Fiscal Education for the G-7

As the G-7 Leaders gather in Ise-Shima, Japan, on May 26-27, the still fragile global economy is on their minds.  They would like a road map to address stagnant growth. Their approach should be to talk less about currency wars and more about fiscal policy.

Fiscal policy vs. monetary policy

Under the conditions that have prevailed in most major countries over the last ten years, we have reason to think that fiscal policy is a more powerful tool for affecting the level of economic activity, as compared to monetary policy.  The explanation can be found in elementary macroeconomics textbooks and has been confirmed in recent empirical research:  the effects of fiscal stimulus are not likely to be limited, as in more normal times, by driving up interest rates, crowding out private demand, running into capacity constraints, provoking excessive inflation, or overheating in other ways.  Despite the power of fiscal policy under recent conditions, economists continue to lavish more attention on monetary policy.  Why?

Sometimes I think the honest reason we economics professors are attracted to monetary policy is that central bankers tend to be like us, with PhDs, and to hold nice conferences.

The reason that one usually hears, however, is that fiscal policy is “politically constrained.”   This is an accurate statement, but not a good reason for us to give up on it.  Indeed, if the political process gets fiscal policy wrong, which it does, that is all the more reason for economists to offer their contributions.

Of course if one is a central banker, or is advising a central banker, then one must concentrate on the job at hand, which is monetary policy.  But precisely because there is a limit to what central bankers can say about fiscal policy, there is more need for the rest of us to do it.

The heyday of activist fiscal policy was 50 years ago. The position “we are all Keynesians now” was attributed to Milton Friedman in 1965 and to Richard Nixon in 1971.  In the late 20thcentury, most advanced countries managed to pursue countercyclical fiscal policy on average: generally reining in spending or raising taxes during periods of economic expansion and enacting fiscal stimulus during recessions. The result on average was to smooth out the business cycle (as Keynes had intended).  It was the developing countries that tended to follow procyclical or destabilizing policies.

Leaders forget how to do counter-cyclical fiscal policy in the US, Europe and Japan

After 2000, however, some countries broke out of their familiar patterns. Too many political leaders in advanced countries pursued procyclical budgetary policies: they sought fiscal stimulus at times when the economy was already booming, thereby exaggerating the upswing, followed by fiscal austerity when the economy turns down, thereby exacerbating the recession.

Consider mistakes in fiscal policy made by leaders in three parts of the world — the US, Europe, and Japan.

US President George W. Bush began the century by throwing away the large fiscal surpluses that he had inherited from Bill Clinton, and then continued with big tax cuts and rapid spending increases even during 2003-07, as the economy reached its peak.  It was during this period that Vice President Cheney reportedly said “Reagan proved that deficits don’t matter.”

Predictably, the rising debt left the government feeling less able to enact fiscal stimulus when it was really needed, after the Great Recession hit in December 2007.  At precisely the wrong time, Republicans “got religion” deciding that deficits were bad after all.  Thus when President  Barack Obama took office in January 2009, with the economy in freefall, the opposition party voted against his fiscal stimulus.  Fortunately they failed then, and the stimulus was able to make a big contribution to reversing the freefall in the economy in 2009.  But having regained the Congress in 2011, they did succeed in blocking Obama’s further attempts to stimulate the still-weak economy for three years. The Republicans appear to be consistently procyclical.

Greece is the “poster boy” of an advanced country that unhappily switched to a systematically procyclical fiscal policy after the turn of the current century.  Its first mistake was to run excessive budget deficits during the expansionary period 2003-08 (like the Bush Administration).  Then, as if operating under the theory that “two wrongs make a right,” Greece was induced after its crisis hit to adopt tight austerity in 2010, which greatly worsened the fall in GDP. The goal was to restore its debt/GDP ratio to a sustainable path; but instead the ratio rose at a sharply accelerated rate, because of the fall in GDP.

Europeans suffer even more than other countries from basing their budget plans on official forecasts that are unnecessarily biased, which can lead to procyclical fiscal policy.   Before 2008, not just Greece, but all euro members were overly optimistic in their forecast and so at times “unexpectedly” exceeded the 3% ceilings on their budget deficits.  After 2008, qualitatively similar stories of procyclical fiscal contraction, leading to falling income and accelerating debt/GDP, also held in Ireland, Portugal, Spain and Italy.

