of PPP programs: their use to anticipate spending. Because fiscal accounting rules keep most PPPs off the balance sheet, governments use PPPs to sidestep the normal budgetary process, just as off–balance sheet vehicles helped banks elude capital requirements and prudential regulation, igniting the 2008–09 global financial crisis. Similarly, some governments have used PPPs to sell the cash flows from existing infrastructure, financing current expenditures with part of the proceeds. This danger looms large in cities, as the Chicago Skyway shows (Based on Cheng 2010). The Chicago Skyway, a 7.8-mile (12.6-kilometer), six-lane, median-divided toll road linking downtown Chicago to the Indiana state line, was developed by the city in 1959, with bond financing linked to toll revenue. But the city could not raise tolls enough to pay off the debt and was ordered by the courts to increase tolls. Even with the increased tolls, however, the first principal payment (after paying off all interest due) was not made until 1991, when the project’s financial situation improved as nearby non-tolled roads became more congested. After retiring the original bonds in 1994, the city made no further toll adjustments until it leased the project in 2005. From then on, the city used the Skyway revenue to fund other transportation projects and anticipated these revenues by issuing bonds in 1996 for the same purpose. In 2004, the city issued a Request for Qualifications, which brought in five qualified bidders for a 99-year lease of the Skyway. Three bidders competed to fund the highway’s operations and maintenance in exchange for toll revenues according to a predetermined toll schedule, with an undisclosed reservation price estimated at $700–800 million. Cintra-Maquarie’s winning bid of $1.83 billion, roughly twice its competitors’ bids of well under a billion dollars, left it with the “winner’s curse.” Under all reasonable demand scenarios, Cintra-Maquarie paid too much for the project (Cheng 2010). Eduardo Engel and Alexander Galetovic 299 Three points stand out from this case study. First, major toll increases were delayed until after the mayor’s term. Second, Chicago procured in advance an exemption from leasehold taxes for the Skyway, thus raising its value at the expense of future revenues. Finally, the initial lease term was 55 years, but the actual lease extended for 99 years at the insistence of potential bidders, perhaps for the tax advantages. Indeed, a private entity with a long lease gains asset ownership and can claim depreciation as an expense for federal tax returns. And over 2009–10, Cintra-Maquarie reported $18.9 million in depreciation expenses for the Skyway.3 The PPP was financially advantageous for the city, because only under implausibly optimistic expectations of traffic growth and an undemonstrated ability to raise tolls could it have generated the revenue it collected from the winning bid (Cheng 2010). Private management has other potential efficiency gains (more efficient maintenance and operations), but their impacts are small (operating costs fell 11 percent, a gain of $1 million a year, for example), so they should have an equally small impact on the overall valuation of the Skyway. The short-term political benefits of the PPP were important. Part of the debt was used to retire Skyway bonds and city debt, and $500 million was put into a long-term reserve. The remaining $475 million went into discretionary funds, of which the city had spent 83 percent by the end of 2009. How can we prevent spending anticipation and accounting shenanigans? Fiscally, PPPs should be treated much like public projects (see Engel et al. forthcoming [b]), following whatever accounting rules conventional provisions follow. But few national governments, if any, have sound accounting rules, and cities keen to experiment with PPPs are not likely to either, keeping spending anticipation a driver of PPPs. Renegotiations PPP contracts are routinely renegotiated, often to the detriment of the public purse. True, circumstances can change over the life of a contract, but renegotiations usually occur shortly after contracts are awarded, and they tend to favor concessionaires. For example, 78 percent of the amounts awarded in Chilean PPP renegotiations 300 Urban Transport have been brokered during construction, shortly after the contract was awarded (Engel et al. 2009). And most renegotiations imply paying more for the works than set out in the contract. Thus, in principle renegotiations allow governments to expropriate conces- sionaires after they have sunk their investments, but in practice the private partner benefits the most. Contract renegotiation is justified when all parties gain, including the public, such as when the environment changes, new information arises, or design errors are discovered. In other cases, however, con- tracts are modified strictly to benefit the procuring authority (expro- priation of the PPP, for example), the project sponsor (by helping a failing project, offering a term extension, or lowering technical stan- dards), or both—at user or taxpayer expense. In practice, it is difficult to distinguish the justifiable negotiations from the unjustifiable. And even when renegotiations are justifiable, the new agreement might not be fair, as contracts are renegotiated in a bilateral monopoly. To snuff out opportunistic renegotiations, an independent panel of experts should ensure little to no change in discounted profits result- ing for the concessionaire from any proposed contract renegotiation. A recent wave of legislative reforms in Latin American countries has implemented proposals along these lines. Flexibility—adapting to changing circumstances As stated above, circumstances change over the life of a long-term contract. If demand grows faster than expected, the PPP facility might need expanding; if the user-fee schedule proves inadequate, it might need amending. In these cases, the regulator should have the flexibility to change the contract or, perhaps, even to terminate it. This would facilitate regulatory takings, however, so many contract clauses restrict discretion to protect concessionaires. A recent PPP concession highlights the tension of protecting the concessionaire from regulatory takings while avoiding the costs of inflexibility. In 1995, the California Department of Transportation (Caltrans) awarded a 35-year contract for a 10-mile segment of the four-lane Riverside Freeway (State Route 91), between the Orange- Riverside county line and the Costa Mesa Freeway (State Route 55), to the California Private Transportation Corporation. Motorists take Eduardo Engel and Alexander Galetovic 301 the express lanes to avoid congestion in the non-tolled lanes, paying up to almost $11 round trip. The concessionaire raised tolls several times to relieve congestion. But by the late 1990s, 33,000 daily trips brought the express lanes to the brink of congestion at peak times, turning the concession into a financial success. At the same time and for the same reasons, the non-tolled public lanes were congested, and expansion became urgent. The contract included a non-compete clause, however, that prevented Caltrans from raising capacity with- out the corporation’s consent. Caltrans, in an attempt to sidestep the clause, argued that expansions were necessary to prevent accidents, but the corporation filed a lawsuit. The settlement stated that the contract’s non-compete clauses ensure the corporation’s financial viability, restricting Caltrans’s right to adversely affect the project’s traffic or revenue—to build new lanes. Protracted negotiations ensued, and eventually the Orange County Transportation Authority negotiated to buy the tolled lanes. But the toll road’s value was disputed; it would have equaled the present value of profits from the State Route 91 express lanes had the franchise continued as planned. Although the lanes cost $130 million to build, the company’s value was initially set at $274 million in an unsuccessful buyout attempt by a non-profit affiliated with the county. After several years of negotiations and continuing congestion, the authority bought the lanes for $207.5 million in January 2003. The purchase was enabled by the state legislature, which allowed the authority to collect tolls and pay related financing costs and elimi- nated non-compete provisions in the franchise agreement to allow State Route 91 to be improved. In principle, the government should be able to unilaterally buy back the concession, provided that it pays fair compensation for the profits forgone by the franchise holder—that is, the expected pres- ent value of future profits had the concession continued under the original terms. However, with a fixed-term concession, as with State Route 91, the value cannot be deduced from accounting data and is thus highly subjective. Here, neither discretion nor bilateral bargain- ing leads to an efficient solution. Engel et al. (2003) have shown that either a PVR contract (for projects funded with tolls) or an availability contract can be struc- tured so that the government retains almost full flexibility while 302 Urban Transport protecting the concessionaire against arbitrary takings. For example, it suffices to add a clause in PVR contracts allowing the regulator to buy out the franchise by paying the difference between the winning bid and the discounted value of collected toll revenue at the time of repurchase (minus a simple estimate of savings in maintenance and operations expenditures due to early termination). An availability contract can offer similar compensation. And in both cases, the gov- ernment bears the risk of early termination—desirable because this risk is beyond the concessionaire’s control. Termination under either contract is independent of future demand and therefore verifiable. Thus, the winning bid minus the payments already received by the concessionaire equals the fair compensation. The government cancels the contract only if doing so is efficient. The government’s ability to cancel the contract at its discretion prevents protracted or inefficient renegotiations. Coordination, multiple jurisdictions, and decentralization Urban regulation developed in industrialized countries during the 19th and early 20th centuries to control negative externalities. In principle, externalities can be mitigated in several ways, such as with taxes, regulations, private bargaining, and contracts. But in practice, externalities are managed almost exclusively with top-down controls and regulations. The resulting system of laws, controls, and planning regulations specifies what can be done and where and is in charge of many authorities, including national, regional, municipal, and local governments. Sometimes, even authority within a level of govern- ment is dispersed among agencies. Conflicts across jurisdictions are thus quite common. So, PPPs face a stiff challenge. No general rules prescribe how to deal with this preexisting system—the distribution of power varies by country—and tensions with urban regulations and institutions persist. An effective PPP requires long-term public planning. And a planner must have the authority to implement and execute it. But the plan’s execution will inevitably involve other agencies and various levels of government. Many times these agencies will have a say in what can be done, when, and how; sometimes they will be pivotal to a project’s execution. Moreover, the interests of each local authority Eduardo Engel and Alexander Galetovic 303 might clash with community interests, especially when one jurisdic- tion bears the infrastructure costs but few of the benefits. Inter-jurisdiction coordination, hard enough under conventional provision, is even harder with PPPs, as the long-lived contractual obligation with the concessionaire adds another constraint to the agreements that different authorities can reach. PPPs can also stand in tension with decentralization, as the need for planning and coor- dination can require local governments to surrender part of their authority to the agency in charge of the PPP. The public-private partnership premium PPPs have been roundly criticized for costing more per dollar of financing than public debt—the so-called PPP premium. The num- bers quoted for this cost difference vary widely. Yescombe (2007) shows that the cost of capital for a PPP, once 200–300 basis points higher than the cost of public funds, has doubled since the credit crisis. He also shows that the spread over the lender’s cost of funds is roughly 75–150 basis points, with highway projects on the upper limit (Yescombe 2007). So, when governments decide between pub- lic provision and PPPs, the argument goes, they trade off a lower cost of funds under public provision against a PPP’s supposed higher efficiency. Other authors, like Klein (1997), question whether there is a PPP premium. One argument claims that bondholder risk under public provision is subsumed under general government default risk—that public debt is cheaper because the public implicitly absorbs the risk through potentially higher taxes or less government spending in case of imminent default on all government debt. Financial economists distinguish systematic risk—which varies with the market or the economy—from project-specific risk. The project’s systematic risk cannot be diversified and should affect public and private financing costs equally. Can the public sector diversify exogenous, project-specific risks better than PPP financiers? Probably not. Both PVR and availability contracts assign all exogenous risk to the government. A PPP shifts endogenous risks to the conces- sionaire to prevent moral hazard and strengthen incentives to cut 304 Urban Transport costs and provide adequate service quality. Unless risk-neutral, the concessionaire will charge for bearing that risk. Moreover, these risks cannot be diversified in the capital market; otherwise, there would be no incentive to improve performance and the agent might indulge in moral hazard. The question is thus whether shifting risks to the concessionaire buys an improvement in performance that justifies the higher cost of risk. Should the government use an incentive contract to improve per- formance under public provision, it would have to transfer risks to an agent and pay accordingly. The cost of preventing moral hazard under public provision—a risk premium—should then be added to the public sector cost of financing. Of course, such an adjustment is never done before comparing—hence the PPP premium. A case of prescient planning and successful implementation of public-private partnerships Between 2000 and 2008, a 225-kilometer (140-mile) system of urban highways was built in Santiago, Chile’s capital (shown in the bold lines in Map 11.1).4 The system was divided among eight PPP concessions. Most of the funding to pay for the $3 billion investment will come from toll collections over the next 20–30 years. Tolls are charged by use and time of day through an electronic device attached to each car. Each month, users receive a bill and pay it like any other utility. Tolls vary by congestion and were fixed in each PPP contract. How did Santiago build this system in less than a decade? The PPP program was planned and executed by a division in the Ministry of Public Works, which has authority over streets and highways across several municipalities. Urban PPPs were part of a broader national plan to upgrade Chile’s urban highways through PPP concession. The program began in the early 1990s, along with studies to build urban highways. A law was passed to regulate concessions in 1996, and PPPs were put to tender between 2000 and 2005. Yet the system’s origin dates to the late 1950s and early 1960s. In 1960, the Ministry of Public Works issued its Santiago plan, PRIS (a Spanish acronym for inter-communal urban regulation plan). Planners anticipated that Santiago’s rapid growth, which had begun in the 1940s,5 would eventually transform it into a polycentric Eduardo Engel and Alexander Galetovic 305 Map 11.1 Urban Highways in Chile city covering a substantial, ever-expanding area. It was thus crucial to plan and build streets connecting metropolitan sub-centers and municipalities, avoiding trips passing through the city center. The plan anticipated the necessary transport investments, reserved strips of land for roads, and gradually executed the investments to put the 306 Urban Transport plan to work. When PPPs came 40 years later, most roads had already been built, though they were in need of substantial upgrading. *** PPPs can help improve street and highway maintenance, relieve excessive congestion, and ensure timely capacity expansion, but they cannot substitute for good government. Indeed, PPPs can make government tasks more difficult and demanding. PPPs can go a long way toward ensuring that transport infra- structure is well maintained. Their long-term contracts force the government to fund the SPVs in charge of the infrastructure. If the contract specifies adequate maintenance and service standards and punishes non-compliance, the concessionaire will be motivated to comply. In addition, PPPs foster productive efficiency, because the conces- sionaire is a private firm free of the typical constraints that a public manager must obey. The concessionaire can freely choose factors of production and reward them contingent on performance. Moreover, SPVs have a narrow focus, answer to only one principal, and can adjust their scale and scope to fit the task at hand. PPPs need not be funded with tolls, but they offer an opportu- nity to make tolls politically acceptable. Because free-flow tolling is now feasible, tolls can be charged to reduce congestion, ensure an adequate mix of public and private transportation, and help finance maintenance and new infrastructure. Indeed, there is no good argument against charging for transport infrastructure: congestion abounds, streets and highways are rival goods, and technology now makes them excludable. Also, making users pay for infrastructure is good public finance. Perhaps we should pay for using streets just as we pay for water, electricity, or garbage collection. Of course, tolls need to be regulated by a public body. Moreover, SPVs cannot ensure proper and timely expansion of transport net- works because planning, a long-term endeavor, must be handled by a public body with authority to achieve inter-jurisdiction coordination and ensure rights of way. Also, public bodies must take charge of delivering projects, monitoring contract compliance, and enforcing service standards. If these preconditions are met, PPPs can build, operate, and maintain urban highways. They can also maintain Eduardo Engel and Alexander Galetovic 307 streets—a city can be divided into sectors, each delegated to a firm in charge of maintaining it under a long-term contract. Cities should take care when developing a PPP program, noting at least three precautions. First, PPPs should be chosen only if they improve efficiency, and not for fiscal reasons, because they have the same impact as conventional provision on the inter-temporal budget. So far, few countries (if any) have modified their accounting rules to acknowledge this fact, and city governments probably will not either. The temptation to use PPPs to anticipate spending is strong and casts doubts on their desirability. Second, in a PPP the concessionaire’s expenses are front-loaded, while revenue collection is back-loaded. Private firms will invest only if they know that revenue streams will not be expropriated—that is, if rules of law and property rights are strong. Without this assurance, only traditional, less risky, public infrastructure provision is feasible. This insight suggests that PPPs are unattractive to low-income countries with weak institutions and governments. Last, PPPs need even more sophisticated governance and public intervention than does conventional provision: planning and project delivery, contract monitoring and enforcement, and inter-jurisdic- tion coordination. These tasks are performed imperfectly today, and just adopting PPPs will not improve institutions. Experience so far has exposed many pitfalls, and inadequate governance has been the rule. Notes 1. This financing technique is known as project finance. See Yescombe (2002, 2007). 2. For example, by an amount equal to a third of the upfront investment in the case considered in Engel et al. (2003) and by an even larger amount in the case considered in Albalate and Bel (2009). 3. For the Indiana Toll Road, depreciation expenses for 2009–10 totaled $73.6 million. 4. According to the 2011 census, 6.2 million people live in the Santiago metropolitan area (Gran Santiago), and the city covers 711.2 square kilometers (71.1 hectares or 274.6 square miles). Densities are 8,700 inhabitants per square kilometer, 87 per hectare, or 22,578 per square mile. Gran Santiago is divided into 37 municipalities. 308 Urban Transport 5. Between 1940 and 1960, Santiago’s population roughly doubled, from about 1–2 million. Santiago’s surface area doubled too, from about 100 square kilometers to 200 (10,000 hectares to 20,000, or 38 square miles to 77). By 1970, the population had increased by another million and surface area by another 100 square kilometers. Bibliography Albalate, Daniel, and Germà Bel. 2009. “Regulating Concessions of Toll Motorways: An Empirical Study on Fixed vs. Variable Term Contracts.” Transportation Research Part A: Policy and Practice 43: 219–29. Cheng, John. 2010. “The Chicago Skyway Concession.” Senior thesis, Yale University. Engel, Eduardo, Ronald Fischer, and Alexander Galetovic. 2003. “Privatizing Highways in Latin America: Is It Possible to Fix What Went Wrong?” Economia 4: 129–58. ——–—. Forthcoming (a). The Economics of Public-Private Partnerships: A Basic Guide. Cambridge, U.K.: Cambridge University Press. ——–—. Forthcoming (b). “The Basic Public Finance of Public-Private Partnerships.” Journal of the European Economic Association. Engel, Eduardo, Ronald Fischer, Alexander Galetovic, and Manuel Hermosilla. 2009. “Renegociación de concesiones en Chile.” Estudios Públicos 113: 151–205. Heggie, Ian G., and Piers Vickers. 1998. “Commercial Management and Financing of Roads.” Technical Paper 409, World Bank, Washington, DC. Klein, Michael. 1997. “The Risk Premium for Evaluating Public Projects.” Oxford Review of Economic Policy 13: 29–42. Mogridge, Martin J.H. 1997. “The Self-Defeating Nature of Urban Road Capacity Policy.” Transport Policy 4: 5–23 Tirole, Jean. 1997. “Comentario a la propuesta de Engel, Fischer and Galetovic sobre licitación de carreteras.” Estudios Públicos 65 (Winter): 201–14. Wilson, James Q. 1989. Bureaucracy: What Government Agencies Do and Why They Do It. New York: Basic Books. Yescombe, Edward R. 2002. Principles of Project Finance. Burlington, MA: Academic Press. ——–—. 2007. Public-Private Partnerships: Principles of Policy and Finance. Waltham, MA: Butterworth-Heinemann. 12 Sustainable and Smart Cities Matthew E. Kahn* Environmental progress in developing cities is daunting. When millions of people and thousands of firms choose to locate near each other and share air, roads, and rivers, pollution tends to rise unless polluters have an incentive not to pollute. To mitigate pollution, government intervention is the textbook solution. But government officials face conflicting goals as they promote economic growth with limited information about polluter activities. In developing nations officials often face severe resource constraints that limit their ability to credibly monitor polluters— inhibiting their ability to implement fines and environmental regulations. Despite these challenges, the World Bank’s environmental econo- mists have been optimistic about the potential for developing cities to generate less pollution during times of growth. Dasgupta et al. (2002) emphasize that the choices of urban citizens, firms, policy makers, regulators, and non-governmental organizations all interact * I thank Julianne Baker and Aubrey Michi for several useful comments. 310 Sustainable and Smart Cities to determine whether a city can refute the traditional pessimistic outlook that economic growth causes environmental degradation. This chapter explores the challenges and opportunities that gov- ernment officials face in designing coherent “rules of the game” for achieving urban sustainability during times of growth. Sustainability is judged by three criteria. The first involves elements of day-to-day quality of life, such as having clean air and water and green space. The provision of these public goods has direct effects on the urban public’s health and productivity. The second focuses on the city’s greenhouse gas emissions. Developing cities are investing in new infrastructure, from highways and public transit systems to electric- ity generation and transmission. They are building water treatment, water delivery, and sewage disposal systems. Residents of these cit- ies are simultaneously making key decisions about where they live and work and whether to buy such energy-consuming durables as private vehicles and home air-conditioning units. Given the long- lived durability of the capital stock, short-term decisions will have long-term effects on the city’s carbon footprint. The third criterion is a city’s resilience to natural disasters and extreme weather events. This subsection focuses on how the urban poor can be better equipped to adapt to the anticipated challenges of climate change. The cities that have performed well on these three criteria will enjoy several benefits. Their people will be healthier and more pro- ductive. Reduced exposure to pollution increases the likelihood that children are healthy and learn more in school and thus become more productive citizens. The adults in a low-pollution, resilient city will enjoy a higher quality of life, and the mobile skilled will be attracted to move there. Cities that provide a safe, clean, healthy environment are more likely to be home to citizens who enjoy a higher quality of life. Consequently, children in these cities are more likely to become able-bodied and productive adults. Improvements in environmental quality will help slow morbidity and mortality risk, and this will reduce the demand for costly health care. In this sense, investment in “sustainable cities” helps produce a richer future society. Cities that become “low-carbon” cities will help mitigate global climate change. And if a global carbon treaty is agreed on, such low-carbon cities will have an edge in complying with its terms. Matthew E. Kahn 311 This chapter proceeds by first investigating how the industrial, transportation, and household sectors contribute to urban sustain- ability challenges. Each sector has policy suggestions that could significantly mitigate local and global pollution. Exposure to this pollution depends on where goods are produced and where urbanites live. For instance, the urban poor tend to live in the most polluted and dangerous parts of the city. Several suggestions are offered for reducing this vulnerable group’s exposure to risk and enhancing envi- ronmental justice in cities. The final section builds on this theme by discussing urban resilience in the face of climate change. Reducing the pollution costs caused by the industrial sector Few cities feature an industrial base that mirrors the country’s over- all industrial shares (Glaeser 2011; Moretti 2012). Individual firms will locate in the city where they can expect the highest profits. For example, labor-intensive industries might seek a city where the market price of labor (wages) is low; electricity-intensive industries might seek areas where electricity is cheap, such as near coal deposits. The geographic distribution of industries across cities has important environmental implications. Some cities will have an industrial base featuring heavy industry, others a low-pollution service industry. Cities that specialize in heavy industry—such as steel production, chemical production, and paper manufacturing—face a more dif- ficult sustainability challenge than cities that specialize in services. Industrial cities suffer from higher local air and water pollution and tend to be major consumers of electricity for production.1 Government officials face tradeoffs in choosing how to reduce manufacturing pollution. They will be well aware that manufacturing offers fairly high wages for low-skill workers. In the United States, the service sector’s share of employment has grown sharply as manufac- turing’s share has fallen. Labor economists have documented the large reduction in wages for workers displaced from manufacturing (Neal 1995). Officials must also be aware that heavy industry contributes to ambient particulate and ozone and elevates water pollution (Cai et al. 2012). When such activity takes place in city center locations, 312 Sustainable and Smart Cities this pollution creates “hot spots” that affect millions of people living in densely populated nearby neighborhoods. In such areas, quality of life declines, as do land prices due to spillover pollution. High pollution has direct impacts on the affected population’s health and can have significant effects on children’s development (Currie 2011; Currie and Neidell 2005; Currie and Schmieder 2009). One fairly inexpensive way for government to reduce manufactur- ing’s pollution costs is to encourage the sector to move to dedicated industrial parks. China’s government has created special economic zones—areas where urban planners seek to concentrate production activity and install infrastructure to increase industrial productiv- ity. If such production areas are selected so that fewer people live downwind, urban planning can break the link between pollution production and residential area pollution exposure. Concentrating industry in a small space may also reduce auditing costs for regulators monitoring these polluters. Over the long run, many manufacturing industries choose to move away from city centers, a dynamic that has played out from the United Kingdom to the United States and from the Republic of Korea to China (Henderson et al. 2001). Land is expensive at the center of cities, and manufacturing is land intensive. As national and urban governments invest in transport infrastructure, the suburban- ization of manufacturing accelerates, posing a pollution tradeoff for urban governments. Suburbanization offers the benefit of reducing industrial pollution exposure for millions of people who live in the city center, but it also encourages the population to live closer to these suburban jobs. This attracts the industry’s supply chain (intermediate goods suppliers) to the suburbs, causing further suburbanization. In the short run, governments have policy tools for reducing the emissions from industry. Several governments, including that of the United States, employ “command and control” regulation, requiring new factories to deploy state-of-the-art emissions control equip- ment. Such an approach raises production costs for new factories but does little to reduce the emissions from older ones. In fact, it encourages industry to rely longer on older, higher polluting factories to delay paying new regulatory costs associated with building new factories. Economists frown on an incentive system that implicitly rewards keeping old factories running and that imposes a regulatory Matthew E. Kahn 313 tax on building and operating new factories. New factories tend to have much lower emissions per unit of output because they embody cutting-edge engineering techniques. Urban officials seeking a vibrant employment base will worry about overregulating industries. If one city adopts regulation to reduce pol- lution while a rival city does not, some factories in the city with high regulation might shut down and move to the city with lax regulation. In such a “race to the bottom,” firms seek geographical areas that reduce their regulatory costs. In this case, the high-regulation city would be “rewarded” for its efforts by job loss and falling incomes (Jaffe et al. 1995). This outcome would be less likely if the city that enacts the regulation has other attractive attributes, such as a good transportation system or a large home market that helps economize on other production costs. Trading pollution permits The ugly scenario of regulation-induced job loss highlights the importance of being smart about designing regulation. An equitable allocation of pollution permits can achieve the dual goals of pollu- tion mitigation and continued industrial production (Stavins 1998). The pollution-permit market approach to industrial regulation starts with the government declaring a cap on total tons of pollution that may be released by industry in a given area surrounding the city. The pollution cap could be set in consultation with public health experts and atmospheric chemists, who would help quantify the social benefits of limiting urban pollution. Once the cap is selected, polluting firms would bid for the per- mits. The market price for this new commodity would be set by the intersection of the aggregate demand curve for the right to pollute and the vertical supply curve. At this price, aggregate demand just equals aggregate supply. For example, suppose this price is $22 per ton of sulfur dioxide released. Every polluting firm that creates a ton of sulfur dioxide must buy a $22 permit to release that amount of pollution. This regulatory approach creates an incentive for firms not to pollute, and they will respond by looking closer at their production processes to economize on pollution. As shown by the United States’ 314 Sustainable and Smart Cities experience with the sulfur dioxide trading market, the net effect will be lower pollution at minimal cost, as those firms with an edge in abating pollution will be rewarded for doing so (Schmalensee et al. 1998). The pollution permit system can add millions of dollars of govern- ment revenue if it requires polluters to purchase the permits. The government’s alternative to keeping all this revenue is for it to freely allocate some of the permits to the affected industries. A skeptic can argue that if one city unilaterally starts such a market and does not freely allocate the permits, “leakage” can result as factories will be more likely to migrate to a city without regulation. In cities with a large informal industrial sector, such regulation in the formal sec- tor could encourage more firms to join the informal sector, making them less likely to be regulated under the emissions cap. The extent of this “leakage” remains an empirical question, but regulators have an incentive to anticipate this effect—and a simple solution. Local governments can freely allocate the permits to industrial firms and then give them the right to sell them to each other at the market price. If the government can keep some of the pollution permit rev- enue, its fiscal resources will increase. Environmental economists have argued that, with the revenue collected from pollution permit auctions, other distorting taxes (such as labor taxes) can be reduced (Metcalf 2007). The famous “double dividend” motto is to “tax waste, not work.” Disclosing information A second policy for reducing industrial pollution is for the state to collect and disseminate information about industrial polluter activ- ity. Information is a public good, and governments’ unique powers give them a cost advantage in requiring firms to report their emis- sions and in auditing the veracity of these reports. After the 1984 Union Carbide chemical disaster in Bhopal, India, the United States created the Toxic Release Inventory dataset, requiring manufacturing firms to publicize their emissions released to air, water, and land. Developing countries, such as Indonesia, have followed a similar path, and research suggests that this informal information regulation Matthew E. Kahn 315 has been effective (See López et al. 2004; Pargal and Wheeler 1996). Such trusted information helps create accountability among those who used to keep information about their polluting activities private. As education attainment rates rise in developing cities, local communities will be empowered to take action (Kahn 2002). Even in China, microblogs are active sources of information about envi- ronmental issues. In July 2012, The New York Times provided a case study of the power of environmental protest in China’s cities. China has long been known as a place where the world’s dirtiest mines and factories can operate with impunity. Those days may not be over, but a growing environmental movement is beginning to make the most polluting projects much harder to build and operate. Large and sometimes violent demonstrations against the planned construction of one of the largest copper smelting complexes on earth prompted local officials in southwestern China’s Sichuan Province to continue backpedaling furiously on Wednesday. The local government of Shifang, the planned site of the smelter, announced in a statement that the construction of the $1.6 billion complex had not only been suspended but also permanently canceled. (Bradsher 2012) In cities with greater demand for environmental news, the media will invest more resources to investigate. Media reports create account- ability and improve local governance (Banerjee et al. 2011; Besley and Burgess 2002). They level the playing field in the competition between industry (which seeks to avoid regulation) and the millions of people exposed to pollution but who face transaction costs in banding together to change the status quo (Olson 1965). Transportation infrastructure and the rise of car cities Cities in developing countries are making major investments in urban transportation infrastructure—investments that will determine a city’s urban form and its ability to move goods and people around the metropolitan area. This section focuses on the environmental consequences of these investments and offers some policy suggestions for minimizing the associated pollution costs. As urbanites grow richer, they tend to use public transit less and private vehicles more—because private vehicles are convenient, high 316 Sustainable and Smart Cities status, and time saving (Glaeser et al. 2008). This transport substitu- tion is relevant for urban environmental performance because public transit tends to have much lower air pollution and greenhouse gas emissions than private vehicles. Buses and subways feature econo- mies of scale, with fossil fuel consumption per mile of travel much lower than for private vehicles. Government officials will recognize that vehicle use offers private benefits to households: greater personal freedom and more possible trading partners in the city. But driving imposes social costs that self-interested households will ignore because the urban air is pub- lic property, resulting in a “tragedy of the commons.” No one who chooses between public transit and a private vehicle has an incentive to consider such environmental costs when choosing a commuting mode. The rising demand for private vehicles in developing cities is well known. Richer people tend to travel by private vehicles, which, though expensive, are faster and offer greater convenience than pub- lic transit. Transportation economists have broadly agreed that a 10 percent increase in income is associated with a 10 percent increase in per capita vehicle ownership (Ingram and Liu 1999). In 2010, Cairo had 7.4 private vehicles per 100 people (Ahram Online 2011). And with its roughly 8 million people, a 10 percent increase in per capita income would mean 59,200 more vehicles owned.2 Increased private vehicle and truck use creates an urban heat-island effect due to running cars and the construction of more paved road. Pollution costs from transportation scale up with private vehicle and freight truck mileage. The environmental impact can be mitigated by regulations that reduce emissions per mile and government policies that encourage greater fuel economy (more miles per gallon). Transportation’s environmental impact can be shown with simple multiplication. Consider a city that is home to 1 million people and in which 10 percent of the population owns vehicles—so 100,000 vehicles are running in the city. If each vehicle runs an average of 5,000 miles a year, 500 million miles are driven in the city each year. Suppose that the average vehicle creates 2 units of pollution and consumes 0.1 gallons of gasoline per mile (10 miles per gallon). The annual environmental impact would be 1 billion units of pollution and 50 million gallons of gasoline consumed. Matthew E. Kahn 317 Government policy can affect each of the four margins sketched above. In studying total transportation emissions, this section focuses on vehicle