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.
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.
DANIEL ROLAND/AFP/Getty Images
Eurozone leaders emerged from their latest all-nighter with a plan that sent the markets into paroxyms of relief: The German and French stock markets were up more than 4 percent Friday. The key heralded result was a commitment to move toward a banking union. This was taken as a critical concession by German Chancellor Angela Merkel and a key move toward resolving the crisis.
As the good folks at Foreign Policy have helpfully documented, this is not the first time European summiteers have stepped out, bleary-eyed, and announced there would be economic peace in our time. It's roughly the 20th. I warned before about celebrating any European plan to have a plan, and that's what this is. But how good is the plan? Is it a significant step toward solving the euro crisis?
The most striking move was the promise of a banking union. The European Central Bank would be given new regulatory powers over eurozone banks and European bailout funds could be sent directly to ailing banks to support them, without adding to national indebtedness. It would be nice to be able to dissect the details of how this new scheme will operate, but there aren't any yet. The bailout funds cannot be tapped until the ECB is empowered, and that will take at least a few months.
In theory, a move to bolster Europe's ailing banks could help. As the 2008 financial crisis aptly demonstrated, the financial sector provides the lifeblood of an economy; cut it off and the economy turns distinctly blue. Europe's economies are notably more dependent on bank finance than the U.S. economy and the banks of the troubled economies on the periphery have had trouble raising funds and retaining deposits. A move to bolster them could potentially stop a direct drain on the funds of impoverished sovereigns and move toward restoring normal functioning and growth in those economies.
There has been a clamor for such moves, partly on the well-established theory that banking panics can be self-fulfilling. The normal operation of banks is risky. If everyone tries to get their money at once, even a healthy bank will succumb. This is the rationale behind deposit insurance. Let all those small savers know their money is secure, restore calm, and the insurance may never even need to pay out.
So that's the hope. If the eurozone banking troubles are just the result of unfounded panic, a new backstop could restore calm. If there are a limited number of banks troubled by past lending into now-burst real estate bubbles, a well-funded cleanup could set things aright.
But the potential problems are enormous. Here are five sets of questions facing the new European banking union plan:
1. Politics of operation. In the story above, banks are just going about their ordinary business when an unfounded panic attack strikes customers. But banks can make choices about how much risk to take on. Riskier projects can offer higher returns. This is why the bailout has been coupled with regulation; Chancellor Merkel does not want a situation in which "Heads Bankia wins, tails Brussels loses." Bank regulation is difficult in ordinary circumstances (banks are big and complicated and even they may not realize the risks they are running). The situation is even more complex when you have close relationships between banks and politicians and bank lending is used to further political or industrial policy ends. Will Germany or France tolerate that kind of interference from the ECB?
2. Back door fiscal union? One of the risky behaviors that European banks have recently engaged in has been lending to the governments of Greece, Spain, and Italy. If the banks are allowed to keep purchasing government bonds, then direct lending to the banks looks like a back-door fiscal union, only without controls on government spending, a point made by James Mackintosh of the Financial Times. That would also beg the question of where the money will come from, since the summit proposed no new resources and existing ones would not cover those countries' needs. If a new bank regulator cuts off the flow of funds from the banks to the governments, that raises the question of who will be left to lend to the governments. When bond buyers disappear, interest rates soar.
3. Politics of resolution. All of the political questions apply even more strongly when it appears a bailout has failed. Who decides to pull the plug? Will powerful governments let national champion banks be disassembled by eurozone technocrats? Who decides how the losses are allocated? There are already lawsuits from small Spanish shareholders who claim they were misled into funding Spanish banks. If such shareholders or bondholders are wiped out - normal in a bankruptcy - that can have an economic and psychological impact.
4. What about London? Britain is not in the eurozone, of course, but London is the financial center of Europe. The EU is supposed to have a single market in financial services. Omitting Britain entirely would be like saying that we would regulate finance in the United States, except in New York. But on what grounds could the ECB hold sway over behavior in London?
5. Which risk are you insuring against? In the standard deposit insurance story, some banks get unlucky with their loans and their depositors are rescued. Europe's problem is that there is another sort of risk lurking: euro departure. Imagine two Greek depositors, one of whom keeps his money in his Athens bank, the other who moves her money to Frankfurt. If Greece were to leave the euro, our two depositors would have drastically different experiences. He would be much worse off than she would be, since his savings would be in depreciated drachmas. Would deposit insurance compensate him? It is hard to believe it would, particularly when one hears Europeans talk about how a departure would be an unacceptable violation of European law. Even if Europe were tempted toward forgiveness and inclined to reimburse such losses, the cost would be enormous. This would be covering virtually all bank deposits in a departing country, not just an unlucky few. The latest summit did not propose any new funds, much less the trillions of euros this could cost. If you do not insure against this risk, then insuring against the lesser, idiosyncratic bank risk is completely futile. If you do insure against this risk, the promise has to be credible to do any good.
In sum: another European summit; a burst of euphoria; a plan to have a plan; and many questions left unanswered. Eurozone leaders have expressed their good intentions, but in mid-crisis it is the seemingly-obscure particulars of banking practice that will determine whether or not the markets' relief was merited.
So far as I know, there is no summit taking place at the moment to address Europe's problems (the Euro2012 quarterfinal between Greece and Germany doesn't count). Given the frequency of meetings between leaders --- the G20 earlier this week, a major European summit next week -- it would seem easier just to report when the leaders have retreated to their own capitals to regroup.
One can hardly begrudge the European leaders their meetings; there is no global economic issue more pressing than the looming euro crisis. But it is worth keeping the frequency in mind when we try to determine whether big, expensive global conclaves accomplished anything. So how should one grade a summit?
In the spirit of next month's London Olympics, I think it would be appropriate to adopt the diving approach of adjusting scores for the degree of difficulty. If Olympic divers perform only elementary dives, with nary a flourish, they will not end up on the podium.
Summitry has its equivalents. The Obama administration emerged from the G20 summit in Los Cabos, Mexico claiming progress; they had impressed upon their European colleagues the urgency of resolving the crisis.
Judges say: Reasonably executed, but negligible degree of difficulty. The Europeans were aware they had a crisis. It's been in all the newspapers. They understand how serious it is; they live there. Yes, there will be negative repercussions for the rest of the world when the euro splits apart, but the potential for repercussions had already fully grabbed their attention.
What else? Per Reuters:
"Euro area countries pledged to "take all necessary policy measures" to safeguard monetary union. Europe also intends "to consider concrete steps towards a more integrated financial architecture", including common banking supervision, bank recapitalization, winding down of failed banks and guarantees for bank depositors..."
Judges say: Yawn. There was a time when this maneuver would have drawn delight from the crowd. Markets would have rallied for days on promises to ‘do what was necessary,' to ‘consider concrete steps' (ever so much better than considering feeble steps). But now one must do more to impress.
The European crisis certainly features a loss of confidence among investors and the public, but it is not exclusively about a loss of confidence. President Obama seemed not to grasp this, when he enthused about summit pledges "breaking the fever" gripping Europe. There are real and pressing problems that require substantial resources and dramatic shifts in sovereign powers. Far too many previous summits ended in "plans to have a plan" or statements of resolve and good intentions. Market critiques have become increasingly discerning.
When earlier this month European governments announced an actual plan to direct real money toward salvaging Spanish banks, the market soured on it in a matter of hours, as details became available. The problem was not the plan's evanescence, it was that the resources for the bailout were being added to the tab of the Spanish government, which was already overburdened. Further, it looked likely that these new loans would take precedence over old loans and thus worsen the already gloomy outlook for holders of regular Spanish government debt.
So what could our avid summiteers do to impress? The problem is sufficiently complex that it probably cannot be solved over a weekend of bilateral chats. But it is worth keeping in mind the three dimensions of the crisis:
Back to our exacting judging. To get a high score, you have to nail all three of these. The problem with the recent Spanish bank bailout was that it addressed the first while worsening the second. The problem with grand austerity plans is that they address the second while neglecting the third. The problem with ambitious plans for a growth agenda is that they address the third while worsening the second.
In the midst of such an intricate challenge for our euro zone performers, having outsiders lecture them on the seriousness of the problem might even come across as annoying. By these standards, the G20 summit did nothing to pull the euro zone out of its dive. Since leaders managed to paper over their differences and preserve the appearance of comity, we can score it as a straight, simple entry into the water, rather than a belly flop. But no need to stick around for the award ceremony.
More than any other economic danger looming on America's immediate horizon, including a possible break-up of the eurozone, sequestration poses the greatest single threat to American recovery in the near term. This arcane process came into force when the congressionally-mandated "super-committee, "officially known as the Joint Committee on Deficit Reduction, failed in its mission. As a result, the sequester calls for reductions in government spending totaling $1.2 trillion over the next nine years, of which $984 billion, or $109 billion annually, will be realized from across-the-board budget reductions.
Although defense accounts for only 14 percent of the budget deficit, when entitlements are taken into account, the annual $109 billion dollar cut will be evenly divided between defense and non-defense reductions, with some small reductions in entitlements contributing to the non-defense side of the ledger. Put another way, once the sequester comes into effect, defense-related appropriations will have to be reduced by $55 billion annually. And these reductions will be of the sledgehammer variety: Every "program, project and activity" will be reduced by the same percentage, regardless of its relative importance to the overall enhancement of national security.
