The policy world has turned on Ken Rogoff and Carmen Reinhart with a vengeance. The two are the celebrated authors of multiple studies showing that very high levels of government debt have historically been associated with slower growth. After a review of one of their articles revealed a spreadsheet mistake, the ever-temperate Paul Krugman was driven to ask: "Did an Excel coding error destroy the economies of the Western world?"
John Maynard Keynes once said that "even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist."Apparently, this bondage is felt even more acutely when those practical men are in the thrall of a living, breathing pair of economists. Now that Rogoff and Reinhart have been discredited, the thinking seems to go, the masses who had been suffering under the yoke of austerity are now free to spend as they had always wished.
There are a number of reasons to see this as an overreaction. The episode is a bit analogous to a researcher finding that a daily Twinkie adds 10 pounds over a year. A subsequent study finds that, with different methodology, a daily Twinkie might add only 5 pounds over a year. Then the baying pack howls that they knew Twinkies were good for you all along, they abjure dieting, and stuff themselves with cake and cream filling. [Reinhart and Rogoff respond to the criticisms and put the dispute in the context of a broader literature without resorting to any talk of dessert cakes.]
An odd strain of the discussion has been the implication that the only restraint on unbounded budget deficits has been the Reinhart-Rogoff admonition that it could slow economic growth. In fact, there are other constraints. How much can Portugal or Greece or Cyprus spend beyond current tax revenue? They can spend the money they have in savings (negligible) plus the amount they can borrow in the open market (negligible) plus the amount that other countries or international financial institutions (IMF, ECB) are willing to lend them. The limitation, then, is not Harvard researchers' findings but rather the willingness of other leaders to risk their funds, as their thoughts teem with admonitions about "sending good money after bad."
Of course, countries such as the United States, France, or the UK can borrow on open markets. That does not free them from all non-academic constraints, however. If borrowing is excessive, a country begins to look riskier. The United States was downgraded in 2011, France in 2012, and the UK last week. Even the IMF, cheering now for a spending boost, has argued for offsetting medium-run budget cuts.
The Reinhart-Rogoff episode has prompted deeper ruminations about how grounded our economic beliefs really are. In the Wall Street Journal, Carl Bialik elicits a confession from the editor of the American Economic Review that peer review rarely involves line-by-line checks of authors' calculations. Bialik lays bare some of the inherent vagaries of working with historical macroeconomic data -- there are no controlled experiments and the numbers can be unreliable.
It is thoroughly healthy to review the limitations of empirical macroeconomics. It is the part of economics that deals with the most moving parts and has the least opportunity to isolate treatment effects from confounding variables. Economics does far better as a field when conditions are more favorable -- predicting how an auction will work, for example. Yet citizens and policymakers want to know what will happen with inflation, unemployment, and growth, and how these will be affected by government spending, taxes, and the money supply. These are all macroeconomic questions.
Let's stipulate, then, that macroeconomic point estimates should be treated as somewhat fuzzy. That was always acknowledged in the formal economics (standard errors), but it does not usually make for good newspaper copy. If multiple studies, using different data sources and different techniques, find similar results, then we will have steadily more confidence in those findings. This has always been true too, though in public debate participants tend to prefer a single bold study to a lengthy lit review.
The newfound caution about macroeconomic findings has, so far, been curiously selective. Foes of austerity argue that, after slaying the dreaded Reinhart-Rogoff result, they are not even bound by warnings of credit downgrades. After all, if only we adopt new fiscal stimulus, it will promote growth and pay for itself (debt/GDP will fall as GDP rises faster than debt).
How do we know this? Why should we believe that the stimulative effects of new spending will overcome people's worries about the new taxes that will inevitably follow? How can we calculate how much stimulus is appropriate? Are tax cuts or spending increases more appropriate? If we do not see booming economic growth after stimulus has been tried, how will we know that the stimulus was worthwhile, that it saved us from an even worse fate?
We have macroeconomic findings. Precisely calculated macroeconomic findings. Based on historical data. Published in peer-reviewed journals. Worked out on spreadsheets. Let the spending commence.
Yesterday the IMF chided the United States and the United Kingdom for their recent pursuit of austerity. The organization released its latest World Economic Outlook in anticipation of the annual World Bank-IMF spring meetings in Washington, when global financial dignitaries gather.
The IMF put forth top officials to discuss the organization's forecast -- which I'll take up in another post -- and also to critique the state of fiscal affairs in major countries. Carlo Cottarelli, the director of the IMF's fiscal affairs division, described 10 economies with serious fiscal problems -- debt in excess of 90 percent of GDP and rising. These 10 -- the United States, Japan, the UK, France, Italy, Spain, Belgium, Greece, Ireland, and Portugal -- account for 40 percent of world GDP (for all the headlines they draw, Greece, Ireland, and Portugal account for very little of that global GDP).
Cottarelli warned that there were numerous studies indicating that when debt hit 80 to 90 percent of GDP, growth would suffer. This seemed an oblique reference to the bubbling controversy over the work of Ken Rogoff and Carmen Reinhart. Count the IMF in the camp that think Rogoff and Reinhart are basically right. Cottarelli's conclusion, given his reading of the broader evidence, was that a country should not seek to stabilize debt/GDP at the 90 percent level, but rather should aim for significantly lower levels of debt.
While that might seem to support a call for austerity, the IMF's short-term policy conclusions were just the opposite. As the Wall Street Journal reported it:
"...the International Monetary Fund on Tuesday called on countries that can afford it -- including the U.S. and Britain -- to slow the pace of their austerity measures ... it warned euro-area policy makers against focusing too much on hitting tough deficit targets, saying they risked further deepening their downturn. ‘Fiscal adjustment needs to proceed gradually, building on measures that limit damage to demand in the short term,' the IMF said."
There were two interesting caveats to this call, however:
1. This recommendation to back off austerity only applied to countries that are not currently subject to market pressures.
2. Short-term easing needs to be paired with credible medium-term restraint. (Borrow more today; pay it back tomorrow).
Those caveats are critical and raise all sorts of questions. Fortunately, I was at Cottarelli's press conference and got to ask.
Take the "market pressures" exception. You know a country is experiencing "market pressures" when that country's bondholders are panicking, a debt sell-off is underway, and interest rates on sovereign debt are soaring. When no one wants to buy or hold your debt, it is an awkward time to try issuing more. On this, there is broad agreement.
But how do you know when investors are about to lose faith in your debt? Is there any reason to expect advance warning? When should preparations begin?
Cottarelli's response was that we do not really know in advance. We have to guess. There are some indications of vulnerabilities -- a country whose debt is held more by international investors is more vulnerable -- but it's an art, not a science.