The native land of austerity philosophy is, of course, Germany.  The Germans had (reluctantly) gone along with an agreement at the London G-20 Leaders Summit of April 2009 that the US, China, and other major countries would expand demand in order to address the Great Recession.  But when the Greek crisis hit at the end of that year, the Germans reverted to their deeply held beliefs in fiscal rectitude.

At first the IMF went along with the other members of the troika in believing — or at least pretending to believe — that fiscal discipline in the European periphery countries would not greatly damage their GDPs and thus could restore their debt/GDP ratios to sustainable paths.  But in January 2013, Fund Chief Economist Olivier Blanchard released a paper that was widely interpreted as a mea culpa.  It concluded that fiscal multipliers were much higher than the IMF (among other forecasters) had thought, suggesting that the austerity programs might have been excessive.  This conclusion was based on a statistical finding that the countries which had attempted the biggest fiscal retrenchment in response to the crisis turned out to experience the most damage to GDP relative to what the IMF forecasters had expected. Today, IMF Managing Director Christine Lagarde explains to the Germans that Greece cannot achieve the elusive path of a sustainable debt/GDP ratio if it is not given further debt relief and is instead told to run primary budget surpluses of 3 ½ percent of GDP.

Now to Japan, host of this week’s G-7 meeting.  In April 2014, even though the economy had been so weak that the Bank of Japan had been pursuing aggressive quantitative easing, Prime Minister Abe went ahead with a planned increase in the consumption tax (from 5% to 8%).  As many had predicted, Japan immediately went back into recession.  Even though the first arrow of Abenomics, the monetary stimulus, had been fired appropriately, it was evidently less powerful than the second arrow, fiscal policy, which unfortunately had been fired in the wrong direction.

Prime Minister Abe has indicated that he is sticking with his plan to go ahead with a further rise in the consumption tax (to 10%), scheduled for April 2017.  It is easy to see why Japanese officials worry about the country’s huge national debt.  But, as near-zero interest rates signal, creditworthiness is not the current problem; weakness in the economy is.  A more effective way of addressing the long-run sustainability of the debt is to announce a 20-year path of very small annual increases in the consumption tax, calculated so as to demonstrate to investors that the ratio of debt to GDP will come down in the long term.

Developing countries

Not all is bleak on the country scoreboard of cyclicality.  Some developing countries didachieve countercyclicalfiscal policy after 2000.  They took advantage of the boom years to run budget surpluses, pay down debt and build up reserves, which allowed them the fiscal space to ease up when the 2008-09 crisis hit.  Chile is the poster boy of those who “graduated” from procyclicality. Others include Botswana, Malaysia, Indonesia, and Korea.  China’s 2009 stimulus was very countercyclical.

Unfortunately some, like Thailand, who achieved countercyclicality in the last decade, have suffered backsliding since then.  Brazil, for example, failed to take advantage of the renewed commodity boom of 2010-11 to eliminate its budget deficit, which explains much of the mess it is in today now that commodity prices have fallen.

Politicians everywhere might improve their game if they re-read their introductory macroeconomics textbooks.

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Talk on trade: TPP & Trump

The ITC Wednesday released its mandated report on the economic effects estimated to result from the TransPacific Partnership.  As is usual in standard trade models, the estimated welfare gains may sound small: on the order of ¼ % of income.  But that would still be way worth doing.    Furthermore the ITC study, by design, leaves out a lot.  For example, the Petri-Plummer study from the Peterson Institute estimates income gains from TPP that are twice as large, in part because it takes into account Melitz-style opportunities for  more productive firms to expand.

I am quoted twice in the associated press coverage this week. They can be tweetably summarized in one sentence:
(1) US rejection of TPP would signal withdrawal from Asia; (2) US acceptance of Trump would signal withdrawal from the entire world!

(1)   One quote appeared in an Associated Press article (titled “Complex US politics of trade will follow Obama to Asia”):
“Many in Asia have come to think that maybe they can’t depend on us, that we’re withdrawing.  That feeling may be worse in this presidential election year,” says Professor Jeffrey Frankel of Harvard University‘s Kennedy School of Government. “The international relations aspect of this is if we don’t pass TPP, Asians are going to interpret it as a U.S. withdrawal from their region. And they’re going to get closer to China.”