It gets worse. The sequester does not begin to bite until January 2, 2013 -- that is, until the beginning of the second quarter of the upcoming fiscal year. That means that the entire $55 billion must be found from programs that had not yet been obligated during the first quarter of the fiscal year. To the extent that such commitments will have been made, the amount of funding susceptible to reductions will itself be reduced, and the percentage of reductions will accordingly increase. Finally, because President Obama is expected to exempt the military personnel accounts, which total some $141 billion, and Congress is expected to exempt the contingency-related accounts (which are the major source of funding for the war in Afghanistan), there will remain some $375 billion, from which $55 billion will have to be found, resulting in a 15 percent reduction in all other defense programs.
The impact of that reduction will be highly disruptive to both the current and longer term defense program. It will result in massive reductions in weapons systems, though not in personnel. It will render the pivot to Asia meaningless; any plans for increasing our military muscle in that region will be completely undermined by the reduction in shipbuilding, aircraft, missile, drones, and a host of other acquisition programs. Our presence in the rest of the world will at best fare no better, and, in light of the so-called pivot, will probably suffer even more.
All the foregoing has long been well-known to Washington's defense cognoscenti and especially its bean counters. What is less well-known, and at least equally alarming, is the impact of the sequester on the economy as a whole. As the recently released study by the Bipartisan Policy Center points out (full disclosure: I am a member of the Center's Task Force on Defense Budget and Strategy), the sequester will result in the loss of about a million jobs in 2013 and 2014 and America's GDP will decline by half a percent. Moreover, of these million lost jobs, it can safely be asserted that at least half will come from the non-defense sector. In other words, the sequester is not just a defense problem that should agitate only hawks. It is a national problem, and it demands immediate relief.
Despite the urgency of the sequester's challenge, the administration continues to sit on its hands. No draft legislation has emerged from the White House that would at least postpone the sequester for a reasonable period to enable Congress to try its hand at another effort to reduce the deficit. The administration's allies on the hill, particularly in the Senate, have been equally nonchalant about the coming programmatic and economic disaster.
Such nonchalance carries with it a very high risk, however, and not only for the economy. In addition to its impact on the government's budget, the sequester will also trigger the WARN Act, which requires employers to give a minimum of sixty days notice to private and public sector employees whose jobs are being targeted for possible termination. Those politicians seeking re-election to national office should take note that Nov. 2, 60 days before Jan. 2, when the sequester comes into force, is just four days before election day. They may find it very uncomfortable having to explain to potentially hundreds of thousands of people who have been given WARN Act pink slips why they deserve to be returned to office after they did nothing about the sequester. America's economic house is burning; the Neros of Washington had better act soon, or they may find that their political fate will echo that of their ancient Roman namesake.
Andrew Burton/Getty Images
Now that summer is upon us, the global economic problems are no less serious, but perhaps our blogging can be. This is summertime, when one just wants to roll down the car windows, crank up some classic songs on the iPod, and sing along.
The pressure on Germany to fix Europe's looming problems is something I've addressed before, more seriously. The ever-louder pleading for Chancellor Merkel to just do it already, though, has lately put me in mind of other sorts of importunings. So, with apologies to Billy Joel, herewith a reworking of his 1977 classic, "Only the Good Die Young" (redone as "Stopping the PIIGS Bank Run"):
Come on, Angela, don't make me wait/ You Protestant countries start much too late/ Ah but sooner or later it comes down to fate/ You know what must be done/ When they sold you the euro and took the Deutsche Mark away/ They promised restraint and said we'd converge some day/ Ah but they never told you the price that you'd pay/ Now that Bankia's come undone
Stopping the PIIGS bank run/ That's what I said/ Stopping the PIIGS bank run
You might have heard we run with a dangerous crowd/ Private investors just can't be found/ Our national budgets often tend to run aground/ Ah but that never hurt no one
So come on Angela show me a sign/ Send up a signal I'll throw you a line/ Those old time treaties you're hiding behind/ Just won't get it done
Darlin stopping the PIIGS bank run/ I tell you stopping the PIIGS bank run/ Stopping the PIIGS bank run
You get a fiscal treaty/ And more input as a consolation/ You'll set a brand new goal/ And no risk of an export hole/ But Angela they didn't give you/ Quite enough information/ You didn't count on Greece/ When you were counting on low debt/GDP
And they say there's political union for those who will wait/ Some say it's better though there may be a taint/ But wouldn't you rather laugh with the sinners/ Than cry with the saints?/ The sinners are much more fun
You know you've got to stop the PIIGS bank run/ I tell you stopping the PIIGS bank run now/ You've got to stop the PIIGS bank run
You said your voters told you/ All they worried about was inflation/ They worry about subsidies/ Transfers that continue endlessly
Come on, come on, come on Angela/ Don't make me wait/ You Protestant countries start much too late/ Sooner or later it comes down to fate/ You might as well get it done/ You've got to stop the PIIGS bank run/ Tell you baby/ You've got to stop the PIIGS bank run
Imagine this with an interwoven saxophone and you should be all set for summer crooning on the autobahn. Of course, from a policy standpoint, Chancellor Merkel should probably have some of the same concerns about giving in that the apocryphal Virginia would have had in the Billy Joel original.
Europe did not collapse this last week. That was something of a pleasant surprise, since portents of the economic grouping's demise have been accumulating for years now. In lieu of collapse, there were just more troubling signs: the fall of the government in the Netherlands; unemployment approaching 25 percent in Spain and a credit rating downgrade; French elections that featured growing nationalist strength and a likely split with Germany over austerity.
This raises a question. Given all the analyses proclaiming "the end is nigh," when, exactly, might we expect it? Some European friends would argue that this is the point -- we shouldn't expect it. This sort of brinksmanship is the way of Europe. Crises loom, there is wailing and lamentation, a summit is held, someone makes a concession (the Germans a likely candidate) and the crisis is averted. Thus it has been and thus it shall always be, they say. This is largely a matter of faith, but one must admit that it is a reasonable description of the recent European experience.
Here, though, is an alternative interpretation, presented in the form of a parable:
Imagine a friend who earns $3,000 a month, but has an unhealthy tendency to spend $5,000 a month. You observe this and remark to yourself: "This is unsustainable; it's got to stop." You wait for your friend to realize this.
But it turns out your friend has some savings he can use. These savings tide him over for a while, but when he burns through those, you once again figure his time has come. Surely he must now change his behavior.
But your friend finds he can take out a home equity loan. This funds his lifestyle for months more until, at last, those funds are exhausted, too. Time's up, you think.
But your friend announces that he still has plenty of borrowing room on his credit cards. The good life continues (albeit at a rather high interest rate). Sooner or later, of course, he maxes out his cards. This has got to be the end of it, you think. But then your friend mentions that he has heard about this loan shark downtown...
So what's the moral of the story? Is it not to worry -- your friend always finds a way? Or is it that a difficult adjustment can be postponed at ever-increasing cost? And what of the original question -- at what point does "the end" come? Is it when you first recognize that the situation is non-viable? Or is it when the loan shark finally shows up with his truncheon to collect?
This is an imperfect parable for Europe's situation in a number of ways. First, not all troubled European countries got there because of profligate spending. Spain and Ireland, for example, saw good fiscal positions go bad when they had to backstop troubled banks. Nor can one argue that Spain and Greece are continuing to live 'the good life' -- they're suffering real pain. It's just that the major adjustments they have made appear insufficient. And Europe's crisis is multifaceted; in addition to sovereign debt there are faltering banks and uncompetitive economies.
The real problem with the parable is that it tends to suggest that the growing costs are all financial. The more troubling costs may be political. Part of the way Europe has pushed past previous decision points has been to shunt aside democratic input -- as when new governments were installed in Greece and Italy, or when the major Greek political parties had to pre-commit to support an austerity plan, or in the push for a zone-wide austerity pact to be enforced from Brussels. Here the "loan shark with a truncheon" takes the form of more extreme movements in these countries taking up a nationalist cause and winning growing support, as with Marine Le Pen's Front National in France, or the slipping support for New Democracy and Pasok in Greece. Indebted and shamed nations in Europe, pushed around by their neighbors, rallying to a nationalist cry, what could go wrong? Europe does have a history along these lines.
The euro zone has bought itself time and may continue to do so for a while, but the costs seem to be mounting.
Milos Bicanski/Getty Images
Within the next 24 hours, observers say, we are likely to see an agreement reached among Greek political parties that will clear the way for a second bailout from Europe and the IMF. Observers have been saying this for two months now, but never mind. It is certainly possible that the members of the Greek ruling coalition will meet the demands of "the troika" of lenders -- the European Commission, the European Central Bank, and the International Monetary Fund. And even plausible suggestions of a crisis resolution have tended to bring a feeling of euphoria to markets -- a good Greek word.
