Thursday, December 30, 2010

Economics in Fiction: Two Post-Christmas Book Reviews

Anyone who has studied a little economics knows that popular fiction usually avoids economic themes, and if it does not, butchers them. Yet this year, two novels landed under our Christmas tree that place economic themes front and center and treat them well. The books are Nineteenth Street Northwest by Rex Gosh (Greenleaf Book Group) and Super Sad True Love Story by Gary Shteyngart (Random House).

Sunday, December 19, 2010

U.S. Ethanol Subsidies: A Bad Policy That Refuses to Die

U.S corn farmers and ethanol distillers are among those celebrating passage of last week's tax bill. A little-noticed provision of the law extends ethanol tax credits ($.45 per gallon, plus a bonus for small producers) and tariffs on ethanol imports ($.54 per gallon), previously set to expire at the end of 2010. Should the rest of us also celebrate? I think not.

Tuesday, December 14, 2010

Does Argentina's "Nike Effect" Hold Lessons for Europe?

What happens when a country faces forced austerity, a banking crisis, a risk of sovereign default, and pressure to abandon a currency peg it has has sworn to be eternal and unbreakable? Several European countries are in this position today, but there is nothing really new about it. It's all happened before, most recently in Argentina in the winter of 2001-02. So what became of Argentina? Are there any lessons there for today's Europe?

Sunday, December 5, 2010

Progress on Korea-US Trade Offers Contrast with Talk of Protectionism

This week's finalization of the long-delayed Korea-US Free Trade Agreement (KORUS FTA) offers a welcome contrast with all the gloomy talk of a protectionist response to the ongoing global crisis. The Bush administration first negotiated the deal, which would be the biggest since NAFTA, in 2006,  under the since-expired system for "fast track" approval by Congress. Due mainly to opposition from auto and beef interests, it was never ratified.

Sunday, November 28, 2010

How Chinese Inflation Policy Will Shape the Yuan-Dollar Exchange Rate

By freezing its exchange rate and pulling out all the stops on fiscal and monetary stimulus, China got through the global recession with only a mild slowdown in GDP growth. Now it is facing the inflationary consequences. Consumer price inflation, after rising steadily all year, hit a 4.4% annual rate in October, approaching the government's red line. How will China choose to deal with the inflation threat? The answer is important both for China and its trading partners, because anti-inflation policy will determine what happens to the exchange rate of the yuan over the coming months.

Inflation is a key factor in exchange rate developments because the balance of trade depends on the real, not just the nominal, exchange rate--a fact that is not always clearly understood. Everyone knows that we need to adjust nominal wages for inflation to reveal trends in real wages, and adjust nominal interest rates for inflation to find real interest rates. For the same reason, we need to adjust nominal exchange rates for inflation to see what is really happening to the competitive balance between any two countries. In the case of the yuan vs the dollar, the simplest way to make the adjustment is to add the difference between the Chinese and U.S. inflation rates to the rate of nominal appreciation of the yuan. Because inflation in recent months has been faster in China than in the United States, the rate of real appreciation of the yuan has been faster than the nominal rate. The following chart breaks the monthly rate of real appreciation into its components, nominal appreciation and the inflation differential.

Some people find it counterintuitive that Chinese inflation causes the yuan to appreciate in real terms. The the confusion arises from a failure to distinguish between two different cases. In the first case, inflation in a country with a floating exchange rate causes its currency to depreciate in nominal terms, leaving leaving the real exchange rate unchanged. (Think of hyperinflation in Zimbabwe a few years back, which was accompanied by an equally rapid nominal depreciation of the Zimbabwe dollar.) In the second case, inflation in a country with a fixed nominal exchange rate causes its real exchange rate to appreciate. The real appreciation reflects the loss of competitiveness of the country's exports on world markets and the greater attractiveness of imports compared to increasingly expensive domestic products. The idea that inflation in a floating-rate country causes nominal depreciation in no way contradicts the idea that inflation in a fixed-rate country causes real appreciation. The two ideas simply reflect different outcomes produced by the same  market forces under different policy regimes.

In the above chart, real exchange rates are calculated using monthly changes in the consumer price index for both countries. Over the most recently reported two months, the CPI-adjusted real exchange rate of the yuan has been appreciating relative to the dollar at about a 13 percent annual rate. That would be enough to eliminate the estimated 20 to 40 percent undervaluation of the yuan in less than three.

Using consumer prices to calculate real exchange rates has the advantage that the monthly CPI for both countries is available with a very short lag. However, many observers think that real exchange rates based on  unit labor costs in manufacturing give a more accurate picture of competitiveness in international trade. Unit labor costs take into account both changes in nominal wage rates and changes in labor productivity, and a focus on manufacturing excludes price and wage changes that affect only non-traded services. Unit labor cost data is not available as rapidly or in as much detail as consumer prices, but estimates from the World Bank suggest that Chinese unit labor costs rose at an annual rate of about 4 percent in the first three quarters of this year. Over the same period, they decreased at an annual rate of about 5 percent in United States, giving a 9 percent differential. Since the June thaw in Chinese exchange rate policy, the yuan has been appreciating at a nominal annual rate of about 6 percent. Adding nine to six suggests that the ULC-adjusted real exchange rate of the yuan has been appreciating at a 15 percent annual rate, even more rapidly than the CPI-adjusted rate.

We can see, then, that rising inflation makes it harder than ever for  Chinese policy makers to restrain the ongoing real appreciation of the yuan. If inflation continues, the real exchange rate would continue to rise even if the nominal exchange rate were frozen once again. But a renewed freeze, or even a slowdown, is unlikely. On the contrary, nominal appreciation of the yuan is the most effective anit-inflation tool available to the People's Bank of China (PBoC). Nominal appreciation has a powerful double effect on inflation. First, a stronger yuan makes imported goods cheaper for Chinese consumers, bringing direct relief to the price level. Second, the more rapidly the PBoC allows the yuan to appreciate in nominal terms, the fewer dollars it has to buy for its already huge foreign exchange reserves. Since the yuan used to purchase dollars flow into the Chinese banking system, allowing more rapid nominal appreciation makes it possible to slow money growth.

Are there any tools available to the Chinese government that would allow it to have its cake and eat it too? To stop inflation while at the same time preventing unwanted real appreciation of the yuan? There may be, but each of them has disadvantages.

One anti-inflation tool used regularly by the PBoC is to "sterilize" its foreign exchange operations by selling PBoC bills, which are IOU's issued by the central bank. Sale of bills soaks up the yuan created when the PBoC intervenes in foreign exchange markets by buying dollars. However, there are limits to how many PBoC bills China's financial markets can absorb. Already interest rates on the bills are rising. This tool alone cannot solve the problem.

The PBoC can instead raise interest rates within the banking system, a tool used to fight inflation by central banks around the world. In some ways, the PBoC has greater powers than the Fed in this regard, since it has administrative control over bank deposit rates as well as the rate at which banks borrow reserves. However, Chinese financial markets are not as interest-sensitive as those in free-market economies. Interest rates have already been increased this year, and more increases are on the way, but this tool, too, is not by itself enough to stop inflation.

Much the same can be said for another anti-inflation tool, increases in the reserves that Chinese banks are required to hold. Reserve requirements have already been increased. Now, at 18.5%, they are far above the similar requirements in the banking systems of developed countries. The downside of high reserve requirements is that they reduce the efficiency of the banking system. That is the reason why central banks in the UK, Canada, and some other countries have stopped regulating required reserves altogether, and why the Fed keeps reserve requirements at much lower levels now than in the past. The Chinese banking system is already not very efficient in channeling saving to its best uses, and raising reserve requirements only makes the situation worse.

Finally, there has been talk of trying to contain inflation by direct price controls on food and perhaps other rapidly-rising components of consumer prices. Although price controls could have an immediate impact on the headline CPI, they would represent a step backward from China's evolution toward a market economy. If kept in place for long, price controls would risk shortages, which in turn would create a need for rationing. And, if price controls were not backed by overall monetary restraint, they could exacerbate the risk of a speculative bubbles in real estate and other asset markets.

Taking all of these considerations into account, the most likely outcome for China over the coming months is the use of all available policies in combination. Expect continued increases in interest rates and reserve requirements. Targeted, temporary price controls are also a possibility. Continued nominal appreciation of the yuan is a virtual certainty. There appear to be factions within the Chinese policy establishment that would even like a slightly faster pace of nominal appreciation. Used together, these tools may succeed in breaking the upward trend of Chinese inflation, but they are unlikely to fully erase the inflation differential with the United States.

As long Chinese inflation remains above the U.S. rate, the real exchange of the yuan will continue its steady appreciation relative to the dollar. Contrary to the political bluster heard from some quarters, appreciation of the yuan will not solve all the world's problems. Over time, however, we can expect it to make a helpful contribution to easing some of the most acute global imbalances.