An honest but unsatisfactory reply. It does little good to say that we know market pressures when we see them. Once the market has turned on your debt, it's too late. Budget processes are slow, with long lags from initial discussion to actual spending. If interest rates were to spike on U.S. debt in September 2014, borrowing for that time period is covered by the budgets currently under discussion in Congress. And, for the record, Federal Reserve data show that in 2011 roughly 46 percent of U.S. debt was held by international investors.
On the question of repaying additional short-term borrowing with medium-term frugality, I asked about judging the credibility of fiscal plans. The U.S. fiscal stimulus of 2009 was supposed to be a temporary measure, but worked itself into spending baselines. Congress regularly adopts measures that ‘balance' 10-year budgets, only to repeal those measures when the time comes. A classic example is the attempt to cut payments to Medicare providers, requiring a regular "doc fix" when it turns out there is a limit to the pro bono services doctors will provide. So how do we know that medium-term promises are credible?
Cottarelli suggested that a first step was to look at whether a plan contained sufficient detail. Beyond that, though, he acknowledged it was a much more difficult issue. His recommendation was to look at a country's past record of implementing fiscal adjustment.
Other than the recent austerity, to which they object, it was unclear which episodes in recent British or U.S. fiscal history offer reassurance on this count.
The rationale for the IMF's call to set aside austerity is pretty clear -- large parts of the world are slumping, central banks are doing all they can on the monetary side, so the IMF would like to see a boost to demand through looser fiscal policy (lower taxes or higher spending). The Reinhart-Rogoff controversy is a sideshow here. The IMF is not embracing ever-rising debt levels; it is pushing select countries to adopt a temporary slump-busting burst.
Yet if one runs through the IMF's own check-list of pre-requisites for short-term relaxation -- current debt at sustainable levels; freedom from worry about a market panic; credible medium-run plans for cuts -- none of them seem to apply. The IMF prescription appears less a careful calculation than a double gamble. It is a bet that further short-term measures are appropriate to address a slow-down that has now dragged on for five years, and also a bet that those who adopt the prescription will not have to pay a hefty price down the line.
Stephen Jaffe/IMF via Getty Images
The conquering of the euro crisis seems like something out of a fairy tale. Faced with a gut-wrenching peril, our hero closes his eyes and chants an incantation: "Whatever it takes!" Suddenly, once-insurmountable troubles melt away and everyone lives happily ever after.
So what happened? Was it all in our minds? Was the episode anything more than a panicked bunch of bond traders, stampeding toward a precipice but now safely pacified and redirected?
As last summer turned into fall, Italy and Spain were wobbling. The two countries -- the third and fourth largest economies in the eurozone -- saw their bonds shunned by global investors. For the heavily indebted pair, a bond sell-off meant that interest rates rose and disaster loomed. At some point, the high price of borrowing would become unbearable. The eurozone nations had gathered funds to try to avert a crisis, but the sum would not be enough to cover the needs of such large member economies.
Then Mario Draghi, head of the European Central Bank, stepped in to save the day. He announced that the ECB would do whatever it took to save the currency. If extra funds were needed, the ECB would provide them through a program it called Outright Monetary Transactions -- the unlimited purchase of troubled nation bonds once those countries asked for help.
The effect of his announcement was dramatic. Bond yields fell as buyers relaxed. While the previous bailout fund might have been limited, the ECB's ability to print money and buy bonds was not. The restoration of calm was so successful that the ECB did not have to actually do a thing -- the mere announcement that it was willing to act relieved the pressure on Spanish and Italian borrowing.
It is hardly a novel idea to think that a dangerous market panic could be settled by words alone, so long as those words were credible and uttered by the right person. So, do we mark this up as an instance of judicious intervention? A daring move by Mario Draghi that saved the European project and merited his selection as the Financial Times' Person of the Year?
Maybe. The problem is that the sovereign debt problems plaguing Spain and Italy were only one part of a multi-dimensional crisis. The other problems remain, two in particular. First, the untenable contradictions of the eurozone's approach to banking have not been resolved. Second, the beleaguered countries along the eurozone's periphery are being asked to endure potentially unbearable levels of unemployment and economic stagnation.
The banking problem can seem the most obscure part of the problem. Yet as the global financial crisis demonstrated, the provision of credit is the lifeblood of an economy. Cut off credit and economic asphyxiation sets in quickly. Europe's additional discovery was that, in a single currency zone, money could flow very rapidly from any bank perceived as risky to others perceived as safe. Any hint that a bank's host country might leave the euro or that the bank might have gorged itself on dubious sovereign debt would be enough to start the exodus of funds. No funds, no credit, no economic activity.
Eurozone leaders resolved to fix this with a banking union. And then they ran into politics. Banking regulation is sensitive. There was little appetite for ceding control. Last week, discussing a recent bilateral move by France and Germany to coordinate their banking policies, the Financial Times' Wolfgang Münchau wrote:
"My suspicion is that the ultimate intent of the Franco-German legislation is to secure the position of their national champion banks ... The most important signal sent by the unilateral legislation in France and Germany is the lack of political will to sort out the banking mess, which is at the heart of the eurozone crisis. Instead, governments are seeking refuge in symbolic gestures ... The renationalisation of banking means that the monetary union is as unsustainable today as it was in July last year -- and now the policies needed to fix this problem have been abandoned."
This was one danger of Draghi's move. By alleviating the sense of impending doom, he also may have undermined the impetus for overcoming entrenched opposition to reform.
The growth and unemployment situation is not much better. A story this week, contrasting positive Spanish sentiment with dismal performance, detailed the economic turmoil in the country:
"...in the last quarter of 2012 ... the number of companies declared bankrupt soared by almost 40 per cent to 2,584. It was the highest number since the crisis began, suggesting that the situation for credit-starved Spanish companies is not only getting worse -- but getting worse faster than before ... Nor has there been any sign of a turnround in Spain's dismal unemployment numbers, which continue to rise towards 6 million, or more than 26 per cent of the workforce ... The IMF expects a drop in GDP of 1.5 per cent this year -- a worse recession than in 2012."
We also come upon another danger of Draghi's move: By restoring confidence in the euro, he paved the way for the currency to rise, which did no favors for eurozone exporters. That's hardly the cause of Spanish economic woes, but it is no help, either.
And then, as always, the democracies of Europe have politics. Spain's governing party is caught up in a political scandal. Italy is moving back to electoral politics after a technocratic interlude. It is not clear that difficult political choices will get much easier in either case.
The list of eurozone perils is alarmingly long. Yet a remarkable sense of calm prevails in the markets. Perhaps this will be a crowd-pleasing story book ending, the sort in which impossible obstacles are overcome and everyone goes home happy. Or perhaps it will be the kind of story one rarely sees out of Hollywood, in which our blissful hero opens his eyes, only to find that he had dreamt his salvation and the threats remained, more menacing than before.