There are optimists and pessimists about Euro zone prospects. I'm in the latter camp, but it's interesting to see where the analyses diverge. You would probably get broad agreement that the essence of the euro zone problem is that a number of countries on Europe's periphery have racked up unsustainable levels of debt. There is also a general consensus that if those peripheral countries followed the traditional prescription of devaluing their currency (by leaving the euro zone), this would be a large economic shock for Europe and, thus, for the rest of the world (note, though, the different views among Northern European leaders on whether Greece alone might be expendable).
The divergence in opinion really comes in the analysis of potential solutions. Here are three ways one might look at fixes:
Europe as a whole handle the debt issue?
This is the question the optimists ask. The answer, they find, is yes, Europe could. While individual countries within the euro zone have debt problems, the zone as a whole is roughly in balance. If everyone agrees that the money is there and that failure to find a solution could be very costly, then it's just a matter of a little obligatory posturing before the money is reshuffled and the matter solved. Another way of putting this would be that economic hurdles are difficult to overcome, but political hurdles are trivial.
2. Could current national leaders in the Euro Zone handle the debt issue? Posing the question this way takes political constraints a little more seriously. While there are certainly now phone numbers and interlocutors for an apocryphal Kissingerian call to Europe, the major players are still national. Chancellor Merkel ultimately answers to a German electorate, President Sarkozy to a French citzenship, and Prime Minister Papademos to a Greek. Those German voters are distinctly unenthused about bailouts and a central bank that is willing to print money to solve problems. Those Greek voters are distinctly unenthused about austerity programs in the face of 19 percent unemployment. With these political constraints, the problem looks significantly harder. The question becomes whether these leaders can overcome the reluctance of their respective electorates and 'do what must be done.' Those who analyze at this level are hanging on every report out of Athens and Berlin.
countries commit that all future governments will follow the paths agreed today?
This is the pessimists' playground. What happens when leaders fail to persuade their electorates that their unpopular measures were really necessary? They're usually ousted in the next election. There are certainly some policies that, once undertaken, are very difficult to revoke. But the central issues in Europe now revolve around annual national budgets, for which commitments are eminently reversible. One can try to lock in good behavior at a constitutional level -- as much of Europe just did with its brand new fiscal pact, and as it did at the zone's inception with the Stability and Growth Pact. These have proven exceedingly difficult to enforce in practice.
A story on Greek politics in the New York Times nicely captured the essence of this last problem.
"After years of turning its back on its social welfare platform, the Socialist Party, known as Pasok and Greece's dominant political force since 1974, has virtually disintegrated, falling to fifth place with 8 percent support, according to a poll that the firm Public Issue released on Tuesday.
...The most probable winner of future Greek elections would be New Democracy, which held power from 2004 until 2009, when Greece's debt soared from slightly more than 100 percent of its gross domestic product to at least 127 percent.
Its leader, Antonis Samaras, has been criticized repeatedly by European leaders as irresponsible, but with every new tax increase in Greece, some voters are warming to his constant critique of austerity in the absence of growth measures. The party is leading in opinion polls, with Public Issue putting its support at 31 percent of the vote."
The story also noted that "the hard left and extreme right are rising."
Thus, Greek acquiescence today guarantees nothing after the next vote. The magnitude of this problem is not lost on the major European players. In fact, the quest for a solution can be seen as the unifying theme behind Northern European proposals to address the crisis: the fiscal austerity pact, fiscal union, Brussels oversight of national budgets, even political union. Each of these would insulate future tax and spending decisions from the whims of Greek voters.
Barring a momentous development along such constitutional lines, Greek voters still have a say. So if, in the near future, there is an announcement of an accord among current political leaders, the question will be which Greek word is most pertinent: euphoria, or democracy.
ORESTIS PANAGIOTOU/AFP/Getty Images
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.
The "democratic deficit" of the European Union as currently constructed is well understood. The treaty under which the EU operates was rejected in its prior ghost as a European constitution by French and Dutch voters. Recast by German lawyers in deliberately incomprehensible language, it was rejected by the Irish before Brussels and its beholden Dublin minions told the benighted sons and daughters of St. Patrick to go back to the voting booths and get it right, or else there would be yet another round of voting. So we have a "president of Europe" who sits in an office established by elitist non-democratic means, and who was personally selected for said office through a backroom process that would make early 20th century Chicago and New York politicians blush. Should we be surprised by anything that emerges from the same people who gave Europe this, ah, system?
But even by the standards of what we've come to expect from European elites, the Sept. 8 Financial Times op-ed by Dutch Prime Minister Mark Rutte and Finance Minister Jan Kees de Jager is a head-spinner. These Dutchmen propose a solution to the Euro-crisis that would involve three stages of supervision by a new European commissioner over the profligate states that threaten the Euro itself. Such states would first be put under the "independent supervision" of a new EU commissioner with powers "at least comparable to those of the competition commissioner." This functionary would be "given clear powers to set requirements for the budgetary policy of countries that run excessive deficits." That may not be enough: "If the results are insufficient, the commissioner can force a country to take measures to put its finances in order, for example by raising tax revenue. At this stage, sanctions can be imposed..." But that still may not be enough: "...in the final stage" of failure on the part of Eurozone miscreants, the offending nation's budget will "have to be approved by the commissioner before it can be presented to parliament."
Wandering the terribly orderly streets of Amsterdam or Berlin or Copenhagen, one can well appreciate how the austere, decent northern Europeans would loath the intemperate habits of their formerly Catholic southern cousins. But what is the right name for the Dutch remedy? An EU commissioner who is a tutor? Empowered advisor? Mentor? Life coach?
Actually, the name for what M. Rutte and M. de Jager propose is "despot." These gentlemen see the failure of democratically elected governments in Greece, Portugal, Spain, Italy, to a different degree Ireland, and soon France. They see no hope for democratically elected governments to fix their fiscal problems absent an iron fist from a central authority. They are bold. They are authoritarian in their defense of a common currency. They have concluded that such a currency, the Euro, is much more important than the beliefs and ideas of the union the currency was meant to solidify. Their view of European integration is technocratic, power-centralizing, and uniquely anti-democratic. They have no apparent memory of European integration as envisioned by Adenauer, Schuman, and de Gasperi.
There is an alternative. Many Europeans, including the entrepreneur and financier Declan Ganley, have put forward a vision of an integrated Europe with fiscal and monetary discipline, as part of real integration within European democratic institutions. That will be a big step beyond Lisbon. But it will be a much better step than the materialist-grounded view of Rutte and de Jager, who seem to believe that a currency is more important than democratically accountable leaders and the freedom of citizens. The economic component of the Euro crisis is very serious. The larger crisis of Europe is even more serious. Rutte and de Jager are right to be anxious for a big solution. But they should not throw European democracy out to assuage their anger over southern European irresponsibility. Europe gave the world democratic values. The Dutch should lead the integration of Europe according to those values, not toss them over the side of a false life raft in another plush Brussels office.
LEX VAN LIESHOUT/AFP/Getty Images
In recent weeks, civil unrest in much of the Middle East has reminded many Americans of the very uncertain world in which we live. Repressive regimes that appear stable one day can just as quickly be overthrown the next, altering the strategic landscape and impacting U.S. interests.
This is an important lesson for the members of the 112th Congress as they debate ways to reduce the United States' spiraling deficit. As the search for savings has begun, some members have gone after areas of the federal budget that have nothing to do with our fiscal woes to pay down the debt.
In recent months, Secretary of Defense Robert Gates faced pressure from the White House to find more savings in the defense budget despite being the one cabinet secretary who has already carried out multiple rounds of cost cutting. Republicans in Congress weren't much kinder. The House approved an FY11 continuing resolution late last week providing $15.9 billion less for the core defense budget than President Obama requested. The House's FY11 continuing resolution would also cut the FY11 international affairs budget by nearly 20 percent from FY10 levels. The debate shifts to the Senate when Congress returns from recess next week.
This pressure to cut international affairs and defense is coming not just from Congress, but also from several blue-ribbon commissions that recently produced deficit reduction recommendations.
As Secretary Gates observed after deficit commission co-chairs Erskine Bowles and Alan Simpson proposed $100 billion of cuts to the defense budget, these recommendations represent "math not strategy." Several task forces have combined a dire assessment of the impact of the financial crisis with questionable proposals about bringing troops home from overseas, closing embassies and consulates, and canceling weapons programs. The long-term implications of these proposals represent nothing less than a rethinking of the U.S. role in the world even though the commissions were ill-equipped to analyze the implications of their proposed cuts.
Defense and international affairs have ended up on the chopping block despite the fact that the 2010 midterms were not a referendum on U.S. foreign policy. In fact, even in the midst of two wars and continuing terrorist threats to the homeland, congressional campaigns were marked by very little discussion of national security. In a late October 2010 poll done by the Pew Research Center, only 12 percent of respondents said that the war in Afghanistan was the first or second issue most important to their vote, and only 9 percent cited terrorism.
As recent events in Egypt and elsewhere in the Middle East have shown, the United States will continue to face strategic challenges in the coming decades that will require significant diplomatic and military expenditures. For most Americans, the need to adequately fund the military, the country's most-respected institution, is clear. For conservatives looking to downsize government, the case for a robust international affairs budget may be less apparent.