(2) Another appeared in a Financial Times article today (titled “Obama fights back against Trump over US trade deals”):
“It is hard to believe he would really be able to follow through — much of it is illegal [and] contradicts US international agreements,” Jeffrey Frankel, a professor at Harvard’s Kennedy School of Government, said of Mr Trump’s economic agenda. “The global impact of that would be tearing down the entire postwar international . . . order.”  

Posted in Budget, Bush business cycle, Change, Congress, Copenhagen, Crisis debt, Deficit, ECB emission, Employment, Euro, Europe, Exchange Rates, Expansion, Fed, Feldstein, Fiscal, Forecast, G20, GDP, George W. Bush, Gold, Greece, Growth, Jobs, Kyoto, NBER, Obama Administration, Oil, Reagan, Recession, Recovery, Renminbi, Tax, TPP, Yuan | Leave a comment

The Domestic Threat to US Leadership

US President Barack Obama has racked up a series of foreign-policy triumphs over the last 12 months. But one that has gained less attention than others was the passage last December of legislation to reform the International Monetary Fund, after five years of obstruction by the US Congress. As the IMF convenes in Washington, DC, for its annual spring meetings on April 15-17, we should pause to savor the importance of this achievement. After all, if the United States had let yet another year go by without ratifying the IMF quota reform, it would have essentially handed over the keys of global economic leadership to China.

The IMF reform was crucial: The allocation of monetary contributions and voting power among member countries had to be updated to reflect the shifts in global economic power in recent decades. Specifically, emerging-market economies like Brazil, China, and India gained a larger role, primarily at the expense of European and Persian Gulf countries.

Obama managed to persuade the leaders of the other G-20 countries to agree to the reform at a 2010 summit in Seoul. The deal’s subsequent approval should have been a no-brainer for Congress, as it neither increased America’s financial obligations nor took away its voting dominance. More important, the reform represented a golden opportunity for the US to demonstrate global leadership, by recognizing that the existing international order must accommodate changing economic-power dynamics.

Instead, Congress attempted to block IMF reform, effectively denying China its rightful place at the table of global governance. “Moving the goal posts” could succeed only in driving the Chinese to establish their own institutions. In this sense, Congressional intransigence may have undermined America’s position in its competition with China for global power and influence.

To most Asians, the US is a more attractive regional hegemon than a China that has been aggressively pursuing territorial claims in the East and South China Seas. But recent US behavior has caused some Asian countries to begin to question America’s commitment to supporting regional security and prosperity.

Against this background, many countries, both inside and outside Asia, were happy to join the China-led Asian Infrastructure Investment Bank, which promised to meet some of the region’s financing needs. The AIIB’s establishment in December was widely viewed as a severe diplomatic setback for the US.

Fortunately, thanks to Obama’s recent string of successes in terms of global engagement, the US now has a chance to get back into the game. Last April, his administration oversaw a breakthrough agreement with Iran over its nuclear program. Moreover, in October, Congress was persuaded to give it Trade Promotion Authority, enabling the completion of the 12-country Trans-Pacific Partnership (TPP). More recently, the US has reestablished diplomatic relations with Cuba, ending a 55-year policy of isolation that succeeded only in giving Cuba’s leaders an excuse for economic failure and handicapping America’s relationships throughout Latin America.

Finally, representatives of the 195 parties to the UN Framework Convention on Climate Change reached an agreement in Paris last December to reduce greenhouse-gas emissions, spurred in no small part by earlier action by Obama and Chinese President Xi Jinping. The two leaders are scheduled to sign the Paris agreement on April 22 on behalf of their respective countries, the world’s two largest emitters of greenhouse gases. Add to that the ratification, at long last, of IMF reform, and the US does seem to be on a global winning streak.

None of these five achievements could have been predicted a year ago. With the Republicans having taken full control of the Congress in November 2014, the overwhelming conventional wisdom was that the administration would be blocked from accomplishing much in its final two years.

Making matters worse, internationalism attracts opposition from the far left as well as the far right. Though trade is the most obvious example, it is not the only one. Beyond opposing the TPP, US presidential candidate Bernie Sanders has historically joined with congressional Republicans in trying to block efforts to rescue emerging-market countries in Latin America and Asia at times of financial crisis. These rescues are invariably called “bailouts,” even when they cost the US nothing – the US Treasury actually made a profit on the 1995 loan to Mexico that Sanders opposed – and help sustain economic growth. Similarly, New York Senator Chuck Schumer joined the Republicans in trying to block the Iran nuclear agreement.

