Ed Dolan's Econ Blog

Latest Economic Data Begin to Shift the Counterfactual in Favor of Democrats

2012-02-06T21:19:00.000-08:00

For all of last year, as the parties tested their rhetoric in the early stages of the election campaign, Democrats were stuck in the unenviable position of arguing a counterfactual: “The economy is bad, but without what we have done, it would have been even worse.” That could very well have been true, but it was not exactly a stirring closer for a stump speech.

Now, in light of the latest economic data, the situation is beginning to shift. Suddenly the Republicans are the ones left with the counterfactual: “The economy is getting better, but if we had been in charge, it would be better still.” Not nearly as good a line as “failed stimulus,” “economy in free fall,” or “record unemployment.” Read more>>>

US Employment Data: Economy Adds 257,000 Private-Sector Jobs in January

2012-02-06T10:25:00.000-08:00

The U.S. employment scene continued to improve in January, according to the latest release from the Bureau of Labor Statistics. The economy added 243,000 payroll jobs in January, and 257,000 in the private sector. Federal and local governments shed jobs in the month, explaining the difference.

The unemployment rate dropped another 0.2 percentage points to 8.3 percent, equaling the rate during President Obama's first full month in office. The unemployment rate decreased despite an increase in the size of the labor force. U-16, the broad measure of employment stress that includes part-time workers who would prefer full-time jobs and marginally-attached workers, decreased slightly to 15.1 percent.

Follow this link to view or download a classroom-ready slideshow of the latest employment data.

What Happened to Corporate Tax Reform?

2012-02-03T06:25:00.000-08:00

President Obama’s 2011 State of the Union Address contained ringing language on corporate tax reform:

Over the years, a parade of lobbyists has rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change.
So tonight, I’m asking Democrats and Republicans to simplify the system. Get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 years –- without adding to our deficit. It can be done.

That was then. This year, instead, the White House is advocating a handful of minor fiddles that would raise corporate taxes on some while creating new loopholes for others. Read more>>>

Faster GDP Growth will be Welcome News for the White House, Despite “Ifs” and “Buts” in the Details

2012-01-27T15:21:00.000-08:00

According to the advance estimate released today by the Bureau of Economic Analysis, U.S. real GDP growth increased to a 2.8 percent annual rate in the fourth quarter of 2011, compared to just 1.8 percent the previous quarter. It was the tenth consecutive quarter of growth since the end of the recession.

Furthermore, the new data show that the economy has now solidly entered the expansion phase of the business cycle. Expansion begins when real GDP surpasses its prerecession peak, which occurred in Q4 2007. Technically, the expansion had already begun in Q3, but by such a tiny margin (just 0.04 percent) that it was hardly enough to count. Read more>>>

Follow this link to view or download a classroom-ready slideshow version of the latest GDP data.

Controversy over Romney's Taxes Underlines the Need for Broad Reform

2012-01-23T06:14:00.001-08:00

The controversy over Mitt Romney’s tax returns underlines the need for broad reform of the U.S. tax system. Much commentary has focused on the low average tax rate that this wealthy candidate for president enjoys, thanks in large part to low rates on capital gains.

The political issue raised by Romney’s taxes is simple: should the rich pay a larger share of the cost of government, or, are they being justly rewarded for their role as job creators? The economic issues are more complex: Does it make sense to treat capital gains differently from other forms of income? How do capital gains taxes interact with the rest of the tax system?

The blogosphere is awash with commentary on the political aspects of the question. (See here for samples from the left and the right.) This post will tackle the economic aspects, under the headings of three economic arguments often advanced in favor of lenient tax treatment of capital gains. >>>Read more.

Court’s Latest Stay of Clean Air Regulations Shows the Best can be the Enemy of the Good

2012-01-12T21:56:00.000-08:00

On December 30, The U.S. Court of Appeals for Washington, D.C. stayed implementation of the Environmental Protection Agency’s proposed Cross-State Air Pollution Rule (CSAPR), which was to take effect on January 1, 2012. The EPA maintains that CSAPR would save 13,000 to 34,000 premature deaths annually, as well as lead to improvements in visibility in national and state parks, and increased protection for sensitive ecosystems including Adirondack lakes and Appalachian streams, coastal waters and estuaries, and forests. The stay was the latest in a long series of setbacks to EPA efforts to regulate a family of air pollutants from coal-fired power plants and other sources, including sulfur dioxide (SO2), oxides of nitrogen (NOx), ozone, and fine particulates. READ MORE>>>

Ed Dolan is the author of TANSTAAFL: A Libertarian Perspective on Environmental Policy.

U.S. Employment Data: Strong Jobs Report Shakes Up the Election Season

2012-01-06T10:34:00.000-08:00

Everyone knows what this election will be about: jobs, jobs, jobs. If so, the latest numbers from the Bureau of Labor Statistics should shake things up a little.

The headline number in the report is a relatively robust gain of 200,000 jobs in December, confirming that the jobs market is picking up after a mid-year slump. The November gain was revised downward from 120,000 reported last month to just 100,000, but that was partly offset by an upward revision of the October figure from an originally-reported 100,000 to 112,000. There was good news in the line-by-line numbers, as well. Goods-producing jobs increased by 48,000, after a decrease in November.
Read the complete commentary then, follow this link to view or download a classroom-ready slideshow with charts of the latest jobs data.

Why the Russian Economy is No Longer a Big Plus for Putin

2012-01-03T21:41:00.000-08:00

Vladimir Putin’s decision to return to the presidency has touched off a wave of protests in Russia. The motives behind the protests are partly social and political (see this recent post), but economics also plays a role in Putin’s fading popularity. It is far from clear that the present regime will be able to continue to offer growth and rising incomes in exchange for a monopoly of political power, as it has in the past. Here are some of the problems facing Russia’s economy in as we look toward the March election and beyond. Read More >>>

Best Economics News Story of the Year: Dickens Meets Hayek in a Mumbai Slum

2011-12-31T07:45:00.000-08:00

My one-man committee has met and made a decision: The award for best economics news story of the year goes to Jim Yardley of The New York Times for an article titled “In One Slum, Misery, Work, Politics and Hope,” published in the December 29 issue.
It is a story about Dharavi, Mumbai’s most famous slum, a seething hive where perhaps as many as a million people live in 60,000 structures on an area smaller than central park. Not surprisingly, in every alley, there are scenes of appalling poverty: Read more>>>

Choral Singing, Malpractice, Italy: More Links for Your Classroom

2011-12-27T07:41:00.000-08:00

Most economists are familiar with the distinction between coordination via spontaneous order and coordination via hierarchy. (See, e.g., discussion in Ch. 1 of my textbook.) In the real world, coordination often involves a mix of the two. This post from Lynne Kiesling of The Knowledege Problem illustrates the coordination issue with the example of choral singing. If you scroll down the comments, you will see one I have added.
The euro crisis is not about tiny Greece, Ireland, or Portugal; it is about Italy. Italy is not only too big to fail, it is too big to rescue. In this post from Economonitor Ed Hugh digs deep into the Italian problem and explains why the euro's ultimate fate will depend on whether Italy can pull itself out of the very deep hole it is in. Hint: Government finance is only part of the story.
Everyone agrees it would be good to slow the runaway growth of medical costs, but where to attack the problem? Conservatives often single out the need to reign in excessive medical malpractice suits. Others dismiss malpractice as a minor problem, citing data that malpractice legal costs and awards amount to only 2.4 percent of medical spending. This interesting post from the NY Times by Pauline W. Chen, M.C., a practicing physician, explains that the damage done to the medical system by excessive malpractice suits may be far greater than the measured 2.4 percent if one takes into account the way doctors respond to the fear of malpractice claims.

US GDP: Can We Blame the Grinch for Yet Another Downward Revision of Growth?

2011-12-23T12:43:00.000-08:00

The third estimate of US real GDP for Q3 2011 brought yet another downward revision. Can we blame the Grinch who Stole Christmas?

GDP is now reported to have grown at an estimated 1.8% annual rate in Q3 2011, less than the 2.0% second estimate released in November and less still than the 2.5% preliminary estimate reported in October Although slowing, the July-September 2011 quarter was the 9th consecutive quarter of growth since the end of the recession that lasted from Dec 2007 to Jun 2009.

Even after the revision, Q3 GDP was still above its pre-recession peak reached in Q4 2007, although only by a razor-thin 0.04%. According to standard business cycle terminology, the recession phase of the business cycle is the downward movement of GDP from its previous peak. The recovery phase is the upward movement from the trough (low point) of the recession and continues until GDP again reaches its previous peak. Once GDP moves above its previous peak, the expansion phase begins. The revised Q3 data still suggest that after a recovery of 2 years duration, the expansion phase has now begun.

Consumption was revised downward but still accounted for much of the growth in Q3. Investment was revised up to weakly positive compared with the negative number in last month’s second estimate. Federal government defense spending grew but was offset by continued decline of federal nondefense spending and state and local government spending. Exports grew even more strongly than previously reported, but they were offset by an upward revision of imports (a negative entry in the GDP accounts).

The revised growth of nominal GDP (NGDP) was 3.9% in Q3. NGDP growth consisted of 1.8% real growth and 2.1% inflation. An increasing number of economists focus on NGDP growth as a key policy target. Over the long run, NGDP growth of about 4.5% would allow real GDP to track its potential level with about 2% inflation. The Q3 NGDP growth of 3.9% suggests that the gap between actual and potential GDP that opened during the recession continued to widen.

Follow this link to view or download a classroom-ready slideshow presentation of the latest GDP data

Linking Keystone XL to the Payroll Tax Only Shows Why we Need a Real Energy Policy

2011-12-22T21:48:00.000-08:00

The administration is coming under increasing pressure to accelerate approval of the Keystone XL pipeline, designed to carry increased U.S. imports of bitumen from Canadian oil sands. The latest form of pressure is a Senate bill that would fast-track KXL in exchange for a two-month extension of the payroll tax cut and other items. After some resistance, it now appears the House will go along with the proposal. It is a bad idea. READ MORE>>>

Latest Price Data Show US on Brink of Deflation as World Economy Slows

2011-12-17T07:21:00.000-08:00

The most widely watched U.S. inflation indicator, the seasonally adjusted all-items CPI for urban consumers, fell in November at an annual rate of 0.23 percent. The decrease was small enough that it will hit the headlines as no change, based on the rounded monthly data reported in the press release from the Bureau of Labor Statistics. (All inflation data in this post are month-to-month changes stated as annual rates, based on the three-decimal version of the data released by the Cleveland Fed.) November marked the second consecutive month of negative inflation, following a decrease of 0.96 percent in October. >>>Read more

Follow this link to view or download the latest inflation charts and data in slideshow format

Huger Rises in American Cities and Other Links for Your Econ Classroom

2011-12-15T08:03:00.000-08:00

The US Conference of Mayors has released a new report that shows increased hunger and homelessness in U.S. cities. Unemployment is the leading cause of both, but many hungry and some homeless are employed. (For more on the relationship between poverty and labor market conditions, type "poverty" in the search box on this blog)
It's hard to keep up with the fast-changing situation in Europe, so now and then I like to give a link to a piece that summarizes the situation well for those who can't read everything. Tim Duy's post in today's Economonitor fits that pattern. Duy explains why the euro has deep-rooted structural problems that are not addressed by the latest Franco-German plan. "I don't see where this ends well," concludes Duy. (BTW, Duy also spikes the rumor that the Fed is about to rescue European banks.)
While the crisis in Europe has attracted the most attention, China is having its problems, too. Here are two good posts to keep up to date on the China scene. In the first, Michael Pettis explains just how we know that China is overinvesting. In this next one, Patrick Chovanec provides the latest data on the collapse of China's housing bubble.

What do the Russian Protesters Want? One Observer’s View of Problems and Needed Reforms

2011-12-11T21:58:00.000-08:00

Commentators have compared the recent Russian protests to those of Tahrir Square and Occupy Wall Street. There are differences, of course, but certain similarities stand out. For one thing, these recent movements differ from, say, Ukraine’s Orange Revolution, in that none of them has a clear leader. Instead, they have coalesced around negatives: Egypt without Mubarek, Russian without Putin, America without Wall Street. They all see the existing political system as corrupt, but they are much less specific about what should replace it.

Although these movements may lack leaders, they do not lack thinkers and opinion makers whose writings provide useful insights into what the protesters want. This post looks at the views of one Russian opposition figure, the journalist and writer Yulia Latynina, as expressed in a recent essay titled “Russian Baker, or Ownerocracy.” READ MORE>>>

Can New Fiscal Rules Save the Euro? Three Details to Watch For

2011-12-06T11:11:00.000-08:00

Yesterday Angela Merkel and Nicolas Sarkozy announced a new set of fiscal rules, their latest idea to save the euro. The new rules would replace the unworkable Stability and Growth Pact (SGP), which mandates a deficit of no more than 3 percent of GDP and debt of no more than 60 percent of GDP. Yesterday’s announcement was short on specifics, but here are three crucial things to watch for that will determine whether the new rules will have any chance of working. READ MORE>>>

China is Overinvesting in Electric Cars and Other Links to Eliven Your Econ Course

2011-12-05T15:30:00.000-08:00

The US government has been roundly criticized for its investment in Solyndra's failed solar panel venture, yet many people think the Chinese government is oh-so-clever when it pours money into "economy of the future" investments of its own. Think again. Governments everywhere are prone to pouring money into the sand. This excellent long post by Michael Pettis explains how the Chinese government has overinvested in the electric car industry and in other sectors as well.
Defender's of Wall Street often defend princely salaries by arguing that a highly efficient U.S. financial sector is adding hugely to the strength of the economy. This nice piece of research by NYU's Thomas Phillippon blows that argument out of the water. It argues that financial sector costs are rising faster than its output, and that the resulting loss of productivity is a drag on the economy at large, not a boost. The comparison of productivity-enhancing IT investment in retail trade with productivity-sapping IT investment in the financial sector is especially interesting.
Last week the stock market got a boost when the Fed announced it would lower the interest rate charged to loan dollars to European banks. Every wonder why European banks need dollars? This report by Binyamin Appelbaum of the New York Times explains some of the reasons.

US Employment Data: Stronger November Report Shows Economy Struggling to Resist Global Weakness

2011-12-03T11:28:00.000-08:00

The latest employment report from the Bureau of Labor Statistics shows stronger, but still moderate, job growth for November. The unemployment rate fell to 8.6 percent, its lowest since March 2009. On the whole, the report shows a U.S. economy struggling to resist being dragged down by even weaker economies in Europe and Japan, and by a still strong but slowing China.

The economy added 120,000 payroll jobs in November. At the same time, figures for the previous four months were revised upward by a total of 114,000. Service jobs, led by retail trade, accounted for all the gains. Producers of goods lost 6,000 jobs and government lost another 20,000, continuing a steady decline. Local governments shed the most jobs last month,

The unemployment rate, which dropped to 8.6 percent in November, is the ratio of unemployed persons to the labor force. The labor force, in turn, includes both employed and unemployed persons. The number of unemployed decreased by 594,000 in November, of which 279,000 found jobs and 315,000 withdrew from the labor force.

The BLS also pubishes a broader measure of unemployment called U-6. The numerator of U-6 includes unemployed persons, marginally attached persons who would like to work but are not looking because they think there are no jobs, and part-time workers who would prefer full-time work but can’t find it. The denominator includes the labor force plus marginally attached workers. U-6 fell to to 15.6 percent in November. As with the official unemployment rate, that was the lowest level since March 2009.

The employment to population ratio ticked up to 58.5 percent, its fourth monthly increase after reaching an all-time low in July. The long-term downward trend in this ratio reflects several factors: Slow job growth, more discouraged workers, who do not look for jobs because they think none are available, more retired persons as the population ages.

Follow this link to view a classroom-ready slideshow presentation of the latest labor market data.

Afghanistan's Economic Future, Aid, and the Curse of Riches

2011-12-01T21:57:00.000-08:00

We hear a lot about the future of Afghanistan after NATO withdrawal in 2014. Most of the speculation focuses on security and politics. Too little of it concerns economics. A pair of new reports, one from the World Bank and the other from the IMF, help fill the gap. If you thought the security and political prognosis was problematic, wait until you read what lies ahead for the country’s economy. READ MORE>>>

Ed Hugh on the Euro and Other Links to Enliven Your Econ Course

2011-11-29T07:14:00.000-08:00

If you don't have time to read everything about the teetering euro, read Ed Hugh's excellent summary in "Last Days of Pompeii" from Economonitor. Hugh shows that many countries share the problems of the euro (excessive public and private debt, aging populations, competition from emerging economies), but the euro is getting hit first and worst.

All of us want to work behavioral economics into our courses these days. Here's a great behavioral econ reading list from Cheap Talk that will help.

If you want to get a good discussion going on consumerism and the environment, show your students this ad from Patagonia, "Don't Buy This Jacket," and the commentary by Mark Gunther.

Follow me on Twitter @dolanecon to get more links like these to enliven your econ courses.

US GDP Data: Downward Revision of Q3 GDP Strengthens Case for Stimulus

2011-11-25T08:16:00.000-08:00

The second estimate of U.S. GDP for the third quarter of 2011 shows a downward revision, making the real growth rate 2 percent rather than the 2.5 percent reported in last month’s preliminary estimate. The slowing growth rate makes the expansion look weaker than before and strengthens the case for new stimulus. >>>READ MORE

Follow this link to view or download the latest GDP charts ready for classroom presentation

Thoma on Taxing the Rich vs. Growth and Other Links to Enliven Your Econ Course

2011-11-23T14:31:00.000-08:00

Mark Thoma offers his opinion as to Why America Should Spread the Wealth: "If those at the top of the income distribution receive far more than the value of what they create, and those at lower income levels receive less, then one way to correct this, at least in part, is to increase taxes at the upper end of the income distribution and use the proceeds to protect important social programs that benefit working-class households, programs that are currently threatened by budget deficits." He acknowledges, however, that beyond a point, there may be a tradeoff between achieving greater equality through taxation, on the one hand, and stimulating growth, on the other. My thought: Greater emphasis should be placed on the difference between raising marginal tax rates on the rich (for example, by letting the Bush tax cuts expire) and undertaking true tax reform. The latter would eliminate loopholes and cut tax rates in a way that simultaneously raised average tax rates on upper-income households while cutting their marginal tax rates. Such a policy could promote both growth and equality, while achieving fiscal consolidation at the same time. (For more on growth-friendly fiscal consolidation, see this earlier post.)

In a recent post on Economonitor, Paolo Manasse and Giulio Trigilia provide evidence that markets are now perceiving a general euro risk rather than confining the perception of risks to just a few countries. They argue that Italy's weak fundamentals, which cannot be cured by a simple change of government, lie behind the emergence of generalized euro risk.

Scott Sumner, drawing on work by Timothy Taylor, calculates that the Transport Safety Administration is killing 100 people (equivalent to the crash of a medium-sized airliner) every month. That happens because longer waiting times at airport security since 9/11 divert a large amount of traffic to the highways, where fatalities per passenger mile are far higher than for commercial air travel.

Follow me on Twitter @dolanecon to get more links like these to enliven your econ courses.

On Technical Barriers to Leaving the Euro and Learning from Others’ Experience

2011-11-20T21:59:00.000-08:00

When discussion turns to the possibility that some country might leave the euro, much is often made of the technical difficulties of introducing a new currency, especially of the months, even years, of planning that went into launching the euro in the first place. Sample: “Computers will have to be reprogrammed. Vending machines will have to be modified. Payment machines will have to be serviced to prevent motorists from being trapped in subterranean parking garages. Notes and coins will have to be positioned around the country.” (Joshua Chaffin in the Financial Times, quoting a 2007 paper by Barry Eichengreen.)

Yes, there would be technical difficulties. Still, lots of countries have switched currencies in the past. Sometimes the process has been planned and orderly, sometimes messy and chaotic. One way or another, the job gets done. Anyone who thinks technical problems pose insurmountable barriers needs to look at the imaginative, pragmatic devices that other countries have used to ease the transition from one currency to another. Here are three lessons from other countries’ experiences that would be relevant to anyone now making plans to leave the euro. READ MORE>>>

US Inflation Data: Moderate October CPI Data Give Fed Room to Maneuver in Face of Euro Crisis

2011-11-16T11:59:00.000-08:00

US inflation pressures continued to ease in October, according to the latest data from the Bureau of Labor Statistics. With the struggling US economy facing headwinds from the euro crisis, low inflation gives the Fed a welcome extra bit of room to maneuver.

The headline CPI actually fell at a 1 percent rate during October. (All inflation rates given in this post are seasonally adjusted monthly changes stated as annual rates.) Energy prices were the main factor driving headline inflation downward. Negative inflation is unlikely to persist, however, given that world oil prices have already pushed back over $100 a barrel this week.

Core inflation remained moderate in October, rising just slightly to a 1.7 percent annual rate. Apparel prices and prices of medical goods and services helped pull the core rate up a bit from September’s 0.6 percent, which was the low for the year. READ MORE>>>

Follow this link to view or download a classroom-ready slideshow including the latest inflation charts and analysis.

Understanding the New View of Poverty (2): What Helps and What Hurts

2011-11-14T22:05:00.000-08:00

Last week, the Census Bureau published a new Supplemental Poverty Measure (SPM) that changes our understanding of poverty in America. The first installment of this post looked at the way it erodes our stereotypes of who is poor, especially by showing that there are more poor white, working-age, home-owning Americans than we thought. No matter what population group or political party you belong too, it is now harder to dismiss income insecurity as something that threatens only people who are not like you. This installment turns to the issue of which government policies help reduce poverty and which policies may be making the problem worse. READ MORE>>>

Understanding the New View of Poverty (1): The Erosion of Stereotypes

2011-11-08T21:46:00.000-08:00

We all thought we knew who is poor in America. Children, especially in one-parent households. Racial minorities. Families who aren't able to participate in the great American dream of home ownership. Really? The Census Bureau's new Supplementary Poverty Measure (SPM) erodes all of these stereotypes. They still contain some truth, but less than it seemed. No matter who you are, you cannot dismiss income insecurity as a problem that doesn't threaten people just like you.

The news does not come without warning. The official 2010 poverty figures, released in September, already showed a record high poverty rate for working-age Americans—some 13.7 percent, up from 12.9 percent in 2009, itself a record. Now the new SPM shows that official figures understate the problem. Why, and what does it mean? READ MORE >>>>

US Employment Data: October Job Growth Still Slow but Details Hold a Bit of Good News

2011-11-05T14:40:00.000-07:00

The Bureau of Labor Statistics reported only 80,000 new payroll jobs in October, still a very slow tempo. However, there was a bit of good news hidden in the revisions for earlier months. The August payroll job figure, originally reported as a shockingly bad zero gain, was revised upward to a more respectable 104,000. September's job growth, in turn, was revised upward from 103,000 to 158,000. Some observers believe that upward revisions are typical of a job market that is beginning to turn the corner toward growth. Optimists can hope this month's 80,000 will eventually be revised up, as well. >>>Read more

Follow this link to view or download a slideshow with the latest unemployment charts and graphs, ready for your classroom or business presentation

NGDP Targeting is the Natural Heir to Monetarism

2011-11-03T22:00:00.000-07:00

In a recent post, Daniel Alpert enlists Milton Friedman as an ally against the newly popular (but not new) idea of targeting nominal GDP. On the contrary, I see NGDP targeting as the natural heir to monetarist policy prescriptions of the 1960s and 70s.

If we look at the textbook version of monetarism, the point is almost trivial. Textbook monetarism begins from the equation of exchange, MV=PQ, where M is money (M1, back in the day), V is velocity, P is the price level, Q is real GDP, and PQ is NGDP. Next it adds the simplifying assumption that velocity is constant. It follows that targeting a steady rate of money growth is identical to targeting a steady rate of NGDP growth.

Of course, Friedman himself propounded a more sophisticated monetarism, one in which the linkage between monetary policy and NGDP was not so tight. He saw two sources of slippage as potential problems for a monetary growth target. READ MORE>>>

Can Spaceship Earth Carry Seven Billion Passengers, and More to Come?

2011-10-30T22:01:00.000-07:00

According to the United Nations, the world population will reach 7 billion people this week. No one really knows the exact date, but the announcement has sparked a round of commentary, most of it pessimistic. The doubling of the world’s population over the past 50 years is the most rapid in history. Demographers expect another 3 billion at least before global population finally peaks early in the next century and begins a gradual decline. Can we make it until then? Or will our overburdened spaceship earth suffer environmental collapse?

Population growth poses real challenges for environmental policy. The more people, the more important it is to get things right in the relationship between people and the planet. At least three issues require even closer attention as the population grows than they would with a constant population. READ MORE>>>

US GDP Data: Growth Stronger in Q3 as Economy Enters Expansion

2011-10-27T21:49:00.000-07:00

There was a bit of joy in yesterday’s advance estimate of U.S. Q3 GDP both for traditionalists who focus on the real value of output (RGDP) and for the growing number of economists who track the nominal value (NGDP).

Real output was reported to have grown by 2.5 percent in the quarter, a bit stronger than analysts’ expectations. That was up significantly from 1.3 percent in Q2. RGDP passed a key psychological threshold as it edged above its previous peak, which it had reached all the way back in Q4 2007. After almost two years of recession and two years of slow recovery, the economy has finally entered its expansion phase. READ MORE>>>

Only Economists Can Save the Planet

2011-10-25T07:10:00.001-07:00

Gernot Wagner’s But Will the Planet Notice? is the book I would like to get my neighbors to read. The ones who use canvas shopping bags, take short showers, recycle, and think that is enough. The ones who think “environmental economics” is an oxymoron. The ones who think concepts like markets, incentives, and property are the roots of our planetary problems, not the keys to solving it.

Wagner can speak to these people as a member of the same club. He is careful to point out that he, too, pays his dues—no plastic bags, no meat, no car, and a day job with the Environmental Defense Fund. But he also has a Ph.D. in environmental economics. That means that even though he may live like your average green progressive, he thinks differently. He thinks recycling is nice, but not enough, and that only economists can save the planet. READ MORE>>>

US Inflation Data: Scant Fuel for Inflation Fears in September CPI Report

2011-10-22T09:14:00.000-07:00

Although some observers still think the Fed's easy monetary policy risks a rise in the US inflation rate, there was scant fuel for their fears in the September inflation report from the Bureau of Labor Statistics. The all-items CPI for urban consumers rose at a seasonally adjusted annual rate of 3.7% in September, down almost a point from the August rate of 4.6%.

Food and energy prices are highly volatile and account for much of the month to month variation in the CPI. Their effect can be removed by taking food and energy out of the CPI. The result is called the core inflation rate, which fell to just 0.6% in September (monthly change stated as annual rate), the slowest for the year. Because food and energy prices contributed more than their share to inflation, as they have for most of the year, the core inflation rate was below the all-items rate.

Another way to remove volatility from the CPI is the 16% trimmed mean CPI, published by the Federal Reserve Bank of Cleveland. The trimmed mean CPI removes the 8% of prices that increase most and the 8% that increase least in each month, whether they are food, energy, or something else. In September, trimmed mean inflation slowed significantly, although it remained above the core inflation rate.

No one measure of inflation is best. The all-items CPI gives the most accurate picture of current changes in the cost of living for urban consumers. The core CPI and trimmed mean CPI give more accurate pictures of underlying trends. Economists at the Fed look closely at the core and trimmed mean CPIs to judge the effect of monetary policy. They pay less attention to the all-items CPI, which includes food and energy prices that are set on world markets, beyond direct control of monetary policy.

The Fed, unlike many central banks, does not set an explicit target for the rate of inflation. However, it has made it clear that it considers an inflation rate of around 2 percent, over a medium-term time horizon, to be consistent with its mandate to maintain price stability. Although inflation has increased from its extremely low levels of 2010, the September inflation data, on the whole, fall within a range that the Fed should not find alarming.

Follow this link to view or download a short slideshow with charts of the September data.

The Senate’s Currency Manipulation Bill is Not Only Bad Policy, but Unnecessary

2011-10-12T22:43:00.001-07:00

China's currency manipulation is bad policy. So is the Senate's latest crackdown on it. The bill passed yesterday is not only bad policy, but unnecessary. Here's why.

First of all, before we get hysterical about Chinese policy, we should recognize that currency manipulation is the global norm, not the exception. By a recent count, only 14 percent of the IMF's member nations allow their exchange rates to float freely. Some 58 percent manipulate their exchange rates by holding them above or below the level to which the market would move them. READ MORE>>>

US Labor Market Data: Job Growth Moderate, Unemployment Steady in September

2011-10-08T01:59:00.000-07:00

The latest data from the Bureau of Labor Statistics show that the U.S. economy added 103,000 payroll jobs in September. That was the best number in five months, but is still well below the rates of job growth earlier in the recovery.