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Many of the news reports on Argentinean President Cristina Kirchner's landslide reelection victory this past weekend contained a healthy dose of skepticism on the sustainability of her populist economic model. The skepticism is well-founded. We've all seen this movie before, and know exactly how it ends.
Heavy state intervention in the economy, massive subsidies, and the
redistribution of income -- the hallmarks of economic populism -- have a way of
playing themselves out, proving time and time again that lasting prosperity can
never be built on acquiring unlimited debt or just printing more money.
As UCLA economist Sebastian Edwards, a Chilean, writes in his brilliant takedown of Latin American populism, Left Behind: Latin America and the False Promise of Populism, all populist experiments begin with great euphoria and surges in economic growth, but invariably lead to rapid inflation, higher unemployment, and lower wages -- and soon thereafter, stagnation and crisis.
There is no question that right now times are good in Argentina. Since the country hit rock bottom in 2002, when it defaulted on $100 billion in debt, the largest sovereign debt default in history, the country has undergone a seemingly remarkable turnaround under the stewardship of the late Nestor Kirchner and now his widow, Cristina. The economy is expected to grow by 8 percent this year and unemployment is at a 20-year low.
But the problem is that Argentina's economic success has been built not on
strong fundamentals, but on a tenuous foundation of heavy government spending,
high commodity prices, and strong demand from China and Brazil for soy and
other agricultural products. And what goes up in economics can always come
Other troubling signs are double-digit inflation, which private economists put at 25 to 30 percent; capital flight ($9.8 billion was pulled out of the economy in the first half of this year, compared with $11.4 billion in all of 2010); and plummeting foreign investment (down 30 percent in the first half of 2011).
The other elephant in the living room is the fact that Argentina has been shut out of credit markets since it left bondholders holding the bag in billions of dollars of unpaid debt from its 2002 default. Not only has there been no reconciliation, but the Kirchner government has gone out of its way to reject lawsuits and other claims from creditors. As a result, the Obama administration and multilateral lenders have refused further loans until Argentina begins to repay what it owes investors and settle with holders of defaulted debt, as well as adhere to its obligations with institutions such as the International Monetary Fund.
Yet despite warnings by economists that the government's profligate spending, coupled with a global economic slump, could spell disaster, the Kirchner administration soldiers on. Indeed, why wouldn't it see her overwhelming reelection victory as anything but a mandate to continue its unorthodox ways? "After a lifetime of pushing those ideas," she said after her victory, "We now see that they were not a mistake and that we are on the right path."
On the other side, former President Eduardo Duhalde, who unsuccessfully challenged Kirchner, said, "We're happily dancing on the Titanic."
Given the prevailing capital flight and declining investment in Argentina, the smart money is obviously on Duhalde. Fortunately, those players are in a position to avoid the risk; what's unfortunate are the millions of poor and middle-class Argentineans who will once again pay the price for Argentina's populist folly when the inevitable day of reckoning returns.
Congressman Gary Miller held hearings earlier today on the impact of the World Bank and
other Multilateral Development Banks on U.S. National Security.
I was asked to submit testimony. If you sort through the details, the stakes could not be higher for the United States and our continued leadership in the world.
The context for the hearing is that the Obama Administration is asking for five $400 million installments for what is called the "General Capital Increase" for the World Bank and several of the regional multi-lateral development banks including the African Development Bank, the Inter-American Development Bank, and the European Bank for Reconstruction and Development. This money is not the typical hat passing exercise that the Hill sees every few years for the lowest income countries (the so-called "IDA replenishments"), the General Capital Increase is about the United States maintaining its de facto control over these institutions and ensuring that they remain instruments of an American Style Globalization.
Asking for additional money for the World Bank and other multilaterals at this time has got to be one of the hardest things I can think of. There are many reasons that Republicans criticize the multilateral banks including the World Bank. Having worked at the World Bank Group for four years, I am keenly aware of the many shortcomings of these institutions but I also understand how useful these institutions are to the United States and our economic and national security interests.
During the 2008-2009 Financial Crisis, we, along with the other owners of the Banks told them to "send everything that can fly." These institutions provided critical financing including trade financing to keep the global trade system open and they supported our friends and allies at a time of great challenge for the global system. As a result, the financial crisis in many parts of the world was less dramatic and they covered for us while we were tending to our problems here at home. The problem is that these banks lend against shareholder capital and all of the existing capital is now "spoken for" because of this massive lending as part of our response to the crisis. If we want these exporters of a U.S. version of globalization to continue we are going to have to put more money into these institutions.
For those of us who live in DC, it is common to think of the World Bank as an exotic institution. If you peel back the accents and the hauteur, you find an American DNA: all the experts studied in the States, they all work in English, they export policy ideas that were made in America, they use U.S. or British law for much of their work and they export American invented standards. U.S. policymakers worry about developing countries taking money from Venezuela, Russia, Iran, or China. The World Bank and the regional development banks (plus the IMF) are our set of alternatives to these funders and models of development. Oftentimes developing countries would prefer to take World Bank money and the expertise that comes with it because these institutions for all their problems have some of the best experts in the world.
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On Wednesday, in response to Rep. Paul Ryan's "Path to Prosperity," President Obama announced sweeping cuts to the budget to pay down the deficit, including significant defense cuts. In contrast, Paul Ryan's budget proposed last week did not significantly decrease defense spending, indeed it matched President Obama's FY12 request submitted in February.
House Republicans seem to realize that defense is different. President Obama appears to believe that defense is a large part of the problem.
His proposals would cut $400 billion in security spending from the budget by 2023. Two months ago, the president submitted a budget to Congress that already included cuts to defense. The president now seems to think that those were not significant enough.
Adding to the confusion is the fact that during the run-up to the administration's FY12 request, Secretary Gates made clear that the $178 billion in cuts forced upon the Pentagon by the White House during the budget process left "the minimum level of defense spending that is necessary, given the complex and unpredictable array of security challenges the United States faces around the globe: global terrorist networks, rising military powers, nuclear-armed rogue states, and much, much more." Gates went on to say that proposals for major reductions in defense spending would be "risky at best, and potentially calamitous."
Instead of listening to Gates, Obama now is following the lead of Deficit Commission co-chairs Erskine Bowles and Alan Simpson. They, at least, were honest about their goals. Their proposals released last December included "Keep America safe, while rethinking our 21st century global role."
Ongoing unrest in the Middle East and U.S. involvement in an unexpected war in Libya, extensive humanitarian operations in Japan, and continued threats from rogue regimes such as North Korea and Iran, should remind us that "rethinking our 21st century global role" is not possible. Just addressing current challenges, let alone preparing for the threats of tomorrow, will be difficult at current funding levels.
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Secretary of Defense Gates is right. It would be a tragic irony if, having come this far in Iraq, the United States faltered and failed to fund adequately the next phase of the mission. Even with adequate funding, the mission will be hard enough.