ownership, use, and emissions per mile driven. It describes the tradeoffs that government officials face in choosing a transporta- tion system. Such a system needs to allow millions of urbanites to move at fairly high speeds around the city, without creating high levels of pollution and while minimizing the fiscal costs of supplying infrastructure. Almost all economists would advocate taxing carbon emissions as a direct way to reduce vehicle pollution. Such a tax would influ- ence the likelihood that a household purchases a vehicle, the type of vehicle it purchases, and the use of this vehicle. But in 2012, Australia was one of just a few countries to introduce a carbon tax (Packham and Massola 2012). Political partisanship has precluded the United States from taking the global lead in reducing greenhouse gas emis- sions (Cragg et al. 2012). These facts make it necessary to consider second-best policies to reduce the cost of pollution. The most direct way to curb the growth of vehicle ownership is to raise its costs. Cities could follow Singapore and introduce a high vehicle-registration tax. Such a tax would be especially effective at reducing pollution if its rate could be set according to the vehicle’s model year and fuel economy. Older vehicles tend to have much higher emissions per mile than newer vehicles; many developing countries import older vehicles from richer nations (Davis and Kahn 2010). A differentiated registration tax would discourage the import of older, fuel-inefficient vehicles. A second strategy to discourage vehicle purchases is a gasoline tax, which would collect revenue for the government and discourage driving. Parry and Small (2005) examine the traffic congestion, traffic safety, and environmental consequences of driving and conclude that the optimal gasoline tax would be between the low U.S. gasoline tax and the higher Western European tax. In 2012, gasoline in Nigeria cost $2.32 a gallon, while in the Arab Republic of Egypt it cost $1.73 a gallon and in Pakistan $3.55 a gallon (Randall 2012). A higher tax in Egypt would collect new government revenue that could be used in part to provide higher quality public transit. A third strategy for discouraging city driving is to price the use of public roads and increase public parking rates. London’s city center 318 Sustainable and Smart Cities charges roughly £8 per vehicle entering during rush hour. Information technology improvements have greatly reduced the costs of such a system (Leape 2006). In a similar spirit, Shoup (2005) advocates time-of-day pricing so that parking is more expensive when demand is high. The local government would collect more revenue from this scheme, and traffic congestion and pollution would decline because fewer vehicles would be cruising at low speeds for parking spots. Urban drivers who could be induced by these public policies to drive less would be more likely to use public transit. In London, a perhaps surprising consequence of road congestion pricing is that many middle-class households that once drove are now using public transit—flexing their political clout to demand better service. If this new rider constituency can lobby government for more frequent and better service, public transit will be more competitive with private driving (Leape 2006). But in developing cities, the government is likely to face financing constraints. The World Bank, along with private international capital, is more likely to invest in projects with clear evidence of high demand. Government investment in transportation infrastructure plays a major role in determining total urban emissions. In China and the United States, the construction of highways contributes to subur- ban growth (Baum-Snow 2007; Baum-Snow et al. 2011). Simply stated, by lowering transportation costs, areas farther from the city center become more valuable because the time cost of commuting there declines. Encouraging more people to live farther from the city center offers housing benefits but has environmental consequences: increased vehicle use and larger homes that require more water and electricity. Subway investment tends to encourage city center development (Zheng and Kahn 2012). Beijing is investing in local infrastructure. Over the last 10 years, it has built new subways and Olympic Park, which played a pivotal role in the successful 2008 Summer Olympics. Four new subway lines were built over 2000–09, for a total investment of 50.3 billion yuan. Olympic Park cost 20.5 billion yuan to build over 2003–08.3 These place-based investments were concentrated in some of Beijing’s less desirable areas, triggering complementary private investment in new residential housing towers and new private restaurant chains (Zheng and Kahn 2012). Real estate prices have Matthew E. Kahn 319 since increased near the subway infrastructure and Olympic Park, highlighting that gentrification can result from public investments that improve local quality of life. Downtown Beijing is both a major employment center, as major government offices are there, and a center of culture and shopping destinations. Subways offer fast transport, but given the huge costs per mile it is likely to be cost-effective only in cities with an extremely high density. For decades, transportation economists have argued that too many cities build costly subways (Meyer et al. 1965; Pickrell 1992). They argue that subway advocates often overstate the expected ridership to obtain funding for the project and that projects rarely deliver the ridership promised. Since subways are enormous irreversible invest- ments, transportation economists advocate instead for investments in rapid buses that stop infrequently and have dedicated bus lanes. Such buses would offer the speed of a car and the environmental benefits of public transit. Bogotá did this with TransMilenio, choosing bus routes targeted to the fastest growing areas.4 Despite the investments in dedicated bus lanes, full service bus stations, and a pay-and-park system, pri- vate vehicle use has been increasing 12.3 percent a year (Suzuki et al. 2011). Governments can reduce total emissions by enacting regulations that reduce emissions per mile, and countries the world over focus their regulatory efforts on new vehicles. The United States first implemented emission control regulations in the early 1970s. Such regulations require that manufacturers produce vehicles that meet a given emissions standard and install specific equipment, such as a catalytic converter. These regulations are easy to enforce but have several consequenc- es. First, in nations with an older vehicle fleet, they might begin to reduce average emissions only years after being implemented. Suppose that a city’s vehicle stock features vehicles that range in age from 0 to 33 years. Suppose also that 3 percent of the fleet is replaced each year with new vehicles. If only new vehicles face more stringent regulation, only years after the regulation is enacted will the fleet’s average emissions decline. An unintended consequence is to encour- age households to keep their old cars running longer, delaying the effects of the regulation (Stavins 2005). 320 Sustainable and Smart Cities The good news is that trends in air pollution across India’s cities suggest that the phase-in of such emission control regulations has reduced urban air pollution. Greenstone and Hanna (2011) exploit the fact that different cities in India phased in catalytic converter regulation at different times. For example, the number of cities with such regulation increased from 4 in 1997 to 22 in 1998. Large reduc- tions in vehicle emissions start roughly five years after regulations are adopted. Stringent new regulations will not reduce the emissions from the stock of older vehicles. Based on remote-sensing data from the United States, engineer Donald Stedman has argued that a small share of the vehicle stock is the cause of most of the vehicle emission pollu- tion.5 To address this social externality, economists have advocated that police issue “pollution tickets” similar to speeding tickets. Such policing could sharply reduce used vehicle emissions. Those caught releasing high emissions would be fined a substantial sum, inducing households to invest in more vehicle maintenance. The approach could also regulate diesel trucks. An additional advantage is that it can substitute for a costly inspection and maintenance program for used vehicles. Another strategy for reducing vehicle emissions is to mandate cleaner gasoline. One major public health success has been to require unleaded gasoline, which richer nations are more likely to do (Hilton and Levinson 1998). Urban lead emissions have declined sharply in richer nations, improving public health by reducing lead’s negative impacts on child development. Until recently, leaded gasoline was the key source of widespread exposure to lead in urban Africa. With its elimination from all of Sub-Saharan Africa in 2007, ambient lead emission levels will continue to decline, offering direct health benefits for children and the exposed population (Nweke and Sanders 2009). Today, environmentalists are counting on the widespread pur- chase and use of electric and hybrid vehicles. At first glance, one would assume that these vehicles have a smaller carbon footprint and lower net environmental impact. However, the net environmental impact of these “cleaner” vehicles hinges on the source of electricity that powers them. If the electricity is generated by a coal-fired power plant, the electric vehicle can hurt the environment more than the conventional gasoline vehicle. But if it is generated using renewables Matthew E. Kahn 321 or natural gas, the rise of the electric vehicle fleet is more likely to offer urban environmental benefits. The household sector Households choose where to live in each city, with implications for urban pollution and their own pollution exposure. In any city, different income groups live in different neighborhoods and homes. In some, such as Beijing and Paris, the very rich live downtown in the high-amenity walking center. Many richer households also seek out the suburbs for cheaper, newer housing (Brueckner et al. 1999; Margo 1992; Zheng et al. 2006). The suburbanization of households offers private benefits but imposes social costs, as the spread out population drives more and uses public transit less. Suburbanites are more likely to own a vehicle and use it more than city center residents. Relative to urbanites in city centers, where the price of land is higher per square foot, subur- banites have larger homes that require more air conditioning and use more electricity and fossil fuels for heating. Poor urban households tend to locate where housing is cheapest and riskiest. The risks they face are from spikes in air and water pol- lution, natural disasters caused by flooding and landslides, exposure to infectious disease due to high population density, and unreliable electricity and access to clean water. A policy objective should be to quantify the actual environmental risk that the urban poor face. This exposure will have higher social costs if the individuals who choose to live there are misinformed or have false perceptions about the negative effects on their health. In many developing countries, the urban poor live in informal areas with no basic public services, such as sewers and drains. The lack of sanitation and waste disposal amplifies the negative impacts of small-scale hazards.6 Without access to clean water and electricity, the poor are at greater risk of disease epidemics and exposure to extreme heat. Given that exposure to air and water pollution poses morbidity and mortality risks, it also reduces worker productivity and the capacity for children to learn in school—and increases a household’s demand for costly medical treatment (Currie 2011; Zivin and Neidell 2012). 322 Sustainable and Smart Cities The urban poor also face the challenge of increased rural-to- urban migration in their cities. Farmers move to the city when their expected urban standard of living exceeds their standard of living in the countryside. As they move to cities, they increase population density in urban slums, raising rents and lowering wages for those already there. In designing “good” housing policies for protecting the environ- ment, it is important to distinguish policies to reduce the social costs of suburbanization of the middle class and wealthy from those to improve the quality of life of the urban poor by reducing their pollu- tion exposure. Public policies that relax controls on city center land use and enhance the quality of life can help reverse the suburbanization trend. Over the last 20 years, an active urban economics literature has sought to identify policies that encourage households and firms to aggregate at high density near the city center against those that— either intentionally or unintentionally—deflect activity to the fringe of the greater metropolitan area. City centers with low crime and good schools and other public services are more likely to attract resi- dents; those offering a high-amenity “consumer city” will be more successful (Glaeser et al. 2001). An ongoing housing debate focuses on the costs and benefits of limiting tall buildings in city centers (Glaeser et al. 2005). In India’s cities, limits on floor-area ratios (FARs) increased suburban growth because urban development cannot “go vertical” and is deflected to the periphery (Brueckner and Sirdhar 2012). Good urban planning would consider the benefits of allowing tall buildings near major public transit nodes. Cities could also create a market where they sell extra FAR to real estate developers, allowing taller building zones near bus rapid transit nodes (Suzuki et al. 2011). Ahmedabad, India, earned about $26 million from the sale of FAR bonuses in 2011, 4.5 percent of the city’s revenue and 5 percent of its invest- ment budget. As new housing is built to accommodate urban growth, cities are more likely to become low-carbon cities if new buildings comply with energy efficiency standards, such as the United States’ Energy Star standard.7 Where electricity prices are high and expected to rise, the operating expenditure savings from such buildings can be Matthew E. Kahn 323 large. Energy-efficient buildings demand less electricity, reducing the probability of blackouts and the need for (polluting) power plants (Davis 2011). Millions of urban poor live in low-quality informal housing—that is well known. Arnott (2008, 16) offers a sketch of the fundamental tradeoffs that the state faces in dealing with this: The limited fiscal capacity of developing country governments makes the provision of urban infrastructure, including transportation, water, electricity, solid waste disposal, sewage, fire and police protection, schools, and medical facilities, more difficult. In informal settle- ments, these problems are compounded by the government’s poor knowledge of their current state and inability to control their future development. Furthermore, even a benign government faces a policy dilemma in deciding on the quality of infrastructure to provide infor- mal settlements. On one hand, if it turns a blind eye to violation of regulations and provides the same level of services to informal as to formal settlements, it encourages the development of more informal settlements in the future. This problem is particularly acute for squat- ter settlements, since the government is naturally loath to implicitly endorse settlements that were established through the expropriation of government or private property. On the other hand, informal settlements contain the bulk of poor households, who would benefit considerably from the provision of at least basic public services. Also, not providing informal settlements with basic services encourages crime and contagion, externalities that hurt all residents, and pro- duces neighborhoods that will remain blighted for years to come. The World Bank (2011) highlighted recent trends in Dar es Salaam and São Paulo. In Dar, the population is growing roughly 6 percent a year, so its total population doubles every 12 years. Dar’s urban poor face heavy rainfall, flooding, and drought. And about 70 percent of the city’s population lives in low-quality, risky housing featuring weak infrastructure with little access to clean water and sanitation. Drainage channels are regularly blocked, flooding houses with sewage-infested wastewater and enabling water-borne diseases to come into direct human contact. Roughly 40 percent of the city is below sea level. In São Paulo, the main hazards include heavy rains, flooding, landslides, and washouts. More than 85 percent of high-risk households (890,000) are in slums. Of those households, 324 Sustainable and Smart Cities 52 percent lack access to sanitation facilities, 33 percent lack access to paved roads in their neighborhoods, and 20 percent lack proper sewage treatment. To protect the urban poor from hazardous environmental chal- lenges, cities will need a new revenue source. For instance, cities could increase their property taxes. A property tax offers a consistent revenue stream, and this stability would help government officials plan capital expenditures into the medium term (Bahl and Martinez- Vazquez 2007). If property ownership is concentrated among a few large land owners, such a tax will be progressive. It can also improve economic efficiency if the money is used for productive local public goods, such as roads and basic infrastructure. Assuming the government invests in improving public goods in slums, who will be the real beneficiaries? Will the urban poor’s qual- ity of life improve, or will the value of these improvements become capitalized into local land prices so that land owners would be the winners? If housing rents are determined in a competitive market, land owners will gain most of these benefits. But if there are barriers like rent control, those who already live in the area will benefit. Urban adaptation to climate change A third criterion for judging a city’s environmental performance is its resilience in the face of climate shocks. Residents in many develop- ing cities face significant flood risk, disrupted electricity supply, and intense heat waves. Increased migration to these cities increases the number of urbanites at risk, and climate change will only intensify the risks. For these anticipated challenges, the goal for public policy is to implement “no regrets” policies. While there are many unknowns about climate change, ongoing economic research highlights direct impacts on the urban sector and indirect impacts on agriculture. Higher temperatures have large, negative effects on economic growth, but only in poor countries, where a 1º Celsius increase in a given year reduces that year’s economic growth about 1.1 percentage points (Dell et al. 2009). In rich countries, temperature changes have no discernible effect on growth. Perhaps surprisingly, both agricul- ture and the urban sector suffer in hotter years. And poor countries Matthew E. Kahn 325 produce fewer scientific publications in hotter years, suggesting that higher temperatures impede innovation. If climate change is expected to significantly reduce farmers’ profits, and if they are unable to substitute and produce another agricultural product, they will have strong incentives to move to cities—accelerating urbanization (Wang et al. 2010). As millions of farmers urbanize, they are likely to be poor and to live in the riskiest, cheapest parts of the city. Their arrival will increase urban density, raise rental prices in slums, and reduce wages for incumbents. The net effects include fewer consumption opportunities for the incum- bent poor, more heavily taxed basic services, and greater risk of infectious disease. Such migration will also lower the incomes of the incumbent poor, leaving them with fewer resources to cope with climate shocks. Policy suggestions In nations with few cities, migration within a metropolitan area offers one strategy for protecting the population. While migrating within a city is unlikely to reduce extreme heat exposure, World Bank researchers have emphasized the importance of reducing the number of people living in areas at high risk of natural disasters. Lall and Deichman (2010) argue that zoning enforcement must attempt to prevent settlement of the most risky areas. This is not easy. Informal settlements can spring up overnight and, once established, are dif- ficult to relocate. Tools like Google Earth can be used regularly to see if informal communities are reemerging in risky areas. Government zoning can reduce the number of people living in areas whose locations and attributes put them at significant risk. Whether zoning is enforced depends on the government’s resources. If safer areas of the city can be identified, encouraging greater density in such areas would promote adaptation. If informal area residents are given formal title to the land they occupy, households will have stronger incentives to invest in their communities and their property (Fields 2005). In return for receiving formal title, such communities would become part of the city’s jurisdiction and be offered such basic services as water and electricity—but they would be expected to pay for the services, as 326 Sustainable and Smart Cities well as property taxes. Whether informal residents would consider this a good deal remains an open question. Government officials could conduct small pilot studies to see how sweet an offer must be to encourage informal communities to integrate into the city. Access to electricity is an important adaptation step, because it allows urban households to cool themselves and refrigerate perish- able goods. It also reduces mortality risks associated with heat waves (Greenstone and Hanna 2011). And it raises the poor’s quality of life (Dinkelman 2011). Flexible electricity pricing can mitigate future climate change impacts. On extremely hot days, demand for power will soar. If cities do not implement peak-time pricing, there will likely be broad blackouts. U.S. research has documented that both the residential and commercial sectors respond to announcements of higher elec- tricity prices by reducing consumption (Wolak 2010). If consumers respond to higher prices by reducing consumption, developing cities will need to build fewer power plants to cope with rising electricity demand and can instead rely on dynamic pricing. The rise of “smart meters” and real-time information about electricity consumption and pricing allows cities to be “smart” about how they encourage consumers to change their behavior. When urban households and firms know that the price of water and electricity can fluctuate, they have strong incentives to invest in durables and to economize on scarce resources. If such cities are experiencing population growth, water and electricity prices should rise to reflect the growing scarcity. By contrast, when governments protect urban households and firms by setting price ceilings for water and electricity, self-interested decision makers have little incentive to conserve. If cities can solve the political problem of allowing utility prices to fluctuate with underlying demand conditions, they will be much less likely to suffer from water and electricity shortages, especially during extreme weather shocks. Such variable pricing can inflict real costs on the poor. An increas- ing block tariff rate with a low bottom rate for households that con- sume a low level of electricity or water would allow them to afford basic necessities. Can a low-carbon city be resilient, or does increasing its adaptabil- ity to climate change always increase carbon production? The answer Matthew E. Kahn 327 hinges on how power is created. Increasing electricity consumption while reducing carbon emissions requires cities to reduce their emis- sions per unit of power generated. One way to do this is to transi- tion from coal to natural gas or to renewables. China and India have sharply increased their exports of renewable power equipment (wind turbines, solar panels) (Sawhney and Kahn 2012). If these countries reduce their cost of renewable power generation, domestic consum- ers could benefit from purchasing such products. Anticipating the rise of the fat tail Extreme weather events are increasing in frequency and intensity. Some areas are suffering from extreme rainfall, others from persis- tent drought. Relative to historical probabilities, some very unlikely events are taking place. Consider the July 2012 mass flooding in Beijing. The city had not invested in a costly drainage system to handle such heavy rain. Had the rain fallen in Dalian or Tsingdao, which have higher design standards, the  consequences would have been manageable. But because Beijing’s government and residents have little experience in handling flood conditions, the consequences were catastrophic. This heavy rain is a “fat tail” event. And as climate change unfolds, the likelihood of these low-probability but poten- tially catastrophic events increases. In poorer cities, climate events exacerbate pre-existing public health challenges. One example is Freetown, Sierra Leone, where a cholera epidemic has broken out due in part to an exceptionally rainy season that flooded shantytowns. The New York Times reports: Cholera, transmitted through contact with contaminated feces, was made worse this year by an exceptionally rainy season that flooded the sprawling shantytowns in Freetown and Conakry, the capitals of Sierra Leone and neighboring Guinea. In both countries, some two-thirds of the population lack toilets, a potentially lethal threat in the rainy season because of the contamination of the water supply … Aid workers said the number of cases of the highly contagious disease continued to increase, particularly in Freetown, where most live in slums and children swim in polluted waters. (Nossiter 2012) 328 Sustainable and Smart Cities Investments in drainage systems are a type of insurance. But it is highly unlikely that the city will need a costly drainage system. So, urban officials face a tough tradeoff in choosing how to allocate scarce public funds to invest in “climate proofing” their city. But moral hazard lurks “Climate proofing” a city will likely increase in-migration and slow out-migration. Consider New Orleans. After Hurricane Katrina, some argued that encouraging more people to leave New Orleans would be a good strategy for improving many people’s quality of life (Glaeser 2005). The U.S. government did not follow this strategy and instead made an enormous, irreversible place-based investment in rebuilding New Orleans. While New Orleans’s population has shrunk in recent years, its population would have fallen even more without such place-based investments. Government investment in sea walls and other defensive barriers is likely to attract private investment in hotels and other components of urban infrastructure that attract households and firms. While this might stimulate economic activity, it also puts more assets and people at risk from the next natural disaster. And it can lull individuals into a false sense of security as engineers climate-proof cities and reassure the general public of the soundness of these structures. But the consequences of underestimating nature can spell disaster if these government investments fail, causing even more death and destruction. Pro–economic growth City policies that encourage economic growth actually facilitate climate resilience. As individuals grow wealthier, they gain access to a broader range of private market strategies for protecting them- selves from risk. Examples include eating higher quality food, using better health care, and occupying sturdier housing. “An emerging conclusion is that the key to adaptation among the urban poor is to continue to address the basic poverty reduction and sustain- able development agenda in cities to improve the livelihoods and resilience of the poor—ensuring adequate and effective delivery of Matthew E. Kahn 329 health care, education, water, energy, public transport, and waste management; providing safety nets and increasing food security; upgrading facilities and infrastructure in slums and other informal settlements; and providing security of tenure and property rights” (Hoornweg et al. 2011, 11). *** As cities grow, the urban poor’s population density will likely increase, and they will likely concentrate in the most precarious parts of the city. The urban poor are moving to cities seeking a better life, and the sources of many jobs tend to be in polluting industries. As urbanites grow richer, they consume more electricity and are more likely to pursue private vehicles. These individually rational choices have seri- ous social consequences. Given these facts, how can “smart” sustainable cities arise? An optimist can point to the successes of New York and London, high- lighting that urban areas can make sharp environmental progress in just a few decades. Such progress requires a delicate balance of urban planning and leveraging market forces to send proper signals of resource scarcity. Improvements in information technology and advances in knowledge of how to mitigate pollution and the health benefits of such steps suggest that more cities will pursue “smart” sustainable growth. Urban officials now have real-time information about the subgroups of their constituents most at risk and the tech- nology to connect with them more efficiently. Cities that can improve their environmental performance will benefit from having a healthier, more productive populace that enjoys a better quality of life. Clean air, clean water, and low risk facilitate the development of human capital for the young and increase the likelihood that they will become productive adults. Because human capital is the engine of economic growth, urban policies that encour- age “greenness” promote the population’s health. Ensuring the popu- lation’s health is not merely an aesthetic choice—it is a cornerstone for a productive society. Notes 1. In India, for example, Ankleshwar, Gujarat, focuses on chemical production (see World Bank’s Growth Poles). The industrial plants in 330 Sustainable and Smart Cities Ankleshwar process large quantities of basic chemicals, solvents, acids, and fuels to manufacture more than 25 percent of Gujarat’s (5 percent of India’s) pharmaceuticals, chemicals, pesticides, and dyes (Kathuria and Sterner 2006). 2. This expected growth in vehicles is calculated based on (0.074) × 1.1 × 8 million–0.074 × 8 million. 3. The official exchange rate used here is 6.5 yuan per dollar. 4. For an excellent series of case studies documenting success stories, see Suzuki et al. (2011). 5. “Fuel Efficiency Automobile Test Data Center,” University of Denver, www.feat.biochem.du.edu/. 6. In Santo Domingo’s largest slum, 45 percent of houses near a river flood when it rains. Housing prices reflect this risk with the poorest living in the lowest quality housing in the areas most at risk. In Caracas and Rio de Janeiro, poor families occupy steeply sloped land prone to landslides (Lall and Deichmann 2010). 7. “ENERGY STAR for Multifamily Housing,” U.S. Environmental Protection Agency and U.S. Department of Energy, http://www. energystar.gov/index.cfm?c=multifam_housing.bus_multifam_ housing. 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While such settlements are not new in the history of rapidly growing cities, their persistence results as much from policies as from economics and demographic transition. Slums have attracted most of the atten- tion on urban housing in developing countries, and the Millennium Development Goals have given prominence to their reduction. However, urban housing issues transcend conditions in slums and are linked closely to economic activity. City economies influence housing demand, and in turn the flexibility of housing supply affects economic activity and city growth. Housing strategies to deal with rapid urban growth have varied over time and at different stages of urbanization. Renaud (2004) points to the dissimilarity of East Asian strategies at the early stages of their urbanization: underinvestment in housing in Japan and the Republic of Korea,1 large-scale public investment in Singapore and Hong Kong SAR, China, central planning in China, and a non-interventionist Sonia Hammam 337 approach in Taiwan, China. The strategies in these countries have evolved with urbanization and economic development. Starting in the early 1990s, housing policy advice was enshrined in the concept of “enabling markets to work.” A 1993 World Bank policy paper defined this concept, elaborating on the enabling approach that had been adopted in 1988 as part of the UN Global Strategy for Shelter to the Year 2000. At its most simplistic, the policy paper emphasized limiting the role of governments to a set of policy instruments and reforms that would allow housing markets to operate effectively. This was as much a reflection of the prevailing consensus on public and private sector roles as it was a reaction to the inefficiencies of public housing production in developing countries. The concept of an enabling role for government has its roots in the dominant policy advice of the 1970s, which argued against gov- ernment programs of direct housing production and slum removal. Instead, governments were urged to take on interventions to facilitate the informal process of self-help housing by reducing development standards and providing infrastructure and tenure for low-income groups. Unlike the earlier enabling approach to self-help housing, the market-oriented view framed the housing policy discussion in the context of the economic effects of good and bad housing outcomes, including for the poor. It drew attention to how policy and institu- tional arrangements affect housing outcomes by shifting the debate away from targeted low-income housing interventions and toward policy instruments that affect how housing markets function. On the demand side, it emphasized policy action in property rights, housing finance, and subsidies. On the supply side, it emphasized serviced land supply, land and housing regulations, and the organization of the sector. These areas of emphasis represent the building blocks of a housing system. By shifting the debate toward policy instruments and away from targeted intervention, the market approach implied that interven- tions were not needed beyond getting the policies right. It was also largely silent on the direct problems of housing for the lowest income groups. While the approach may appear abstract and prescriptive in its reforms and views on the role of government, its focus on market processes has highlighted the importance of understanding housing 338 Housing Matters market performance when designing reforms or specific interven- tions. The policy environment not only influences outcomes but also constrains the scaling up and sustainability of targeted interventions. The debate often appears to be over a singular focus on targeted inter- ventions, on the one hand, and policy, regulatory, and institutional reform, on the other. Yet a mix of both is required. The World Bank’s recent urban strategy suggests that the market approach was “far too sanguine” about the difficulties of creating well-functioning housing markets with private construction and financial sectors that respond to low-income housing demand. It instead argued for a more pragmatic view that includes interventions through measures such as land readjustment, a return to sites and services, upgrading, and subsidies to the poorest (World Bank 2010). There is, however, no consensus on the sequencing and content of policies and targeted interventions. One view, recently put forward by the 2009 World Development Report on economic geography, suggests that land-use regulatory reforms and targeted interventions should take place at advanced stages of urbanization (World Bank 2009). Addressing the causes and outcomes of poor housing sector performance at such a late stage is likely to be costly, given the dura- bility of housing. As Martine and McGranahan (2010) warn about Brazil’s poor performance during its urban transition, “the unwilling- ness to prepare for massive growth has not only made Brazil’s urban transition unnecessarily traumatic but also left a legacy of social and environmental problems that prevent the country from benefiting from all the inherent advantages offered by urbanization” (Martine and McGranahan 2010, 55). The housing sector’s performance continues to present chal- lenges, even in middle-income countries that are well past their urban transformation. The debate on housing market performance has been limited by inconsistent data on and definitions of slums that indicate a billion slum households. While one may argue about definitions and quantities, the existing data clearly signal that urban housing markets are under pressure—not only in the least urban- ized (but rapidly urbanizing) regions but also in the most urbanized developing country regions. This, however, does not imply that the main response should be to focus solely on “solving” the problem of Sonia Hammam 339 slums without addressing the policies that influence housing system performance and give rise to slums. This chapter provides an overview of the policy and institutional building blocks that determine housing sector performance, drawing on studies from both developed and developing countries. It focuses on property rights, including tenure choice, housing finance, and subsidies. It also reviews the factors that affect supply: the availability of serviced land, as well as land and housing regulations. While these elements have been standard tools of housing policy, they are still the subject of considerable debate over their sequencing, policy content, and priority. There has been a great deal of emphasis over the last two decades on demand-side measures to improve property rights systems, develop housing finance, and even to introduce new subsidy systems. All these developments are important, but as this chapter argues, less progress has been made in understanding and addressing the factors that constrain supply, which often thwart improvements on the demand side. Property rights Clear, enforceable, and tradable property rights, along with systems for settling disputes and determining compensation for public acqui- sition, are necessary for effective housing market performance. Secure property rights improve market efficiency by reducing transaction uncertainty and making it easier to transfer rights, thereby increasing the volume and value of real estate transactions. In addition, clear titles are as important as collateral for access to finance and the devel- opment of housing finance. In developing countries, these benefits are often compromised by a regulatory environment that reduces the value of legally owned property and its use as collateral. Moreover, even where property rights are well established, they have little value without institutional structures for enforcement and adjudication. Many cities have a continuum of tenure statuses with various bundles of rights, ranging from squatting to leasehold and freehold. Property rights systems tend to be fragmented and poorly developed, causing delays in public and private land acquisition and infrastructure provision, and inefficiencies in land and housing markets. Without 340 Housing Matters effective dispute settlement institutions, the lack of clarity in real property rights leaves land in legal limbo, distorting land prices and hindering private real estate transactions, finance, and development. The ambiguities and conflicts over property rights that are com- monly found in informal settlements, and that lead to various degrees of tenure insecurity for their residents, reflect the shortcomings and inefficiencies of the system for enforcing and adjudicating exist- ing property rights or for establishing clear rights in the first place. Registries tend to be incomplete and poorly maintained, property disputes account for large caseloads in the courts, and registration processes are often lengthy and costly. While the institutional aspects of property rights (definition, enforcement, and adjudication) are the critical elements for ensuring secure rights and reducing risks for real estate investment, most of the debate has been narrowly focused on titling and tenure security for slum dwellers. Do titles matter? De Soto (2000) framed tenure security as a matter of property rights embodied in legal title, which converts the informally held hous- ing and land assets of the poor to usable wealth. Titling essentially allows the poor to benefit from a flow of investment and credit and to become more