The service sector provided nearly all of the new jobs, with health care and temporary work leading the way. Goods producing sectors added just 18,000 jobs and manufacturing jobs actually fell in the month. Government jobs decreased by 34,000, continuing a steady decline.

A separate household survey that includes farm jobs and the self-employed showed that the labor force, which includes both employed and unemployed persons, grew by 423,000. Of these, 398,000 found jobs and 25,000 joined the ranks of the unemployed as soon as they started to look for work. The unemployment rate, which is the ratio of unemployed persons to the labor force, remained unchanged at 9.1 percent for the third month in a row.

The BLS also calculates a broader measure of unemployment called U-6. The numerator of U-6 includes the officially unemployed, plus persons marginally attached to the labor force who would like to work but are not looking because they think there is no work, plus part-time workers who would prefer full-time work, but can't find it. The denominator includes the labor force plus the marginally attached. U-6 increased from 16.2 to 16.5 percent in September, its fifth increase in the past six months.

Another important labor market indicator, the employment-population ratio, increased slightly in September, but remained just above its all-time low reached in July. The long decline in the employment-population ratio primarily reflects an aging population, but cyclical factors, like more discouraged workers, have also kept this indicator at a low level.

Follow this link to view or download a short classroom-ready slideshow with graphical presentations of the main employment indicators.

What the Wall Street Protesters Want: An Economic Commentary on the "Contract for the American Dream."

2011-10-06T23:39:00.000-07:00

Nearly every news story I read about the occupation of Wall Street begins by saying that the protesters are vague about what they want. Even Paul Krugman, who is supportive of the demonstrations, complains in today's New York TImes about a lack of specific policy demands. Maybe that is a valid critique of individual protestors, but if you look instead at what some of their sponsoring organizations say the protest is about, you get a different picture—one that is not only more specific but often makes surprisingly good economic sense. READ MORE>>>

How Gordon Brown Saved Britain from the Euro and Why that Makes him a Hero

2011-10-02T23:10:00.000-07:00

In his new book, Alistair Darling describes Gordon Brown's political style as "appalling," "volcanic," and "brutal." He should know. The two men sat together in the cabinet for years while Brown was chancellor. Darling then served as chancellor himself when Brown finally became prime minister. Now that Brown is out of office, it seems he has few political friends left. Still, his successors should erect a statue to him, for one accomplishment if nothing else: He saved Britain from the euro. Here's why that makes him a hero.

The story starts back in 1997, when Tony Blair was new to the job of prime minister. The euro was still three years away from realization, but already Blair was an enthusiast. Brown was skeptical, but he had a problem. Political solidarity required him to support the euro in principle, but his stronger sense of economic reality made him realize that it was a bad idea for the UK. His solution was to endorse the euro subject to the following five tests, which together were vague enough and tough enough that they could never be fully met: >>>READ MORE

US GDP Data: Growth for Q2 2011 Revised Upward, But Still Weak

2011-09-29T07:16:00.000-07:00

U.S. GDP growth for the second quarter of 2011 was revised upward to a 1.3 percent annual rate from the 1.0 percent second estimate reported last month. The upward revision, which returned GDP growth to the same rate as the advance estimate released in July, was a relief to some observers, even though it was still very weak . About 2.5 percent growth is generally considered necessary to keep unemployment from rising, when growth of the labor force is taken into account.

Although a recovery has been underway for two years, the level of U.S. real GDP has not yet reached its peak level of mid-2007, before the recession. When GDP finally reaches its previous peak, the economy will have been considered to make the transition from the recovery phase of the business cycle to the expansion phase.

Investment remained a relative bright spot in the GDP data, accounting for .79 percentage points of the 1.3 percent growth in the quarter. Business fixed investment was relatively strong while housing investment remained weak. Consumption grew by about 0.49 percentage points, with personal expenditures on healthcare services leading the way. The government sector contracted. Federal defense expenditures rose, but they were more than offset by decreases in federal nondefense spending and in state and local government purchases. Net exports performed better than previously estimated. Exports were revised upward and imports downward compared with the August report.

Follow this link to view or download a set of classroom-ready slides with graphical presentations of the latest GDP estimates.

Natural Gas Flaring, Carbon Taxes, and the Risk of Alien Invasion

2011-09-29T00:02:00.000-07:00

To an alien orbiting Earth in a flying saucer, natural gas flares would be one of the most visible signs of human life on earth. Notice I said "human life," not "intelligent life."

Flaring is the practice of burning off the natural gas that is produced in association with oil rather than piping it to market, using it at the wellhead, or reinjecting into the ground. Flaring was once common, but in more recent times, it has largely been limited to places like Russia and Nigeria. Now, though, it is becoming a big source of controversy in the United States. According to a recent New York Times article, some 30 percent of natural gas produced from rapidly expanding North Dakota oil fields will be flared this year—more than enough to heat every home in North Dakota through the state's harsh winters. Elsewhere in this country, less than one percent of gas is flared. READ MORE>>>

For more environmental topics, check out my new book, TANSTAAFL: A Libertarian Perspective on Environmental Economics.

The UBS-Adoboli Scandal Shows the Problem of Negatively-Skewed Risk is Still With Us

2011-09-20T20:02:00.000-07:00

In my banking courses, I point to negatively skewed trading strategies as a key cause of the crash of 2008. The recent loss of more than $2 billion attributed to rogue trades by Kweku Adoboli at Swiss banking giant UBS shows that the problem of negatively skewed risk is still with us. It is an old story, but with a new twist.

The problem of negatively skewed risk arises from the way incentives change when you gamble with someone else's money. >>>Read more

US Inflation Data: Headline CPI Inflation Slows, Core Inflation Up a Bit in August

2011-09-16T15:21:00.000-07:00

The Consumer Price Index for all items purchased by U.S. urban consumers rose at a seasonally adjusted annual rate of 4.6 percent in August, somewhat slower than the July rate of 6.2%. Gasoline and food prices added significantly to inflation in August, as in the previous month.

Food and energy prices are highly volatile and account for much of the month-to month variation in the CPI. Their effect can be removed by taking the food and energy components out of the CPI. The result, called the core inflation rate, was 2.97 in August, slightly faster than in July.

Another way to remove volatility from the CPI series is the 16 percent trimmed mean CPI published by the Cleveland Fed. That index removes the 8 percent of prices that increase most and the 8 percent that increase least each month, whether they are energy, food, or something else. In July trimmed-mean inflation rose slightly. At 3.6 percent, it remained slightly above core inflation, as it has for most of the year.

There is no "right" and "wrong" way to measure inflation. Each index answers a somewhat different question. Economists often look at the core or trimmed mean measures to judge the effects of monetary policy. The all-items CPI includes food and energy prices that are set in global markets, beyond direct control of domestic policy.

Although inflation is beginning to rise, it is not yet a great cause for concern. The Fed does not set an explicit target rate for inflation, but it tends to view 2 percent inflation as consistent with prudent monetary policy in the long run. After slowing to a crawl during the recession, headline inflation is now running about 3 percent on a year-on-year basis, while core measures have not yet reached the 2 percent threshold.

Follow this link to view or download a set of classroom-ready slides with graphical presentation of inflation data.

US Working-Age Poverty Hits a Record High: What it Means for the Budget Debate

2011-09-13T20:18:00.000-07:00

Adding to the gloom from recent labor market data, the Census Bureau reported today that the poverty rate among working-age Americans hit a record high in 2010. Last year some 13.7 percent of the U.S. population aged 18-64 years fell below the poverty threshold of $22,314 for a family of four. That was up from 12.9 percent in 2009, also a record. The Bureau has reported working-age poverty figures since 1966, at which time the rate was 10.5 percent. Read the full post>>>

The Truth About Taxes: What are Our Choices?

2011-09-12T17:29:00.000-07:00

This post is an abbreviated version of a recent presentation to the League of Women Voters of San Juan County, Washington. You will find a link to the slideshow version at the end of the post.
The question we most often hear about taxes is, are they too high, or too low? The answer to both questions is YES. How can that be?

Taxes are too high in the sense that they distort the decisions made by households and businesses. At the same time, they are too low in the sense that they do not bring in enough revenue to pay for government as we know it. We cannot continue to operate the government that way.
Economists measure the sustainability of the federal budget in terms of the cyclically adjusted primary balance (CAPB). That is the deficit or surplus averaged over the business cycle, without including interest payments. To be sustainable, the CAPB should be near zero, or slightly in surplus.

As of 2011 the United States has a CAPB of -6.8 percent, the largest deficit of any developed country. That means we need to cut nearly 7% from the deficit, through spending cuts or tax increases, to achieve sustainability. Failing to do so will cause the government debt to grow out of control. We will inevitably end up like Greece, or worse. Not tomorrow maybe, but not in the far distant future, either.

Where to start? The first choice we have to make is, how big a government do we want? Opinions differ. Some people are happy with the size of federal government we have now. At 23 percent of GDP (cyclically adjusted), it is about the same size relative to the economy as in the 1980s, although it is larger than it was in that lucky period between the end of the cold war and the start of the wars in Iraq and Afghanistan. Others would like to cap total federal spending at 18% of GDP, about where it was in the last year of the Eisenhower administration. Economists can't answer the question of how big the government should be; only voters can.

Once we decide how big a government we want, we need a tax system that can pay for it. Our current tax system cannot do the job. Its tax rates are too high. They distort the decisons of consumers, savers, employers, producers, everyone.

What we need is tax reform that lowers tax rates and broadens the tax base.

One approach to tax reform is to lower marginal tax rates for everyone while eliminating loopholes. There are lots and lots of loopholes.

Another approach to tax reform is to replace existing taxes like payroll taxes and the corporate income tax that distort incentives, while replacing the lost revenue with broad-based taxes like energy taxes or value added taxes.

The bottom line: Tax reform is a must. It is good for liberals, it is good for conservatives. It should not be hard to find a compromise. Remember, continuing business as usual is NOT a viable option.

Follow this link to view or download the slideshow version of this presentation.

Why Rolling Back Environmental Protection is the Wrong Fix for Jobs

2011-09-11T21:17:00.000-07:00

Originally published on Economonitor.com.

Just when it seemed nothing could do it, persistently high U.S. unemployment has produced bipartisan agreement in Washington—agreement to roll back environmental protection in an attempt to save jobs and create new ones.

The White House, shrugging off off environmentalist opposition, has quashed a major EPA initiative that would have strengthened ozone regulations and is reportedly leaning toward endorsement of the Keystone XL pipeline to carry petroleum from Canadian oil sands. Republicans have applauded and issued their own list of proposals, including rollbacks of regulations for coal ash, farm dust, greenhouse gasses, and cement plants, among others.

None of this is good news, either for the environment or the economy. Rolling back environmental regulations is the wrong way to fix the jobs problem. Here's why.

Jobs are created when businesses hire workers, combine their labor with capital and natural resources, and use them to produce goods or services. If the products that come out are worth more than the inputs that are used up, the process adds value to the economy. Businesses make profits, workers get jobs, and consumers get goods or services that enhance their standard of living.
Right now, though, not enough jobs are being created that way to bring the unemployment rate down. High unemployment is creating a lot of pressure on the government to force-feed the job creation process. But how to do it?

One approach would a program of federally financed infrastructure investment. As discussed in an earlier post, there is reason to think there are plenty of projects, from repairing dams and sewers to modernizing the electric grid, that would both create jobs and add value to the economy. The Obama administration's new jobs initiative includes some of them. Many independent economists endorse immediate infrastructure spending, paired with a credible commitment to medium-term deficit reduction, as components of a sensible fiscal strategy.

Unfortunately, the costs of infrastructure projects are highly visible. They must either be covered by borrowing or by raising new revenue, but right now too many politicians have sworn to do neither. That is why the search is on for programs that would create jobs—or at least appear to do so—while hiding the costs.

Rollbacks of environmental regulations are a perfect vehicle for that purpose. The jobs they save or create are highly visible. Without regulatory relief, jobs would be lost at cement plants that might have to close, utilities that would sell less power if they couldn't keep costs artificially low, and farms that could export less if they had to worry about environmental compliance. The costs of rollbacks are less visible. They take the form of damages to health, property, or other environmental values that are collectively large but widely spread in space and time. Furthermore, if rollbacks, although saving some jobs, cause others to be lost—for example, jobs that would have been created to produce pollution control equipment or energy from alternative sources—those would-have-been jobs, too, are less visible. Taken together, it easy to exaggerate the net job creation from any given reversal of environmental protection.

The trouble is, when producers are allowed to capture the benefits of increased output of cement, energy, crops, or whatever while shifting the costs to others, they produce too much. They expand production up to the point where the value of additional output is just equal to the visible cost of production (the internal costs, to use the economic term), but not enough to cover the invisible (external) costs. That means that even if they create net jobs, rolling back environmental regulations subtracts value from the economy, rather than adding it. Not a good idea.

In fact, if creating jobs by subtracting value and shifting costs were a good idea, we would have no jobs problem. Job creation would be easy, at zero cost the federal budget. Here are three suggestions:

For unemployed urban youths, a Licensed Shoplifter Corps. LSC members would have immunity from prosecution for theft. They could appropriate cell phones, Levis, and canned goods from local stores and sell them at discounted prices in special neighborhood shops. Jobs would be created both for LSC members and for workers who resold the stolen goods.
For unemployed rural youths, a Biofuel Expansion Initiative. BFI participants would be given permits to cut trees (without paying for them) on anyone's property, or any public land, and chop them up for firewood. Jobs would be created not just in harvesting the trees, but in hauling them, making chainsaws and wood splitters, and other steps in the supply chain.
For properly qualified unemployed professionals, a designation of Certified Public Embezzler. CPE members would receive immunity to hack into people's bank and credit card accounts and divert funds to their own purposes. As self-employed professionals, CPE members would disappear from the unemployment statistics, and, in addition, would create jobs in subsidiary markets for computer services and hardware.

Absurd? Why is licensing people to shoplift, poach firewood, or embezzle money any more absurd than licensing them to poison the air, pollute waterways, or add to the pace of climate change? If jobs are the goal, it is never hard to create jobs at someone else's expense. The trouble is, when the hidden costs are added to the visible ones, such jobs end up costing more in the long run than real, value-adding jobs do. There Ain't No Such Thing As A Free Lunch.*

Originally published on Economonitor.com.
*Follow this link to get a copy of my new book TANSTAAFL: A Libertarian Perspective on Environmental Policy

Data for the Classroom: No New Payroll Jobs in August

2011-09-05T14:27:00.000-07:00

Private payroll job growth for August was zero, the worst showing since since September 2010. Adding to the gloom, the job growth numbers for May and June were revised downward by a total of 52,000 jobs. Private nonfarm jobs increased by a slim 17,000 but that gain was offset by a loss of 17,000 government jobs.

The labor force, which includes both employed and unemployed persons, grew by 366,000. Of these 331,000 found jobs and 35,000 were added to the officially unemployed as soon as they started looking for work. The unemployment rate, which is the ratio of unemployed persons to the labor force, remained unchanged at 9.1 percent.
The unemployment rate is based on a survey of households. It uses a different methodology than the payroll job report, which is based on a survey of employers. Among other things, the household survey includes farm workers and self-employed persons. It is not unusual for the two surveys to point in different directions in any given month, as was the case in August.

The government also calculates a broader measure of unemployment called U-6. The numerator of U-6 includes unemployed persons, marginally attached persons who would like to work but are not looking because they think there are no jobs, and part-time workers who would prefer full-time work but can’t find it. The denominator includes the labor force plus the marginally attached. A shorter average work week led to an increase in involuntary part-time workers and caused U-6 to rise in August.

The employment to population ratio ticked up to 58.2 percent, just above the all-time low reached in July. The long decline in the ratio reflects several factors, including slow job growth; more discouraged workers, who do not look for jobs because they think none are available; and more retired persons as the population ages. For a full discussion of the trend in the employment to population ration, see this earlier post.

Follow this link to view or download a set of classroom-ready slides with graphical presentation of the latest unemployment data.

How Germany Free-Rides on the Euro

2011-08-29T07:22:00.000-07:00

For years, I have warned my European students of the fiscal free-rider problem built into the structure of the euro area. My examples have always been fiscally undisciplined peripheral governments seeking political gain by running budget deficits at the expense of their euro partners. Now, though, as the debate unfolds over measures to cope with the European sovereign debt crisis, it is becoming increasingly apparent that Germany, the long-time locomotive of the euro, is also, in its own way, free-riding on the common currency.

The free-rider problem arises whenever someone is able to capture the full benefits of an action while shifting all or part of the the costs to others. I introduce the concept to my students with the example of ten friends eating dinner in a restaurant. If they know they will get separate checks at the end of the meal, they all order hamburgers and beer. If they know there will be one check, to be split equally among everyone at the table, they order steak and champagne.

In the case of deficit-prone peripheral members of the euro, individual governments capture the full economic and political benefits of fiscal stimulus while shifting part of the costs to other euro members. This happens in two ways. Read more>>>

Already Weak, US GDP Growth in Q2 2011 is Revised Downward

2011-08-27T17:18:00.000-07:00

U.S. GDP growth for the second quarter of 2011 was revised downward to a 1 percent annual rate from the 1.3 percent advance estimate reported last month. The downward revision disappointed many observers. About 2.5 percent growth is generally considered necessary to keep unemployment from rising, when growth of the labor force is taken into account.

Although a recovery has been underway for two years, the level of U.S. real GDP has not yet reached its peak level of mid-2007, before the recession. When GDP finally reaches its previous peak, the economy will have been considered to make the transition from the recovery phase of the business cycle to the expansion phase.

About three-quarters of the growth of GDP was attributable to investment, mostly business fixed investment. Housing investment remained weak. Consumption grew by about 0.3 percentage points. The government sector contracted, with slight growth of federal government activity more than offset by falling state and local government purchases. Net exports barely edged up, with moderately strong export growth almost fully offset by growth of imports.

Follow this link to view or download a set of classroom-ready slides with graphical presentations of the latest GDP estimates.

Why Rick Perry's Position on Climate Change Makes Him a True Conservative

2011-08-18T18:54:00.000-07:00

Rick Perry is a climate-change skeptic. Sure, he says, the world is getting warmer, but the climate has often changed. He doesn't buy in to the idea that human activity has an effect on the current warming trend. Friedrich Hayek would say that makes him a true conservative.
Hayek liked to view the political spectrum not as a left-to-right line with socialist and conservative poles, but as a triangle. Conservatives were at one corner, socialists at another, and liberals at the third. The terminology has changed a little since Hayek's time. Conservatives are still conservatives, but, at least in the United States, those on the left now prefer to identify themselves as progressives rather than socialists. Most of those who, in Hayek's time and before, called themselves liberals, today prefer to identify themselves as libertarians, or sometimes, classical liberals.
In a famous essay "Why I Am Not Conservative," Hayek identified a number of characteristic tenets of conservatism, including:

Habitual resistance to change, hence the term “conservative."
A claim to self-arrogated superior wisdom in place of rational argument.
A propensity to reject scientific knowledge because of the consequences that seem to follow from it.
Use of state authority to protect established privileges against the forces of economic and social change.

All of these tenets feed into Perry's views on climate change. He resists any change to an American path of economic development based on cheap, carbon-intensive energy; a path economists sometimes call extensive as opposed to intensive growth. He proudly claims superiority of faith-based wisdom over rational argument. And, especially in the case of climate change, he is quick to reject scientific knowledge. Read more >>>

US Employment-Population Ratio Hits a New Low: Why It Matters for the Budget Debate

2011-08-08T06:45:00.000-07:00

By and large, U.S. media have spun the July employment report as more positive than negative. The 117,000 new payroll jobs created last month and the upward revisions for May and June were a relief after two months of very bad data. The downtick in the unemployment rate, although slight, was also welcome. One indicator that rarely makes the headlines told a different story, however. The employment-population ratio fell to a new low of 58.1 percent. What does it mean? Why should we care?

We should care, because the sinking employment-population ratio has big implications for the budget debate. The cuts-only faction of budget balancers are demanding a cap on federal government spending at 18% of GDP. They tout that as a level we lived with happily in the past, and should therefore be happy to live with in the future. The trouble is, the future isn't going to be like the past. The smaller the fraction of the population that is working, the harder it becomes to put the country's fiscal affairs in order. That becomes even clearer if we take a closer look at the reasons the ratio is falling. Read More >>>

Data for the Classroom: US Labor Market Shows Slight Improvement in July

2011-08-05T16:56:00.000-07:00

The U.S. labor market showed a slight improvement in July, if only in comparison to the very dismal June numbers.

The closely-watched figure for non-farm payroll employment showed a gain of 117,000 jobs. Private sector jobs increased across a broad range of sectors, but those gains were offset by continued declines in the state and local governments, which lost 37,000 jobs in the month. There was some good news in the form of an upward revision of very weak preliminary numbers reported earlier for May and June. May job gains were revised upward from 25,000 to 53,000 and June from 18,000 to 46,000.

A separate household survey that includes farm jobs and self-employed showed a loss of 38,000 jobs for the month, along with a decrease in unemployment (by 156,000), and in the size of the labor force (by 196,000). Because the unemployment rate is calculated as the ratio of unemployed persons to the labor force, the paradoxical result was that the unemployment rate fell (from 9.2 to 9.1) despite the decrease in employment. Because the decrease in the unemployment rate was largely the result of the exit of discouraged workers from the labor force, it is really more of a negative than a positive development.

The Labor Department also publishes a broader measure of unemployment, called U-6, which is based on the sum of officially unemployed persons, plus marginally attached persons who would like to work but are not looking for work because they think there are no jobs, plus persons who are working part time but would prefer full-time work. That measure also fell in July, from 16.2 percent to 1.1 percent.

An even broader labor market indicator is the employment to population ratio. It fell to 58.1 percent in July, and all-time low.

Follow this link to view or download a set of classroom-ready slides with charts showing the evolution of the labor market situation.

Data for the Classroom: Weak Q2 GDP Growth, Downward Revisions

2011-08-02T07:18:00.000-07:00

It is hard to find a good way to spin the latest US GDP data. The economy grew at an estimated 1.3% annual rate in Q2 2011. Although the January-March 2011 quarter was the 8th consecutive quarter of growth since the end of the recession that lasted from Dec 2007 to Jun 2009, the growth rate of 1.3% disappointed many observers. About 2.5% is needed to keep unemployment from rising, when increases in the labor force and productivity are taken into account.
Q1 growth was revised sharply downward to just 0.4 % from 1.8%. Revised 2008 and 2009 data show that the recession was much deeper than previously thought. After the latest revisions, it now appears US real GDP has not yet reached its pre-recession peak (Q3 2007).

Looking at the report line by line, consumption barely grew in Q2 2011. Investment grew at 0.87%, with strong business fixed investment helping to make up for weak residential investment. Federal government spending grew slightly but was more than offset by continued decline of state and local government spending. Net exports grew strongly on good export growth and slowing growth of imports.

Follow this link to view or download a classroom-ready slideshow with charts of the latest US GDP data.

How Smart Fiscal Rules Keep Sweden's Budget in Balance

2011-07-31T22:11:00.000-07:00

Almost three decades ago, Herbert Stein, the former Chairman of Nixon's Council of Economic Advisors, lamented that the United States had no long-run budget policy—no policy for the size of deficits and for the rate of growth of the public debt over a period of years. He pointed out that Congress makes annual budget decisions that are wholly inconsistent with professed long-term goals, hoping that something will happen before a point of crisis is reached. He might have added that when the crisis does arrive, it is resolved by a combination of hasty, one-off measures; the making of promises that are rarely kept; and the appointment of special commissions whose advice is rarely heeded.

What Stein said then remains true today. The rational way out of this destructive cycle of irresponsibility and crisis is to establish long-term fiscal policy rules and stick to them. There is at least a vague recognition among some members of Congress of the need to do so. The problem is that the rules they actually propose are primitive and counterproductive. The debt ceiling itself, which Congress routinely sets at levels that are inconsistent with its own spending and taxing decisions, is one such rule. The balanced budget amendment championed by many fiscal conservatives is also deeply flawed, for reasons detailed in this earlier post.

Instead of these "dumb" fiscal policy rules, we need to be looking at what can be learned from countries that have faced the same problems and introduced smarter rules to overcome them. Last week's post examined how intelligent budget rules have helped Chile prosper. Today we look at the smart fiscal rules that have put Sweden's budget on a sustainable path and made that country's economy one of the strongest in Europe. READ MORE>>>

How Intelligent Budget Rules Help Chile Prosper: Lessons for the US

2011-07-25T06:46:00.000-07:00

As everyone knows who has followed the current budget debate, U.S. fiscal policy needs more than a quick fix. It needs budget rules to put the debt and deficit on trajectories that are sustainable in the long run. Where better to look for workable rules than to countries that have done things right? Chile, which has managed to prosper under an intelligent set of budget rules, is a good place to start. READ MORE>>>

Is a 56.2 MPG Fuel Economy Standard Really a Good Idea?

2011-07-15T08:12:00.000-07:00

According to news reports, the Obama administration is talking to automakers about raising the Corporate Average Fuel Economy standard for passenger cars to 56.2 miles per gallon by 2025, more than double the 27.5 MPG in force for the 20 years up to 2010. Economists, even those like myself who favor policies to reduce fuel use, have argued that CAFE standards are a bad idea. Has anything changed to make stricter fuel economy standards look better now than in the past? Read the full post >>>

Yes, the US Needs Budget Rules, but Not Hatch-Lee

2011-07-10T22:09:00.000-07:00

Sometimes the United States is slow to join a global trend. Fiscal policy rules are a case in point. Economists love the idea of rules that decouple tax and spending policies from short-term politics and focus instead on long-term growth and sustainability. Such rules used to be rare; as recently as 1990, they were in effect in only 7 countries, according to an IMF survey. By 2009, the number had grown to 90. Aside from failed attempts like the Gramm-Rudman-Hollings Act of 1985, the United States has been missing from the list.

It won't be missing for long if Utah Senators Orin Hatch and Mike Lee have their way. They are pushing a set of budget rules in their Hatch-Lee Balanced Budget Amendment, which was introduced on March 31 with the backing of the entire Senate Republican delegation. Just this week, Senator Lee gave it added momentum by including it in his Cap, Cut and Balance Act. That new proposal would require the Hatch-Lee amendment to be passed, along with a set of short-term cuts and caps, before the debt ceiling could be raised.

Linking long-term rules to a short-term increase in the budget ceiling is an excellent idea. The IMF cites several examples, from Sweden to Bulgaria to New Zealand, where a fiscal crisis provided the impetus for the adoption of successful budget rules. But is Hatch-Lee the right kind of rule? Unfortunately it is not.

Follow this link to read the full post on Ed Dolan's Econ Blog at Economonitor.com

Data for the Classroom: US Unemployment Rises in June

2011-07-10T16:58:00.000-07:00

U.S. job growth slowed again in June. Although total payroll jobs increased for the ninth straight month, the Bureau of Labor Statistics reported a disappointing total increase of just 18,000. At the same time, the May figure was revised down from 54,000 new jobs to just 25,000. An increase of 57,000 private nonfarm jobs was offset by a loss of 39,000 government jobs. Jobs decreased at all levels of government, federal, state and local.

The unemployment rate, based on a separate survey of households, edged up by 0.4 percent to 9.2 percent, its highest level since December 2010. The unemployment rate is the ratio of unemployed persons (those looking for work but unable to find it) to the labor force. Unemployed persons increased by 173,000 in the month, and at the same time, 272,000 discouraged workers stopped looking for work and left the labor force. All in all, the household survey showed a net loss of just under 445,000 jobs.

The government also calculates a broader measure of unemployment called U-6. The numerator of U-6 includes unemployed persons, discouraged workers who would like to work but are not looking for jobs because they do not think there are any to be found, and persons working part time who would prefer full-time work, but can't find it. U-6 rose to 16.4 percent in June, its highest rate in half a year.

One final measure of the job situation is the employment-population ratio. The numerator consists of people who are officially employed, while the denominator includes the entire population. The employment to population ratio has decreased not just because of the poor job situation, but also because of the increased number of retired persons in an aging population. The ratio fell to 52.8 percent in June, equaling its lowest level of the recession.

Follow this link to view or download a brief, classroom-ready slideshow with graphs of the June employment situation.

If QE2 Was Price-Level Targeting, It is Starting to Work

2011-06-17T08:02:00.000-07:00

Has QE2 worked? Some say yes, some say no. The answer depends on what you wanted it to do.
If you wanted a quick revival of the housing market, a boost to GDP growth, and rapid job creation, it's easy to say QE2 has failed. None of those indicators look good. On the other hand, if you thought the purpose of QE2 was to save the country from deflation, then it looks better, especially if you are a fan of price level targeting.

Follow this link to read the full post on Ed Dolan's Econ Blog at Economonitor.com

One Year Later, How Much Has China's Yuan Appreciated?

