US Monetary Policy and East Asia

I visited Korea earlier this summer and gave a talk on effects of U.S. Tapering on Emerging Markets.  (This was also the subject of comments at an Istanbul conference sponsored by the NBER and the Central Bank of Turkey in June.)

An interview on the effects of policy at the Fed and other advanced-country central banks on East Asian EMs now appears in KRX magazine (in Korean), August. Here is the English version:

Special Interview with  Jeffrey A. Frankel <KRX MAGAZINE> August

Q: On 10 June 2014, Federal Reserve Bank of Boston President Eric Rosengren said in a speech that the Fed’s “new” monetary policy tools, including forward guidance and large-scale asset purchases, were “essential” in ensuring the economic recovery in the United States. What do you think about the ‘ongoing’ U.S’s ‘Tapering’ policy? And what is your idea about appropriate “new” monetary policy?

JF: The authorities in the US and other countries were in 2008 faced with a challenge greater than any since the Great Depression of the 1930s. After they reduced short-term interest rates to zero, the “Zero Lower Bound” meant that they had exhausted their conventional monetary tools and it was indeed necessary to turn to “new” monetary policy tools, specifically Quantitative Easing (QE), in its various forms, and forward guidance in its various forms.  For one thing the use of these tools has worked to keep long-term interest rates lower than they otherwise would be.  I think that they have done a good job.  (One mis-step was the Fed decision two years ago to phrase forward guidance in terms of the unemployment rate; it has since had to abandon that guidance because an unexpectedly rapid fall in labor force participation reduced the unemployment rate more quickly than the economy recovered.)  A second Great Depression was averted in 2009 because of the policy responses in three areas: unfreezing of the financial system, fiscal stimulus, and the monetary expansion.

I also think that the tapering of QE, before the Fed is ready to start raising short-term interest rates, is appropriate. It wants to reduce the rate of growth of the monetary base, and eventually perhaps reel some of it back in, before the economy is fully operating at normal capacity and banks are ready to resume converting all of their excess reserves into loans. (If they were to wait too long, long-standing warnings of inflation might eventually acquire a germ of truth that they have previously lacked.)

Q: A World Bank policy research working paper “Unconventional Monetary Policy Normalization in High-Income Countries” noted that “volatility and eventual tightening of global financial conditions” related to policy normalization and “the possibility of a sharp slowdown in China”, represent major risks to the regional outlook. What do think about the meaning of ‘normalization’?

JF: There are always risks to the world economy and it is always wise to consider them ahead of time.  I agree that high on the list of possible risks to the world economy in general and to emerging markets in particular is a loss of enthusiasm on the part of international investors, which could arise either from a return to “risk off” mode, from an increase in US interest rates, from a hard landing in China, or from any combination of such factors. We saw some of this in the “taper tantrum” of a year ago. Another possible risk is a worsening of conflict in parts of the Mideast.

Regarding the meaning of “normalization,” there are some who think that the “new normal” is interest rates that will remain low indefinitely far into the future I am a bit skeptical of this proposition. But it doesn’t really matter how far interest rates eventually rise in the US and other major advance economies; the danger of a sudden stop of capital flows to Emerging Markets should be contemplated regardless.

Q: Market experts warned emerging markets that the next financial unrest situations may catch them off guard, recommending smaller budget deficits, higher interest rates and measures to boost productivity. Speaking of developing or emerging market countries, what approach is the best preparation plan?

JF: Some emerging market countries have learned from the mistakes of the past and from the crises in the 1980s and 1990s, and have adopted policies that leave them less vulnerableto shocks in the global system. These include exchange rate flexibility, holding plenty of foreign exchange reserves, avoiding debt that is excessively short-term, dollar-denominated, or bank-intermediated, eliminating current account deficits, and adopting strong andcounter-cyclical fiscal policy.  (Hardest of all are structural measures to improve productivity growth, such as labor marker flexibility and trade liberalization.)  In the last five year, however, there has been some backsliding, notably the return of large current account deficits in some countries and dollar-denominated debt in the corporate sector.

Q: On 5 June 2014, The ECB cut interest rates to record lows, imposing negative rates on its overnight deposits, meaning that banks will have to pay to leave money in the bank. But Market experts said that developing countries can expect rising interest rates. What do you think?