integrated in the urban economy. The 2009 World Development Report on economic geography echoes the primacy of titling (World Bank 2009). It identifies titling as the critical first step in building fluid land markets and defers regulatory reform to later stages of urbanization. Buckley and Kalarickal (2006), on the other hand, draw attention to the role of regulatory and other con- straints in preventing the emergence of effective land and housing markets, even where titles are well established. While not denying the importance of titles, they give precedence to reforming regulatory frameworks. The differences in the two perspectives are more about appropriate sequencing, but Buckley and Kalarickal’s views imply that titles are a necessary but insufficient condition for the development of more fluid housing markets. The experience in transition countries is instructive in this respect. The massive transfer of ownership rights to sitting tenants in the 1990s was not sufficient to unlock the value of Sonia Hammam 341 housing assets. Ten years after the initial reforms, housing markets had begun to show some signs of recovery, and market transactions were growing; however, housing investment remained historically low, the stock had deteriorated, and homelessness had grown (Tsenkova and Turner 2004). The transition countries had achieved a high degree of private ownership without any of the complementary institutional structures associated with real estate markets and transactions. Regulatory factors can reduce the benefits of titles. The planning process and regulations that define what can be built, where, and to what standard mitigate property rights even in the most market- oriented housing systems. However, in developing countries where land use and building regulations are frequently thwarted, even legally acquired property might not qualify for title registration or credit. Changes in regulatory measures defining minimum lot sizes may informalize development of legally purchased property that does not meet standards, as in Brazil, where the law specifying minimal plot sizes prohibits the registration of property within non-conforming subdivisions. Property rights are compromised as a result, because title registration is the critical guarantee in most Latin American legal systems (Biderman 2008). While titling is necessary for overall housing finance develop- ment, there is little evidence that titling programs in informal areas have substantially increased access to credit for their low-income beneficiaries. Despite the implementation of a large titling program in Peru, access to credit reportedly increased 9–10 percent for house- holds with newly titled properties and tended to be limited to public banks. This underscores that collateral security through titles is a necessary but insufficient condition for accessing finance. Lower income or informally employed borrowers must also demonstrate repayment capacity. Moreover, newly titled properties might not qualify for finance where plots are below formal minimum sizes or where the construction does not comply with building standards. The debate over tenure security and title regularization programs Tenure security has long been a central tenet of upgrading pro- grams to protect slum dwellers from eviction and to encourage 342 Housing Matters greater investment. It was emphasized as a means of dealing with the non-income aspects of urban poverty and integrating informal settle- ments by improving living and housing conditions, rather than as an instrument for reducing poverty overall. The way to achieve such security has, however, been a matter of fierce debate, even before De Soto’s insistence on titles as the key instrument. Informality does not always signify insecurity. Nor does it prevent property transactions and investment. De facto tenure security is often sufficient to induce investment in housing improvements in informal settlements. As Doebele (1978) remarked, “while tenure is generally considered a legal category, it is, just as fundamentally, a matter of the state of mind of the persons concerned” (Doebele 1978, 111). Housing investment and improvements are common in consolidated settlements where the fear and practice of eviction are low, where customary rights are well established and recognized, or where services have been provided. In India, notified slums, which are slated for regularization and services, tend to have a lower pro- portion of poor-quality housing than non-notified slums. At times, even promises of non-eviction for a sufficiently long period provide enough incentive. Where there are strong traditions of customary rights, some governments have shown flexibility by recognizing these rights and transactions. At the same time, customary practices tend to evolve in an urban setting and mimic some of the processes in the formal system (Razzaz 1992). Clearly, in many instances informally acquired rights benefit indi- vidual households, allowing them to build and sell fairly easily. There is, however, some evidence that titled households are more likely to invest than non-titled households and that titled property commands a premium (Lanjouw and Levy 2004; Payne et al. 2008). Moreover, as Bertaud (1989) suggests in his study of Indonesia, informal rights generally prevent small-scale developers from acquiring and develop- ing land, thus slowing the process of secondary and tertiary infra- structure provision and the activities of small-scale developers in the housing market. On an operational level, Gulyani and Bassett (2007) suggest that what matters for tenure security is providing services, as formalization can unnecessarily delay investment. They find that “simplified” processes for providing intermediate rights tend to be as Sonia Hammam 343 time-consuming and difficult as titling. In a later review of informal settlements in Kenya, Gulyani and Talukdar (2008) are less categorical about infrastructure as the key to tenure security. They take note of slums’ heterogeneity and suggest that the choice of interventions, such as titling and infrastructure, depends on the living conditions in slums. In practice, tenure regularization and upgrading programs have often provided less than full title. These varied intermediate tenure systems provide some of the rights embodied in titles in a permanent or time-bound manner but are usually not accepted as collateral by private financial institutions. The effectiveness and impact of intermediate tenure systems on land markets have not been evaluated, and the assumption is that such measures would or could eventually lead to more formal legalized tenure.2 Critics of formalization programs point to their potential for dis- placing low-income groups as a result of the higher values associated with titled property (Payne et al. 2008). There has, however, been little empirical analysis of the distributional impacts of formalization programs. It is unclear how prevalent such displacement is or whether it is an outcome of titling or the accompanying provision of services, which also increases property values and is more likely to encourage landlords to raise rents. Razzaz and Galal (2001) suggest that the level of displacement as a result of titling may be more significant in local formalization programs. When programs are carried out on a broader scale, there is a greater incentive for landlords to consolidate and expand, ensuring a more elastic supply of rental housing. An additional concern is titling’s potential to displace poor households in high-value locations, leading some to suggest that such areas should not be formalized (Payne et al. 2008). Legalization of tenure, when limited to a few informal areas in cities where the overall quantity of titled land is at a premium, would certainly encourage raiding, indicating a need for much broader city-wide efforts. However, poor households in high-value locations are not less vulnerable to displacement by government or market raiding based on their informal tenure. The issue in these instances is not so much titling as it is the accompanying legal processes for the protection of rights and the provision of adequate compensation. To prevent displacement, some countries have enacted prohibitions on sales in newly formalized areas. However, this has just led to new forms of 344 Housing Matters informal transactions and distortions. Brazil, on the other hand, has used such planning tools as Zones of Special Social Interest, which provide for reduced zoning standards and property rights. To ensure that the benefits of formalization remain available to lower income households, sale of property within these zones requires municipal approval. The effectiveness, feasibility, and impacts of such measures have not been evaluated and are worth reviewing. A very different set of criticisms of formalization programs ques- tions their effectiveness in addressing informality. Biderman and Smolka (2011) draw attention to the fact that tenure formalization and upgrading programs can increase informal settlements in Latin America—or at least not reduce them. They argue that formaliza- tion can encourage further informal development, in anticipation of future regularization of tenure and service provision. The programs mitigate some of the difficulties confronted by existing residents of informal settlements but are largely an ineffective cure for the dual land and housing development process. This can be seen in the lack of progress in tenure security despite long-standing formalization programs in many Latin American countries. Regional data indicate that the overall level of tenure informality affected 10 percent of households in 1995 and had not declined a decade later. Even Peru, which embarked on a large titling program that provided 1.5 million titles, experienced an increase in tenure informality, from 18 percent of households in 1995 to 21 percent in 2006 (Rojas and Medellin 2011). To sum up, the concerns expressed by critics of tenure formaliza- tion programs point to the limitations of fragmented interventions in integrating informal areas—and to their potential for introducing further distortions. Durand-Lasserve and Selod’s (2007) review of formalization programs provides some insight into the critical fac- tors that determine their effectiveness. They suggest that in successful interventions, tenure is not limited to its legal aspect; it is linked with reforms in land administration, allocation of rights, and conflict resolution. These institutional aspects take time to develop but are often overlooked in titling programs. While many of De Soto’s claims about titling’s potential for reducing poverty appear exaggerated, critics’ claims of the potentially harmful social effects of formalization programs raise important Sonia Hammam 345 concerns that need to be better understood and empirically verified. Formalization is clearly not sufficient on its own, and it needs to be undertaken on a less fragmented basis within a broader context of reform of the regulatory environment for land and services. Ultimately, its success depends not on the number of titles issued but on strengthened institutions and systems for defining, enforcing, and adjudicating property rights (registry, contract enforcement, protection of rights, conflict resolution, and compensation policies). The rental market The rental market is suited to meeting housing demand particularly in rapidly growing cities and in countries undergoing substantial changes in employment structure and location. Development of the rental sector provides the following advantages: • Enhancement of labor mobility, because tenants have less transac- tion and fixed costs in moving. • An option for households that do not have the means to buy a home or do not wish to, such as young families, young adults, recent migrants, and lower income households. • A choice for asset investment and a source of complementary income. Despite the rental sector’s importance, it has received little policy attention. Instead, many countries have focused on homeownership, partly in the belief that this form of tenure is socially and politi- cally more desirable. Government policy has, therefore, often favored homeownership over rental through the tax system, access to credit, and subsidies. Most low-income programs, such as upgrading, sites and services, public housing, and subsidies, have also emphasized homeownership in developing countries. Private rental markets provide the bulk of rental housing in most developing countries. But little is known about the operations and size of this market. Part of the problem is that rental is largely informal in developing countries, without contracts in the formal or informal housing stock. While it is difficult to generalize about tenure patterns, rental housing dominates in African cities in both formal 346 Housing Matters and informal sectors. By contrast, it represents barely one-fifth the urban housing overall in Latin America. At the same time, contrary to conventional wisdom, most of Latin America’s poor people are not tenants, perhaps because informal housing “ownership” is so preva- lent. Rental is not the dominant form of tenure for lower income groups. Even in Colombia, which has a fairly large rental sector, less than half the lowest income groups are tenants (Figure 13.1). Rental housing has been neglected not only in policy discus- sion but also in recent analytical work on housing in developing countries, beyond reviews of rent-control regimes. An important exception is Gulyani and Talukdar’s (2008) study of Nairobi’s slum rental sector, which makes up 30 percent of the city’s housing. The study describes the sector as “a low quality–high price trap” for ten- ants, with absentee landlords, poor services and housing quality, little tenure security, and few incentives for either consolidation or Figure 13.1 Incidence of renters by income quintile in selected Latin American countries, 2006 Source: Rojas and Medellin 2011. Sonia Hammam 347 improvement. This may not be the norm for rental housing in infor- mal areas, but it is not unique to Nairobi.3 The results, nonetheless, highlight the importance of understanding the dynamics of this market, which challenges not only the conventional wisdom about informal housing and its inevitable progressive improvement but also the presumed distributional effects of traditional remedies, such as upgrading and tenure security. Fay’s (2004) study of urban poverty in Latin America, on the other hand, reports that absentee slumlords are no longer the norm in informal settlements. Owners tend to be individuals living in the same informal areas as their tenants, have similar or slightly higher socioeconomic status, and own few rental properties. Rental housing in 19th- and early-20th-century European, U.S., and many colonial cities was built by investors for the middle and upper classes. With the expansion of alternative investment oppor- tunities, the increased access to finance for homeownership, and the enactment of rent controls in many countries, the role of investors has declined substantially. Today, small-scale individual landlords are the main suppliers of private rental housing, even in developed countries where institutional and corporate investors are more active. They account for about two-thirds of the rental supply in the United Kingdom and more than three-quarters in France (Oxley et al. 2010). Small-scale individual landlords also appear to provide much of the formal and informal rental housing in developing countries and deserve policy attention in any effort to expand this market. Rental sector reform tends to focus on direct public interventions, such as rent and eviction controls. As important as these may be, they are not always the only binding constraints. In the United States, for example, studies have shown that restrictive zoning regulations favoring single-family housing have had a greater influence on the supply of low- and middle-income rental housing than have rent controls (Schuetz 2007). Among other factors that influence the supply of rental housing are differential tax and subsidy policies. In Morocco, for example, removal of rent control is unlikely to lead to a large expansion of the rental stock given prevailing fiscal policies and incentives. Not only are there tax exemptions on mortgage inter- est, but owner-occupied units benefit from preferential treatment on capital gains and property taxes. The fiscal exemptions afforded to 348 Housing Matters homeowners represent the largest subsidies in the housing sector and discourage investment in rental housing, which is essentially taxed at a rate four times that of owner-occupied housing. Rent control Rent control has been widely practiced in both developed and devel- oping countries. It has also been widely decried for the distortions it introduces in the overall housing market and for its inefficiency as a redistributive mechanism. In cities with rigid and extensive rent- control regimes, residential mobility is constrained, a large propor- tion of the stock is essentially frozen out of the market, and the quality of the stock is reduced through lack of maintenance. The benefits of rent control accrue to sitting tenants when con- trols are introduced and tend to be regressive. In the Arab Republic of Egypt, for example, a recent survey suggests that upper income groups tend to benefit disproportionately (Technical Assistance for Policy Reform II) (USAID 2008). However, even tenants of rent- controlled units generally experience a reduction in benefits through greater responsibility for various side payments and key money. A study by Mayo et al. (1995) found that key money in Cairo was roughly equivalent to the net present value of the difference between market rent and the frozen rent level over the duration of a long-term tenancy contract. Once additional payments were factored in, total housing costs for tenants were about twice the nominal controlled rents, though still below market rates. Benefits are also reduced by the decline in the quality of rent-controlled units. A striking example is the rent-controlled stock in Mumbai, which has yielded very low rents for such a long time that almost half the units are either con- demned or beyond repair due to lack of maintenance. Rent control can shift supply to the owner-occupied sector. The shift is often also from the formal into the informal rental sector in the form of a secondary market in controlled units, which can be found in cities from New York to Cairo. In Cairo, successive restric- tive regulations contributed to the development of an active second- ary market and a parallel informal rental market. More important, the combination of low rents and strong eviction controls, which give tenants quasi-ownership rights, have contributed to a high Sonia Hammam 349 vacancy rate. Reforms introduced in 1996 decontrolled vacant and newly constructed units and increased the availability of rental units. However, almost 40 percent of the housing stock in Greater Cairo is estimated to still be subject to controls. Rent-control regimes vary in whether they set rent levels, rent increases, or both; allow rents to be freely negotiated for new ten- ants; and permit changes to reflect costs or adjust for inflation. They also vary in breadth of coverage, strength of tenants’ rights, and effectiveness of enforcement. Their impacts, therefore, vary by these features and market conditions. In recognition of the evolu- tion and differences in rent-control regimes, Richard Arnott has put forward a more nuanced view on their effects, though it is hardly a consensus. Arnott (1995) distinguishes controls that freeze rents and provide strong tenant security from those that simply regulate increases in rent levels and contract terms while not controlling rents between tenancies. Some form of the second type of tenancy controls is common in Western Europe. While the first-generation restrictive controls are roundly criticized, Arnott suggests that the impacts of the second generation controls need to be empirically verified and evaluated case by case, given the variations in rent-control regimes. In a later paper on the Swedish rental market, Arnott (2003) suggests that the newer types of controls provide a basic level of tenure secu- rity and do not necessarily restrict supply. Malpezzi and Ball’s (1991) review of rent control in developing countries also recognizes the variations in rent-control regimes and their impacts. The authors also emphasize the need for policy makers to carefully study the nature of rent-control regimes and evaluate their impacts before undertaking reforms. The relationship between rental regimes and market size is not always straightforward. Analysis of rental markets by Oxley et al. (2010) indicates that a range of contrasting regulatory environ- ments can be compatible with a large private rental sector. Germany and Switzerland have some controls on rental increases and strong tenure security for their tenants, but they have large private rental sectors, which account for 45 percent (Germany) and 67 percent (Switzerland) of the stock. Conversely, the United Kingdom and Spain, after decades of stringent controls that discouraged investment, have liberalized their rental regimes, but they now have fairly small 350 Housing Matters private rental sectors, representing 13 percent (the United Kingdom) and 15 percent (Spain) of housing. Discrepancies between rental regimes and rental rates also exist in developing countries, indicating that rent control is not the only vari- able in determining rental housing supply. Morocco, which has only recently introduced reforms to its rent control laws, has a rental rate of 28 percent, compared with 16 percent in Tunisia, which removed controls in the 1970s. The lower rate in Tunisia could reflect the easier access to land and finance for homeownership and the persistence of strong tenancy rights, which make eviction difficult and lengthy even in cases of non-payment. Similarly, Colombia has maintained the highest rental rates in Latin America, at 32 percent, comparable to the United States. Gilbert (2003) attributes Colombia’s high rental rates to more stringent land controls that limited opportunities for invasion. The decontrol process Reform of housing systems affected by rent control requires analyz- ing its impacts and the underlying market distortions from taxes, subsidies, and regulatory policies. The positive influence of decontrol in stimulating rental markets is not always immediate or inevitable. Decontrol in a supply-constrained market (as a result of other distor- tions) is likely to raise rents without a significant increase in rental supply. Where the process involves protracted revisions and changes, the uncertainty about the permanence and nature of changes dis- courages investment. Successive decontrol measures in Spain and some Canadian provinces failed to significantly increase the rental stock. In the United Kingdom, the initial decontrol measures in the 1960s led to a surge in the ownership market, as landlords preferred to sell their units rather than continue to rent them. Similarly, despite the subsequent full liberalization of rental housing, the reduction in social housing production, and the privatization of a large portion of public housing, the United Kingdom private rental market has seen some increase but has become a marginal niche market with short-term leases. Decontrol measures provide a number of benefits by removing distortions and inequities in housing markets. They offer opportunities Sonia Hammam 351 to better maintain, use, and redevelop the existing private rental stock, which is often on valuable, centrally located land. As complex as the effects of rent control are, the decontrol of rental markets is a challenging undertaking. Decontrol raises strong political economy concerns and is administratively complex. It involves striking a balance between landlord and tenant interests in lease termination and rent-setting rules and defining minimum default contract terms. Just as important, decontrol requires adjustments in tenants’ rights, with clear rules for contract termination and remedies for contract violation. Adjustments need to be introduced gradually to ultimately converge toward market rents. While the gradual adjustments imply an often lengthy process, a blanket decontrol of rents is often both politically difficult and too much of a financial hardship for the lowest income groups, resulting in pressures to reverse the process. Decontrol is often followed by an overshooting of rent levels, which should eventually stabilize provided more units come on the market. Providing allowances to ease the rental burden on the poor is often necessary, but it might not be fiscally feasible in countries with large controlled sectors where rents have fallen far below market levels. In Spain, for example, administrative delays in designing allowances led to the maintenance of control for low-income tenants, with tax support to compensate landlords. Finally, decontrol is unlikely to influence rental in informal settle- ments, where most low-income rental occurs. Upgrading services and tenure security for the subsistence landlord will more effectively encourage a greater supply of rental housing in this sector. But decon- trol, along with appropriate tenure-neutral regulation and taxation, is needed to stimulate supply in the formal private rental sector, especially by small-scale individual investors. The extent to which more organized formal investors might enter this sector depends on a number of factors, including tax policies and the availability of financing. Subsidies The chief rationales for government intervention through subsidies include negative externalities affecting public safety and social 352 Housing Matters stability; equity concerns, whereby low-income groups are deemed to need housing assistance; and market failures. In practice, the three rationales are not always mutually exclusive or explicitly stated. In fact, Hong Kong SAR, China’s, massive public housing programs grew initially out of concerns for public safety and the needs of low- income groups after a disastrous fire in a large squatter settlement. The initial programs aimed to resettle slum dwellers, but out of a desire to maintain social stability by improving housing conditions, they grew to cover a much broader segment of the population (Renaud 2004). Similarly, Chile’s housing reforms and policies intended to correct perceived market failures were also motivated by a desire to improve social stability. However, rather than rely on public production, Chile chose to address both these concerns through a combination of regulatory reform and demand-side subsidies to stimulate private sector production and finance. Subsidies, regulations, and taxation are among the most impor- tant interventions by which governments influence housing market outcomes. In principle, the three forms of intervention can be seen as substitutes, but the relative efficacy of the measures depends on their interactions with one another and on specific market condi- tions. Of the three forms of intervention, subsidies have caused the most intense debate and controversy, reflecting the difficulties and inefficiencies in their design and implementation. The early housing literature on developing countries generally critiqued existing sub- sidy programs, emphasizing the need to reduce most of them. With growing interest in affordability and social housing policy in middle- income countries, there has been a broader discussion of subsidies’ role in housing policy in developing countries and a greater focus on policies to improve their efficiency, transparency, and targeting (Buckley and Mathema 2007). The case for demand-side subsidies Most of the economic literature on housing subsidies favors market-friendly, demand-side subsidies. These are considered more cost-effective and equitable than project-based, supply-side subsidies. They enable low-income beneficiaries to rely on competitive markets to access a range of affordable choices. Unlike public housing Sonia Hammam 353 programs, they generate fewer distortions and are simpler to phase out when beneficiary incomes rise. The empirical case for the superiority of demand-side subsidies in cost-effectiveness and equity has relied primarily on extensive studies comparing public housing production programs with rental allowance programs in the United States. These studies found substantial differences between the costs of public housing rental programs and direct subsidies to households through rental allowances. They also indicated that the direct subsidies were better at targeting low-income households. The shift to demand-side subsidies has usually occurred in coun- tries well into or past their urban transition, where the housing problem concerns affordability rather than overall supply shortages due to market or regulatory constraints. Therefore, it is not surpris- ing to find an increased use of demand-side subsidies through rental allowances in the United States and many European countries. In the United Kingdom, for example, more than 80 percent of housing subsidies in 1975 supported the direct production of social rental housing. By 2004, 67 percent of subsidies were on the demand side, with housing allowances as the main subsidy instrument (Whitehead et  al. 2005). Supply-side subsidies have been reduced but not eliminated as a means of supporting affordable housing in developed countries—even in the United States, where the Low-Income Housing Tax Credit supports developers producing low-income housing. The debate on whether supply- or demand-side housing subsidy programs represent better policy is not fully settled in Europe, despite a marked shift away from public production. Public assistance depends increas- ingly on a combination of rental allowances to households and direct fiscal and financial support to the municipal or non-profit sector to provide, manage, and maintain the stock of social housing. In principle, demand-side subsidies through allowances or upfront capital grants allow greater consumer choice at the lowest cost to government. But in practice, they perform best in markets where they can trigger a supply response. If markets are tight, as they often are in developing countries, demand-side subsidies might, in fact, exacerbate the affordability problem for non-subsidized low-income households as rents or prices increase. Their benefits will then accrue to landlords or developers, with little impact on the overall housing supply. 354 Housing Matters Demand-side subsidies through capital grants have been intro- duced in a number of Latin American countries and in South Africa, based on a model pioneered in Chile. The Chilean experience illustrates the challenges of shifting to a market-friendly housing assistance system. The transition was not a simple textbook process of relaxing supply and demand constraints. Starting in 1977, Chile undertook a comprehensive reform of the sector to promote private sector production and financing of housing—with the government as enabler. The market’s failure to serve the needs of lower income groups was attributed to weak demand. To address this constraint, the government provided demand-side subsidies through vouchers to enhance access to private bank financing. In addition, traditional supply constraints were reduced through changes in the regulatory framework governing urban land use and conversion. These broad, sweeping reforms did not elicit the anticipated response from either private developers or banks. Both failed to show any interest in moving down-market, confining their activities to the middle-income beneficiaries of the capital grants and mortgage programs. As a result, the government had to become more active in contracting with private developers for building low-income housing and allocating units to beneficiaries, effectively adopting a supply- driven approach in the programs targeted to the lowest income households. Moreover, the government had to assume the role of lender, incurring large arrears in the process. The overall program stimulated both private supply and financ- ing for middle-income beneficiaries. However, it failed to do so for beneficiaries in the bottom two income quintiles. Chile continued to refine the programs over several decades, expanding their size and purpose to include the purchase or renovation of existing units. It wound down the supply-driven program for the lowest income groups in 2002, replacing it with a program that eliminated the loan component and instead provided a capital grant for the purchase of new or existing units, to which beneficiaries were required to con- tribute a small amount of savings. It also substantially reduced public loans and assistance to middle-income groups. While the Chilean model is often considered a successful market- based model, it has been marked by heavy public sector interven- tion. The mix of programs resulted in a massive surge in housing Sonia Hammam 355 production, significantly reducing housing shortages. While certain aspects of the Chilean program are debatable, its main lessons are that one size does not fit all and that there are no quick fixes. The program owes its success to its flexibility, offering a range of options for various segments of the population rather than focusing exclusively on the lowest income groups. The deeply subsidized programs were accom- panied by a host of regulatory land-use reforms to ensure a more flexible market response and to reduce and improve the targeting of subsidies over time. Instead of being a one-off approach, the program was allowed to evolve and adjust. It benefited from this continual process of review and adjustments over several decades, phasing in different approaches, such as coverage of existing units, and phasing out programs that did not work or were no longer needed. Targeting efficiency of demand-side subsidies The rationale for demand-side subsidies is based partially on the idea that they are easier to target to the poor and are therefore more equitable. The evidence from programs modeled after the Chilean system is, however, not compelling on that score. The results of a comprehensive evaluation by the Inter-American Development Bank of nine Latin American programs that provide upfront capital grants linked to mortgages indicate that they violate both horizontal and vertical equity. The evaluation found both high leakage and low coverage rates of the target populations (both poor and non-poor) (Ruprah 2010). On average, only 2 percent of eligible households actually ben- efited from these programs, partly because the target groups covered a broad segment of the population. In Chile, for example, the target group extended to households in the 60th percentile of the income distribution, so it is not surprising that coverage was limited. The lowest quintile initially received about 25 percent of the subsidies; however, with the program’s recent evolution, there was a shift to substantially increase their share of resources and improve their hous- ing conditions. The high rate of leakage, averaging about 44 percent for all nine programs, highlights the challenges of enforcing strict eligibility criteria, even in countries with fairly sophisticated means of testing for income. 