2011-06-13T12:06:00.000-07:00

A year ago this week China announced a major change in its exchange rate policy. After holding the yuan-dollar exchange rate fixed for almost two years during the global crisis, the country's central bank, the People's Bank of China (PBoC) announced that the yuan would once again be allowed to float, albeit in a highly controlled way. The yuan began appreciating against the dollar immediately, touching off intense speculation about how far it would be allowed to move. A year later, what has happened?

Follow this link to read the full post on Ed Dolan's Econ Blog at Economonitor.com

Data for the Classroom: US Unemployment for May 2011

2011-06-03T15:00:00.000-07:00

Latest data from the Bureau of Labor Statistics shows a very weak job US job market in May, 2011.

Payroll employment increased for the 8th straight month of job growth in May, but the pace of job growth slowed to a weak 54,000, the slowest September 2010. An increase of 83,000 in private nonfarm jobs was offset by a decrease of 23,000 in state and local government jobs. A separate survey of households, which includes farm jobs and self-employment, showed an increase of 105,000 jobs.

The unemployment rate edged upward to 9.1 percent, its highest level since December 2010. The number of unemployed persons increased by 167,000. The labor force, which includes both employed and unemployed persons, increased by 272,000.

The unemployment rate would have been even higher if not for the fact that many people have dropped out of the labor force because of the weak job market. The employment to population ratio dropped slightly in May to a level close to its lowest point during the current downturn.

Follow this link to view or download a set of classroom-ready slides with highlights from the May 2011 employment situation report.

Data for the Classroom: US GDP First Quarter 2011

2011-05-27T07:30:00.000-07:00

US GDP grew at an estimated 1.8% annual rate in Q1 2011, according to the latest data from the Bureau of Economic Analysis. The January-March 2011 quarter was the 7th consecutive quarter of growth since the end of the recession that lasted from Dec 2007 to Jun 2009. The growth rate of 1.8 percent disappointed many observers. Growth is expected to recover somewhat later in the year, but the recovery remains weak.

Consumption was the fastest growing GDP component, but slower than in Q4 2010. Investment grew at 1.45%, with strong business equipment purchases offsetting weak residential investment. Federal, state, and local government spending all declined, led by a drop in defense spending. Net exports were almost unchanged, as strong export growth was slightly more than offset by rising imports.

Follow this link to view or download a classroom-ready slideshow presenting highlights of the Q1 2011 GDP data.

Failure of Austerity in Europe? What Does the Latvian Exception Prove?

2011-05-26T12:13:00.000-07:00

Writing in The New York Times this week, Paul Krugman argues that austerity has failed in Europe. Budget cuts and tax increases were supposed to provide the confidence needed to get troubled EU economies back on track, but the "confidence fairy" hasn't shown up. Austerity has not just failed to work, says Krugman—it has made matters worse. He shares the view, held almost universally outside official circles, that doubling down on austerity will not save Greece, Ireland and Portugal from eventual default in one form or another.

Meanwhile, there is the case of Latvia, where a stringent austerity program, supported by the EU and the IMF, predates those of Greece, Ireland, and Portugal. Austerity brought on a stunning 18 percent drop in Latvian GDP in 2009, but now the country is returning to growth. Unemployment and the budget deficit are still high, but falling. Is Latvia the exception that proves that austerity is a good idea after all?

→Read the full post on Ed Dolan's Econ Blog at Economonitor.com

Will Shifting Political Winds Finally Kill Ethanol Subsidies?

2011-05-18T07:31:00.000-07:00

As recently as last December, the coalition backing U.S. ethanol subsidies appeared to be alive and well, despite the fact that everyone knew they were bad for the environment, bad for energy efficiency, and bad for the budget. The largest subsidy, a tax credit for blending ethanol into gasoline, was set to expire at the end of 2010. At the last minute, though, ethanol's friends rallied to slip a little-noticed one-year renewal of the subsidy into a bill extending the Bush tax cuts and benefits for the long-term unemployed. As I blogged at the time, it looked like ethanol subsidies were a classic case of a bad policy that refused to die.

Now ethanol subsidies are back in the news, and this time they may be on the way out. One piece of legislation, introduced by Senators Tom Coburn (R-OK) and Dianne Feinstein (D-CA), would not only end the 45-cent per gallon tax credit, but also eliminate the 54-cent per gallon tariff on imported ethanol. To understand what has changed, we need to look at the economics behind the shifting pro- and anti-ethanol coalitions.

One shift is that environmentalist support for ethanol has pretty much evaporated. Environmentalists originally joined the ethanol coalition in the belief that using more ethanol, a renewable biofuel, would reduce greenhouse gas emissions. Years of study, however, have shown that corn-based ethanol, over its full life cycle, does little to reduce carbon emissions and may actually increase them. Late last year even Al Gore, long an ethanol booster, reversed his position. While serving as vice-president, Gore had cast a critical tie-breaking Senate vote to secure support for corn-based fuel. Now he admits that there are no environmental benefits, and that his original support was motivated, in part, by the hope of getting Iowa caucus votes in a later run for president.

Environmentalists are not the only ones to fall away from ethanol. As time has gone by, it has proved easier than once thought to find fault lines in the seemingly solid ethanol coalition. At first glance, it might appear that subsidies would find strong support all along the supply chain, from landowners to corn growers to ethanol distillers to fuel suppliers who blend ethanol with gasoline. However, closer economic analysis has shown that benefits are not distributed equally among the parties.

An interesting paper by Farzad Taheripour and Wallace Tyner of the Purdue University Department of Agricultural Economics analyzes the way subsidies are distributed by looking at elasticity of substitution between ethanol and gasoline as a motor fuel, and at the elasticity of supply at various points along the supply chain. (Elasticity means the percentage by which one variable, like quantity supplied, changes in response to a one percent change in another variable, like price.) The authors reach two conclusions that are relevant to the politics of ethanol.

One is that ethanol distillers and corn growers are engaged in a tug-of-war over the benefits of the subsidies. Who wins the biggest share depends partly on government policies that encourage blending of ethanol with gasoline and partly on the supply elasticity of corn. The authors find that over time, as the share of total corn production that goes to ethanol increases, corn farmers can be expected to capture more of the subsidy, leaving less for blenders and distillers. According to USDA data, the percentage of the U.S. corn crop going to ethanol increased from about 7 percent in 2001 to almost 40 percent by 2010. The predictable result would be for ethanol producers to become less attached to the subsidy, and farmers to become more attached.

A second conclusion is that farmers, in turn, are driven by market forces to pass much of the benefit of the subsidy along to landowners. That happens because land suited to growing corn is in less elastic supply than farm inputs of labor and capital. The pass-through to landowners, too, tends to splinter the ethanol coalition. Farmers who own their own land and landowners who lease to corn farmers remain solidly in favor of ethanol subsidies, but farmers who grow corn on leased land gain little or nothing.

Still another factor behind shifting pro- and anti-ethanol coalitions is the effect of corn ethanol subsidies on food prices. A paper by economist Bruce Gardner of the University of Maryland explains how the effect on food prices helps farmers capture a larger share of ethanol subsidies. The gain comes because demand for corn as food is less elastic than the demand for corn as an ethanol feedstock. If corn were used only for ethanol, distillers and blenders would capture a large part of the subsidy. Instead, though, farmers lose part of the benefits of the subsidy to ethanol producers but they more than gain it back when diversion of corn to ethanol drives up the price of corn as food.

When it comes to coalition building, the effect on food prices cuts both ways. Although higher corn prices increase the tenacity with which landowners cling to subsidies, they generate opposition from corn consumers. Those include both domestic consumers of everything from cornflakes to corn-fed beef, and people who are concerned about the effects of high corn prices on consumers in poorer countries.

All of the above suggests a paradox: Subsidies have succeeded in increasing the percentage of the corn crop that goes to ethanol, but that very success has narrowed the originally broad pro-ethanol coalition. Too much of the benefit goes to too small a group, landowners, and others in the supply chain have too small a stake. The Coburn-Feinstein proposal further splits ethanol producers from downstream users by removing the tariff on imports. Fuel suppliers would be quite happy to blend in tariff-free imported ethanol in place of subsidized domestic ethanol.

The final blow is likely to come less in the form of defections from the pro-ethanol camp than from a powerful addition to the anti-ethanol forces, namely, Congressional deficit hawks. True, ethanol subsidies, estimated to cost the budget about $6 billion a year, are chump change beside the trillions needed to close the federal budget gap. Still, everything helps. Many fiscal conservatives—at least those who do not plan to participate in next year's Iowa caucuses—know that farm subsidies must be cut back across the board, ethanol included.

The present relationship of the deficit to ethanol subsidies is a little like that of inflation to transportation regulation during the Carter administration. At that time, captive regulatory agencies had long propped up cartels in trucking, airlines, and railroads, and the cartels, in turn, were keeping prices high. Realistically, inflation was mostly a macroeconomic problem. The effect of the cartels on inflation was small. Still, the effect was there, and it was enough to allow free-marketeers, who favored deregulation as a matter of principle, to bring inflation hawks into their coalition. The outcome: the transportation cartels were busted once and for all. (Disclosure: I myself played a bit part in the deregulation drive as a transportation analyst for the Department of Justice and later the Interstate Commerce Commission.)

The bottom line: Ethanol subsidies may not be dead yet, but they are breathing their last. A symptom of their weakened position is that pro-ethanol forces are no longer trying to maintain the status quo. Instead, the counterproposal to Coburn and Feinstein's ethanol legislation is a bill being pushed by Sen. Chuck Grassley (R-IA) that would phase the subsidies out gradually rather than ending them cold turkey. The only remaining element of suspense is whether ethanol subsidies will go before the firing squad as part of current negotiations over the debt ceiling, or will instead be left to expire peacefully at midnight on December 31.

Are Financial Regulators Flying Blind? Could Better Risk Topography Help?

2011-05-10T21:51:00.000-07:00

Data on the capital and liquidity of banks are the navigation aids that regulators depend on to avoid another financial crash. Improvements to these indicators, adopted last year by the Basel Committee on Bank Supervision, are among the most heralded regulatory reforms since the 2008 crisis. But what if the instruments are faulty, even in their upgraded form? If so, regulators are flying blind, and our chances of avoiding another crash are slim. What can be done?

A recent paper by three prominent financial economists suggests one possible answer: a sort of Manhattan project that would map out a "risk topography" of the financial system. The authors are Markus K. Brunnermeier of Princeton, Gary Gorton of Yale, and Arvind Krishnamurthy of Northwestern. All three are also affiliated with the National Bureau of Economics Research. ( I will refer to the team in what follows as BG&K.)

Their work on risk topography is part of a growing literature on macroprudential regulation of the financial system. Traditional microprudential regulation focused on the safety and soundness of individual institutions. It operated on the implicit premise that if each institution was sound, then the system as a whole would be sound, too. Macroprudential regulation, in contrast, recognizes that interactions among disparate institutions—commercial banks, investment banks, hedge funds, derivatives markets, and all the rest—may pose threats to the system as a whole even when each firm taken separately appears sound. The need for better macroprudential regulation was recognized in last year's Dodd-Frank Act, which created an interagency Financial Stability Oversight Council (FSOC) to deal with systemic risks. It was the subject of an important speech that Fed Chairman Ben Bernanke gave in Chicago last week.

The problem, say BG&K, is that as things now stand, macroprudential regulation cannot be effectively implemented because the FSOC lacks the data needed to measure systemic risk. BG&K compare the situation to that faced by Presidents Hoover and Roosevelt in the early years of the Great Depression. Because national income accounts did not then exist, those presidents and their advisors struggled to develop stabilization policy using fragmentary data like factory output and boxcar loadings.

Some people have reacted to the data deficit by throwing up their hands in surrender. For example, in a recent Financial Times op ed, Former Fed Chairman Alan Greenspan argued that modern financial markets are "unredeemably opaque," and that neither regulators nor anyone else can ever "get more than a glimpse" of their internal workings. If so, attempts at macroprudential regulation would not just be doomed to failure, but would have harmful unintended consequences.

BG&K are not willing to accept the opacity of financial markets as irremediable. Instead, they propose developing a whole new system of reporting and measurement, no less ambitious in its scope than the national income accounts. It is hard to summarize the breadth of their proposal in a few words, but some key ideas will give an idea of their general approach.

First, BG&K point out that in assessing systemic risk, it is not enough simply to look at balance sheet measures during periods of calm. Instead, regulators need to know where pockets of risks are building up within the system in ways that are not revealed by existing balance-sheet based measurements of liquidity and capital adequacy. Instead, they propose requiring financial firms to report, on a regular basis, their sensitivity to a list of specified scenarios. For example, firms might be asked to estimate their dollar gain or loss if house prices rise or fall by 5, 10, or 15 percent, and also how such events would affect their liquidity position. Sensitivity estimates like these are already required as part of stress tests that regulators conduct from time to time, but BG&K propose gathering the data more frequently and from more institutions.

The BG&K approach also focuses on feedback mechanisms between problems of capital adequacy and problems of liquidity. They are particularly concerned with "liquidity spirals" that begin when firms that use short-term funding to finance longer-term investments experience runs or have trouble rolling over short-term borrowing. They are then forced into sales of illiquid assets at fire-sale prices. Those sales, in turn reduce capital and lead to further funding problems. When liquidity spirals, off-balance sheet positions, derivatives, and collateral requirements are taken into account, concepts like leverage and liquidity, which are well-defined in simple, stylized models, become fuzzy and hard to measure on the basis of data derived solely from balance sheets.

Cross scenarios that involve interactive exposure to two or more different risks are the third problem addressed by the BG&K proposal. Their paper uses the example of a U.S. bank that buys Spanish mortgage backed securities, denominated in euros, leaving it exposed both to the risk of falling Spanish housing prices and that of euro depreciation. If both risks materialize simultaneously, the impact on the bank may be greater than the sum of the events taken individually, and may not be adequately revealed by anything the bank would be required to report under the current system.

The end product of the required reporting would be a multidimensionl "risk map" of the financial system that would make visible all manner of risk pockets, sinkholes, pitfalls, soft spots, and other hazards, not only as they exist at the moment, but as they would shift and grow with changes in interest rates, exchange rates, asset prices, and so on.

A final key feature of the BG&K proposal is to make the resulting risk map of the financial system publicly available, just like the national income accounts and the Fed's flow of funds accounts. Public availability of the data would do more than just increase transparency. More importantly, availability of the new data would stimulate the development of macroeconomic models that better incorporate the financial sector than today's models do. The authors point out that when national income accounts and flow of funds accounts were first introduced, no one really knew how to use them. Their full value became apparent only over time as models based on them were developed.

Is this ambitious risk topography project feasible? I can see two kinds of barriers to its effective implementation.

First, the very complexity and novelty of the project would make it expensive and time-consuming to implement. True, as BG&K point out, many building blocks of a risk mapping system already exist. Past experience with stress testing of financial institutions provides one building block. Another is provided by the internal risk models already in use by the financial firms for their own purposes. Presumably, well-run firms are already equipped, at the click of a mouse, to answer questions about the impact on their operations of changes in asset prices and exchange rates. Even so, figuring out just what scenarios should be explored, how to assemble the resulting data, and how to ensure its integrity would be enormous tasks. One imagines a long process of sampling, beta-testing, and revision before the system would be up and running. Even then, by its very nature, we would not know whether the whole exercise was worthwhile until it was tested in a real-world crisis.

Second, we can be pretty certain that a large-scale risk mapping project would run into political resistance. BG&K rightly point out that the Dodd-Frank Act already provides the needed legal framework. The Act calls for establishment of an Office of Financial Research (OFR) within the Treasury Department, which, in turn, is tasked with providing research and information to the Financial Stability Oversight Council. The OFR even has subpoena power to require financial institutions to produce the data that it requests.

Legal authority or no, there would be resistance to the idea of using the OFR to undertake the vast task that BG&K propose. Given the tight-fistedness of the current Congress, just coming up with the money needed to staff and operate the exercise would be hard enough. Furthermore, not all of the component institutions of our financial system are as deeply in love with transparency as are critics in academia. One can easily imagine that every appointment and authorization would give rise to the same kind of trench warfare currently being waged over the Bureau of Consumer Financial Protection. That agency, also authorized by the Dodd-Frank Act, may very well end up stillborn, or if not, extensively re-engineered before it sees the light of day. The same thing could happen to the OFR if it were given too large an assignment.

Still, despite the technical and political hazards of a large scale risk mapping project, to give up on the idea in advance would be to admit that the financial system is in fact "unredeemably opaque." If so, the alternatives are bleak. Regulators would then either have to abandon the concept of macroprudential regulation altogether and passively await the next crisis, or they would run a severely heightened risk that their regulatory initiatives would have harmful unintended consequences.

The People's Budget: Cutting the Deficit the Progressive Way

2011-05-03T11:52:00.000-07:00

In previous posts, I have discussed bipartisan attempts to find a fiscal policy compromise (here and here), and also Republican plans for closing the budget gap through spending cuts alone (here and here). Today's post turns to the less widely publicized People's Budget from the Congressional Progressive Caucus. What is there to like about the progressive fiscal plan, and what not to like?

First what I like. On the spending side, the People's Budget does not limit itself to swinging a meat-ax at tiny targets like NPR and AmeriCorps within the 12 percent of the budget that is made up of discretionary nondefense spending. Instead, it goes after some really juicy chunks, including defense. Not just at waste, fraud, and abuse in the military budget, either. It comes right out and proposes an orderly but swift end to the military adventure in Afghanistan, thereby saving something between $400 billion and $1.6 trillion, depending on what baseline you compare it to. But the progressives do not really have a monopoly here. Concerns that the United States has not gotten its money's worth from wars in Iraq and Afghanistan are increasingly voiced on the Republican side of the aisle, including like Ron and Rand Paul, Jason Chafitz, and Walter Jones.

Next, the People's Budget takes aim at the nation's infrastructure deficit. As I argued in an earlier post, cutting infrastructure investment below what is needed to cover depreciation, as has been done in many areas, is an illusory way of improving the national balance sheet. What is saved in terms of reduced financial liabilities is offset by more rapid depreciation of real assets like bridges, dams, and power lines. In fact, since deferral of needed maintenance almost always means greater spending later when something breaks, cuts to infrastructure spending often end up making the nation's consolidated balance sheet weaker, not stronger. On the whole, without endorsing every line item, I would count the $1.7 trillion added to infrastructure investment over ten years as a plus for the People's Budget.

On entitlements, the People's Budget recognizes, as every observer must, that any realistic plan for fiscal consolidation must do something about the projected growth of government health care outlays. The Republican budget plan deals with this problem largely by shifting the cost of Medicare from the federal government to senior citizens themselves. There are relatively few cost-saving measures in the Republican plan except for malpractice reform and a vague hope that competition will force costs down in the future, even though it has not done so in the past.

The People's Budget takes cost saving in health care more seriously. Its initiatives include adding a public option to the array of private plans to be offered on health insurance exchanges and allowing the government to bargain with pharmaceutical companies over drug prices. Big insurance companies and big pharmas are terrified of these ideas: They might work!

The experience of countries like France and Germany shows that when a full array of cost-saving strategies are used, it is possible to provide better quality health care at lower cost, and to do so without moving to British-style, single-payer, "socialized medicine." The People's budget picks up some good ideas that have been shown to work elsewhere, although more could be added.

Let's turn now to the revenue side of the People's Budget. Out of $5.6 trillion in projected deficit reduction in the progressive plan, $3.9 billion, or nearly 70 percent, comes from revenue increases. That contrasts with the one-third revenue, two-thirds spending-cut formula of the bipartisan Simpson-Bowles plan, and even more with Republican plans to balance the budget with spending cuts alone.

What disappoints me about the revenue side of the People's Budget is the degree to which it depends on higher marginal tax rates rather than on tax reform. The biggest piece of revenue, an estimated $873 billion, is to come from enacting Representative Jan Schakowsky's Fairness in Taxation Act (HR 1124), which would create several new income tax brackets, ranging from 45 percent on incomes over $1 million to 49 percent for incomes over $1 billion. The second biggest piece, $330 billion, is to come from Senator Bernie Sanders' Responsible Estate Tax Act (S 3533), which introduces estate tax rates up to 65 percent. Some smaller new taxes for the financial sector are added, as well.

The revenue estimates for the tax increases are set out in a technical analysis of the People's Budget prepared by the Economic Policy Institute. Those, in turn, rely on analysis by the Joint Committee on Taxation that has not been released to the public. From context, it would appear that we are looking at static estimates, which do not take into account behavioral responses to tax rate changes, in contrast to dynamic estimates, which do. Static scoring tends to overestimate the revenue from tax rate increases, although it is often hard to know by how much.

Popular discussions of dynamic scoring often focus on the idea that corporations and small businesses won't try as hard to innovate and create jobs if their tax rates go up. However, the real damage of higher marginal tax rates comes not from decreased work effort, but from increased efforts to avoid taxes. Given the complexity of the federal tax code, the possibilities for legal tax avoidance are almost limitless. Everyone has heard the horror stories: Warren Buffet pays a lower tax rate than his secretary; the corporate giant General Electric no tax at all.

Tax avoidance does not just reduce revenues; it leads to efficiency-killing distortions when investment decisions or operational strategies are modified to make income from one source look like something else from somewhere else. Raising marginal tax rates only makes the problem worse. Tax reform that keeps marginal tax rates low while closing loopholes is a much better strategy. Reform could raise as much, or more, revenue than boosting rates, while reducing opportunities for tax avoidance rather than increasing them.

To its credit, the People's Budget does close a few loopholes. For example, it equalizes the tax treatment of capital gains and ordinary income, although it sacrifices potential efficiency gains by raising the marginal rates on both. It leaves most itemized deductions in place, but does take the modest step of capping the degree to which top earners' taxes can be reduced. It eliminates the deductibility of municipal bond interest, although the deduction is replaced with a subsidy to municipal bond issuers that not everyone will like. It broadens the corporate tax base by eliminating oil and gas preferences and taxing foreign corporate income as it is earned, although it leaves the marginal corporate tax rate unchanged at what is already one of the highest in the world.

But these tax reform proposals are half-steps compared with what could have been done, in complete consistency with the progressive agenda. For example, why not repeal the mortgage interest deduction? As I noted in an earlier post, the Urban Institute-Brookings Tax Policy Center estimates the mortgage interest deduction to be worth $5,393 a year for tax units in the top 1 percent of the income distribution (average income $1,302,188) but only $215 per year to those in the middle 20 percent (average income $43,678). For households in the bottom 20 percent of the income distribution, the deduction has almost no value. Getting rid of the deduction would raise $108 billion in 2012, rising to $162 billion a year by 2019. What keeps the mortgage interest deduction off the progressive hit list? Who knows. Maybe campaign contributions from the United Brotherhood of Carpenters.

In all, the People's Budget leaves untouched the entire top half of the dirty-dozen list of tax loopholes. All of those loopholes—from employer-paid health care to mortgage interest to charitable deductions—are regressive in their impact. All of them encourage efficiency-sapping tax avoidance strategies, the effects of which would be even worse if the higher marginal rates of the People's Budget were to be enacted. Collectively, eliminating the top six loopholes could raise close to $500 billion a year in added revenue, enough to pay for a cornucopia of progressive delights.

The bottom line: The People's budget does represent a real alternative to Republican budget plans. It takes on some sacred cows that the Republicans fear to touch, most notably defense spending. It correctly recognizes that cuts to infrastructure investment are false economies that reduce the headline deficit number without really improving the national balance sheet. It also deserves credit for seeing that real cost savings, not just cost shifting, will be needed to make health care affordable.

Finally, the People's Budget is more realistic than Republican plans in recognizing that both spending cuts and revenue increases will be needed to close the budget gap. Sadly, though, the way it seeks added revenue is just plain bad. Its "millionaire's tax" plays to the class warfare instincts of the progressive base, but its efforts fall flat when it comes to tax reform. The People's Budget could have been very much better, and without giving an inch on its progressive principles.

Follow this link to view or download a short slideshow with graphs, data, and other highlights from the People's Budget.

The Ecosocialist Critique of Capitalism vs. Real World Socialism

2011-04-27T08:01:00.000-07:00

It has been twenty years now since first glasnost and then the collapse of the USSR lifted the curtain on the appalling environmental record of Soviet socialism. Over that same 20 years, the burgeoning economy of socialist China has overtaken the United States as the world's largest emitter of greenhouse gasses. Still, it remains common to hear capitalism singled out as the greatest environmental threat to our planet, and socialism as its salvation.

A forceful statement of the environmentalist case against capitalism can be found in the Belem Ecosocialist Declaration, the product of a conference held in Paris in 2007. That document sets out a simple chain of cause and effect: Capitalism requires profit, profit requires growth, and growth means environmental destruction. Here are some excerpts:

Humanity today faces a stark choice: ecosocialism or barbarism. . . .We need no more proof of the barbarity of capitalism, the parasitical system that exploits humanity and nature alike. Its sole motor is the imperative toward profit and thus the need for constant growth. . . . Capitalism’s need for growth exists on every level, from the individual enterprise to the system as a whole. The insatiable hunger of corporations is facilitated by imperialist expansion in search of ever greater access to natural resources . . . . The capitalist economic system cannot tolerate limits on growth; its constant need to expand will subvert any limits that might be imposed . . . because to do so would require setting limits upon accumulation – an unacceptable option for a system predicated upon the rule: Grow or Die!

To be right up front about it, the critique is not all wrong. There is a “Drill, Baby, Drill!” version of capitalism with a throughput mentality and a contempt for environmental values that provide fodder for the ecosocialist critique. Clearly, neither neither capitalism nor socialism has a monopoly either on environmental sin or environmental virtue. Reaching a considered judgement about their relative economic impacts requires asking two questions:

Which has been more environmentally destructive in practice, capitalism or socialism?
Which system, capitalism or socialism, is more receptive to the changes that need to be made to achieve long-run environmental sustainability?

It had long been evident, to anyone who cared to look, that the world’s preeminent experiment in socialism, the Soviet Union, had serious environmental problems. As early as 1972, many of them were detailed by Marshall Goldman in Spoils of Progress. Peresroika in the 1990s and, finally, the collapse of the Soviet Union, made access to information easier for authors like Murray Feshbach and Alfred Friendly, Jr., who provided a thorough survey in Ecocide in the USSR. Here are some of the most prominent problems featured in these and other sources:

Pollution of Lake Baikal, the world’s oldest, deepest, and once cleanest body of fresh water, caused by paper mills and other industries that dumped untreated waste into the lake.
The near-disappearance of the once-vast Aral Sea, which dried up due to diversion of water for irrigation, leaving behind salt deserts poisoned by agricultural chemicals.
The 1986 Chernobyl nuclear disaster, the world’s worst, caused not just by operating errors but by a reckless design that provided no containment vessel in case of accident. The nuclear accident that had been considered the world’s worst up to that time also occurred in the Soviet Union, the 1957 explosion of a waste storage pond at the Mayak nuclear weapons complex.
Disastrous peat fires in the Moscow region, a legacy of ill-conceived Soviet projects for draining the local wetlands.
Enormous emissions of greenhouse gasses, due to heavy reliance on coal and far lower energy efficiency than capitalist economies.
High levels of air pollution in major cities, caused by factories sited close to populated areas and operating with minimal if any pollution controls.
Destructive farm and forestry practices, leading to widespread erosion and habitat loss.

China, the world’s other big socialist economy, also has its long list of environmental sins. Due in large part to intensive use of coal, it has recently taken the world lead in greenhouse gas emissions, despite an economy half the absolute size the United States. In air quality, it is home to 16 of the world’s 20 most polluted cities. Water pollution is a pervasive national disaster. Its leadership in production of rare earth metals was achieved largely due to illegal pirate mining that caused intense heavy metal pollution and local health disasters. An increasing percentage of pollutants, from mercury to soot, that are deposited in the western United States are being traced all the way to China.

To their credit, ecosocialist documents like the Belem Declaration direct at least token criticism at what they call “productivist" socialism. The ecosocialists are on to something, although not perhaps quite what they think, when they introduce this concept.

The adjective productivist, as applied to an economy, appears to mean one that concentrates on maximizing output without paying sufficient attention to the costs of inputs. By “costs of inputs,” of course, I mean what economists call opportunity costs, that is, costs as measured in terms of the value of alternative uses for the same resources. The opportunity costs of industrial production include both the costs of depletion of nonrenewable resources (lost opportunities to use the same resources for some other purpose in the future) and external costs (for example, the lost opportunities to use or enjoy property damaged by pollution).

If we understand the term in this way, then it can identify not only a productivist variant of socialism, but also a productivist variant of capitalism. The “affordable energy” lobby in the United States is an example of productivist capitalism in action. Affordable energy is a favorite slogan of the American Petroleum Institute, as used, for example, in this comment by API President Jack Gerard: “A ban on offshore drilling will hurt growth “by undercutting our nation's access to affordable, reliable, domestic sources of oil and natural gas.”