In the post-9/11 era, funding via the U.S. State Department and affiliated agencies increasingly goes toward civilian missions in war zones. These programs are essential to our long-term success in front-line states such as Afghanistan, Iraq, and Pakistan. These targeted funds go toward U.S. efforts to support democracy and human rights abroad and help train and equip allied militaries around the world. Such security assistance is pivotal amid the increased threats of rogue states and terrorist organizations and allows an already overstretched U.S. military to focus on more immediate threats.
U.S. aid programs provide the United States with tools to counter emerging threats from weak and failing states. Often thought of solely as evidence of American goodwill and values, these programs are in fact key components in the battle against extremism, battling the conditions that often fuel anti-U.S. sentiment.
As President George W. Bush recently wrote in his memoirs, "After the attacks [of 9/11], it became clear to me that this was more than a mission of conscience. Our national security was tied directly to human suffering. Societies mired in poverty and disease foster hopelessness. And hopelessness leaves people ripe for recruitment by terrorists and extremists."
It is also important to remember that America only spends roughly 1.4 percent of the federal budget on international affairs. In polls, Americans routinely overestimate the amount spent on such programs, perhaps contributing to the temptation of lawmakers to look to such programs first when drawing up constrained budgets.
Like any part of the government, there are certainly wasteful programs and inefficiencies that should be targeted and eliminated, but the deficit is not going to be paid off by savings generated from gutting the international affairs budget.
Although the amount spent on defense is significantly larger, it too is not the source of our current fiscal predicament. Oddly, given the now frequent proposals in Washington to cut international affairs and defense, it is not apparent that the American public supports this agenda.
It was, in fact, outrage over the Obama administration's runaway domestic and entitlement spending that drove many voters to the polls last November. It is thus these areas of the federal budget that lawmakers should focus their attention on first. Targeting our military and diplomatic capabilities will only serve to put the country at greater risk.
The 112th Congress faces some tough choices about how to improve America's fiscal situation without sacrificing our standing in the world. Unfortunately, thus far, many have skirted over the strategic debate and jumped directly to the budget cutting. The United States' current economic woes are concerning, but abdicating the global responsibilities of the United States is not the solution.
Mark Wilson/Getty Images.
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.
FABRICE COFFRINI/AFP/Getty Images
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:
MANDEL NGAN/AFP/Getty Images
In 2009, the Group of 20 nations committed themselves to rebalancing the world economy. Summiteers in London and Pittsburgh resolved that the large trade surpluses and deficits that had characterized the global economy in the lead-up to the financial crisis should no longer be tolerated.
The G-20 leaders were so effective in their proclamations that much of the requisite rebalancing took place in anticipation, before the leaders could even implement any collaborative policies. China's current account surplus of $426 billion in 2008 fell 33 percent to a surplus of $284 billion in 2009. The Middle East, which as a region ran a surplus of $348 billion in 2008, saw it drop 90 percent to just $35 billion in 2009. The United States current account deficit of $706 billion in 2008 shrank by over 40 percent to $418 billion in 2009.
Such anticipatory compliance on the part of the world economy would have been most welcome, had it only continued. Yet recent economic data shows it has not. The New York Times summarized the latest numbers:
The United States trade deficit ballooned to $49.9 billion in June, the biggest since October 2008. In July, one month later, China recorded a $28.7 billion trade surplus, the biggest since January 2009. In the first five months of the year, Germany's trade surplus... rose 30 percent compared with 2009, to about $75 billion.
So what does this mean? Before the world's leaders could even assemble, the imbalances shrank, but once they issued their proclamations, the imbalances revived. The moral is that trade balances are driven by deep-seated forces within an economy and are difficult to manipulate. The shock of the housing bust and financial crisis dampened consumption and, thus, imports. Some countries were hit harder than others. U.S. monthly imports peaked at $232 billion in July of 2008. They bottomed out at $151 billion in May of 2009. That 35 percent plunge is a pretty good depiction of economic panic. Over the same period, exports fell by "only" about 24 percent, and they were smaller than imports to begin with (hence the deficit).
Of course, relative consumer confidence around the globe was not the only factor driving these numbers. There were also wild exchange rate swings as investors tried to puzzle out which of the world's major markets posed the least risk.
The point is that none of this was due to the fine-tuning of finance ministers or chancellors of the exchequer. They were all trying everything they could to restore confidence among consumers and investors and to revive economic growth. The standard tools that would be used to manipulate external imbalances were instead directed toward crisis response. This is unlikely to change in the near future. China is much more worried about steering between their Scylla and Charybdis of inflation and unemployment than it is about its trade surplus with the United States. Fed Chairman Ben Bernanke is far more preoccupied with concerns about a double-dip recession and deflation than he is about the value of the dollar. Their moves may end up shrinking global imbalances -- significant new quantitative easing by the Fed might depress the dollar -- but this would not be the principal intended effect.
From an economic standpoint, the inability to tackle the imbalances is less worrying than some commentators made it seem. There was a connection between a global savings glut (one aspect of the imbalances) and the U.S. financial crisis, but the latter did not follow inevitably from the former. It took a whole raft of unwise U.S. domestic policies to mishandle the offer of cheap global funds (e.g. offering mortgages with no money down to purchasers of dubious credit was problematic). Similarly, there is no inevitable link between trade deficits and unemployment. Countries with flexible exchange rates and sound policies can adjust to all kinds of external shocks, though the adjustment may be painful.
From a political standpoint, however, the situation may be more dire. Michael Pettis, an astute observer of the Chinese scene, this week concluded that "The world seems to be marching inexorably towards trade war." He argued that the United States will be forced to choose between protection and soaring trade deficits, with the former threatening an ensuing round of global protectionism.
The issue will re-emerge in Washington when Congress returns next month. The Obama administration won a respite from Congressional pressure when China agreed to allow its currency to move in June. Since then, the Chinese yuan has appreciated from a rate of 6.83 to the dollar all the way up to 6.80 to the dollar (less than half a percent). Congressional hearings are already scheduled.
None of this is to argue that it was wrong for the world's major nations to try to address imbalances at their 2009 gatherings, just that the problem is more intractable than they acknowledged. To navigate the economic and political imperatives successfully will require substantially more deft diplomacy.
Advocates of a strong national defense ought to be thinking seriously about entitlement reform. Whatever one thinks of our current policies, recent reports by the Congressional Budget Office and testimony by Federal Reserve Chairman Ben Bernanke make clear our current course is unsustainable. The most frightening description to date of our problem is that if we continue as we are, "by 2058, the economy enters a free-fall, beyond which the catastrophe cannot be measured: CBO cannot model the impact because debt rises to levels the economy cannot support."
This has important effects not just for our national solvency, but also for our national security. Our current national indebtedness and its projections based on the president's budget will increase spending to $5.1 trillion by 2019, nearly a full quarter of the nation's economic resources. As CBO points out, "deficits never fall below $633 billion in the next 10 years, and exceed $1 trillion by the end of the decade." With non-discretionary spending constituting an increasing proportion of federal outlays, defense, diplomacy, and foreign assistance will inevitably be squeezed.
The United States' Joint Forces Command (JFCOM) sounded the alarm earlier this year by naming federal debt and deficits as a major threat to the continued strength of our American military. JFCOM's Joint Operating Environment 2010 states that "interest payments, when combined with the growth of Social Security and health care, will crowd out spending for everything else the government does, including National Defense."
As Representative Paul D. Ryan of Wisconsin stresses in his "Roadmap for America," the threat to adequate defense spending is entirely from the price tag for domestic programs. Defense spending isn't even addressed in the roadmap, because it is not material to the debt picture. That is, before we fight about what defense spending should be (and I've argued here it should be reduced), we ought to be arguing about a long-term program for bringing our national spending into alignment with our revenue.
The "Roadmap for America" is a terrific place to start. It proposes sweeping changes to our tax code, provision of medical insurance, retirement programs, and process of budgeting for entitlements. It would raise the age of retirement and reduce benefits for those under 55. But it would also expand our choices -- and not simply by keeping entitlement programs solvent. The roadmap would allow individuals to determine for themselves what they value and want in their medical plans, retirement programs, and would even allow a choice in type of taxation.
It is often work to read, with sections on the investment and labor force participation effects of taxes, calculation of the fiscal gap, unfunded liabilities and third-party payer health care. But it is a genuine delight to see a major public policy proposal argued passionately for, with assists from Thomas Jefferson, John Locke, and Alexander Hamilton's "Federalist No. 12." The driving philosophy of Ryan's approach is empowerment of the individual. And on the whole it explains in plain language the current state of our public finances, and the choices available to us to remedy our problems.
Importantly for conservatives, Ryan's plan recaptures our proud legacy of fiscal prudence without sounding reckless about what government should and does contribute to our lives.
He makes a sound fiscal argument for acting now by demonstrating the cost of delay: "waiting just 11 years to take action increases by nearly 20 percent the amount of spending reductions or tax increases (as a percentage of GDP) needed to close the fiscal gap. Waiting until 2030 increases the amount by about 50 percent; and waiting until 2040 nearly doubles the spending cuts or tax hikes needed to close the gap."
There will be many who denounce Ryan's plan as radical. They should be rebutted by CBO data showing that under his proposals, "the standard of living for a child born today would double (i.e. per-capita output would rise from $45,000 to more than $90,000) by the time he or she reached middle age, just after the middle of the century." What a fantastic legacy for us to leave our children and with which to strengthen our nation. Unless we get our spending in line with our revenues, we will not only leave our children worse off than we have been, but we will be unable to afford a strong military.