Follow this link to view or download a short slide show with additional details regarding the relationship between Chinese inflation and the yuan-dollar exchange rate

Tuesday, November 16, 2010

No Fix For US Fiscal Policy without New Rules

A short time ago, I wrote that the EU needs better rules for fiscal policy. So does the United States. A new report from the Peterson-Pew Commission on Budget Reform provides an outline for such a set of rules. It is unfortunate that the Peterson-Pew report has been overshadowed by the almost simultaneous release of the draft co-chairs' report of the president's fiscal reform commission, because they complement one another. The mandate of the president's commission is to figure out a combination of tax reform and spending cuts that will get the deficit down to a sustainable level, whereas the Peterson-Pew report focuses on the rules needed to maintain sustainability over the long term.

The Peterson-Pew Commission  is a joint effort of the Peter G. Peterson Foundation and the Pew Charitable Trust. Its co-chairs are three former Congressmen, Bill Frenzel, Republican, Timothy Penny, Democrat, and Charlie Stenholm, a conservative Democrat and former member of the Blue Dog Coalition. The Commission has issued two reports. Red Ink Rising, December 2009, which documents the nature of the budget problem, and the just-released report, which is titled Getting Back in the Black.

In its new report, the Commission characterizes the problem in these terms (slightly paraphrased): "Budgets are created annually, without any kind of fiscal target guiding the process . . .  Increasingly there is no comprehensive action on the budget at all: rather, a series of short-term continuing resolutions followed by huge omnibus spending bills. . . .  The bulk of spending and revenue occurs on autopilot without annual review or any constraint on growth . . .  Lawmakers routinely continue programs that could not withstand rigorous evaluations of their costs and benefits."

To correct the situation, the Commission proposes a thorough revision of the rules of the game, consisting of two main components.

The first component is to set medium-term and longer-term fiscal policy targets. Working from a baseline scenario that is somewhat more pessimistic than the CBO baseline, the Commission suggests a medium-term debt target of 60 percent of GDP, to be achieved by 2018, with further reductions below that target for the longer term. The report is less explicit about deficit targets, but it is not hard to fill in the blanks. As I have explained elsewhere, achieving sustainability for the debt would require a moderate cyclically adjusted primary surplus, that is, a surplus on the budget when adjusted to take into account both interest expenditures and cyclical changes in tax revenues and expenditures. Keep in mind that as of 2009, the United States had a cyclically adjusted primary deficit of some 7 percent of GDP. That was the highest in the OECD except for Ireland, which is now teetering on the edge of the abyss. It is easy to see, then, that the Peterson-Pew target for the debt is an ambitious one.

The second component of the Commission's plan, and really the most important one, is a set of revisions to the budget process. In part, these aim to lengthen the time horizon of the budget process beyond its current one-year span. Even more important, they include tough automatic mechanisms that would come into play if targets are not being met. Failure to pass a budget consistent with targets would trigger automatic adjustments consisting 50 percent of across-the-board spending cuts and 50 percent of broad-based tax surcharges. The president would also be empowered to impose rescisions of excess spending.

The Commission's call for long-term budget rules and enforcement mechanisms is sound economic policy. The unfortunate thing is that many of these ideas have been tried before, without lasting success. The report details the history of past budget rules, including Gramm-Rudman-Hollings, the Budget Enforcement Act of 1990, PAYGO, the line item veto, and others. Some of these have met with temporary success, contributing to the period of relative fiscal soundness in the 1990s. However, three factors have undermined them all in the long run.

One factor is a U.S. Constitution that gives Congress preeminent authority in budget matters. The Supreme Court has tended to reject budget rules that give the president or others outside Congress the authority to impound, rescind, sequester, or override Congressional spending decisions in pursuit of broader economic policy goals.

A second factor is the inherently political nature of fiscal policy. With monetary policy, it is to some extent possible to spin off macroeconomic aspects to the central bank while leaving microeconomic financial regulation to others. It is much more difficult to do the same with fiscal policy, since every tax and spending decision has very specific microeconomic as well as macroeconomic impacts.

The third problem is the time-inconsistency between fiscal policy decisions geared to a two-year political cycle and the needs of fiscal sustainability averaged over a significantly longer business cycle. Fiscal sustainability becomes a political issue only during recessions, when current deficits are high. That is just the time it is most difficult to carry out the adjustments needed for long-run sustainability. When a period of expansion comes and deficits shrink, pressure for long-run sustainability evaporates, and nothing is done. Eventually the debt grows to a point where the country finds itself in a recession with no "fiscal space" to carry out needed countercyclical policy--exactly the situation we are in now.

In the end, I must say that I found the Peterson-Pew Commission's report to be more depressing than encouraging. The report is right to insist on the need for fiscal policy rules. Although there is room for discussion regarding the technical details of targets and processes, the Commission's ideas are on the whole sound. But how is our politically divided country going to get together on viable set of fiscal policy rules, when it has failed so often in the past? There seems to be no answer, either in this new report or anywhere else.

Follow this link to view or download a brief slide show presenting additional data and details from the Peterson-Pew Commission report.

Thursday, November 11, 2010

Update on Fiscal Consolidation: The Draft Report of The President's Debt Commission

My initial reaction to yesterday's draft report of the bipartisan National Commission on Fiscal Responsibility and Reform is very positive. It has already been called "unacceptable" by both the left and the right, which pretty much proves it is on the right track.

The version I downloaded from the New York Times is marked "DO NOT QUOTE CITE OR RELEASE," so I will play be the rules for the moment and forgo line-by-line comments. However, if you read my post on growth-friendly fiscal consolidation a few days ago, you will know that one thing I like about the draft NCFRR report is its focus on tax reform. The draft shows that taking the ax to tax expenditures makes it possible to cut both personal and corporate tax rates and at the same time improve revenue collection. That's a real winner.

I also like its endorsement of an increase in the gasoline tax. The increase in the gas tax will be panned by the "affordable energy" lobby, but, as I have argued before, affordable energy is something we cannot afford. However, I would go beyond draft report in that I would prefer a broader-based energy tax or carbon tax to steer non-transportation sectors, as well as transportation, toward an energy mix more consistent with national security and environmental realities.

I also like the realistic goals set by the draft report. It rejects some of the pie-in-the-sky demands of the Tea Party right, including an annually balanced budget and a near-mythical 20% cap on federal government spending. Given the demographic realities of an aging population, we are not going to get back to 20% no matter how hard we try. Can't be done, won't be done. So stop talking about it. Also, instead of focusing on headline budget balance, the draft report is sophisticated enough to realize that the really important thing for sustainability is a small primary surplus. If that goal is achieved, small annual deficits in the overall budget are consistent not just with long-run fiscal sustainability, but with gradual reduction in the debt as a share of GDP.

There must be something I don't like about the draft, right? OK, here is one. Although the draft endorses substantial cuts in defense spending, its proposals focus mainly on waste in the defense department. They don't touch the hot iron of what we should actually be doing with our armed forces. I think foreign policy and national security strategy have to be dragged into the budget discussion at some point. To put it bluntly: Are our adventures in Iraq and Afghanistan really cost-effective as ways of protecting the homeland? A few courageous voices on the right, notably Rand Paul, are willing to discuss this issue, but I suppose it is too much to hope for the NCFRR to take it on.

Follow these links for related slide shows on tax reform, affordable energy, and the primary deficit.

Wednesday, November 10, 2010

India's Secret Weapon in its Economic Race with China

The eclipse of the G7 by the G20 puts the spotlight more than ever on India and China as the economic superpowers of the future. So far, China has the lead, but India has a secret weapon that will carry it into first place by the end of the century. What exactly? Widely spoken English? That helps India's service sector, but it is not decisive. Democracy? True, democracies outperform authoritarian regimes on average. It is no coincidence that 17 of the G20 are functioning democracies, but China is hanging in there as an exception to the rule. No, the real secret weapon that will carry India into the lead is demographics.

It is not just that sometime around 2030, India's total population will become larger than China's. Total population is an ambiguous factor in prosperity, as those of us know who were raised on the intellectual sparring of Julian Simon and Paul Ehrlich. On the one hand, people are a country's most valuable resource; on the other hand, badly managed population growth can overtax other resources and leave a country populous but impoverished. Rather than total population, it is the inner dynamics of population growth, in particular, the evolution of the dependency ratio, that will make the difference for India and China.

The total dependency ratio is the ratio of the nonworking population, both children and the elderly, to the working age population. Low-income countries with fast population growth have high dependency ratios because they have lots of children. Rich countries with slow population growth have high dependency ratios because they have many retirees. In between these two states, countries go through a Goldilocks period when the working age population has neither too many children nor too many parents to support. The dependency ratio reaches a minimum, and growth potential reaches a maximum. The following chart shows the dynamics of the dependency ratio for India and China, with the United States included for comparison.

As the chart shows, India is just entering its Goldilocks period while China, like the United States, is already leaving. Furthermore, The dip in the Indian chart is more gradual and longer-lasting than the corresponding dip for China. For the next several decades, China will be tacking into the wind while India still has its spinnaker up. Chinese economic growth will slow, while India's, assuming a supportive policy environment, will edge past it.