The affordable energy lobby worries about attempts to force oil companies to raise the price at the pump by enough to cover external costs of petroleum production and use. In the case at hand, Gerard was concerned about regulations aimed at ensuring that oil companies bore the cost of oil spills and of the precautions needed to avoid them. At other times, the same affordable energy argument has been directed at regulations intended to control air pollution, both on a local level and in the form of global climate change.

The fact is, businesses seek profit, and they tend to go after any and all profit opportunities. We cheer when entrepreneurs increase profits by improving products or reducing production costs. However, profits can also be boosted by lobbying the government to restrict the activities of competitors, and, equally, by lobbying for laws that allow a company to shift part of its costs of production to unwilling third parties. OK, so you don’t want to call those profits? I agree. Economists call them “rents,” but that term is too wonky for many people. Ayn Rand had a better term: Loot. Polluters are looters.

Let’s come back now to the ecosocialist critique. What it really comes down to is less a critique of capitalism than of productivism. The question we have to ask is, which system, capitalism or socialism, is more susceptible to productivist tendencies? I think the answer is socialism, although capitalism is by no means immune.

The first reason that socialism is more likely to develop environmentally damaging productivist tendencies is that economic incentives do not work very well under socialism. In a capitalist society, the number one objective of environmental policy is to ensure that externalities are fully recognized in market prices. If the price of gasoline at the pump fully reflects the opportunity costs of pollution and resource depletion, drivers, regardless of their personal environmental sensitivities, will be forced to think about driving less or buying a more efficient vehicle. The same principle applies to users of industrial energy, whether they be plastics makers, farmers, or power plants. I don’t mean to underestimate the difficulty of getting the legislature of a democratic capitalist country to pass laws that protect property rights to the needed degree. But when the price system is used to fight pollution, it seems to work. For example, in the United States of the 1990s and early 2000s, a system of tradable permits was used with great success to bring down sulfur dioxide emissions from coal-burning power plants, with the result that the intensity of acid rain in the eastern part of the country was cut by half.

Under socialism, economic incentives to fight pollution do not work well. Yes, I know, there is such a theoretical construct as “market socialism.” Under that hypothetical system, advocated by 20th century writers like Oskar Lange and Abba Lerner, managers of collectively owned firms guide their production activities in accordance not with true market prices set by supply and demand, but instead by following “shadow prices” that are set by government planners at a level supposedly equal to opportunity costs. In theory, there would be no reason why the shadow prices could not include appropriate adjustments for environmental impacts. I don’t want to reargue the whole market socialism debate here. The concept has been widely judged to be impractical, and as far as I know, it has no living proponents. I think Ludwig von Mises said it all when he suggested that a real market is to market socialism as a real railroad is to a boy playing with toy trains. So we can drop market socialism, and look at socialism in the real world.

In the Soviet Union, as Goldman pointed out, both law and ideology provided for a degree of environmental protection. To at least a small degree, these protections were backed up by economic sanctions against polluters. The problem, however, was that industrial managers were not just insensitive economic incentives for protection of the environment, but to any kind of economic incentive at all. The Soviet system did not just encourage environmental waste, it was wasteful in every conceivable way. It wasted labor, capital, energy, natural resources, cement, steel, coal, tractors, fertilizer, wood, water—it wasted everything. Why? Because there was no profit motive.
Today, some people worry that big banks like Goldman Sachs do not operate efficiently because they know the government will bail them out if they make a loss. We call this "privatizing the gains, socializing the losses.” Well, the Soviet economy was a system in which every enterprise was a Goldman Sachs. No wonder it collapsed.

Now for the second reason why socialism tends to be more productivist than capitalism, which has to do with social attitudes that arise when there are no property rights. Where there are property rights, there is always an owner to resist trespass, whether by people on foot or noxious chemicals wafting through the air. True, the legal system doesn’t work perfectly. Sometimes owners can’t adequately protect their rights, but the rights are there. Furthermore, where there is widespread ownership of at least small scraps of property, respect for the property rights of others also becomes widespread, although, alas, not universal.

But wait, the ecosocialist might say, under socialism there are collective property rights and respect for the property of society as a whole. Really? Let me tell a story.

At the business school my wife and I used to run in Moscow, the students put on an annual May picnic. After some advance scouting by the class president, the entire student body and faculty would jump on the electric commuter train. A few stops outside the city, we would jump off and head into the woods for a nice picnic. Whose woods? Some ministry’s or institute’s or collective farm’s, no one ever seemed to know exactly. A picnic needed a campfire, of course, so someone would bring an ax and cut down the nearest sapling to make a fire. When cleanup time came, the students followed their standard practice, which was to toss all the beer cans and vodka bottles into the remnants of the campfire, where they would become broken, charred, and harder to pick up in the (unlikely) event that someone were to try doing so later. When we suggested bringing our own fuel or packing out our garbage, we were met by looks that suggested that such things had never been thought of before.

I started asking friends and colleagues about all this. Why didn’t the socialist property owner care who picnicked there? Why didn’t kids learn to respect socialist property, and clean up after themselves? The answer was that people didn’t think of those woods as socialist property, even though nominally, they were. Instead, they were seen as nich’ia sobstvennost—“no one’s property.” As such, no one took responsibility for them, and no one felt bad about abusing them. Extend the same attitude to Lake Baikal, the Aral Sea, and the Chernobyl nuclear station, and what you get is Ecocide in the USSR.

The third reason that socialism tends to be more productivist than capitalism stems from political economy. Private property provides political power bases to multiple interest groups. Sometimes that can work against the environment, as when Appalachian coal unions and mine owners join to lobby against restrictions on sulfur dioxide emissions. At the same time, though, producers of low-sulfur coal from Western states can lobby on the other side, achieving some kind of balance. Furthermore, not-for-profit groups like the Nature Conservancy can use the mechanisms of private property to protect critical habitat, and private ownership sustains an independent voice for media that can publicize environmental causes. Even ecosocialists enjoy the protection of private property for their web sites and conferences.

In a socialist system, producers have a stronger grip on the levers of political power. After all, as state enterprises, they are not mere lobbyists—they are themselves a part of the government structure. For example, Goldman noted that there were protests in the Soviet Union when paper mills first started dumping waste into Lake Baikal. However, the protesters themselves were always one government institution, say, the Limnological Institute of the Academy of Sciences, working against another, in that case the Ministry of Timber, Paper, and Woodworking. Sometimes the protesters were able to exploit personal rivalries within the government in order to plant articles in government newspapers, but in the end, they always lost. The whole incentive system of the Soviet economy, from the Politburo down to the local plant manager, was focused on just one thing: meeting the impossibly demanding production targets of the Five Year Plan. The environment always lost.

Once again, let me emphasize that private property and a market economy may be necessary conditions for protection of the environment, but they are not sufficient conditions. The sad story of environmental protection in post-Soviet Russia is a case in point. Socialism no longer reigns in Russia, but the variant of capitalism that has replaced it is no less productivist. Civil society is weak. Green protesters still struggle to get publicity for their causes in a largely state-controlled press. It is no longer casual picnickers who chop down the saplings in Moscow’s green belt, but instead, billionaire oligarchs who fence off whole swathes of protected habitat for their sprawling dachas. Oil is king, and a blind eye is turned to spills on land or at sea. BP, chased from the Gulf of Mexico with its tail between its legs, is getting ready to drill for oil among the drifting icebergs off Russia’s northern coast. The last wild Siberian tiger may soon fall to a shot from the helicopter of an oligarch or government minister out for a weekend’s “sport.”

Are things better in China, where private industry has made huge inroads into the still nominally socialist economy? Now and then there are a few hopeful signs. This year has seen a belated campaign to shut down some of the worst pirate rare-earth mines in favor of better-run government ventures. China has become a leader in alternative energy, although its efforts may reflect an opportunistic effort to corner the world market for windmills and solar panels more than a genuine concern for the planet. Meanwhile, urban air pollution remains so bad that the Olympics could be staged in Beijing only by shutting down most local industry for the duration. I sit here in my house in Washington State wondering how much Chinese mercury is coming down from the rainclouds that drift in across the Pacific. But at least I won’t have to get the approval of a socialist censor to post this essay to my blog.

This post is an excerpt from the forthcoming 40th anniversary edition of my 1971 book, TANSTAAFL: The Economic Strategy for Environmental Crisis." Watch for it later later this year.

What Can We Learn about the Ryan Medicare Plan from German Experience?

2011-04-21T22:21:00.000-07:00

Last week Republicans in the US House of Representatives, following the lead of Representative Paul Ryan, endorsed a far-reaching plan to reform Medicare, the nation's health care system for the elderly. Since it began in 1965, Medicare has been a government-run, single-payer system that reimburses private doctors and hospitals for the health care services they provide. Under the Ryan plan, it would be transformed into a system in which seniors would choose from a list of competing private insurance plans, with the premiums paid partly by government and partly by the beneficiaries themselves.

Supporters of the Ryan plan see several benefits. An open letter, posted on the web site of the American Enterprise Institute and signed by a list of prominent physicians and economists, puts it this way:

Having more control over their health care spending would encourage consumers and patients to make better health care choices. It would stimulate more innovative and accountable competition by health care providers and give them incentives to better coordinate the care of their patients. Enhanced competition could offer seniors relief from rising Medicare premiums. Just as important, this reform could begin to ease the crushing tax burden imposed by the current program on our children and grandchildren.

Critics fear that in its zeal to ease the burden on taxpayers, the Ryan plan would make Medicare-equivalent health care unaffordable for many, if not most seniors. Under the plan, the value of government payments would be capped at the rate of growth of the Consumer Price Index. If medical costs continued to grow faster than the CPI, as they have in the past, more and more of the financial burden of health care would be shifted over time to beneficiaries. A study from the Center for Economic and Policy Research, using assumptions from the Congressional Budget Office, claims that by 2022, a senior citizen at the median income would have to pay 35 percent of that income to obtain coverage equivalent to Medicare, with the figure rising to 68 percent by 2050.

The idea of competing private health insurance plans, with premiums split between beneficiaries and the government, is far from new. It has been used for many years in Germany, among other places. What insights regarding the likely effects of the Ryan plan can we get by looking at the German experience?

Under the German system, seniors choose insurance coverage from among a list of approved, nongovernmental "sickness funds" (Krankenkassen). As in the United States, those insurers, in turn, pay for health care provided by private physicians and hospitals. Beneficiaries and the government each pay a share of health care premiums. In these respects, the German system is closer to the Ryan plan than to the current version of Medicare.

Does the German system work? Broadly, the answer is yes. A variety of international comparisons rank the performance of the German health care system above that of the United States. That good performance is achieved at a cost of 10.5 percent of GDP, compared with 16 percent here. In dollar terms, Germany spends less than half as much per capita on health care. (See the slideshow attached to this post for details.)

So far, so good. Germany has competing private health insurers with premiums paid in part by the government and in part by beneficiaries. It achieves better health care outcomes at a lower cost than the United States. But before we jump to the conclusion that the German experience supports the claims of the Ryan plan, we need to look more closely not just at the results the German system achieves, but at how it achieves them.

In contrast to the rhetoric of Ryan-plan supporters, the German system does not achieve its results primarily by unleashing the forces of competition. In fact, both the German system and the Ryan plan explicitly prohibit one of the main forms of competition among insurance companies, namely, the use of experience rating, that is, the practice of differentiating premiums according to demographics, health status, past health care use, and similar factors. Experience rating in health insurance leads to "cherry picking," in which insurers compete to lower their premiums by excluding all but the healthiest customers. Under such a system, the very elderly and those with chronic illnesses are likely to find that insurance is unaffordable or completely unavailable.

Unfortunately, prohibiting experience rating also weakens the extent to which competition encourages people to make better health care choices. Lifestyle decisions like smoking, diet, and exercise no longer affect the availability of insurance or its price. Instead market forces must operate indirectly, through competition among insurers to devise packages that offer consumers the best value for money. One way to do so is to assemble provider networks of doctors and hospitals that offer good quality services at reasonable prices. Another is to cover only treatments that are known to be cost effective. Still another is to encourage preventative care, when doing so reduces total health care costs.

Would those forms of competition among insurers be enough to achieve the slowdown in growth of health care costs that supporters of the Ryan plan hope for? Competition based on cost-effectiveness already exists in some sectors of the US health care market, for example, in the provision of employer-paid group health plans and in the Medicare Advantage program. Health care costs have continued to rise faster than the CPI in both of those cases, and many observers are skeptical that the Ryan plan would lead to a different outcome.

Germany, too, encourages sickness funds to compete in providing patient-friendly and cost-effective care. However, it backs up the effects of competition with an array of proactive cost-control regulations, including the following:

National and regional budgets to cap total quarterly health-care outlays.
Diagnosis-related groups to reimburse hospitals for care of patients with specific conditions, rather than paying for each test and procedure performed.
A reference-price system for drugs that provides for similar payments for drugs with equivalent therapeutic effects, favors use of generic drugs, and encourages pharmaceutical companies to concentrate on innovation rather than developing follow-on drugs with little added benefit.
Disease management programs for chronic conditions like diabetes and heart disease, which use evidence-based guidelines for cost-effective treatment protocols and focus on preventing high-cost complications.
A national institute that assesses the effectiveness of medical treatments and products; encourages speedy introduction of new treatments that offer added value; permits the use of new treatments that provide similar value to existing ones, but without higher reimbursement; and disallows reimbursement for new treatments that have no demonstrated added value.

Germany's health care system, which dates back to the rule of Otto von Bismarck in the 19th century, did not always have these cost-control features. They were introduced gradually, many of them over just the last 20 years, in an attempt to curtail a tendency for medical costs to grow faster than the rest of the economy. They have not been completely successful, but the excess growth of health care expenditures has been less than in most other developed economies. In the decade from 1999 to 2008, health care costs grew only from 10.3 to 10.5 percent of GDP in Germany, compared with an increase from 10.1 to 11.2 percent in France and from 13.4 to 16 percent in the United States. (In the preceding decade, before many of the cost-control regulations were implemented, German health care expenditures had grown from 8.3 percent to 10.2 percent of GDP.)

There is one more difference between the Ryan plan for Medicare and the German system. The former is what is popularly described as a "voucher" program. It provides beneficiaries with a fixed payment toward the purchase of health insurance that increases only with the general cost of living. Any excess growth of health care costs beyond the CPI is borne by the individual. That formula assures that as the economy grows, the government's share of health care costs decreases as a share of GDP regardless of what happens to total costs. At the same time, the share of a typical senior's retirement income that goes to health care would increase over time unless total health care costs decreased steadily as a share of GDP, something that has never happened in any developed country.

In contrast, the German system uses a premium support approach. Beneficiaries and the government share the cost of health insurance, but the individual's share is capped as a percentage of his or her income. Any excess increase of health care costs relative to the CPI or to GDP is borne by the government. Long-time US backers of the premium support concept, like Henry Aaron of the Brookings Institution, strongly object to applying that term to the Ryan plan. So does Alice Rivlin, who worked with Ryan on an earlier Medicare reform plan, but vehemently rejects the version that appears in the current Republican Plan for Prosperity.

Taking all these similarities and differences into account, then, what do we learn about the Ryan plan from the German experience? I see three lessons.

First, there is nothing inherently unreasonable in the idea of replacing today's single-payer, government-run version of Medicare with a system that offers beneficiaries a choice among competing private plans. The Germans do it, and it works.

Second, the German experience suggests that it would be unrealistic to rely on unregulated market competition to hold the rate of growth of health care costs to the rate of CPI inflation. That has never happened anywhere, not in any foreign country, and not in any sector of the US health care system where competition has been tried. The point is an important one because Republicans tend to have an ideological aversion to government regulation in all forms. One cost control measure, medical malpractice reform, does pass the Republican litmus test, but, although helpful, it solves only a small part of the problem. If the Ryan plan is to have any hope of achieving its promised results, it will have to embrace a full-court press of cost control regulations.

Third, if the Ryan plan were implemented, and if health care costs did continue to grow faster than the CPI, the burden of health care for seniors would increasingly shift to individuals. If that happened, there is no conceivable way the American political system could resist the resulting political pressure to increase benefits. There are just too many senior voters. Anyone with the slightest sense of realism must realize that a clash between growing health care costs and lagging government benefits would be resolved through annual Congressional approval of benefit increases, just as used to happen with Social Security before benefits were indexed, and just as happens now with the alternative minimum tax.

In short, the Ryan plan, as it stands, does not represent a realistic path forward. Either it will not be enacted, or it will be modified to look more like the German system before it is enacted, or it will be enacted first and modified later. Meanwhile, it will remain more of a political platform than a serious policy initiative.

Follow this link to view or download a brief slideshow with additional information on the German health care system.

Is Tax Reform Really on the Table, or Not?

2011-04-14T22:08:00.000-07:00

Last October I wrote a lengthy post explaining why tax reform is the best path to growth-friendly deficit reduction. At that time, six short months ago, hardly anyone in Washington was talking about tax reform. Now both the Republicans, in the Ryan plan, and President Obama, in this week's deficit-reduction speech, are trumpeting tax reform as the centerpiece of their respective proposals. Does that mean tax reform is finally on the table? Should we expect a dramatic, bipartisan breakthrough soon? I'm afraid not.

Economists are in rare agreement about the basic principles of tax reform. The objective of reform should be, first, to lower marginal tax rates, that is, the rates paid on each additional dollar of income or profit, as much as possible. Low marginal tax rates minimize distortions and maximize incentives for growth and job creation. Second, for any given amount of revenue to be raised, the way to get tax rates low is to make the tax base as broad as possible, that is, to eliminate loopholes that allow some income or profit to go untaxed while the rest bears a disproportionate share of the burden. Unfortunately, agreement on the principles of tax reform is easier to achieve than agreement on the politics of it.

The first barrier to achieving political agreement lies in a difference between Republic and Democratic notions of the purpose of tax reform. Republicans are interested in tax reform only if it is "revenue neutral." Any base-broadening must be fully offset by rate reduction. Democrats, on the other hand, view tax reform as a way to help close the budget gap. They would only partially offset the effects of closing loopholes with reductions in tax rates.

I think Republicans are making a strategic mistake. By insisting on revenue neutrality, they are, in effect, divorcing the discussion of tax reform from the issue of deficit reduction. In doing so, they are missing a historic opportunity to reform the catastrophically complex, perverse, and inefficient US tax system they constantly complain about.

Instead, Republicans should seize on the big bargain chip presented by the Democrats' recent, grudging, admission of the need for deficit reduction. They should be saying to Democrats, "OK, we will meet you part way. We will go along with closing the budget gap partly with increased revenue, provided every penny of that added revenue comes from genuine, growth-friendly, loophole-closing, marginal-rate-reducing tax reform." Several Republican members of the Bowles-Simpson deficit-reduction commission endorsed such a deal, but not those currently serving on Capitol Hill.

By refusing to make this offer, the Republicans in Congress are going to come away empty handed. They are going to get neither deficit reduction nor tax reform. Is the mantle of ideological purity more important to them than making real improvements to public policy? If so, it's just plain sad.

So much for the differences between the Republican and Democratic approaches to tax reform. The second reason tax reform isn't yet truly on the table lies in a fundamental similarity between between them: Both parties endorse tax reform in the abstract, but neither is ready to designate which specific loopholes they want closed.

What should they be looking at? Here is a dirty-dozen list of tax expenditures from the Urban Institute and Brookings Tax Policy Center (figures in parentheses show the 2008 value in billions of dollars):

Employer-paid health care (131)
Pension contributions and earnings (117)
Mortgage interest deduction (89)
Accelerated depreciation (56)
State and local tax deduction, other than property taxes (49)
Charitable contributions (47)
Deferral of income from foreign corporations (31)
Exclusion of capital gains on sale of homes (30)
Property tax deduction on homes (29)
Child credit (28)
Capital gains rate (24)
Capital gains basis step-up at death (22)

Notice that elimination of any one of the top six, or any two of the second six, would exceed the "historic" $38 billion deficit reduction passed by Congress this week. Some of the twelve are beloved of Republicans, some beloved of Democrats, and none (yet) hated enough by both to be placed on the chopping block.

The bottom line: Tax reform, the idea, may be in the air, but tax reform, the thing itself, is not yet on the table. It will remain off the table until Republicans wake up to the fact that compromise means giving up part of one thing you want (revenue neutrality) in order to get other things you want (tax reform and deficit reduction). How will we know when things have changed? When either party starts listing which of the dirty dozen tax expenditures it would like to eliminate. Until then, it's just hot air.

Follow these links to view or download slideshows from earlier posts on tax reform: Pro-growth fiscal consolidation; the case against the mortgage interest deduction.

Is Financial Reform Working or Will It Make Things Worse?

2011-04-07T22:07:00.000-07:00

The 2008 financial crash gave rise to a world-wide call for a review of regulations. In the United States, the EU, and international forums like the Basel Committee on Bank Supervision, the conclusion was reached that regulators had allowed banks and other financial institutions to take risks well in excess of those justified by the public interest. Legislatures were brought into the act where needed to change the regulatory framework. Everyone vowed to fix things.

Now, with some of the key pieces finalized on paper, but not fully implemented, financial reform is running into a backlash. Skeptics, including former Fed Chairman Alan Greenspan, who expressed his misgivings recently in the Financial Times, argue that reform efforts not only will not work, but are making things worse. Others, like U.S. Representative Barney Frank, co-sponsor of the 2010 Dodd-Frank financial reform act, strongly disagree. In a reply to Greenspan, Frank argued that the financial system can be made safer while still leaving it able to perform its essential economic functions. Who is right?

I find it helpful to frame the discussion in terms of a simple risk-return diagram like the one shown here. Financial markets, by their nature, present banks and other institutions with a trade-off between risk and return. Financial managers move up and to the right along the frontier until they reach a preferred point, say point A, beyond which they judge that any additional increase return not is not worth the extra added risk.

Regulators tend to be more cautious. They would prefer to see banks operate at a lower point along the risk-return frontier, say, point B. There are three main reasons why regulators think financial managers, left to their own devices, tend to take risks greater than are justified by the public interest:

Contagion: Failure of one financial institution can spread to others, harming the broader economy in the process.
Moral hazard: Banks and their creditors may neglect needed precautions because they believe they will be bailed out when threatened with failure.
Agency problems: Bank managers are supposed to act in the interests of their shareholders, but bonus schemes, golden parachutes, and other incentives may induce them to take risks that are excessive from the shareholders' point of view.

The fundamental dilemma of financial regulation is that attempts to move the system down along the risk-return frontier from A toward B can have unintended consequences that move it, instead, to a point inside the frontier, like point C. Such a point is inferior both from everyone's point of view. It has the high risks that the regulators would like to avoid without the high returns that the bankers seek.

This framework helps us refine the question of whether financial reform will make things better or worse. We need to ask which elements of the post-2008 round of reforms are likely to produce the desired effect of moving from A toward B, and which are in danger of producing unintended consequences like a move from A to C.

The kinds of regulations most likely to fail are those that prohibit specific activities. The Dodd-Frank financial reform act includes a number of these, for example, restrictions on proprietary trading and use of derivatives. The problem is that they take out specific items from the mix of activities that bankers formerly judged to offer the most attractive risk-return profile without curbing the underlying appetite for risk.

There is no reason to think that bankers, faced with, say, a prohibition on derivatives, would simply replace them with safe government bonds. Instead, they would turn to activities that they passed over before, either because they were riskier ways to earn the same returns, or offered less return for the same risk. To put it in terms of our diagram, instead of responding to the prohibitions by moving along the curve from A toward B, they would be motivated to move up and to the left from point A, hoping to end up at a second-best point a little northeast of point C. But if that happened everyone would be worse off.

When it comes to regulations that prohibit specific risky activities, then, Greenspan may well be right. It is like parents telling their overweight kids, "Don't eat ice cream, don't eat pizza." Little Jimmy and Jenny just replace their favorite fatty foods with second-favorites, like Twinkies or Big Macs or something even more disgusting that their poor parents didn't even know existed.

The prohibitions in Dodd-Frank are not the only reforms that can produce unintended consequences. For another example, consider the increased capital requirements mandated by the Basel III agreements that were finalized late last year. The thinking behind Basel III is of course correct to the extent that, other things being equal, increasing a bank's capital will tend to move it down and to the left along the risk-return frontier. But will other things remain equal? If they are forced to maintain more capital, what is to keep bankers from clawing their way back toward their preferred risk-return point by acquiring riskier assets, or choosing riskier funding alternatives, or engaging in risky operations that don't show up on their balance sheets at all?

The members of the Basel Committee on Bank Supervision are well aware of that problem. They have tried to deal with it by defining capital more strictly than in the past, by using risk-weighting to require banks that hold low-quality assets to hold more capital, by issuing a separate set of regulations dealing with liquidity risk, and by paying more attention to off-balance sheet risks. Still, Basel III is, at its core, not that much different from a parental ice-cream-and-pizza list. The Basel III list is longer and more comprehensive, but we can be pretty sure that devious financial engineers will figure out new ways to subvert its intention.

Does that mean nothing can or should be done? Not really. Greenspan is far too complacent in assuring us that if bankers continue to operate at their preferred point of high risks and high returns, all will be well "with notably rare exceptions." Those rare exceptions are the tsunamis and meltdowns of the financial world that we should be most worried about. They are exactly what provide the motivation for financial reform in the first place.

It seems to me that the elements of financial reform that are most likely to work are those that eschew the ice-cream-and-pizza approach in favor of directly attacking the underlying causes of excessive risk taking: contagion, moral hazard, and agency problems. Dodd-Frank, Basel III, and financial reform measures in other countries do include some measures of this kind, although not enough. For example:

The Financial Stability Oversight Council set up by Dodd-Frank should help control contagion. Its job is to spot systemic risks before they build to the point where failure of one financial institution would trigger the failure of many.
The counter-cyclical capital buffer set up by Basel III could help overcome the problem that strict enforcement of high capital requirements during a financial downturn acts as a trigger for forced deleveraging, which then spreads financial stress from weaker to healthier institutions.
Dodd-Frank provides for a new resolution regime intended to allow orderly dissolution of large, complex, insolvent financial institutions. Orderly dissolution would help control contagion of the type that followed the failure of Lehman Brothers. It is also intended to mitigate the too-big-to-fail problem and to ensure that bondholders and other counterparties of failing institutions bear an appropriate share of losses. The new resolution mechanism is untested, but if it can be made to work, and if regulators and politicians have the courage to invoke it when needed, it could materially reduce moral hazard.
Agency problems could potentially be reduced through reform of compensation practices. Mechanisms like deferred compensation or clawback of previous bonuses could ensure that top managers and mid-level traders suffer personal consequences when their financial strategies produce short-term profits but longer-term losses for shareholders. Dodd-Frank includes only token steps to reform compensation practices, for example, nonbinding "say on pay" votes by shareholders and more transparency in golden parachutes. The UK and France have introduced more aggressive measures.

The bottom line? Financial reforms undertaken since 2008, including Dodd-Frank and Basel III, contain some promising elements and some that are likely to disappoint. How well they will work depends to a large extent on how well they are implemented. And that is where we come to the darkest cloud on the horizon right now, which lies not in the unintended consequences of reform, but in the unintended consequences of the backlash against it.

The worst of all possible worlds would be to enact complex new regulations and then starve regulators of the funds they need to work out key operational details or provide consistent enforcement. Doing so would impose heavy compliance burdens on financial institutions and subject them to great legal uncertainties, while doing little to reduce systemic risk. Unfortunately, the current efforts by some in Congress to starve the Securities and Exchange Commission, the new Consumer Financial Protection Bureau, and other regulators of the funds and leadership they need to do their jobs may lead to just such an outcome.

Follow this link to view or download an updated slideshow discussing Dodd-Frank, Basel III, and other elements of financial reform.

Econ 101, Hayek, and Why We Are Losing the War against Drugs

2011-03-30T23:01:00.000-07:00

Last week The New York Times reported that the drug cartels, after shaking the political and economic structures of Colombia and Mexico to their foundations, are moving into Central America. Just one more sign, as if we needed it, that the United States is losing its endless war on drugs.

No one who has ever taken Econ 101, or read the works of Friedrich Hayek, should be the least bit surprised. The drug cartels are strong because the US strategy in the drug wars makes them strong. Here's why.

First, what we learn from Econ 101. The key concept is price elasticity of demand—the percentage change in quantity demanded associated with a one percent increase in the price of a product. If a one percent price increase reduces the quantity people buy by more than one percent, demand is said to be elastic. If the quantity sold falls less than one percent, demand is said to be inelastic. Elasticity, in turn, determines what happens to the seller's total revenue when the price changes. If the percentage change in quantity is greater than the percentage change in price, demand is elastic, and revenue goes up when the price falls. (For example, suppose you can sell 100 widgets at $1 apiece and 120 when you cut the price to $.90. Your revenue goes up from $100 to $108.) If the percentage change in quantity is less than the percentage change in price, demand is inelastic, and revenue goes up when the price rises. (Suppose you can sell 100 gadgets at $1 and that you still sell 90 if you raise the price to $1.20. This time it is a price increase, not a decrease, that will increase your revenue.)