356 Housing Matters The targeting challenge in these programs lies in balancing cover- age of the poor through subsidies with the risk of default on the complementary mortgage loans. Full coverage of the poor would require generous capital grants to mitigate the risks of mortgage delinquency. The evaluation estimates that the programs would have had to triple in size to fully cover the poor.4 Supply-side subsidies The choice of subsidy instrument depends largely on the perception of the housing problem, the policy goals, and the market and institu- tional context. Apgar (1990) cautioned against the consensus among housing economists on the superiority of demand-side subsidies and argued for flexibility in the choice of instruments, taking into account specific market conditions and the potential adverse effects of subsidy choices on non-subsidized low-income households. He suggested that in markets where supply is inelastic, demand-side subsidies are likely to increase rents for non-recipient low-income households. In these markets, supply-side programs are more likely to result in a net addition to the stock and a price decrease in response to demand. Apgar’s views underscore that there is no best policy in what are often second-best situations. Glaeser and Gyourko (2008) refine Apgar’s conclusions about the appropriate use of supply-side subsidies in their discussion of federal housing policy reform in the United States. They criticize such sup- ply programs as the Low-Income Housing Tax Credit, noting that a large part of the benefits is absorbed by developers. For Glaeser and Gyourko, demand-side subsidies have performed better, but they take into account concerns about the impact on non-subsidized households in supply-restricted markets. In this context, they sug- gest that “the best case for subsidizing new construction occurs in constrained markets where demand is high and local economies are strong” (Glaeser and Gyourko 2008, 126). This may describe the situation in many developing country cities experiencing rapid growth; however, the scale of housing requirements for low-income groups and the scarcity of resources have usually resulted in limited, costly, poorly targeted programs operating on a national scale across different market conditions. Even where supply-side subsidies for Sonia Hammam 357 new construction may be justified, improvements in housing sector performance still require the more difficult task of addressing supply constraints. Public construction of rental housing in developing countries has not been extensive, with a few notable exceptions (for example, China, Singapore, and Hong Kong SAR, China). Even less com- mon is the provision of rental allowances, which are administratively more complex and require a supply-responsive private rental system.5 Instead, assistance has tended to be supply-driven, with a focus on new construction and financing of units for sale at discounted prices and with subsidized financing. Public housing models have generally been limited in scale in most countries due to resource constraints. While smaller in scale, they have generally suffered from being costly, inappropriately located, and poorly targeted. Singapore’s and Hong Kong SAR, China’s, experiences eliminat- ing slums through massive public housing interventions are not easy to replicate in developing countries. These programs benefited from a robust financing system, total control of land supply, and healthy growth of their economies and incomes. However, no country has resolved the slum issue without some form of public intervention on the supply side. While upgrading is generally accepted as an appro- priate and less costly supply-side intervention than direct provision of housing, it remains a largely remedial solution to the immediate problems confronting informal development. For this reason, policy makers often see upgrading as an endless process of catching up with informal housing development. It is more costly than servicing land prior to development and an insufficient response on its own. Interventions need to be upgraded within the context of an overall effort to address property rights, land regulation, and infrastructure deficiencies. With growing emphasis on privatization and deregulation, there has been a general reduction in the scope and funding of public hous- ing programs. At the same time, fiscal constraints have encouraged both developed and developing countries to use the planning process to require that private developers incorporate affordable housing under certain conditions. In Europe, these requirements are justified as a means of recapturing the increment in land value created by the planning approval process. The programs are often complemented by 358 Housing Matters a number of incentives, such as density bonuses and faster approval processes, or they can allow buyouts in cash or in kind to be used for low-income housing. Variants of such programs include “inclusion- ary zoning” in the United States, Section 106 housing in the United Kingdom, and the imposition of quotas for low-income housing in privately developed sites in China and India. The programs are attractive to policy makers as a means of providing housing with minimal public investment. An additional advantage is that, unlike traditional public housing programs, they allow a greater mix of incomes in different neighborhoods. They are seen as an alternative model to traditional public housing, which generally traps the poor in their own neighborhoods. Evidence of the success of these programs in meeting afford- able housing demand is limited. Even though inclusionary zoning programs have operated in the United States since the 1970s, their performance is difficult to evaluate given their variability across juris- dictions. A study by Schuetz et al. (2007) indicates that affordable housing through inclusionary zoning accounted for about 2.3 per- cent of total production in the San Francisco Bay Area over a 28-year period. It represented a small fraction of total housing produced by other supply-driven programs, such as the Low-Income Housing Tax Credit. In short, it is not, nor does it intend to be, a substitute for other public subsidies to achieve affordable housing objectives. In the United Kingdom, Section 106 of the Town and Planning Act of 1990 allows localities to negotiate the incorporation of afford- able housing as a condition of the planning approval process. These are site-by-site agreements based on general guidelines, not blanket requirements across all private residential development projects. The planning obligations under Section 106 have produced less than half of annual affordable housing requirements (Whitehead 2011). However, a government report indicates that the vast majority of Section 106 housing entails additional subsidies and has not resolved the shortfall in public resources (Whitehead et al. 2005). Moreover, some analysts have suggested that the protracted negotiations and requirements of planning obligations might have contributed to the slowdown in overall housing supply (ODPM 2005). In India, mandatory requirements to set aside 25 percent of all new development projects for affordable housing production are Sonia Hammam 359 considered not only a less costly alternative to direct public provi- sion but also a means of accommodating existing slum dwellers and stemming the flow of informal housing. The incentives to developers include access to land and greater density allowances. However, their potential to alleviate or prevent slum conditions is hampered by lim- ited formal production and the inherent weaknesses of mandatory cross-subsidy schemes that tax higher income housing or landowners in already restricted markets. These public-private arrangements are not a panacea and are less effective when market conditions are poor. They present oppor- tunities to capture surpluses that arise from government action in planning for the benefit of the community, but their potential for delivering affordable housing should not be overstated. Housing finance With financial liberalization, the availability of mortgage finance has grown in developing countries. China and India have seen their housing finance systems expand at impressive rates, starting from a low base. A few middle-income countries have seen mortgage debt rise to 20–35 percent of gross domestic product (GDP). As notable as the growth has been in a few countries, housing finance is still limited in size and reach, accounting for barely 10 percent of GDP on average. In most developing countries, a significant majority of households still do not qualify for market rate mortgages to purchase formal sector housing. Expansion of finance has improved housing affordability in a num- ber of countries, particularly for middle-income groups. The Chilean case and similar programs in Costa Rica highlight the importance of finance in stimulating private housing supply for middle- and lower middle-income groups. Bertaud (2010) credits Thailand’s housing finance system with facilitating a rapid increase in affordable housing production by the private sector in the 1980s. He emphasizes that Bangkok’s more flexible land and housing development standards would not have been sufficient to increase the supply of affordable housing without the availability of finance through the National Housing Bank. 360 Housing Matters Governments have attempted to make housing loans more affordable through a variety of on- and off-budget instruments, such as subsidized loans; lump-sum grants to buy down the inter- est rate or toward down payments on the price of the house; and preferential tax treatment for mortgages.6 Governments also tend to focus their support to mortgage lending for new housing, ignor- ing the existing stock, which normally accounts for the majority of transactions. Despite many of the government measures to expand access to finance, the informality of housing and employment in many developing countries necessarily limits the reach of mortgage finance systems. Guarantee programs to encourage banks to lend to low-income groups have been introduced in some countries and are being considered in India. Morocco has established such a program, FOGARIM, as part of its sector reform to encourage access to market finance for lower income households, including beneficiaries of its national slum-upgrading program. FOGARIM awarded guaran- tees for 34,600 market rate mortgages over 2003–08. However, by 2010 participating banks began to reduce their lending as arrears were mounting, reaching 27 percent in some of the country’s poorer regions. While the arrears may be attributed to lax underwriting practices, the significant 50 percent increase in the prices of eligible units due to real sector constraints also contributed to the decline in lending. While reforms to expand housing finance are critical as urbaniza- tion progresses, they must be placed in the appropriate sequence and housing market context. In the absence of measures to address the real sector issues that shape the responsiveness of the housing sup- ply system, the expansion of finance and subsidies may exacerbate existing imbalances. As Buckley and Mathema note in their study of Accra’s highly distorted housing market, “just improving access to formal housing finance without making housing supply more elastic will fuel further price increases in the already expensive and inelastic housing market” (Buckley and Mathema 2007, ii). Moreover, reforms to expand access are usually not sufficient for the mortgage market to function at scale, simply because real sector supply-side con- straints result in fewer eligible houses to finance. Thus, despite East Asia’s more developed housing finance systems and favorable credit conditions, the expansion of finance is constrained by land supply Sonia Hammam 361 rigidities and urban development regulations, which cause housing prices to rise faster than household incomes (Chiquier 2006). As mortgage finance systems in most developing countries still fund a small share of overall housing transactions and have limited coverage of middle-income groups, it is unrealistic and unwise to expect them to begin lending on a broad scale to the lowest income groups. The more critical priorities in this context are to address the land and infrastructure issues that limit housing supply while ensuring that private resources can be leveraged to expand access to mortgage finance for middle-income groups. Factors affecting supply Ensuring adequate supply is the main housing challenge in devel- oping countries undergoing rapid urbanization. At the same time, most distortions in the housing systems of developing countries are found on the supply side. Even where there are few market distor- tions, housing supply is not like the production of cars or washing machines. At a minimum, it requires a longer lead time and tends to respond more slowly to increased demand in the short term. It also depends on the availability of serviced land, which in itself is not elastically supplied, and requires planning, organization, and funding. Land market distortions, inappropriate standards, a lack of infrastructure, and cumbersome and costly permitting processes can further slow the availability of developable land and the pace of hous- ing construction. Filtering the existing stock of units from higher to lower income households is a long-term process that cannot be counted on to provide an adequate supply during periods of high demand and increased prices.7 At the same time, the filtering process in the existing stock is often slowed by such regulations as rent and eviction control, which limit the mobility of households. Many countries have focused their support for improving housing affordability through demand-side policy interventions in the form of improvements in property rights, direct subsidies, tax exemptions, and support to increase housing finance affordability. There has been less emphasis on supply-side processes to encourage a more flex- ible response that adjusts to changing economic demands in cities. Interestingly, the UK Treasury commissioned a study to explore the 362 Housing Matters causes of sluggish housing supply, which had fallen below the rate of new household formation in the 1990s. The report identified the need for better informed and more flexible land-use planning and regulations to ensure a more responsive supply system. It also high- lighted how the lack or inadequacy of infrastructure was preventing or delaying construction even in the country’s most affluent regions, adding to the affordability and supply problem (Barker 2004). While the context and policy environment are different, the supply con- straints are very similar to those faced by rapidly growing cities in developing countries. The supply of serviced developable land The shortage of serviced developable land is perhaps the most impor- tant obstacle to increased formal housing supply. The limited supply of serviced land tends to drive up urban land prices and encour- age developers to serve the high-end market, where profits can be maximized. At the same time, remedial action to deliver services to informally built-up areas is estimated to be three to seven times more costly than providing infrastructure for new development, drain- ing public resources that could otherwise be spent more efficiently on increasing the overall supply of services (Biderman and Smolka 2011). Many cities, when confronted with the costs or pressures of additional development, have imposed restrictions. Faced with inadequate infrastructure, Indian cities have maintained uniformly low floor-area ratios (FARs) to limit building heights in central locations—rather than increase investment in services—and to mobilize resources either through property taxes or impact fees to pay for them. Bertaud and Brueckner’s (2003) study of the impact of uniform FARs in central Bangalore indicates that the city is about 32 square kilometers larger in area because of the FAR restriction, an amount equal to 17 percent of the built-up areas. So it is not clear how much real savings in infrastructure investment this policy has achieved. As they emphasize, “in major Indian cities like Mumbai, Delhi, or Bangalore, consuming more land to save on infrastructure investment is a bad bargain” (Bertaud and Brueckner 2003, 3). Sonia Hammam 363 Infrastructure shortcomings translate into higher rates of infor- mal housing in developing countries. Few cities take on the task of preparing for growth by securing public rights of way and making the necessary infrastructure investments. This can be seen not only in the rapidly growing cities of Africa and South Asia but also in middle-income, highly urbanized countries with growing economies, like Brazil, where housing production has continued to outpace the infrastructure supply. Dowall (2006) suggests that Brazil’s infor- mal housing (defined as housing lacking in infrastructure) can be expected to rise from 23 percent in 2000 to 35 percent by 2030, if infrastructure and housing production trends continue. International experience indicates that cities’ productivity and livability is enhanced by infrastructure investments that can accom- modate population growth. Bertaud’s (2010) review of Korean urban development policy describes the massive government investment in infrastructure and intervention in urban land development. The initial objective was to ensure an adequate supply of serviced land to support industrial productivity, not to deal with the shantytowns that made up more than a third of Seoul’s housing stock in the 1960s. Korea’s interventions to provide high-quality servicing of large quantities of land early in its urban transition allowed it to rapidly absorb a large influx of households with increasingly better living conditions. In their study of Indian housing markets, Annez et al. (2010) point to the experiences of Bangkok, Seoul, and Hong Kong SAR, China, noting that they significantly improved housing conditions and reduced the percentage of slum households by focusing on devel- oping infrastructure to increase effective land supply and allow more intensive use of urban land. Tunisia is another interesting example in this regard. Its national upgrading program has been justifiably praised for its contribution to the dramatic decline in slum hous- ing from 23 percent in 1975 to 2 percent in 1995. The program’s success, however, would not have been possible without the simul- taneous massive investment in water and sewer trunk infrastructure by the national utilities. As a result, coverage of existing informal settlements through upgrading was made possible, and additional land was opened up for further development. This contrasts with 364 Housing Matters the situation in most Indian cities, where the inadequacy of exist- ing infrastructure systems limits reform of land-use regulations to allow more appropriate and less costly development and reduces their capacity to scale up service delivery in slum areas. Government intervention to increase the supply of serviced land has varied, and there does not appear to be a single model for suc- cess. Bertaud’s (2010) case studies of Asian cities provide examples of contrasting strategies, none of which is perfect but all of which contributed to ensuring an adequate supply of serviced land for hous- ing development for a range of income groups. Korea exemplifies strong state intervention, carrying out land readjustment schemes that initially allowed it to service land on a self-financing basis and that affected about 35 percent of the land in Seoul. Bangkok’s more laissez-faire approach of extremely flexible development stan- dards attracted private investment in affordable housing in centrally located areas. Among the many reasons for the inadequacy of serviced land supply are weak fiscal and financial performance, inappropriate regu- latory norms, and poor planning practices that distort requirements for the planning and provision of infrastructure. Compounding the problem are the weak incentives and diffuse accountabilities for ser- vice provision and financing across levels of government, land, and infrastructure institutions. In many instances, city governments bear the costs of development without the capacity to capture the benefits or much authority to guide development or service provision. While these constraints require longer term institutional changes, there is a renewed interest in tapping various land-based instruments to finance infrastructure. Infrastructure provision significantly influences land values, indicating that cities could capitalize on the increased value through effective property taxation, development impact charges, develop- ment exactions, and other land-based instruments to finance service delivery. If, in the past, responsibility for infrastructure provision by developers was limited to on-site services, fiscal pressures have encouraged cities in the United States and Europe to look for ways to require developers to pay for all or part of the costs of infrastructure for new development through impact fees. A number of countries have successfully used variants of land-based financing instruments Sonia Hammam 365 to expand service delivery: land readjustment in Korea, valorization charges in Colombia, land leasing in Hong Kong SAR, China, and tradable development rights in São Paulo. With the exception of property taxes, these instruments do not provide a steady stream of income, but they nonetheless have allowed many cities to fund large investments in infrastructure in the absence of other sources of finance. Land and housing regulations Regulations, in principle, deal with externalities and correct for market failures. Henderson (2007) provides a useful description of the types and purposes of regulations, which can be summarized as follows: • Land-use planning, which segments land uses to ensure that incompatible activities are kept separate. • Density and open-space regulations, (including minimum lot size, set-back and frontage standards, height restrictions, and land set-aside standards), which deal with neighborhood crowding or congestion, ensure sufficient open space, and regulate how build- ings impede each other’s view and access to sunlight. • Developer requirements to ensure adequate services so developers do not “free-ride” off public services, such as in strip development. • Construction regulations to set minimum quality and safety stan- dards to help with asymmetric information problems. • Environmental and health standards. Given these broad objectives and powers of enforcement, government interventions through the regulatory process exert a significant influ- ence on housing costs and housing market performance. Regulations tend to be easier to impose, without much attention paid to their consequences, and difficult to reverse. In most developing countries, these interventions are likely to have a greater impact on housing out- comes for a significantly larger share of the population than is direct public investment in housing or upgrading of slums. Also, almost any system of land-use planning is likely to restrict supply and affect low-income groups more than other segments of the population. By 366 Housing Matters the same token, a totally unregulated system also disadvantages lower income groups, as they have to compete for land in the same loca- tions as more affluent groups. The issue in practice is not to do away with regulation and planning, as unplanned development implies large costs borne by both the city and its inhabitants. Instead, there is a need to review the extent to which supply is restricted and whether these restrictions cause significant price distortions or welfare effects. The overall net welfare effects of regulations can be either positive or negative. Angel’s (2011) study of urban expansion emphasizes the cost of minimal regulation and not planning for growth in develop- ing country cities. He describes how Bangkok was once considered a model of efficient land and housing markets, with its flexible and minimal regulations that allowed the private sector to build afford- able housing for a large segment of the low-income population. The city’s failure to keep up with private building activity by ensuring space for an adequate system of secondary roads and securing public rights of way resulted in high welfare costs from severe congestion and pollution. Most studies of regulations have focused on their negative impacts. Cheshire and Sheppard’s (2002) study of the welfare impacts of plan- ning regulations indicates that the supply restrictions imposed by both the greenbelt boundary and the amount of land zoned for residential development in Reading, UK, are equivalent to a 4 percent income tax. While they do not argue for a removal of regulations, they suggest that relaxing the restrictions, particularly pushing out the greenbelt boundary, would have a positive welfare effect. Similarly, analysis by Bertaud and Brueckner (2003) indicates that restrictions imposed by a low uniform Federal Acquisition Regulation (FAR) in central areas of Bangalore result in a welfare loss of 3–6 percent of income in additional commuting costs from suburban areas. At the same time, the draconian FAR limit the financial viability of redeveloping acces- sible central city locations where older structures were built to much higher FAR values. FAR limits, while not inherently problematic, should fit the market context and the locations where they are applied and serve as a guide rather than as a binding constraint. Moreover, once values are set, they must be periodically reviewed and adjusted to reflect changing demand in different locations, and infrastructure adjustments can then be made accordingly. Sonia Hammam 367 Regulations can affect the pace and affordability of housing supply through a variety of means. They can exclude low-income groups if consumption standards (minimum lot sizes, height restrictions, and so on) are set at levels significantly beyond what this population can afford. Often not recognized in setting minimum standards at such levels is that, in the absence of subsidies, low-income groups will be forced to double up or find informal housing. At the same time, restrictive standards that limit supply and increase prices drive up the number and size of households requiring subsidies, which makes it difficult for governments to develop sustainable or equitable subsidy policies. Regulations also affect construction costs by creating lengthy approval processes, driving formal developers to focus on the high- end market, where profits are more certain, or to the informal sector, where approvals and authorizations are ignored. The time required to obtain permits and the associated uncertainty of the process result in higher transaction costs and fewer transactions. Mayer and Somerville’s (2000) study of U.S. regulations estimates that a met- ropolitan area with a 4.5-month delay in approval and two different types of growth-control restrictions would have about 45 percent less construction than a metropolitan area with a 1.5-month delay and no growth management policy. Similar studies on the impact of approval delays have not been undertaken for developing countries, but the average time for approval of construction permits, according to Doing Business surveys, is about seven months, ranging from five months in the Middle East and North Africa to eight months in South Asia. These averages measure the time required to go through the processes, so they probably understate the actual time it takes to obtain approvals. The impact of regulations on supply The impact of regulatory standards on affordable housing supply is a widely recognized, if rarely acted on, constraint in developing countries. Analysis of housing programs in Malaysia in the 1990s demonstrated that regulations discourage private developers from serving the low-income market. Even where developers received sub- stantial subsidies through low-cost land and reduced infrastructure 368 Housing Matters standards, the subsidies were outweighed by the costs of subdivi- sion regulations and pricing restrictions imposed by the program. Under these circumstances, developers were willing to participate in programs for low-income housing only in exchange for easing of planning approvals on other sites (Hannah 1989). Yet, Bertaud and Malpezzi’s (2001) analysis of site development standards (FAR and percentage of developable land) in Malaysia suggests that if restric- tions on construction and roads were eased to increase salable land to 55 percent of the developable land, this would double develop- ers’ profitability ratio and provide sufficient incentives to shift their activities to the lower income market. Similar analysis of the impacts of restrictive density standards in Brazil also indicates that relaxing standards would reduce costs for informal land developers. However, attracting these developers to the formal housing market in Brazilian cities requires further reductions in titling and infrastructure devel- opment costs. The impact of land-use regulations on housing supply and prices in developed countries has been studied extensively in the economic literature. Glaeser and Gyourko’s (2003) review of the relationship between zoning regulations and housing supply in many U.S. cit- ies suggests that heavily regulated cities have both lower levels of construction and higher prices. Similarly, their study of New York City attributes the high cost of housing to regulatory restrictions on building heights, which resulted in lower construction levels. Glaeser et al. (2005a) take the arguments on regulation further in their study of housing and urban growth. They suggest that cities with restric- tive regulatory regimes are less able to absorb demand arising from increased productivity. In such cities, growing demand as a result of productivity increases translates into higher prices and less output. This implies that severe restrictions on housing production in cities experiencing high demand may ultimately push growth out to other areas, which may not be as productive. Although the literature may overstate the impacts of regulations on prices in cities experiencing high demand, or productivity increases, it nonetheless persuasively argues that restrictive regulations contrib- ute to high housing prices and less supply. The main weakness is that it does not identify the impact of specific regulations in specific Sonia Hammam 369 contexts. Bertaud notes that “the problem is not so much whether cities are overregulated or under-regulated but rather what the regu- lated value of specific parameters is and how distorting these values are in the economic context of a specific city” (Bertaud 2010, 45). The differential impacts of restrictive uniform FAR regulations, for example, are evident in studies of Mumbai and Chennai. In Mumbai, FAR restrictions have contributed to very high real estate prices. However, Dowall and Monkkonen’s (2007) analysis of Chennai’s land markets indicates that despite having similar restrictions on the books, construction and land prices reflect patterns found in less regulated cities. Regulations and informality Studies on the impact of regulations on informality highlight the dynamics between formal and informal sectors. The fact that the informal sector largely ignores regulations does not mean that it is not affected by them. To a large extent, it owes its creation to the restrictions imposed but not universally enforced by the formal sector. As Bertaud notes, “the boundary between the formal and informal systems is set entirely by regulations and the level of transac- tions costs required to pass from the informal to the formal system” (Bertaud 2010, 45). The link between the two sectors argues against designing policies and interventions that focus exclusively on the informal sector. Several studies have been undertaken in Latin America analyzing the relationship between regulations and the growth of the informal sector. Most of the studies confirm the regulatory link between formal and informal sectors described by Bertaud. The assumption is that regulatory restrictions that limit formal supply result in higher rates of informality. Rather than paying the higher price in the formal sector, lower income groups resort to the informal sector where supply is more elastic but where services and secure tenure might be lacking. However, informality is not synonymous with poverty, particularly in middle- and lower middle-income countries, where informally developed settlements are often undertaken on the outskirts of cities by private land and housing developers. While these settlements may 370 Housing Matters be unauthorized and lacking in services, they differ from squatter areas where land is illegally occupied. Goytia et al. (2010) analyze the impacts of regulation (using different indexes for regulation) on the informality of tenure in Argentina’s major cities. Their study analyzes ways that regulations affect formal supply, but their most robust results are for regulations that specify minimum consumption levels (that is, the amount of housing that can be built and other quantitative regulations, such as minimum lot sizes, building heights, and open-space requirements). Not surprisingly, they find that the more regulated cities have higher rates of informality. And more specifically, their analysis suggests that cities that have incorporated land-use plans into their regulatory or legal frameworks are more likely to have larger informal sectors. This finding seems to argue against planning regulations in general, but the authors suggest that it may simply reflect the effect of “minimum consumption” standards, enforced through legally binding land-use plans. The enforcement of these plans presumably results in higher levels of informality for households that cannot afford to comply with formal standards. The authors also find that long, expensive approval processes reduce tenure formality, underscoring the need for their simplification. Souza (2009) looks at regulation’s impact on prices in the formal sector and the development of the informal sector in Curitiba. Her study is one of the few that takes into account spatial factors in ana- lyzing informal development. The results of her analysis suggest that more restrictive land-use regulations, which increase formal housing prices in one area, push households into the informal sector but in more distant peripheral locations. Henderson (2007) takes a somewhat different view of regulatory impacts. He argues that because direct regulations are largely ignored by the informal sector, Brazilian cities attempted to control infor- mality in the 1980s by denying services to informal settlements—a practice not unique to Brazilian cities. The Brazilian law establish- ing minimum plot sizes made it illegal for cities to provide services to areas that did not comply with these requirements. His analysis suggests that wealthier cities experiencing high migration rates had a greater tendency to deny services in an effort to control migra- tion and informal development. Interestingly, this analysis does not Sonia Hammam 371 isolate the increase in informality from the larger context of urban growth and the political economy of managing growth. *** This chapter has examined the building blocks of housing systems and the debates around these instruments. It has noted the efforts to improve demand-side policies and the challenges on the supply side, which have received less emphasis in practice. The search for the right enabling policies, the correct sequencing and emphasis on a universal set of dos and don’ts to enabling markets, overlooks the fact that housing markets are fundamentally local. There is no one-size- fits-all workable solution or set of optimal policy prescriptions and interventions. Rather than models for how markets should perform, cities need to better understand and monitor local market dynamics, processes of supply and demand, the formal and informal markets, and the stock and flow of housing if they are to formulate adequate policies and design appropriate interventions. The recognition of the impacts of land regulations and policy on housing supply is not new. However, the debate on how to move for- ward has not advanced much in practical terms. In some cities, we are a long way from understanding the impacts of different regulations and the tradeoffs involved. Evidence that regulations tend to affect the choices of the poor more adversely, or that they result in greater informality, should not detract from their wider impacts on hous- ing supply across broad segments of the market. In some ways, we have come full circle to the early concerns of urban projects, which focused on servicing land, planning processes to improve housing affordability and supply, and revision (not removal) of land regula- tions. These concerns were fragmented and limited to specific sites. They tended to ignore city-level outcomes and policies. However, they are now echoed more widely at the city level as issues deserving greater policy attention and intervention to improve overall housing and land market performance. Finally, there is a need to develop a much longer term and wider perspective when assessing housing policies and interventions. There has been a frequent tendency to write off different interventions and expect high paybacks in a short period of time. Yet develop- ing countries that have dealt with housing successfully have done 372 Housing Matters so through a sustained commitment over a long time. Two vastly different approaches in Chile and Singapore underscore the need for a comprehensive framework focused on improving housing affordability across a broad spectrum of the population. The Chilean experience had a fairly lengthy process of public intervention, adjust- ments, and revisions to achieve a policy aimed at ensuring better housing outcomes for a large segment of the population. Similarly, Singapore’s very different housing strategy, which relied on signifi- cant public investment and control, also underwent adjustments and revisions in programs and policy over many years. Notes 1. While the Republic of Korea viewed housing as a non-productive sector and did not intervene directly in building housing in the early period of urbanization in the 1960s, it intervened quite heavily in land development. In the late 1970s, it began to intervene in the housing sector and had one of the more regulated housing development and finance systems. 2. Evidence from Brazil suggests that municipalities have a difficult time reconciling and keeping track of the multiple layers of rights through regularization programs and of historical systems of allocation, making for an opaque and even more cumbersome system of land administration. 3. The authors suggest that such arrangements may also be common in South Asian cities. There is evidence that similar arrangements existed in the bustees of Calcutta. 4. The program in Costa Rica that allowed much broader uses of the subsidy to purchase or improve existing units or build new housing had better results in both coverage and leakage. It initially managed to attract private developers, but it functions primarily through the non- profit sector. However, budget constraints resulted in a reduction in resources available to support the program. 5. Rent subsidies (Bolsa Aluguel) through rental allowances were created to allow a limited number of low-income families to access the private rental market in São Paulo. However, rental ceilings were set below available market rental rates, and the subsidy levels required were sig- nificant. 6. For a comprehensive review of housing finance, including subsidies related to housing finance, see Chiquier and Lea (2009). Sonia Hammam 373 7. Filtering has not been studied in developing countries. An early study by Ferchiou (1988) of Mexico and Tunisia indicated that filtering was limited, with very short-moving chains. Bibliography Angel, Shlomo. 2011. “Making Room for a Planet of Cities.” Policy Focus Report PF027, Lincoln Institute of Land Policy, Cambridge, MA. Annez, Patricia, Alain Bertaud, Bimal Patel, and V.K. Phatak. 2010. “Working with the Market: Approach to Reducing Urban Slums in India.” Policy Research Working Paper 5475, World Bank, Washington, DC. 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Lessons from the Past, Challenges for the Future for Housing Policy: An Evaluation of English Housing Policy 1975–2000. Office of the Deputy Prime Minister, London. World Bank. 2009. World Development Report 2009: Reshaping Economic Geography. Washington, DC. ——–—. 2010. Systems of Cities: Harnessing the Potential of Urbanization for Growth and Poverty Alleviation. Washington, DC. 14 Converting Land into Affordable Housing Floor Space Alain Bertaud Cities emerge from the spatial concentration of people and economic activities. But spatial concentration is not enough; the economic via- bility of cities depends on people, ideas, and goods to move rapidly across the urban area. This constant movement within dense cities creates wealth but also various degrees of unpleasantness and mis- ery that economists call negative externalities—such as congestion, pollution, and environmental degradation. In addition, the poorest inhabitants of many cities are often unable to afford a minimum-size dwelling with safe water and sanitation, as if the wealth created by cities was part of a zero-sum game where the poor would be at the losing end. The main challenge for urban planners and economists is reduc- ing cities’ negative externalities without destroying the wealth created by spatial concentration. To do that, they must plan and design infrastructure and regulations while leaving intact the self- organizing created by land and labor markets. The balance between letting markets work and correcting market externalities through Alain Bertaud 379 infrastructure investment and regulation is difficult to achieve. Too often, planners play sorcerer’s apprentice when dealing with markets whose functioning they poorly understand. It is possible to ignore markets for a while, as in the cities of former command economies like China and the Soviet Union before the 1990s. Planners in those cities were free to design cities by allocat- ing land among uses and deciding how these uses would be spatially related. They proceeded with full design control over cities in the same way that an architect designs a house. The result was less than optimal, with extreme pollution, severe housing shortages, and vast obsolete underused industrial land areas. Planners, no matter how technically competent, cannot design and plan every aspect of a city, because they do not have the information that each individual land user alone possesses. The information about individual location and land consumption preferences, together with land supply responses, is bundled into real estate prices. These prices need constant monitoring and interpretation to guide planners’ responses to the ever-changing equilibrium between supply and demand for land and infrastructure. But empirical evidence also shows that, without any government intervention, markets cannot create large well-functioning cities. Large informal settlements, for instance, surrounding Cairo, Kabul, and Lagos, demonstrate that indispensable primary infrastructure and public parks cannot be created by private initiative alone. In these spontaneous settlements—pure products of market forces unadulterated by regulations—the absence of sewers, storm drainage, and arterial roads impose extreme health and economic hardships on their inhabitants. And these settlements impose a cost on the entire city because their impenetrability interrupts the continuity of citywide transport and other networks. The role of the urban planner is then, first, to better understand the complex interaction between market forces and government inter- ventions—infrastructure investment and regulation—and second, to design these interventions based on precise quantitative objectives. Each city’s priorities would depend on its history, circumstances, and political environment. But maintaining mobility and keeping land affordable remains the main urban planning objective common to all cities. 