What explains the difference in population dynamics? The answer can be found in the evolution of the total fertility rate in the two countries. (Total fertility is a measure of the number of children born to a representative woman over her lifetime.) China's total fertility rate dropped from almost six in 1965-70 to under three just a decade later. The famous one-child policy, introduced in 1978, contributed to the decline, but it was already well underway before that. By 1990-95, China's fertility rate had dropped below the replacement mark of about 2.1. In India, by contrast, the decrease in total fertility from six to three took 30 years to accomplish, and fertility is not expected to drop to the replacement rate until sometime in the coming decade. To switch metaphors, China slammed on the brakes, leaving big skid marks, while India made a more prudent deceleration. Furthermore, as Adam Wolfe, among others, has pointed out, China's official data may understate the true rate of decline in fertility, and therefore understate the future demographic drag on the country's growth.

There is nothing inherently wrong with slow, or even negative, population growth, but the transition to it is not easy to manage. The United States is not doing a particularly good job, as we know from the wrenching debate over the impact of social security and Medicare on the budget deficit. China is not doing well either. It has not yet found a social safety net to replace the long-vanished "iron rice bowl" of the Maoist era, and social insecurity, in turn, contributes to other imbalances in its economy. India, too, is not not exactly a Swedish-style paradise for the young and the old, but at least it has more time to get its act together.

In short, India, by all indications, is likely to be the world's largest economy at the end of the 21st century. It appears that President Obama knew what he was doing when he endorsed India for a permanent seat on the UN security council during his recent South Asia visit. He wasn't just maneuvering to put together a coalition to contain China, as some commentators suggested. Instead, he was backing the probable winner in the global economic race.

Follow this link to view or download a short slide show with additional demographic data for India and China.

Sunday, November 7, 2010

Could QE2 Cause the Fed to Go Broke?

The Fed's new program of quantitative easing, QE2, once again raises an old question: Can central banks go broke? Conventional analysis, aptly summarized by Willem Buiter in a 2008 report, says no, or at least, hardly ever. However, when we look closely, the conventional analysis is not altogether reassuring. Although the Fed most assuredly is not going to go broke, preventing that from happening could raise difficult political issues and perhaps even threaten the Fed's independence.

We can start by noting that the Fed, like most central central banks, is rather thinly capitalized. As of November 3, 2010, it had capital of some $56 billion, about 2.5% of its assets of $2,303 billion. By comparison, Bank of America, with approximately the same total assets, had 7.8% Tier 1 common equity at the end of 2009. If the Fed were a commercial bank, its financial condition would not be dire, but it would be on the watch list.

Of course, the Fed is not a commercial bank. As the conventional analysis is quick to point out, the unique nature of its assets and liabilities normally allows it to operate safely with just a sliver of capital. Normally, the Fed's assets have consisted largely of short-term Treasury securities, which are as close to risk-free as you can get. As for liabilities, as recently as the end of 2007, 90% of them consisted of Federal Reserve currency. Currency is a truly marvelous thing to have on the right-hand side of your balance sheet, since it is neither interest-bearing nor redeemable. With a assets and liabilities like that, who needs capital?

Since 2008, however, alterations in the Fed's balance sheet have undermined the conventional analysis to a certain extent. First, the nature of assets has changed, and continues to change. The Fed's all-Treasury asset portfolio is only a memory. It now holds more than a trillion dollars worth of mortgage backed securities that are neither very liquid nor risk-free. In addition, QE2 is in the process of lengthening the maturity of the Fed's Treasury portfolio, so that while there is still no credit risk, there is growing exposure to market risk in the event of a rise in interest rates.

On the liability side, nonredeemable monetary liabilities still predominate, but the composition of the monetary base has changed. More than half of the base (as opposed to less than 10% three years ago) now consists of reserve deposits of commercial banks. Reserves are no longer interest free. True, as of 2009, interest expense on reserve deposits was less than 4% of the Fed's net interest income, but that is up from zero. And keep in mind that while the rate paid on reserve deposits is now just 0.25%, a potential increase in that rate looms as part of the Fed's exit strategy from its current expansionary policy stance. Another potential exit strategy tool, reverse repurchase agreements, also comes with interest cost attached.

That, shaped by earlier rounds of quantitative easing, is the starting point from which QE2 is being launched. Suppose that at first QE2 has little impact on the economy, but then, about the time the Fed's balance sheet hits the $3 trillion mark, inflation expectations and interest rates begin to rise. Perhaps they rise sharply as everyone tries to bail out of Treasuries before prices collapse. As promised, the Fed counters by implementing its exit strategy, selling bonds at a loss, using reverse repos on a large scale, and raising interest rates on excess reserves. The Fed's net income would certainly decrease, and it is far from impossible that its capital could drop below zero. What then?

First, it should be made clear that even if the Fed slipped into balance-sheet insolvency (negative capital), that would not bring about equitable insolvency (inability to meet financial obligations as they fall due). Because of the nonredeemable character of its monetary liabilities, and because both its liabilities and assets are denominated in dollars, any kind of run on the Fed is absolutely impossible. Beyond interest on reserves and reverse repos, the Fed still would have to meet some six or seven billion dollars a year in operating expenses and obligatory dividends to member banks, but even if its net interest income were much reduced from the $50-odd billion it will earn in 2010, it could probably cover these.

Still, a position of negative capital would be uncomfortable even if the Fed were able to keep up with its current obligations. Recapitalization would clearly be desirable. But just how could it be accomplished?

Recapitalization would be complicated by the Fed's odd legal status as a joint-stock entity that is "owned" by private commercial banks, yet is in every functional sense a part of the federal government. The only conceivable entity that could recapitalize the Fed is the Treasury, but this would be no ordinary capital injection. For commercial banks, a capital injection means a swap of good assets for equity, but the Fed could not just issue new common or preferred shares to the Treasury, at least not without a revision of its charter. Instead, a recapitalization would have to take the form of an outright grant, in which the Fed transferred tens or hundreds of billions of dollars in newly issued bonds to the Fed completely gratis. It is hard to see how that could be done without an act of Congress--and would Congress in its current mood approve this mother of all bailouts?

Let me emphasize this: The Fed is NOT a private corporation in any ordinary sense of the word. If the Treasury were to gift the Fed with a $100 billion capital grant, that would NOT amount to putting it in the pockets of the Rothschilds, whatever you might read to the contrary on the internet. But, can you guarantee that all those paranoid myths about the Fed would not be raised in Congressional debate or on talk radio? I cannot make that guarantee, and for that reason I cannot guarantee quick passage of the Treasury Asset Recapitalization Package of 20**, or whatever they might call it. Whatever the name, it would be called TARP II and it would be controversial. It would be so controversial that in return for passage, Congress might insist on new audit or oversight authority, something already high on the agenda of certain members.

So, what is the bottom line? Could the Fed go broke if QE2 creates a bond bubble that suddenly bursts in a surge of inflationary expectations? In fact, it actually could become insolvent in the balance sheet sense. Presumably, it could not become insolvent in the equitable sense. But we cannot rule out the emergence of a situation from which the Fed could be extracted only at the cost of a high degree of political discomfort and perhaps a loss of independence.

Follow this link to view or download a short slide show with data from the Fed's balance sheets and further analysis.

The Economics of a Soda Tax: Update

My April post on The Economics of a Soda Tax has been a favorite with readers, drawing more hits than almost any other post on microeconomic policy. Unfortunately, it appears that a soda tax is less popular with the electorate than it is with readers of this blog. In a ballot initiative this month, voters in my home state of Washington endorsed a repeal of the state's pioneering tax on soda and candy by a nearly 2:1 margin. It seems that we have to look elsewhere for a resolution to the twin crises of obesity and insolvency.

Thursday, November 4, 2010

EU Leaders Struggle to Fix Fiscal Policy Rules

At a summit last week, EU leaders made another try to fix their fiscal policy rules. Why is this latest round of tinkering unlikely to solve the euro's endemic problems of budget crises, bailouts, and fiscal free riders?

Budget problems, of course, are not unique to the euro area. Democratic governments everywhere have a hard time holding fiscal policy to an optimal path. Election cycles are short and the ill effects of excessive deficits take years to develop. The resulting bias toward deficits is a classic example of what economists call time inconsistency--a clash between short-term and long-term goals.

Time inconsistency is a problem everywhere, but membership in a currency union compounds it by adding a second source of bias toward deficits--the free rider problem. An everyday example of the free rider problem occurs when you get together in a restaurant with a group of friends. What you order depends on how you agree to handle the bill. If you know in advance that you are going to get a separate check, you order a beer and a hamburger. If everyone agrees to pay an equal share of single check for the whole table, you order steak and champagne. Countries with their own currencies currencies are in the first position with regard to their fiscal policy, whereas members of a currency union are in the second.