What is the elasticity of demand for illegal drugs? Intuition suggests that demand should be inelastic. If cocaine, heroin, and the rest are addictive, people who use them will not find it easy to kick the habit just because the price goes up a bit. Econometric studies of the question are hampered by the fact that drug lords don't post accurate price and revenue data on their web sites, but such research as has been done tends to confirm the hypothesis of inelastic demand. For example, one survey of the literature found that a 1% increase in the price of cocaine would tend to reduce consumption by only 0.51 to 0.73 percent, solidly in the inelastic range.

This gives us our first clue as to why the war on drugs isn't going so well. The main strategy is interdiction of supply. To the extent interdiction succeeds in reducing supply, it drives up the market price. With inelastic demand, a higher price means more revenue for the drug cartels.

Note that more revenue for the drug cartels does not necessarily mean more profit, because interdiction efforts also raise suppliers' expenses. However, from a public policy point of view, it is the expenses that do the damage, not the profits. If drug lords just earned profits, they would probably spend them harmlessly on fancy cars and villas. It is not so harmless to see their expenses rise. Those consist largely of salaries paid to thugs who guard shipments and shoot anyone in the way, bribes to officials on both sides of the border, and pay and equipment for more thugs who are assigned to inter-gang warfare, with innocent victims caught in the crossfire. With inelastic demand, a higher price for drugs means more revenue available to finance all of those things. To the extent that is the case, the interdiction strategy on which the war against drugs is based is self-defeating.

The inelastic-demand model of the war on drugs cannot be the whole story, however. In its simple form, it cannot explain the paradox that while drug violence is on the rise, the prices of cocaine and heroin have been falling steadily for decades. How can that be?

One possibility is that demand is elastic in the long run even though it is inelastic in the short run, a pattern that can be observed for other commodities, as well. It is a pattern that accords with the intuition that an addicted user will not forgo the drug even if the price goes up (inelastic short-run demand), but that cheap drugs might, over time, attract new users (elastic long-run demand). For example, one study found that between 1981 and 1995, the price of cocaine fell by a factor of 5 while the number of emergency room admissions mentioning cocaine increased by a factor of 15. (This interesting graph from the study shows the pattern holding for heroin as well as cocaine.)

Although long-run elastic demand could explain why drug cartel revenue has held up in the face of falling street prices, it cannot explain the price decrease itself. The price decrease suggests that some of the cartels' revenue has gone to investments in capital and technology, and that those investments, over time, have shifted the supply curve downward, more than offsetting the efforts of the drug wars to push it upward.

As one example of the willingness of the drug cartels to undertake investment and innovation, consider the development of drug-smuggling submarines. When satellite surveillance and more extensive patrolling raised the risk for surface boats, smugglers began building primitive semisubmersibles that evaded detection by riding just below the surface, but they were not a perfect solution. The next step is indicated by the recent discovery by the U.S. Drug Enforcement Administration, working together with Ecuadoran police, of a 100-foot fully submersible submarine. "The submarine’s nautical range, payload capacity and quantum leap in stealth have raised the stakes for the counterdrug forces and the national security community alike," commented the DEA's Jay Bergman.

The growing viciousness of the drug wars and their destabilizing impact both on the United States and its allies cannot be explained by economics alone, however. That is where some of Hayek's insights come into the picture. In one of his most important books, The Road to Serfdom, Hayek examines the internal dynamics of totalitarian movements. This passage from the chapter "Why the Worst Get On Top" applies to the case at hand with only minimal editing:

Yet while there is little that is likely to induce men who are good by our standards to aspire to leading positions in a [drug cartel], and much to deter them, there will be special opportunities for the ruthless and unscrupulous. There will be jobs to be done about the badness of which taken by themselves nobody has any doubt . . . and which have to be executed with the same expertness and efficiency as any others. And as there will be need for actions which are bad in themselves, and which all those still influenced by traditional morals will be reluctant to perform, the readiness to do bad things becomes a path to promotion and power.

The point of this is that drug cartels are like normal business in some ways, but not in all ways. If cocaine and heroin were legal products like tobacco and alcohol, their producers' revenue would still respond to changes in price as predicted by elasticity, and increases in revenue would still be devoted, in part, to innovation and capital investment aimed at expanding supply. But those businesses would not share the extreme badness of the drug cartels. It is not the nature of their products that makes drug gangsters so readily engage in murder, kidnapping, and other forms of mayhem. Rather, the conditions in which skill and enthusiasm in committing acts of violence become a path to promotion and power are created by the very fact that cocaine and heroin are prohibited substances, and those conditions are only intensified the more vigorously the prohibition is pursued.

What is the alternative? A strong case can be made for full legalization of cocaine and heroin, on a par with alcohol and tobacco. (For a sampler, see these items from the Drug Policy Alliance, the Economist, and the Guardian.) Another excellent source of material in favor of legalization is the web side of Law Enforcement Against Prohibition, where you can find the views of former undercover narcs, sheriffs, and judges, all intimately familiar with the unintended consequences of prohibition. Short of legalization, a demand-related approach that treated drug addiction as a public health problem, not a law-enforcement problem, would produce less violence abroad and fewer unintended consequences at home than present US policy. At any rate, that is the answer you come to if you look at the problem in terms of Econ 101 and Hayek.

Follow this link to view or download a short slideshow on the economics of the war on drugs.

Will Central Banks Accommodate the Oil Price Shock?

2011-03-24T19:16:00.000-07:00

Inflation rates are rising in the world's major economies. The consumer price index rose by half a percent in the United States in February, equivalent to an annual rate of 6.2 percent. Consumer prices rose at a 4.4 percent annual rate in the UK and a 2.4 percent rate in the euro area. All three central banks have explicit or implicit inflation targets of 2 percent or less.

In all three economies, rising oil prices accounted for a big part of the increase of inflation. That fact poses a dilemma for monetary policy. Should central banks tighten monetary policy to counteract the effects of oil price increases and prevent general inflation? Or should they instead accommodate oil price increases with easy monetary policy, in order to maintain growth of output and employment? Two problems make the choice a difficult one.

The first problem is that nothing central bankers can do will prevent an increase in world oil prices from harming an oil-importing economy. It must either be left with fewer other goods and services after paying for the oil it imports, or learn to live with less oil, or go deeper in debt, or do a little of each. Monetary policy, at best, can only determine what form the damage takes.

The second problem is that central banks have little direct control over the real economy, as manifested in variables like real GDP and employment. By and large, monetary policy can only control the growth of nominal GDP. If it applies its policy instruments correctly, a central bank could, for example, cause nominal GDP to grow at four percent per year rather than 0 percent per year. However, it cannot do much to determine whether that four percent nominal growth will consist of 4 percent greater output of real goods and services, without inflation; 4 percent inflation without growth of real output; or some combination of inflation and real output change that adds up to four percent.

Putting these two problems together leaves the central bank of an importing country with limited options when an oil price shock hits:

It can tighten policy to keep inflation from rising. Doing so will cause real GDP to decrease, or at least to lag behind the growth of potential real GDP. The resulting negative output gap will cause the unemployment rate to increase.
It can use expansionary monetary policy to try to offset the impact of oil prices on real output and employment. However, doing so will cause nominal GDP to grow faster. Given the negative impact of the oil shock on real GDP, inflation will accelerate.
It can compromise by doing nothing, that is, hold the rate of growth of nominal GDP to its previous path, despite the oil price shock. The result will be intermediate between Cases 1 and 2, that is, there will be some increase both in inflation and unemployment.

None of these options is completely satisfactory. None of them fully neutralizes the harm done by the oil price increase. The choice among them depends on the phase of the business cycle at the time oil prices spike, the preferences of the monetary authorities,the legal framework they work in, and the need to coordinate monetary policy with fiscal policy. Those factors play out somewhat differently for the central banks of the United States, the UK, and the EU, so we should expect different policy decisions.

The situation in the UK is shaped by the aggressive program of austerity being followed by the Conservative-Liberal Democrat coalition government that was elected last year. The program proposes reducing government spending by nearly a fifth and cutting half a million government jobs. Austerity is not limited to cuts in discretionary spending. There are cuts to entitlements, including a scheduled increase in the retirement age, cuts to a health-care system that is already relatively austere by European standards, decreases in defense spending, and tax increases.

A case can be made for the UK's austerity program, considering that the budget deficit in 2010 was among the largest of all developed economies. However, it came at a time when the British economy was just beginning to recover from recession. In the fourth quarter of 2010, real GDP actually decreased. That left monetary policy with the burden of preventing a full-blown double-dip recession. The Bank of England, which had already lowered its main policy interest rate to 0.5 percent, undertook further expansionary policy with a program of quantitative easing. The combination of low interest rates and QE was expected to restore real GDP growth in 2011, but only at 1.7 percent, not enough to keep up with the growth of potential GDP.

Given the circumstances, the Bank of England, so far, has opted for accommodation. Despite January and February inflation more than twice the bank's target rate of 2 percent, six of the nine members of its rate setting committee voted to keep rates low at their most recent meeting. To try aggressively to bring down inflation at this point would not only undermine already-weak economic growth, but would also risk failure for the fiscal austerity plan itself, which depends for its success on a growing tax base and a falling unemployment rate.

In the euro area, circumstances would also appear to favor accommodating the oil shock, or at least taking a neutral stance. Real output growth in the euro area, as in the UK, is expected to be weak this year, just 1.6 percent. Inflation in February was less than half a percent above the 2% target rate, a smaller overshoot than in the United States or the UK. The ECB's policy interest rate, unlike those in the UK and the United States, was never cut below 1 percent. Several euro area economies, notably Greece, Ireland, and Portugal, are in the midst of stringent fiscal austerity programs, which could be derailed by a tightening of monetary policy.

Nonetheless, it appears that the ECB will soon raise interest rates. One reason is the uneven pace of euro area growth. Although peripheral members of the euro are struggling, growth in the core economies of Germany and France is strong. More importantly, the ECB is more inflation averse than the Fed or the Bank of England. The treaty that brought the ECB into existence gives the central bank a strong mandate to focus single-mindedly on inflation. Willingness to take that mandate seriously has been a litmus test for appointments to its executive board.

As one token of its hard-line approach to inflation-fighting, the ECB focuses exclusively on headline inflation, which includes all goods and services. Other central banks pay more attention to core inflation, which excludes volatile food and energy prices, and is currently running well below headline inflation. As a result, the ECB's official inflation target of 2 percent, although nominally on a par with those of the United States and the UK, is effectively more stringent.

Also, the ECB appears to give more weight to the issue of credibility. It seems to fear that the slightest sign of weakness would call its inflation-fighting credentials into doubt. Policy makers at all three central banks would agree, in principle, that credibility is important. None of them want to see the emergence of long-term inflationary expectations on the part of firms and households. However, the Fed and the Bank of England are more willing to gamble on public understanding that any present departures from strict inflation targeting are driven by circumstances, and do not justify an increase in long-run inflation expectations. [Footnote: On April 7, the ECB raised its benchmark interest rate a quarter of a percentage point.]

Last, we come to the Fed. In some ways, the case for accommodation seems weaker in the United States than in the UK or the euro area. US GDP growth in the fourth quarter of 2010, at a revised 3.1%, was stronger than in the UK or the euro area, and forecasts for 2011 growth, running at 3% or better, are also higher. January and February inflation, as measured by the month-to-month increase in the headline CPI, was the most rapid of the three economies. The Fed's policy interest rate, set at a range of 0 to 0.25 percent, was the lowest of the three. Finally, as in England, the Fed had gone beyond low interest rates to engage in a vigorous program of quantitative easing.

What is more, the Fed, unlike the Bank of England, does not face the need to maintain easy monetary policy as an offset to tight fiscal policy. On the contrary, US fiscal policy, especially after December's new round of tax cuts, remains strongly expansionary. Neither the administration's budget, nor any actions taken to date by Congress, come close to dealing seriously with a budget deficit that continues at record levels.

Yet, despite these circumstances, the Fed seems least likely of any of the big three central banks to tighten its policy in response to rising oil prices. As in the case of the ECB, both legal and attitudinal factors come into play. Unlike the ECB, the Fed, by law, is tasked with balancing price stability against the need to fight unemployment, which remains very high. Also, the Fed, more than other central banks, focuses on core inflation, and on measures of expected inflation, neither of which is rising as rapidly than the headline CPI.

Unless some strong indications of higher inflation emerge, for example, a sharp increase in long-term interest rates, it seems almost certain that the Fed will keep interest rates low and carry its current program of quantitative easing through to its scheduled completion in June. At that point, if oil prices are still on an upward trajectory, if Congress has still done nothing about the deficit, and if there are signs that headline price increases are spilling through into core inflation and indicators of expectations, a turn to a less accommodative policy becomes likely.

Follow this link to view or download a short slideshow on accommodation of price shocks. The slideshow incorporates simple macroeconomic analysis.

Move Over Ethanol, Market Forces Favor CNG as a Gasoline Replacement

2011-03-16T23:10:00.000-07:00

Ethanol is finally getting the bad press (1) (2) it richly deserves. Cracks are even beginning to appear in its once-solid support on Capitol Hill. In April, the Senate Environment and Public Works Committee plans to hold hearings that are expected to skewer ethanol. The Committee is led by Democratic Chair Barbara Boxer and ranking Republican James Inhofe, both committed foes of burning food to run our cars.

However, whether or not Congress has the courage to cut ethanol subsidies, corn-based fuel faces a more fundamental challenge, this one from market forces. Although it has not been widely noticed, the one-two punch of the latest oil price spike and wider development of unconventional natural gas, including shales, tight sands, and coal-bed methane, have pushed the gap between the prices of oil and gas to a record high. Click through to this nice little graphic from The New York Times, and you will see that on an energy-equivalent basis, oil now costs four times more than gas. As recently as 2005, gas was actually the more expensive of the two fuels.

But run your car on natural gas? Isn't that one of those loony ideas from the inside back cover of Popular Science? No, not at all. Compressed natural gas (CNG) is a fully proven, off-the-shelf technology in wide use around the world. Perhaps only its very simplicity and low-tech reliability have kept it from catching the public imagination in the United States.

I first encountered CNG as an automotive fuel several years ago when I was teaching in Bulgaria. You may associate Bulgarian transportation technology with horse-drawn carts and Soviet-era sidecar motorcycles, but in fact, Bulgaria is way ahead of us when it comes to inexpensive, low-emission automotive fuel. My wife and I rented a car from a neighbor to make a weekend getaway to nearby Greece. Very ordinary on the outside and far from new, the car turned out to have two fuel tanks, one for CNG and one for gasoline. In Bulgaria, all the filling stations had CNG pumps, self-service just like those for gasoline, distinguished only by funny-shaped nozzles. CNG was less widely available in Greece, so before the weekend was over, we finally filled up the gasoline tank (at more than twice the price). After doing so, we threw a switch under the dashboard and kept right on driving without noticing the difference.

So why don't we use CNG in the United States? Well, some people do. Fleets of buses and delivery trucks, including many UPS vehicles, are some of the biggest users. Honda sells a CNG-powered version of the Civic, the Honda GX, in the United States. Many major manufacturers sell CNG cars elsewhere in the world. Presumably, they could enter the US market quickly if there were a demand. In addition, several small companies make kits that will convert a variety of gas and diesel cars and trucks to CNG or dual fuel use. NGV America, an umbrella organization for promoting natural gas vehicles, maintains a useful business directory for anyone wanting to jump on the bandwagon.

Of course, there must be a downside to CNG. Otherwise, with a potential fuel price advantage of 2:1 or better and cleaner operation, everyone would be using it.

Limited range is one disadvantage. CNG tanks are bulkier than gasoline tanks. The Honda GX has a range of about 200-250 miles, half that of the gasoline model, and the fuel tank takes up room in the trunk. Still, 200 miles is better than the range of all-electric vehicles like the Nissan Leaf.

Some consumers are also concerned about the safety of CNG, but the industry claims it is safer than gasoline. Gasoline, after all, is incredibly dangerous stuff. The only reason we are crazy enough to drive around every day with enough gasoline in our tanks to blow us to smithereens is that we are used to it. Anyone who is really safety conscious should stick to diesel.

Another barrier to wider use of CNG is a lack of filling stations. There are more than 1,000 CNG filling stations in the United States, but only about half of them are open to the public. There are clusters of public stations in California and New York, but elsewhere they can be few and far between. If you don't have a CNG station nearby, a company called FuelMaker sells a home fueling kit, which connects to the natural gas main in your home. However, unlike commercial filling stations, the home device takes several hours to fill your tank, and the device costs several thousand dollars to purchase and install. Of course, the scarcity of filling stations is much less of a problem for dual-fuel vehicles like the one I drove in Bulgaria. Unfortunately, although dual-fuel is a realistic option for converted vehicles, the Honda GX is CNG only. No one sells a road-ready dual-fuel vehicle in the United States.

Probably the biggest barrier to wider use of CNG in private cars is the high cost, up to $20,000 or more, of converting existing vehicles. At that rate, you might hope to pay off the conversion of a fuel-hungry pickup or SUV, if you drive a lot, but the cost can be prohibitive for a small passenger car.

It turns out that the high cost of conversion is one of the hottest controversies on CNG web sites and chat boards. Evidently, the biggest component of the cost of CNG conversion is compliance with strict EPA regulations and even stricter state regulations in California. Conversion kit makers must go through a complex certification process that costs $200,000 or more, and each certification applies only to a single engine type. Furthermore, you can't just buy a kit and install it yourself. Installers also have to be certified, adding another layer of cost. If you look around on the web, you can find a gray market in uncertified kits made elsewhere in the world. You can install one in your own driveway for as little as $1,000, but that is clearly a buyer-beware proposition. Considering how inherently clean CNG is, it is ironic that the EPA bans uncertified conversions on the grounds that they constitute tampering with an approved emission control system.

In the last Congress, Sen. Jim Inhofe and Rep. Dan Boren, both of Oklahoma, introduced legislation that would have promoted CNG use by streamlining the certification process. Unfortunately, despite
attracting several co-sponsors and the support of Senate Majority Leader Harry Reid, the legislation failed to make it through the Congressional gridlock. Meanwhile, those wanting to pay the high up-front price for an approved conversion can get part of the cost back through the same clean-energy tax credit used to promote electric vehicles. However, first making it unnecessarily costly to convert to CNG and then partially subsidizing those same high conversion costs hardly seems like a shining example of optimal public policy.

That brings us back to market forces. The price gap between CNG and gasoline is now higher than it has ever been. Although the gap will always vary a little, depending on geopolitics and on the number of gas and oil wells drilled each year, it seems likely that a substantial cost advantage for CNG is here to stay. Given that reality, rather waiting for top-down legislation to open the door for wider use of CNG on the highway, a bottom up scenario seems more plausible. Continued low CNG prices will help spread use of that fuel for fleet vehicles and, at the same time, should steadily increase the user base of converted private cars and trucks. It is a classic case where the long-run supply and demand elasticities are greater than short-run elasticities. CNG users, kit manufacturers, installers, and fuel sellers will gradually become stronger as a political force. As they do so, the legislative and regulatory climate for CNG should become more favorable.

After all, our government can't be that inept, can it? Surely, it cannot go on spending billions on fuel-of-the-future pipe dreams like hydrogen fuel cells and budget-busting ethanol subsidies when a cheap, clean, made-in-America alternative is available right off the shelf, right now. Please, tell me it can't.

Follow this link to view or download a brief slideshow on CNG vehicles.

What Can the US Learn from the French Health Care System?

2011-03-10T10:57:00.000-08:00

As reported in the first post in this series, the French health care system comes in at or near the top of international rankings, while the US system falls well down the lists. It stands to reason, then, that US health care reformers should have something to learn from the French experience, but just what? There seem to be lessons both for those who are optimistic about US health care reform and those who think reform will be difficult.

On the optimistic side, the French experience clearly shows it is possible to have universal access to health care of the highest quality while maintaining broad freedom of choice both for patients and doctors. French patients have the right to choose their own primary care doctors, and with only minimal restrictions, to see specialists of their choice. French doctors can choose whatever treatments they believe to be appropriate. That includes even use of cutting-edge treatments like the cancer drug Avastin. (Because that drug, which can cost up to $100,000 per year, does not cure cancer and appears to extend life by, at most, a few months, its use is restricted as not being cost-effective by many US private insurers and also by government health care systems in Canada and the UK.)

Freedom of choice is critical to the politics of health care reform in the United States. Opponents of reform love to play the "socialized medicine" card, which, in the minds of many people, means an impersonal, regimented, system where one stands in line at a government clinic for the first available doctor, who then prescribes a course of treatment according to strict regulatory guidelines. The French health care system is far from fitting that picture.

On the critical issue of costs, the lessons are more complex.

The good news is that their highly rated health care system costs the French 11.2 percent of GDP, compared with 16 percent in the United States, based on 2008 OECD data. In dollars per capita, the gap is even more dramatic. By that measure, the United States spends exactly twice as much on health care as France, with less to show for it.

There is reason to think that some of the cost-saving features of the French system could be incorporated in US reforms. Lower costs of administering the medical payment system are one example. France does not have a true single-payer system. Not-for-profit insurance funds closely supervised by the government pay most of the cost of care, but people also carry supplementary insurance, similar to Medigap plans, that cover deductibles and co-pays. Still, despite the involvement of multiple insurers, the French system spends less than half as much on administration and marketing than the 7% of health care costs reported for the United States.

Another area where the French save costs is through more aggressive government bargaining with hospitals, doctors, and pharmaceutical companies. The US government has done less in this area. For example, under Medicare Part D the government is explicitly prohibited from bargaining for lower drug costs.

Medical malpractice is a third area where would-be US cost cutters might learn from French experience. France uses an approach pioneered in Scandinavia, under which cases of alleged malpractice are decided by special review boards that operate outside the court system. This Scandinavian approach is sometimes compared to the US worker compensation system, in that it is less focused on finding fault than on providing compensation to patients who have been harmed by improper care. Payments are made from a national fund, freeing doctors from the burden of malpractice insurance. Costs of administering the malpractice system are lower than those of adversarial court proceedings, and the chances of freakish "jackpot" awards are lower than when juries are involved.

At the same time, other elements of the French cost control experience are are less encouraging for US reformers. One is the fact that despite all efforts, health care costs have been growing faster than GDP in France, as they have in the United States, and are increasingly a cause for concern. The Sarkozy government has made some efforts to tighten controls, but these have met with opposition. For example, a 2009 reform law that was supposed to strengthen the cost control authority of hospital administrators was perceived by doctors as a threat to their autonomy, and brought them out on the streets in protest.

A final factor that complicates any comparison between French and US health care costs is the fact that French physicians earn only about a third as much as their US counterparts. Although doctors in France are respected, well-compensated, professionals, a medical career there is by no means a guaranteed ticket into the top 5 percent of the income distribution, as it is in the United States. The gap in doctors' earnings makes a big difference for national health care costs. About 20 cents of every US health care dollar is paid to individual physicians and clinics, and that does not count staff doctors in hospitals, whose salaries are included in the 30 cents of the US health dollar that goes for hospital services.

One reason that French doctors can get by on lower earnings is that they do not have to pay for medical education. As a result, they do not begin their careers with tens of thousands of dollars in student debt. Another reason, mentioned earlier, is that they do not have to spend more tens of thousands on malpractice insurance. French doctors also seem to complain less about the burden of paperwork than do those in the United States, presumably because of a simpler system for health care payments. Still another reason for lower earnings is that the French government controls a bigger share of the total health care system, and uses that market share to drive a harder bargain on fees. Finally, we should keep in mind that GDP per capita is almost 20 percent less in France than in the United States, so on average, everyone there earns less.

Nonetheless, despite lower earnings, there is no indication that France suffers from a doctor shortage. According to OECD data, France has 30% more professionally active physicians per capita than the United States.

What should reformers make of the fact that French doctors produce such good results while earning less? It would be an oversimplification to draw the inference that across-the-board pay cuts should be a priority element of US health care reforms. Attempts to cut payments to doctors have not always worked well. Low reimbursements have been blamed for difficulties in finding doctors willing to take new Medicaid patients. Fears that the same could happen to Medicare has led Congress to overrides previously mandated cost-cutting formulas.

Instead, the earnings differential would seem to carry implications more like the following:

First, replication of the main elements of the French system in the United States could very well end up costing considerably more than in its home country. The difference in doctors' earnings alone would probably erase half of the cost differential that the French system currently enjoys.
Second, doctors' earnings cannot be considered in isolation. The combination of high prospective earnings, high student debt, and the US malpractice system create a risk-reward profile for a US medical career that is quite different from that in France. Over time, changes in policy could plausibly attract sufficient numbers of qualified people to the medical profession even if the package included a lower equilibrium level of earnings. But to say that is quite different than to say that doctors who are already practicing in the United States would or should accept immediate pay cuts.
Third, to some extent, the earnings differential between US and French doctors reflects decisions that shift costs from one government account to another without any real saving to the economy. Lower payments to doctors may be at least partly offset by higher government spending on education and costs of administering the malpractice compensation system.

So, what is the bottom line? What can reformers in the United States learn from the French health care system?

On the one hand, the French experience really does make it look like Americans are not getting their money's worth. It shows that the possibility of high quality combined with universal coverage is a reality, not a utopia. Furthermore, such a result can be achieved without sacrificing freedom of choice either for doctors or for patients. In fact, choices of doctors and treatments are in many case less restricted by the French public health care system than by private insurance companies in the United States.

On the other hand, the prospect of replicating the admirable performance of the French system in the United States and at the same time realizing a cost saving of something like 5 percent of GDP seems less realistic. For one thing, as discussed above, there are reasons to think that running the same kind of system in the United States would be inherently more costly than in France, not to mention the fact that costs are rising there, too.

What is more, the politics of cost control are daunting. During the debate over the 2009 US health care reforms a broad variety of cost-cutting proposals were raised, ranging from streamlining the administrative costs of payments and record keeping, to malpractice reform, to striking harder bargains with drug companies. One by one they were rejected or watered down to the point of tokenism. There is a reason that happens. Every dollar of national health care cost represents a dollar of income for someone. Insurers, drug companies, hospitals, medical associations, and other health care providers do not hesitate to deploy the full arsenal of political contributions and lobbyists to defend their interests.

If Americans want a better health care system—they should want one, and they deserve one—they will probably have to pay about as much for it as they pay for their current dysfunctional one, at least initially. Reform is going to require getting at least large parts of the medical-industrial complex on board, and taking a way a big chunk of their revenues is not a good way to start.

As a quid pro quo, however, insurers, drug companies, hospitals, doctors and all the rest will have to accept measures to restrain costs in the future. That includes moving, over time, to a regime in which doctors can expect lower earnings in return for relief from the financial burdens of malpractice insurance, medical school costs and excess paperwork. As part of the same deal, pharma companies should expect harder bargaining from the government, insurance companies should accept measures to cut administrative and marketing costs, and so on. In many ways, those are bargains the French government seems already to have struck.

Follow this link to view or download a short slideshow comparing the French and US health care systems. Thanks to Charlie Janeway for comments on an earlier draft.

How a Price-Smoothing Oil Tax Could Help Make This the Last Oil Price Shock

2011-03-01T22:08:00.000-08:00

It must be Groundhog Day. Events in Libya have pushed world oil prices over $100 a barrel yet again. Retail gasoline prices, usually low this time of year, are at an all-time seasonal high. Are we in for another round of the same-old, same-old? A replay of Jimmy Carter pledging, "Never Again!" and then doing nothing? Or is there some way we can make this the very last oil price shock?

Producing countries have already figured out how to cope with the curse of oil price volatility. Over the years, producing countries, from Norway to Saudi Arabia to Russia, have established national wealth funds that build up when prices are high and run down when prices fall. Meanwhile, consuming countries have done next to nothing.

The US Strategic Petroleum Reserve, designed to offer short-term protection against physical interruptions of supply, is not intended to serve the purpose of price stabilization, nor would it be capable of doing so. But there is a way. Now would be an ideal time to revive an old idea, a variable oil tax that would reduce price volatility and, at the same time, offset the national security and environmental harms of oil dependency.

A variable, price-smoothing oil tax would work like this. Congress would establish a floor oil price of X dollars per barrel. Whenever the world market price P fell below X, an oil tax T would come into effect to fill the gap: T=X-P. Whenever the price rose above the floor, the tax would be zero. Nothing could be simpler.

Why would it be a good idea? There are two parts to the answer, one making the case for an oil tax in general, and the second explaining why a variable tax would be better than one with a fixed rate.