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Europe's attempt at shock and awe exploded Sunday night, blasting the markets into a Monday of euphoria. Now the dust and debris are settling and we can inspect what just happened. In particular, we can ask whether Europe's big move will solve the problem and what this means for the European Union going forward economically and politically.
To figure out whether it will solve Europe's problem, we first have to decide what the problem is. That, in fact, is at the crux of the matter. There are two very different ways of thinking about the crisis along Europe's periphery (Portugal, Ireland, Italy, Greece, and Spain -- PIIGS):
Europe's solution of a trillion dollars of backup funds is aimed squarely at the liquidity crisis interpretation. By providing funds to the beleaguered countries at reasonable rates, those countries will have time to get their fiscal affairs in order and work their way out of this mess.
LOUISA GOULIAMAKI/AFP/Getty Images
Watching Greeks fire-bomb their banks, shut down their airports and ruin the tourist trade that is their economy's main prospect, I can't help but hear Virgil reprised. In that Roman poet's great narrative The Aeneid, survivors of the Trojan War seek a place to start anew, after much difficulty founding what will become the Roman Empire. It's rough going, and after much hard luck and stormy seas, the Trojan women burn the ships in order to prevent the men returning them all to sea.
They knew the Sybil (a rough approximation to an oracle for the Greeks) had prophesied that when they "quit at last of the sea's dangers / for whom still greater are in store on land... wars, vicious wars / I see ahead, and Tiber foaming in blood." Seeing the fleet in flames, Ascanius' reaction is "but your own hopes are what you burn!" And so it is with the Greeks -- they burn their own hopes by such unwillingness to do the unpleasant but necessary belt tightening.
Tourism provides one in five jobs in the Greek economy and a full sixteen percent of its gross domestic product. Being tied to location, it cannot be manufactured elsewhere. Being tied to history and culture, it is inherently Greek. And the best way to attenuate the effects of the austere cutbacks in government spending necessitated by Greece's financial crisis is to grow their economy as fast as possible. The debt to GDP ratio goes down both by reducing the numerator and increasing the denominator. Yet the Greek riots against the austerity program are sure to diminish tourism.
It is difficult not to sympathize with German hesitation to bail Greece out. Germany has labored for nearly 20 years to bring the former East Germany up to par with the West. Greece leapt into the euro on questionable accounting and proceeded to splash around the cheap credit that German stolidity in finances extended to the rest of the eurozone. One in three Greeks is a government employee. Hairdressers can retire at age 50 with full pensions because their jobs are categorized as hazardous.
But now much more outrageous is that than our Foreign Service Officer's Union refusing rewarding diplomats that serve in war zones? When Secretary Rice tried to give preferential promotion to diplomats that volunteered for service in Iraq or Afghanistan, the union representatives argued that every posting is dangerous -- as though volunteering to serve in Iraq took no more courage than volunteering to serve in Costa Rica. Currently two-thirds of foreign postings are designated as hazardous duty posts.
The state of our public finances is not as bad as Greece's, but we'll get there fast. Current and future obligations already incurred by our government amount to 500% of our GDP. And President Obama's budget will triple our already staggering national debt by 2020.
What may -- may -- save America from Greece's fate is that public outrage is building at our government spending money we don't have. When California governor Arnold Schwarzenegger tried to move against public sector unions in 2005, voters rejected his ballot initiatives. Californians cannot yet bring themselves to make the hard choices Greece is now having imposed on it by the IMF and its EU allies. New Jersey governor Chris Christie seems more successful, perhaps aided by greater public awareness of the parlous state of government finances. The hold of "entitlements" and public sector unions over government finances needs to be broken -- otherwise we really will be Greece.
Markets will not bankroll U.S. profligacy forever. No one can say when the chill will start, but once it does -- as Greece's example demonstrates -- the effects are dramatic. The longer we stall before facing up to the unpleasant reductions we must make, the more draconian will be the demands. As the spiraling cost of reassuring markets of the EU's commitment to support Greece demonstrates, it's much better to beat markets to the reckoning.
Here again Virgil offers sound advice. As the Sybil gives Aeneas instructions to Hades, she cautions:
The way downward is easy from Averinus.
Black Dis' door stands open night and day.
But to retrace your steps to heaven's air,
There is the trouble, there is the toil.
It's easy to become Greece. But it's very hard to get out of their predicament.
LOUISA GOULIAMAKI/AFP/Getty Images
Why would the U.S. stock market drop so dramatically this week, just after Europe and the IMF agree to back Greece and the Greeks adopt a painful package of fiscal measures? Even if Thursday's roller-coaster ride turns out to be partly due to the mother of all typos that cannot explain the week's global stock market slide. One possibility is that long-term economic arguments are telescoping into the short-term.
One of the great memes to emerge from the financial crisis was that economists had no idea what they were talking about. After all, professional economists had urged deregulation and faith in markets; an internet full of amateur economists could easily see that such misguided nuggets of advice were solely responsible for all the woe that ensued.
This analysis was always a bit problematic. First, we may need a bit more perspective to properly attribute causality in the crisis. The snap analyses have been politically convenient, in that they have supported snap policy responses, but they have their flaws. For example, what about Fannie Mae and Freddie Mac? These were hardly paragons of unfettered market extremism and they were central to the housing bubble and to the cost of the eventual government bailout. I know firsthand that this was a crisis foretold by economists, since I served as a senior staff economist for Greg Mankiw when he chaired President Bush's Council of Economic Advisers. Greg, working with excellent economists like Karen Dynan, now of Brookings, was vocal about the dangers posed by these government-sponsored enterprises and helped formulate proposals for reining them in. Congress blocked the proposals.
Setting aside the pathology of the financial crisis, there is a second problem with the ‘refutation' of economics that is more fundamental. Economics is best at describing incentives for behavior. As a forecasting tool, economists assume that sooner or later people will respond to those incentives. This works reasonably well in the long run, but far less well in the short run, when psychology dominates. Economists are not so good at predicting next quarter's consumer behavior; they are much better at predicting the ultimate consequences of unsustainable debt.
And so we come back to today's shaken market. Financial economists have for decades espoused the "efficient market hypothesis," which roughly said that all the relevant information for stock prices would be built into today's quotes. If not, there would be an incentive for someone to act on the omitted information and make some money off it. Yet the persistence of housing bubbles and overvalued feeble institutions in the prelude to the crisis seemed to mock the very idea. Prices could be wrong for a long time, it seemed. But the incentives for acting quickly were still lurking out there. Investors did not heed them in the past, and they got burned for waiting. What about the next time?
Now turn to Europe. Its crisis was supposed to play out in an orderly and gradual fashion: Greece would look ready to crumble, but it would be small enough to risk a bailout. There was not much hope that the healthy European economic powers could bail out every troubled country on Europe's perimeter, but by taking care of Greece today, they could buy themselves some time until the next country went. Maybe something good would happen in that interregnum (e.g. a surprise burst of growth, which cures many ills) or maybe today's politicians would leave office, in which case it would be somebody else's concern.
From an efficient markets perspective, there was a serious problem with a crisis unfolding in such an unhurried fashion. Looking ahead to the final stage, when a truly big country like Spain went and was too big to be bailed out, those left holding the debt of the fallen countries -- or of the banks who had lent them money -- would be hurting badly. Investors might always try to enjoy high yields on debt for a while, then sell before things really turned bad. But who knew when that would be? That strategy failed miserably for those entangled with Lehman Brothers. Perhaps it would be safer to exit now and not lend to anyone dubious.
CNBC reported today's stock market swoon thus:
The Dow plunged Thursday amid buzz in the market that European banks have halted lending.
One trader... said he heard fixed-income desks in Europe shut down early because there was no liquidity -- basically European banks are halting lending right now.
"This is similar to what took place pre-Lehman Brothers," the trader said.
And thus longer-term incentives telescope into the short term. Beware the return of efficient markets.
Chris Hondros/Getty Images
Europe's financial difficulties were predictable, but they have been unfolding at a startling clip. This has brought out different reactions in different commentators. Paul Krugman, for example, is preparing to hide under a table. I am no less impressed by the potential for disaster, but I am also struck by the undemocratic nature of major deliberations in Europe and by parallels here in the United States.
"Far too much time has been wasted on inaction," said Angel Gurría, secretary-general of the Paris-based Organisation for Economic Co-operation and Development. "We should have intervened two or three months ago. The markets have developed negatively since then, unnecessarily. That's why we have to act now, quickly and decisively."
The North Rhine-Westphalia election has the potential to upset the existing balance of power. At stake is not only the state legislature, but also control for Mrs. Merkel's coalition over the little-watched upper house of Parliament, the Bundesrat, which has to sign off on legislation. Billions of dollars in assistance for Greece may not play well with voters in a state with its own financial problems.
"May not play well" is an understatement. A German poll found that only 16 percent of Germans support a Greek bailout while 65 percent are opposed. I am not an advocate of governing by referendum (a number of years living in California clarified the problems with that approach). Yet the avoidance of the electorate on such matters is deeply problematic.