JF: Ever since 2010, most developing countries have experienced substantially stronger growth than the advanced economies, and indeed many have had problems with overheating and inflation.  Thus it has been perfectly appropriate that countries such as Brazil, for example, have had higher interest rates than the major advanced countries. Beyond this, the ECB and the Bank of Japan have seen the need to pursue new rounds of monetary easing over the last year, at a time when the Fed and the Bank of England are beginning to think about raising interest rates. But it apparently remains true that the Fed’s actions have a greater immediate effect globally than does the ECB’s actions, even though the euroland economy is as big as the US, probably because of the reserve-currency role of the dollar. So it would be prudent to expect that world financial conditions will get a bit tighter next year.

Q:  Asian central banks (especially China and Japan’s) are delaying a normalization of interest rates, either having to play catch-up when the US Fed starts to increase – or, worse, suffering a financial bust. What is your opinion?

JF: Most likely, when the Fed starts to raise interest rates, it will put downward pressure on the currencies of China and Japan.  Many countries would not want downward pressure on their currencies and would feel a need to raise their own interest rates correspondingly, so as to remain attractive to international investors. But China and Japan would be rather happy to see their currencies depreciate under circumstances where they cannot be blamed for it.  So I don’t see a problem for them.  This is not to rule out a worsening of their own problems on other grounds, particularly bad loans in China’s shadow banking sector and very high public debt in Japan.

Q: I see a direct correlation between “Fast normalization” and long-term interest rates. What is this point of view? What do long-term interest rates say about economic policy?

JF: How are long-term interest rates determined, given short-term interest rates?  The expectations hypothesis of the term structure of interest rates focuses on the extent to which market participants expect short term rates to go up in the future.  The portfolio-balance model focuses on the supplies of bonds that have to be held.  Both theories have some truth to them. Forward guidance works through the first channel while QE works through the second channel.  Both have helped keep long-term interest rates down.  But if markets expect “fast normalization,” that will immediately reverse the downward effect that forward guidance has had.

Q: Market analysts generally divide into two sides by country. Some urge reinforcing global coordination, further strengthened in the context of the Group of 20 (G-20). How long does this classification standard remain valid?

JF: The line between emerging market countries and industrialized economies has become blurred. Korea’s income per capita puts it even with some European countries and Singapore’s income is ahead of most of them. The same inter-shuffling of country categories is true by other criteria, such as credit ratings.  Meanwhile, within the category of developing countries, we need a line between Emerging Markets and Low-Income Countries, but it too is very hard to define.

Regardless, the distinction between the advanced economies and the others is still useful. Indeed, the uncoupling of the two categories of economies has been in evidence since 2010.

Policy-makers in some G-20 countries have called for greater coordination of macroeconomic policies, and in particular for the Federal Reserve to take their interests into account when setting US interest rates.  I am skeptical of the complaints that go under the name of “Currency Wars.”  The main point of floating exchange rates is so that the United States can set its interest rate at the level that is appropriate for its economy and Brazil or India can set their interest rate that is appropriate for theirs.

But I am sympathetic to the point that the big Emerging Market countries should be given more weight in the institutions of global governance.  The introduction of the G-20 itself, and its supplanting of the G-7, was a step in the right direction; so was the negotiation in November 2010 (at the G-20 summit in Seoul) to shift some IMF quota share weight from European countries to large EMs.  President Obama deserves some credit for this.  Unfortunately, the myopic US Congress refuses to ratify the agreement, in a foolishabdication of global leadership.

Q: In that way, China is very special country in the ‘emerging’ group. China has great influence in developed countries’ markets as well as emerging markets. What do you think?

JF: Yes, this is true.  I have pointed out that claims of China’s GDP surpassing US GDP are premature.  Nevertheless, its growth over the last few decades has been truly miraculous.  It will probably take the “# 1” position in terms of economic size around 2021 or so.

Q: Developing countries should further enhance policies supporting private saving and intermediation via domestic financial markets, hence reducing exposure to volatile external capital flows. Could you explain more specifically?

JF: Countries that maintain persistently high rates of national saving tend to grow faster than others and also to be less exposed to financial crises. National saving includes both public saving (government budget surplus) and private saving (household plus corporate). Public saving is under the control of the government. It is much harder for policy to control private saving. But one successful example is Singapore’s history of “forced saving.”