The main argument for a tax of any kind is that oil consumption has adverse spill-over effects on third parties—effects that are not taken into account when bargaining between producers and consumers sets the price. Economists call those spillover effects externalities. The two most commonly cited externalities of oil consumption are effects on national security and effects on the environment. Imposing a tax on oil would be one way to mitigate them.

Consumption of oil has a negative impact on national security because so much of the world's oil comes from countries that are corrupt, authoritarian, anti-American, or all of the above. Any increase in US oil consumption pushes up the world price and enriches bad guys in exporting countries. Any reduction in oil consumption undercuts them. An oil tax would insert a wedge between the price paid by US consumers and the price received by foreign producers. To the extent it raised the US price at the pump, it would encourage conservation and investment in alternative energy. To the extent that it lowered the world market price,the tax would take money from the pockets of the bad guys.

An oil tax would be much more effective than the current US oil security strategy, which consists of buying as much as possible from friendly, nearby countries like Canada and Mexico. That strategy does provide some limited protection against a revolution or embargo that might cause a physical interruption of supply, but it does nothing to mitigate negative national security spillovers that operate through prices. The world oil market operates as one big pool. If something sends the price up, as is happening right now, it goes up for everyone. Canada and Mexico are our friends, to be sure, but they are not so friendly as to sell us their oil below its market price. If excess US consumption drives the world oil price higher, it drives it higher for bad-guy producers, too, even those from whom we do not directly buy any oil.

As for environmental externalities of oil consumption, they have been so widely discussed that there is little to add. In recent years, much of the discussion has focused on climate change from oil-related CO2 emissions. But even if you are a climate-change skeptic, don't forget there are other environmental effects, too. Low oil prices and high consumption mean more local smog and more traffic congestion, regardless of any effects on polar bear habitat. To the extent an oil tax cuts consumption, it improves the environment across several fronts.

Of course, national security and environmental objectives would also be served by a conventional, fixed-rate tax. Why would a variable tax would be better?

One reason is that a variable tax would provide an anchor for expectations about oil prices. During episodes of high prices, investments in conservation and alternative energy production become more attractive, but there is also a risk. If oil prices crater again, those investments will not pay off. Knowing that oil prices would not be allowed to drop below a stated floor would make it less risky for consumers to buy energy-efficient cars and entrepreneurs to build plants to produce biodiesel from pond scum. Greater investments in conservation and alternative energy, in turn, would help moderate the next upward movement of oil prices.

Second, a variable oil tax would help mitigate the impact of oil price spikes on the business cycle. James Hamilton has written extensively on that subject. (See here, here, and here.) He points out that most recent oil price spikes, including that of 2008, have been followed by US recessions, and argues that the depth of those recessions has been greater than would be predicted by the effects of higher oil prices acting alone. One reason seems to be that retail gasoline prices have such a high visibility that price spikes disproportionately undermine consumer confidence. Another is that oil price spikes disrupt the automobile market. They not only harm new cars in general, but also shift the mix from large to small cars. Widespread layoffs have followed at US auto companies, which have traditionally specialized in SUVs and light trucks. Finally, says Hamilton, it appears that high oil prices in 2008 exacerbated other factors that were undermining the housing market. As evidence, he cites the fact that the prices of homes in locations that required long commutes fell by more than those with short commutes.

A third advantage of a variable oil tax compared to a fixed one would be political, especially if it were introduced at a time when oil prices were already above the chosen floor. Right now, for example, a tax with a price floor of, say, $85 per barrel would produce no immediate pain at the pump, but the knowledge that prices would never again fall below $85 would encourage long-term investments in conservation and alternative energy. Introducing a variable oil tax at a time when prices were already high could make an actual virtue of the often-lamented tendency of politicians to operate on a much shorter time horizon than business investors.

The idea of a variable, price-smoothing oil tax is not going to appeal to everyone. Let me close with two preemptive comments addressed to the most likely critics.

First, to those for whom all taxes are bad: Fine, for the sake of discussion, let's stipulate that all taxes are bad. Still, some taxes are worse than others. The worst taxes are those that discourage businesses from investing in the future while encouraging activities with negative spillovers on third parties. The least bad taxes are those that encourage sensible investment and discourage negative spillovers. Given the current state of the budget, even the most fanatical fiscal hawks concede that we need a federal revenue base of 19 or 20 percent of GDP to have any hope at all of averting fiscal catastrophe. So, if we need more than zero tax revenue, wouldn't it be better to replace really bad taxes, like our loophole-ridden corporate income tax, with less-bad taxes, like a variable oil tax?

Second, to the affordable energy crowd: I've said it before and I'll say it again, if there is one thing we can't afford, it's affordable energy. "Affordable energy" is really a code-word for holding the price of energy below its true cost to the economy. If we don't pay for oil at the pump, we pay for it through the back door, in the form of distorted investment decisions, pollution, and reduced national security. Artificially low energy prices make our economy weaker, not stronger. There Ain't No Such Thing as a Free Lunch. Never was, never will be.

Follow this link to view or download a brief slideshow about the variable, price-smoothing oil tax. Thanks to Henry Lee for comments on a draft of this post.

What Can the US Learn from Other Countries' Health Care Systems?

2011-02-27T21:41:00.000-08:00

Even after the Patient Protection and Affordable Care Act (PPACA) of 2010, and in part, because of it, health care remains a major issue of public policy in the United States. It is central to ideologically charged discussions of fairness, the role of government, and even the budget, since the cost of health care is the single largest driver of the federal deficit. In confronting this complex and sensitive issue, it seems only reasonable that we ask what we can learn from the experience of other countries. As the first in an occasional series, this post will look at broad international comparisons of health care systems. Subsequent posts will examine what can be learned from individual countries.

To some on the right, the answer to what can be learned from other countries' health care experience is simple: Nothing! In a recent survey by the Harvard School of Public Health, 68 percent of respondents who identified themselves as Republicans maintained that the United States already has the best health care system in the world. (So did 32 percent of Democrats). There is a widespread view among conservatives that foreign health care systems are socialized medicine. Socialized medicine is bad. Don't go there. Keep the American way.

To some on the left, the answer is equally simple: Providing universal health care is just a matter of political will. Once the commitment is made to treat access to health care as a basic human right, everything else, including better health outcomes at a lower total cost, follows automatically.

Sorry, folks, those easy answers are wrong.

To those on the right: Socialized medicine vs. the American way is catchy political rhetoric, but it has little descriptive value. The role of government varies widely among countries that offer universal health care—so widely that it is meaningless to lump them all together as "socialized medicine." In some countries the government pays the bills, in others, private insurers, and in still others, as in the United States, there is some of each. The same variety is found in other areas of government involvement, including pricing, choice of physicians, choice of treatments, and choice of drugs. What is more, even before passage of the PPACA, US government spending on health care, as a percentage of GDP, was already greater than total expenditure, public and private, in many countries with universal coverage.

To those on the left: Many countries do combine wider access to care with lower total costs and better outcomes, but none of those systems satisfies everyone. All countries face pressures from rising costs. All systems face tough decisions regarding treatments that are costly, but produce small or unproven benefits. All systems struggle with potential conflicts of economic interest between providers and patients. Furthermore, each society poses unique health care challenges. It is unlikely that any other country's health care system, if transplanted intact to the United States, would replicate the results in its home country.

So, does the United States have the best health care system in the world, or not?

There are certainly some good things to point to. The United States does have some of the best medical technology, best medical research, and best-trained doctors in the world. Most Americans, even those critical of the health care system as a whole, report that they are satisfied with the care they personally receive. Yet international comparisons consistently give the US system poor marks overall.

Perhaps the most widely cited study is one put out by the World Health Organization in 2000. Its headline rankings placed the United States 37th in terms of overall performance among 190 countries surveyed, just behind Costa Rica and just ahead of Slovenia and Cuba. France was first and Myanmar last.

To be sure, the WHO ranking has its critics. It is based on a weighted average that combines measures of population health, distribution of health care services, fairness of the financial burden of providing them, and efficiency. The resulting index is subject to several paradoxes: Because of its emphasis on equality, a country with uniformly bad health care could rise in rank relative to one with good health care for the poor and excellent care for the rich. Because it gives a substantial weight to efficiency, a country with excellent care obtained at great expense could rank lower than one with mediocre outcomes attained very cheaply. A country with good health habits in areas like diet and tobacco use could be ranked more highly than one with worse habits, but better treatment for the resulting medical conditions. A 2008 study from the Cato Institute provides a detailed discussion of these and other problems of the WHO rankings.

Although the WHO survey has its methodological problems, many people would still agree, in principle, that a health care system can't be called the best unless it provides good care to all at a reasonable cost. Others, though, would prefer a less subjective measure that focuses on the effectiveness of care. That is the approach taken in a study by Ellen Nolte and C. Martin McKee, both of the London School of Hygiene and Tropical Medicine. Nolte and McKee focus on amenable mortality, that is, deaths among people under 75 that could be prevented by timely and effective medical treatment, for example, deaths from infections, treatable cancers, diabetes, and heart disease. Their study covers the United States, fourteen European countries, Canada, Australia, New Zealand and Japan. Data for 1997-98 and 2002-03 were compared to capture rates of improvement as well as levels of mortality.

Nolte and McKee's findings, shown in the following chart, do not support the claim that the United States has the world's best health care system. In 1997-98, the United States ranked 14 out of the 19 countries surveyed. Over the next five years, all countries improved their amenable mortality rates. For the most part, countries that had performed poorly in the earlier ranking made the largest gains. The United States was the exception. Although its performance was well below average to start with, its improvement over the next five years was the smallest of any country. As a result, its ranking fell to dead last by 2002-03.

Let's turn now to the issue of cost. While the WHO rankings can be criticized for paying too much attention to cost, the amenable mortality approach can be criticized for paying too little. It could well be that some countries have worse health care outcomes because their spending priorities lie elsewhere. For example, the United States has poor passenger rail service and lots of risky dams, but that is mainly because we have decided not to spend much in those areas.

Unfortunately, the same is not true of health care. The US health care system performs poorly not because we spend too little on it, but despite the fact that we spend more on it than anyone else. The next chart shows some data. France, which scored first in both the WHO rankings and the amenable mortality study, spends only two-thirds as much as the United States. Japan, second in the amenable mortality ranking, and Italy, second in the WHO ranking, spend barely more than half as much.

The fact that so much is spent without achieving better results suggests to some that the US health care system is uniquely inefficient. A paper by economists Alan Garber and Jonathan Skinner points to two possible kinds of inefficiency that could explain the results. One is productive inefficiency, which would occur if more capital and labor were required to provide a given service, say implanting a stent or administering a course of antibiotics. The other is allocative efficiency, which would occur if each given medical procedure were efficiently produced, but too much was spent on procedures that provided little benefit compared with their cost.

Comparing the US system to those of other countries, Garber and Skinner's study finds some evidence for both kinds of inefficiency. Higher administrative costs than in other countries suggests productive inefficiency. A tendency toward rapid adoption of expensive new therapies in advance of evidence that they produce significantly improved outcomes suggests allocative inefficiency. Their study also suggests that even when health care resources are used efficiently, their relative prices in the United States are higher than elsewhere.

What, then, is the bottom line? What can we take away from broad, multinational comparisions of the US health care system with those of other countries?

First, we learn that there really is a problem. True, the question, "Whose health care system is best?" is not sharply defined. By playing around with the weights given to coverage, efficiency, medical effectiveness, and fairness, we can get widely different rankings. However, no matter how deftly the data is massaged, it is hard to find empirical support for the claim that the United States has the world's best health care system. That means there must be something we can learn by studying the experience of others.

Second, although broad, multinational comparisions confirm that there is a problem, they suggest few specific solutions. They reveal no magic bullet, no single factor that determines whether a country's health care system works well or poorly. Making the US health care system work better will require multiple, well-coordinated reforms across a broad front, including many areas that the PPACA does not even attempt to come to grips with. Future posts in this series will examine specific strengths and weaknesses of other health care systems with an eye to generating recommendations for improving our own.

Follow this link to view or download a brief slideshow with additional data on international health-care comparisons.

How Chronic Budget Optimism Helped Dig The Hole We Are In

2011-02-18T07:55:00.000-08:00

The budget for fiscal year 2012, just published by the White House, presents an optimistic prognosis for US fiscal health. Like all budgets, it looks ahead not just one, but several years. The budget deficit, expected to be 10.9 percent of GDP in 2011, is projected to fall to 7 percent in FY 2012 itself (October 2011 through September 2012), then to 4.6 percent in 2013 and 3.6 percent in 2014. By 2018, the budget is supposed to show a small primary surplus (surplus before interest expense), something essential if the debt-to-GDP ratio is to be stabilized.

Some of the deficit decrease is to come from spending cuts and measures to enhance revenues, but most of it comes from assumed improvements in the economy. Real GDP growth, which is expected to be 2.6 percent this year, is assumed to rise to 3.6 in FY2012, and then to 4.4, and 4.3 percent in the next two. At the same time, according to assumptions, the unemployment rate is supposed to fall steadily from 9.6 percent in 2011, to 8.6, 7.5, and 6.6 percent for 2012 through 2014. The numbers are not brilliant, but compared to the recent past, they don't look bad.

However, if the assumed improvements in the economy don't materialize, neither will the deficit reductions. Overly optimistic assumptions for future years may bring short-term political gains at the moment the budget message is delivered, but they spell long-term trouble. They give Congress an excuse for tax cuts and spending increases the country can't really afford, and they give the White House an excuse for signing off on them. Unfortunately, the experience of the recent past suggests that the Office of Management and Budget (OMB) has had a tendency to look at the world through rose-colored glasses.

That tendency toward chronic budget optimism is well documented in the OMB's own data base, which lets us compare the assumptions on which past budgets were based with the actual performance of the economy. Here is what we find if we compare actual data for 2003 through 2010 with budget assumptions:

The following chart shows that during 2003 through 2010, the OMB assumed economic growth in the budget year itself (labeled Year B in the chart) would be an average of 1.6 percentage points higher than it actually turned out to be. There were no cases in which budget-year growth was underestimated. The same is true for the year following the year being budgeted (Year B+1). For the second year after the one being budgeted (Year B+2), the upward bias of the growth estimate was 1.8 points, even when the one year that was underestimated is averaged in.

Take 2003 as an example. The budget proposal for FY 2003 was delivered in January 2002. That proposal assumed real GDP growth of 3.8 percent, but actual growth turned out to be only 2.5 percent. The error, +1.3 percentage points, is shown by the bar B for 2003. The previous year's budget had estimated 2003 growth at 3.2 percent, for an error of +0.7 points, shown by the bar B+1 for 2003, and so on.

A similar pattern of bias can be traced for the OMB's assumptions regarding unemployment, shown in the next chart. The unemployment rate for each current budget year (B) was underestimated by an average of 0.9 percentage points. For the year following the budget (B+1), the average underestimate was 1.4 points, and for the year after that (B+2) 1.5 points.

No one could expect the OMB's budget forecasts to be accurate every year. Economic forecasting is an inexact art. What we could hope for, though, would be unbiased forecasts that would miss on one side as often as the other, unlike those of the OMB. The chronic bias toward optimism in the budget assumptions for the years covered in the charts clearly contributed to the budget mess the United States finds itself in today. If more cautious economic assumptions had been used, the tax cuts and unfunded spending increases in those budgets would have been harder to justify, and the national debt might well now be considerably lower.

What about the budget assumptions used by the Obama administration? Are they subject to the same optimistic bias as those of the Bush years? The simple answer is that we don't know yet. The first full fiscal year budgeted by the current administration was 2010, so the above charts each contain only one observation—the "B" observation for 2010—that compares assumptions with outcomes for the Obama OMB.

In preparing the FY 2010 budget, which was published soon after the 2009 inauguration, the Obama OMB overestimated 2010 GDP growth by 0.1 percentage point more than the Bush OMB had done in the previous two budgets, but the error was small in all cases. The Obama OMB assumed 2010 unemployment of 7.9 percent, a large underestimate compared with the actual 9.7 percent, but the Bush OMB had made even larger underestimates for 2010 in the preceding two budgets.

Although we can't yet compare actual with assumed values for FY 2012, the economic assumptions in the just-published budget may once again turn out to be overoptimistic. In a refreshing change from usual practice, however, this White House freely admits that its just-released budget proposal is not sufficient to put the nation on the path to fiscal health. "To get where we need to go, we're going to have to do more," the President said in a February 15th press conference.

He went on to address the concerns of those who were disappointed that the FY 2012 budget incorporates so few of the proposals contained in last year's bipartisan fiscal policy commission. Asked why the commission's report had been shelved, Obama denied that it had been. Despite his disagreements with some specific proposals, he insisted that it still provided a framework for discussion. Why are things taking so long? He compared those who are unhappy with the fact that the deficit has not yet been eliminated to those who were impatient that it took three whole weeks for demonstrators to oust Egyptian president Hosni Mubarak, after three decades in power.

"My goal here," the President said, "is to actually solve the problem. It’s not to get a good headline on the first day. My goal is, is that a year from now or two years from now, people look back and say, you know what, we actually started making progress on this issue."

Let's hope that, working with Congress, he can realize that goal.

Follow this link to view or download a short slideshow on the FY 2012 budget and past budget optimism.

A Policy Dilemma: Budget Deficit vs. Infrastructure Deficit

2011-02-13T22:04:00.000-08:00

As the federal budget season moves into full swing, infrastructure is not only on the table, but in the center of the table. The Obama administration budget, which would cut some areas of spending and freeze others, calls for more infrastructure spending, including high-speed rail, wireless Internet, and modernization of the electric grid. Across the aisle, House Republican leaders, vowing to "leave no stone unturned and allowing no agency or program to be held sacred," envision infrastructure cuts, including Amtrak, EPA grants for municipal clean water, and other programs. Some Republicans want to outdo the leadership and cap federal spending at 20 percent of GDP, something that would require even more drastic infrastructure cuts.

Who is right? Is infrastructure spending an essential investment in our future or a morass of waste and boondoggles? Where can we safely prune the infrastructure budget, and where can we not?

A good place to start is to ask why we are concerned with the budget deficit in the first place. The cliché is that we do not want to be the first generation to leave our children a national balance sheet with a thinner margin between assets and liabilities than we inherited from our parents.
The trouble is, the federal budget deficit is not the only thing that shapes the national balance sheet. There is also an infrastructure deficit--the difference between what the country invests each year in new bridges, sewers, and power lines and the rate at which the old ones fall apart. If investment in infrastructure exceeds depreciation, the country is that much richer at the end of the year. If depreciation exceeds investment, it is poorer, as surely as if the Treasury sells bonds and uses the proceeds for the most shortsighted spending programs you can think of.

If you have any doubt that the infrastructure deficit is real, try taking a look at the Report Card for America's Infrastructure published periodically by the American Society of Civil Engineers (ASCE). The Report Card assigns grades of "A" through "F" to various infrastructure categories. In the latest report, no area rates higher than a "C+." Roads, aviation, and transit system all declined in score from the previous report, which was issued in 2005. Dams, schools, drinking water, and wastewater stagnated at grades of D or lower. Just one category, energy, improved, from a D to a D+.

Consider dams, for example. There are more than 85,000 dams in the United States with an average age over 50 years. Some 4,000 dams are rated as deficient, including 1,819 high hazard dams. As the following chart shows, for every deficient high hazard potential dam repaired in recent years, two more were declared deficient.

The same story repeats itself in one category of infrastructure after another. The Report Card estimates 5-year infrastructure spending needs at $2.2 trillion. Actual spending is expected to be less than half of that. The 2009 fiscal stimulus package, the American Recovery and Reinvestment Act (ARRA), included $72 billion for infrastructure upgrades, but that was enough to cover only six percent of the 5-year infrastructure deficit estimated by the ASCE.

These realities suggest why we have to be very careful when cutting infrastructure spending. Cuts to essential repairs and upgrades will decrease the federal budget deficit only at the cost of increasing the infrastructure deficit. The trade-off is especially unfavorable when deferred maintenance leads to costly catastrophic failures. And realistically, just eliminating the infrastructure deficit isn't enough. Future economic growth will require an infrastructure surplus, so that wireless communication networks and renewable energy grids can be built at the same time needed repairs are made to aging sewers and bridges.

Still, although cut, cut, cut is not the right approach to infrastructure, spend, spend, spend isn't the answer, either. The problem is, not all infrastructure projects are created equal. Spending on roads, sewers, and parks has a reputation for pork-barreling and corruption that is all too often deserved. If your community is anything like mine, you probably can't drive to the store without "benefiting" from some infrastructure project that has no visible purpose other than generating revenue for some politically connected contractor. Is there any way to separate the wheat from the chaff?

Another useful infrastructure report, this one from the Bipartisan Policy Center, tries to address that question. Although it focuses specifically on transportation infrastructure, it makes some common sense recommendations that are more widely applicable.

Beware of putting new, borrowed money into existing distribution channels. Those channels tend to share out funds on political grounds rather than zeroing in on the most productive projects. It would be better not to spend at all than to spend without rational prioritization.
At this stage of the recovery, the highest priority should go to projects that are both shovel-ready and consistent with long-term productivity standards. That is not an argument against budgeting funds now for planning and design of long-term projects like high-speed rail, in order to move them along to the shovel-ready stage. But funds for such projects will never become available if debt is piled on now to fund unproductive, short-term make-work projects.
Be skeptical of the "jobs multiplier" rationale for infrastructure projects. Focus on the outputs from infrastructure spending, not the inputs.

Unfortunately, these principles are easier to state than they are to implement. At present, the government's budget process seems to be moving away from them, not toward them. Since the onset of the global economic crisis, far too much infrastructure money has been spent on an ad-hoc basis, with specific projects thrown in as "sweeteners" to get bills like TARP and the ARRA through Congress or added as earmarks to unrelated legislation. Congress seems completely to have abandoned the kind of orderly budgeting-authorization-appropriation process that is supposed to allow considered evaluation of individual spending proposals. Instead, we get omnibus spending bills and across-the-board freezes that spend and cut without any sense of priorities.

In short, dams and electric grids are not the only things in need of essential upgrades. President Obama is right that "we can't expect tomorrow's economy to take root using yesterday's infrastructure," and that goes for the infrastructure of budget policy rules, too.

Follow this link to view or download a short slideshow on infrastructure spending.

The Case Against the Mortgage Interest Deduction

2011-02-06T21:51:00.000-08:00

As the US economy struggles to recover from recession and cope with a budget crisis, all past policies must be put on the table for review and revision. Even the sacred cows. Even the mortgage interest deduction.

A new report from the OECD, which deserves more attention than it has been getting, explains the role badly-designed housing policies played in triggering the recent economic crisis. As the report shows, housing policy varies greatly among developed economies. There are some areas where the United States scores well. For example, it has a relatively liberal regime of building and land use permits. As a result, the supply of housing responds more to rising prices than in other OECD countries. Also, with the exception of some urban areas like New York and San Francisco, the US rental housing market has a healthier balance between the rights of landlords and tenants. However, in the area of tax treatment of owner-occupied housing, the United States comes off poorly.

From an economic perspective, the goal should be equal tax treatment of housing and other forms of investment. Unequal tax treatment of housing encourages speculative behavior, increases price volatility, and crowds out more productive forms of investment, all to the detriment of growth and macroeconomic stability.

In principle, there would be two ways to level the playing field. One would be to tax the imputed rental value of owner-occupied housing (that is, the rent it would bring if put on the market), while allowing interest costs to be deducted as an expense, just as interest is deductible and rental income taxable for owners of rental housing. The alternative would be to tax mortgage interest but leave the imputed rental value of owner-occupied housing untaxed.

On purely theoretical grounds, the better approach would be that of taxing imputed rents while allowing deductions for interest and depreciation. However, this approach is hard to implement and has rarely been used. A survey of international housing tax policy notes that Sweden taxed imputed rents until 1991 and the UK until 1963, but that both countries have since abandoned the system. Italy still taxes imputed rents, but the marginal rate is lower than for other forms of income, and the tax basis is thought to understate actual rental values. Many countries, including the United States, have property taxes that vary according to value, but these are considered to be imperfect substitutes for taxes on imputed rents. Among other reasons, they are believed to seriously understate both the market value and imputed rents of housing.

The alternative would be to forgo both taxation of imputed rents and deductibility of mortgage interest. Several countries take that approach, including Australia, Canada, Germany, and Japan. Such a system does not level the playing field as well as a fully implemented system of taxing imputed rents, but is far more practical from an administrative point of view.

Other tax policies can also affect the relative attractiveness of housing investment, including tax treatment of capital gains on housing and deductibility of local property taxes against national income taxes. One way to capture the total impact of the tax system on returns to housing investment is to look at the gap between market interest rates and the after-tax debt financing costs for housing. The greater the gap, the greater the pro-housing bias of the tax system. The following chart from the OECD report shows that the gap for the United States, while not the largest of all member countries, is considerable.

Aside from its effects on growth and economic stability, the mortgage interest deduction is open to criticism on distributional grounds. For reasons detailed in a recent study from the Urban Institute-Brookings Tax Policy Center, the great bulk of the benefits go to higher-income households. First, because it is a tax deduction, not a tax credit, mortgage interest relief benefits only those who itemize deductions on their personal income tax returns. Some 98 percent of tax units with incomes over $125,000 itemize, compared with just 23 percent with incomes of $40,000 or less.Second, because there is no cap on the deduction, owners of more expensive homes gain more than those with more modest homes. Third, a dollar of tax deduction is worth more to households in higher tax brackets than to those in lower tax brackets.

The Tax Policy Center study concludes that the mortgage interest deduction is worth $5,393 a year for tax units in the top 1 percent of the income distribution (average income $1,302,188) but only $215 per year to those in the middle 20 percent (average income $43,678). For households in the bottom 20 percent of the income distribution, the deduction has almost no value.

The final element of the case against the mortgage interest deduction is the potential contribution its elimination would make to resolving the US budget crisis. As I have argued in a previous post, tax reform that lowers marginal rates while broadening the tax base is by far the most growth-friendly path to fiscal consolidation. The Tax Policy Center study estimates that elimination would increase federal revenues by $108 billion in 2012, rising to $162 billion in 2019. Taking into account the likelihood that people would sell interest-earning assets to pay down mortgages would reduce the revenue figures slightly, to $91 billion in 2012 and 138 in 2019. By comparison, it would take a 15% across-the-board cut in non-defense discretionary spending to achieve the same deficit reduction.

On the other side, the principal argument in favor of the mortgage interest deduction is the claim that home ownership would otherwise be unaffordable for a large segment of the population. For two reasons, that argument does not hold water.

First, as explained above, the mortgage interest deduction has little value for lower- and middle-income families, those most likely to be on the borderline between rental and ownership. A subsidy worth $215 a year is not going to move many $40,000 families out of rental housing into a home of their own. Neither would a tax increase of $5,000 a year be likely to induce many millionaires to move out of their own homes into rentals.

Second, the impact on the affordability of housing is reduced to the extent that the interest deduction is capitalized into the market value of homes. Greater tax benefits cause buyers to bid up home prices. Conversely, elimination of those benefits would make home ownership less attractive, so home prices would fall. Capitalization of tax benefits does not fully offset the impact on home ownership because higher prices also encourage construction of new homes, but the effect is substantial.

The above discussion is framed in the context of immediate and full repeal of the mortgage interest deduction. Some would argue that such a cold-turkey approach is politically infeasible and would be too disruptive to the housing industry and family finance. For those who prefer a more gradual approach, at the cost of a more modest contribution to fiscal consolidation, there are many well-developed proposals for partial or phased repeal. One idea would be to switch from a deduction to a tax credit, which would be worth more to low-income families. At the same time, the value of the deduction to upper-income families could be capped in one way or another. Either of the above ideas could be phased in gradually over time, and structured to make a larger or smaller contribution to deficit reduction.

Will any of it happen? Some people think not. There is a widespread, although poorly substantiated, belief that home ownership makes people better citizens. (Skeptics think it is just as likely that the causation runs the other way, with responsible, hard-working citizens being more likely to own homes.) There is a more strongly substantiated tendency for wealthy individuals, who receive the bulk of the benefits of the interest deduction, to exercise disproportionate political influence through higher voting rates and bigger campaign contributions. For both reasons, the mortgage interest deduction is truly a sacred cow of American politics. It is a cow that should be led to slaughter.

Follow this link to download a brief slideshow with additional charts and data concerning the mortgage interest deduction.

Could an Obscure Loophole Send the Euro the Way of the Ruble?

2011-01-31T21:20:00.000-08:00

Could an obscure loophole known as emergency liquidity assistance (ELA) lead to the collapse of the euro area, much as the post-Soviet ruble area collapsed in 1991-1993? Some people seem to think so. The Irish Independent says that use of ELA by the Irish central bank amounts to "printing its own money." Tracy Alloway, writing on ft.com/alphaville, emphasizes the secret, hush-hush nature of ELA operations. One blogger goes so far as to speak of hyperinflation. Is there really something fishy going on? And what does ELA have to do with the ruble?