Suppose first that your country has its own currency. There are always short-term political benefits of increasing the deficit. You can reward friends with contracts, subsidies, or tax cuts. A quick boost to aggregate demand can raise incomes and cut unemployment ahead of the next election. Offsetting these benefits are the long term costs of excessive deficits. The central bank, if independent, may react to fiscal expansion by raising interest rates. A bigger budget deficit may trigger unwanted exchange rate movements. Ultimately, if fiscal policy is unsustainable for a long period, your country may face the unpleasant alternatives of default, hyperinflation, or forced austerity. With an independent currency, both the costs and the benefits are internalized within your own economy, so that the long-term costs help keep in check the pro-deficit bias that arises from time inconsistency.

If your country is a member of a currency union, the situation changes in a fundamental way. The benefits of fiscal profligacy--goodies for your friends and expansion ahead of the next election--still accrue largely to your home economy. However, the costs of excessive deficits are now spread widely among your currency partners. Three mechanisms spread the cost. First, the central bank of the currency area cannot raise interest rates for just one member at a time to offset its excessively expansionary fiscal policy. Second, the budget position of a single member of a currency union (especially a small one) will have little effect on the common currency's exchange rate, and to the extent it does, any pain from exchange rate movements is spread among all members. Third, the costs of a threatened default are also spread to currency-area partners, since default by any one member of a currency union would adversely affect the reputation of all members, driving up their borrowing costs.

A country in a currency union, then, is subject to a double bias toward excessive deficits. First, it is subject to the same time-inconsistency bias as are countries with independent currencies. Second, because benefits of deficits are concentrated at home while costs are spread to currency-area partners, it is subject to an additional free-rider bias.

The free-rider bias toward excessive deficits was well known to the designers of the euro area. The 1992 Maastricht Treaty, which led to the establishment of the euro, included rules placing limits on members' budget behavior. Deficits should not exceed 3 percent of GDP (with limited allowance for recessions) and government debt should not exceed 60 percent of GDP. EU authorities were authorized to impose fines on countries that exceeded the limits. Furthermore, the treaty included a tough no-bailout clause forbidding any member from assuming another's sovereign debts.

Unfortunately, these mechanisms haven't worked very well. As the chart shows, even at the peak of the expansion, in 2007, only 7 of 12 euro members were safely inside the 3/60 limits. Two years later only Finland and Luxembourg remained in full compliance. The problem lies not just the fact that many members missed the deficit target at the trough of a deep recession. That is to be expected. A more serious flaw is how poorly the 3/60 rules served to give early warning of fiscal risk. Spain and Ireland went from full compliance to the brink of insolvency almost overnight because the crisis exposed fiscal fragilities not visible in the simple debt and deficit ratios.

The failure of the Maastricht treaty's budget rules had two results. First, in May of this year, to avoid an imminent default by Greece and likely contagion to other weak euro members, the EU cobbled together the temporary European Financial Stability Fund (EFSF). The fund violated at least the spirit of the no-bailout rule, while at the same time showing that rule's lack of political realism. Second, it prompted a major rethink of fiscal policy rules as a whole.

Both issues were on the table at last week's summit. Proposals were made to make the bailout fund permanent, and, in mitigation of any increase in moral hazard, to institute a new, much tougher set of penalties for countries that violate the rules in the future. However, prospects for an effective set of rules and penalties seem dim.

First, there is the problem of the 3/60 formula itself. For some time, it has been evident that these numbers are arbitrary, and that the idea of uniform debt and deficit limits for all countries is unsound. This time around, Poland was the one to raise this point. Poland, at the urging of the EU, recently carried out a sweeping pension reform that strengthens its budget in the long run but makes its numbers look bad in the short run. Not surprisingly, it wants any new rules to recognize its efforts.

Second, there is the issue of how to design an appropriate set of penalties. Financial penalties for noncompliance are simply unworkable. For one thing, imposing a large fine on a country that is already in a budget crisis only makes the matter worse. In addition, there is a widespread belief that no one would ever have the courage to impose big fines on the euro's core members. When Germany and France ran excessive deficits for several years in the early 2000s, EU authorities simply waived the penalties. Small countries are not so sure the courtesy would be extended to them in the same circumstances.

Third, there is the problem that any rule changes beyond minor tinkering would require amendment of the EU's founding treaty, and such changes require unanimity. Some EU members stipulate that treaty changes be approved by referendum. That dooms the prospects for major changes, such as the sensible proposal  that penalties for fiscal noncompliance should be administrative rather than financial, taking the form, for example, of a temporary suspension of voting rights. What leader would like to be tasked with asking voters to approve that proposal?

Fourth, there is the lopsided nature of the EU as a fiscal entity in the first place. In the US, the split of central vs. state and local budgets is about 60/40. That makes possible large-scale federal-to-state transfers that help keep states solvent in a crisis. In the EU, the split is something like 2/98. There just isn't enough money in the EU's central budget to devise a workable system of carrots, instead of sticks, to coax member states into fiscal compliance.

Fifth, there is the problem of how tough to get with creditors of member countries that get into into solvency troubles. To limit the moral hazard associated with a permanent bailout fund, French and German negotiators have been pushing for inclusion of the principle that bondholders should absorb part of the costs of future bailouts. That might add to the pressures for countries to keep their budgets in order, but it has potential risks. One lies in the fact that that EU banks are big holders of bonds of member countries, including those that are fiscally weak. As a result, haircuts on bondholders might reduce the cost of bailouts for member governments only at the expense of more bailouts for banks. Another risk is  that the threat of losses for bondholders might send interest rates soaring, pushing marginally solvent countries over the edge. In fact, the mere discussion of imposing losses on bondholders pushed rates sharply higher for Ireland, Portugal, and others in the days following the summit.

All things considered, then, prospects are dim that the euro area will find a solution to its fiscal policy woes any time soon. Although EU heads of state did unanimously agree on the need for new rules, their exact form remains to be worked out. The most likely outcome is a revision of existing rules drawn narrowly enough not to trigger the unanimous ratification and referendum mechanisms. Very optimistically, that might help contain the current crisis. It could give countries like Portugal and Ireland time to achieve credible fiscal consolidations before Greece is forced to restructucture, as many observers still think it must eventually do. Sooner or later, though, the long-term structural weaknesses of the euro area as a fiscal entity will resurface, and yet another attempt at reform will have to be made.

Follow this link to view or download a short slide show on the euro area's fiscal policy rules 

Thursday, October 28, 2010

Tax Reform as a Path to Growth-Friendly Fiscal Consolidation

The Communiqué of the recent G20 Meeting of Finance Ministers and Central Bank Governors included a line committing the world's major economies to "ambitious and growth-friendly medium-term fiscal consolidation." Fiscal consolidation (FC) is econ-speak for what most of the world calls "austerity" or "budget cuts." It refers to any program that gets the deficit down through cuts in outlays, increases in revenue or a combination of the two.

Almost simultaneously with the G20 meeting, the IMF released its latest World Economic Outlook. Chapter 3, titled "Will It Hurt?" is devoted to fiscal consolidation. It tells us that FC is almost always contractionary. To round out the picture, Christina Romer, on whose earlier work the WEO chapter is in part based, followed up with a passionate plea in the New York Times saying that now is not the time to cut the deficit.

So what gives? Is such a thing as "growth-friendly fiscal consolidation" possible, or is it not?

Let me begin by saying that no orthodox economist can be surprised to hear that fiscal consolidation has at least the potential to shrink the economy. Economists see the economy as the sum of consumption, investment, government purchases, and net exports. Tax increases eat into consumers' take-home pay and disincentivize investment, while cuts in government purchases take money out of the pockets of civil servants and contractors. Quite possibly FC also reduces imports. If so, net exports increase, but the expansionary effect is not normally enough to fully offset other, more contractionary impacts. Besides, as the WEO chapter points out, not all countries can increase net exports at the same time. Going for export-led growth when most of the world is in a slump at the same time risks unleashing a beggar-thy-neighbor trade war that nobody wins.

Rather than fiscal consolidation during a recession, the orthodox approach is countercyclical fiscal policy. That means increasing outlays or cutting taxes during a recession and then undertaking FC during the subsequent expansion. Christina Romer's New York Times piece is completely orthodox in this regard. The theoretical case for countercyclical fiscal policy is unassailable. The only sticking point is the political economy of it.

It is politically easy to pull off the "spend your way out of a slump" half of countercyclical policy. The other half, the fiscal consolidation half, is much harder. It requires the willingness to raise taxes or cut spending programs at a time when the economy is booming and it seems the party can go on forever. It is never easy to build a coalition to take away the punch bowl.

Consider the following chart, which shows the cyclically adjusted primary balance (CAPB) for the US, the UK, and the average of all OECD countries over the past two business cycles. (The CAPB is the deficit adjusted to exclude both interest expense and the effects of automatic stabilizers like income taxes and unemployment benefits.) For reasons discussed in an earlier post, the CAPB is perhaps the single best indicator of a country's long-term fiscal sustainability.

Sustainability requires that on average over the business cycle, the CAPB be kept near zero or slightly in surplus. Unfortunately, many countries fall short of the sustainability requirement. Often their CAPB remains in deficit even at the height of the business cycle, as in the 2005-2007 period on this chart. On occasion, as at the end of the 1990s, a small surplus is achieved, but not large enough to balance out longer and larger episodes of deficit over the course of many cycles.

