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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

No Fix For US Fiscal Policy without New Rules

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

India's Secret Weapon in its Economic Race with China

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

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

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

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

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

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

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

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

Could QE2 Cause the Fed to Go Broke?

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

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

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

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

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

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

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

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

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

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

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

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

The Economics of a Soda Tax: Update

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

EU Leaders Struggle to Fix Fiscal Policy Rules

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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