Thursday, October 28, 2010

Tax Reform as a Path to Growth-Friendly Fiscal Consolidation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sunday, October 24, 2010

China's Fragile Rare Earth Monopoly

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Friday, October 22, 2010

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

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

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

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

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

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

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

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

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

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

Monday, October 18, 2010

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Friday, October 15, 2010

How Successful Is China's Currency Manipulation?

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

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

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

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

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

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

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

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

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

Monday, October 11, 2010

Chocolate Lovers Keep Nervous Watch on Volatile Cocoa Prices

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

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

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

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

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

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

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

Wednesday, October 6, 2010

The Continuing Resolution: Fiscal Alchemy in Action?

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

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

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

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

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

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