LOUISA GOULIAMAKI/AFP/Getty Images
The U.S. federal budget released Monday was deflating, particularly for those who had seen our current president as a panacea. The budget is stark in its depiction of the fiscal challenge: unless we can hold deficits below a stabilizing threshold -- roughly 3 percent of GDP -- they threaten to spiral out of control.
Having set itself this challenge, the administration abjectly fails to meet it. The nadir of its deficit projections is 3.6 percent of GDP in 2018. After that, the upward spiral begins. The only hope the administration offers is a call for a deficit commission to put forward solutions that it was unable or unwilling to generate on its own.
This fiscal gloom was linked to foreign policy in a prominent piece by David Sanger in the New York Times. He expresses dismay at the long-term budget numbers and argues that this profligacy could erode American power in the world.
There is ample cause for alarm at the budget picture, in particular the administration's plans for extraordinary levels of spending. The question of what this will do to America's potency on the world stage is a bit more subtle.
It may help to put all the anticipated impairments into a more general framework. We can consider three potential sources of national power:
1. Economic and military capability. A strong economy allows a country to produce and pay for many things, among them a cutting-edge military force.
2. Leadership by example, or soft power. A country that seems to embody an attractive ideal will draw followers, in economic as well as cultural matters.
3. Relationships and leverage. There may be other reasons why one country has a special hold over another, such as a colonial history. I toss it in here because of the common suspicion that the creditor-debtor relationship might serve as a similar lever.
JEWEL SAMAD/AFP/Getty Images
It is a quality of human nature to extrapolate the present into the future. What else explains the pervasive gloom about America's future in the international system? Headlines around the turn of the new year were full of learned and normally astute commentators bemoaning the inexorable diminution of the West by the ever-growing economies of Asia in the wake of the global financial crisis and what many perceived to be a lost decade from 2001- 2009. Surveys show that three in five Americans believe their country is in decline. A little more New Year's cheer is in order.
The United States today enjoys a share of global GDP no different than it did in the 1970s. The spread of democratic capitalism to large parts of the world that, during the Cold War, suffered from closed economies of scarcity is an enormous victory for American power and principles, and has made this country -- not to mention billions of people across Asia, Latin America, Central and Eastern Europe, and at least parts of Africa and the Middle East -- decisively better off.
This outcome, no less than the end of the U.S.-Soviet balance of nuclear terror, is the ultimate victory of the Cold War, and its final chapters have yet to be written -- as China's leaders, consumed by domestic insecurities even as the world lauds their unprecedented ascent to world power, seem to understand.
The United States remains the world's indispensable nation, even if President Obama has cast off the bracing language of American primacy in favor of a more subtle and understated poetry about American purpose. Washington's security commitments continue to order Asia, deter aggression in the Middle East, and make possible Europe's historic experiment in regionalism. The United States remains the international system's core convening power -- as seen most recently at Copenhagen-- and no solution to any pressing international problem is possible without American leadership.
The same cannot be said of China, so often conflated to be America's global equal despite possessing an economy one-quarter of America's size and political, demographic, and economic challenges that dwarf those of any other great power (with the possible exception of Russia, whose future appears bleak). China's passive acquiescence may be necessary on a host of international challenges, from stemming Iranian proliferation to (not) agreeing to climate change targets. But where is Beijing forging international solutions on the hard issues of the day? More often it is free-riding on the leadership of others, or belatedly consenting to decisions after being forced to take a position by the more active leadership of the West.
Uniquely within the developed world, America possesses a population that does not face a demographic crisis over the coming few decades, thanks in part to our historical tolerance for immigration. U.S. universities continue to educate the global elite -- and if they go back to India or China to start software companies rather than staying in the United States, that is in part an indictment of our tough controls on highly skilled immigration that deter the world's best talent from staying. At the same time, while it would be better to import than to export talent, we shouldn't diminish the value of the latter in extending American influence into these important new centers of power and seeding economic growth there that benefits us, too.
The United States is well-placed to compete in a globalized world -- we always have been, which is why generations of American presidents have pursued free trade and freedom of the seas as enduring national objectives. Half the S&P 500's earnings come from abroad, which means every American who owns a retirement fund in stocks, even if not invested internationally, benefits from the economic "rise of the rest" (as does every American who doesn't own a retirement fund but shops at Walmart and chooses to consume cheap imports). And it's worth pointing out that economic growth in the BRICS relies in part on the soft infrastructure of trade and finance that is dependent on the security of the global commons, still policed overwhelmingly by the U.S. military and our allies.
The United States suffered calamitously from the financial crisis of 2007-2008, which started here at home from our own Schumpeterian excesses of capitalism. But the United States also appears poised to lead the developed world out of recession and into sustained, if moderate, growth. It is true that China, in contrast to the West, had a good financial crisis. But its extraordinary stimulus spending combined with its artificially undervalued currency is creating a different set of financial and economic risks. The country's opaque and underdeveloped banking system, not to mention its rigid and non-transparent political regime, will be hard-pressed to manage these with ease.
More broadly, as Thomas Friedman has said, the 21st century cannot belong to a country that doesn't let its citizens use Google. Americans (and our friends abroad) should have a little more confidence in the values and purpose that have inspired us to help make the new world we live in. We have plenty of problems at home, from inadequate infrastructure to an underperforming educational system and, perhaps most disturbingly, a growing burden of national debt that, if not corrected, will increasingly undermine our welfare at home and our leadership abroad.
That said, I wouldn't trade America's problems for those of any other country. For his part, President Obama certainly doesn't want to spend four or eight years presiding over American decline. It doesn't pay to bet against the United States. We should have faith in our political leadership -- and actively involve ourselves in the political process -- to shape a coming decade and century that prove the skeptics wrong.
ADRIAN DENNIS/AFP/Getty Images
In foreign policy terms, it has to be President Obama's evolution from Afghan hawk to Afghan dove back to Afghan hawk (we think). This evolution will have a lasting impact on the president's first term. On the one hand, the tortuous course raised doubts (confirmed fears?) about the Obama's war-time resolve. On the other hand, the president's decision to escalate means that when push came to shove, he ignored advisors who said he could protect American national security on the cheap.
President Obama embracing the role of a war-time president. For much of his first year, Obama seemed more interested in domestic policy (the economy, health care, etc) than foreign policy, and in particular seemed ambivalent about the role of being a wartime president (cf. the inexplicable delays in the Afghanistan strategy review). Yet in the past month -- first with Obama's decision to adopt a strategy for victory in Afghanistan, and then with his Oslo speech defending the use of American power and the concept of a just war -- he has shown a new embrace of his role as a commander in chief leading his nation during a time of war.
The recovery from the financial crisis. That does not mean we're out of the woods by any means, but we can be thankful that we have so far avoided catastrophic breakdowns of the trade and banking systems.
The most remarkable foreign policy story of the year has been Iran. The past year has seen dramatic developments in two intertwined story lines -- the growing discontent and unrest of the Iranian people, and the increasingly tense showdown between the Iranian regime and the United States and its allies over Tehran’s nuclear ambitions. The former raises one’s hopes for Iran’s future and the latter serves as a reminder of the obstacles to the realization of those hopes. 2010 will likely witness a deepening of these crises, and the United States will face the formidable challenge of crafting a policy which is effective in halting Iran’s nuclear weapons progress, sufficient to maintain an international coalition, and true to our democratic values.
President Obama's slow conversion to a realist foreign policy. He learned the hard way: he was frustrated in his attempts to engage enemies such as Iran, Venezuela, and North Korea; he was unable to bully the Israelis into shutting down all settlement activity on the West Bank; and he recognized that to be serious about winning in Afghanistan required far more troops than the Bush administration ever envisaged. But he did learn. In so doing, he now seems determined to squeeze Iran financially. The president has won the grudging respect of even his European allies, who finally have stepped p with pledges of troops for Afghanistan that no one could have predicted a year ago. And, amazingly, Benjamin Netanyahu has ordered an unprecedented -- for him or any other Israeli prime minister -- freeze on settlement construction.
Pete Souza/The White House via Getty Images
By Phil Levy
The dollar has been drooping. This week, a broad measure of the dollar's value against other currencies fell to a 14-month low. Depending on the commentator, this is either a global vote of no-confidence in the United States; or it is good news, a return to normality as worldwide fears subside. Without exactly leaping between Paul Krugman and his latest sparring partners, there are a number of questions one might ask about the dollar's recent decline. This post kicks off a short series to consider four of them, beginning with: Is the drop in the dollar "natural" currency depreciation or the result of "manipulation?"
The dollar has fallen roughly 15 percent from its recent high this spring. When we see sharp movements in a price, it's natural to look for an active protagonists driving those movements. Every now and then in the past, we've found some. There have been attempts to corner markets in silver, wheat, and even salad oil. Each of these instances involved attempts to drive up a price and some were spectacular failures, but that's not what sets them apart from the case of the dollar. The market for currency absolutely dwarfs these other markets.
The last time statistics were gathered on this (late 2007), the average daily turnover in foreign exchange markets was $3.2 trillion and growing rapidly (up 69 percent since the 2004 survey). To put this in perspective, if we divide U.S. GDP over 240 business days in a year, it was about $0.06 trillion ($60 billion) in 2008. So every business day, the value of currency transactions averaged about 50 times the total value of U.S. output.