Congress is right to take a hard look at the Iraq situation. The security needs in Iraq exceed anything the U.S. State Department ever has dealt with in the past. The current plan, which will shift the burden almost entirely from the Department of Defense to State, is distinctly inferior to the original plan, which envisioned a renegotiation of the Status of Forces agreement to allow a modest U.S. military presence as a stabilizing factor. The administration fumbled the original plan and while Gates hints at the possibility of reviving it at the eleventh hour, it may be too late. The current plan relying on the U.S. State Department to do more than it ever has done before is a barely satisfactory Plan B. But it is manifestly superior to Plan C, which involves walking away from Iraq entirely and hoping for the best. I believe once Congress has looked at and thought about the situation carefully, it must conclude that funding the State Department plan is the only responsible course of action available at this point.
I understand the frustration of people who believe the Iraq war was a mistake from the start, but I do not understand their desire to compound what they believe to be one error with strategic blunders of comparable proportions: abandoning Iraq or failing to provide the resources necessary to keep Iraq on a successful trajectory.
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In an alternate universe, today's Washington Post would have a screaming, 4-column front-page headline:
U.S. must reduce deficit, IMF warns
Responding to the imaginary lead story, a contrite President Obama, fresh from ignoring his own deficit-cutting panel's recommendations in this week's State of the Union address, would appear before the media with International Monetary Fund chief Dominique Strauss-Kahn at his side, looking on sternly. The president, with a glance back at Strauss-Kahn, would step up to the podium and sheepishly retract his newly-announced grab bag of spending plans. "Never mind. Back to the drawing board."
When pressed by reporters ("Really?"), the president would reply, "The IMF has spoken. What can we do?"
It is in this alternate universe that the hopes of G-20 enthusiasts reside. Despite the best efforts of Treasury Secretary Tim Geithner in Seoul last fall, the G-20 rejected plans for automatic criteria that might have pushed unbalanced economies into rehab. Instead, the countries settled for a world in which the IMF would play the leading role, naming and shaming countries with excessive borrowing or lending.
Back in our universe, the president continues with his plans for green energy 'investments' and promises to get serious about the deficit at some unspecified future date. The IMF did, in fact, issue its name-and-shame warning and the Washington Post did, in fact, run the story -- on p. A16, just 15 pages after its lead story about how the Office of Personnel Management released federal workers too late for Wednesday's snow storm.
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Foreign aid is once again under fire. Every so often a few politicians -- usually Republicans -- get up in arms about our government's gift of large amounts of money to other countries. Equally often, media stories appear detailing how ineffective aid supposedly is. The picture emerges that foreign aid is unnecessary, ineffective, and wasteful.
For example, the Republican Study Committee (RSC) released a proposal last week to cut the budget for the U.S. Agency for International Development (USAID) by $1.39 billion as part of a broader package of deficit-reduction proposals. (Hat tip to our friends at The Cable for their post on the subject.) There were similar rumblings after the Republican takeover in 1994. Republicans seem to have an inborn suspicion -- usually dormant, but one that fitfully flares up once per decade -- that aid is just a handout from rich countries to poor ones to help the former ease their consciences.
Or take the lengthy Wall Street Journal story last week that declares, "A massive U.S. aid program that has made Pakistan the world's second-largest recipient of American economic and development assistance is facing serious challenges, people involved in the effort say. The ambitious civilian-aid program is intended in part to bolster support for the U.S. in the volatile and strategically vital nation. But a host of problems on the ground are hampering the initiative." Despite billions of aid, the United States remains unpopular in Pakistan; thus, the article implies, aid is ineffective.
These criticisms of foreign aid rest on faulty notions of what aid is and what it is supposed to accomplish. There are two views of aid reflected here, neither of which are helpful.
I propose a third view of foreign aid.
The advantage of this view is that it is realistic. The United States can actually do this. The U.S. is not trying to change people's heart or minds, contrary to the bribery view. It is only trying to change their capacity. Additionally, this view helps the U.S. prioritize which countries should get aid, and what kind, contrary to the charity view. Giving billions to Tuvalu would be a commendable act of charity for the Salvation Army, but it would be folly for USAID because Tuvalu is not a strategic priority for the United States.
(I am not arguing that we should never be charitable. Rather, every possible foreign aid program is an act of charity. Charity by itself cannot help us decide which charitable programs to undertake. The United States either has to flip a coin to allocate our charity randomly, or consult our own interests to allocate it strategically.)
The Marshall Plan is a good model. The United States gave something like $25 billion (in today's dollars) per year to Western Europe after World War II. It was undoubtedly an act of charity. The money helped the Europeans rebuild their economies and saved tens of millions of people from poverty or even starvation. But it was also a strategic investment. Policymakers at the time worried about a return of the Great Depression following demobilization and the Marshall Plan helped Europe become a strong trading partner for the United States. Most importantly, U.S. officials feared the rise of Soviet power and hoped the Plan would bolster European governments' stability and prevent the spread of communism.
This view of foreign aid would help protect it from the kind of cuts the congressional Republicans are proposing. Aid is hard power. It is a weapon the United States uses to strengthen allies and, thus, ourselves. But this view would also help save it from the kind of limitless, grandiose visions Democrats sometimes seem to have for it. This is the sort of view that I hoped Secretary of State Clinton would incorporate in the recent Quadrennial Diplomacy and Development Review. But despite the document's many strengths it did not seem to offer a framework for prioritizing among the Unites States' many foreign aid opportunities.
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Well, that was awkward. The world's leading economic authorities just gathered in Washington for a weekend session of policy glowering. Heading into the regular fall meeting of the World Bank and International Monetary Fund, there was some hope that some constructive, multilateral dialogue could defuse tensions and calm talk of currency wars. It was not to be.
What happened? The United States went into the meetings pushing for multilateral solutions, in particular an enhanced role for the IMF. In a speech at the Brookings Institution last week, Treasury Secretary Tim Geithner addressed the issue of global misalignments:
This problem exposes once again the need for an effective multilateral mechanism to encourage economies running current account surpluses to abandon export-oriented policies, let their currencies appreciate, and strengthen domestic demand.
He noted that this was part of the long-standing mission of the IMF, then went on to argue that the world's powers had already agreed to address these issues:
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During the mid-1970s, while working as a very junior banker in the City of London, I was an eyewitness to a bank run. It was not a pretty sight. Small savers in particular were desperate not to lose their life savings. And the desperation showed.
The run was a small part of a rash of bank failures that were taking place across Europe, among them the German Herstatt Bank, as well as London and County Securities in the UK. Apart from facing down angry clients, banks immediately pulled back from lending funds on the overnight market, for fear that they might not be repaid. This behavior only compounded an already difficult situation. (Ironically, one bank all we were ready to deal with was Moscow Narodny; everyone figured the Soviets would never let their bank go under.)