Last summer I wrote a post about the breakup of the short-lived ruble area that existed among the 15 successor states of the Soviet Union from 1991 to 1993. The ruble area had several flaws that made its demise inevitable. One of them was the fact that the Central Bank of Russia, as the lead institution within the currency area, retained less than full control over monetary policy. Although it had a monopoly on the issue of paper currency, it allowed national central banks almost unlimited latitude to create bank credit. The national central banks could use bank credit to finance their own government deficits and make loans to state-owned industries. The inflationary consequences of doing so were spread among all 15 ruble area members, creating a serious free-rider problem.

In the earlier post, I saw fiscal policy free riders as a real threat to the euro, as they had been to the ruble, but at the time, I did not see the possibility of a spillover into monetary policy. Now it appears that things are not quite so simple, as a post on Open Europe Blog first called to my attention.

Tracking down the story down led to a research note by Willem Buiter that gives a detailed explanation of emergency liquidity assistance in the euro area. To make a long story short, it turns out the the national central banks (NCBs) of euro-area members retain lender-of-last-resort powers in at least partial independence from the European Central Bank (ECB). For example, the Irish central bank can loan liquid reserves to Anglo Irish Bank, taking securities as collateral. That causes total reserves of the euro-area banking system increase. If those reserves are used as a basis for further loans, the euro money stock increases. Under the right conditions, the increase in the money stock could cause inflation throughout the euro area. Add in the fact that ELAs are, as a matter of policy, conducted behind a veil of secrecy and it becomes tempting to make a leap to a parallel with the ruble.

But hold on a minute. The whole story is overblown. What is going on with euro ELAs is far different from what brought down the ruble area--so far, at least.

The first big difference is that the ECB has the tools it needs to override any monetary impact of ELAs by national central banks. For one thing, the ECB can use any of its usual policy instruments to withdraw an equivalent quantity of reserves from the euro banking system, thereby sterilizing the effect of ELAs. In addition, although NCBs do not have to report ELAs to the public, they do have to report them to the ECB, which can veto them by a two-thirds vote of its board. True, as Buiter points out, the ECB may choose not to sterilize or veto the monetary effects of ELAs, but presumably, that would either be because it regards their effects as minimal, or because it considers the resulting monetary expansion to be consistent with euro-wide monetary objectives.

The second difference lies in the motivation for liquidity creation by national central banks. In the case of the euro, ELAs are supposed to be made for lender-of-last-resort purposes. As such, they are subject to rules first outlined by Walter Bagehot a century and a half ago. Such loans must be made only to institutions that are illiquid but not insolvent, they must be made on good collateral, and they must be made at a penalty interest rate. Although ELAs made under these conditions do add reserves to the banking system, their purpose is not to bring about an expansion of the money stock. Instead, it is to prevent an undesired contraction that might occur if a solvent but illiquid bank were forced to close its doors. Far from having inflationary potential, properly executed lender-of-last-resort operations contribute to the goal of price stability.

It is true that central banks are sometimes tempted to fudge on matters like collateral and solvency. Some observers suspect the Irish central bank of doing so in some of its recent ELAs. Still, if a national central bank were to violate the lender-of-last-resort principles too egregiously, ECB rules would allow it to veto the operation

The monetary manipulations of NCBs in the post-Soviet ruble area were very different. The post-Soviet NCBs began life as the republic branches of Gosbank, the central bank of the USSR. Gosbank was a monobank that combined central banking and commercial banking functions. As such, it held retail deposits and made loans both to the government and to state-owned industries. When Gosbank broke up, at least some of the NCBs in the post-Soviet ruble area continued those monobank practices. They extended credits directly to local governments and made generous loans to often-failing state enterprises. Those operations were inherently inflationary. When local enterprises used the funds borrowed from their local NCBs to make purchases from firms in other former Soviet republics, and those payments were cleared through the banking system, the inflationary pressures spread throughout the ruble area. The ability to finance national government and state enterprise operations in this way created a free-rider problem on an altogether different scale than anything associated with ELAs in the euro area.

In short, there is no real parallel between emergency liquidity operations as currently conducted by NCBs in the euro area and the inflationary machinations of NCBs in the ruble area. One has to stretch the imagination to see how ELAs could pose an inflationary threat to the euro. Something like one or all of the following would have to happen:

The NCBs of the euro's biggest members would have to get involved. Buiter estimates that Ireland's central bank has extended ELA credits equal to 31 percent of the country's GDP, but Ireland is a small country. If Germany were to act on the same scale, then ELAs might start to matter.
ELAs would have to break through the limits set for lender-of-last resort functions in a big way. Ireland may have put a toe over the line in treating banks like Anglo-American as solvent or by accepting less than gilt-edged collateral, but something more than that would be needed. We might start to be worried, for example, if NCBs were to make loans to banks in the guise of liquidity assistance, and then require the banks to use the proceeds to purchase local sovereign bonds on terms better than those offered by the open market.
If several NCBs combined to form a blocking coalition of one third plus one on the ECB board to prevent veto of excessive ELA activity, then monetary expansion inconsistent with ECB policy objectives would become possible.

At present, there is no sign that any item on the above list is happening or about to happen. The euro does have its problems, but emergency liquidity assistance operations do not yet add greatly to them.

Follow this link to view or download an updated slideshow on the breakup of the ruble area with comparisons to the present condition of the euro.

Demographics and Politics as Much as Floods and Security Undermine Pakistan's Economy

2011-01-25T21:36:00.000-08:00

In a recent White House meeting with President Asif Ali Zadari of Pakistan, US President Barack Obama underscored the importance of the US-Pakistani relationship and emphasized continued US support for the country. Unfortunately, the prospects for a payoff to US strategic commitments in Pakistan remain clouded by deep economic weaknesses that have their origins as much in demographics and political factors as in the more widely publicized natural disasters and security issues.

Just a few years ago, Pakistan's future looked brighter. Its economy seemed to be taking off after years of stagnation. The World Bank was applauding wide-ranging economic reforms. As the chart shows, in the mid-2000s it looked as if Pakistan might be capable of playing in the same league as neighboring India and China. Since then, however, things have fallen apart. The global economic crisis is only partly to blame. More fundamental problems are preventing the kind of recovery that other emerging markets are experiencing.

Demographic factors play a big role in Pakistan's problems. According to UN data, the country has a population growth rate of 2.13 percent, compared to 1.27 percent in India and .61 percent in China. True, as the late Julian Simon was fond of pointing out, people are a country's most important resource. A large or growing population by itself does not necessarily mean a weak economy. But more people are a source of prosperity only to the extent that they are engaged in productive activity. Pakistan scores poorly in that regard.

One key demographic indicator is the dependency ratio, that is, the number of children and retirees per 100 people of working age. Pakistan's dependency ratio, as of 2010, was 69, compared to 56 for India and just 39 for China. China's dependency ratio will rise somewhat in coming decades as its population ages, but India's will decrease as its falling total fertility rate reduces the number of children. Meanwhile, Pakistan's total fertility rate remains high, and as long as it does so, its dependency ratio will remain high as well.

The labor force participation rate of women is another important factor in the effectiveness of human resource use. In Pakistan, just 22 percent of working-age women are in the labor force, putting it in the lowest decile among countries of the world, even lower than India's 36 percent. By comparison, 76 percent of Chinese women of working age are in the labor force.

Education matters, as well. Pakistan's secondary-school enrollment rate is just 33 percent, compared with 57 percent for India and 74 percent for China. Only half as many of Pakistan's women as men have a secondary-school education.

These demographic factors reinforce one another to create a vicious cycle. A high fertility rate keeps women out of the labor force. If women are not expected to enter the labor force, there is less incentive for families to send them to school. And women with less education tend to have more children.

In principle, well conceived pro-growth policies could go a long way toward offsetting all of these handicaps. However, implementing such policies would require a government capable of rising above short-term electoral politics and taking hard decisions with longer-term payoffs. Unfortunately, Pakistan does not have such a government.

The events of early 2011 are a case in point. Under international prodding, the government advanced a promising set of reforms. Key measures were a restructuring of the country's weak tax system and big cuts in energy subsidies, which together would have reduced a huge budget deficit (now over 5 percent of GDP) and helped to bring inflation (now at 15 percent) under control. Unfortunately, Pakistan's fragile governing coalition chose just that moment to collapse. Although the planned economic reforms were not the only cause, it proved necessary to abandon them in order to restore a workable parliamentary majority.

For the time being, it seems that non-economic issues like the country's draconian blasphemy laws are sucking away all of the political oxygen, to the frustration of the many capable technocrats in the government. Molly Kinder of the Center for Global Development puts it this way: "Time and again, the documents cite the same problems, the donors recommend the same solutions, the government of Pakistan promises to implement the same reform, the government breaks (and donors lament) the same promises. And the cycle repeats."

None of this is meant to belittle the effects of last year's devastating floods or Pakistan's appalling security situation. Those are real problems. The point made here is that Pakistan would be in bad shape even without them. Real GDP is barely keeping up with population growth, and in some years not even that. Meanwhile, what should be done about the $10 billion or so of US and IMF aid that is in the pipeline? Do US taxpayers and other donors really just want to watch it trickle away into the sand, with little prospect of payoff either for the people of Pakistan itself or for those who like to view it strategic ally?

Follow this link to view or download a short slideshow with additional details on Pakistan's economy.

The Impossible Trinity, or, Why Latin America Hates QE2

2011-01-19T22:31:00.000-08:00

Latin America is up in arms over QE2. Brazil's finance minister, Guido Mantega, sees the Fed's program of quantitative easing as a form of currency manipulation on a par with China's efforts to maintain an undervalued yuan. We hear dark talk of currency wars and threats to raise the issue with the G20, the WTO, and anyone else who will listen. Why all the anger directed against what most people in the United States view as a purely domestic policy that hopes to reboot a sluggish recovery? Why wouldn't that be welcomed by US trading partners in Latin America and everywhere?

Part of the answer is that in today's world, there is no such thing as purely domestic monetary policy. Actions of the central banks even of small countries send out little ripples through the global financial system. Those of major central banks can send out big waves.

QE2 is a case in point. Under that program, the Fed plans buy some $600 billion worth of longer-term Treasury securities by the middle of this year. Operationally, the policy is purely domestic; both the assets and liabilities it adds to the Fed's balance sheet are denominated in dollars. In that sense, QE2 is quite different from what the Chinese central bank does when it buys dollars in exchange for yuan. Nonetheless, the Fed's actions do affect the world economy.

One reason is that when the Fed buys Treasuries, it reduces the stock of those securities in the hands of the public. Other things equal, that tends to raise their prices and reduce their yields. In practice, the effects have been a little messier. Treasury yields fell when the idea of QE2 was first floated in August, but since the purchases actually began, they have risen again. In a recent speech, Fed Vice-Chair Janet Yellen argues that yields, although higher than they were, are lower than they would have been without QE2. Some people believe the models on which that conclusion is based, and some are skeptical. Latin American finance ministers seem to be among the believers.

Beyond that, when the Fed pays for the Treasuries it acquires, its liabilities, in the form of bank reserve deposits, increase by the same amount. To the extent that banks want to put the new reserves to work by lending them out or investing them, there is additional downward pressure on interest rates. True, because banks are not currently putting all their reserves to work, this effect is weaker, but it is still there. At the very least, the growing mass of excess reserves overhanging financial markets affects expectations.

That would be the end of the story if the United States were a closed economy, but it is not. With QE2 putting downward pressure on interest rates across a broad front, some investors who currently hold dollars are going to start looking for better yields abroad. At that point, the ripples from QE2 begin to affect Brazil, Chile, and other economies that offer attractive investment opportunities. The exact form taken by the external effects of QE2 will differ according to the policies each country pursues regarding exchange rates and international capital flows. We need to consider three possibilities.

First, suppose a country has a freely floating exchange rate and open capital markets. If so, increased financial inflows will put upward pressure on the exchange rate. Exchange rate appreciation is beneficial to importers and consumers of imported goods, but harmful to exporters and to local manufacturers that compete with imports. If exporters and import-competing manufacturers are disproportionately influential in government, as is often the case, the political reaction to currency appreciation will be more negative than positive.

Suppose, instead, that a country has opted for a fixed exchange rate but still maintains an open capital account. In order to hold the exchange rate steady, the central bank will have to counteract increased financial inflows by purchasing foreign currency and adding it to its international reserves. Each dollar added to reserves must be paid for with newly issued domestic currency, pumping new liquidity into the domestic banking system. The resulting increase in lending and spending create inflationary pressure. As long as the nominal exchange rate is held constant, inflation undermines the country's competitiveness, or, to put it another way, causes its currency to appreciate in real terms. Exporters and import-competing manufacturers are harmed by real appreciation that takes the form of a stable nominal exchange rate plus inflation just as much as they are harmed by nominal appreciation without inflation.

There is one other possibility: A country can fight both nominal currency appreciation and inflationary increases in the domestic money supply by closing its capital account to unwanted financial inflows. However, that option, too, has its drawbacks. Closing a country's capital account to financial inflows can cut off much needed sources of credit to domestic consumers and industry, thereby slowing the economic growth. Stability is then gained only at the cost of isolation and stagnation. On the whole, orthodox economics has frowned at restrictions on international financial flows.

Economists use the term impossible trinity in discussing these alternative policy regimes. It is impossible for a country to choose more than two items from the following menu of three: An independent monetary policy, a fixed exchange rate, and an open capital account. Countries that want to maintain an open capital account and freely use monetary policy to control inflation must let their currencies float; those that want a fixed exchange rate and an open capital account must give up an independent monetary policy and accept the inflationary and deflationary shocks produced by international financial flows; those that want both a fixed exchange rate and an independent monetary policy must introduce capital controls. None of these combinations is painless for a country faced with unwelcome developments in global financial markets.

Of course, just saying something is impossible does not mean no one will try to find a way around it. Brazil, Chile, and some similarly affected countries elsewhere are pursuing blended policies that strike compromises among the three elements of the impossible trinity.

One approach is to impose partial capital account restrictions designed to filter out destabilizing, short-term "hot money" while allowing growth-enhancing, long-term direct foreign investment. Examples are Chile's requirement that investors make interest-free deposits at the central bank and Brazil's measures to curb short-selling of the dollar. Such limited controls are gradually gaining acceptance even by institutions like the IMF, which has discouraged them in the past. However, doubts persist on their effectiveness in the long run, and international treaties are thought to pose barriers to more comprehensive capital controls.

Sterilized foreign exchange intervention is another compromise approach. A central bank is said to sterilize when it buys foreign currency to slow nominal appreciation, but neutralizes the inflationary monetary effects by financing the forex purchases with sales of long-term bonds or other non-monetary financial instruments. However, sterilization also has its drawbacks. For one thing, it can be expensive, since interest rates on instruments issued by emerging-market central banks are likely to be higher than those earned on foreign exchange reserves. Also, if investors think a central bank will not be able to continue to sterilize indefinitely, expectations of future appreciation could increase hot-money inflows and make the situation worse.

In short, it is easy to see why Latin America hates QE2. Small wonder that finance ministers and central bankers throughout the region, faced with an unappetizing menu of policy options, wish QE2 would just go away.

Still, the "currency wars" rhetoric deployed against QE2 seems overblown. The following chart, which gives real effective exchange rates for Brazil and Chile, two of the most affected countries, shows that the trend toward real appreciation was underway well before QE2 was launched, and indeed, even before its keel was laid. One factor behind the appreciation is simply that these are well-managed and dynamic economies that offer many attractive investment opportunities, quite apart from short-term speculation. Another factor is a sharp run-up in the prices of regional commodity exports since the depths of the global crisis. These underlying pressures would not disappear even if the Fed were to cancel QE2 tomorrow. Finally, there is often-repeated fact that if QE2 does succeed in getting the US economy back on track, Brazil, Chile, and all our trading partners will benefit from increased demand for their exports.

The bottom line: Yes, QE2 is making waves in international financial markets, although hardly a tsunami, as some have called it. Yes, it does make the life of Latin American finance ministers and central bankers just a bit harder. But their lives would be hard anyway, so perhaps they should at least be grateful for a convenient scapegoat.

Follow this link to view or download a short slideshow discussing QE2, its effects on Latin America, and the impossible trinity.

Could Federal Spending be Capped at 20 Percent of GDP? Should it Be?

2011-01-13T22:52:00.000-08:00

As the budget debate heats up, we will hear much about capping U.S. federal government spending at 20 percent of GDP, roughly its level for several decades leading up to the global financial crisis. Likely presidential candidate Rep. Mike Pence (R-Ind.) has been among the most vocal backers of this idea. Together with colleagues, he has packaged it in the form of a proposed Spending Limit Amendment. Would it really be possible to impose such a spending limit? Yes. Would we like the results if we tried it? Not all of us would. Here is why.

Part of its attraction is that the 20 percent solution appears to require no real sacrifice. If we were content with the level of government services enjoyed in past, pre-crisis decades, why would there be any hardship in holding to that level in the future? Unfortunately, the pretense that it would be possible to maintain the same level of real government services as in the past without future increases in spending is an illusion. The reality is that holding government spending to past levels would require a significant reduction in real public services. To see why, we need to look in more detail at what has happened to individual components of government spending over past decades. The following chart gives the basic data.

First, the chart shows that the discretionary component of federal spending was not constant over the decades leading up to the crisis. Instead, discretionary spending, which includes defense, law enforcement, education, highways, and all the daily business of government, followed a long downward trend, from more than 12 percent of GDP in the 1970s to less than 8 percent in the mid-2000s. A 20 percent cap on total federal outlays would lock in not current levels of discretionary spending, but the downward trend.

Second, we notice that there was a moderate recovery in discretionary spending in the mid-2000s. The recovery was facilitated by a decrease in net interest payments on the federal debt, which fell from their usual level of around 3 percent of GDP to about half that. The decline occurred partly because of unusually low interest rates and partly because of a decrease in total debt due to the the budget surpluses that appeared at the end of the Clinton administration. Unfortunately, federal interest expense is now on its way back up, with a vengeance. By the end of this decade, it will be well above its historical average. If total spending is capped at 20 percent of GDP, interest payments will soon be adding to the squeeze on discretionary programs, rather than relieving it, as in the mid-2000s.

A third budget trend evident from the chart is the growth of entitlement spending, from 6 percent of GDP in 1970 to over 10 percent by the mid-2000s. Perhaps something could be done here. If the growth in the share of entitlement spending could at least be stopped, even if not reversed, that might preserve at least an austere sliver of funding for defense, schools, and highways.

Unfortunately, the idea of freezing the growth of entitlement spending runs up against some hard demographic realities. The growth of entitlements, mostly in the form of social security and Medicare, does not primarily reflect increasing generosity of these programs. True, in some respects benefits have grown, for example, through the addition of drug benefits to Medicare and overly generous inflation adjustment of social security benefits. However, future growth in entitlements will be driven less by growth in benefits per recipient than by demographics, especially a dramatic increase in the country's elderly population, as shown in this chart:

The implication of these demographic trends is that capping total entitlement spending as a share of GDP would do more than simply deny benefit increases to future generations of retirees. Instead, it would mean sharply cutting both social security and medicare benefits per recipient. Real cuts would be needed even if stringent cost-cutting measures held medical inflation to the rate of increase of average consumer prices.

So, could federal spending be capped at 20 percent of GDP? Yes, it could. Some set of measures like this would do the job:

Cram discretionary spending down to its pre-9/11 level of 6.3 percent of GDP, compared with 8 percent in the last year of the George W. Bush administration. That would make room in the budget for a doubling of net interest payments, which, given the size to which the total debt has already grown, will inevitably be necessary when interest rates recover to normal.
Within the discretionary spending category, make a choice between drastic cuts to defense spending, including withdrawal of troops from foreign deployments, or cuts deep into the muscle, not just the fat, of every domestic discretionary program, including law enforcement, education, infrastructure and all the rest.
Cap entitlements at their current level of GDP. Convert social security from a pension program for all into a means-tested safety net for the neediest. Implement cost-cutting measures for Medicare that have been rejected in the past, such as malpractice reform, elimination of tax preferences for employer-provided plans, a phase-out of fee-for-service medicine, and increased co-pays for all but the lowest-income elderly.

Should it be done? That depends on what kind of government you want. If you want approximately the real level of government services per capita as in the past, and the same level of real social security and medical benefits per retiree, then forget about the 20 percent solution. On the other hand, if you are content with a pared down government that provides a pre-1930s social safety net along with third-world levels of defense, education and infrastructure spending, then by all means, slap on the cap. But please, don't pretend you can have it both ways.

Follow this link to view or download a brief slideshow containing additional data related to the federal budget and the 20 percent solution.

Hidden Pitfalls of Increasing U.S. Dependence on Canadian Oil Sands

2011-01-09T21:45:00.000-08:00

Canada is the biggest supplier of oil imports to the United States. Increasingly, those imports come from its vast reserves of oil sands. Is the growing U.S. dependence on Canadian oil sands a win-win deal for both countries, crucial for U.S. energy security, and a source of jobs and economic growth, as American Petroleum Institute President Jack Gerard claims? Is the development of Canadian oil sands "the most destructive project on earth", as a Canadian environmental report calls it? What pitfalls for policy makers and investors lie hidden in the heated rhetoric coming from both sides in the oil sands debate?

The debate places much emphasis on how just dirty or clean oil from the Canadian sands is compared with the alternatives. Detractors prefer to call them "tar sands" to project an image that is as dirty as possible. (Both "oil sands" and "tar sands" are popular terms; purists prefer "bituminous sands.") They cite data showing that greenhouse gas (GHG) emissions for a barrel of oil from Canadian sands run from three to as much as seven times as high as from a barrel of conventional Texas crude. Oil sand supporters cite different numbers that indicate only 5 to 15 percent more GHG emissions from the sands than from conventional oil.

Surprisingly, the widely differing numbers do not come from competing scientific teams. Instead, both sides draw on the same studies, like this one from the National Energy Technology Laboratory of the U.S. Department of Energy. A closer look at the underlying data shows that two factors account for the gap between the "clean" and "dirty" numbers for oil sands.

One is whether GHG emissions are measured on a "well-to-tank" basis or a "well-to-wheels" basis. Most of the extra GHG emissions for oil sands come from the energy-intensive process of getting the gunky bitumen out of the ground, upgrading it to refinery quality, and then refining it. That is the well-to-tank part. Subsequent highway use of the fuel, regardless of its source, produces the bulk of GHG emissions for the whole well-to-wheels fuel cycle. As a matter of simple arithmetic, then, moving from a well-to-tank measure to a well-to-wheels measure makes oil sands look relatively less dirty.

The second source of the gap between the clean and dirty numbers lies in what oil sands are compared to. Oil sands detractors like to use U.S. domestic crude as the basis for comparison. On a well-to-tank basis, DOE data show that production of diesel fuel from Canadian sands emits two and a half times more GHG than the average for diesel from domestic crude. But domestic crude is a poor basis for comparison. We use all our domestic crude first; after that, we have to go out and import the rest. The decision to use more or less oil from Canadian sands means importing correspondingly less or more from other sources. It turns out that almost all U.S. oil imports are low quality, heavy, or high in sulfur, meaning more emissions from extraction and refining. Long-distance transportation adds more emissions. All things considered, then, it appears that oil from Canadian sands is about 10 percent dirtier than crude from Nigeria (8 percent of imports) and 42 percent dirtier than oil from Mexico (12 percent of imports) on a well-to-tank basis. The gap is even less on a well-to-wheels basis.

So what do we really learn from parsing the DOE emissions data? We learn that although oil from Canadian sands is dirtier than average, no oil is really clean. As far as GHG emissions are concerned, what really matters is the total quantity of oil that is used. Where it comes from makes some difference, but a fairly small one.

Our discussion of the environmental impact of Canadian oil sand development would be incomplete if it stopped with the GHG issue. There are also major adverse effects on the local environment. One big issue is land reclamation. Much of the bitumen is recovered by surface mining, which leaves a moonlike landscape in place of the original boreal forests and wetlands. Water is another issue. Both surface and subsurface extraction of bitumen use vast quantities of fresh water and leave behind huge storage ponds full of toxic tailings. Candice Beaumont, an industry supporter who thinks oil sands may help delay "peak oil," describes the situation this way: "If a bird flies over a river near the oil sands, the bird dies just from flying over the river. It's that toxic. They are just dumping all the waste into the waterways. If you did that in the U.S. you would be in jail." (She discounts environmental impacts on the grounds that few people live in the main mining areas.)

Canadian authorities, to their credit, require that producers restore the land and water, and deposit funds in escrow to ensure that they do so. However, critics question the adequacy of the regulations. They point out that restoration technology is poorly demonstrated--very little land and none of the most toxic tailing ponds have actually been restored as yet. Furthermore, they argue that the required escrow deposits are not adequate to protect against potential disasters like a major wastewater spill.

Because environmental concerns cannot be entirely dismissed, oil sands supporters play the national security card. As the American Petroleum Institute's Jane Van Ryan puts it, "Every barrel imported from Canada could replace one from a less secure source, adding to our energy security and benefiting our economy." To evaluate the energy security argument, we have to think both about the nature of the oil security threat and that of the global oil market.

One aspect of the security threat is logistical. If, say, a civil war cut off supplies from Nigeria, the United States would have to scramble to find alternative sources. Contracts would have to be renegotiated. Tankers would have to be rerouted. Refineries would have to be reconfigured to handle a different type of crude. Even if those adjustments were eased by releasing oil from the strategic petroleum reserve, there would be short-term costs.

A second aspect of the security threat comes from oil price volatility. Oil is an import into virtually everything produced in the economy, and a major component of the cost of living. Sharp spikes in oil prices caused by war, politics, natural disasters, or industrial accidents send shockwaves through the whole economy.

A third security concern is who ends up pocketing the vast revenues generated by high oil prices. It has become a cliche to point out that not all oil producers are among America's closest friends. At worst, oil money funds authoritarian governments, the weapons programs of hostile states, and terrorism.

What could be better, then, than to replace oil from unstable countries like Nigeria with oil from friendly, democratic, and near-by Canada? It sounds good, but when you think about it, the security benefits are less than they seem. Again, consider a hypothetical Nigerian civil war. How much would it matter if, before the war started, Canadian output had expanded by enough that the United States was no longer an importer of Nigerian crude? It would not matter very much, because the global oil market operates as a single pool. Oil prices everywhere would spike as other countries scrambled to replace Nigerian oil. The dictators, hostile arms programs, and terrorist training centers we worry about would still get their inflow of new money. The U.S. economy would still be set back by higher import costs, unless, perhaps, our friendly neighbors to the north generously agreed to keep selling us oil at the low, pre-crisis price. True, there would still be logistical benefits to a short pipeline link with a stable Canada compared with a long sea route to a volatile Nigeria, but those would be of a second order of magnitude. For national security, as for the environment, the biggest part of the threat lies in excessive total consumption of oil, not in the specific sources from which that oil comes.

The preceding discussion of environmental and security issues reveals the hidden pitfalls of growing U.S. dependence on Canadian oil sands.

The pitfall for U.S. policy makers is that stable and abundant Canadian supplies will serve as an excuse to avoid the hard work of implementing a rational energy policy. Such a policy would be one that accounted for the full cost of every unit of energy from every source, new and old, and imposed those costs on the end user through higher prices. Meanwhile, Canadian policy makers would hopefully make sure that producers were pricing in the full costs of contingent liabilities from land reclamation and wastewater spills. A well-coordinated set of policies would place appropriate charges against all forms of energy, but oil from Canadian sands would take one of the biggest hits. Yes, such a policy would substantially increase end-user energy prices in the United States, but once the transition was complete, the economy would be strengthened, not weakened. As I have argued elsewhere, the one thing the country definitely cannot afford is "affordable energy."

The pitfall for investors is that putting money into the development of Canadian oil sands amounts to a bet that both the United States and Canada will, for the foreseeable future, remain committed to pro-producer policies that are non-rational from the point of view of broader national interests. True, that is not a completely stupid bet. Oil has a strong lobby on both sides of the border, and both governments are currently committed to further oil-sand development. But that might change.

It would be a mistake for investors to fool themselves with the arguments their own lobbyists are using to underplay the environmental impact of oil-sand development and overplay its national security benefits. Experience shows that a crisis can quickly shift public sentiment, and when that happens, politicians tend to run for cover. A generation ago, Chernobyl and Three Mile Island shifted sentiment against nuclear power. Last summer, BP's blowout in the Gulf of Mexico did the same for offshore drilling. A dramatic climate event like an ice-free summer on the Arctic Ocean or a burst dam on a big Alberta tailings pond could do the same for Canadian oil sands. At such moments policy can shift quickly from irrationally permissive to irrationally restrictive. Investors beware.

Follow this link to view or download a short slideshow on Canadian oil sands. The slideshow includes graphic material too extensive to include in this blog post.

If a Stronger Yuan is Good, Can A Weaker Dollar be Bad?