The implication is that it's very hard to manipulate the value of the dollar. In fact, this enormity of the market for dollars is one of its great strengths as a reserve currency; no one wants to keep their wealth in a thinly-traded currency that can be easily manipulated. As a general rule, the U.S. government doesn't even try to move the dollar around, and it gets to print the stuff. Every Treasury secretary since Robert Rubin has chanted the mantra "a strong dollar is in the U.S. interest" to avoid making any news that might move the markets in unpredictable ways.
But how can it be "natural" for the dollar to drop as far as it has in the last six months? Ever since the dollar was de-linked from gold almost four decades ago, the value of the dollar is determined continually in those massive global markets. The markets are populated by investors and traders, some with business ideas, some with money to save, some with goods to buy and sell. Some of them want to turn their dollars into euros to buy some French wine, others wish to turn their yen into dollars to buy some oil, a Treasury bond, or an American office complex. Exchange rates balance dollar buyers against sellers.
That means, in part, that we can have many explanations for what happens in these markets. The dollar could go up because American vinophiles turned to Sonoma Valley, or because the U.S. commercial real estate market became more attractive. One popular explanation for the dollar's rise and fall in the recent crisis is offered by Paul Krugman: "the dollar rose at the height of the financial crisis as panicked investors sought safe haven in America, and it's falling again now that the fear is subsiding."
That certainly seems to be part of the explanation. But it gives the impression that all is well, that we have returned to normal and there's little to worry about on the currency front. In fact, there is no indication that we've reached a long-term equilibrium and there is a serious basis for worries about the dollar's fall. That, though, will be the subject of the next post in the series: Has the dollar stabilized or is there risk of a further plunge in its value?
PAUL J. RICHARDS/AFP/Getty Images
By Phil Levy
The G20 leaders meeting wrapped up in London with a long list of promises of virtuous behavior in the future. Close followers of global summitry may remember back to the last such meeting in November, when solemn vows of fealty to open trade were broken in short order. If a skeptic were to set aside the more nebulous statements of intent and dismiss the self-congratulations on policies already adopted, what did the meeting really accomplish?
The headline number was $1.1 trillion of new money, with most of that flowing through the International Monetary Fund and some through the World Bank. According to the Financial Times,
When all the sums are added together, rather than $1,100bn, the new commitments appear to be below $100bn and most of those were in train without the G20 summit.
Even if one were willing to credit the G20 with the much larger figures, there was an oddity about their IMF ardor. It seemed to suggest that one of the key difficulties so far has been a shortage of resources at the IMF. In fact, the IMF just had to rework its loan offerings since a recent attempt at a no-conditions loan facility attracted not a single customer. When the IMF assessed its own likely needs prior to the London meeting, it requested $250 billion. So the G20 promised $500 billion.
This seems like a new twist on John Maynard Keynes's "pushing on a string." The phrase usually describes a situation in which monetary policy cannot work anymore. Central banks drive interest rates to zero and then have real challenges getting more money out the door. The exhaustion of traditional monetary policy is the rationale behind the rediscovered passion for fiscal stimulus, as well as unorthodox measures by the central bank.
In the case of the IMF, the problem is that many countries are determined to avoid these measures. In Asia, after the financial crisis of the late 1990s, this has been a major motivation for the large buildup of currency reserves: no reserve crisis, no IMF. There is similar antipathy in Latin America and Africa. Traditionally, countries have complained about the policy conditions the IMF has attached to its loans. Now, there is a sufficient stigma that even condition-free loans are a hard sell.
This is not to argue that all of the IMF money will go unused. There seems to be enough trouble looming in central and eastern Europe that the IMF will find some takers. That, in turn, should help western European banks that made extensive loans to the region. But doubling the IMF's request is unlikely to double the impact.
Increasing regulation was the other key focus of G20 attention. It has its own string-pushing issues. The fascination with regulation stems from a belief that the current crisis was caused by either a lack of regulatory power, or through wild American deregulation over the last 8 years. There are some oddities about this belief. As my colleague Peter Wallison has argued, the major financial deregulation that is cited, the repeal of restrictions on mixing regular and investment banking, was undertaken at the end of the Clinton administration. The only important role it seems to have played in the crisis was to allow Bank of America to take over a troubled Merrill Lynch.
Poor regulation was certainly an important cause of the crisis. There is a fascinating story in the Washington Post about the regulation of major banks such as Citigroup. The key U.S. financial institutions were under the supervision of the New York Fed, run at the time by now-Treasury Secretary Tim Geithner. The Post concludes:
A confidential review ordered by Geithner in 2006 found that banking companies could not properly assess their exposure to a severe economic downturn and were relying on the "intuition" of banking executives rather than hard quantitative analysis...
Records and interviews show that Geithner and his colleagues did not employ some of the harsher tools at their disposal to bring the banks into line. From 2006 through the start of the credit crisis in the summer of 2007, they brought no formal enforcement actions against any large institution for substandard risk-management practices. The Fed also did not use its confidential process during that period to downgrade any large bank company's risk rating, according to two people familiar with the process, a step that could have triggered costly consequences for the firms.
At least Mr. Geithner knew enough to worry. In the context of mortgage regulation, former Senator Phil Gramm writes: "It was not that regulators were not empowered; it was that they were not alarmed." Nor is this a uniquely American problem. The troubled European banks that relied heavily on dubious AIG credit default swaps to avoid capital requirements were under the watchful gaze of European regulators.
Poor regulation and inadequate regulation have very different implications. If our difficulty was that regulators were human and fallible and unwilling to use the tools at their disposal, it is not clear how expanding the tools at their disposal will solve the problem. We can at least be grateful that President Obama resisted French and German attempts to go even further on the regulatory front.
Thus, it appears the G20 did little harm, but did little to save the world either. At the core of the current global crisis lie failed banking systems. As the communiqué noted, "Our actions to restore growth cannot be effective until we restore domestic lending and international capital flows." The leaders promised to work on that in unspecified ways.
Perhaps it's better not to examine these things too closely. We can be happy that the whole thing went off without walkouts or fisticuffs (at least not inside the meeting hall). It can be reassuring just to close one's eyes and try to believe the leaders' grand proclamations that they are taking dramatic joint action and that we are swiveling around at an historic turning point.
By Will Inboden
Here in London, as I write, the G-20 proceedings have recently ended, and local attention remains split essentially across three fixations:
On #1, the emerging narrative of the inchoate Merkel-Sarkozy pro-regulation/anti-stimulus alliance against the Obama-Brown pro-stimulus camp was intriguing as political sideshow, but unsettling both in terms of economics and geopolitics, with one ironic by-product being the creation of even more maneuvering room for China and Russia to position themselves as global leaders on economic policy. Given the alternatives, perhaps the "best" outcome was the sort of anodyne statement that failed all of these tests, which is what we got, seriously sweetened with $1 trillion in pledges to the IMF.
On #2, April is a pivotal month for Brown, bracketed as it is by the G-20 at the beginning and the unveiling of his government's budget at the end of the month. Early returns seem to regard Brown's meeting and press conference with President Obama on Wednesday as a success and a much-needed boost, though given the painful optics from their first meeting last month, the bar of expectations was set very low.
On #3, mindful of reports that some protestors might throw eggs or target spray paint at business attire-wearing capitalists, I wore an old suit just in case of any uncivil encounters with the agitators down the street - but thankfully it was a quiet walk to the office.
Meanwhile, many voices (including my Shadow colleagues Philip Zelikow and Phil Levy) have rightfully decried the global lurch towards protectionism, exemplified by the 17 leading nations that have adopted protectionist measures just months (sometimes even days) after pledging not to at the last G-20 summit in November. The pro-free trade and anti-protectionism rhetoric from yesterday's G-20 statements was to be expected, but trade policy embodies the wisdom of watching what nations do rather than what they say. It is doubtful that "naming and shaming" violators will be sufficient.
So Wednesday's release of a letter defending free trade and warning against protectionism, signed by over 2,000 economists (and a number of non-economists as well, including yours truly) will hopefully continue to speak to the G-20 leaders even - especially - as they return to their home countries and face fierce domestic pressures otherwise. Even allowing that group letters signed by economists don't automatically equate with wisdom (for example, the notorious example of the 364 economists who denounced Thatcher's economic policies in 1981), this letter's message deserves to be heeded.
While Norman Angell remains the paragon of benighted optimism that economic integration will obviate military conflict, the 1930s offer the ominous counter-warning that protectionism can accelerate the risk of war. Or to take a lighter comparison, if 50 million Elvis Fans Can't Be Wrong, then surely 2,000 economists can't be wrong either?
A final, and brief, piece of advice for a better G-20 agenda:
Find a concrete move that shows commitment to an open world trading system.
I assume the upcoming G-20 statement will offer some lip service to this goal. The problem is that world trade is falling fast and national actions are starting to belie the multilateral rhetoric. Right now, the United States is part of the problem, not part of the solution -- as Washington set off a rapidly escalating trade dispute with Mexico, even at a time when that vital and precariously situated country is also heading into recession.