Afghanistan's largest bank, Kabul Bank, is now in the midst of fending off a run on its deposit accounts. As was the case those many years ago in Europe, it is the small depositors who are the most angry, vociferous, and panicked. Big depositors are bailing out as well. Somewhere between $180 million and $300 million have been withdrawn, and the bank has only some $250 million left in liquid funds.
Like so many other institutions in Afghanistan, Kabul Bank is both politically well connected and the subject of rumors about corruption. Moreover, the news that Khalilullah Frozi, one the two largest Kabul Bank shareholders, was recently ousted as CEO because of purported corruption by the bank's leadership, does not help matters at all. That one of President Karzai's brothers, Mahmoud Karzai, is the bank's third largest shareholder -- and that the bank manages the government's payroll -- provides particular ammunition for Karzai's enemies. Finally, because a bank run is not a rational affair -- depositors panic when they read of other depositors withdrawing funds creating the human equivalent of a cattle stampede -- it matters little whether the rumors of corruption are true or not.
The United States has rushed a small number of experts to Kabul to provide technical assistance to the bank and reassure depositors. Mahmoud Karzai wants more than just technical assistance, however. He is calling for American financial assistance to cover all depositors. Since the bank has assets of only about $1.3 billion, it is not a large sum relative to what the United States pours into Afghanistan on a monthly basis. The money is not really the issue, however.
The United States has still not pulled out of its own recession, and unemployment remains high. There is continuing resentment of the administration's various bailouts, with anger directed at Wall Street in particular. In these circumstances, bailing out a foreign bank whose leaders are being accused (whether rightly or wrongly) of corruption is a highly risky undertaking. It does not help that Kabul Bank has acknowledged that it made some large and risky investments in Dubai villas for rich Afghans. These investments turned to dust when the real estate bubble in the Gulf state burst wide open in 2008. Moreover, American taxpayers could legitimately ask why Afghans are rushing to pull out their money, and where those funds are being deposited. Are they back in Dubai? In Switzerland? In the Cayman Islands? Or have they been retained in Afghanistan -- as they should be -- and recycled into the eight other, smaller, Afghan banks? And will Kabul Bank continue to manage the government's payroll? Or will that lucrative business be transferred to another Afghan Bank?
It is critical that Washington continue to assist with the restructuring of the Afghan banking system in general, and with sorting out Kabul Bank's problems in particular. A healthy banking system is critical to the strength of the Afghan economy, which in turn is a necessary condition for winning the war against the Taliban and other insurgents that plague the country.
Nevertheless, before any American money is funneled into the Afghan banking system, that system needs to be completely overhauled. Too much money has been alleged to have seeped out of the country to foreign bank accounts. It is therefore critical that the banking system be a model of financial probity. Until now, bank regulation clearly has not been all that it should be, and that must change immediately. In addition, there should be a loosening of the nexus between private ownership of the banks and the government. The tight links between the two sectors seem to have hurt both parties. Only if those conditions begin to be met should American taxpayers' funds be used to prop up Kabul Bank -- but by then, Kabul Bank will have become a very different kind of bank.
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In the Cold War, public sensibilities about imminent threats were partly shaped by pop culture offerings, such as the spy thriller. For a modern version, imagine the following scene:
The camera captures the late afternoon sunlight glittering off the Aegean Sea as music thrums and hints of action to come. A yacht coasts across the screen, sporting a languid beauty sunning herself on its prow. Eventually, the cabin comes into view. Within, we see a dapper gentleman in a tuxedo. The voiceover intones:
"The fate of Europe rests with one figure: Bond. Greek Bond."
Zoom in on gentleman's laptop spreadsheet.
Greek government bonds have been sinking, and they threaten to take the grand European integration project down with them. The crisis has tapped into deep-seated feelings about Europe and its history: Greek politicians claimed they would not have these problems if not for the residual effects of Nazi plunder; German politicians responded that if the Greeks were really hard up, why didn't they go ahead and sell a few islands?
Greece is deeply in debt and borrowing heavily, its economy is contracting, and since joining the euro in 2001 it no longer has its own currency. A bailout would be nice, but the European Union has rules forbidding it. If we run down the standard list of palatable economic remedies, that leaves Greece with...
Nothing. A currency depreciation is a standard remedy when prices and consumption have risen too high, but that's not possible within the euro. Austerity can bring down borrowing, slow the economy, and induce deflation, but it would be extraordinarily painful in Greece's case. Greece has a budget deficit above 12 percent of GDP. Draconian budget cuts could slam the brakes on an economy in which unemployment crested 10 percent -- before adoption of serious austerity measures.
So Greece is left only with unpalatable options. It could tough it out with cuts and contractions, it could look to renegotiate its debts, or it could leave the euro. The last option is seen as nearly unthinkable. FP's Annie Lowrey has explained that a withdrawal from the euro would necessitate a departure from the European Union at the same time. Since Greece has been borrowing in euros, a departure and depreciation would make its massive debts harder still to pay, thus almost ensuring default. A default would have its precedents; University of Maryland economist and debt expert Carmen Reinhart notes that since its independence in the 1830s, Greece has been in default roughly half the time.
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By Phil Levy
Tom Friedman tries to make the case for China as a juggernaut in today's New York Times in a piece entitled "Is China the Next Enron?" Not to worry, he writes:
[China] has a political class focused on addressing its real problems, as well as a mountain of savings with which to do so (unlike us)... Think about all the hype, all the words, that have been written about China's economic development since 1979. It's a lot, right? What if I told you this: "It may be that we haven't seen anything yet."'
There are a lot of factors that determine the fate of a country with over 1.3 billion people. Let's just focus on the question of savings, though, since it is central to Friedman's case and he has raised a basic fallacy that often drives China discussions.
The mountain of savings is China's accumulated foreign exchange reserves. Friedman facetiously offers up this wisdom:
...a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves."
As he well knows, China's massive reserves are unprecedented. They may also now surpass $2.4 trillion.
This image of a dragon sitting atop a hoard of gold colors a number of international policy discussions. It was central to the debate at Copenhagen, in December, when China led the developing world in asking for compensation from the West for policies to cut greenhouse gas emissions. This seemed risible to Western nations swimming in debt and trade deficits.
China's stock response is that it's a poor country. Just how poor depends on how you deal with China's misaligned exchange rate, but the numbers for 2008 range from about $3,000 to $6,000 annual income per person. That compares with roughly $47,000 per person for the United States.
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What should we make of the kerfuffle over the Indian Prime Minister's state visit to Washington today? Manmohan Singh's summit with President Obama, scheduled in part to offset the president's unfortunate decision not to visit India on his first Asian tour, has been plagued by disappointment in Delhi. India does not enjoy the pride of place in America's foreign policy agenda granted it by President Bush and even by President Clinton in the last years of his administration. Why not?