380 Converting Land into Affordable Housing Floor Space Land-use policies and plans: between utopia and reality With few exceptions, planners are asked not to design new cities but to modify existing ones. Development options are thus quite limited, and theoretically optimal land-use spatial arrangements—even if they could be identified—become irrelevant when confronting the reality on the ground. Planners often have a hard time facing this reality. They lose precious time and resources in preparing utopian plans hoping to transform the structure of an existing city into a new clever optimal form. Periodic fads focusing on a single aspect of urban development can also push planners toward “bold visions” that border utopia. Legitimate concerns for air pollution and the global warming caused by urban transport’s greenhouse gas emissions have triggered an assault on mobility. Any extension of the urban land supply often qualifies as “sprawl,” whether in a North American city with an average built-up density of eight people per hectare or in an Asian city with a density 20 times larger! Many measures to restrict sprawl restrict the land supply and usually make housing less affordable. Desperate to reduce congestion and pollution, planners too often opt for reducing mobility rather than improving it through new transport systems. Reducing traffic by preventing cars from running on some days of the week depending on the ending digits on their license plate reduces mobility and often does not achieve lasting environmental results. By contrast, congestion pricing can reduce congestion and pollution without reducing mobility. This partial solution should expand now that technology’s high transaction costs have declined. Overall, planners should be aware that reducing envi- ronmental externalities constrains urban development and so cannot be the main objective of urban planning. The land use of large cities is extremely resilient. Land use changes in areas already built, whether widening streets or recycling obso- lete land use on a large scale, are slow and involve high transaction costs. And spatial structural changes are usually path-dependent. In large cities, population densities could change in the long run—but extremely slowly. Average urban population densities tend to go down, not up (Angel 2011). Dominantly monocentric cities tend to Alain Bertaud 381 become polycentric in the long run, but once a city is polycentric it cannot return to being monocentric. The slow evolution of existing land use does not mean that a city does not change. Incomes, technology, and relative prices may change very rapidly, as in many cities of Asia and some cities of Africa. These changes affect the supply and demand for land and transport. In Vietnamese cities, household incomes rising over 10 years have allowed commuters to shift from bicycle to motorcycle as the main mode of transport. This change affected not only traffic management but also housing. The quasi-universal use of the motorcycle in Hanoi (81 percent of all vehicle trips in 2008) allowed firms to relocate in suburban areas—where land was cheaper than in the traditional central business district—while maintaining accessibility for its labor force and suppliers. Densified urban villages at the fringe of urban- ization became a major source of cheap housing for commuters with increased mobility provided by the motorcycle. But not all changes have positive impacts. Further increases in household incomes are already creating a demand for cars that Hanoi’s existing road network cannot accommodate. The decentral- ization of jobs has created dispersed commuting destinations into suburbs that traditional transit solutions—bus rapid transit, buses, or subways—will struggle to reach with adequate service. The problem facing planners is thus to maintain mobility and affordability and reduce environmental externalities—because cities’ land use evolves slowly but technology and incomes change rapidly. By monitoring changes, analyzing current land use, and finding solutions for maintaining mobility and affordability, planners have plenty to do without having to redesign existing cities. The following sections concentrate on only a few aspects of land-use management in an existing city, mainly monitoring land supply and looking at how land development practices, regulations, and markets allocate land among users. The supply mechanism for urban land—often opaque and poorly understood by planners and city managers The economic efficiency and social equity of cities depend on an adequate mechanism for the supply and distribution of urban 382 Converting Land into Affordable Housing Floor Space land. Governments have a crucial role in the land supply by pro- viding transport infrastructure. The spatial pattern of the primary infrastructure network and the mix and speed of transport modes determine the potential supply of developable urban land that would be compatible with an integrated labor market. Despite the government’s well-known and accepted role in pro- viding primary infrastructure, it is assumed that in most countries markets largely determine the allocation of developed land and the price of the floor space built on it—with the obvious exceptions of Cuba and the Democratic People’s Republic of Korea. A preliminary evaluation of new greenfield development in Ahmedabad, India, shows that only about a third of the land developed in the last 10 years has been distributed through market mechanisms. While this proportion will vary greatly by city, I do not think that Ahmedabad is an outlier. The market for urban land is unique and complex. The supply and consumption of urban land depends heavily on government invest- ment and regulation. And as a consequence, land market mechanisms are often opaque to both land consumers and suppliers. Land development is crucial for city development. But urban land is only an intermediary product in the construction of cities; the real end-product is the floor space built on it. We all have a tendency to focus on land use and land prices because cities are managed and monitored mostly through maps, two-dimensional simplifications of a three-dimensional reality. What differentiates urban land from rural land is the floor space built on it. The amount of floor space that can be built on a unit of land is thus a crucial variable whose value should be monitored to manage urban land effectively. Low consumption of land per person is not necessarily an indicator of household deprivation; low consumption of floor space per person always is. The amount of floor space built on a unit of land should be determined by consumer demand limited only by the obvious externality costs imposed on its neighbors. But as shown below, the ratio between land and floor space is too often constrained by inadequate infrastructure and arbitrary regulations. In many cities, the high price of floor space prevents poor house- holds from being able to afford housing in the formal sector—that is, to build on land that conforms to the regulated development Alain Bertaud 383 process. So poor households can afford only land developed infor- mally in a much simpler parallel process. Instead of having this dichotomy, there must be a way to develop land and build floor space with different characteristics that make doing so legal, affordable, and safe. City managers and urban planners often quote the “high price of urban land” as responsible for the poor’s inability to afford formal housing.1 The responsibility for the high prices is generally attributed to either the actions of speculators or the greed of land owners. Very little can be done to stop vaguely defined land speculation—and even less to prevent greed. Even so, land supply bottlenecks—the real cause of high land prices—are seldom analyzed. What determines the supply of urban land for future develop- ment, and how is this land distributed? Urban land development is a linear process, similar to an industrial production chain. How long does it take for the primary input—rural land—to be transformed into the finished product—floor space? How much land is frozen, and for how long, during the various stages of transformation on the production chain? How much land is permanently wasted or mis- allocated? Because floor space is what urban firms and households consume, how many units of land have to be developed to produce one unit of floor space? The answers obviously will vary with each city, depending on its topography and resources and the technology available to it. I will spell out the various steps of the complex process that transforms land into buildable, salable lots and eventually into floor space. This chapter aims to identify when the original land fed into the supply chain is all gone. I identify what constitutes the potential supply of land—and then how this land is transformed into developed land and eventually into floor space. The supply of developable urban land—constrained by the speed of daily trips The efficiency of large labor markets is the raison d’être of large cities. The daily trips by the active population from home to work and urban amenities allow labor markets to work. Spatial mobility makes cities economically viable. 384 Converting Land into Affordable Housing Floor Space As cities grow very large, travel distance increases, and traffic con- gestion slows commuting and increases the time spent on transport. The time spent daily moving from residences to jobs and amenities is like a tax on urban productivity, and when this time becomes too long it is also a tax on family and social life. Some urban planners argue that it should be possible to put jobs and housing in the same location. This would reduce travel time and perhaps allow walking or cycling to work, even in very large cities. The attempts in new satellite towns in cities as diverse as Stockholm and Seoul show that this does not reduce commuting distance. In so-called self-sufficient satellite towns, the distance traveled increased, compared with the rest of the city, as people living in satellite towns usually work in the core city and people working in the satellite towns often commute from a suburb of the core city.2 Why is it not possible to match the locations of housing and jobs in large cities? Most of the world’s cities are already built with hous- ing next to where jobs are concentrated. But people moving to a large city are unlikely to look for a job only within a short distance of their new home, and employers are not going to limit their search for workers to their firm’s neighborhood. The wide choice of jobs and potential employees that large cities offer is the main motive for moving to a large city, for both individuals and firms. Firms are better off when they can select from a large number of workers; individuals are better off when they can choose from a wide range of jobs. The job market is thus city-wide and cannot be fragmented into discrete neighborhoods. Labor market integration is found not in a clever land-use arrangement but in better and faster transport. In a large city, an efficient urban transport system should take a commuter from any part of the city to any other in an acceptable length of time. This acceptable commuting time multiplied by the speed of travel defines the radius of the circle reachable under the commuting time limit and thus defines the potential land supply for city extension under the current transport system. Acceptable travel times What then is the acceptable limit to daily travel time? In U.S. and Western European cities, the mean travel time stayed about constant Alain Bertaud 385 over the last 10 years, despite increases in population and in distance traveled (25 minutes mean travel time for U.S. cities in both 2000 and 2009) (McKenzie and Rapino 2011). The mean one-way travel time for large cities varies from around 25–35 minutes. Many large cities in emerging economies are growing much faster in both popu- lation and income than are American and Western European cities, pushing mean commuting times well beyond 35 minutes because their transport systems are unlikely to be able to adjust to the more rapid physical expansion. The median travel time in Gauteng, South Africa, is 29 minutes—seemingly similar to a European or North American city—but almost 15 percent of commuters travel more than one hour one way each day, while in the New York metropoli- tan area (with a population 150 percent larger than Gauteng’s) only 7 percent of commuters commute more than one hour (Figure 14.1). The supply of urban land will thus be constrained by the distance that can be traveled in less than one hour to jobs and amenities from the various residential locations in and around the city (Figure 14.2). As a city expands in population and area, the distance between jobs and amenities will likely increase, requiring higher speeds to connect in less than one hour. Figure 14.1 Commuting trip travel time in Gauteng, 2009 Source: Stats SA 2009. Figure 14.2 Land supply corresponding to one hour commuting time for three spatial arrangements for jobs and amenities Source: Author’s analysis. Note: Monocentric jobs are concentrated in the central business district; polycentric-clustered jobs are concentrated in a few clusters; polycentric- uniformly dispersed jobs are completely dispersed within the built-up area. Alain Bertaud 387 The potential land supply is the yet-unbuilt area where a city can expand while avoiding the fragmentation of its labor market. Studies in Asia and Western Europe show that a 10 percent increase in travel speed corresponds to a 15 percent expansion in the size of the labor market and a 3 percent gain in productivity (Prud’homme and Lee 2009). To approximate the effect of the existing transporation system on the potential land supply, assume that one hour for a one-way commute is the maximum travel time to define a city’s potential land supply. In a labor market perfectly integrated (and thus with maximum productivity), any job should be reached in less than one hour from any part of the built-up area. This first hypothesis is shown on the top part of the figure for the three spatial arrangements for job distribution. Keeping the urban area constant, the travel length to the more distant job from any point at the urban periphery increases as the jobs move away from the center. To limit commutes to an hour, the speed of travel has to increase when jobs are more dispersed. This is what often happens in real life, because trips from suburbs to suburbs are usually faster than those from suburbs to the central business district. A second hypothesis shows a less perfect world, where only a frac- tion of the jobs would be accessible in less than one hour from the city’s periphery. The labor markets would then be fragmented—depending on their location, workers will have access to only a fraction of the jobs available in the city. Productivity would fall in proportion to the percentage of jobs that can be reached in less than one hour over the total number of jobs. Increasing travel speed would expand the size of the labor market, and productivity would, as a consequence, also increase. In the real world, the means of transport—and thus the speed of travel—depend on income groups and patterns of travel. Higher income groups, which can afford faster transport, would have access to the entire labor market, while poorer households would have access to only a fraction of it, significantly lessening their earning opportunities. The schematic representation of Figure 14.2 shows the relation- ship among land supply, job spatial distribution, and speed of travel. For a given urban area with less than one hour travel time, the 388 Converting Land into Affordable Housing Floor Space monocentric distribution of jobs allows the slowest travel speed, because the central location of jobs reduces distance to all house- holds. The polycentric arrangement would require travel speeds to double, holding the land area constant, to allow one hour travel time from all parts of the city to all jobs. So far the time spent traveling is the major constraint on urban land supply. Economists traditionally use the cost of transport from the city center as a determinant of the limit of urbanization (or by extension, to the land supply). The cost of transport includes both the cash paid for transport (gasoline, tolls, transit fare) and the opportunity cost of time spent traveling. The cost per unit of time traveled, an opportunity cost, is different for travelers belonging to different income groups—higher for higher income and lower for lower income. The direct costs of commuting trips in large modern cities—by individual vehicles or by public transit—are often heavily subsidized, directly or indirectly. The failure to include the economic price of carbon emissions in the cost of the fuel consumed, for example, further removes the incentive to use direct transport costs to influ- ence travel behavior. In assessing the supply of land, I am using current behavior influenced by the actual price paid for transport and not the economic price, which reflects the real economic cost of commuting. However, for the lowest income households, who can afford only to walk, the cost of travel is even more important than travel time in limiting their choice of residential location. In some cities, the poorest inhabitants spend more than two hours a day commuting from home to work (Box 14.1). The extreme commuting hardship in Gauteng might be exceptional (about 4 percent of commuters in Gauteng are estimated to commute more than 90 minutes one way), but it may become more common with increasing income disparities in even larger cities. There would certainly seem to be a correlation between the high cost in time and money commuting in Gauteng and the 26 percent unemployment rate (OECD 2011). The area where this person is living—two and a half hours from her job—would be considered outside the urban supply area with a maximum of one hour commute time. But a different mode of transport would put her residence inside the land supply zone. Alain Bertaud 389 Box 14.1 The five-hour commuting burden in Gauteng, South Africa A single mother of four children ages 3–12 lives in Tembisa with her mother. She spends nearly five hours each day commuting to and from work in the Pretoria suburb of Brummeria, where she is an office cleaner. The journeys cost nearly 40 percent of her monthly salary of 1,900 rand. She leaves home at 05:00 to be at the office at 07:30, starting with a 2-kilometer walk to the taxi stand, which takes her to the train station. In Pretoria, she takes another taxi to Brummeria. After leaving work at 16:00, she may not get home until 19:00, as the trains are often late. She spends over 700 rand a month on transport and nearly 100 hours on the road. —National Development Plan Vision 2030, Presidency’s National Planning Commission, South Africa, November 2011. The length of the trip for the woman commuting to her work: 47 kilometers. Her average commuting speed is only about 19 kilo- meters an hour, very low due to the many changes in the mode of transport she must use. She must first walk to a taxi stand, then wait for a collective taxi that takes her to a railway station, then wait for a train that takes her to a station, and then wait for a collective taxi that takes her to her job. If she could afford a motorcycle, she could do the trip in less than one hour and would gain three hours every day. Clearly, in defining the land supply area the real issues are speed and mode of transport, not distance. The negative impact of more than two hours total daily travel time on the life and welfare of poor people causes their real income to be far lower than the already low level measured in monetary terms. Trips longer than one hour disrupt family life, with serious long-term social consequences on employment and on children’s education. Too often, the proponents of transport systems fail to evaluate the door-to-door users’ time of transport, considering the viability of the proposed transport system from only the view of the operator, not the user. As a consequence, travel time by different transport mode is seldom monitored. Robert Cervero, in his otherwise comprehensive and authoritative book in advocacy of urban transit, devotes only a 390 Converting Land into Affordable Housing Floor Space few lines to travel time by different mode (Cervero 1998). He admits that the usual faster travel time by car, even in transit-based European and Japanese cities, is the main challenge in shifting the transport mode from car to transit. Indeed, this is a major challenge! The mode and length of the transport network determines the supply of land Assuming that one hour each way is the maximum commuting time acceptable in a city, we can calculate the area that can be accessed in less than one hour from a central point. The part of this area yet to be built corresponds to the supply of land that can be developed for city expansion without imposing significant and unmeasured welfare costs on long-distance commuters. The size of this area will depend on the speed of different transport modes and the pattern of the road network. Figure 14.3 illustrates the steps that can help derive the supply of land from the speed of different transport modes. The distance covered during one hour’s travel time depends on the speed of transport. The speed of transport depends on the mode of transport. Transport modes are divided into two categories: individual and collective. Individual means of transport—walking, bicycling, motorcycling, and driving a private vehicle—provides access to any area along a road network at any time and without the need to walk to a station or bus stop. By contrast, collective transport—minibuses, buses, bus rapid transit, and rail—provides access only along a transit network that is usually a fraction of the length of the road network. It depends on the frequency of transport and the network’s operating hours (for instance, buses operate at, say, 10 minute intervals, between 6 in the morning and midnight). Figure 14.3 shows the distance that can be covered in one hour using different transport modes and their corresponding door-to-door speed. The various supply areas are based on the distance covered in one hour by different transport modes at the door-to-door speed and on an assumption that the urban area is covered by a continuous road network and that the transit network covers the existing network at 1-kilometer intervals. These areas would measure the potential land supply corresponding to various transport modes in a monocentric Figure 14.3 The potential supply of land depends on the speed of different transport modes Source: Author’s estimates. 392 Converting Land into Affordable Housing Floor Space city, where most jobs and amenities are concentrated in a central location. In a polycentric city, the supply area would have to be divided by about two.3 However, the speed of motorized individual transport would be faster for suburb-to-suburb trips than for suburb to urban core trips. See Box 14.2 for an example of the door-to-door speed of public transport. Box 14.2 Door-to-door speed of public transport Commuting time is the total time it takes to go from trip origin to final destination, called the door-to-door commuting time. Commuting speed is the distance from origin to destination divided by the door-to- door commuting time. It is usually significantly lower than the speed of the means of transport itself. When collective means of transport are used, the difference in speed is significant, because it requires walking to and from transit stations, and the differences become even larger when there is a need to transfer between transit lines and larger still when the transfer is between different transport modes (bus to subway, or train to collective taxis). Suppose that to catch a bus a passenger has to walk on average about 500 meters at 4.5 kilometers an hour, taking about 7 minutes. If a bus arrives every 10 minutes the average waiting time will be 5 minutes before boarding. The bus runs at 25 kilometers an hour between stops. Assume that stops are spaced every 500 meters and that the bus stops for 30 seconds at each stop to let passengers board and alight. Over 10 kilometers, the real speed of the bus will be 17.6 kilometers an hour because of the time waiting at stops. Finally, after arriving at his or her stop, the passenger will still have to walk an average of 500 meters to final destination. Using the above parameters, the door-to-door commuting speed of the bus is only 12.6 kilometers an hour. If a transfer is necessary to another bus line and the headway or time between buses is 10 minutes, an average of 5 minutes will be added and the door-to-door speed will drop to 11.5 kilometers an hour. For individual means of transport, the average speed of the vehicle is usually very close to the door-to door-speed, except for car trips to downtown areas where the distance from car parking to workplace destination might be significant and must be walked. Alain Bertaud 393 In a city where the road network is idiosyncratic, as is typical, the area accessible through the road network in a given time can be measured directly on a map (Figure 14.4). In Ahmedabad, a scooter runs at about 30 kilometers an hour. The total area accessible in less than one hour from a central location (1,675 square kilometers) using the existing road network represents the land supply under current infrastructure for somebody using a scooter as transport and working in central Ahmedabad. Part of the area accessible in less than one hour is already built—in this case 384 square kilometers of area available for development. So, the new potential land supply is 1,291 square kilometers, but it is available only to users of scooters or faster vehicles. Figure 14.4 Ahmedabad’s land supply within 30 kilometers of the city center Source: For area within 30 kilometers of central business district, author’s calcula- tions; for built-up area, Annez et al. (2012). 394 Converting Land into Affordable Housing Floor Space Ahmedabad has also a network of city buses and a newly built bus rapid transit network. The supply of land for people using the public transport system—bus, bus rapid transit, or a combination of the two—would be different and certainly much smaller than the area accessible by scooter. In addition, the use of auto-rickshaws, com- mon in India, would expand the reach of the bus or bus rapid transit network and, as a consequence, the land supply for users of public transport who can afford the supplemental cost of an auto-rickshaw. The potential supply of land where a city can expand is dependent on the city’s transport system, and each income group is limited to its own potential land supply dependent on the affordable transport mode. For people who can afford only to walk, the land supply area is very small (about 40 square kilometers). In cities where jobs are dispersed, as in Gauteng, low-income walkers have access to only a fraction of the job market and are likely to face either high unem- ployment or much lower real income due to the implicit taxes they pay through transport costs. Increasing the supply of land through faster transport would have more positive impact on the housing of the poor One frequent reason for the high cost of land is an inadequate trans- port system. Transport networks should be planned to expand the land supply area for the lowest income urban groups. Expanding the land supply would hold down housing costs by putting more land on the market. Increasing transport’s door-to-door speed by allow- ing fast and efficient transfers between transport modes could have more impacts on the quality of housing of the poor and on their employment rate than many more traditional low-income housing programs. In the large cities of Vietnam, where household incomes are sufficient to afford a motorcycle for every worker, the land supply has become very large, and the quality of housing is thus generally high. Motorcycles allow access to undeveloped areas with narrow roads or even unpaved rural trails. In these areas, low-income households do not have to compete for land with higher income groups, who generally require car accessibility for their housing location. The land area accessible only by motorcycle becomes a parallel land market Alain Bertaud 395 “reserved” for lower income households. In most of the world’s cities, the rich, because of their superior mobility, have access to a much larger land supply area than the poor. In Vietnamese cities, because of the quasi-universal social acceptability and affordability of the motorcycle, this advantage is reversed, and the poor, by accepting to live in areas accessible only by motorcycle, have a larger and more affordable land supply than the rich. A costly obstacle course: the transformation of potential supply of land into residential floor space Basing the land supply area on the speed of transport modes is only the first step in getting land to its final urban user. It measures only accessibility—it does not mean that the land is available for use. The transformation of the potential land supply into buildable land and eventually into floor space is nearly always long and costly. Transforming rural land into urban developed land differs by country, and it is not possible to provide a general description of the process. In some market economies, land development is a state monopoly, even though the developed land is eventually sold on the free market, as in Singapore and the Republic of Korea. In China, the local government has also a monopoly on land develop- ment, though most of the land, once developed, is auctioned on the free market. As an example, consider Ahmedabad. India is a market economy with a well-established legal system that supports property rights. But the country’s often overreaching government often slows land development to a halt, reducing the potential land supply. The state of Gujarat, where Ahmedabad is located, has the pecu- liarity of having perfected over the last 30 years a land readjustment system that in principle would greatly simplify and rationalize the transformation of rural land into urban developed land. In reality, the administrative hurdles created by several levels of government make this transformation lengthy and expensive. In India, as in most countries, land development is an obstacle course with many players, many rules, and many referees who often do not even realize that their actions or principled obstructions are the major causes of the shortage of developed land. 396 Converting Land into Affordable Housing Floor Space The undeveloped area within less than one hour travel time from Ahmedabad’s city center is potentially part of the land supply only for people with access to a car or a motorcycle (see Figure 14.4). Before this land area can be developed, it will be subjected to time- and money- consuming controls, permits, and regulations. And it will require the coordinated construction of tertiary infrastructure to enable access to individual lots. In Ahmedabad, which is not exceptional, being able to build legally on a lot in a greenfield development requires 14 steps involving the federal revenue department and multiple offices of the state and local government. The process would normally take several years, with no guarantee of success. In emerging economies, household incomes are rising quickly, and financial services are becoming more available. This creates a large increase in demand for housing and office buildings and thus for land. Because of the time lag in getting the necessary permission, the land supply response to increasing demand is always very slow, resulting in rapid land appreciation. In Ahmedabad, the theoretical supply of land accessible to the population will be adequate for many years to come, but the time required for getting from greenfield to developed plot is so long that it has already created an artificial short- age of developed land. Only a very small part of the land within the theoretical acces- sibility supply area will end up “on the market” for development. The ability to develop enough land in time to accommodate the demand coming from an increasing population and increasing incomes is the major challenge of modern urbanization. As shown below, more land could be put on the market faster by simplifying the administrative system and reducing the amount of land allocated administratively. Only a fraction of the land developed each year is submitted to market forces The economic efficiency of cities rests on the assumption that land is valued at market prices and that it is periodically recycled to its best and highest use as determined by market forces. Land owners, under this assumption, periodically review the value of their land assets and change to a different use if the return net of the sometimes significant Alain Bertaud 397 transaction costs is not optimum under the current use. That is why tall office buildings in some locations replace old townhouses, and why detached houses on large lots are replaced by townhouses. The high transaction costs of land use readjustment explain why this pro- cess does not happen quickly. When land becomes more expensive, developers substitute capital for land by building taller buildings, using less land per unit of floor space. This constant creative destruc- tion is what allows cities to adapt to changing consumer demand and to new technology. Because adjusting to a new use is expensive, only a small fraction of the developed urban land is ever submitted to the market forces just described. A large part of the urban land supply is allocated each year by regulation or by government acquisition through eminent domain. The majority of this administratively allocated land is used for roads, parks, railways tracks, utilities, government buildings, and more. As a consequence, the possibility of rapid changes in land use and density, which could improve the productivity of cities, would happen very slowly. I am not arguing that the value of the land on which roads and parks are built should be constantly updated and that alternative, more financially rewarding uses should be constantly explored. Obviously, large areas of a city have to be devoted either to public goods, which should escape the rigors of the market, or to potentially private goods, such as roads, which are almost everywhere treated as pure public goods. But calculating what proportion of the land area developed each year is submitted to market forces could be a good indicator of how the scarce land is used, underused, or wasted. I have tentatively tried to measure how the 2,682 hectares of land developed in Ahmedabad over 2000–10 had been allocated (Figure 14.5). Not perfect, the measure is probably accurate enough to help guide future land policy. It is based on existing statistics, interpre- tations of Google Earth imagery, and the preliminary results of an ongoing study on public land use. Ahmedabad is probably typical of land use in large Indian cities and reflects Indian land development practices and regulations. The analysis of the flow of land developed in cities outside India would certainly show different results. The purpose of measuring Ahmedabad’s greenfield land allocation is to show a method for Figure 14.5 The land allocation process in new areas in Ahmedabad over 2000–10 Source: Author’s calculations. Alain Bertaud 399 comparing across cities the transformation of land from agricul- tural to urban use and the transformation of developed land into floor space. How many hectares of rural land have to be developed to produce 1 hectare for building housing, industries, and commerce? Every mayor and urban planner should know this ratio for their city. From the preliminary land study in Ahmedabad, the ratio between devel- oped land and salable land is 3.3. That is, under current development practice in Ahmedabad, 3.3 hectares of rural land have to be devel- oped to allow 1 hectare to be used at its highest and best use (this includes land developed by the informal sector). On this 1 hectare of land, 1.7 hectares of floor space would be allowed to be built by current regulations. That is, roughly 2 hectares of developed land are required to produce 1 hectare of floor space. I am not implying that the land allocated for roads, utilities, and government buildings is being wasted—far from it. I am just distinguishing the land set aside for permanent public use from the land that will be on the market—and determining which type of use can be changed depending on its market value and consumer demand. Roads, railway tracks, and sewer plants almost never change their use over the years. The land used by government buildings could theoretically change its function over the years, and the floor space built on it could be expanded. Such changes seldom happen, however, because governments are not in the habit of carrying in their books the capital value of the land they occupy.4 There is thus no incentive to use the capital value of government land more effi- ciently. Just ask any ministry or municipality the total area of their land holding. Nobody knows, unless a study is specially designed and financed to find out (such a study is currently being conducted in Ahmedabad). The land allocation for the extension of Ahmedabad over 2000–10 The 2,682 hectares of land developed over 2000–10 are of two types: land developed formally (95 percent) and land developed informally (5 percent), including slums and additions to villages absorbed into the new urbanization. 400 Converting Land into Affordable Housing Floor Space Before private development can take place, some land areas are typically allocated by the master plan to various uses. These include major road and railway right of ways (11 percent) and utilities (5 percent). The land allocated to major roads depends on norms and regulations for right of ways. The land allocated to utilities depends on engineering standards and technology. The next allocation, 14 percent of the land developed, concerns government administrative buildings and major public facilities, including schools, government hospitals, police stations, and large parks. The allocation is sometimes through the master plan but often through ad hoc eminent domain acquisitions. This land is usually acquired at below-market prices.5 Once allocated, its use tends to become permanent. The low intensity of use shown by the small footprint of buildings and the low floor-area ratio—compared with adjacent privately used land—shows a frequent disconnect between the value of land and the intensity of its use in administrative build- ings. This should be no surprise because land’s value, once acquired by government, rarely if ever figures as an asset in government finan- cial accounts. The land used under “local roads and small open spaces” (17 percent) is not acquired but is set aside by Gujarat Development Control Regulations, which define minimum street width, open space, setbacks, and parking (Figure 14.6). The allocation is similar for all areas of the city, whether near the center where the land is expensive or in a faraway suburb where the land is cheap. The cost of land for internal streets and common open space is paid for directly by the developers and eventually by individual end-users. “Land retained by government in town planning schemes” (22 percent) is specific to the State of Gujarat and includes the land retained when the government creates “town planning schemes,” land readjustment projects that now extend to all of urban Gujarat. The government retains land for special purposes when implement- ing land adjustments. This land could be used for any public purpose the government sees fit, including parks and public buildings, large infrastructure, or a utility. It can also be allocated to public housing or even sold to finance the construction of infrastructure. Over 2000–10, 69 percent of the total land developed was administratively allocated by acquisition or regulations. Not enough Figure 14.6 Typical low-cost housing layout according to Gujarat Development Control Regulations Source: Author’s redrawing based on Annez et al. (2012). 