No one can expect the Doha Round problems will be solved in a few weeks, if they can be solved at all. But some concrete actions, by a few leading countries, are critical. A big reason why world trade was crippled in the 1930s was because the world's leading advocate of free trade -- Great Britain -- abandoned its leadership and instead chose the path of "imperial preference" in 1932. The paragons of an open world have to be willing, at a time of crisis, to set an example.
The next step toward a better agenda for the G-20 summit is this:
On financial regulation, don't fall for the dumb dichotomy of global vs. national; adopt a smart synthesis, a global framework for coordinated national regulation.
The papers are playing up an issue for the G-20 summit of Europeans emphasizing the need for new financial regulation vs. Americans talking up stimulus. This would be a truly terrible way for the debate to evolve. The Europeans would be all about attacking bad bankers (like the Wall Streeters they want to scapegoat) while the Americans would seem wedded to their preferred panacea. And the biggest issues get lost both ways.
Fortunately, the U.S. side has moved adroitly to develop an agenda for future regulation (important but not critical right now) that should help answer the European mail. Geithner laid out a set of ideas on this point in the statement he issued last week. They seemed plausible. But Bernanke did an even better job of discussing this issue in an address he delivered to the Council on Foreign Relations on March 10. Here is his four part outline:
First, we must address the problem of financial institutions that are deemed too big--or perhaps too interconnected--to fail. Second, we must strengthen what I will call the financial infrastructure--the systems, rules, and conventions that govern trading, payment, clearing, and settlement in financial markets--to ensure that it will perform well under stress. Third, we should review regulatory policies and accounting rules to ensure that they do not induce excessive procyclicality--that is, do not overly magnify the ups and downs in the financial system and the economy. Finally, we should consider whether the creation of an authority specifically charged with monitoring and addressing systemic risks would help protect the system from financial crises like the one we are currently experiencing.
Bernanke added, crucially, that it is "self-evident that, in light of the global nature of financial institutions and markets, the reform of financial regulation and supervision should be coordinated internationally to the greatest extent possible." In other words, the U.S. side is clearly developing a constructive approach toward the topic of regulation.
One red herring, though, is the "mark to market" issue. The SEC and others are being pressured by Congress (e.g. Barney Frank) to revise these accounting rules. Conservatives like Steve Forbes have jumped on this too, arguing that this is a relatively recent deviation from good old traditional accounting rules. Well, the problem is that in the good old days accountants weren't being asked to sign off on the asset value of hundreds of billions of dollars in collateralized debt obligation derivatives whose asserted value was based on statistical modeling rather than the ability to assess the quality of individual loan performance. These CDOs were also being traded in, shall we say, a rather murky marketplace. As the trading of these derivatives skyrocketed in the last decade, honest accountants tried to cope.
Here again the administration's instincts seem right to me. Geithner in particular has resisted devices to cheat on assessing the asset value of troubled banks, while everyone acknowledges being open to smaller adjustments in the ways the rules work. My only footnote is to observe that, here again, the United States would be well advised to coordinate its regulatory framework with the one being developed by other leading states, like the participants in the G-7's Financial Stability Forum.
The next part of a better agenda for the G-20 summit is keeping this in mind:
The proposal for global stimulus spending of 2 percent of GDP (with IMF monitoring) is not so good.
Last week, Geithner drew on a new IMF report for support in his call for the world to spend 2 percent of its collective GDP on fiscal stimulus. True in general, and the IMF wants countries "with fiscal room" to plan to keep the fires burning on into 2010.
But the IMF also re-emphasized two other points: 1) Hold on to money that governments will need for "upfront" financial sector support, and these needs will be large; 2) "Reinforcing fiscal credibility is paramount. Thus, fiscal support needs to be anchored by a sustainable medium-term fiscal framework."
The Great Depression was aggravated, if not caused, by ideological commitment to monetary stringency. But this crisis has very different structural origins, almost the exact opposite. Yet, in responding to this generation's Great Recession, Geithner and the administration seem to be exhibiting a reflexive ideology of their own, assuming that already highly leveraged economies can borrow/spend their way out -- relying on what World Bank president Robert Zoellick recently called "a sugar high."
As a historian, an interesting pattern one sees is how often governments rarely make the same mistake twice. Instead they are damn sure they "won't make that mistake again." And they don't. They slavishly act to avoid the last mistake. Which becomes their new mistake.
Two other recent comments help place these global stimulus proposals into a proper global perspective, one from a historian and one from an economist. Yale historian Paul Kennedy recently tried to imagine what Keynes would think of the current debate. Kennedy thought Keynes "would be uneasy at parts of Mr. Obama's deficit-spending scheme." Not only the domestic part, but also unease with:
... a Washington spending spree that seems uncoordinated with those of Britain, Japan, China and the rest; and, most unsettling of all, at the fact that no one is asking who will purchase the $1,750bn of US Treasuries to be offered to the market this year - will it be the east Asian quartet, China, Japan, Taiwan and South Korea (all with their own catastrophic collapses in production), the uneasy Arab states (yes, but to perhaps one-tenth of what is needed), or the near-bankrupt European and South American states? Good luck! If that colossal amount of paper is bought this year, who will have ready funds to purchase the Treasury flotations of 2010, then 2011, as the US plunges into levels of indebtedness that could make Philip II of Spain's record seem austere by comparison?
For those who don't remember Kennedy's book on The Rise and Fall of the Great Powers, Philip II of Spain was the exemplar of "Fall."
If Kennedy's worries seem a bit hyperbolic, there are more nuanced cautions from Simon Johnson's recent congressional testimony.
First, Johnson pointed out that America's own stimulus plans are predicated on economic forecasts (for a recovery later this year) that he regards as too rosy. Thus, "In the United States, the budget deficit is approaching a trajectory that is sustainable only if rapid growth returns in 2010."
Second, commenting on Geithner's 2 percent proposal, Johnson (aside from noting its "fuzzy" math) observed:
Very few countries now have room for a fiscal stimulus; debt levels are too high and fiscal capacity is hard pressed by contingent liabilities in the banking system, particularly with an increasing probability of quasi-nationalization. As a result, the idea of a 2 percent of GDP global fiscal stimulus seems quite far fetched at this point.
Contingent liabilities in the banking system: Has anyone noticed that, while some Republicans are worrying aloud that Obama wants to turn the United States into a big-spending and high-taxing version of Western Europe, the actual governments in Western Europe (e.g. France) think the United States is focusing too much on fiscal stimulus!?
What is going on? Did Friedman and Hayek just get translated into French? No, but the French are indeed a bit worried about "contingent liabilities in the banking system." They wish the Americans would focus more on that. Meanwhile, the AIG bonus blowup is going to make that problem even harder for the Obama administration to tackle.
By Philip Zelikow
The next step toward a better agenda for the G-20 summit:
The proposal to expand U.S. contributions to the IMF is good and important.
Not to be confused with Secretary Geithner's call for global stimulus spending (about which more below). Geithner's call for expanding IMF "New Arrangements to Borrow" is timely and important. The proposal is to add $500 billion of emergency credit facilities for countries trying to stay afloat, like Ukraine. The money is not for stimulus; it is for fiscal survival and sustaining international trade. Indirectly, the plan might also help mitigate the growing exposure of the European banking system which, incidentally, is one of the reasons that leading European countries are against the stimulus part of Geithner's proposals.
This move should get bipartisan support, showing the United States will do its part in fashioning an international approach to an international crisis. Japan has also stepped up with some large financial commitments to expand the IMF. Its new finance minister, Kaoru Yosano, looks like he is prepared to be a lively, constructive player.
Europeans are already uneasy about the corollary part of Geithner's proposal, the need to update, ahead of the usual schedule, the voting powers in the IMF based on current contributions. Such a review is bound to increase Asia's voice at the expense of Europe. This review is the right move, though, and would not happen -- in the U.S. proposal -- until 2011.
To achieve a better G-20 summit agenda for next month, policymakers need to answer this question:
Are the leading countries coordinating their monetary moves?
I include China as a leading country. It is a principal creditor to the world and is entitled to be heard. So what does it mean when Wen Jiabao issues an extraordinary warning shot to the United States to preserve the value of the dollar. Then, a week later, Bernanke and the Fed answer him promptly with loud deeds: a huge quantitative easing (printing money to buy Treasuries and other securities) that has already reduced the value of the dollar nearly 5 percent, just in the last 72 hours.
Question #1: It would be interesting to learn when and how did we explain this move to the Chinese government? Or at least be reassured that we handled this seemingly scornful response in an appropriate way.
Question #2: As both we and the Eurozone engage in this aggressive injection of liquidity, what is the underlying analysis about the danger of competitive devaluations and inflation?
Sure, we all know that some inflation will be a good counter to expected deflation. But, after the price declines of late 2008, the seasonally-adjusted Consumer Price Index has now gone up in both January and February even though unemployment has also been shooting up.
It has long been evident that the Fed would probably have to employ some quantitative easing for at least the reason of helping to keep the price (interest rates) down in the huge coming U.S. debt auctions and also to keep from swamping the rest of the world's need for capital. But why did the Fed move so fast, so soon -- which may constrain its freedom of action later? Does it see something the rest of us don't?
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.