This U.S. administration, unlike its predecessor, appears to disfavor values-based cooperation as an organizing principle of American foreign policy, diminishing policymakers' appreciation of India as the world's largest democracy and subjecting cooperation with both India and China to an unsentimental cost-benefit calculation as to whether Asia's largest democracy or soon-to-be-largest economy should be Washington's privileged partner on any given issue. Yet this interest-based calculus itself reflects a misreading of the many congruent national objectives and ambitions between Washington and New Delhi. Even an Obama-esque judgment of American interests over the coming decade -- one that is cool, hard-headed, and dispassionate -- argues in favor of elevating India to the top tier of American partners in Asia and the world.
Let's briefly, and unsentimentally, review the main facts and trends. The CIA has labeled India the key "swing state" in international politics. It predicted some years ago that India would emerge by 2015 as the fourth most important power in the international system. Goldman Sachs predicts that, within just a few decades, the world's largest economies will be China, the United States, India, and Japan, in that order.
The United States has an enormous stake in the emergence of a rich, confident, democratic India that shares American ambitions to manage Chinese power, protect Indian Ocean sea lanes, safeguard an open international economy, stabilize a volatile region encompassing the heartland of jihadist extremism in Pakistan and Afghanistan, and constructively manage challenges of proliferation, climate change, and other global issues. And even by purely material standards of market access and national security, the United States has a definitive interest in investing in India's success to prove to all those enamored of the Chinese model of authoritarian development that democracy is the firmest foundation for the achievement of humankind's most basic aspirations.
India possesses the world's second fastest-growing major economy and has defined a compelling interest in preserving the gains from globalization by liberalizing international flows of trade, investment, services, and human capital. India's rapidly expanding middle class, currently the size of the entire U.S. population, is expected to constitute 60 percent of its billion-plus population by 2020. Domestic consumption constitutes two-thirds of India's GDP but well under half of China's, giving it a more sustainable, less export-dependent economic foundation for growth. While India's 400-milllion strong labor force today is only half that of China, by 2025 those figures will reverse as China's population "falls off a demographic cliff," in the words of the demographer Nicholas Eberstadt, with dramatic implications for India's economic development. India is expected to bypass Japan in the 2020s as the world's third-largest economy, and to bypass China in the early 2030s as the world's most populous country.
India is the kind of revisionist power with an exceptional self-regard that America was over a century ago. America's rise to world power in the 19th and 20th centuries is, in some respects, a model for India's own (peaceful) ambitions, partly because both define their exceptionalism with reference to their open societies. As Indian analyst Pratap Bhanu Mehta puts it, Indians have "great admiration for U.S. power" and want their country to "replicate" rather than oppose it. How many strategists -- in China or among Washington's European allies -- share such sentiments?
So let's put to bed the myth that America has more in common with China, or Washington needs Beijing's interest-based cooperation more than New Delhi's, on issues as diverse as Afghanistan and Pakistan (both countries in India's backyard whose destabilization hits India first and hardest), terrorism (which has killed more Indian civilians than those of any other nation not at war), the international economy (whose primary structural imbalance results from China's manipulation of its currency and the trade distortions that result from it), nonproliferation (China actively assisted another state, Pakistan, in developing its nuclear arsenal, which India has never done), energy security (the basis for the unprecedented Indo-U.S. civilian nuclear partnership as well as for greater Indo-U.S. naval cooperation), space (where the countries' ambitions and technology-trade arrangements argue for expanded joint cooperation), and even the difficult issue of climate change (which is predicted to hit India harder than any other major Asian economy).
It goes without saying that Indo-U.S. cooperation promises to reshape the Asian balance of power in ways that conduce to America's hard security interests. As Singaporean elder statesman Lee Kuan Yew has cogently asked, why is no one in the Asia Pacific fearful of India's rise even as they quietly shudder at the implications for their autonomy and security of a future Chinese superpower?
President Obama would do well to ponder that question today as he sits down with Prime Minister Singh to sketch out what we must hope is an ambitious and sustained agenda for expansive Indo-U.S. cooperation over the coming years.
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Overall, Obama's Asia policy has been largely driven by events and domestic priorities rather than by an overarching strategic vision. The Obama team had to closely coordinate with China on financial matters in response to the financial crisis. Passing a cap and trade bill at home means that we need China to sign up to a global climate change pact; Americans will chafe at a costly bill if the world's largest carbon emitters do not agree to carbon reductions.
The Obama team attempted a new policy on Burma. The idea is to find a way to engage the military junta which would strengthen relations with the Association of Southeast Asian Nations, of which Burma is a member. But the policy change has been overtaken by events.
Aung San Suu Kyi was unfairly punished when an American swam across a lake to her residence. And the junta began a new round of repression, as its leaders jail and harass political opponents in the run up to their 2010 "elections." Obama could not radically shift Burma policy. Rather, adjustments to our relations with ASEAN and Burma have been only marginal. There has been some more contact with the junta. And as part of the broader attempt to build stronger relations with Southeast Asia, the administration signed the Treaty of Amity and Cooperation (TAC). These and visits to Southeast Asia by Secretary Clinton and her deputy, Jim Steinberg, demonstrate a desire to deepen American engagement with that region. It is unlikely that engaging Burma or signing the TAC will increase America's regional influence.
There are several Obama Asia policies that have been surprising. On a positive note, the Obama team has given much greater attention to the Japan alliance than I had expected. Secretary Clinton's first stop in Asia was in Tokyo, which eased Japanese concerns that they were in for another round of "Japan passing." Since the Democratic Party of Japan took over last September, Obama officials have visited Japan frequently to get a sense of how to deal with a party that has never before governed. The Obama team should be commended for trying to find its way with this inexperienced and eclectic ruling coalition.
Other policies should give us pause. For example, Obama is sticking to his campaign promises on trade, which means we have no trade policy. The Korea-U.S. Free Trade Agreement has been collecting dust in the Congress. The rest of the region, however, is not standing still. China seems to sign a trade agreement a minute and South Korea is moving forward on an FTA with the EU. If this continues, not only will our economy be disadvantaged, but our regional leadership will also suffer. While the Obama administration has done a fine job showing up to Asian multilateral meetings, without new trade proposals it has shown up empty handed.
A second troubling policy is the absence of any agenda on Taiwan. The Obama team was effusive in its praise of President Ma when he was elected in March 2008 and they applaud his attempts to ease tensions with the Mainland. The Taiwan president is doing what he thinks Washington wants - easing cross Strait tensions. But there was an implicit bargain with Taiwan that we are not upholding. We were supposed to strengthen Ma's hand by strengthening our ties to Taiwan. The Obama team is not helping Ma. We have not sold any arms to Taiwan even as China has continued its arms buildup across the Strait. And Obama has no plans of yet to deepen economic ties as Taiwan goes forward with a China FTA.