402 Converting Land into Affordable Housing Floor Space information is known about its use to know if some areas have been overallocated or are underused. There may be an underallocation in some categories (major roads, storm drainage) and an overallocation in others (government buildings). This arbitrary land allocation sharply limits the land available for private development, particularly for housing. And it increases the likelihood that most of this land will be frozen under uses largely not dictated by the market. The residual land not included in the categories described— 26 percent of the total—is developed as private plots and bought and sold at market prices. This 26 percent is the only part of the land developed likely to change use or intensity of use according to consumer demand. The floor space that can be built on this land is, however, severely limited by floor-area ratio regulations. In Ahmedabad, the floor-area ratio is uniformly limited to 1.8 square meters of floor space per square meter of land (with some areas as low as 1) in most of the city. This limit is imposed on residential and commercial areas alike, whether in the city center or in faraway suburbs. Slums and villages account for only 5 percent of the developed land. But they serve a much larger populace. For example, the ratio of slum area over total area built before 2000 was 7 percent—but people living in slums in 2000 represented 35 percent of Ahmedabad’s population. Villages are not bound by the development regulations constrain- ing formal residential areas. The land within informally developed areas—slums and village extensions—is allocated purely through markets. Whether the original settlers in slums were squatters or paid for the land, a market was immediately created, and properties are now constantly traded. Change of land use, from residential to commercial, for instance, is also dictated by market forces. So is the allocation of land for street and open space. The allocation of land submitted to market forces For urban land submitted to market forces, commercial and busi- ness users will usually outbid residential users in the most accessible location. The higher income groups will in turn outbid lower income groups in the more environmentally desirable locations. The lowest Alain Bertaud 403 income group that can still afford formal housing will be able to afford only the residual areas. And the households that are too poor to afford the minimal regulatory norms defining formal construction will have to settle in informal areas. Low-income residents may be able to outbid higher income groups by consuming less land per household, as in many U.S. cities, but this possibility declines when low-income residents cannot afford the higher construction costs of multistory building—that is, they cannot substitute capital for land. Poorly designed regulations often prevent low-income households from reducing their land consump- tion and therefore cause them to be systematically outbid by higher income groups. Their only alternative is to move into the slums in the informally developed areas. While the density in slums is produced by market forces, the total area developed informally and its location depend more on historical accidents than on consumer choices and market forces. The transformation of land into floor space A city is defined by its buildings and by the economic activities or consumption in them. The end-product of urbanization is therefore not land but floor space. This truism is often ignored because of the difficulty of representing the third dimension on a map. Perhaps the three-dimensional images of cities constantly updated on Google Earth will change that. Land-use regulations usually restrict the floor space that can be built on each parcel of commercial and residential land. Typically, regulatory limits on floor-area ratios prevent higher income groups and commercial users from building as tall a structure as they would like (reducing their ability to substitute capital for land), forcing them to consume more land than they would in the absence of regu- lations. This regulatory constraint, by increasing the land area used by commercial users and high-income groups, indirectly reduces the area of land available for lower income groups. In the informal areas, the lack of regulation leads to intensive land use, but the lowest income households either cannot afford the cost of sturdy concrete construction required to build several floors or their property rights are so ambiguous that they are reluctant to make 404 Converting Land into Affordable Housing Floor Space the investment. They compensate for the inability to build multistory buildings by minimizing plot size, open space, and road areas, even reducing further their consumption of land. In Hanoi, where even poor households can afford to buy or rent multistory buildings, informal areas have buildings with up to five floors, multiplying the floor space affordable to low-income house- holds. The examples of Hanoi and Bangkok suggest that a key factor in creating affordable housing is removing the regulatory constraint on floor-area ratios. Removing constraints on land supply—be they imposed by defi- cient transport systems, poor land allocation practices, or arbitrary normative regulations—has two main objectives: improving urban productivity and improving the housing quality of the poor. Housing affordability is thus linked directly to land supply. The demand side: rethinking affordability The traditional method for evaluating housing affordability is to measure the ratio between the median housing price and the median household income. It does not work well in cities with wide income disparities and a large informal housing stock. Rapid changes in income distribution, as seen in India and in many East Asian cities, further reduce the usefulness of the tradi- tional normative approach. Government institutions usually define “affordable housing” by minimum lot size, minimum floor size, and minimum water and sewer infrastructure. The price of land becomes the only dependent variable in the traditional “affordable housing” equation, the values of all other variables having been fixed by norms as rigid as they are arbitrary. Under the traditional approach, the government promotes the building of so-called “affordable housing” on the cheapest land possible—housing in the distant periphery of cities or in very undesirable locations. In Gauteng, a massive state-subsidized hous- ing program had spacious individual houses with well-designed infrastructure and social services but—to save money on land—they were built in distant locations that would have been considered outside the land-supply area defined by the transport mode that the beneficiaries could afford. The result has been costly and lengthy Alain Bertaud 405 commutes, chronic unemployment, or both. The study of land supply thus needs to be complemented by an understanding of the land consumption for each income group. Every urban dweller consumes some urban land. In the same city, some consume very little land, others a lot. Consuming very little urban land is not in itself a bad thing and is not necessarily caused by poverty. For instance, people living in luxury apartments along Old Peak Road in Hong Kong SAR, China, consume about 4.5 square meters of land per person while slum dwellers in Sankar Bhuvan Slum in Ahmedabad consume just a little more, or about 6.5 square meters per person (Figure 14.7). What is the real difference? The luxury apartment dweller in Hong Kong SAR, China, can build 35 square meters of floor area per person on this 4.5 square meters of land by living in a high-rise building. But the slum dweller in Ahmedabad can build only 4.1 square meters of floor area on her 6.5 square meters of land—because the light construction she can afford can support only a roof. Because apartment dwellers in Hong Kong SAR, China, can spend enough to leverage the little land they consume into a large area of floor space, they enjoy high environmental quality while con- suming very little land. By contrast, Ahmedabad slum dwellers lack the capital to build multistory dwellings on the little land they can afford. As a result, the environmental quality of the dwelling of the slum dweller is extremely low while consuming the same amount of land as a high-income city dweller. The possibility of leveraging a small area of land into a large area of floor is restricted in three ways: by income, by regulation, and by access to finance. Only households that can afford to pay or borrow for the minimum capital investment—represented, say, by the mini- mum cost of about 25 square meters of concrete construction—can leverage a small area of land into a spacious floor. This minimum varies by country: it is around $5,000 in Ahmedabad and about $30,000 in Hong Kong SAR, China. Poorer households that cannot afford this cost have to live in dwellings whose areas are often even smaller than the plot of land they can afford. Various government regulations fix minimum land consumption per households, either directly by fixing a minimum plot size or 406 Converting Land into Affordable Housing Floor Space Figure 14.7 Ahmedabad—typical slum layout: Sankar Bhuvan Shapur Source: Author’s drawing and calculations based on 2010 survey conducted by the Self Employed Women’s Association of India. indirectly by fixing a maximum floor-area ratio (the proportion between the land area and the floor area that can be built on it). Arbitrary regulations fixing minimum land consumption affect the poor differently than the rich. Poor households that cannot afford the minimum land consumption fixed by regulations are forced to live in informal housing. More affluent households are often forced by regulations to consume more land than they would in the absence of regulations. Evaluating current household land and floor space consumption standards and the prices corresponding to these standards in different Alain Bertaud 407 locations is the only way to evaluate housing demand and current affordability. The search for affordable housing should include measures to improve the existing low-income housing stock and to increase the supply of new low-cost housing. The flow of new low- cost housing might come from developing new greenfields, recycling older housing stock, or densifying existing residential areas. Housing is a continuum: different income groups with different mobility compete for the same land. So it is necessary to have a com- plete view of the current consumption characteristics of all income groups. Detailed housing consumption surveys by income group should be conducted yearly to provide an updated overall view of the market. On the supply side, the regulatory constraints on the richer households, obliging them to consume more land than they demand, have a negative effect on the poorest. Over the years, the income distribution of households will be constantly changing. Some who were poor will become middle class, but they might be partially replaced at the bottom of the income scale by poor people moving into the city. The stock of housing units will also change each year because of new additions (often at the top of the income scale), while some of the older stock will be demolished. The inability to increase the supply of new units, usually because of land supply bottlenecks, will raise housing prices and reduce housing consumption for all, with more dramatic consequences for the lowest income groups. Due to new land and housing flows, it is essential as part of the land supply quantification to project the change in housing stock and to compare it with the changes in the number of households in each income group. Cities usually monitor the number of new formal units being built each year, but they often fail to monitor the drop in the existing housing stock due to demolitions or land-use changes and the growth or contraction of the informal sector. Housing policy should be based on a complete understanding of the land supply process and the current pattern of land consumption among income groups We have seen the complexity of the land supply process in Ahmedabad. Over the years, different cities have developed different ways of 408 Converting Land into Affordable Housing Floor Space transforming rural land into urban floor space. No “best practice” in supplying urban land can be relevant to all the traditions, culture, and topography that make the world’s cities so different and attrac- tive. It is possible, however, to recommend a method for analyzing the land supply process quantitatively and defining the limits of the potential land supply based on existing transport modes and their speed. This quantitative analysis could help establish priorities and eliminate the practices and regulations that have fewer benefits and higher costs. Get the numbers right on supply and demand On the supply side, most cities are now using geographic information system (GIS) technology to map existing land use, making it possible to extract fairly accurately the area of land consumed by different users. GIS and satellite imagery allow establishing a complete “land accounting” system that can detect the inefficient and costly leaks in the land development process. The unresponsiveness of land supply to demand caused by identifiable bottlenecks is the major obstacle to land development, reducing housing consumption for all and especially the poor. Establishing the potential supply of land based on the commuting speed of income groups is also essential. Many housing policy failures have been caused by the notion that the cheapest land, whatever its accessibility, is the best location for the poor. The patterns of land consumption for business, industries, and housing also have to be analyzed. Both technology and rising house- hold incomes can dramatically change these patterns of consumption. Audit regulations and discard ones that impose high constraints but few benefits Land-use regulations are the result of years of government action reacting to the perceived problems of the moment. As the city econ- omy changes and the understanding of what makes a city productive evolves, many regulations lose their rationale. But nothing is more resilient and long-lived than an obsolete regulation. Alain Bertaud 409 Many land regulations contradict each other. Some increase land consumption: minimum plot size, maximum floor-area ratio, mini- mum number of parking spaces per dwelling. Others reduce land supply: green belt, restriction of land conversion from agricultural to urban. The combination of regulations that boost land consumption with those that reduce land supply greatly increases the price of land to the detriment of all households, more dramatically for the lowest income households. Weeding out obsolete land regulations would itself go a long way toward improving the housing consumption of lower income groups. Other actions will be needed, of course, such as investing in infrastructure and transport to increase the supply of land accessible from any point in a city in less than one hour. Define a supply-side policy program Housing standards could be dramatically improved for the poor if many supply-side barriers were removed—or at least reduced—and if the spatial aspect of housing, particularly the transport cost for each location, is taken into account when designing a land and housing policy. Several actions are available in different sectors: • Transport. Increase the land supply by expanding the reach of infra- structure and the speed and convenience of transport. Calculate current land supply based on the dominant mode of transport used by income groups. • Management of public land holdings. Audit and map govern- ment land holdings, and eventually reconvert some underused government land into salable land or use it as a public good (parks, for instance). • Regulatory reform. Remove some of the regulatory constraints on commercial and high-income groups that artificially increase their land consumption. Remove some regulatory constraints mostly affecting low-income groups to increase the number of households that can afford formal housing (reviewing minimum plot sizes, apartment sizes, parking requirements, and so on). 410 Converting Land into Affordable Housing Floor Space • Informal areas and slums. Monitor the areas, densities, growth rates, and land-use standards of informal areas. Consider formal- izing these areas as parallel markets where land-use rules are purely demand-driven instead of normative. Urban planners need to take full responsibility for the timely delivery of buildable land to markets Urban planners have the merit of playing an operational role in city management; they are key actors in the design of infrastructure and urban regulations. They often consider their role as “designer” of more efficient and more “livable” cities. But they also often ignore the role of markets—and in particular the demand from households and firms for land and floor space. As a result, the plans they prepare lose relevance and fail to be implemented, particularly when they fail to monitor the growth of informal land markets that are the only source of land for the poor. To play a more efficient role, planners should monitor the supply and demand for land and floor space. They should monitor the supply of developable land, defined by the area accessible through the transport network in less than one hour. They should ensure the elasticity of the supply of land by expanding the reach and the speed of the transport network when prices and household incomes are rising. Failure to do this inevitably results in high land prices that become unaffordable to the poor and even the middle class. Mapping, monitoring, and eventually expanding the developable land supply is of course not sufficient to make it readily buildable. Developable land is a raw input that needs to be processed before it can be used and built on. In the great majority of cities, the respon- sibility for processing undeveloped land into developed buildable land is fragmented among multiple departments, acting in successive sequence and with few time constraints and no sense of urgency. Municipal services having to give their approval for land develop- ment often prefer to prevent or slow down land development to avoid potential problems rather than to try to solve problems as rapidly as possible. They tend to see developers as mostly greedy creators of negative externalities, rather than as necessary intermediaries in the delivery of land and floor space to households and firms. Alain Bertaud 411 So, to increase the yearly flow of land put on the market, it is necessary to infuse municipal services with a sense of urgency. In rapidly developing cities, mayors should publicly fix a yearly target area for developed land delivered to users. To implement the land supply target, a municipal land manager should be in charge of following up the stream of land being transformed from developable to fully developed. This would include the preparatory infrastructure work completed by the municipality as well as the various regulatory approvals. The land manager should become the equivalent of a factory manager—fully responsible for the output of a factory. To my knowledge, no official fulfills this role in any city. In most cities, the numerous planning officials involved in the transformation of land have the power to slow down the process; none has the power to accelerate it. The absence of municipal accountability in the supply of urban land made available to the market contributes to the inelastic supply of land when prices increase, making land and eventually housing unaffordable for a large portion of the urban population. Only when the monitoring and delivery of developable land would become a normal municipal tasks will cities see a decrease in the share of the total population that have to rely on the informal sector to have access to land and housing. Notes 1. An economist would argue that the land price can qualify as high only when compared with something else, such as the price of construction or the median household income. But for most urban planners land price is always too high. 2. For Stockholm, see Cervero (1998); for Seoul, new towns see Lee and Ahn (2005). 3. In a polycentric city, all else equal, the maximum travel distance of a worker located in the periphery would have to equal the diameter of the built-up area (assumed to be a circle), rather than the radius, if jobs are concentrated in the center. Alternatively, speeds would have to double to cover the same area. 4. To my knowledge, only the government of South Africa taxes itself for the land it occupies (see Figure 14.2). 412 Converting Land into Affordable Housing Floor Space 5. The acquisition price for eminent domain is fixed at “jantri rates,” which are administrative land values fixed by the Gujarat state govern- ment for tax purposes. It is usually much below the market value, even with the 30 percent bonus usually added to it. Bibliography Angel, Shlomo. 2011. Making Room for a Planet of Cities. Washington, DC: Lincoln Institute. Annez, Patricia Clarke, Alain Bertaud, Marie-Agnes Bertaud, Bijal Bhatt, Chirayu Bhatt, Bimal Patel, and Vidyadhar Phatak. 2012. “Ahmedabad: More But Difficult Government for ‘Slum Free’ and Livable Cities.” Policy Research Working Paper 6267, World Bank, Washington, DC. Cervero, Robert. 1998. The Transit Metropolis: A Global Inquiry. Washington, DC: Island Press. Lee, Chang-Moo, and Kun-Hyuck Ahn. 2005. “Five New Towns in the Seoul Metropolitan Area and Their Attractions in Non-Working Trips: Implications on Self-Containment of New Towns.” Habitat International 29: 647–66. McKenzie, Brian, and Melanie Rapino. 2011. Commuting in the United States: 2009. American Community Survey Reports, U.S. Census Bureau, Suitland, MD. Organisation for Economic Co-operation and Development (OECD). 2011. OECD Territorial Reviews: The Gauteng City-Region, South Africa. Paris: OECD Publishing. Prud’homme, Rémy, and Chang-Woon Lee. 2009. Size, Sprawl, Speed and the Efficiency of Cities. Observatoire de l’Économie et des Institutions Locales, Grenoble, France. 15 Housing and Urbanization in Africa Unleashing a Formal Market Process Paul Collier and Anthony J. Venables* The accumulation of decent housing matters both because of the difference it makes to living standards and because of its centrality to economic development. The consequences for living standards are far-reaching. In addi- tion to directly conferring utility, decent housing improves health and enables children to do homework. It frees up women’s time and enables them to participate in the labor market (Franklin 2011). More subtly, a home and its environs affect identity and self-respect. Commentary on the emergence of an African middle class has become common, but it is being defined in terms of discretionary spending and potential for consumer markets. A politically more salient defini- tion of a middle class would be in terms of home ownership and the consequent stake in economic stability. The role of housing in economic development is perhaps not sufficiently recognized. Investment in housing is often regarded with * Thanks to Bob Buckley, Richard Manning, Steve Malpezzi, and participants in the World Bank conference on “Rethinking Cities” for helpful comments. 414 Housing and Urbanization in Africa disquiet due to its association with speculative property bubbles and financial instability. Yet in developed economies, housing is by far the most important tangible asset. For example, the total private wealth of households in Britain is $15 trillion, of which $5.5 trillion is property, overwhelmingly housing (ONS 2009). The aggregate process of national asset accumulation is thus fundamentally bound up with investment in housing. Not only is housing the single most important asset, it completely dominates an economically strategic asset class. Investment is con- ventionally disaggregated by agency and type. Agency distinguishes between private and public, the two generally being complements. Private investment is usually seen as particularly important for devel- opment because private agents are more likely to discipline their decisions. A further disaggregation of private agency is between firms and households, the two having different objectives and different access to finance. Housing is overwhelmingly a private, household investment. Investment by type disaggregates into equipment and structures, these also being complements. In low-income countries, this dis- tinction is particularly important because equipment is imported, whereas structures are internationally non-tradable and so must be produced domestically. Investment in structures thus has a counter- part in the output of the construction sector. And unlike equipment, it can be frustrated by failures in either domestic demand or domestic supply. Combining the two key analytic distinctions, housing dominates the category of private, household, non-tradable capital. Yet with regard to African investment, this massive and distinctive category has received far less analytic and empirical attention than either pub- lic investment or investment by firms. A further respect in which housing matters for economic devel- opment is through the labor market. Construction creates employ- ment, particularly because housing is typically more labor-intensive than other structures (such as public infrastructure and commercial property) and considerably more so than equipment, which in Africa is imported. As the major asset class and labor intensive to produce, investment in housing has the potential to make a sub- stantial contribution to aggregate labor demand. Even in high- Paul Collier and Anthony J. Venables 415 income countries, this is apparent during periodic housing booms. However, in low-income countries that are only partly through their urbanization process, housing has the potential for prolonged and substantial employment demand, as in the 19th-century miracle cities of Manchester, Chicago, and Melbourne. During the peak decades, their main activity was their own construction (Belich 2009). In addition to this direct effect, housing (together with transport services) determines the ease with which workers can access employ- ment and firms servicing local markets can reach consumers. In Africa, the process of formal investment in housing for ordinary urban households has yet to get under way. The typical household lives in a low-cost shack, likely to have been self-built. It will not comply with official building standards. Rights of occupancy, though probably robust, will be informal, and the building will have been self-financed. The shack will be located in a shantytown, which itself is informal: the local government will not have provided roads, electricity, street lighting, water, or sewerage. Housing provision in the 21st-century African city contrasts with 19th-century London and many other such cities (see Dyos 1968; Porter 1995). The fundamental conditions of migration and income were similar. Between 1800 and 1900, London grew from a population of 1–6 million, as peasants migrated to the city. Further, per capita income levels in 19th-century London were compa- rable to those in 21st-century urban Africa. Yet housing growth in 19th-century London, and indeed throughout Europe, remained largely formal. The new housing for the English peasants who migrated to London was built by small firms. Typically, the free- hold on the land would be owned by one of the great estates, which therefore had the incentive to plan the development process. This was inequitable, as the estates captured much of the value of land appreciation but had the advantage of creating incentives to invest in local public goods and services. The estates would install basic infrastructure—such as a road network on a tract of land—and then sell off leaseholds in smaller plots to building companies.1 A building company might build a row of houses, constructed using standard- ized architectural plans and labor-intensive techniques. Only around 20 percent of houses were owner-occupied, most occupants being tenants. Their landlords were usually not large corporations; instead, 416 Housing and Urbanization in Africa they were older people who invested their retirement savings in a few properties, living in one of them and renting out the others. This produced three desirable side effects. The housing was professionally built to standard designs and therefore easy to value. Its construction generated jobs, and there was mixed occupancy by tenants, owner- occupiers, and landlords, tending to produce both better mainte- nance of the housing stock and greater social cohesion. This chapter examines why such a process has not happened in Africa. Our hypothesis is that the peculiarity of housing exposes it to multiple points of vulnerability not found together either in private consumer goods or in other capital goods. Each point of vulnerability can be addressed by appropriate government policies, but addressing only one or two of them has little payoff if the oth- ers remain unresolved. Further, the vulnerabilities faced by housing are the responsibility of distinct branches of government, with little natural collaboration. Unblocking multiple impediments to housing therefore requires coordination that can come only from the head of government: ministries of housing have neither the political weight nor the analytic capacity to play this role effectively. Yet in Africa, housing has never received such high political priority. This in turn is because the centrality of housing in well-being and of housing invest- ment in development has not been sufficiently appreciated. In 19th-century London and the other cities in which adequate housing was built by an efficient market-led process, success rested on simultaneously resolving five potential vulnerabilities. First, for- mal housing was affordable. Building regulations were set at a level appropriate for the level of income rather than based on some elite notion of “desirable” accommodation. As a result, the building costs of adhering to formal standards were not pushed so high as to induce informality: they could actually be enforced. Second, there was clarity in legal rights. Leaseholders had enforceable title and could, in turn, use title as collateral because there was a functioning legal process of foreclosure. Landlords had clear rights to evict tenants for unpaid rent: indeed, tenant security was week-to-week. Third, formality and legality unleashed financial innovation. Banks have seldom been able to provide finance for non-elite housing: their administrative costs are too high. Instead, specialist housing finance organizations (building societies) emerged, pulling in deposits from lower-income Paul Collier and Anthony J. Venables 417 households and lending them to middle-income households with low risk, thanks to the sound collateral—and consequently at long maturities and low margins. Fourth, the benefits of housing infrastructure—roads, water, and sewerage—were internalized by a coordinating authority and were so provided in advance of housing construction. While efficient, this was achieved by the highly regres- sive mechanism of ownership of huge tracts of land by the great ducal estates. Finally, housing combined decent conditions for living with opportunities for income. Reconciling residence with opportunities depends on lenient zoning rules and effective transport connectivity to the rest of the city, which was provided by the underground and surface rail networks. These five vulnerabilities form the organizing framework for this chapter. We argue that, in conjunction, they have stifled the development of the formal private sector, particularly for low- and middle-income households. While it has become conventional to regard upgrading the existing stock and the flow of informal housing construction as the only practical solution to Africa’s housing needs, we explore the complementary approach of reestablishing formality. A well-functioning formal sector dominates informality by reaping the benefits of scale, continuity, and legality. Affordability of construction Affordability of construction is a prior condition to mass household investment in housing. Affordability can only be assessed relative to income and the share of budgets that ordinary households are willing to devote to housing. For example, in Dar es Salaam, the typical rental rate per room is around $10 a month, and in Dakar around $16. So, a modest four-room home (equivalent to the “two-up, two- down” of 19th-century Britain) would be affordable, albeit perhaps for multi-occupant use, in the repayment range of $500–800 a year. What this implies for a viable purchase cost depends on the real interest rate and terms of financing, but it is difficult to see such a repayment rate supporting a home costing more than around $15,000. This, of course, includes the price of land, which in Dar es Salaam on the informal market is currently around $5,000 for a plot of 300 square meters. Clearly, such a plot could support more than 418 Housing and Urbanization in Africa one small house, but given current land availability, land costs per house could not be reduced much below $2,000. The unit costs of house construction depend partly on building standards, partly on input costs, and partly on the organization of the construction industry. Building standards All cities need building standards: London has had them since the early Middle Ages (1216), when thatched roofs were banned due to the fire hazard.2 Because housing investment is to an extent putty clay, it is appropriate for standards to anticipate rising incomes. However, the most important characteristic to anticipate may well be the need for rising density. Flats, while initially more expensive to build than houses, become more cost-effective at higher densities. Thus, it may be more valuable to force an increase in the ratio of flats to houses than in the building standards of individual homes. When standards are set appropriately, they function as a form of “mental shorthand,” which reduces decision costs. However, in 1947 Britain suddenly and substantially raised its housing standards (the Parker-Morris standards) and implemented them through the Town and Country Planning Act. This was part of a much larger agenda of social reform introduced by the British government of 1945–50. Fortuitously, Britain shared in Europe’s “golden decades” of growth, with household incomes rising rapidly to levels at which the new standards were broadly appropriate. Unfortunately for Anglophone Africa, the British government promptly applied the 1947 Town and Country Planning Act in its colonies. Hence, on independence, African governments inherited building standards that were inappropriate for their level of income. This was not immediately apparent because in the early 1960s African cities were still small and occupied predominantly by well-paid gov- ernment officials and expatriates. Further, it would have been an act of extraordinary courage and insight for newly installed governments to lower standards. The new African political elite wanted to join modernity, not to dilute it. And so Africa was stuck with building regulations that, had they applied to 19th-century London, would probably have frustrated formal housing for ordinary households. Paul Collier and Anthony J. Venables 419 Regulations cover building standards, such as wall thickness, room size, and depth of foundations, and also the minimum plot size. For example, in Nairobi, the minimum legal plot size is one-sixteenth of an acre, unaffordable for ordinary households. These regulations were not only revised down but also inevitably conveyed the impression to African regulatory authorities that modernization would require that standards be raised from time to time. Were the standards of 1947 to be good enough indefinitely? Hence, for example, in Dar es Salaam the minimum plot size is 500 square meters, but the authori- ties are discussing whether to raise it to 700. In East Asia, authorities took a more independent view. For example, in the 1980s, Thailand reduced minimum housing standards.3 How out of line were the standards of the 1947 British Town and Country Planning Act with African incomes? They were ambitious in relation to British incomes as of 1947, and during the 1980s some aspects of them were seen as so excessive that they were revised down. In purchasing power parity terms, African per capita income is less than a twentieth of British incomes as of 1970 (a date by which the standards were probably reasonable). How long it will take Africa to raise per capita incomes 20-fold is not amenable to forecasting, but it is far longer than any reasonable horizon for the durability of basic housing. Perhaps a more reliable indication that regulations are excessive is that housing construction has bifurcated, with regulations being ignored in the informal market, which caters to ordinary households. Elite homes are individually designed and adhere to building stan- dards. Ordinary people live in informal housing, which does not adhere to costly building standards, and the design of which is in consequence idiosyncratic. An important consequence of informal- ity is that such housing is hard to price. It is non-standard, and key aspects of its quality, such as the depth of foundations, cannot be observed. In turn, being hard to value impedes the resale market and means that it would need to be heavily discounted before it could be used as collateral. There have been several attempts around Africa to use formal firms for low-cost housing. In Mozambique, the “low-cost” housing ended up so expensive that it became upper-income housing. In South Africa, housing costs were kept low, but this was achieved using land 420 Housing and Urbanization in Africa that was remote from centers of employment and therefore cheap. In Angola, the government resorted to Chinese firms to construct a new city. However, even with Chinese workers and methods, the homes ended up costing between $50,000 and $100,000 and so were beyond the reach of ordinary households. Yet the costs of decent housing need not be so high. In Mexico, where per capita incomes are much higher than in Africa, mass housing—typically around 800,000 units a year—has been provided by the private sector at a unit cost of around $35,000. A pilot project by Tanga Cement in Dar es Salaam, using modern techniques of pre-casting and four-story construction, suggests unit costs of around $15,000. Unit costs of inputs The key inputs into housing are land, material inputs, skilled and unskilled labor, and finance. In the absence of market imperfections, the cost of land should be determined predominantly by three fundamentals: its distance from the city center, the population of the city, and per capita income.4 However, African cities abound in market imperfections for urban land. We discuss land rights in a later section, but here we note that because very little urban land is fully marketable, markets are thin and prices are inflated. Further, in many countries there are few other inflation-protected domestic assets, so asset demand is disproportion- ately skewed towards urban land, some of it speculative. The wealthy elite are often from the political class rather than entrepreneurs—and so are not well placed to keep their wealth in self-owned enterprises. Stock markets are underdeveloped, and in any case weak corporate governance makes minority shareholdings in other enterprises risky. Further, the political class has a comparative advantage in land specu- lation because it is in a privileged position to anticipate economic development and the granting of planning permissions. Material inputs, such as cement, have been surprisingly expensive in Africa, typically around three times the world average price. This is due largely to dysfunctional ports that provide considerable natural protection, the uncompetitive organization of domestic production, and the hostile climate for domestic business activity. For example, Aliko Dangote, the richest individual in Africa, with a fortune Paul Collier and Anthony J. Venables 421 estimated at $11 billion, founded his business empire on cement imports to West Africa before going into domestic production (The Nigerian Voice 2011). In Mozambique, building sand is reported to be imported despite a 2,000-kilometer coastline. Whereas unskilled labor in Africa is abundant and fairly cheap, skilled construction labor is very scarce. This reflects decades of little investment in structures and a construction industry small relative to gross domestic product (GDP). A manifestation of this shortage is the importing of foreign skilled construction workers—for example, welders in Zambia and Chinese across the continent. The state has withdrawn from training skilled manual workers, and firms may limit training because of the historically volatile nature of demand. Finance for the sort of small firms that would build low-cost hous- ing for ordinary households has been expensive, to the extent that it has been available at all, because of wide spreads in the banking system. In turn, this has reflected an uncompetitive financial market, crowding out by government borrowing, and high risks of default.5 Industrial organization The organization of the construction industry is also bifurcated. Elite homes are constructed by foreign construction companies using capital-intensive techniques and imported materials. The firms that operate in Africa also operate in the Gulf States, and their unit costs are far beyond the budgets of ordinary African households. As an indication of the irrelevance of such firms to the housing needs of ordinary people, the largest housing construction firm in Ghana claims to have built around 3,500 houses over the past decade. By contrast, ordinary urban housing is largely self-built to ad hoc personal designs. This compounds idiosyncrasy and hence the difficulty of valuation. Largely missing are small but formal private building firms employing a mix of unskilled and skilled labor, able to raise formally the finance required to buy a plot and build houses on it, constructed to standardized, architect-prepared designs, and com- plying with building standards. It is unlikely that there are significant direct impediments to the emergence of such firms, so the most likely explanation for their scarcity is that the other problems discussed in this chapter limit demand for their services. 