2011-01-05T22:42:00.000-08:00

One of the top themes for 2010 in economics, politics, and diplomacy was the damage being done to the U.S. economy by an undervalued Chinese yuan. As the yuan began to appreciate in the second half of the year, slowly in nominal terms but more rapidly in real terms, everyone cheered. At the same time the yuan appreciated, the dollar depreciated, not just relative to the yuan, but to all foreign currencies on average. The broad weakness of the dollar was welcomed much less enthusiastically. Words like "unpleasant" and "grim" tended to be used instead.

So what gives? If a stronger yuan is good, can a weaker dollar really be bad?

It is easy to understand why appreciation of the yuan has been so widely sought and so well received. A weak yuan makes it hard for U.S. manufacturers of toys, shoes, and solar panels to compete with imports from China, and for U.S. exports of goods and services to penetrate Chinese markets. That, in turn, puts downward pressure on U.S. wages as employers struggle to cut costs and stay in business. Yuan appreciation takes some of the pressure off. It is even more welcome at a time when there is already so much slack in the U.S. economy.

Of course, the yuan is not the only currency out there. If it appreciated while other exchange rates stood still, not many of those toy and T-shirt jobs would come home. Importers would just find new sources in Bangladesh, or Vietnam. Trade deficits and political tensions would increase with those countries and there would be calls for them, too, to realign their currencies.

Fortunately for those who look after the interests of U.S. exporters and import-competitors, the yuan-dollar relationship has not moved in isolation. Instead, the dollar has depreciated across a wide front. The broadest measure of the trend is the real effective exchange rate (REER), which is a weighted average of a country's exchange rate relative to the currencies of all its trading partners, adjusted for differences in national rates of inflation. As the following chart shows, by the end of 2010 the dollar's REER reached a low point for the decade. The weak dollar contributed to a healthy 14 percent growth in U.S. exports (based on data through October). Interestingly, that 14 percent is right on track with the president's National Export Initiative, which aims to double exports over five years.

Of course, there are downsides to the dollar's weakness. The chief one is an increase in the cost of imports. In part, that means toys and T-shirts cost more at Wal-Mart. At the same time, it means the dollar costs of imported raw materials, from oil to neodymium, also rise. As high import costs pass through wholesale and retail markets, dollar depreciation puts upward pressure on the rate of inflation.

But even the inflationary impact of the weak dollar is not entirely unwelcome at present. U.S. inflation, whether you measure it by the consumer price index, the personal consumption expenditure core deflator, or whatever, is well below the 2 percent or so that is widely thought to be consistent with a healthy economy. In a heroic attempt to get the inflation rate back up to target, the Fed has undertaken a program of quantitative easing in the form of massive purchases of Treasury securities. Although for diplomatic reasons the Fed is reluctant to say so, dollar depreciation is one of the channels through which quantitative easing is supposed to work. For that reason, a bit of depreciation-induced inflation is actually welcome at the moment.

It would be nice to end this post with a confident prediction about the dollar's exchange rate in the coming year, but I cannot. There are too many uncertainties, the future direction of U.S. fiscal and monetary policies being among the greatest. Instead, I will end with a more modest reminder: Exchange rate changes always produce both winners and losers, but the balance between the gains and the losses can vary according to circumstances. At the moment, and with the proviso that last year's gradual adjustments do not turn into a rout, both a stronger yuan and a weaker dollar are more to be welcomed than lamented.

Follow this link to view or download a brief slideshow discussing appreciation of the yuan and depreciation of the dollar during 2010.

What is Price-Level Targeting? Has Its Time Come?

2011-01-03T21:03:00.000-08:00

As we enter 2011, we are hearing more about something called price-level targeting. It clearly has something to do with monetary policy, but what does the term really mean, and why is it coming up for discussion right now? Is it a policy the Fed is likely to adopt, or is perhaps already using?

Price-level targeting is not a new idea. It was used by the Swedish central bank as long ago as the 1930s. It has been widely discussed in the academic literature. It is most easily explained by comparing it with inflation targeting, its more widely used policy alternative. An inflation-targeting central bank tries to hold the price level on or close to a path that increases at a steady rate over time, say 2 percent per year. When everything is functioning smoothly, a price-level targeting central bank would aim for exactly the same path. The difference between the two policies comes when the inflation target is missed.

Suppose, as is the case in the United States now, inflation drops below its target rate for an extended period, as at point A in the chart below. (The vertical scale of the chart is exaggerated for clarity, but it is roughly based on actual U.S. data and Fed forecasts.) Having arrived at point A, the question is what kind of corrective action to take. The inflation targeter would take whatever actions are necessary to get the rate of inflation back to 2 percent. If successful, those actions would put the price level on a new path parallel to, but permanently below, the original one. The price-level targeter would instead undertake policies to return the price level to the original path, even though doing so would require the rate of inflation temporarily to exceed 2 percent, along the segment A to B, until the price level had made up for its earlier shortfall.

Either strategy can be interpreted as broadly consistent with price stability, but price stability is not the only goal of monetary policy. The Fed operates under a dual mandate that requires it both to maintain price stability and to achieve the highest level of employment consistent with doing so. In the case at hand, price-level targeting involves more aggressively expansionary actions that in all likelihood would reduce unemployment more rapidly than simple inflation targeting. At the same time, it would cause no more inflation than there would have been if the price level had never fallen below its its intended path in the first place.

If price-level targeting is consistent with price stability and at the same time is superior to inflation targeting in terms of employment, it seems that it should be the hands-down favorite. Price-level targeting does have some support at the Fed. New York Fed President William C. Dudley, a permanent voting member of the Federal Open Market Committee (FOMC), has written favorably of the policy. Charles Evans, President of the Chicago Fed, has been an even more outspoken proponent. Fed Chairman Ben Bernanke, however, has been lukewarm on price-level targeting. In a 2003 speech, he spoke favorably of it as an option for Japan, which was then in a situation not too different from the U.S. today. However, in an August 2010 paper, he rejected price-level targeting for the United States. On balance, price-level targeting appears to lack majority support on the FOMC at this time.

One source of opposition to price-level targeting is the fear that it could increase uncertainty. It could "befuddle a public long accustomed to thinking in terms of inflation rather than price levels," as The Economist put it in a critical article. Increased uncertainty, in turn, could raise risk premiums and make business planning more difficult.

Another concern is that price-level targeting could undermine the Fed's hard-won credibility. The thinking seems to be that if the Fed openly encouraged a rate of inflation above 2 percent even for a brief period, people might come to doubt its commitment to price stability altogether.

A third objection is that price-level targeting might not be appropriate in all circumstances. In particular, it could cause problems if an external shock, like an increase in global energy prices, temporarily pushed inflation above, rather than below, its target path. In such a case, rigid adherence to a price-level target would require policy measures sufficiently contractionary to achieve absolute declines in prices and nominal wages in non-energy sectors. Rather than subject the economy to such harsh medicine, it might be better to let bygones be bygones, and put the economy on a new 2 percent inflation path starting from a higher base.

Not everyone finds these objections persuasive. Charles Evans argued in an October 2010 speech that the standard objections could be overcome by using what he calls state-contingent price-level targeting. His version of the policy would work as follows:

First, the Fed need not, and should not, commit to price-level targeting as a policy for all seasons. Instead, it should make it clear that that price-level targeting would be undertaken only when the economy has undershot the rate of inflation that is desirable in the long run. Other states of the economy, including overshooting of the inflation target due to external shocks, would be handled differently.

Second, Evans addresses the problem of expectations. The worry is that inflation expectations could become unanchored as price-level targeting began to move the economy along the high-inflation A-to-B segment in our earlier chart. To prevent that from happening, the Fed should be explicit about its exit conditions. It should make it clear that as soon as the desired long-run price-level path has been reached, monetary stimulus will be ratcheted down by enough slow inflation to the rate thought desirable in the long run.

Third, clear communication would eliminate the risk that price-level targeting would undermine the Fed's credibility. Credibility can come under threat only if the Fed fails to make clear what it is trying to do, or makes a clear statement of its intentions and then does something else instead. State-contingent price-level targeting that is explicit about both entry and exit conditions is arguably more consistent with preservation of credibility than what the Fed is now doing.

Consider, for example the FOMC's most recent policy statement of December 14, 2010. The statement does not really give much guidance about just what the Fed is targeting or what its exit conditions are. We are told that the Fed will try to keep the fed funds rate low for "an extended period." We are told that it will continue its QE2 program of buying long-term Treasury securities. But clarity is significantly undermined by the vagueness of the statement of exit conditions: "The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate." Does that mean that the Fed will ease off as soon as inflation hits 2 percent? Will it instead persist with its current aggressively expansionary policy until employment has recovered, even if doing so temporarily results in a higher rate of inflation? In short, the statement could easily be read as consistent either with pure inflation targeting, or with price level targeting, or with flying by the seat of the FOMC's pants.

The bottom line: We can look forward to a renewed debate on price-level targeting in 2011. Support for the policy will be strengthened a bit by the fact that the Chicago Fed has a voting seat on the FOMC in odd-numbered years. If inflation remains stubbornly low, as it did throughout the fall, perhaps Chairman Bernanke will become less confident that "both inflation expectations and actual inflation remain within a range consistent with price stability," one of the reasons he gave for rejecting price-level targeting in his August speech. It is even possible that the FOMC has already committed to de-facto price level targeting without saying so explicitly. Developments over the coming months should make it clear whether the time for price-level targeting has now come.

Follow this link to view or download a brief slideshow discussing price-level targeting, including the views of supporters and critics of the policy.

Economics in Fiction: Two Post-Christmas Book Reviews

2010-12-30T11:25:00.000-08:00

Anyone who has studied a little economics knows that popular fiction usually avoids economic themes, and if it does not, butchers them. Yet this year, two novels landed under our Christmas tree that place economic themes front and center and treat them well. The books are Nineteenth Street Northwest by Rex Gosh (Greenleaf Book Group) and Super Sad True Love Story by Gary Shteyngart (Random House).

Rex Gosh, better known to econ wonks as IMF economist Atish R. Gosh, sets his tale of terror and high finance at the fictional International Monetary and Financial Organization (IMFO), whose address and functions are oddly close to those of the real-world IMF and World Bank. The central character is the brilliant and beautiful Sophia Gemaye. Sophia, the daughter of a martyred third-world freedom fighter, has a big grudge against the developed world. At the same time, her upbringing in England has made her squeamish about blowing up planeloads of holiday-bound mothers and children. She reconciles her conflicting values by infiltrating the IMFO's young economists program, where her goal is to draw attention to her homeland's plight by engineering a bloodless crash of the world financial system. Once inside the IMFO, she steals central bank intervention data, which she plugs into a fiendish neural-network model (described by the author in lovingly accurate detail) that is designed to execute the mother of all bear raids. What happens next you will have to read for yourself.

I will confess that I sat down to read this little thriller with very low expectations regarding its likely merits as literature. The first couple chapters did seem predictably clunky, but pretty soon Gosh gets into the rhythm of things, and the text starts to read more like a novel and less like an IMF working paper. Passion, greed, revenge, and suspense interplay nicely with econometrics and exchange rate dynamics. Gosh avoids some of the most obvious stereotypes, for example, by giving his terrorist plotters a wide variety of backgrounds and motivations that make them, while not exactly sympathetic, at least credible as characters.

Where Gosh's thriller is grimly serious, Shteyngart follows the Russian literary tradition of laughter through tears. Super Sad True Love Story depicts a near-future dystopian United States in which economic and social trends already at work today have plunged us deep into a tunnel that has no obvious light at the end.

The world monetary system has undergone several changes in Shteyngart's near future. Debt, inflation, and repeated devaluation have turned the poor greenback into a parody of its present proud status as a reserve currency. The dollar continues to circulate as a medium of exchange, but it can no longer serves as a reliable unit of account. Instead, prices and contracts are indexed to the yuan, so that they adjust automatically to changes in the exchange rate. If you are a HNWI (high net-worth individual), your income and assets are pegged the the yuan but your expenses and debts are not. If you are a LWNI, it is the other way around. Anyone who remembers Russia in the 1990s would immediately understand the system. The European monetary system is not described in as much detail, but there are references to a monetary unit called the "Northern euro" that suggest that much the same has happened there.

Meanwhile, the U.S. political scene has evolved into a single-party system under the aegis of the Bipartisan Party--an entity that bears uncomfortable resemblance to Vladimir Putin's party, United Russia. The Bipartisans are intent on pursuing a losing war in Venezuela, despite the fact that they can't pay their returning veterans. Their economic policy consists of begging the Chinese central bank for more loans and exhorting fellow Americans with slogans like "Spend More! Together We Will Surprise the World!"

Everyone carries around an iPhone-like apparat that includes a handy face-recognition feature. Point your apparat at any stranger, and you can immediately download all kinds of personal data, including the person's all-important credit rating and several other personal indexes that I would perhaps best not describe here. Texting is the dominant mode of communication, although when in close proximity, people occasionally still engage in "verbaling". Reading is out, scanning text streams for data is in, except for Shteyngart's super-nerd hero, who has hidden away a smelly two-volume copy of War and Peace for his private enjoyment.

Rest assured, beneath all the economic and social satire, there is a real love story between a real boy and girl, but the "Super Sad" part of the title seems to refer not so much to their fate as to that of the country. At one point Love Story's hero, who, like its author, comes from a family of Russian immigrants, laments "the looks on the faces of my countrymen--passive heads bent, arms at their trousers, everyone guilty of not being their best, of not earning their daily bread, the kind of docility I had never expected from Americans, even after the many years of our decline. Here was the tiredness of failure imposed on a country that believed only in its opposite."

In short, these are two nice winter reads, and when you finish them, you can put them down with the comforting thought that they are, after all, only fiction. Right?

U.S. Ethanol Subsidies: A Bad Policy That Refuses to Die

2010-12-19T21:37:00.000-08:00

U.S corn farmers and ethanol distillers are among those celebrating passage of last week's tax bill. A little-noticed provision of the law extends ethanol tax credits ($.45 per gallon, plus a bonus for small producers) and tariffs on ethanol imports ($.54 per gallon), previously set to expire at the end of 2010. Should the rest of us also celebrate? I think not.

U.S. ethanol policy contradicts every principle of sound economics. It encourages use of fuels whose opportunity costs are high while discouraging use of those whose costs are low. It promotes trade flows that run opposite to comparative advantage. It creates new market failures instead of correcting those that already exist.

First consider opportunity costs. Economists use this term to mean the full costs of goods and services, taking into account all opportunities sacrificed to produce and use them. The opportunity costs of petroleum, ethanol, and other transportation fuels include costs of production, most of which are reflected in market prices, plus other costs, which are not. The effects of pollution, including both climate impacts and harm to local air quality, are one reason that opportunity costs exceed market prices. National security risks arising from dependence on foreign energy suppliers are a further important opportunity cost. The ostensible purpose of ethanol policy is to offset these costs by encouraging substitution of low-carbon domestic fuel for high-carbon foreign fuel, but in reality, the policy makes the situation worse, not better.

One problem is that corn-based ethanol, the kind produced in the United States, saves little if any carbon and produces little if any net gain in energy compared with petroleum. Measuring the exact carbon and energy efficiency of corn ethanol is not easy. Different assumptions regarding technologies, fuels consumed in farming and distilling, energy value of byproducts like cattle feed, land use impacts, and so on, give answers ranging from small net carbon and energy gains to small net losses. But even the most optimistic studies give corn ethanol only a tiny advantage over petroleum, nowhere near large enough to justify the scale of current subsidies.

What is more, even if corn ethanol were much more carbon- and energy-efficient than petroleum, subsidies would be the wrong way to bring prices into line with opportunity costs. Instead of subsidies, every type of fuel, including but not limited to ethanol and oil, should bear a surcharge equal to its external costs, calculated to account for climate change, local local air pollution, national security, and any other external effects of production and consumption. Gasoline, ethanol, biodiesel, compressed natural gas, and electricity would each bear a larger or smaller charge. Whereas ethanol subsidies act only to encourage substitution between ethanol and gasoline, a broader system would encourage many kinds of substitution. It would spur use of low-carbon, domestic energy sources like natural gas and electricity at the expense of both gasoline and gasoline-ethanol blends. At the same time, it would encourage across the board reduction in transportation fuel use by giving people incentives to buy smaller cars, move closer to work, use more local goods, and make other life-style changes. The fuel surcharges would be likely to generate considerable revenue, which could be used to reduce the marginal rates of other taxes or used to reduce the government's deficit.

Let's turn next to trade and comparative advantage. In the case of ethanol, comparative advantage belongs, hands down, to sugarcane-based ethanol from Brazil. The net energy yield from sugarcane-based Brazilian ethanol is about 8:1, compared to barely more than, or perhaps less than, 1:1 for the U.S. corn-based product. Unfortunately, Brazilian ethanol is saddled with a prohibitive $.54 per gallon tariff, just renewed. The result is an enormous loss of potential gains from trade in the form of a cleaner environment and lower consumer costs--gains that far outweigh the added profits of U.S. corn farmers and ethanol distillers. Need I add that Brazil is a friendly, democratic country, unlike the often corrupt, hostile, or authoritarian regimes from which we import much of our petroleum?

Comparative advantage in ethanol trade takes another kick in the face from a quirk of policy under which some Caribbean sugarcane producers can export ethanol to the United States duty free. For years they did not do so. Their inefficient sugar industries instead catered to the European Union, which granted them the same subsidized prices set for even less efficiently produced European beet sugar. Now the EU has reformed its sugar regime, and that particular free ride has ended. Rather than look for something they can produce efficiently, the Caribbean sugar producers are closing sugar mills and opening distilleries that cater to the sheltered U.S. ethanol market.

The trade effects of ethanol policy would be bad enough if they only involved the closing of U.S. markets to imports, but in reality, matters are even worse. When the effects of tax credits are added to those of import tariffs, they are, together, enough not just to block imports, but to turn the United States into a net exporter of ethanol. Ethanol exports are officially expected to run a record 315 million gallons this year, more than double the 2009 figure. True exports might be half again that if ethanol blended with exported gasoline is included. Exactly how do subsidized ethanol exports promote U.S. energy independence? Go figure.

The bottom line? Yes, there are market failures in transportation fuels. Yes, this is an area where government intervention in markets could actually make us better off. But current policy does not do so. Instead of mitigating market failures arising from pollution and national security effects, U.S. ethanol policy exacerbates them. A 2008 study by Robert W. Hahn of the AEI-Brookings Joint Center estimated that the costs of U.S. ethanol policy exceeded its benefits by more than $3 billion per year. Letting ethanol subsidies and tariffs expire as scheduled would have been a fine holiday gift for the U.S. economy. The next step would be a comprehensive rationalization of energy policy that took into account all opportunity costs of all fuels. Would this mean the end of ethanol as a motor fuel? Not necessarily. Some might still be imported from Brazil and elsewhere, boosting national security by diversifying energy sources. Research into cellulose-based ethanol would continue, although that potential clean domestic energy source has been slower to come on line than some have hoped. But our goal need not be a world free of ethanol--just one free of bad ethanol policy.

Follow this link to view or download a short slideshow on the economics of ethanol.

Does Argentina's "Nike Effect" Hold Lessons for Europe?

2010-12-14T22:08:00.000-08:00

What happens when a country faces forced austerity, a banking crisis, a risk of sovereign default, and pressure to abandon a currency peg it has has sworn to be eternal and unbreakable? Several European countries are in this position today, but there is nothing really new about it. It's all happened before, most recently in Argentina in the winter of 2001-02. So what became of Argentina? Are there any lessons there for today's Europe?

Argentina introduced what it called its "convertibility plan" in April 1991 as a way of stopping its latest episode of recurrent hyperinflation. Rather than opting for outright dollarization, as Ecuador would do a few years later, Argentina introduced a new version of own currency, the peso, and pegged it to the U.S. dollar at a 1-to-1 rate. The peg was underpinned by a currency board arrangement, which required the central bank to hold sufficient dollar reserves to back the entire monetary base (paper currency in circulation plus bank reserves) and to exchange pesos freely for dollars.

At first it worked. A fixed exchange rate can be a powerful tool to stop run-away inflation. As inflation came down, Argentina experienced a few years of good growth. However, it was not long before the fixed exchange rate showed its negative side: inflexibility in the face of external shocks. The Mexican "tequila crisis" and a devaluation of the Brazilian real, among other things, left Argentina with an overvalued currency, a big trade deficit, and excessive dependence on foreign borrowing. In addition, Argentina had a hard time mustering the fiscal discipline needed to live with a fixed exchange rate. By the end of the 1990s, Argentina was again in crisis. With IMF encouragement, it first tried fiscal austerity, and when that did not work, more radical measures, including a freeze on withdrawals of bank deposits. "This buries whatever hypothesis may exist that we will devalue," said Finance Minister Domingo Cavallo, speaking, in December 2001, of the banking freeze. But just a month later devalue they did, and defaulted too.

What happened next is very interesting. Devaluation and default did not bring the end of the world. Hyperinflation did not return. The peso, when floated, did not go into free fall, but instead settled into a range between 3 and 4 to the dollar, where it remains to this day. Most importantly, the real economy recovered strongly. Since 2003, Argentina has grown more rapidly even than neighboring Brazil, widely touted as a developing-world success story. One of my students dubbed Argentina's recovery the "Nike effect" because of the resemblance between a graph of Argentine GDP growth and the shoe company's famous "swoosh" logo.

Does Argentina's Nike effect hold a lesson for embattled euro area countries like Ireland, Greece, Spain and Portugal, or for those like Latvia, Lithuania, and Bulgaria, whose currencies are pegged to the euro with currency boards or similar policies? Could devaluation and even default be a better path to recovery than forced austerity?

The first lesson is that fixed exchange rates work best when all partners in a currency area have similar exposure to shocks. In the case of Argentina, probably the greatest problem lay in pegging the peso to the currency of the United States, a country with which it carried on only about 8 percent of its trade. Shocks like the Mexican crisis and the Brazilian devaluation, which hit Argentina hard, were hardly noticed in the U.S. With regard to trade in goods and services, the euro area makes much more sense than did the Argentine currency board. Intra-euro trade shares run in the 60 to 70 percent range. However, asymmetrical financial shocks remain a problem for the euro. Germany and a few other countries with persistent trade surpluses are sources of financial outflows. During the boom of the mid-2000s, countries like Ireland, Spain, and Latvia were in the opposite position, with large current-account deficits and huge financial inflows. When the global financial crisis exposed the fragility of the asset values that had attracted the inflows, those countries were left high and dry.

The second lesson is that a fixed nominal exchange rate does not protect countries from real exchange rate misalignment. A 22 percent real appreciation of the Argentine peso from 1998 through 2001 contributed to the problems of the convertibility policy by undermining the country's competitiveness and adding to its current account deficit. Similarly, as the following chart shows, some of the most distressed EU members experienced real currency appreciation in the years leading up to the crisis, both relative to the rest of the world, and relative to Germany, the anchor economy of the euro. Since Ireland, Spain and Germany all use the euro, and Latvia's lats has been pegged to the euro since 2005, nominal exchange rate changes account for none of differences in the evolution of real exchange rates. Instead, most of the real appreciation in the peripheral euro countries was caused by higher inflation than in Germany, and the inflation, in turn, was largely fueled by financial inflows chasing real estate bubbles.

The third lesson is that when all options are bad, the unthinkable may become the least bad. The orthodox recovery path for a currency-area member is "internal devaluation," that is, real devaluation through deflation of wages and prices rather than through nominal devaluation. Tax increases plus public sector wage and spending cuts are used to bring the budget back into balance. High unemployment, perhaps supplemented by labor market reforms, is used to force down private sector wages and prices. Once prices fall enough and creditor confidence is restored, growth can resume again. The IMF has traditionally favored this set of policies when giving assistance to countries like Argentina, Greece, and Latvia, in part because they protect foreign creditors, who tend to include the most influential IMF members. But it is a slow path to recovery, and one that is socially and politically painful for the patient.

The alternative to austerity and internal devaluation is to abandon the fixed exchange rate. That option, too, is not free of pain. For one thing, in an attempt to make the fixed exchange rate maximally credible, it will often have been locked in by constitutional amendment or treaty or some other mechanism above the reach of mere administrative authority. In addition, it may not be possible to devalue without triggering both public and private defaults on borrowing denominated in foreign currencies. If banking problems have not already been a trigger of the crisis, as in Ireland, devaluation is likely to bring about a banking collapse, as it did in Argentina. Despite all those drawbacks, however, devaluation can open the door to a more rapid recovery than is possible under internal devaluation--a Nike effect.

The bottom line: Life in a fixed-rate currency area is not for everyone. Some countries are structurally unsuited for a fixed exchange rate because of their patterns of trade, their exposure to external shocks, or their inflexible labor markets. Others may be structurally suited but lack the needed fiscal or financial discipline. A country locked into a currency union for which it is not suited is like a spouse locked in a bad marriage. Sticking to one's vows and blaming one's own failures for all the problems of the relationship is certainly one alternative. But the option of divorce should not be too hastily taken off the table.

Follow this link to view or download a short slideshow on Argentina, the collapse of its currency board, and its subsequent recovery.

Progress on Korea-US Trade Offers Contrast with Talk of Protectionism

2010-12-05T22:01:00.000-08:00

This week's finalization of the long-delayed Korea-US Free Trade Agreement (KORUS FTA) offers a welcome contrast with all the gloomy talk of a protectionist response to the ongoing global crisis. The Bush administration first negotiated the deal, which would be the biggest since NAFTA, in 2006, under the since-expired system for "fast track" approval by Congress. Due mainly to opposition from auto and beef interests, it was never ratified.

The Obama administration made revival of the stalled agreement a centerpiece of its National Export Initiative. Final renegotiation of KORUS FTA was supposed to be a big take-home from the otherwise lackluster G-20 summit in Seoul last month, but last-minute snags ruined the timing. Finally this week the two countries were able to announce agreement on the difficult issue of automobile trade. Korea will admit 25,000 cars each year from each U.S. automaker, and the United States will eventually, but not immediately, lower tariffs. The beef issue remains unresolved.

What has changed to offer hope that Congress may ratify KORUS FTA now, when the parties seem deadlocked on nearly all other issues? Nothing much has changed in the economic case for KORUS FTA. In terms of the usual models, which attempt to balance the interests of consumers, firms, and workers against one another in an unbiased manner, it is hard to see the agreement as anything but a win-win deal. Instead, the important changes have all been political.

In two ways, the political trade game is played by different rules than the economic game. First, whereas economists tend to focus on net gains, politics is very sensitive to the fact that any change in trade policy produces some losers along with the winners. Second, the political influence of winners and losers is not necessarily proportional to the magnitude of their economic gains or losses. Instead, well-organized groups, like corporations, farm groups, and unionized workers, have disproportionate political power compared to poorly organized groups like consumers and non-unionized workers.

KORUS FTA provides a perfect illustration of the political economy of free trade. The strongest opposition to the original treaty came from the Big Three automakers and their unions, which controlled enough Democratic votes in Congress to block ratification. Opponents claimed that US-Korean automobile trade is inherently unfair because Korea exports 700,000 cars a year to the United States while importing 100 times fewer US cars. Little attention was paid to the fact that KORUS FTA would lower Korean auto tariffs by more than US tariffs would be lowered, or that Korean and US automakers each produce many cars in the others' country, which do not show up in import figures, or that trade in auto parts is closer to balance than trade in finished cars.

Additional opposition came from US beef producers. Korea has blocked US beef imports, alleging risks of mad cow disease. This has infuriated Senator Max Baucus (D-Mont.), Chairman of the Senate Finance Committee, which is a key gateway for ratification. Many observers think Korean health concerns are bogus, but whatever the science behind them, they are political reality. An earlier attempt to lift the beef ban led to riots in the streets of the Korean capital, and the government now views beef in third-rail terms.

The political balance of forces has now changed greatly. US auto companies and their unions have lost leverage due to bankruptcies and bailouts. Max Baucus will still chair the Finance Committee, but Democratic leverage will be notably weaker. A long list of big corporations--FedEx, Microsoft, General Electric, Wal-Mart, GE and others--have favored KORUS FTA from the beginning, not least because it will significantly weaken non-tariff barriers to trade in services. Unless Senate Republicans decide to vote against KORUS FTA solely because the Obama administration backs it, we can expect ratification in the spring.

The bottom line: There is often a big gap between the economics and the politics of trade liberalization. Economics tells us that when the interests of all groups are taken into account, trade liberalization leads to net gains for both importing and exporting countries. However, in Washington, politics is played as a zero-sum game where the interests of consumers and non-unionized workers often count for little. It is only at certain moments that the economics and politics of trade liberalization line up favorably. Let us hope this is such a moment.

Follow this link to download a short slide show on trade liberalization and KORUS.

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

2010-11-28T22:04:00.000-08:00

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