Third, the bluntness with which the team has downplayed China's miserable human rights record is an unfortunate break with past administrations' practices. Secretary Clinton announced that she would deemphasize human rights concerns on her first trip to China. This was followed by the president's refusal to meet with the Dalai Lama when the Tibetan spiritual leader was in Washington last month. The administration has also been silent on Uighur repression and will not meet with Uighur leader Rebiya Kadeer. It does not help either country for us to pretend that we are indifferent about Chinese respect for human rights, when in reality we have a huge stake in China's political liberalization.
Overall, despite a regular barrage of criticism by Candidate Obama directed at President Bush for his supposed neglect of Asia (never a fair criticism), the Obama team has not wowed the region with new ideas or lavished it with attention. During Bush's first year, his administration had offered the largest arms package ever to Taiwan, was well on its way to substantially upgrading ties with Japan, and was negotiating a diplomatic breakthrough with India of historical significance. Then-U.S. Trade Representative Bob Zoellick was negotiating free trade agreements with Singapore, Australia, and Korea.
The criticism of the Bush administration was that it was "distracted" by the war on terror. The Obama team is learning that fighting a war saps a nation's energy and attention. Now in office, the Obama team can see that the threat from Islamic extremism is very real. The Obama team may have really believed that they could "fix" Afghanistan, disengage from Iraq, and then move on to "re-engaging" the rest of the world.
As Obama is learning, it is not so easy to "move on" when you are at war. No president can disconnect a major foreign policy issue such as war from other foreign policy issues. Asians have a stake in America's Afghanistan policy. A loss in Afghanistan would have stark consequences, as friend and foe alike would question our resolve, and Islamic extremism would rear its head again in Southeast Asia.
Obama's Asia team must be finding that during wartime, presidential attention is the scarcest of commodities. Obama has no choice but to focus on "the wars we are in," often at the expense of the Obama team's hopes for a grand "re-engagement" with Asia.
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The U.S. dollar enjoys a privileged position in the world. The federal government can print up the little slips of green paper and exchange them for barrels of oil or digital cameras. That trick is not unique to the United States; almost all countries print money and spend it at home. The difference is that the dollar can be so easily spent abroad and that foreigners are so willing to hold on to large quantities of those little slips of papers, instead of trading them back in for American-made goods. This raises the question: Is the dollar likely to be replaced as the world's reserve currency?
There have certainly been similar shifts in the past. Some time in the first half of the last century, the dollar took over the exalted position long held by the British pound. Nor are the questions about the dollar's status as a reserve currency merely conservative fantasies aimed at stirring doubts about President Obama's leadership. As with so many other things, this idea was made in China. Alarmed by his country's exposure to a potential slide in the dollar, the head of China's central bank floated the idea of a global currency to replace the dollar. The Russians liked the idea. The United Nations and the IMF were intrigued.
If we're to hold auditions for a new dominant global currency, we can start by considering the job description. We're really looking for three things in an aspiring new currency:
The dollar excels on the first two counts. Given the size of the U.S. economy, the dollar has a broader reach than any other currency. U.S. capital markets (bonds, stocks) feature enormous trading volumes; that means that a government wishing to adjust its reserve position by selling Treasury bonds generally need not worry about whether it can unload them.
The dollar concerns stem from fears about U.S. fiscal incontinence. The Obama administration often deflects such concerns by arguing that it is necessary to run large deficits in a time of economic crisis. This conflates the short-term and long-term deficit problems. The administration declared early on that America's fiscal position was unsustainable because of burgeoning entitlement costs, especially in health care. Yet the plans under consideration would likely increase overall health spending while raising the government's share of costs. Nor has the administration earned much credibility for its promises to offset costs. The situation beyond health care does not look much brighter.
Runaway deficits can spiral out of control and have frequently ended in bouts of serious inflation, as governments print money to cover costs. That directly undermines the currency's role as a store of value. Inflation means that those green slips of paper buy less tomorrow than they do today.
Hence, the search for a successor to the dollar. But a review of the serious applicants suggests the dollar's position is secure, at least for a while.
At the front of the line is the euro. It already accounts for almost 30 percent of global reserve holdings, compared to the dollar's roughly 60 percent. The euro zone certainly has the economic size to be a viable contender. But the recent crisis has shown up some serious weaknesses in the currency. First, there was the question of how the euro zone would deal with bank failures, as in Ireland and Iceland. The European Central Bank does not have the full panoply of powers enjoyed by U.S. federal bank overseers. Europe also faces its own deficit problems, exacerbated by the fact that some members are more profligate than others.
In line behind the euro are the British pound and the Japanese yen. The economies are smaller, but still large enough to be contenders. Yet British debt problems are even more serious than those in the United States. Japan's fiscal problems are severe as well, offset only by that country's great propensity to save.
Beyond the yen and the pound, we come to the long shots, such as the Chinese yuan or the Brazilian real. For all its eagerness, China is disqualified because it does not have an open capital account (the opposite of deep capital markets; good luck unloading those RMB bonds). Brazil recently got a small taste of what it is like to be a favored currency and started running in the other direction. After the real appreciated 36 percent against the dollar this year, the Brazilians decided to start taxing investment flows.
So who's left? Just the imaginary currencies. These are artificial constructs like the IMF's SDR (special drawing rights). It's not widely traded; there are no deep SDR capital markets; nor are there any special guarantees about its prospects as a store of value. It has gained a following because it seems to offer an escape from all the failings of the other currencies. In fact, the SDR is nothing more than a basket of those very currencies.
So the dollar's reign looks likely to continue for a while. It's not a very resounding victory -- champion because everyone else fell over -- but a win is a win, as the cliché goes. It does beg the question: is it a win? Has the U.S. benefited from the dollar's special role? More particularly, what do the dollar's role and value mean for U.S. foreign policy?
That will be the subject of the next and last post in this series.
By Phil Levy
The Pittsburgh G-20 meetings concluded with a call for strong, sustainable, and balanced global growth. Countries were going to get their acts together, to shape up, to mend their ways. And if they don't? What if they just go with their own domestic political imperatives? Then someone will call them out, the leaders said.
But who? The International Monetary Fund, perhaps. After a meeting of finance ministers, the AP reported:
Four governments -- including the United States and China -- renewed promises to enact policies aimed at rebalancing global trade.
They said an orderly reduction in the U.S. trade deficit and trade surpluses in Asia would benefit the world by defusing protectionist trade action...
"It was agreed that a rebalancing of domestic demand growth across economies would be key to reducing imbalances...," said the statement, issued on behalf of the group by the IMF.
China pledged to take steps to increase domestic demand, deepen financial reforms and increase the flexibility of its currency, a step long demanded by the United States and other industrialized nations.