The result of this pattern is that debt gradually accumulates until one day, a country finds itself in a slump without the "fiscal space" needed to spend its way to recovery. At that point there is much wailing and many Augustinian promises of the "make me chaste, oh Lord, but not yet" variety. But those promises are not credible. The only way for a country in that position to buy credibility is to make at least a solid down payment on fiscal consolidation right now, slump or no.

In a way, things are easiest for countries like Greece or Latvia. There, the political resistance to FC is broken when, one morning, they wake up to the brutal realization that the markets will no longer buy their bonds. To avoid a shameful default, they have to turn to the IMF or their currency-area partners for help. Help is provided, but only with stringent conditionality. The conditionality turns out to be a blessing because it gives the local government the political cover of blaming evil speculators and harsh foreign taskmasters for the pain of spending cuts and tax increases. Unfortunately, it is difficult to call that kind of forced fiscal consolidation "growth-friendly," unless in the very limited sense that the alternatives could be even more anti-growth.

Countries like the US and UK are in a more difficult political position. They can still borrow cheaply and they lack foreign taskmasters to impose budget discipline from outside. When such countries run out of fiscal space, they need to find a different way to purchase the required credibility.

Faced with such a situation, the UK has chosen what I would call the G. Gordon Liddy approach. Liddy, who came to fame as a Watergate conspirator, is also noted for the feat of holding his hand over a candle until his flesh burned. Did it hurt? Of course it did. The whole point was to demonstrate that he had the willpower to do what needed to be done, pain or no. Proponents of that approach argue that willingness to suffer pain serves as a token of commitment. Commitment is then supposed to engender confidence, which boosts investment and consumption.

If the confidence-boosting effects outweigh the immediate negative impact on demand, fiscal consolidation becomes expansionary. Supposedly Denmark accomplished this trick in 1982 and Ireland
 in 1987, although the IMF analysis argues that Denmark and Ireland were special cases. Only time will tell whether British fiscal consolidation turns out to be pro-growth or not.

Meawhile, since Washington seems unlikely to join Cameron and Clegg in the "Austerian" camp, what alternatives are there? Will it be enough to do as Romer advocates--just wait it out, with promises to eat that nasty spinach before going to bed? That does not seem like a growth-friendly strategy either.

Fortunately, as I am about to argue, the United States does have a genuinely growth-friendly fiscal consolidation option. It is one made possible by the fact that the U.S. tax system, as it now exists, is so massively dysfunctional that reforming it could stimulate growth and increase revenue at the same time. The elements of a comprehensive tax reform have been around for a long time. Few of them are even controversial, at least within the economics profession. The problem is that each needed element of reform involves a degree of political pain that no previous Congress or administration has ever been willing to endure.

In a single sentence, the elements of comprehensive tax reform are broadening the tax base to raise revenue while at the same time reducing high, incentive-killing marginal rates in key areas like the payroll tax, the corporate income tax, and perhaps the personal income tax as well. If the economy were now on an even keel, with the cyclically adjusted primary balance at a sustainable level, tax reform could be accomplished in a way that was revenue neutral. But the ineffiencies of the present system are so great that even revenue-enhancing tax reform could end up giving a solid boost to growth.

More specifically, the needed tax reform would very likely include one, two, or all three of the following big ideas:
  • Elimination of tax expenditures. Some of the biggest are deductability of retirement plan interest, employer-provided medical insurance, and home mortgage interest. Eliminating these and other tax expenditures could broaden the base by enough to raise 5% of GDP. Closing them all and at the same time cutting marginal rates by enough to make a 2% contribution to closing the budget gap would be very growth-friendly.
  • A carbon tax. I can see readers' eyes rolling already. The very first comment posted will be something about "shaky climate science." But there are good reasons for even climate deniers to love a carbon tax. It is very broad-based, since energy is an input to all goods and services. Even setting climate change to one side, there are enough other externalities of carbon-fuel dependence to justify the tax on efficiency grounds. Think Gulf oil spills, think national security, think traffic congestion, think of the boost to low-carbon natural gas, America's biggest on-shore energy source.
  • A value added tax. More rolling of eyes, but think about it. Every day someone in Washington beats up on the Chinese for their notorious imbalances--their low consumption, undervalued exchange rates, and big trade surplus. But--duh--who is on the other end of the teeter-totter? Simple arithmetic dictates that China can't rebalance its economy unless the US rebalances too. Reducing the budget deficit is only part of that rebalancing. Another part has to be a permanent, substantial increase in household saving, say, back to the 7 or 8 percent of GDP it was a generation ago. However much you might hate the VAT as a subversive European plot to sap America's vital bodily fluids, you have to admit it is a lot more pro-saving than the income tax, and therefore a lot more pro-rebalancing and more growth-friendly.
I hope to explore each of these tax ideas in future posts, but meanwhile, you can find good numbers and good analysis on all of them from the Tax Policy Center. My point today is not to argue the relative merits of a VAT versus ending employer-paid health care deductions. My point is that given the political will, comprehensive tax reform really is an option for pro-growth fiscal consolidation. It is one that could start right now, without having to be back-loaded into some low-crediblity future. Sure, there is pain in tax reform. Every single line of the billion-page US tax code is there because someone loves it, someone is getting rich on it, and someone is getting re-elected on it. But maybe now is the time to put our collective hand over the tax reform candle. 

Follow this link to download a short slide show with selected figures from the IMF fiscal consolidation study, together with data and figures on tax reform.

Sunday, October 24, 2010

China's Fragile Rare Earth Monopoly

On September 7, a Chinese fishing boat collided with a Japanese Coast Guard vessel near a group of disputed islands in the East China Sea. The collision sparked a chain of events that led to an apparent cutoff of China's shipments to Japan of rare earth elements (REEs), vital ingredients in many high-tech products. Suddenly the world became aware that China, home to some 95% of global REE production, held an alarming strategic monopoly.

The episode raises several economic questions. What factors allowed China to become the world's leading producer of REEs? Does China's current 95% market share represent a true natural monopoly? What factors could undermine China's current REE dominance? Application of a few basic economic concepts can go a long way toward providing answers.

We can begin by revealing what everyone already seems to know: Rare earths are not really rare. All 17 rare earth elements are more abundant in the earth's crust than gold, and some of them are as abundant as lead. The thing that makes them hard to mine is the fact that they are not found in highly concentrated deposits like gold and lead are. Even the best REE ores have very low concentrations. On the other hand, such ores are found widely throughout the world. Until the 1960s, India, Brazil, and South Africa were the leading producers. From the 1960s to the 1990s, the Mountain Pass Mine in California was the biggest source. China's dominance of REE production dates only from the late 1990s.

So, what explains China's big market share? Good ore deposits, but not uniquely good, are one factor. Second, low labor costs help China's REE mines just as they help its toy factories. A third consideration may have been most important of all. Mining of REEs can produce very nasty waste products. Up until recently, Chinese authorities were willing to turn a blind eye to environmental devastation caused by primitive, often illegal, but low-cost small-scale mines. Meanwhile, environmental problems were a major factor leading to the shutdown of the Mountain Pass Mine. Following a big spill of radioactive waste, US authorities demanded new environmental safeguards. Already facing low-cost Chinese competition, the mine closed rather than undertake the needed investments.

The abundance of REE ores suggests that China's 95% market share does not represent a true natural monopoly, that is, one based on ownership of unique resources. However, that does not mean it lacks short-run monopoly power. In the short run, supply of REEs is much less elastic than in the long run. Any short run increase in supply can only come from mines that are already open or, to a very limited extent, from "urban mining"--recycling of REEs from scrapped computers and the like.

Short-run demand is also inelastic. High-tech production lines are set up to produce hybrid cars and computer hard drives using well-tested but REE-dependent technologies. You can't just substitute nickel for the neodymium in a magnet and expect the product still to do its job.

Given highly inelastic short-term supply and demand, it is not surprising that China's cutback in supplies this year sent market prices soaring. Bloomberg reports that prices of Neodymium jumped from $41 per kilogram in April to $92 in October, and Cerium oxide from $4.70 to $36 per kilo over the same period.

In the long run, all evidence points to much greater elasticity of both supply and demand. The press is full of news about old mines reopening or new ones under development. California's Mountain Pass Mine is expected to come back on line in 2011. Canadian companies are moving rapidly forward with projects in Wyoming and Tanzania, among other places. Australia, a supplier of nearly every other mineral, may also become a player.

On the demand side, it is not quite true to say that REEs are irreplaceable ingredients of today's high-tech products. At least in many cases, current REE-dependent technologies were chosen not because they are the only way to do something, but because they are a good way to do it given reasonable prices and reliable availability of the raw materials. Finding alternative technologies can take time, but the clock is now ticking. Japanese researchers are reporting success with REE-free technologies for electric car motors. Several new technologies are competing to replace conventional hard drives for computers, until now another big REE user. The Korean government is encouraging research into REE substitutes, as well.