Obama’s recent international successes are not unassailable. Although the IMF deal is done, Obama’s other key initiatives could still be derailed by US politics, especially if the political extremes unite. Congress could reject the TPP, in effect telling Asia it is on its own. It could undermine the emerging relationship with Cuba; after all, it has yet to repeal the embargo. As for the Paris agreement, a federal appeals court will first hear a challenge to the administration’s implementation strategy, the Clean Power Plan, on June 2.

 

Posted in 2016 Presidential Campaign, Europe, IMF Reform, International Monetary Fund, Obama Administration | Leave a comment

No, Japan Does Not Intervene in FX These Days

There has been recent speculation that the Japanese authorities might intervene to push down the yen.  One can see the reasoning.  The yen has appreciated against the dollar by about 9 per cent this year, even though the fundamentals have gone the other way: weak growth and renewed easing of monetary policy.

Saturday’s Financial Times even cites BNY Mellon as saying of the Bank of Japan, “Since mid-1993, they have on average intervened once every 20 trading days in dollar-yen.”   But this is misleading.  The period of frequent intervention was in the 1980s and 1990s.  The Japanese have rarely intervened in the foreign exchange market since 2004.  The last time was in 2011, in cooperation with the US and others, to dampen a strong appreciation of the yen that came in the aftermath of the Tohoku earthquake and tsunami.

The G-7 partners in February 2013 agreed to refrain from foreign exchange intervention, in a US-led effort to short-circuit fears of competitive depreciation (a sort of truce in the supposed “currency wars”).   Intervention will return some day.  But it strikes me as unlikely that the Bank of Japan would intervene now without the cooperation of the US (and other G-7 partners); and unlikely that the latter would agree at the current juncture.

 

Posted in Dollar, Exchange Rates, Foreign exchange, Intervention, Investing, Japan, Yen | Leave a comment

Stagnant Wages Do Not Explain Trump

The mainstream media are busily reproaching themselves for having been so out of touch with the economic troubles of angry white working men that they were late in taking Donald Trump’s presidential campaign seriously.   Most of us can join in to admit that we were very slow to take Trump seriously.   For one thing, we all thought that any candidate would be permanently derailed by even a small number of the many things that Trump has said.  We used to call these gaffes — either the ones that seemed designed to alienate particular groups (Hispanics, women, etc.) or the ones that revealed his lack of familiarity with real-world issues.

But can the under-estimation of Trump’s candidacy really be attributed to inadequate appreciation of the economic troubles of American workers?

The increase in inequality is very real, particularly the stagnation over the last 40 years of wage income among low-skilled men (defined as those without college education).  For many years, Democrats have made proposals to ameliorate the problem, while Republican presidential candidates have consistently pursued tax cuts for the rich as their number one policy response.

The puzzle is why anyone thinks that Donald Trump’s candidacy offers a break with this particular pattern.  The problem is not that he himself inherited great wealth.  The problem is rather that his policy proposals, such as they are, would not address the inequality issue.   He, like virtually all Republican candidates, proposes big tax cuts for the rich, with no way of paying for the lost revenue.

But he has also said something that no candidate has ever said: “wages are too high.”  He said it at least twice:  November 10, 2015, in the Republican presidential debate on Fox and November 11, on MSNBC’s Morning Joe.  (He has also denied having said it.  But the tapes are very clear. This is a pattern we have seen many times, of course.  Sometimes he brazenly accuses the media of having made up the quote.)

The elite media have beaten themselves up over their eliteness many times before.  Remember how, during the GWB years, journalists swallowed Karl Rove’s line that Republican votes were rising on an unstoppable tide of middle-America family values?  This was before people noticed that the red zip codes had higher rates of divorce, teenage pregnancy, and other indicators of lack of personal responsibility than the blue zip codes.

I don’t claim to understand the remarkable Trump phenomenon.   But whatever is the explanation, it is not a response by working white men that could have been logically predicted based on their stagnant incomes.

 

Posted in 2016 Presidential Campaign, Candidates, inequality, Presidential, Uncategorized | Tagged , , , , | Leave a comment

Did the Markets Overlook a Sign of Fed Bullishness in the March 16 FOMC Statement?