422 Housing and Urbanization in Africa What policies would help bring unit costs down? The starting point might be a realistic estimate of affordability generated from urban budget survey data. While the results would differ by city, they would reset norms, forcing difficult tradeoffs to the fore. A similar exercise could price the minimum cost of complying with current building standards. A discrepancy between these numbers would force policy discussion. The cost chain could then be benchmarked, component by component, on costs in low-income countries elsewhere in the world, again making differences apparent. Other approaches are to discuss with small, formal building firms the key impediments to lower costs and to undertake quantitative surveys of firms’ cost and productivity differences. Legal rights Legal rights affect the housing market in three respects: the owner- ship, security and marketability of land rights; the extent to which housing can function as collateral; and the rights of tenants relative to landlords. Land rights Urbanization creates value, and rising density increases productiv- ity. Because the effect is location-specific, much of the increase in value accrues to the owners of urban land. The growth of cities is a classic coordination phenomenon, and so the enhanced value is not readily attributable to the actions of any single agent. But coordina- tion, whether planned or spontaneous, is to a considerable extent the result of public action. Hence, there are reasonable ethical grounds for assigning the ownership of value addition to a city authority as the representative of the residents who have collectively generated it. This has been the strategy in Chinese urbanization that has enabled the finance of urban infrastructure. By contrast, as noted above, in Africa the ownership of prime urban land has often been appropri- ated by politicians on a speculative basis. This appropriation is recent, as rights of possession of rural land did not extend to marketability and were often further circumscribed by being partially under the authority of chiefs. In turn, the authority vested in chiefs reflected Paul Collier and Anthony J. Venables 423 their functions as leaders of their communities. This history rein- forces the ethical case for socializing much of the increase in urban land values. However, the most straightforward way to capture these land value gains would be not to reassign land ownership but to use the tax system. While African urban land rights have often been privatized, they have seldom been clarified. In some cities, such as Freetown in Sierra Leone, a history of dysfunctional registration has left land ownership radically unclear. The same piece of land may have several claimants, each supported by some sort of documentation. Clearly, the number of claimants to a plot is likely to increase in response to construction because ownership becomes more valuable. The rights to property constructed on the plot follow directly from the rights to the plot. Resolution of these disputes through the court system is neither reliable nor swift. Indeed, the legal basis for settlement is often still in dispute. For example, in Ghana lawyers have been attempting to resolve the rules of urban land rights for four decades. In other cities, de facto ownership is accepted, but the owner does not have legal title. These weaknesses in land rights make both land and the property constructed on it less marketable and make both less able to function as collateral. There is a tension here between the perspective of lawyers, whose aim is to resolve complexity by deducing the strongest claim to ownership, and that of economists, whose aim is to establish clear marketable rights as swiftly as possible. A possible resolution is to radically increase the taxation of value addition so that ownership becomes less important. From this base, it might be possible to follow an approach pioneered by the government of Uganda in 1992 to resolve the property claims of Asian Ugandans who had been expelled by Idi Amin. All claims to urban land and property were required to be registered by a set date, after which no further claims would be valid. Then, all cases of multiple claims were settled transparently at a later date by an ad hoc court. Property as collateral Clarity in plot rights, though necessary for property to function as collateral, is not sufficient. The function of collateral depends on the 424 Housing and Urbanization in Africa ability of a creditor to foreclose on the property in defined circum- stances of arrears. This, in turn, depends on the law and the reliability and speed with which courts implement it. The common experience has been for delays in court proceedings and judicial corruption to make foreclosure unreliable. However, reform is feasible. Ethiopia has recently introduced draconian legislation that is being enforced in its courts whereby creditors can foreclose after only a few months of mortgage arrears. Tenancy Tenancy is likely to be more affordable than ownership for most urban households, though there appears to be considerable variation among African cities. Purchase may well not be optimal for the median urban household, yet owner-occupation has usually been the policy goal. However, absentee landlordism is often dysfunctional. An ideal model might be for households above mean wealth—for example, those who have accumulated savings for retirement—to own a few houses in a settlement, living in one and renting out the rest. In many countries, tenant and landlord rights have been subject to long political cycles. When tenants are in a majority, governments are inclined to legislate in favor of rent controls and tenancy protection. As buy-to-rent investment becomes unviable, formal tenancy gradu- ally diminishes so that at some point the scarcity of such accommo- dation induces changes in the law. In much of urban Africa, there is a well-functioning formal rental market for expatriates, but that for ordinary households has largely informalized in response to gener- ous tenant protection. For example, in Nairobi tenants with rent of less than $60 a month have enhanced rights, and landlords cannot raise rents. A realistic approach to reforming tenancy law may be to grandfather in tenancy contracts but, for new tenancies, to allow landlords to write fixed term contracts and to repossess property for non-payment of rent. In sum, the confusing nature of urban land rights in Africa reflects the continent’s recent urbanization and the very slow and confusing evolution of rural land rights. In societies with few other assets and a long and recent attachment to the soil, land rights are inevitably politically sensitive. Governments have until recently Paul Collier and Anthony J. Venables 425 lacked legitimate authority to resolve them. This is widely perceived as an immovable impediment around which housing policy must navigate, rather than as a fixable problem. Financial innovation Housing finance is needed both for the short-term support of the construction phase and the long-term process of purchase. Banks normally provide the working capital for construction firms. In Africa, banks would probably regard lending to small, formal building firms for low-income housing as being too risky. This perception may, however, stem from some other underlying risk, such as the difficulty faced by ordinary households in financing house purchases. Were these other impediments to be addressed, the lack of working capital might resolve itself. To estimate the finance that would be needed for an ordinary household to buy a decent home, we make some assumptions about viable debt service and the cost of a house. Recall that based on typical rental rates in African cities, payments of interest and prin- ciple would be affordable to the occupants of informal housing at around $500–800 a year. Suppose that the unit cost of decent housing could be reduced to around $15,000. Then, a mortgage of around two-thirds of the cost of the house would be viable at an annual repayment rate of around 5–8 percent. What are the impedi- ments to such terms? In 19th-century Britain, urbanization triggered innovation in the mortgage market in the form of building societies. They were able to outperform banks because they had much lower administrative costs and much lower risks and so could work on narrower spreads. Their lower costs reflected their specialization in long-term, low-risk lending. The setup costs of a loan could be spread over many years, and default was limited by good collateral. Inflation was very low, so nominal interest rates could be low. As a result, the repayment of a loan was not artificially brought forward by the erosion in real terms of the principle. With low administrative costs and a substantial branch network, building societies were able to lend at repayment rates of within this range of 5–8 percent a year. They were also able to build a large deposit base from ordinary savers. While lending 426 Housing and Urbanization in Africa very long and borrowing short was potentially a recipe for a run on deposits, the conservative business model protected them from insolvency, and the central bank protected them from illiquidity. It was the banks, rather than the building societies, that faced runs on their deposits. Although some African cities have building societies, they cater to either high-end housing or to civil servants. Except in the Franc Zone, inflation is periodically fairly high, so that on conventional interest rate practices the principle is at times rapidly eroded. Such high and variable inflation makes 5–8 percent repayment rates completely unviable on conventional lending models. Typical terms on African “affordable” mortgages are an interest rate of 22 percent and a term of only 10 years. Thus, in the first year of the loan the repayment rate is around 25–30 percent of the amount borrowed. Unsurprisingly, such “affordable” mortgages only cater to a tiny income elite. Also unsurprisingly, defaults are typically concentrated in the first two years of the loan. A common policy response has been to place ceilings on inter- est rates or to offer subsidized public mortgages. For example, the Nigerian government has been providing mortgages at 6 percent at a time when the market interest rate is 18 percent. This kills the possibility of a private market and would be fiscally ruinous at scale. A more viable way of overcoming this impediment might be to index-link both the principle and the repayments. Such an innova- tion is not currently feasible because it would require indexes in which both borrowers and lenders could have confidence. To build such confidence, one might subject government-produced indices to regular and well-publicized independent verification by a respected authority, such as the International Monetary Fund. For example, an overall repayment rate of 8 percent would accommodate a real inter- est rate of 3 percent, a repayment of principle starting at 3 percent, and an administrative charge of 2 percent. This would be radically more affordable than current practice and would reduce the risk of early default. Of course, by shifting the structure of repayment into the future, indexation at some point increases the risk of default in later years. This can be guarded against both by setting a prudent loan-to-value level and by macroeconomic management that con- tains incipient housing bubbles. Paul Collier and Anthony J. Venables 427 Such mortgages would not impose high risks on lenders. Over the 20-year horizon appropriate for a mortgage, African wages should rise relative to prices so that repayments become increasingly afford- able. By both historical and current international standards, a real interest rate of around 3 percent would be a reasonable return on a loan that was both highly collateralized and affordable. While index- ation of mortgages is rare in Africa, it has been common in Ghana for 20 years and appears to have worked well. Currently, there is much discussion of how mortgages might be financed using innovations like securitization. However, the building societies of 19th-century Britain did not depend on such innovations. They were instead able to tap the small savings of ordinary house- holds. There is some evidence that African households have similar savings potential that has generally gone untapped. In the 1970s, there were some highly successful initiatives through post offices (Von Pischke 1975), but subsequent bouts of inflation wiped these savings out. Recently, with the advent of e-banking, the scope for mass savings has again been demonstrated: Kenya’s M-Pesa scheme is serving as both a savings vehicle and a payments mechanism. There is potential for building societies to use e-technology to harness this depositor base. Indexation not only makes mortgages more afford- able but also makes savings safer—and so is very popular with savers. By matching the indexation of their mortgage assets with the index- ation of their deposit liabilities, building societies could have a safer business model. For housing to function as low-risk collateral, building societ- ies need the conditions discussed in previous sections. Legal title has to be clear, and court processes have to be reliable. Further, systems whereby a lender can cheaply observe the credit history of the borrower, whether there are other liens on the property, and the actual occupancy of property (to establish whether it is tenanted) are needed. Housing must be affordable, of standard design, and built to enforced standards so that it can be accurately valued. Supporting infrastructure For housing to be decent, the property itself must be supported by complementary physical infrastructure and social services: roads, 428 Housing and Urbanization in Africa drainage, street lighting, electricity, water, and sewerage, together with policing, schools, waste disposal, and health care. While the capital costs of some of these services may be provided by property developers, ultimately supply is best undertaken pub- licly. This is partly because many of the services are network goods and so cannot be provided by each household individually and partly because even where they can be supplied by each individual household, as with sanitation, there are substantial externalities. At African levels of income, the private benefits from installing good sanitation in a house are generally insufficient to warrant the expense. The public benefits imply that provision must be either subsidized or enforced by compulsion. Cost-effective provision of physical infrastructure requires that it be installed in advance of housing construction and then serviced. If infrastructure is retrofitted, the costs may be prohibitive. For example, the prolonged civil war in Sierra Leone induced massive population growth in Freetown, while at the same time precluding public investment in even the most basic urban infrastructure. As a result, there is now a striking lack of roads. Since squatter-style settlements have occupied the land on which roads might have been built, even the legal processes required for clearance before road construction are beyond current government administrative and political capacities. These characteristics highlight the need to internalize local exter- nalities, to finance long-lasting investment, and to plan ahead. The three problems are interdependent. Without planning, population growth will still occur, but settlements will be informal, so it will be more difficult to build a tax base that internalizes externalities. Unless externalities are internalized, neither services nor infrastructure investment can be financed. Without credible prospects of finance, there is little point in planning for services and infrastructure that anticipate urbanization. Localized externalities of infrastructure can be captured and thereby internalized, either through ownership of the land itself (as in modern China and the estates of 19th-century London) or through a local tax system. Where it is politically feasible, ownership is admin- istratively less cumbersome and avoids distorting side-effects, but Paul Collier and Anthony J. Venables 429 taxation is the more common approach. Urban planning is standard around the world. The starting point is realistic forecasts of urban population growth to provide estimates of demand for housing, schooling, and health care. On this base, planners need to integrate a view of likely local economic developments, including growth of manufacturing locations and city center service activities. From this demographic and economic information, the key decisions on new residential locations and their supporting infrastructure follow. African governments have underinvested in both internalization and urban planning. As noted above, Africa has not adopted the Chinese model of government ownership of urban land, so that the imperative is to achieve internalization by building local tax systems. With few exceptions, notably recent developments in Lagos, African city administrations have not generated significant tax revenue. As a result, they have little political interest in local economic growth, and infrastructure needs are unaffordable. This in turn rebounds on urban planning: without finance, otherwise sensible plans become idle dreams. Underlying the neglect of internalization and urban planning is a deeper explanation: African governments have resisted urbaniza- tion rather than embrace it. For example, the government of Liberia has adopted a deliberate policy of refraining from infrastructure investment in the recent settlement areas of Monrovia, as part of a strategy of inducing urban residents to return to the countryside. Underpinning this official resistance to urbanization is a political fear of organized urban protest. Africa’s demographics imply that rapid urbanization would create cities populated overwhelmingly by young adults. The failure of African cities to generate sufficient opportuni- ties for formal wage employment makes them potentially dangerous concentrations of disaffected youth. Coincident with these political fears of policy makers, donor agencies have emphasized rural devel- opment as a priority for public spending. This bias stems from the simplistic mantra that because the majority of poor people live in rural areas, they should be the focus of public spending, and from a deeper prejudice among non-governmental organizations (the key political constituency for development agencies) against urban-based economic growth. 430 Housing and Urbanization in Africa Opportunities for income It is not sufficient for housing to be of decent quality and to be prop- erly serviced by public goods; housing must also enable households to generate a viable income. At a minimum, new settlements must be compatible with employment opportunities elsewhere in the city. However, viable settlements should aspire to more than com- patibility with exogenously generated employment opportunities. Well-planned settlements can create employment in the provision of local services and workshops, enabling most members of the resident labor force to find employment within the locality. Hence, planning for households to generate viable incomes involves both compatibil- ity with exogenous employment opportunities and the generation of endogenous local opportunities. Compatibility with exogenous opportunities involves physical access to places of work, the accumulation of pertinent characteris- tics for employability, and information about opportunities in other parts of the city. Physical access is the most straightforward aspect to plan. It requires that the location of settlements and transport infrastructure permit commuting. This raises the initial cost of settle- ments because it implies some combination of sites that are closer to the city center and therefore have higher land prices and because it implies more investment in transport infrastructure. The accumu- lation of pertinent characteristics for employability is more subtle but may also be important. The most obvious attributes are the hard skills acquired through education and occupational training, both of which can be directly planned and provided. The more nebulous attributes come from the community attitudes and norms that form in the settlement. For example, once unemployment becomes the norm for young people, it will affect aspirations accordingly. Such hysteresis effects are well-established—in both attitudes to work and parental attitudes to education. These effects suggest that there may be a premium on getting the early stages of new settlement right. In a new, large settlement, the generation of endogenous opportunities for employment is likely to be more important than compatibility with exogenous opportunities. Employment is most often devoted to serving local markets. The fundamental aspects of endogenous opportunities are density and regulation. The higher Paul Collier and Anthony J. Venables 431 the density of settlement, the greater the economic opportunities per square mile. In typical low-income cities, this creates a tradeoff between the economics of housing-as-accommodation and housing- as-opportunity. The least expensive form of residence is single-story, because greater height requires more substantial walls and more sophisticated building. But the greatest opportunity per square mile is through proximately spaced tower blocks. The market does not handle this tradeoff well. The economic opportunity–generating aspect of increased density is an externality, whereas the increased costs of construction necessary for higher density are fully internalized by the household. As a consequence, building heights and density will be too low in an unregulated market. Density will increase as settlement proceeds because land values will increase. But the putty-clay nature of residential investment inhibits what would otherwise be a gradual market-driven increase in height. Clearly, the informal settlements of African cities have not yet induced investment in height. As a result, the floor-area ratio of persons per hectare in the typical African city is essentially flat over the spectrum of distance from the city center, whereas the normal global pattern is for it to fall steeply as distance increases. The floor-area ratio is substantially too low in areas close to the center.6 This may be because of the other impediments discussed above, such as finance or the lack of secure title, but it may also be due to a coordination failure inherent in a market-driven process. At low per capita incomes, low-rise residence may remain privately optimal, because it never achieves a density that justifies writing off the fixed costs of a low-rise and replacing it with a high-rise. Saunders (2010) suggests that from the social perspective, in which the economic opportunity externalities of density are internal- ized, the most appropriate choice along this tradeoff is blocks of five- story buildings in which the ground floor is used for small businesses. Five stories is the maximum height before the need for a lift, which involves a quantum increase in costs. While this hypothesis is plau- sible, it has not yet been researched. If it is correct, it would indicate a substantial market failure in African cities, because structures in informal settlements are generally only single-story. Inappropriate regulation can destroy the potential of high density, as in many high-rise estates of the developed world that are zoned for purely residential uses. While inappropriate regulation will constrain 432 Housing and Urbanization in Africa employment generation, a city government can do much to promote it. The market process is replete with local coordination failures and externalities that astute official intervention can help offset. Local marketplaces are themselves public goods. The weights, measures, and hygiene practices adopted by local businesses benefit from public standardization and verification. Local dispute settlement procedures can reinforce contracts and reduce opportunism. And formalization and certification of apprenticeships can enhance skill formation. The potential for damage and benefit inherent in public regulatory policy at the city level mirrors the standard debate about national industrial policies: a passive state is better than a predatory state but worse than an astute developmental state. At the national level, the conventional critique of the African regulatory policies adopted for much of the post-independence era has been that they tended to be predatory, in contrast with the developmental states of East Asia. The same critique might apply to urban regulatory policies. Just as Africa inherited inappropriately high building regulations, it might have suffered a similar fate with zoning restrictions. However, the informal settlements that have been the predominant process of post-independence urban residential growth are usually beyond the confines of the colonial city and seldom subject to effective zoning. The key impact of urban regulatory policy toward settlement has been to make it informal. From failures of market coordination to failures of policy coordination African housing investment has been affected, directly and indirectly, by public policies that have prevented the formal sector from provid- ing housing that meets the needs of ordinary households. However, these policies have not been enforced beyond the remit of the formal sector. So, if informality were efficient, urban Africans would be well housed. Informal builders would build decent homes cheaply, infor- mal finance would finance them cheaply, informal dispute settlement procedures would restrain opportunism, community processes would coordinate to provide the public goods of settlement, and the mar- ket would internalize the value of rising density. Yet ordinary urban households are not well housed: the typical living quality provided Paul Collier and Anthony J. Venables 433 by informal housing is pitiful and fails to provide the resident labor force with sufficient proximate opportunities for decent incomes. Our message to Africa’s urban policy makers is not the need for deregulation but the need for policy coordination. Housing invest- ment on a large scale through formal channels requires a series of supporting conditions. Unit construction costs in the formal sector must be low enough to be affordable by ordinary urban households. Legal title must be secure, be marketable, and support collateral and rental. Finance must be available and affordable for both small con- struction firms and mortgages. Infrastructure must be planned and provided in advance of settlement. Residential services must come swiftly after settlement. Both must be financed by capturing a share of the value added to productivity by density. The location of settle- ment, transport infrastructure, and public regulation must support income opportunities, and each is not merely vulnerable to inept policies but in need of appropriate policies. Not all impediments are important in all African cities. For exam- ple, in Nairobi the constraints make the ownership of a property unaffordable for ordinary households, even in an informal settlement, In Dakar, most households own such property but find it difficult to rent. We suggest that the persistence of multiple impediments is because the payoff to policy reform in any one of these areas in isolation is very limited, given that the others remain and will in aggregate be binding. Since each is the responsibility of a different group of policy makers, the rational strategy for each policy team is inaction. The potential for urban housing can be unleashed only by a coordinated push across a wide range of policy teams. This in turn requires that housing policy be elevated to the highest political level. This has not yet occurred, partly because of the bias against promoting urbaniza- tion and partly because, as the informal nature of settlement became established, formal policies became impotent and hence irrelevant. Within African governments, ministries of housing largely restrict their focus to the provision of housing to senior civil servants and to the maintenance of inherited formal regulatory standards, which conform to international practice. Meanwhile, among international thinking on African housing policy, the prevailing view has become that the priority is to help informal housing work better and to 434 Housing and Urbanization in Africa upgrade infrastructure rather than to make formal housing invest- ment work for ordinary households. While this is probably correct given the confines of current policy discussion, such an approach accepts the lack of formal market housing and the absence of coordi- nation rather than confronting them.7 Yet the political elevation of housing necessary for coordination is no longer a forlorn goal. The post-apartheid government of South Africa made decent housing a priority for its discretionary spending. With revenues from the commodity booms, other African govern- ments at last also have some discretionary income. Coincident with these revenues, the Arab Spring in North Africa has focused concern south of the Sahara on the well-being of their urban populations and in particular on the need to provide jobs for young men. Affordable housing built on a large scale using labor-intensive techniques by small private construction firms is one of the few credible approaches to a rapid expansion in jobs for this social group. Hence, housing policy might now be able to achieve a political salience that has previ- ously been infeasible. Notes 1. This secured a supply of local public goods, but citywide public goods, such as a complete sewerage system, were supplied only after the health scares of the mid-19th century and the development of effective city government—first with special purpose authorities and starting in 1889 with the London City Council. 2. Regulations were formalized in the London Building Act of 1667, which specified building materials and the width of streets. Surveyors were appointed to enforce the regulations (www.buildinghistory.org/ regulations.shtml). 3. Personal communication from Maya Hoek-Smit. 4. Bertaud and Malpezzi (2003) present comparative work on urban density in 38 cities. Urban density gradients are prevalent in world cities but not in the two African cities in the sample, Cape Town and Johannesburg. We know of no systematic cross-country work on rent gradients. 5. British building societies, which came to provide mortgage finance, started as societies of builders who pooled working capital. 6. Personal communication from Steve Malpezzi. Paul Collier and Anthony J. Venables 435 7. Further, the enhanced infrastructure benefits landlords who are largely absentees. For example, connection to electricity raises the rent per room in informal settlements 27 percent in Nairobi and 44 percent in Dakar (Gulyani et al. 2012). Bibliography Belich, James. 2009. Replenishing the Earth: The Settler Revolution and the Rise of the Anglo-World, 1783–1939. New York: Oxford University Press. Bertaud, Alain, and Stephen Malpezzi. 2003. “The Spatial Distribution of Population in 48 World Cities: Implications for Transition Economies.” ECA Region Working Paper, World Bank, Washington, DC. http://rsrcs. elretoincae.com/webinars/1201/Bertaud%20and%20Malpezzi%20 Density%2050%20World%20Cities.pdf. Buckley, Robert M., and Jerry Kalarickal. 2005. “Housing Policy in Developing Countries: Conjectures and Refutations.” World Bank Research Observer 20 (2): 233–57. Dyos, Harold James. 1968. “The Speculative Builders and Developers of Victorian London.” Victorian Studies 11: 641–90. Franklin, Simon. 2011. Enabled to Work? The Impact of Housing Subsidies on Slum Dwellers in South Africa. Unpublished manuscript. Gulyani, Sumila, Ellen Bassett, and Debabrata Talukdar. 2012. “Living Conditions, Rents and Their Determinants in the Slums of Nairobi and Dakar.” Land Economics 88 (2): 251–74. Malpezzi, Stephen. 2006. “Cross-Country Patterns of Urban Development.” In A Companion to Urban Economics, edited by R.J. Arnott and D.P. McMillen. Hoboken, NJ: Blackwell. Malpezzi, Stephen, and Jarjisu Sa-Aadu. 1996. “What Have African Housing Policies Wrought?” Real Estate Economics 24 (2): 133–60. Olsen, Donald J. 1976. The Growth of Victorian London. London: B.T. Batsford. Office of National Statistics (ONS). 2009. Wealth in Great Britain: Main Results from the Wealth and Assets Survey 2006/08. London: HMSO. Porter, Roy. 1995. London: A Social History. Cambridge, MA: Harvard University Press. Saunders, Doug. 2010. Arrival City: How the Largest Migration in History Is Reshaping Our World. London: Heinemann. The Nigerian Voice. 2011. “Dangote is Africa’s Richest Man.” March 11. Von Pischke, J.D. 1975. A Penny Saved: Kenya’s Cooperative Saving Scheme and Some Related Aspects of Rural Finance. Institute for Development Studies, University of Nairobi. Index Abramowitz, Moses, 151 agglomeration economies, xix–xx, accommodation of migrants, 237 xxii–xxiii, xli, 51, 53, 93, 117, advanced economic sectors, 211–12 183, 185, 187, 199–200, 290 advanced economies of the west, 27 agricultural productivity, xlii affordable housing, xxxv–xxxvi, Ahmedabad, 394–6 404–7, 417–22; see also housing floor-area ratio in, 402 construction of: greenfield development in, 382 building standards for, land allocation for extension 418–20 over 2000–10, 397–402 industrial organization land supply, 393, 396 construction, bifurcation sale of FAR bonuses, 322 of, 421–2 slum layout, 406 unit costs of output, 420–1 air pollution, 311, 316, 320 developable urban land, supply Amazon, xxv, 136 of, 383–96 amenity(ies), xxxii, 80, 89–90, 96, traditional method of evaluation 98–9, 102–109, 384–6, 392 of, 404–7 provided by city, 93 urban land, supply mechanism public, 255 for, 381–3 urban policies in China and urban planners role to deliver Mexico, 110–11 buildable land to markets, urban, 383 410–11 American Research and African housing investment: Development, 154–5 failure of market and policy Angel, Shlomo, 1–2, 13 coordination, 432–3 Annual Survey of Industries, 185 438 Index anti-immigrant sentiment in car cities, rise of, 315–21 Europe, 227 differentiated registration tax, area-level entrepreneurship, xxv 317 Arnott, Richard, 349 electric and hybrid vehicles, Asian Development Bank, 32 320–1 fuel-inefficient vehicles, 317 backward locations, 96 time-of-day pricing, 318 Bangalore Cluster, xxv traffic congestion and pollution, Bethune House Migrant Women’s 318 Refuge, 217 vehicle ownership, 317 Bhalla, Surjit, 32 vehicle-registration tax, 317 big city(ies), xli, 51, 60 Western European tax, 317 bias, 52, 69–76 casual jobs, 176 Biharis rural migrants, 236 Central Statistical Organization, BioValley complex, Malaysia, 156 185 Boeke, Julius H., 175 Cervero, Robert, 389–90 bond financing, 298 charter schools, United States, xxiv, Brazil, 20, 31, 40, 42, 75 xxvii high-income households, 34 Chicago Skyway, 298–9 subsidized agricultural lending Childcare for factory workers, programs, 71 Bangladesh, 219 British building societies, 434n5 China, 28 Brown, Gordon, 11 city-size distribution, 91 business(es): comparison with United cycle policies, 96 States, 100–6 in large cities, 20 demand for municipal water, 36 Canadian labor fund program, extension of social services to 163 migrants, 41 CAPCO program, 166 global investors in, 160 capital, 159 high-income households in, 34 need for growing cities in internal migration restrictions, emerging markets, 35–7 xxviii, 94 venture, see venture capital intracity transport investment capitalist: in, 67 agriculture, 176 metropolitan areas contribution mode of production, 181 to GDP in 2010, 26 carbon: national controversy in 2012, emissions, 317, 327 236 footprint, 310, 320 population share in towns and tax, 317 cities, 25–6 Index 439 railways role in production mayors, 202, 205 decentralization, 68 national and regional cross- rate of return to capital in, 71 fertilization of ideas, 61 urbanization in, 36, 80: in national system, xli–xlii pace of, 27 need to reduce labor market policy on, 74, 92; rigidities, 201 variables and sources for data new, see new cities collection, 94–5 and political subjectivity, 222–5 churning, 60–1 and the power of networks, citations, 130–1 41–3 city(ies), xv, 90, 203–4, 211, 215, productivity advantage of, 403 19–23 areas for future research, xlii–xlv shifting economic balance as a benefits from conditions, 210 challenge for, 37–8 challenges confronting, 229 -size distributions, 52, 80–2, 90 competition for people and sizes, 52, 76–80 investment, 16, 40–1 City 600, 29 criteria for economically City, The (Max Weber), 222 successful, 117–23 climate change, xxxvi–xxxvii, 226, in developing countries, see 229, 310–11 developing countries, cities in urban adaptation to, 324–9 economic efficiency of, 396 environmental performance, as engines of growth, 53–7 324 essentials for timely formation moral hazard, 328 and expansion of, 78–9 mortality risks and, 326 existing, see existing cities negative effects on economic framework for system of, 92–6 growth, 324 as frontier spaces, 225–8 policy suggestions on, 325–7 global GDP of developing and pro–economic growth, emerging, 29–31 328–9 governance: rise of “fat tail” event, 327–8 formality and informality, climate; see also climate change 247–6 -proof cities, 328 recognition and belonging, proofing, 328 246–7 coal-fired power plants, 320 rights and rational city, college-educated: 244–5; couples, 126 in growing emerging markets, residents, 121 35–7 workers in United States, 118, as home to 1 billion new 121, 128 consumers, 31–5 college graduates, 118–22, 128 440 Index commercial and residential space: 123, 150, 270, 277, 347, 353, demand for, 265 368 Common Basic Principles on cities in, 62 Integration, EU Council, 244 great-growing cities of, xxvi communications capabilities, 287 link between urbanization and commuting trip travel time, income growth, 83 Gauteng, 385, 389 market formation of new cities congestion charging, xxxvii–xxxviii issue in, 77 consumer city(ies), 57–8, 322 task of city leaders in, 38 consumer/consuming class(es): transport investments role in, see definition of, 32 transport investments role in demand for deposit services, developing countries 34–5 urban and big-city bias in, 52, demand growth for products, 69 34 Dharavi slum, Mumbai, 214 households income in, 33 diasporic network, 246 size of, 32 digitization, 223–5 tastes of, 35 direct housing production: container port capacity, 269–70 programs of, 337 demand for, 265 division of labor, xxi, 220 container traffic, global, 270 door-to-door speed of public contract renegotiations, 299–300 transport, 392 corporate services sector, 214 dual economy, 175 cost of living in cities, xxxi, 122, dualism: 142 between activities under colonial country-wide shocks: spatial impact law jurisdiction, 175 of, 92, 113 between capitalist and traditional mode of debt crisis, 262 production, 175 deindustrialization, xx, 60, 62, 83, between modern/capitalist 250 sector and traditional sector, democratized states: urban 175 concentration in, 72–4 traditional literature on, 181 deregulation, xliv, 199, 201, 205, dualistic development model, 175 357, 433 De Soto, Hernando, 340, 342, 344 economic globalization, 223 destitution, 211 economic growth, xvii–xix, xxiii, developed world, xvi, xxi, xxxiii, xliv, 10, 18, 24, 53, 71, 126–9, xxxvi, xliii, 151, 218–19, 431 150–1; see also urbanization developing countries/cities/world, educated countries, 127 xx, xvi–xvii, 2, 12, 24, 57, 60, educated workers, xxiv, 132, 193 Index 441 education systems, xxii–xxiv, activity(ies): xxvii–xxviii, 53, 127–8, 157, hubs of, 149 241, 245, 315, 329, 430 less-consistent approaches differences in, 118 for, 166–8 economic disparities between research and case study cities impact on, 121 findings, 159–66 emphasis on: dimensions, strategies and limitations of 165–6 government to encourage, efficiency of cities, 93–4 156–9 electric and hybrid vehicles, 320–1 entrepreneurial innovation: electricity: importance of, 150–4 consumption of, 326 entrepreneurs, xxiv–xxvi, xxix, 1, demand management program 62, 76, 150, 154–6 (California), 277 demand of local, 166 generation of, 320, 327 dependence on partners, 159 -intensive industries, 311 urban, see urban entrepreneurs for mitigating future climate entrepreneurship, xxii, xxiv, 150, change, 326 189–92, 202–3 peak-time pricing, 326 action of group impact on, 155 sources of, 320 area-level, see area-level electronic road pricing, Singapore, entrepreneurship xxxvii definition of, 155 Emerging 440 cities/group, 29–34, and innovation: relationship 45n9, 265, 271 between, 152 emerging cities, 33, 35 promotion of public schemes by emerging economies, 29–31, participants, 158 112–13 environmental issues: alternative demand/need for infrastructure approaches to, xxvii–xxxviii in, 263–4 European Union, 92, 117, 244 emerging markets, 20, 35–7 excessive frictions: concept of, 93 eminent domain, 13 existing cities: employment, xxi, xxv–xxvi, xxx, locals long wait for political xliv, 25, 62 consensus, 4 in manufacturing sector, 184–5 switching costs in, 4 enabling markets to work: concept of, 337 “fat tail” events: rise of, 327–8 energy efficiency, 36, 277 favored cities, 72–3 in buildings, 272, 322–3 favoritism, 52, 71–2, 75 entrepreneurial: Federal Acquisition Regulation firms, 150, 153, 159, 168 (FAR), 366 markets, 155 Federalism, 72 442 Index Female Youth Employment formal sectors, xxix, xliv, 178, 185, Initiative, Afghanistan, 218 196, 199–201, 204–5, 314, financing environmentally sound 369–70, 382, 417, 432–3 infrastructure: challenges of, deurbanization of, 187 xxxvi–xxxvii housing, 75, 359 firms, xx, xxiii, xl, 59–60 probability of employment in advantage of cities for, 124 urban sector, 181 churning among, 61 wage, 182 driven away from cities, 65 fossil fuel consumption, 316 in economic sectors, 214 fragmented governance structure in informal, see informal firms cities, 39 within large cluster, 127 fuel economy, 316–17 low success rate in China for fuel-inefficient vehicles, 317 start-up, 4 private, see private firms gasoline, 316–17, 320 small service, xxx genderless urban planning in floor-area ratios (FARs), xxxi, 65, societies, 215 322, 362, 369, 400, 402–4, geographical distance, 131 406, 409, 431 geographic information system floor space, demand for, 266–8 (GIS), 287, 408 FOGARIM program: for housing geographic scale jumping, finance, 360 251–2; see also urban food security program in Belo migration Horizonte, 42, 47n22 global financial crisis (2008–09), forced migrations, 236, 250 149, 236, 298 foreign buyers spent on property, global north cities, 236, 240–1, central London, 258n1 245, 254–5 foreign domestic worker (FDW) global pollution, 311 rights, Hong Kong SAR and global population, 2 China, 217 global south cities, 212–13, 245, foreign firms, 3 247, 251, 253, 256 formal firms, 204–5, 419 good city, 234, 247 formality, concept of, 174–8, Google Earth, 325 247–6 “go on green” rule in small town, 15 measurement and trends, governance, xl, 11–12, 38–9, 90, 178–80 96, 104, 223, 258, 262, 264, urbanization and transition to, 281–3, 289, 307, 315 180–93 city, see city governance formalization, 173, 180, 200, corporate, 420 203–5; see also urbanization rural, 74 policy implications on, 193–201 urban, 184, 200–1, 203 Index 443 greenhouse gas emissions, 310, tall buildings, 322 316–17 urban pollution, 321 gross domestic product (GDP), 3, housing, xvii–xviii, xxvii, 10, 46n16, 261, 359 xxx–xxxiii, 407; see also in MDRs vs LDRs, 11 affordable housing U.S. population contribution in assets, value of, 340–1 2010 to, 23–5 African housing investment: failure of market and policy Harris-Todaro model, 176, 181–2, coordination, see African 193, 195 housing investment: failure Hart, Keith, 177 of market and policy health care, 140, 168, 237, 240–1, coordination 310, 328–9, 428–9 19th-century London, higher education attainment in vulnerabilities in 416–17 India, 19 finance, 359–61, 425–7 hinterland city/regions, 58, 62, 64, development, 341 68 FOGARIM program, see home bias, 130 FOGARIM program: for homeland network, 246 housing finance homelessness, 211, 249, 341 in Thailand, 359 homeownership, land and finance formal investment in Africa, for, 350 415 household sector, 321–4; see also incomes, 33, 361, 381, 394, urban housing 396, 404, 408, 410, 418 air and water pollution, 321 investment in, 413–14 consumption, 45n12 legal right effect on market: in developed economies, 414 affordable tenancy, 424–5 housing policies, 322 land rights, 422–3 low-quality informal housing, property as collateral, 423–4 323 low-income, see low-income market-oriented, 341 housing performance of, 338–9 opportunities for income, price of water and electricity, 430–2 326 policy, determination of, property rights, 339–45 407–10 rural-to-urban migration, provision in 21st-century impact of, 322 African cities, 415 sanitation and waste disposals, reform of, 350 321 rental, see rental housing standard of living, 322 self-help, see self-help housing suburbanization of, 321 standards, 409 444 Index supported by physical disclosing information on, infrastructure and social 314–15 services, 427–8 policy tools for reducing, 312 urban, see urban housing right to pollute, 313 hukou household registration Toxic Release Inventory dataset, system, China, 44n6, 74, 91, 314 103, 113, 242–3 trading pollution permits, 313–14 identity politics of new migrations, Union Carbide chemical disaster 246 (1984), Bhopal, 314 immigrants, 74, 213–14, 224, 226, vertical supply curve, 313 229, 261 industrialization, xlii, 27, 31, 51–2, European integration, 226 54, 62, 83, 174 women, 216: in New York city, drives development, 53 221 industrial mix, xxviii–xxix workers, 228 Industrial Revolution, 271 immigration, 217, 226–8 inequality in urban life, xxvi income(s), xxvii, xxxv, 27, 45n11, informal economy, xxix–xxx, 56, 73, 94–5, 104, 195–6, 202, 177–8, 195, 198, 202, 212 210–13, 253, 266–8, 291, 307, informal enterprises, xliv, 177, 184, 321, 325, 337, 345 200, 203, 205, 214 disparities in, 117 informal firms, xxix, 196, 204–5, in emerging cities, 33 xxix Emerging 440 population, 32–3 informality, concept of, 174–8, growth, 266–8 205, 247–6 hinterland, 70 agenda for city mayors to informal, 177 address challenges of, 201–3 low-and middle-income concern in policy circles, countries, 144, 338 194–8 rural and urban, 181–2 measurement and trends, and urbanization levels, 55 178–80 India Factories Act of 1948, 184 policy perspective on, 198–201 individual firms, 74, 76, 311 trends in, 203–5 industrial city(ies) 213, 223, 235, informal sector(s), xliv, 174, 176–7, 240–1, 311 180, 199–200, 204 industrial clusters, 124, 126–7, association with high poverty 133, 136 rates, 194 industrial decentralization in India, contain smaller experimental 65–7 firms, 67 industrial emissions: in Indian cities, xxix “command and control” less-advantaged workers benefit regulation, 312 from employment in, xxx Index 445 workers in developing countries, internal cross-border labor 178 migration, 227 informal settlements, 13, 238, International Institute for the 336, 342, 363, 379, 432–3, Environment and Development, 435n7 251–2 of African cities, 431 international investors, 157 ambiguities and conflicts over International Labour Organization property rights, 340 (ILO), 177 Brazilian cities attempt to intra-European migration, 228 decontrol in 1980s, 370 investments, 139, 144, 154, 163, challenges of, 247, 323 165–8, 261, 281–2, 287–9, decontrol influence on rental 297, 341–2, 362–3 in, 351 in capitalist sector, 181 difficulty in relocate, 325 competition for, 40–1 in Kenya, 343 in drainage systems, 328 in Latin America, 344, 347 equity-linked, 153 informal urbanisms, cities of, 253 foreign, 117 information technology networks, by government: 269, 284, 287 in sea walls, 328 infrastructure, xviii, xxii–xxiii, in transportation xxix–xxxi, xxxiii, xl, 23, 25, infrastructure, 318 27, 35, 38, 92, 100, 203, 205, growing cities in emerging 211–13, 215, 219, 221–2, markets need, 35–7 228 need for growing cities in building of right, xxxviii–xxxix emerging markets, 35–7 payment for, xxxix physical capital, 262, 264 sanitation, see sanitation private, see private investment sewage, see sewage; wastewater public, see public investment treatment systems savings in, 284 transport, 57, 65–6, 68–9; subway, 318 see also transportation in sustainable cities, 310 infrastructure transport, see transport urban, 39, 78, 90, 103, 105, investments 242, 248 urban infrastructure, 269 water, see water supply water supply, 270 innovative firms, 132 invisible hand, 3 integration framework indicators, Irish Industrial Development 245 Agency, 41 Inter-American Development Bank, 355 Jacobs, Jane, xxii, xxxv intercity transport investment, 68 jantri rates, 412n5 446 Index Japan: supply, 109 electronics firms, 59 thick labor markets, see thick “lost decade”, 263 labor markets post-war economic renaissance, -to-land ratios, 53 27–8 urban labor markets, see urban jobs, xxxii, xxxiv, xxii–xxiii, xxviii– labor markets xxix, 40, 89, 121, 124–7, 129, land transformation into floor 132, 134–6, 138–9 space, 403–4 casual, see casual jobs land use, xxxiii–xxxv, 13, 322, 355, creation, xviii, 162: 362, 363, 384, 397, 407 formal manufacturing, change of, 402 189–92 controls, xxvii informal manufacturing, densification, 257 190 GIS technology to map existing, in informal sector concentrated 408 in developing countries, legacies, 256 179 planning, xxxv, 365 innovative, 133 policies and plans, 380–1 local, 139–41 regulations/rules, 142, 184, 364, manufacturing, 143 370, 403, 408, 410: urban, xxviii, xxxiv impact of 368; Juntos program, Peru, 220 regulatory reforms in, 338 standards, 249, 410 Kharas, Homi, 32 large/larger cities, 20, 26, 41, 96, Knowledge: 112 economy, 212 creating innovations, 152–3 spillovers, xxiii–xxiv, 65, 117, in emerging economies, growth 123, 127–33, 138, 140 of, 385 evolving role of, 62–5 labor, 14, 25–6, 41, 53, 68 firms in, 60 -intensive industries, 311 functional specialization, 60 Lewis perspective on, 175–6 land use of, 380 markets, 79, 93, 118, 121, role in economy, 23–4 124–5, 387 Late Middle Age cities, 223 benefits of migration, 237 Latin America, 31 integration, 384 GDP in 2007, 29 migrant, see migrant labor incidence of renters by income, productivity, 121, 123: 346 in unorganized industry, informal settlements in, see 196–7; informal settlements in Latin -receiving country, 227 America Index 447 maturity of urbanization in, 25 market: middleweight cities in, 40 failures, xvii, 71, 145, 352, 365, lead emissions, 320 431 lean manufacturing system, 279 formation of cities, 77–9 less-advantaged workers, xxix–xxx rental, see rental market less developed regions (LDRs), size, 124–5, 193, 349 6–12 marriage market, 125 less-skilled workers, xxviii mass urbanization, 27–37 life expectancy in low and middle mature economies, 37 income countries, 7, 10 megacities, 20, 43n3, 44n9, 90, 96; “livable” cities, xvii–xviii, xxx, 410 see also cities location of formality in India, metropolitan areas, xxv, xxvi, 21, 184–93 23–4, 26, 39, 43n3, 59–60, 64, London Building Act of 1667, 80, 94, 118 434n2 average income of Indian, 121 “low-carbon” cities, 310, 322, 326 college graduates percentage in low-income housing: U.S., 119–20 Low-Income Housing Tax Mexico, 31, 40, 42, 72, 91 Credit, 353, 356 city-size distribution: quotas for, 358 comparison with United Lucas, Robert, xxiii States, 100–6 economic crisis (1994), 92 McKinsey & Company, 262, 273 high-income households, 34 McKinsey Global Institute (MGI), total factor productivity of, 262, 264 196 report on global urbanization, variables and sources for data 265 collection, 94–5 McKinsey Global Institute Microsoft, xxv, 140 Cityscope database, 21–2, 25, middle class(es), xxxi, 31–2, 45n11, 44n8, 45n13 210–11, 224, 318, 322, 407, Maddison, Angus, 11 410, 413 Maharashtra Navnirman Sena, 236 middle sectors, post–World War II Mahila Milan (organization), India, growth of, 210–11 251 middleweight city(ies), 25–6, 29, Manhattan, New York (city), 31, 39–40, 43n3 United States, 3, 5, 13 migrant(s), xxiv, xxxi, 12, 41, 52–3, manufacturing cities, 60, 83 74, 228, 235–6, 239–58, 345; manufacturing density of India see also migration (2000–05), 66 access to health care for new, manufacturing industries, xx–xxi, 237 xxviii, xlii, 3, 53, 59 labor, 74, 242 448 Index religious, see religious migrants Mother Centers International rural, xxviii Network for Empowerment, subsidized housing access for Germany, 221–2 new, 238 mother city, 20 migration(s), xxvi, 181–2, 370, municipal water systems, 12, 15, 415; see also city governance; 265–6 informal settlements urban residential demand by internal migration in China, 2025 for, 36 xxviii, 94 into cities during 21st century, national citizenship, 250 234–5 National Housing Bank, Thailand, forced, see forced migrations 359 high-skilled labor, 235–6 National Slum Dwellers Federation, irregular, 247 India, 251 plural migrations in London, see natural hazards; management of, plural migrations in London xvii, 323 policy formulations to integrate natural resources: demand for, 271 scale of future, 256–8 new city(ies), 3–5, 12 reasons to move into cities, competition for residents, 15 236–44 free market formation of, 77 rural-to-urban, see rural-to- small town governments in, 77 urban migration new firms, xxiii, 16, 153, 160, 167, settlement dynamics in city, 188 248–9 new urban residents population in urban, see urban migration MDRs and LDRs, 8–9 within metropolitan areas, New York City, 5 325 expansion plan in 1811, 5 Millennium Development Goals, transformation of, 63–4 United Nations, 16, 45n10, non-capitalist mode of production, 269 181 mixed-use cities, xxxv non-governmental organizations, monocentric cities, 380–1, 390 309 more developed regions (MDRs), non-inflationary consistently 5–12 expansionary (NICE), 242 mortgage(s), 347, 354, 425–7, 433 Non-SSA (NSSA) Developing, arrears, 424 54–6 debt, 359 finance systems, 361, 434n5 oil shock of 1973–74, 277 loans, 356 Organisation for Economic preferential tax treatment for, Co-operation and Development 360 (OECD), 123, 178, 271 Index 449 organized manufacturing sector, prefecture-level cities in China, 185, 188, 193, 197 94–5 organized sector, 66, 183–5, 188, pre-industry urbanization, 57 193, 195–6 present-value-of-revenue (PVR) deurbanization of, 186–7 contract, 295–6, 301 India’s urban shares in, 67 private: in manufacturing sector, 184 bargaining, 302 Ostrom, Elinor, 175, 250–1 developers, 13–14 overengineering entrepreneurship, firms, xl, xxxix, 12, 61 162 investment, xxxii, 40, 280, 318, 328, 364, 414 peri-urban areas, 64, 67, xlii productivity differences within place-based economic policies, country, 117 117 property rights, 339–45 plural migrations in London, ambiguities and conflicts over, 238–9 340 pollution: formalization programs, caused by industrial sector, 344–5 311–13 housing finance development, industrial, see industrial 341 emissions legally owned property, 339 lead emissions, 320 legal titles, 340–1 permit system, 314 mitigation of, 341 in residential area, 312 ownership rights, transfer of, trading pollution permits, 340 313–14 public and private land vehicular, 317–19 acquisition, 339 poor people, xxvi, 45n10, 195, real estate transactions, 339 346, 389, 407, 429; see also registration of property, 341 poverty tenure, legalization of, 343 population growth, 266–8 tenure security, 341–5 Portes, Alejandro, 246 title regularization programs, poverty, xv–xvi, xxvi–xxvii, xliv, 341–5 31, 45n10, 134, 173–4, 194–5, zoning standards and, 344 199–200, 205, 269, 328, 342, public: 344, 369, 405 finance, 297–9 informal sectors associated with, goods, 310 194 housing production in in Latin America, 220 developing countries, 337 rural, see under rural investment, xxxviii, 358, 372 urban, see urban poverty sectors, see public sectors 450 Index public-private partnerships (PPPs), capital programs, 168 xxxix–xli, 21, 32, 34, 279–81, initiatives, 157–8, 162, 164 291 approach for, 295–7 quality of life, 310, 322, 328 availability contracts, 297 cash flows, 298 raise the doorsill: meaning of, 74 circumstances for use of, 293–5 Randel, John (Jr.), 3 contracting under, 293 real estate developers, 322 contract renegotiations, refugees, 227, 250, 253 299–300 regional differences: coordination, multiple in China, 144 jurisdictions, and in India, 121 decentralization, 302–3 regional economic development cost of capital for, 303 policies, 117, 132–42 factors contributing to the regions, maturity of urbanization success of, 280–1 in, 23–6 flexibility in, 300–2 regression discontinuity analysis, implementation of, 304–7 164, 170 meaning of, 292–3 religious faith, 246 pitfalls of, 297–304 religious migrants, xviii political benefits of, 299 remote-sensing, 320 premium, 303–4 renewable power equipment, 327 present-value-of-revenue (PVR) rental housing: contracts, 295–6, 301 funding of, 357 project-specific risks, 303 liberalization of, 350 public debt and budget public construction of, 357 appropriations, 292 public-private arrangements for, public finance, 297–9 359 rights of way, 294 quotas for low-income housing, role of institutions in, 297 358 for urban highways, 296 rental market, 345–51 public sectors, xvii, xxv–xxvi, xxxiii, in 19th- and early-20th-century xxxviii, xl–xli, 79, 82, 149, 347 154–6 advantages of, 345 public services: social benefits from, decontrol process, 350–1 261 importance of, 345 public transit systems, 310, 316 inclusionary zoning, 348 benefits of, 319 investment in, 348 public transportation, 272, 291 lease termination and rent- public venture: setting rules, 351 capital funds, 166 low- and middle-income, 347 Index 451 as “low quality–high price trap” sanitation, xvii, xxx, 202, 269, 321, for tenants, 346 323–4, 378, 428 for meeting housing demand, Saunders, Doug, 235 345 sea walls, 328 mortgage interest, 347 Self Employed Women’s owner-occupied units, 347–8 Association (SEWA), 195 quality of rent-controlled units, self-help housing, 337 348 self-organization of residents and reforms in, 347 firms, 76–7 rent control, 348–50 serviced developable land: supply restrictive zoning regulations, of, 362–5 347 service delivery, 23, 38, 200, 202, and single-family housing, 347 364–5 Swedish, 349 services density of India (2000–05), tenants of rent-controlled units, 66 348 sewage, xviii, xxxviii, 15, 39, tenants quasi-ownership rights, 227–8, 264, 310, 323 348 lack of facility xxxiii rent control, 348–50 treatment of, 324 replacement housing, global Shenzhen city (China), demand for, 268 development of, 3–4, 15–16 residential construction, 267 Shenzhen Speed, 242–3 resources needed by growing cities Silicon Valley, xxv, 118, 121–3, in emerging markets, 35–7 127, 136, 154 rethinking cities: Singapore Economic Development interventions, xxx–xli Board, 41 reasons for, xv–xvii single-family housing, 347 strategies of, xvii–xxx skilled: Romer, Paul, xxiii migrants, xxiii–xxxiv Roosevelt, Franklin, 135–6 workers, xxii, xxiv, xxvi, 19, 122, rural: 124, 129, 214 migrants, xxviii slumlords, 238, 347 poverty, xlv, 31 slums, xvi, xxvi–xxvii, xxx, 202, -to-urban migration, 37, 103, 204, 212, 229–30n2 174, 176, 181, 322 for developing world, xxxiii dwellers, 352, 359: salary(ies), 116–17, 122 slum-upgrading program, in China, 121 360 level in U.S. metropolitan areas housing, 25, 74 of college graduates, 118–20, removal, 337 128 rise of global, 213 452 Index urban, see urban slums start-ups, 4, 189 urban manufacturing in, 213 Stedman, Donald, 320 Small Business Investment Sub-Saharan Africa (SSA), 52, 69, Company (SBIC), U.S., 155–6 72, 178 small/smaller firms, xxx, 152–2, hinterland income and transport 152–3, 183, 188 cost in, 70–1 smart city(ies), 234, 253 rainfall shocks impact on, 72 smart governance in cities, 38–9 urbanization fostered by Smith, Adam, xix, xxi agricultural booms in, 58 social housing eligibility for urbanization level in, 54–7 migrants, east London, 238–9 subsidies, housing, 351–9 social rule for converting private capital grants and mortgage land into public space, 15 programs, 354 social welfare, 275 Chilean model of, 354 Society for the Promotion of concerns for public safety, 352 Area Resource Centres, India, demand-side, 352–6 251–2 middle-income beneficiaries, solar panels, 136, 327 354 Solidarity for the Urban Poor public housing production Federation, Cambodia, 252 programs, 353 Solow, Robert, 151 for public housing programs, spatial concentration, 62, 91 352 spatial differences in cities, xli, 91, rental allowance programs, 353 96, 112 supply-side, 356–9 spatial dispersion reduction: targeting efficiency of, 355–6 in China, 100–4 suburban: in Mexico, 106–9 areas, xxx, 64, 366, 381 spatial location of economic firms, 68 activity, 186 suburbanites, 271–2 spatial transformation in cities, suburbanization, 67, 312, 321–2 53–7 subway investment, 318–19 special economic zones, 4, 103, sulfur dioxide, 313 117, 145n1, 242, 248, 312 trading market, 314 specialized business services, superblocks, 13–14 xxi–xxii, 134 supply chain, 183–4, 312, 383 special purpose vehicle (SPV), 292, sustainable cities, 254, 310 294, 306 Special Zones of Social Interest, Technical Assistance for Policy Brazil, 249 Reform II, 348 standard of living, 261 technological innovation, 36, Starbucks, xxv 151–2 Index 453 technology transfer offices role in Millennium Development entrepreneurial activities, 160 Goals, 269, 336 Thackeray, Raj, 236 United Nations High thick cities, 125–6 Commissioner for Refugees, thick labor markets, xxiii, 117, 250 124–6 United States (U.S.), 28, 57–9 thick markets for specialized service city-size distribution as providers, 126–7 benchmark, 96–100: topographies of cities, 212 comparison with China and Town and Planning Act (1990), Mexico, 100–12 United Kingdom, 358 computer industry in, 61 Toxic Release Inventory dataset, deindustrialization, 60 314 federal policy of 1960s, 91 traffic congestion, 317 hourly wage of workers in transportation infrastructure, metropolitan areas, 116 315–21 metropolitan areas: emissions, 317 college graduates, 119–20 environmental impact of, 316 public spending and ongoing fiscal costs of supplying, 318 deficits in, 150–1 government investment in, 318 transport investments impact place-based investments, 318 on, 69 quality of life, 319 variables and sources for data regulations to reduce emissions, collection, 94–5 316 workers living in educated cities, total urban emissions, 318 xxiii vehicle ownership, 317 United States’ Energy Star standard, transport investments: 322 in hinterland development, 72 unorganized manufacturing sector, role in developing countries, 184–5, 188, 193, 196–7 65–9 unorganized sector, 67, 193–6 employment share for, 185–7 unemployment, 25, 37, 61, 117, in services sector, 185 125, 151, 222, 261, 388, 394, urbanizing, 186–7 405, 430 unskilled workers, 124, 129 compensation in U.S., 117 urban accommodation, 2 Union Carbide chemical disaster urban areas, xx, xxii, xxiv, xxvii, (1984), Bhopal, 314 xlii, 15, 18, 116, 235 United Nations (UN), 2, 5–6, 18, urban bias, 69–76 26, 89 urban citizens, 309 Global Strategy for Shelter to urban clusters in India, 20–3 the Year 2000, 337 urban cultures, 215 454 Index urban demographic change, 235 land use regulations: impact of, urban development, 223, 250, 368, 371 264, 322, 361, 363, 380 for lowest income groups, 337 hierarchy of, 52 market performance, 338 urban dweller, 405 property rights, 339–45 urban economic growth, 273 regulations and informality, urban economics, 322 369–71 urban economy(ies), 21, 23, 25, rental market, 345–51 210 self-help housing, 337 multiple articulations between serviced developable land, backward and advanced supply of, 362–5 sectors, 211 single-family housing, 347 network effect, 214 strategies for, 336 urban entrepreneurs, xxvi subsidies, 351–9 urban environments, 53 zoning regulations and, 368 urban governments, 253, 312 urban imperative, xviii–xix urban growth, patterns of, 264–73 urban infrastructure: in China, 267 benefits of, 261 demand for floor space, 266–8 build capabilities, 283 in emerging countries, 264 building of, 274–6 and need for a range of capabilities, 286–8 improvements, 268–70 car cities, rise of, 315–21 physical capital investment and, closure of gap in, 281–9 264 communications capabilities, pressure on natural and capital 287 resources, 270–3 cost of, 261 value creation, 273 effective use of, 276–7 urban hierarchy, 81 efficient delivering of, 277–9 largest cities evolving role, 62–5 funding for, 273 product and functional governance of, 282–3 specialization, 57–62 institutions, 283–4 urban households, 19, 34, 266, inter-jurisdiction coordination, 272, 321, 326, 415, 424, 432–3 303 urban housing: optimizing existing and new factors affecting supply of, infrastructure, 273–81 361–71 predictive modeling of, 287–8 finance for, 359–61 price of water and electricity, impact of regulations on supply, 326 367–9 processes of making, 285–6 land and housing regulations, public-private partnerships, 337, 365–7 279–81 Index 455 quality of, 323 faster transport impact on social and economic development poor housing, 394–5 objectives of, 276 transformation into residential transportation infrastructure, floor space, 395–6 315–21 urban living, xxii, xlii, 23, 214 urbanism, 243, 246–7, 253 urban manufacturing, xxviii, urbanization, xv–xvi, xxxi, 18–19, 212–15 26–7, 29, 31, 51–2, 83, 173, urban migration, 26, 244, 251–2, 203–5; see also formalization 257, 322 in Asia, 54 Urban Performance Index, 47n19 end-product of, 403 urban planners, 291, 312, 378–9, improves conditions in rural 383–4, 399, 410–11 areas, 53 urban planning, 276, 312 interpreting lags in, 10–11 urban pleasures, xxii maturity in regions, see regions, urban policy(ies), xlv, 90, 113 maturity of urbanization in in China, 104–6 peaking in developing countries, in Mexico, 109–11 11–14 urban pollution: policy implications on, in household sector, 321 193–201 social benefits of limiting, of rural societies, 235 313 stages of, 338 urban poor, xvii, xxxiv, 45n10, and transition to formality, 248, 250–1, 310–11, 321–4, 180–93 328–9; see also urban poverty urbanization project: urban population, 19, 54, 72, 89 building integrated social for 1950–2010, 5 system, 14 in less developed nations, 2 in developed countries, 2 limiting value of, 2 estimation on completion of, 5 UN projection for, 8 origin of, 1 urban productivity, xvii urban labor markets, xxi, xxxiii urban poverty, xxvi, 174, 248, 342, urban land, xviii, xxxi, 78, 250, 347 253, 290, 362–3 in Latin America, 347 fraction of land submitted to non-income aspects of, 342 market forces, 396–403 urban regulation, in industrialized mode and length of transport countries, 302 network determines, 390–4 urban residents, xv–xvi, xxxi, xxxv, supply mechanism of, 381–3 2, 8–9, 210, 429 supply of developable, 384–90 demand for municipal water by acceptable travel times, 2025, 36 384–90 Weber’s observation about, 224 456 Index urban-rural consumption, 53–4 wages, xxx, 93, 141–2, 159, 176, urban services, xxi, xxx–xxxi, 181–2, 188, 204, 228, 311, 200–1, 212 322–3, 325, 429 urban share of world population, 1 African, 427 in MDRs and LDRs, 7, 9 rise in United States, xviii–xix urban shift, 18, 31–2 urban, xxii urban slums, xvii, 177, 322 Ward, Peter, 253 urban space(s), 211, 215–16, 221, Washington Consensus, 3 226 wastewater treatment systems, 262, urban sustainability, 310 269 pollution costs, caused by the water-borne diseases, 323, 327 industrial sector, 311–13 water pollution, xxxvii, 311, 321 urban villages, 74, 381 water supply, 202, 262, 269 urban water: demand for, 266, clean water, access to, xi, 269 xvi–xvii, xxx, 90, 321, 323, Urban World: Cities and the Rise 329, 378 of the Consuming Class report Weber, Adna, xv–xvi (2012), 265 welfare externalities of migrants, U.S. Illegal Immigration Reform London, 238–9 and Immigrant Responsibility wind turbines, 327 Act of 1996, 227 women in cities, obstacles and vectors to urban inclusion, vehicle ownership, growth of, 317 215–22 vehicle pollution, 317 World Bank, xliii, 45n10, 64, 67, emission control regulations, 178, 198, 252, 309, 318, 323, 319–20 325 reduction of, 320 urban strategy, 338 vehicle-registration tax, 317 World Development Report venture: (2009), 338, 340 capital, 146n5, 153–7, 159–60, world size distribution of cities, 162–8 81 capitalists, 135–7, 146n5, 154–5, 158–9, 166–7 Xiaoping, Deng, 3–4 funds, 153, 160–1, 163, 166, 170 Zipf ’s law, 97–8 investors, 160–2, 166 Zones of Special Social Interest, visual orders of cities, 211–15 344 About the Editors and Contributors Editors Edward Glaeser is the Fred and Eleanor Glimp Professor of Economics in the Faculty of Arts and Sciences at Harvard University. He is the Director of the Rappaport Institute of Greater Boston and was the Director of the Taubman Center for State and Local Government, John F. Kennedy School of Government from 2004 to 2014. He regularly teaches microeconomic theory and occasionally urban and public economics. He has published numerous papers on cities, economic growth, and law and economics. His work has focused on the determinants of city growth and the role of cities as centers of idea transmission. Abha Joshi-Ghani is the Director for Knowledge Exchange and Learning at the World Bank. She headed the Urban Development and Local Government Practice in the World Bank during 2007–12 and led the World Bank’s Urban Strategy in 2010. She also headed the Global Urbanization Knowledge Platform during 2010–12. She was the Chair of the World Economic Forum Global Agenda Council on Urbanization in 2013. She has worked primarily on infrastructure finance and urban development at the World Bank in South and East Asia, Africa, and the Middle East. Before joining the World Bank she worked for the Reserve Bank of India. 458 About the Editors and Contributors Contributors Alain Bertaud is an urban planner with over 30 years of interna- tional professional experience in America, Europe, and Asia. He is currently working as a consultant for the World Bank and for private clients. He was previously a Principal Urban Planner in the Urban Development Division of the World Bank. His most recent work involves advising municipalities in land use and land regulatory issues as they relate to land markets. Paul Collier is Professor of Economics and director of the Center for the Study of African Economies at Oxford University. His research focus includes the causes and consequences of civil war, the effects of aid, and the problems of democracy in low-income and natural- resource-rich societies. He also works on a wide-range of macroeco- nomic, microeconomic, and political economy topics concerned with Africa. He is the author of The Bottom Billion: Why the Poorest Countries are Failing and What Can Be Done About It. Klaus Desmet is Professor of Economics at Universidad Carlos III de Madrid. His research focuses on regional economics, international trade, economic growth, and diversity. He has held visiting positions at a number of institutions, including the University of Illinois, Stanford University and the Bank of Spain. He is a Research Fellow at the Centre for Economic Policy Research. Richard Dobbs is a director of the McKinsey Global Institute (MGI), McKinsey’s business and economics research arm, and a director (senior partner) of McKinsey based in Seoul. From 2004 to 2009, Dobbs co-led McKinsey’s Corporate Finance Practice, where he was also responsible for research and development. Richard has written numerous articles about the implications of the financial crisis for companies and managing in a downturn. Eduardo Engel is Professor of Economics at Yale University. Previously he was a faculty member at the University of Chile, where he taught economics and directed the Center for Applied Economics. He held positions as Visiting Professor at Stanford University About the Editors and Contributors 459 (1998–99) and Assistant Professor of Public Policy at Harvard University (1992–94). He has published widely in the areas of mac- roeconomics, public finance and regulation. Brandon Fuller is deputy director and research scholar at the New York University (NYU) Stern Urbanization Project. He is also serv- ing as interim deputy director for NYU’s Marron Institute for Cities and the Urban Environment. Prior to joining NYU, Fuller was direc- tor of the Charter Cities non-profit. Previously he worked for Aplia, an education technology company, during its startup phase. He was also an adjunct professor of economics at the University of Montana, where he earned a Master of Arts degree in Economics in 2003. Alexander Galetovic is Professor of Economics at the Universidad de los Andes in Santiago. His current research interests are the deter- minants of industry structure, antitrust, the economics of regulated industries (particularly electricity and telecoms), and the economics of public private partnerships. Ejaz Ghani is Lead Economist in the Macroeconomics and Fiscal Management Global Practice of The World Bank. He has worked on Africa, East Asia, South Asia, Corporate Strategy, and Independent Evaluation Unit at the World Bank. He has written and published extensively on economic growth, macro policies, poverty, employ- ment, entrepreneurship, urbanization, gender, trade, decentraliza- tion, and agriculture. Sonia Hammam is an independent consultant on urban develop- ment. She worked at the World Bank from 1995 to 2011, where she has held positions of urban advisor, and sector manager for urban development in the Middle East North Africa region, South Asia and East Asia. Earlier, Hammam was at USAID where she held the posi- tion of Director of Urban Policy and Programs in Washington and served as the Regional Housing and Urban Development Director in Warsaw, Poland. Vernon Henderson is the Professor of Economic Geography at the London School of Economics. Previously, he was the Eastman 460 About the Editors and Contributors Professor of Political Economy and Professor of Economics and Urban Studies at Brown University, and a Research Associate of the National Bureau of Economic Research. He has conducted research on aspects of urbanization and local government finance and regulation in various countries and his recent work is on urbanization in Sub-Saharan Africa with a focus on migration and climate change. His teaching interests include urban economics, urbanization in developing countries and the economics of China. Matthew E. Kahn is a Professor at the UCLA Institute of the Environment, the Department of Economics, and the Department of Public Policy. He is a research associate at the National Bureau of Economic Research. Before joining the UCLA faculty in January 2007, he taught at Columbia and the Fletcher School at Tufts University. He has served as a Visiting Professor at Harvard and Stanford. Ravi Kanbur is T.H. Lee Professor of World Affairs, International Professor of Applied Economics and Management, and Professor of Economics at Cornell University. He holds an appointment tenured both in the Charles H. Dyson School of Applied Economics and Management in the College of Agriculture and Life Sciences, and in the Department of Economics in the College of Arts and Sciences. Kanbur’s main areas of interest are public economics and develop- ment economics. Michael Keith is Director of the ESRC Centre on Migration, Policy and Society at the University of Oxford. He holds a personal research chair in the Department of Anthropology and a Professorial Fellowship at Merton College, Oxford. COMPAS works on migra- tion and its dynamics and is funded by the Economic and Social Research Council as the principal migration research center in the UK. Keith’s research has focused on issues of urbanism, city change and multiculture. Joshua Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, with a joint appointment in the Finance About the Editors and Contributors 461 and the Entrepreneurial Management Units. He graduated from Yale College with a Special Divisional Major which combined phys- ics with the history of technology. He worked for several years on issues concerning technological innovation and public policy, at the Brookings Institution, for a public-private task force in Chicago, and on Capitol Hill. Much of his research focuses on the structure and role of venture capital and private equity organizations. Enrico Moretti joined the Berkeley faculty in 2004. He holds the Michael Peevey and Donald Vial Career Development Chair in Labor Economics. He is also a Research Associate at the NBER (Cambridge), a Research Fellow at the Centre for Economic Policy Research (London) and a Research Fellow at the Institute for the Study of Labor (Bonn). He is the Director of the Infrastructure and Urbanization Program at the International Growth Centre (London School of Economics and Oxford University). His research interests include Labor Economics, Urban Economics and Applied Econometrics. Herbert Pohl is founder of Jones Pohl Group, an infrastructure investment group. Previously he was a global leader of McKinsey‘s Infrastructure Development Practice, covering cities, regions, and ministries of transportation. He has served more than 35 clients in infrastructure and transportation over the past 12 years, during which he has worked with some of the leading players in infrastruc- ture and transportation across the globe, including Hong Kong, India, Malaysia, and Brazil. Jaana Remes is a senior fellow and Partner at the McKinsey Global Institute (MGI), McKinsey‘s business and economics research arm. Since 2003, Remes has co-led MGI‘s research on productivity and competitiveness. Her most recent research sheds light on the patterns of global urban growth through the lens of MGI’s global Cityscope database of 2,000 cities. Paul Romer is Professor of Economics at NYU’s Stern School of Business and director of its Urbanization Project. Prior to joining 462 About the Editors and Contributors Stern, Romer taught at Stanford’s Graduate School of Business, where he took an entrepreneurial detour to start Aplia, an education technology company dedicated to increasing student effort and engagement. Romer is a research associate at the National Bureau of Economic Research and a fellow of the American Academy of Arts and Sciences. Esteban Rossi-Hansberg is a Professor of Economics and Woodrow Wilson School at Princeton University. He performs research in macroeconomics, international trade, and urban economics. His research focuses on the internal structure of cities, the distribution of economic activity in space, economic growth and the size distribu- tion of cities, the effect of offshoring on wage inequality, the role on information technology on wages and organization, and firm dynamics and the size distribution of firms. Saskia Sassen is the Robert S. Lynd Professor of Sociology and Member, The Committee on Global Thought, Columbia University. For UNESCO she did a five-year project on sustainable human settlement with a network of researchers and activists in over 30 countries, as part of the 14 volume Encyclopedia of Life Support Systems. She has received several awards, most recently being doctor honoris causa from Delft University (Netherlands), and others from DePaul University (USA) and from Université de Poitiers (France). She is the Chair of the new Urbanism competition at the Venice Biennale of Architecture (2010). Tony Venables, CBE, is Professor of Economics at the University of Oxford where he also directs the Centre for the Analysis of Resource Rich Economies. He is a Fellow of the British Academy and of the Econometric Society. He also served as Chief Economist at the UK Department for International Development, professor at the London School of Economics, research manager of the trade research group in the World Bank, and as advisor to the UK Treasury. Jonathan Woetzel works for McKinsey & Company and is based in Shanghai, China. He advises clients in a range of industries—includ- ing energy, materials, technology and industrial—helping transform About the Editors and Contributors 463 local companies into global leaders, and developing policy recom- mendations for government. He has led McKinsey‘s Asia Energy and Materials practice, the McKinsey Global Institute, McKinsey‘s macroeconomic research institute, in Asia, and its Corporate Finance practice in China. ‘Glaeser and Joshi-Ghani bring together insights from thought leaders on the key issues of economic growth, competitiveness, housing, infrastructure, environmental sustainability, informality, and inclusion.’ —Isher Judge Ahluwalia, Chairperson, Board of Governors, Indian Council for Research on International Economic Relations ‘[N]early two-thirds of South Africans live in urban areas. The challenge now is to ensure that urbanization is truly transformational for the ordinary citizen and makes a difference to their lives... As Cape Town and other African cities plan for the future, it will be vital to take these findings and policy guidance into account.’ —Patricia de Lille, Executive Mayor, Cape Town, South Africa ‘Overwhelmed by the rapid and unstoppable changes, we are only now beginning to see the path towards a more humane, fair, and equitable world for all... [The book] aims to understand the complexity of the urbanization phenomena.’ —Antoni Vives, Deputy Mayor for Urban Habitat, Barcelona City Council ‘Urbanization is transforming the socio-economic and political dynamics globally as developing country cities see rapid economic growth and the center of economic power shifts to the global south... [This book brings] together valuable policy perspectives on competitiveness and urbanization.’ —Klaus Schwab, Founder and Executive Chairman, World Economic Forum ISBN 0-19-945777-8 9 780199 457779 www.oup.com ` 995