The bottom line: China has a big market share, but no natural monopoly. Any efforts it makes to exploit its advantage based on low short-run elasticities only accelerates the development of alternative sources and new technologies.

Instead of trying to keep prices at the current high levels, once the ripples from the fishing-boat episode die down, China is likely to practice "limit pricing." Limit pricing is a classic monopoly tactic that involves holding prices high enough to give moderate but steady profits, while still low enough to discourage the growth of competition. At the same time, expect China's own rapidly expanding high-tech industries to absorb more of its REE output. In fact, encouraging them to do so seems to be an element of Chinese policy. Preferential access to low-cost REE supplies could give those industries a competitive advantage on world markets over a longer time horizon than that over which China could hope to maintain its near monopoly as a supplier of raw REEs.

Meanwhile, China's competitors in Asia, North America, and Europe should get serious with incentives to develop alternative sources and REE-free technologies. Targeting research funds would be helpful. Military research dollars should be included, since REEs have key applications in helicopter blades, laser gun sites, radars, and other military hardware.

The issue of environmental harm from REE mining also needs to be addressed. Relaxing environmental regulations in the United States and other new source countries is not the way to go. We do not want the Mountain Pass Mine to go back to spilling radioactive waste water in the California desert. China is showing signs of cleaning up its own worst REE polluters, and if it follows through, this may become a non-issue. If it does not, one option for consideration would be countervailing environmental tariffs, to the extent these are allowed by WTO rules.

With or without major government action, however, market forces appear unfavorable to China's continued dominance of REE production. After the East China Sea incident, concerns over reliability of supply, as much as concerns over price, are triggering research and investment to an extent that suggests that the long run--as in "long-run elasticity"--is fast approaching.

Follow this link to download a slide show with charts and additional analysis related to China's fragile rare earth monopoly.

Friday, October 22, 2010

What Is QE2 Trying to Do? Is the Fed Rebasing its Inflation Target or Not?

What exactly is the Fed trying to do with QE2? Assuming that our central bankers don't surprise everyone and forgo quantitative easing after all, they seem to be following some kind of inflation targeting strategy, but what kind?

The cautious variant of inflation targeting would be one of "rebasing." In the figure below (not drawn to scale) the Fed has been trying to keep the price level close to the inflation path marked 2%, but has slipped below it to nearly flat inflation, leaving us at point A. From there, the cautious variant of inflation targeting would be to rebase by setting a new target path with the same 2% slope, but lying entirely below the previous one. To implement this variant, the Fed would calibrate QE2 to try to bring the price level up to, but not above, the new path leading toward point B. If market participants believe the Fed will try this, and will succeed, they will set their inflation expectations at about 2% going forward.

The more aggressive strategy would be not to rebase. Instead, QE2 would aim to bring inflation up to the original 2% target path, which would mean following the arrow toward Point C. Doing so would provide a much stronger stimulus, and would, ideally, lead to faster recovery of the economy while still being consistent with the Fed's mandate.

There is a lot to be said for the more aggressive strategy, the one without rebasing. However, it would be tricky to pull off. One obvious issue is whether there is really a reliable transmission mechanism running from an increase in the monetary base via massive bond purchases to an increase in aggregate demand. I have rarely seen a more divided economics profession than we have regarding this question. The only honest answer is that we won't know if the transmission mechanism will work until QE is actually tried.

Assuming the transmission mechanism does work, the second issue will be managing inflation expectations. The path back to point C, without rebasing, implies an interim period during which the rate of inflation is purposely allowed to exceed the long-term 2% target. Without that, the economy can't get back on its former target path. But if market participants do not have confidence, even a short period of higher inflation could quickly spread fear that the Fed has lost control of the price level altogether. There are a lot of people out there who look at today's bloated monetary base and get very nervous about an inflation breakout. With all that dry tinder lying around in the form of excess reserves in the banking system, such a scenario is far from impossible.

The Fed's delicate task, then, has to be to steer inflation expectations within a narrow corridor. To push the floor of the inflation expectations corridor up to the 2% mark, it has to carry out a convincingly aggressive program of bond purchases. At the same time, in order to put a ceiling on the corridor, it has to convince everyone that it has a workable exit strategy in case things start to get out of hand. The recent trial run of the reverse repo tactic for withdrawing reserves from the banking system should be read in this context. 

We could have greater confidence in the Fed's exit toolkit if it had the power to sell its own central bank bills, like the People's Bank of China does. Congress is not about to grant that power, but in theory, the Treasury and the Fed working together could do the same thing. The tactic would be for the Treasury to sell newly issued bonds or bills, soaking up excess reserves of the banking system, and then sequester the funds in deposits at the Fed, with the promise that these would be left untouched until the operation had its desired effect.

Get ready to watch exactly how the Fed frames its expected QE2 gambit, both in its official statements and in speeches of board members. Will it cautiously try to rebase its inflation target, or will it act more boldly? We should find out fairly soon.

For a more detailed discussion of the mechanics of quantitative easing, see this earlier post and its accompanying slide show.

Monday, October 18, 2010

Tutorial on Central Bank Operations with Answers to FAQs About Monetary Policy and Exchange Rates

I have been doing some blogging lately on the topics of quantitative easing and exchange rate manipulation. Looking around, especially at comments,  I can see that many bloggers, myself included, are wrongly assuming that their readers understand the basic mechanics of central bank operations. In the hope of making a small contribution to economic literacy, I have prepared a short tutorial explaining what happens when the Fed, the People's Bank of China,  or any other central bank carries out certain monetary policy operations:
  • Purchases and sales of securities, including the large-scale programs called quantitative easing
  • Intervention in foreign exchange markets
  • Sterilization of exchange rate intervention
In addition to explaining basic terms and concepts, the tutorial attempts to answer certain frequently asked questions. Here are four of those questions with answers in brief. These are real questions taken from recent comments on several blogs, edited only to combine a greater number of original questions into these four generic FAQs. The full tutorial slide show gives more complete answers, illustrated with balance sheets and T-accounts.

FAQ No. 1: What is "quantitative easing" (QE) and how does it affect the money supply?

Answer: "Quantitative easing" means large-scale purchases of securities, incuding long-term securities, by a central bank. QE is an extension of the normal day-to-day buying and selling of short-term securities, which are called open market operations.

When the Fed or another central bank buys Treasury securities, whether as part of a program of QE or otherwise, it does not buy them directly from the Treasury, but rather, from some dealer or other party in the private sector. It pays the seller by means of a bank transfer. The result of the transfer is to increase not only the seller's bank deposit, but also the reserves of the banks where the sellers hold their accounts. Those bank reserves count as part of the economy's "monetary base," which can be thought of as the raw material from which money is created.

When banks later use this raw material (their new reserves) as a basis for making new loans, total bank deposits held by the public expand further. Looking at the procedure from start to finish, then, any purchases of securities by the Fed tends to expand the money supply.

Notice the words "tends to expand." Sometimes market conditions are such that banks are reluctant to make loans. Then the new reserves that the Fed injects into the banking system just pile up on banks' balance sheets, and the effect on the money supply is much weaker. That is what seems to have been happening since the start of the financial crisis. For that reason, among others, some people doubt that QE is a very effective way of stimulating the economy.

FAQ No 2: When the Fed buys Treasury bonds, does it lift the burden of interest costs from the shoulders of taxpayers? Does that mean there is, after all, such a thing as a free lunch?

When the Fed buys Treasury securities, the Treasury keeps right on making interest payments. The interest now becomes a source of income for the Fed. In contrast to an ordinary commercial bank, however, the Fed is not allowed to make a profit when its interest income goes up. Instead, after deducting its operating costs, it turns any surplus back to the Treasury. In that sense it is true that there is no interest burden on the taxpayer, and the government is getting a sort of free lunch, at least in the short term.  However, there are two important qualifications to the free lunch concept.

First, since October 2008, the Fed has had the power to pay interest on bank reserves, and does so. Because purchases of Treasury securities add to bank reserves, they also add to the Fed's interest costs. As a result, part of the interest that the Treasury pays to the Fed leaks out into the banking system before it gets recycled back to the Treasury. True, the interest rate the Fed pays on bank reserves is less than the rate on long-term Treasury bonds, so there is still a net saving to taxpayers. In this sense, we might say that taxpayers are getting their lunch at a discount, even if it is not free.

Second, there are limits to how big a portfolio of Treasury bonds the Fed can accumulate. Right now, because of the financial crisis, the limit is larger than usual, so the Fed can hold a lot of bonds, but that situation cannot be expected to last forever. Sooner or later, the economy will recover and banks will become more aggressive about making loans. At that point the Fed will have to sell off a large part of its holdings of bonds in order to keep the money supply from growing too fast and causing unwanted inflation. When that happens, the free lunch is over and the interest burden shifts back to the taxpayer.

FAQ No 3: Why do the Chinese central bank's efforts to manipulate the value of the yuan cause inflationary pressures in China?