Wait! This story is from April 2007, on the eve of the global financial crisis. (Plus ça change...). That meeting followed a 2006 agreement that the IMF would adopt a new surveillance system to identify misaligned exchange rates. The surveillance program essentially came to naught. This ineffectiveness was not due to any analytical weakness on the part of the good folks at the IMF. It turned out, rather, that big countries like the United States and China dislike being publicly criticized.
Of course, smaller nations share this distaste for criticism, but they usually have no choice. The IMF has leverage when it lends money. When a nation like Hungary or Iceland finds itself in serious trouble, it must accept IMF policy prescriptions along with the cash. The bitter memories of this cash/criticism combo from the Asian financial crisis of the late 1990s help explain why Asian countries have built up such substantial piles of exchange reserves; they want to ensure they are not in that position again.
Why should the IMF or World Bank care, though? Why not just call it the way they see it and let the big countries deal with their own bruised egos? Because the big countries are the IMF and World Bank. The leaders of the bank and fund spend their days reporting to boards of executive directors, seeking the boards' approval for all they do. These institutions are not like the U.N. General Assembly -- one country, one vote -- the executive directors' votes are roughly weighted according to the economic heft of the countries they represent.
This creates a dynamic that played out this week in Istanbul, where the bank and fund are holding their fall meetings. According to the Financial Times, World Bank President Robert Zoellick asked his governing council for an infusion of $5 billion. Without it, he said,
"[A]s we start to get towards the middle of next year we are going to start to face some serious constraints and we would have to ration..." He said uncertainty over future financing capacity was already affecting bank work with developing countries.
Developing nations voiced unanimous support for a capital increase.
But developing nations are not the ones paying the bills. Zoellick faced a much more skeptical reception from the British, the French, the Japanese, and the Americans. It is the major donors to which any bank president is beholden. This dependence did not stop Zoellick from making a relatively forthright speech about global imbalances last week at the Johns Hopkins School of Advanced International Studies, but the FT pictured him yesterday with his head in his hands.
The independence deficit of the IMF and World Bank is serious, but perhaps not the most significant obstacle to achieving global rebalancing through coordinated reform. Even if Bob Zoellick launched the kind of scathing critique of which he's certainly capable, it would not suffice to bring serious cuts to U.S. federal deficits or to prompt revaluation of the Chinese currency. President Obama's political prospects depend heavily on delivering a costly expansion of health-care coverage. The Chinese leadership's legitimacy rests heavily on maintaining employment in the manufacturing sector. In each case, the domestic political stakes are far too high to be overcome by global opinion, no matter how blunt.
Change will come, of course. But it will be through average American voters worrying about borrowing from their grandchildren, or from average Chinese worried about the value of their massive dollar holdings. Right now, even if the IMF or the World Bank were to call out, those key constituencies aren't listening.
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By Phil Levy
This week's budget sketch from the Obama administration has stirred lots of partisan debate: A liberal dream come true! A conservative nightmare! For all of its occasional tedium, one of the nice aspects of economics is that markets often let you keep score in real time. And markets seem to be sending an unambiguous signal that the U.S. economy is now headed in the wrong direction.
At the heart of the debate, President Obama believes that massive spending and borrowing will ultimately strengthen the country. He regards the new proposals in health care, education, and energy as investments. Critics counter that these massive programs will bankrupt the country.
A first temptation is to look to the stock market for a verdict, and the stock market did not seem pleased. It has shown a tendency to swoon with almost every landmark moment of this administration. But supporters of the administration have argued that the stock market is too focused on the short term, that it is driven by other factors, that the market is more of a moodring than a carefully reasoned verdict.
Fortunately, there are other markets that give a cleaner reaction. In particular, one can look at the government bond market, which is now giving the Obama plan a decided thumbs-down. The interest rate on the 10-year U.S. Government Treasury note helps set borrowing rates for corporations and households. It is not the very short term rate that the Fed has pushed near zero. It covers the same time frame that the Obama administration has now picked for its budget outlook. Unlike the stock market, there are no questions of dividend cuts, consumer fads, new competition, or management failures to muddy the picture.
This clarity led to the classic James Carville quote from early in the Clinton administration: "I used to think if there was reincarnation, I wanted to comeback as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody."
A bond investor need only consider a few particular risks. There is the risk of inflation, which cuts into the spending power of the dollars investors receive later on. For foreign investors, there is the risk of a falling dollar, since they will ultimately need to convert their bond returns back into their own currency. Then there is the risk of default. That has been an important consideration for shaky businesses and emerging market basket cases, but not for a country like the United States. Until now.
In November and December, as investors panicked worldwide and rushed to the safety of U.S. government bonds, the interest rate on 10-year government bonds plunged to near 2 percent. From a low on December 30, the rate has rocketed back up to over 3 percent today, reflecting a sharp drop in the value of bonds. This is not because the rest of the world has solved its problems.
An even clearer negative verdict on Obama's approach comes from the much-maligned market for credit default swaps. These swaps function like insurance contracts that pay off if a borrower fails to make good. That insurance gets more expensive when the likelihood of default increases. The idea of a U.S. government default has recently gone from "unthinkable" to close to 10 percent over the next five years.
So what is scaring the bond traders? Perhaps they spent last weekend reading a timely report by the distinguished economists Alan Auerbach (UC-Berkeley) and Bill Gale (Brookings). The upshot is that the United States has serious long-term fiscal challenges, between the downturn, an aging population, and major entitlement programs. None of the options for getting out of the mess looked particularly palatable. And that was before the president spoke of an extra trillion dollars for health care.
Despite claims of a new realism, the administration's budget is loaded with optimism. It assumes the economy will have a quicker and more vigorous recovery than most private forecasters predict. It assumes that individuals won't change their behavior much to avoid new, higher tax rates. It assumes that sacred cows such as mortgage interest deductibility and agricultural subsidies are ready to be made into hamburgers. And even with all this optimism, the administration predicts red ink as far as the eye can see.
Meanwhile the administration is trying to pretend the crises in the financial and housing sectors will go away on their own. Although a storm is already raging, the administration is not setting much aside for a rainy day. The IMF recently predicted potential bank sector write-downs of $2.2 trillion globally, perhaps half of that in the United States. Nouriel Roubini (NYU) suggests $3.6 trillion. Any such loss would leave the administration with a choice: borrow even more to fill the holes, or watch tax revenue shrivel up as the financial sector crumbles and the economy asphyxiates. If they continue to borrow, at some point we will test the limits of the world's willingness to lend and call into question America's status as a financial safehaven. Higher interest rates will then make a bad situation worse.
I can't say for certain that this is what is scaring the bond market. But I know it's what's scaring me.
Shadow Government is a blog about U.S. foreign policy under the Obama administration, written by experienced policy makers from the loyal opposition and curated by Peter D. Feaver and William Inboden.