Financial markets reacted to the outcome of the FOMC meeting on Wednesday, March 16, as if what the Fed had revealed was highly dovish, that is, diminishing expected future interest rates.  The markets focused on the shift in the “dots plot” which formally rescinds the Fed’s previous forecast that it would raise interest rates four times in 2016.  (Now it says twice.)   Furthermore, Chair Yellen in her press conference said, “Most Committee participants now expect that achieving economic outcomes similar to those anticipated in December will likely require a somewhat lower path for policy interest rates than foreseen at that time.”

But this is old news. It reflects developments at the start of the year, such as the US report that GDP growth had been weak in the 4th quarter and the global financial market volatility in January and early February (especially related to China).  Everyone knew all this a month ago.

The new news pertains to what has happened since mid-February.  A lot of trends that had appeared to be negative have reversed in the last month.  Statistics on US domestic final sales in January suggest that GDP will likely be stronger in the first quarter. Meanwhile, strong employment reports continue the record-long streak of private jobs gains, which have been running in excess of 200,000 per month.  And globally, downward pressure on the renminbi, the stock market, and commodity prices — which had so worried investors – all abated in February-March.

So did the Fed recognize these signs of economic strength in its statement Wednesday?  Yes, it did.   Gone was the January sentence “…economic growth slowed late last year.”   In its place was a note that “economic activity has been expanding at a moderate pace…”   (Also “Inflation picked up in recent months.”)  Unless I am mistaken that language wasn’t there before, only the longstanding positive language about employment.  It seems to me that the markets this week may have missed an acknowledgement from the Fed that things have turned around since the first six weeks of the year.

 

Posted in dot, Fed, Federal Reserve, FOMC, Interest rates, Investing, Markets, Monetary Policy, Yellen | Leave a comment

Who is right on US financial reform? Sanders, Clinton, or the Republicans?

Eight years after the financial crisis broke out in the United States, there is as much confusion as ever regarding what reforms are appropriate in order to minimize the recurrence of such crises in the future.

There continue to be some good Hollywood movies concerning the crisis, including one nominated for multiple Oscars at the February 28 Academy Awards.  The Big Short has been justly praised for making such concepts as derivatives easy for anyone to understand.  As has been true since the first of the movies about the crisis, they are good at reflecting and crystalizing the audience’s anger.  But they are not as good at giving clues to those walking out of the theater as to the implications.  What policy changes would help?  Who are the politicians that support the desirable reforms?  Who opposes them?

If an American citizen is “mad as hell” at banks, should he or she respond by voting for the far left?  By voting for the far right?   (Or by refusing to vote at all?)   Each of these paths has been chosen by many voters.  But each is misguided.

There is a place in political campaigns for short slogans that fit on cars’ bumper stickers.  (“Wall Street regulates Congress.”)   And there is a place for ambitious goals.  (“Shrink the financial sector.”)  But the danger is that those who are attracted to inspirational rallying cries and sweeping proposals will lack the patience required to identify which is the right side to support in the numerous smaller battles over financial regulation that take place every year and that ultimately determine whether our financial system is becoming structurally safer or weaker.

Breaking up banks

Senator Bernie Sanders has proposed breaking up the banks into little pieces.  It is the centerpiece of his campaign for the Democratic presidential nomination.   The goal is to make sure that no bank is too big to fail without endangering the rest of the financial system.   That would require quite a sledge hammer.  The American banking system historically featured thousands of small banks.   But having thousands of small banks did not prevent runs on depositary institutions in the United States 1930s.

Continental Illinois was the original case of a bank that was deemed “too big to fail” in 1984, when it was bailed out by the Reagan Administration.   So banks would have to be broken into smaller pieces than that.  Merely turning the deregulatory clock back 30 years would not be enough to do it.

I am not sure whether or not, if one were designing a system from scratch, it would be useful to make sure that no bank was above a particular cap in size chosen so that any of them could later be allowed to fail with no further government involvement.   I do know that having a financial system dominated by just five large banks did not prevent Canada from sailing through the Global Financial Crisis of 2008-09 in better shape than almost any other country.

Attacking banks is emotionally satisfying, for understandable reasons.  But it won’t prevent financial crises.

Reforms proposed by Hillary Clinton

Hillary Clinton is correct in pointing out that the most worrisome problems lie elsewhere:  hedge funds, investment banks, and the other so-called non-banks or shadow banks.  These are financial institutions that are not commercial banks and that therefore have not been subject to the same regulatory oversight and the same restrictions on capital standards, leverage, and so on.  Recall that Lehman Brothers was not a commercial bank and AIG was an insurance company.