China's huge trade surpluses create a constant flow of dollars into China. The big supply  tends to push down the value of the dollar and, correspondingly, causes yuan to rise in value (appreciate). If the Peoples Bank of China (PBoC) wants to keep that from happening, it jumps into the foreign exchange market itself. To mop up some of the excess supply of dollars, it buys dollars from the various private forex dealers that are acting on behalf of the ultimate suppliers--companies that import Chinese goods to the US.  The dollars the PBoC buys are used to acquire U.S. Treasury securities, adding to China's ever-growing foreign currency reserves.

When the PBoC buys dollars from private dealers, it pays in yuan. Those yuan end up in the bank accounts of the dealers, and eventually in the accounts of Chinese companies that are exporting goods to the US. The end result is an increase in the Chinese money supply. If the PBoC intervenes too often and too aggressively in the foreign exchange market, the Chinese money supply starts to grow faster than the country's expanding economy can safely absorb. Ultimately, the excess supply of yuan pushes up China's rate of inflation.

FAQ No. 4: If currency manipulation by the PBoC causes inflation, why hasn't China's inflation rate been a lot faster?

The PBoC has another policy instrument in its toolkit that we haven't mentioned yet. If its foreign exchange intervention threatens to cause inflation, it can mop up at least some of the excess yuan by selling its own securities, which are called PBoC bills. The PBoC bills, which do not count as part of the monetary base or money supply, replace bank reserves, which do count. This operation--the swap of PBoC bills for yuan-denominated bank reserves--is called "sterilization."

Sterilization looks like a kind of free lunch for the PBoC--it lets it resist unwanted appreciation of the yuan without paying the inflationary price of doing so. But like all apparent free lunches, this one is not quite as good a deal as it looks at first. After a while, the market becomes saturated with PBoC bills. The bank has to offer higher and higher interest rates to sell them. That would not only create a potentially enormous interest expense, it would push up interest rates throughout the Chinese financial system, slowing investment and growth. Because the PBoC exercises great administrative authority over Chinese banks, it can pressure them to absorb a lot of bills at low interest rates, but that tactic has its limits, too. Eventually the unwanted PBoC bills start to clog up the banking system and prevent it from operating efficiently. 

Although no one outside China really understands the internal politics behind the government's exchange rate manipulation, there are hints that the PBoC would just as soon allow a little more appreciation of the yuan in order to ease inflationary pressures. Presumably there are interests on the other side, including China's huge export industry, that use their political influence to resist appreciation. Outsiders can only guess how this will all play out.

Follow this link to download the complete tutorial in the form of a classroom-ready slide show.

Friday, October 15, 2010

How Successful Is China's Currency Manipulation?

The US Treasury has been reluctant to name China as a currency manipulator. It fears that official use of these words would be seen as the start of a trade war. In the plain-English sense, however, China certainly does manipulate its currency, doing so by frequent intervention in foreign exchange markets. Heated rhetoric aside, the real question is, how successful has the manipulation been in maintaining the competitiveness of Chinese exports?

To answer that question, we need to look not just at nominal exchange rates, but at real rates. In nominal terms, the yuan has strengthened about 2.5% since China's June 19 decision to ease its currency policy. That works out to an annualized rate of nominal appreciation of almost 8%. The simplest way to calculate real appreciation is to add on the difference between China's inflation rate (3.5%, according to August data) and US inflation (about 1%, or even less if the dip in the September figures holds up). Doing so gives us an annual rate of real appreciation of more than 10%. Two or three years of that would pretty well eliminate the 20 to 40% undervaluation that critics are talking about. True, three years is longer than the time horizon of your average politician, but it's not exactly a glacial pace of change, either.

But wait, you might say, we can't be sure that China will continue to allow an 8% rate of nominal appreciation. The latest hints from inside the PBoC suggest that 3% nominal appreciation could well be the maximum. Wouldn't that mean it would take a lot longer to correct the existing undervaluation?

No, not necessarily. In order to slow the rate of nominal appreciation, the PBoC would have to step up its currency intervention. Chinese inflation is already accelerating month after month. Slowing nominal appreciation from its recent 8% pace would increase inflationary pressure even more, both by keeping import prices from falling, and via the newly minted yuan that intervention pumps into China's domestic money supply. With inflation accelerating further, the rate of real appreciation might not slow by much, if at all.

The bottom line: Yes, China is a currency manipulator, but not a completely successful one. Condemning as trivial the 2.5% appreciation of the yuan since June sounds good in the halls of Congress, but that number far understates the rate at which the yuan is really losing its competitive edge against the dollar.

Flash footnote (published on Treasury web site shortly after the above post)

"WASHINGTON – Secretary of the Treasury Timothy Geithner recognized China's actions since early September to accelerate the pace of currency appreciation, while noting it is important to sustain this course.

Since June 19, 2010, when China announced it would renew the reform of its exchange rate and allow the exchange rate to move higher in response to market forces, the Chinese currency has appreciated by roughly 3 percent [sic] against the U.S. dollar. Since September 2, 2010, the pace of appreciation has accelerated to a rate of more than 1 percent per month. If sustained over time, this would help correct what the IMF has concluded is a significantly undervalued currency. "

Follow this link to download a free set of classroom-ready slides discussing China's currency policy and the real exchange rate. An earlier version of this post appeared on

Monday, October 11, 2010

Chocolate Lovers Keep Nervous Watch on Volatile Cocoa Prices

World cocoa prices have been on a long upward trend, with a lot of volatility along the way. Prices have fallen a bit in the last few months, but chocolate lovers are watching nervously. What is going on? Will chocolate soon become a luxury good?

One of the factors driving chocolate prices has been strong income elasticity of demand. In the United States, a 10% increase in income has been estimated to increase per capita chocolate consumption by 9.2%. Income elasticity is a little less or a little more in other countries, but everywhere chocolate is a normal good. Global income growth thus explains much of the long-term price trend.

As for volatility within the trend, supply conditions play the bigger role. Cocoa supply, like that of any farm product, is subject to fast-developing changes in growing conditions. For example, earlier this year market-watchers were worried about a virus called stunted shoot disease that threatened the crop in the Ivory Coast, the world's biggest producer. Later the virus threat proved to be overstated. Good weather, especially in neighboring Ghana, the second biggest producer, boosted supply and prices fell.

Volatility of prices is increase by the fact that chocolate demand is very inelastic. In the US, short-term elasticity of demand has been estimated at about -0.2, and is even lower in some big European consumer countries. When demand is inelastic, even a small shift in the supply curve can produce a big change in the market price.

An interesting episode earlier this year illustrates how volatile cocoa prices can be. In July, Armajaro, a London-based commodity trader and hedge fund, took an exceptionally large physical delivery of cocoa when July futures contracts expired. The price spiked in response to fears of an attempted squeeze on the market, and competitors cried foul. Armajaro vigorously denied any wrongdoing. It insisted that it was not trying to hold the delivered cocoa off the market, but needed it only to meet contractual commitments of its own. If Armajaro really had been holding the cocoa off the market, it would have lost big, since prices have fallen sharply since July.

The bottom line? You may have to get ready to pay more for your chocolate--or you may not. But look at the bright side--if the thought of rising chocolate prices depresses you, just remember that chocolate itself is a reliable cure for depression!

Click here to view or download a free set of classroom-ready slides that use the concepts of supply, demand, and elasticity to tell the story of chocolate prices. The slide show includes questions that can be used for an in-class quiz or discussion of supply and demand theory.

Wednesday, October 6, 2010

The Continuing Resolution: Fiscal Alchemy in Action?

Once again, on October 1, 2010, the federal government's fiscal year started without completion of the budget process. Instead, Congress passed a continuing resolution allowing most branches of government to keep on spending at the same rate as last year until early December. The budget process has been completed on time, without continuing resolutions, only three times in the past 35 years.

Continuing resolutions, with their short time horizons and failure even to attempt optimization of policy, are an example of what Eric Leeper has called "fiscal alchemy." (Monetary Science, Fiscal Alchemy, presented at the Kansas City Fed's 2010 Jackson Hole conference.) "Monetary policy choices," writes Leeper, "tend to be based on systematic analysis of alternative policy choices and their associated macroeconomic impacts: this is science. Fiscal policy choices, in contrast, spring from unsystematic speculation, grounded more in politics than economics: this is alchemy."

Leeper sees another sign of fiscal alchemy in the long-term debt projections issued by the Congressional Budget Office. These project debt within limits marked by a "baseline scenario" that assumes no changes in law, and an "alternative scenario" that shows an exploding debt that cannot possibly be achieved. The gap between these two projections, neither of which can rationally be expected to occur, is not only large--it is growing larger every year. (He would like to see the CBO issue more realistic, model-based projections that would narrow, although not eliminate, the range of uncertainty.)

Although no one claims monetary policy is perfect, there is a great contrast between fiscal policy by continuing resolution, with no attempt at all to provide a stable framework for expectations, and the carefully worded policy statements issued by the Fed, which explicitly recognize the importance of anchoring expectations about the future course of policy.