Well-functioning financial markets can contribute to the level of private saving and, especially, to its efficient allocation to high-return investments.  As is often pointed out, financial repression (oligopolistic or government-owned banks that pay savers interest rates lower than inflation and an absence of alternative places for them to put their money) is an obstacle to well-functioning financial markets in many countries.  On the other hand, simple sweeping financial liberalization is not the right answer.  Prudential regulation of banks and other financial institutions is necessary, to minimize cycles of excessive credit booms followed by bank runs or other kinds of financial crash. I admire some of Korea’s macro-prudential regulations, such as loan-to-value limits for home mortgages. I wish we had more of that in the United States.

Q: Jan Dehn of investment house Ashmore told the Financial Times. “The idea that EM (Emerging Market)’s have benefited from QE (Quantitative Easing) is nonsense – they haven’t gorged themselves on cheap money. Most QE money has gone to developed markets. EM is incredibly boring. Growth is being achieved through cyclical means, not cheap money”. What do you think about?

JF: That the US or other advanced countries still invest more in each other than in emerging markets does not mean that QE or other US investment or financial conditions among the advanced world are unimportant for emerging markets. They are very important. For example, US attitudes towards risk as measured by the VIX index are probably the most important single variable for determining capital flows to emerging markets.  But as some point out, these capital flows can have negative effects alongside the positive effects.

If the question is the importance in advanced economies of monetary policy compared to other determinants of growth, such as fiscal policy and structural reforms, I agree that the latter are probably more important. Some of the short-term vicissitudes of perceived Fed policy do receive more attention than they deserve. But, again, this does not mean that monetary policy does not matter.

Posted in Asia, International Cooperation, International Monetary Fund, Monetary Policy | Tagged , , , | Leave a comment

It Takes More than Two to Tango: Cry, But Not for Argentina, nor for the Holdouts

U.S. federal courts have ruled that Argentina is prohibited from making payments to fulfill 2005 and 2010 agreements with its creditors to restructure its debt, so long as it is not also paying a few creditors that have all along been holdouts from those agreements.  The judgment is likely to stick, because the judge (Thomas Griesa, in New York) told American banks on June 27 that it would be illegal for them to transfer Argentina’s payments to the 92 per cent of creditors who agreed to be restructured and because the US Supreme Court in June declined to review the lower court rulings.

It is hard to cry for Argentina or for its President, Cristina Fernández de Kirchner. Nevertheless the ruling in favor of the holdouts is bad news for the international financial system.  It sets back the evolution of the international debt restructuring regime.

Why is it so hard to feel sympathy for a developing country that can’t pay its debts?  In the first place, Argentina in 2001 had unilaterally defaulted on the entire $100 billion debt, rather than the usual effort to negotiate new terms with the creditors.  Thus when it finally got around to negotiating a settlement with the 92% majority of bondholders four years later, it could almost dictate the terms: a 70% “haircut” or loss.

In the intervening decade, the Kirchners have gone out of their way to pursue a variety of innovatively bad economic policies, reversing a preceding decade of good policies.  Ms. Fernandez has seriously impaired the independence of the central bank and the statistical agency, forcing the adoption of CPI statistics that understate the inflation rate, so systematically that most people no longer use them.  She has broken contracts and nationalized foreign-owned companies.  When prices for Argentina’s leading agricultural export commodities, reached very high levels on global markets –  a golden opportunity for the country to boost growth of output and foreign exchange earnings (chronically insufficient)  – she imposed heavy tariffs and quotas on soy, wheat and beef exports, thereby preventing producers from taking advantage.

On the other hand, some might counter that the holdout hedge funds who brought the suit to Judge Griesa are not that sympathetic either. Many of them are called “vulture funds” because they are not the original creditors but rather investors who came along later, buying the debt at deep discount, hoping to profit subsequently through court decisions.

But all this is beside the point. (And these investors shouldn’t let the name bother them so much; after all vultures have their own ecological niche.  When Alexander Hamilton, the first U.S. Treasury Secretary, redeemed the debts of the 13 colonies at full face value, he was well aware that some speculators who bought at deep discount would profit.) The problem with the Argentine debt case has little to do with moral failings of either the plaintiffs or the defendants.  Instead the problem is the precedent for resolution of international debt crises.