Secretary Clinton has done her homework and proposes specific measures to address specific problems with the non-banks.     Four examples:

  • She puts priority on closing the “carried interest” loophole that currently allows hedge fund managers to pay lower tax rates on their incomes than the rest of us pay.  This is a more practical step than most proposals to address the very high compensation levels in the financial sector that cause so much resentment.  It would help moderate inequality, reduce distortion, and raise some tax revenue to help reduce the budget deficit.
  • She proposes a small tax targeting certain high-frequency trading prone to abuse. (Sanders proposes a tax on all financial transactions.)
  • She also supports higher capital requirements on financial institutions, including non-banks, if necessary, beyond those increases already enacted.
  • She proposes a “risk fee” on big financial institutions that would rise as they get bigger.  This is reminiscent of a fee on the largest banks that the Obama Administration proposed in 2010, to discourage risky activity while at the same time helping recoup some revenue from bailouts.  It was going to be part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, but in the end three Republican senators demanded that it be dropped as their price for supporting it.

The Dodd-Frank reforms

The Dodd-Frank law was a big step in the direction of needed financial reform.  It included such desirable features as increasing transparency for derivatives, requiring financial institutions to hold more capital, imposing further regulation on those designated “systemically important,” and adopting Elizabeth Warren’s idea of establishing the CFPB, the Consumer Financial Protection Bureau.

It goes without saying that Dodd-Frank did not do everything we need to do.  But the law  would have moved us a lot further in the right direction if many in Congress  had not spent the last six years chipping away at it.  Those who worked to undermine the financial regulatory reform legislation – mostly Republicans – appear to have paid no political price for it, since most of these issues are below the radar for most voters.

Here are a few examples of how Dodd-Frank has been undermined:

  • I mentioned the abandonment of the fee to discourage risk-taking by large banks and of an earlier proposed global bank levy.
  • Auto-dealers, amazingly, lobbied successfully to get themselves exempted from regulation by the CFPB, allowing the resumption of some abusive lending practices that resemble the sub-prime mortgages which played such a big role in the 2008 financial crisis.  There are 17,838 auto dealers.  I guess highly concentrated industries are not the only ones that can buy their way to special-interest carve-outs.
  • The Dodd-Frank law was supposed to require banks and other mortgage originators to retain at least 5% of the housing loans they made, rather than repackaging every last mortgage and reselling it to others.  The reason is that the originators need to have “skin in the game” in order to have an incentive to take care that the borrowers would reasonably be able to repay the loans.  Under heavy pressure from Congress, that requirement was gutted in 2014.   (This one is not especially the fault of the Republicans.  Virtually every American politician in both parties still acts as though the goal should be to get as many people into as much housing debt as possible, even if many will not be able to repay the loans and even after such practices caused the worst financial crisis and recession since the 1930s. Other countries manage to do this better.)
  • The Congress has refused to give regulatory authorities such as the SEC (Securities and Exchange Commission) and CFTC (Commodities Futures Trading Commission) budgets commensurate with their expanded regulatory responsibilities, in a deliberate effort to hamper enforcement.  Many Republicans appear still to believe that these agencies represent excessively aggressive regulation.  This is remarkable in light of the financial crisis.  Remember that Bernie Madoff — who is himself now the subject of new Hollywood portrayals — was able to run his Ponzi scheme right up until 2008 despite repeated tip-offs to the SEC, because it systematically refrained from pursuing investment management cases during this period.

Who can get the job done?

Sanders has indicated that if he were president, nobody with past experience on Wall Street would be allowed to serve in his administration.  A blanket rule like this would be a mistake.  Judging people by such superficial criteria as whether they have ever worked for Goldman Sachs, for example, would have deprived us of the services of Gary Gensler.  As CFTC chairman from 2009-2014 Gensler worked tirelessly to implement Dodd-Frank.  To the consternation of many former Wall Street colleagues, he aggressively pursued regulation of derivatives and, for example, prosecution of a case against five financial institutions who had colluded to manipulate the LIBOR interest rate (London Interbank Offered Rate]. Yet Sanders tried to block his appointment in 2009.