In a rare comment on fiscal policy, Fed Chairman Ben Bernanke has recently noted that countries that continually spend beyond their means suffer slower growth in living standards. The only real question, Bernanke says, is whether the needed adjustments to fiscal policy will take place through a careful and deliberative process that weighs priorities and gives time to adjust to new policies, or whether it will be the kind of rapid and painful response to crisis that we have recently witnessed in Greece and elsewhere.

Follow this link to download a free set of classroom-ready slides that discuss continuing resolutions and fiscal alchemy.

Tuesday, September 21, 2010

Poverty and the Recession: Is The Worst Still Ahead?

Reports released over the last few days provide final dating for the 2007-2009 recession and data on U.S. poverty and income for 2009. How are they related? How did the recession affect poverty? Now that the recession is officially over, can we expect that the worse is behind us in terms of poverty and income?

The Census Bureau report showed the poverty rate rising from 13.2 percent in 2008 to 14.3 percent in 2009, the highest rate since the early 1980s. The figure that grabbed the headlines, however, was not the overall rate but that for working-age Americans, which climbed to 12.9 percent, its highest level since the Census Bureau's continuous data series began 35 years ago. The remarkable increase in working-age poverty is undoubtedly linked to the extreme rate of long-term unemployment, which has risen far above its levels of any previous recession. The economic distress of the working-age population is further indicated by the record numbers of people without heath insurance, also a subject of the Census Bureau report.

Is the worst behind us? Unfortunately, there is little reason to hope that it is. In recessions of the 1960s and 1970s, the peak rate of unemployment tended to coincide with the year in which the recession ended, but starting with the dual recessions of 1980-82, the picture changed. Since then, peak poverty has begun to lag farther and farther behind each recession.

The bottom line: We can expect even worse poverty data in 2010 and probably in 2011 as well.

Follow this link to download a free set of classroom-ready slides with charts and analysis based on the 2009 poverty report.

Saturday, September 18, 2010

US Inflation: What is the Trimmed Mean CPI and What Does It Tell Us?

On September 17, 2010, news headlines reported that the US Consumer Price Index for August had increased by 0.3 percent. Is this a good or bad number? Unfortunately, monthly CPI changes don't tell us much. What steps can we take to make inflation data more useful for interpreting and formulating economic policy?

The first step is to convert monthly data to annual rates.  If the July-to-August monthly change (which was 0.254 percent, before rounding) were to continue for a full year, the annual rate of inflation would be about 3.1 percent. Annual rates are almost universally used in discussions of economic theory and policy.

Month-to-month changes are highly volatile. To reveal the underlying inflation trend, the next step is to look at changes in the CPI from the same month a year ago rather than changes from a month ago. Since inflation was lower for most of the previous year than it was in August, the year-to-year figure that month was just 1.1 percent, much lower than the annualized monthly figure of 3.1 percent.

The next step takes into account the fact that some prices, like those for food and energy, lie largely beyond the influence of domestic monetary and fiscal policy. Those prices are set in world markets and are subject to influences ranging from world politics to weather to oil spills. To show inflation trends with volatile food and energy prices removed, the Labor Department publishes a core CPI series. The core CPI increased at just a 0.9 percent annual rate in August.

Finally, we might ask, why adjust only for food and energy prices? Why not exclude any prices that show unusual changes in a given month? The Cleveland Fed publishes just such a series, called the trimmed mean CPI. It excludes the most extreme 16% of price movements each month. Many economists see it as the clearest indicator of underlying inflation trends, an improvement over the core CPI. The trimmed-mean CPI and core CPI numbers were about the same for August, 2010, but the trimmed mean series shows a more pronounced trend toward lower inflation over the previous two years.

The bottom line: Monthly inflation figures can sometimes signal a turning point in inflation, but those turning points are just as often masked by random noise. At present, the core CPI and trimmed mean CPI show that US inflation is still on a downward trend. Expect the Fed to stick to its easy-money policy until the trend shows a clear upward turn.

Follow this link to download a free set of classroom-ready slides discussing the trimmed mean CPI and other CPI variants. You may also want to steer your students to the Cleveland Fed's nifty interactive tool for generating inflation charts using all sorts of different inflation measures.

Monday, September 13, 2010

More on Financial Reform and Basel III: Regulating Bank Liquidity

As an earlier post explained, the Basel III agreement, now under negotiation, will set international capital adequacy regulations for banks. It will also set regulations for bank liquidity, which are the subject of this post.

Banks need liquidity because they cannot always control the timing of their needs for funds. For example, depositors may make unexpected withdrawals, sources of wholesale funding may not be rolled over in a crisis, line-of-credit agreements may create demands for liquid assets to fund loans, and off-balance sheet obligations provide further liquidity needs.

Bank runs are the classic form of liquidity crisis. Although deposit insurance mitigates runs on retail deposits in most advanced countries, insurance does not extend to large depositors or wholesale funding. As runs deplete a bank's liquid reserves, it can be forced to sell less liquid assets at "fire-sale" prices below book value. Doing so erodes its capital and may lead to insolvency.

During a crisis, a liquidity spiral may develop that spreads problems from weaker to stronger banks. Early in the crisis, a few weak banks are forced to dump assets to cover deposit losses, collateral calls, or other liquidity needs. Falling asset prices weaken the balance sheets of other banks, and force them, too, to sell assets are fire-sale prices. Soon even healthy banks are subject to stress. In the fall of 2008, just such a liquidity spiral helped spread the financial crisis throughout the globe from its origins in the U.S. subprime mortgage market.

Regulations to moderate liquidity risk can apply to both the asset and liability sides of bank balance sheets. Asset side regulations can require minimum cash reserves, including reserve deposits at central banks, and can also encourage holding of additional liquid assets like short-term government bonds. Liability-side regulations can limit banks' reliance on volatile wholesale funding while encouraging use of stable funding like capital and insured retail deposits.

The Basel III negotiations, now underway, include discussion of two major liquidity regulation initiatives. One is a proposal for a liquidity coverage ratio sufficient to guarantee that a bank could survive a 30-day stress period, hopefully long enough to permit recapitalization or orderly wind-up. Another proposal calls for a net stable funding ratio based on a ratio of available stable funding to required stable funding. The former is a weighted average of liabilities, with stable sources of funding like retail deposits and capital having high weights, and the latter is a weighted average of assets, with the most liquid assets having low weights.

The Basel III agreements are supposed to be completed by the end of 2010. They are the object of tough negotiations among national governments and fierce lobbying by banking interests. A preliminary meeting in July already resulted in some watering down of the initial proposals, including an agreement to postpone implementation of the net stable funding ratio during several years of observation. The final form of the Basel III agreements is certain to be a significant factor in shaping the timing and severity of the next banking crisis.

Follow this link to download a free set of classroom-ready slides explaining the need to regulate bank liquidity and discussing the Basel III proposals. These slides are best used together with those attached to my earlier post on Basel III and bank capital, which provides additional information on the Basel agreements in general.

Thursday, September 2, 2010

Bernanke Confronts "Too Big to Fail"

In recent testimony before the Financial Crisis Inquiry Commission, Fed Chairman Ben Bernanke confronted the "too-big-to-fail" problem head on. "If the crisis has a single lesson," he said, "it is that the too-big-to-fail problem must be resolved."

How did the US banking system get into this position? It used to be known as a system of small banks, and there are still nearly 4,000 community banks with assets under $100 million. However, most of the growth of banking in recent years has come from large, multi-bank holding companies. According to FDIC data, the 105 banks with more than $100 billion in assets hold 78 percent of all bank assets. Even more striking, just four banks, each with $1 trillion or more in assets, control 58% of all bank assets.

A bank is too big to fail if its failure would threaten the function of the whole banking system via losses to uninsured depositors, losses to counterparties on complex transactions, and general fear of dealing with all banks when even the largest are seen as vulnerable. When banks become aware that they are protected from to failure, they become subject to the problem of moral hazard. Knowing they will be bailed out when they get in trouble, they take too many risks. Confident of bailouts, investors, in turn, supply capital to the biggest banks at favorable rates, so the big grow ever bigger.

What can be done? One solution would be to break up the biggest banks into smaller institutions. Such measures were discussed, but rejected, during recent discussions of financial reform. Instead, the 2010 Dodd-Frank Act took a different approach. It attempted to eliminate moral hazard by instituting a new resolution mechanism for complex banking organizations that would allow even the largest institutions to be wound up without bailouts of management, shareholders, or counterparties.

Will it work? It all depends on credibility. "Simple declarations that the government will not assist firms in the future . . . will not be credible on their own," Bernanke said in his recent remarks. Declarations of intent need to be backed up not just by Dodd-Frank type resolution mechanisms, but by other measures as well, such as the stronger capital requirements expected under the forthcoming Basel III agreements.

Ultimately, though, we will not know if the new measures will work until they are tested. We will find out only when the next crisis strikes.

Follow this link to download a free set of classroom-ready slides discussing the too-big-to-fail problem.