Shadow Government

Two cheers for the "Washington establishment"?

By Christian Brose

I finally got around to reading this Fareed Zakaria piece that some have recommended, and I can't say I'm much impressed. He's usually a smart writer, but he makes assumptions in this piece that are far more reflective of the so-called "Washington establishment" he aims to criticize, and it's worth picking at it for those reasons. Here's his main point:

The problem with American foreign policy goes beyond George Bush. It includes a Washington establishment that has gotten comfortable with the exercise of American hegemony and treats compromise as treason and negotiations as appeasement. Other countries can have no legitimate interests of their own -- Russian demands are by definition unacceptable. The only way to deal with countries is by issuing a series of maximalist demands. This is not foreign policy; it's imperial policy. And it isn't likely to work in today's world.

I'm all for a serious discussion of diplomacy, but unfortunately this isn't it. Is negotiating akin to appeasement? No, not inherently, but as with everything, the devil's in the details. Diplomacy is not just a synonym for talking. It is the balancing of incentives and disincentives to elicit changes in another party's behavior. So the question should never be, are we negotiating? -- but rather, are we aligning our tools of engagement and coercion to get our desired result?

I'd be the first to say that the Bush administration did not always pass that test. Indeed, one of the many tragedies of the Iraq war was that, at the moment (in April 2003) when U.S. leverage over Iran was highest, the Bush administration did not attempt to use it to change Iran's behavior. Would it have worked? Who knows. But it should have been tried, because the administration then spent its final years trying (unsuccessfully) to recreate the leverage it once had for a policy that was too-little-too-late.

We've been hearing a lot about the Obama administration's plans to talk to adversaries -- Iran, Russia, Syria, the Taliban, etc. But we've heard preciously little about how the administration intends to create conditions of strength that are the requirement for diplomatic success. Everyone knows Obama is willing to talk. The question is what new leverage he will bring to bear to make that talk effective. Will we use the military forces we are withdrawing from Iraq to exert greater pressure on Iran? Are we asking our European allies to take any bold new steps on financial coercion? What exactly is Russia willing and able to do to change Iran's decision-making? So far, answers to questions like these have not exactly been forthcoming, and in their absence, it's not at all off-base to think that talking without leverage could harm U.S. interests. (And all of this is assuming that Iran hasn't just said, screw it, we're getting the bomb, and damn the torpedoes, which opens up a whole new world of problems.)

Similarly, there's Zakaria's assertion, which is echoed so often by people in Washington, that "other countries can have no legitimate interests of their own." Well, there's interests, and then there's interests. It is perfectly legitimate for Russia to use its national power to advance its commercial and security interests. And Obama's team, like Bush's, will have plenty of conversations with Russia about whether our interests and theirs are reconcilable. Some will be; others won't. And we should never mistake, as Zakaria and others seem to do, a lack of agreement for a lack of diplomacy.

But in some sense, this is the less important issue. The real sticking point is how a Syria or a Russia defines some of its "interests." Damascus's desire to dominate Lebanon is not an interest. Nor is Russia's attempt to create a sphere of influence in its old imperial stomping grounds and prevent sovereign nations from making free choices about their own foreign policies. Such "interests" should be, in Zakaria's words, "by definition unacceptable." And to capitulate on this point, in the case of Russia specifically, is not only craven; it plays into what increasingly seems to be Moscow's real goal: to force the United States into a position where every decision we make about our own interests in Europe and Central Asia has to go through the Kremlin first -- be it resupply to Afghanistan or cooperation on missile defense with NATO allies. We can call this many things, but a partnership isn't one of them.

These are hard problems, and rather than tired cliches or pleasant rhetoric about outstretched hands, it's getting to be time for serious answers. Zakaria I suspect knows better. I hope the administration does too.

Shadow Government

The ongoing problems of "stimulust"

By Phil Levy

It was not hard to predict that an Obama administration's skeptical approach to trade could cause international tension. But who ever would have thought we'd be berating Europe over insufficient enthusiasm for domestic spending?

And yet that was at the heart of last week's less-than-diplomatic lead up to the weekend meeting of G-20 finance ministers in the United Kingdom. White House aide Larry Summers, in a reprise of his past role as Treasury Secretary, called for further European stimulus. The European reaction ranged from "significant bewilderment" to outright rejection.

The U.S. theory is that we're in a Keynesian world in which any federal spending is worth its weight in economic activity and then some. There are at least two big problems with this. First, there's the most basic question: what is fiscal stimulus? The answer might seem obvious: it's an increase in government deficit spending. That, though, would be the European answer. The U.S. answer seems to be: fiscal stimulus is a new package that goes above and beyond what you were planning to do anyway.

The difference is pretty big, as a recent IMF paper showed. Countries with extensive social safety nets and high taxes see greater automatic deficit increases as welfare payments rise and taxed activity falls. That reduces the need for new legislative packages; the response is largely built-in. To take the most extreme example, Britain's stimulus package for 2010 actually shows a 0.1 percent decrease in net government spending relative to GDP under a narrow definition. But Britain's overall increase in deficit spending for 2010 is predicted to be 5.4 percent of GDP, second only to that of the United States among major nations. The difference is in the automatic stabilizers.

Why should it matter if a stimulus was built-in or delivered in a shiny new package? One might argue that gloomy consumers already knew about the built-in spending, whereas the shiny new package might surprise and stimulate them. Here we come to the second big problem with the idea of fiscal stimulus as a panacea. A big reason that fiscal stimulus had fallen out of favor in economics was that it's hard to tell a consistent story about how it will work. This problem is particularly acute when we start worrying about people's expectations.

The intellectual foundation for the administration's claim that its fiscal stimulus will create or save up to 3.5 million jobs is a short paper by Christina Romer and Jared Bernstein. It is based on old-school theorizing (i.e. don't worry about expectations). It relies critically on assumptions such as a zero interest rate in perpetuity. What if we revisit that assumption and apply some of the macroeconomics learned over the last few decades? A recent paper by former top Treasury official and Stanford economist John Taylor and colleagues does just that. It finds that the U.S. stimulus package is likely to create or save a total of about 500,000 jobs -- roughly the level of recent monthly job losses.

While the Obama administration deals with its fiscal stimulus fixation, the financial sector lurks. Without a banking fix, even beguiling new fiscal packages are unlikely to save the economy. The problem is that a financial sector fix may cost dramatically more than the administration has acknowledged. Holes in bank balance sheets have been estimated to be in the trillions. The U.S. Treasury has decided to check how bad this problem really is by putting major banks through "stress tests." In Western Europe, they're already stressed as they grapple with weakened banks with major exposure to a faltering Eastern Europe.

One European argument is that they don't want to exhaust their credit lines with this potential trouble on the horizon. The Obama administration has no such worries, planning trillions of deficits for years to come in its new budget. Perhaps it should listen to its creditor, though. Chinese Premier Wen Jiabao is worried. He just called on the the United States to guarantee the security of Chinese assets, a guarantee the United States can certainly not provide (it would require perpetual low interest rates, a fixed exchange rate, price stability, and fiscal responsibility).

While the Europeans may be more mature on fiscal discipline, they have their own obsessions. In their view, the world will be set aright if only we could all get together and regulate. The last great effort at global financial regulation was to set standards to make sure banks had enough capital to avoid a financial breakdown (the Basel II negotiations). Years of technical talks wrapped up in 2004, but the approach has not worked so well. Nor is it clear that tighter financial regulation needs to be globally coordinated to be effective.

All of this should make for a fun set of G20 talks over the next few weeks.