Financial issues are complicated.  Getting the details of regulation right is hard.  (The examples mentioned here are just the tip of the iceberg.)  We need leaders and officials who have the wisdom, experience, patience, and perseverance to figure out the right measures, push for their enactment and then implement them.  If such people are not the ones who receive political support for their efforts, we should not be surprised if the financial sector again escapes effective regulation and crises recur in the future.

 

Posted in 2016 Presidential Campaign, Democrats, Financial Crisis, Financial Regulation, Investing, Republicans | Tagged , , , , , , , , | Leave a comment

China crash?

An extended version of my column on “China’s slowdown” now appears at VoxEU, including academic references.

Someone at Seeking Alpha responds with the following question:  What are the odds of an outright recession in China, with substantially negative GDP growth?

My reply:

This scenario is certainly possible. I have even described financial bubbles-and-crashes as a sort of “rite of passage” that newly arrived economic powers undergo (Holland 1637, England 1720, US 1929, Japan 1990, Korea 1997).  In China the crash would probably come from the accumulation of bad loans (especially in the shadow banking system) and financing of unused capacity (especially in residential construction).

I would put a 25% probability on a Chinese recession happening within the next few years. Even then, however, China would more likely recover before long, as Korea did, rather than stagnate as the US did in the 1930s or Japan in the 1990s-2000s.

 .

Posted in China, Chinese, Financial Crisis, Rite of passage | Leave a comment

China’s Slowdown

Investors worldwide are closely watching the steep decline in China’s stock market.  The Shanghai Stock Exchange Composite Index is down more than 40% since June 2015.

The reason observers are concerned is not because they themselves are invested: China’s stocks are overwhelmingly held by Chinese themselves.  Rather, many are interpreting it as evidence that China’s economy is going down the tubes.

China’s growth rate has indeed slowed down and there are plenty of reasons to believe that the slowdown is not just temporary.  But none of them have much to do with the stock market.

For one thing, market prices are still well above where they were in 2014.  That was a time when many observers were bullish on China, proclaiming that its economy had just surpassed the US to become the world’s largest, on the basis of new PPP-based GDP statistics.  But in fact the slowdown in Chinese growth began four years ago.  According to the official statistics, growth averaged 10% over the three decades 1980-2010, but slowed down to the 7%-8% range in 2012-14.

Indeed, the reason that China’s stock market started to ascend at the end of 2014 is that the People’s Bank of China began to cut interest rates in November, in an appropriate response to the slowdown in economic growth that was already evident.  But the market’s continuing rise took on the character of a credit-fueled bubble in the spring of 2015.  The peak came on June 12, when the China Securities Regulatory Commission tightened margin requirements.

The bubble has now been reversed.  That doesn’t necessarily convey much information about China’s growth prospects.

There are plenty of reasons not to be surprised that China’s growth rate has slowed down and not to expect it to return to 10%.  The human instinct of some forecasters five years ago was simply to extrapolate the preceding three decades.   But casting a wider statistical net would have revealed that a fourth decade at 10% would have been historically unprecedented.

The Middle Kingdom is not exempt from the broader statistical regularities.  Some see the slowdown as a case of the middle-incometrap. Others find that the more relevant statistical pattern is regression to the mean in growth rates.

What are the economic forces behind the tendency for a rapidly growing country to slow down?  There is a wide variety of possible economic interpretations. Six come to mind:

  • One is diminishing return to capital.  China’s investment in steel mills, transportation infrastructure and residential construction became “too much of a good thing.”
  • Another interpretation is the observation that productivity growth is easier when it is a matter of copying the technologies, production processes, and management practices of the Western countries.  When the gap between the economic frontier and the newcomers narrows, the latter countries have to do some of the innovating on their own.
  •  A third explanation is that rural-urban migration has been a big source of China’s growth, but that the surplus labor has finally been used up, wages have risen, and the competitive advantage in labor-intensive manufactures has been lost.  (The “Lewis turning point” has been reached.)
  • A fourth is that the population is ageing.  The working-age population peaked in 2012.  The ratio of retirement-age people to working-age population is rising.  This demographic transition occurs naturally in advanced countries; but the one-child policy accelerated it prematurely in China.
  • A fifth is that urban land prices have been bid up and the “carrying capacity” of the environment has been exhausted.
  • A sixth is that the composition of the economy is shifting away from manufacturing and into services, which is appropriate but which entails slower growth because in all countries there is less scope for productivity growth in services than there is in manufacturing.