The popular reaction to the recent rulings, even among those less familiar with the sad history, is anti-Argentina. After all, the judge is just enforcing the legal contract embodied in the original bonds, isn’t he?   As President Calvin Coolidge supposedly said, about American loans to the WWI allies, “They hired the money, didn’t they?”

If only the world were so simple. If only a simple legal regime of consistently enforcing the explicit terms of all loan contracts, by making the debtor pay, were sufficiently practical to be worth pursuing.  But (even leaving aside jubilee-style forgiveness by “bleeding-heart social workers”) capitalists figured out many years ago that the financial system requires procedures for rewriting the terms of debt contracts under extreme circumstances.    The British Joint Stock Companies Act of 1857, for example, established the principle of limited liability for corporations.  Debt bondage and debtors prison have also been illegal since the 19th century, regardless what the debt contract might say.  Individuals can declare bankruptcy.  So can corporations, of course.   (And if the prophetic Keynes had been able to persuade Americans like Calvin Coolidge to recognize reality and forgive unrepayable debtsof European governments, the history of the interwar period might have been different.)

Corporate bankruptcy law works relatively well at the national level.  There will always be times when it is impossible for a debtor to pay — and admittedly other times, hard to distinguish, when the debtor merely claims that it can’t pay.  A poor legal system is one that keeps otherwise-viable factories shuttered while assets are frittered away in expensive legal wrangling, and everyone is left worse off.   A good legal system is one that: (i) allows employment and production to continue – in those cases where the economic activity is still viable (in re-organized form]; (ii) divides up the remaining assets in an orderly and generally accepted way (even if some creditors oppose the “cramdown”), and (iii) makes these determinations as efficiently and speedily as possible and with the minimum of moral hazard (by imposing costs on managers, lenders, shareholders, and – if necessary – bondholders, so as to avoid encouraging future carelessness).

No such debtors’ court or body of law exists at the international level.  Some think that this long-standing lacuna is the primary difficulty with the international debt system.  Ambitiousproposals to solve it over the years, such as a Sovereign Debt Restructuring Mechanism (SDRM) which might be housed at the IMF, have always run into political roadblocks.

But incremental steps had been slowly moving the system in the right direction since the 1980s.   In the international debt crisis that began in 1982, IMF country adjustment programs went hand in hand with “bailing in” creditor banks through “voluntary” coordinated loan rollovers.  Eventually it was recognized that a  debt overhang was inhibiting investment and growth in Latin America, to the detriment of both debtor and creditor;  after 1989, Brady-Plan write-downs alleviated the debt overhang.   Subsequent programs to deal with emerging market crises featured an analogous combination of country adjustment and “Private Sector Involvement” [such as agreement by lenders to stretch out maturities].  Voluntary debt exchange offers worked, roughly speaking, with investors accepting haircuts.

After Argentina’s unilateral default in 2001, many borrowers and lenders saw more clearly the need to allow explicitly for less drastic alternatives ahead of time and so incorporated more “Collective Action Clauses” when writing their lending contracts.  CACs are provisions that are voluntarily agreed to by all participants ahead of time to facilitate restructuring.  They make it possible, if the borrower subsequently runs into trouble, to restructure debt when a substantial majority of creditors wishes to do so, even if a few hold-outs do not.  The minority is then bound by the majority decision. The incremental steps had created a loose sort of system of debt restructuring.  It still had many deficiencies.  Restructuring often was too late and too little to restore debt sustainability.  But it worked, more or less.  (The IMF has continued to work on ways to make its biggest rescue programs conditional not just on country reforms but also in some cases on private sector involvement, in the form of reprofiling or, when necessary, reduction of debt.)

The real danger of the court ruling in the case of the Argentine hold-outs is that, in a parochial instinct to enforce a written contract, it will undermine the possibility of negotiated re-structuring of unsustainable debt burdens in future crises, because free-riding holdouts may be able to prevent it.   Contrary to the saying, it takes more than two to tango.   It is not enough for the debtor and 92 per cent of creditors to reach an agreement, if holdouts and a New York judge can block it.

The court delivered a peculiar interpretation of the pari passu (equal treatment) clause that is standard in many sovereign debt contracts.  It interpreted pari passu to mean that creditors who had not agreed to the debt exchange were to be paid 100% of the original claim at the expense of the creditors that had accepted the new bonds. Moreover, the court gave the holdouts a very powerful weapon to enforce their claims by holding settlement and clearing institutions in the US and even in Europe responsible for routing any payments of Argentina.