Thus a shift from 10 per cent growth in China to a more sustainable long-term 5-7 per cent trend is perfectly natural.  The important question is whether the transition takes the form of a soft landing or a hard landing.  In a soft landing China would continue to grow at the slower-but-sustainable trend rate.  In a hard landing it would suffer a financial crisis and more severe economic recession.

High dependence on investment spending and debt financing can work well during a high-growth phase but then lead to excess capacity and financial crisis when the long-run growth rates slows down.  Precedents include post-1980s Japan and 1997-98 Korea.

Some say that the official statistics seriously overstate GDP and that the true growth rate has already fallen well below the 6.9 per cent that the government has reported for 2015.  It is indeed suspicious that official growth statistics seem in most years to come close to the numbers in plans that had been announced by the government ahead of time.  So the skeptics reasonably turn to more tangible measures.  They point out that energy consumption, freight railway traffic, and output of such industrial products as coal, steel, and cement have slowed sharply.  (These are components of the so-called Keqiang Index.)  But Nicholas Lardy persuasively argues that those statistics are also consistent with the interpretation that the composition of China’s economy has been shifting away from heavy manufacturing and toward services.

The shift away from manufacturing to services is one component of a desirable package of policies to smooth the transition to a sustainable growth rate.  Another is a reduced reliance on investment spending and export demand, and a greater role for household consumption.  Other desirable reforms include increasing the flexibility of land markets and labor markets.  For example labor mobility is still impeded by insecure land rights in the countryside and the hukou system in the cities.  More generally, the markets should continue to play a growing role in the economy.  State-owned enterprises should be reined in.  Reforms are also needed in health care, social security, and the tax system.  And, of course, environmental regulation and the end of the one-child policy.

Chinese economists and leaders know all this. Indeed a very similar list of reforms was the outcome of the Communist Party’s Third Plenum in 2013.  Beijing has taken some steps to implement them over the last two years.  But there is still a long way to go and it is by no means guaranteed that the implementation will be fully successful.  As Shang-Jin Wei of the Asian Development Bank points out, the fate of China’s economy depends a lot more on how well the reforms go than on anything about last year’s stock market bubble and its subsequent reversal.

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Posted in Asia, China, Convergence, Growth, Investing, Stock market | Leave a comment

Forecasting 2016 Economic Developments & Candidates’ Reactions

As the new year starts, Politico asks a set of economists for forecasts.  Prognostication from 23 appears at “Could the Economy Tank in 2016?

By the way, I think my forecast last time, two years ago, turned out to hold up pretty well:

Something important will get better in 2014: Fiscal policy will stop hurting the economyThe biggest impediment to economic expansion over the last three years has been destructive budget policy coming out of the CongressThere are good grounds for optimism in 2014. For the first time in four years, Congress will probably not inflict contractionary fiscal policy on the American people. If the government sector stops making a negative contribution, that will show up as economic growth.”

This time I focused on the following question from Politico:

Q: How will the 2016 presidential candidates have to adapt to economic realities and unforeseen developments in the coming year, such as the risk of recession, as they make the case to voters about their own economic visions?

A:  Recessions are not forecastable.  A downturn is no more likely in 2016 than in a typical year, nor less likely.

The next president will, like his or her predecessors, have to shift gears from the campaign and adjust to a very different set of developments and realities upon taking office.  But this is because of politics, not mainly because of uncertainty regarding what lies ahead.   The adjustment process will not begin until after the election, even if major new developments in the domestic or global economy take place during 2016.  The polite way to phrase it is to observe that “politicians campaign in poetry and govern in prose.”

Republican nominees, for example, always promise to cut taxes, increase military spending, protect seniors, and yet to run a strong budget balance, even though that combination is arithmetically impossible.  Democratic nominees too make unrealistic claims about how they will be able to combine spending increases with budget discipline.   Unforeseen disasters – financial, economic, national security – do not cause candidates to rethink their plans, but only to double down.   It is only after they take office that they are forced to confront the arithmetic, and sometimes they can postpone facing up to it for several years.

Some presidents adjust to fiscal realities immediately, during the presidential transition (Bill Clinton), some after a year or two of fiscal failure (Ronald Reagan and George H.W. Bush), and some later still (George W. Bush).   But none do it before the election.

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Posted in 2016 Presidential Campaign, Budget, Candidates, Democrats, Fiscal, Forecast, Presidential, Recession, Republicans, Tax cuts | Leave a comment