Financial markets may find a way around the precedent of the court ruling in future contracts.   Likely responses to the problem include a shift toward writing contracts outside the United States, greater use of CACs, and elaboration of the pari passu clause.   But some warn of extra-territorial reach by the US court.  Some even think the decision could inadvertently interfere with CACs, though there is probably a fix for this. 

Other recent developments have also worked to reverse the progress in the global resolution regime, as inadequate as it already had been.  Europe’s handling of the crisis that beganwith Greece in 2010 was too slow, too optimistic, too reluctant initially to restructure bond-holders, and too enamored of fiscal austerity.  The mistakes eventually encompassed even such specific no-nos as a consideration in the Cyprus case of haircutting small bank depositors.

Time will run out for the Land of the Tango by the end of July.  Perhaps the result of the court decision will be that, unable to pay all its debts, Argentina will be forced instead to default on all its debts.  More likely, in the end it will manage to come to some accommodation that hold-outs find more attractive than the deal accepted by the other creditors.  Regardless, the outcome will undermine voluntary debt workout agreements in the future.  This is bound to make debtors and creditors alike worse off.

This column appears also at VoxEU, July 22, 2014.  A condensed version appeared at Project Syndicate; Comments can be posted there.

Posted in Emerging markets, Financial Crisis, Financial Regulation, International Monetary Fund, Latin America | Tagged , , , , | Leave a comment

The ECB’s Unprecedented Monetary Stimulus

After the recent Draghi press conference announcing new measures to ease monetary policy in euroland, I responded to live questions from the Financial Times“The ECB Eases,” podcast,  FT Hard Currency, June 5, 2014 (including regarding my proposal that the ECB should buy dollar bonds).

And also to questions in writing from El Mercurio, June 5:

• Many critics point that these measures do not solve the economic problems of the Eurozone and in that they only benefit the financial markets. Do you agree?

JF: It is too much to expect monetary policy by itself to solve all the economic problems of the Eurozone. But I think the measures announced by the ECB today were steps in the right direction. Mario Draghi emphasized steps to facilitate the transmission of easier money to the real economy, as part of the Targeted LTROs, and also as part of possible plans for Quantitative Easing in the future.

• The ECB also announced that long term loans will be monitored to assure the liquidity is allocated as new loans to businesses. Is that feasible?

JF: There is no guarantee. It is hard to stimulate increased lending to firms and business fixed investment if firms are not experiencing demand for what they are producing already. The ECB can only try and the Target LTROs look like a good attempt.

• If at the same time the ECB cuts GDP projection for this year and forecasts inflation at 1.4% in 2016, under 2%, is not that a kind of recognition of the limitations of monetary policy?

JF: It is a recognition that the euroland economy has been weaker lately, and inflation lower, than they had hoped.

• Will these measures be enough to boost the recovery? Even when there are still structural problems in the Eurozone?

JF: There are limits to what monetary policy can do, especially when interests are at the Zero Lower Bound, as they are. Far more needs to be done in structural reforms, for example.

• Is it possible that, without the pressure of the markets, the governments of the periphery countries will delay even more the needed reforms?

JF: Any time you use one policy to try to make things better, there is the possibility that it will “take the pressure off” of other policies. But that is not a reason not to do it. And in this case, popular discontent with the long period of economic hardship is so high in Europe — as shown for example by the gains of anti-EU parties in the recent elections — that some positive economic pay-off could arguably help rather than hurt the chances for structural reform.

• The measures of the ECB also imply an intervention in the exchange market. Should we expect measures of other banks in response? Will the pressure over the euro last?

JF: These measures are far short of intervention in the foreign exchange market in the sense of buying dollars for euros. And even if the ECB moves to Quantitative Easing in the future, it is unlikely to adopt my proposal to do it by buying dollar bonds instead of euro bonds. You are wondering about the fact that today’s measures appear so far to have caused a depreciation of the euro (along with some boost to stock markets in Europe, and in some emerging markets as well). I see no reason for other countries necessarily to worry or to respond. Given the chances of higher interest rates soon in the US, I don’t think the current phase is back in the situation of several years ago, when easy monetary policy sent waves of capital into emerging markets and put upward pressure on their currencies. But in any case, the beauty of floating exchange rates is that they can automatically accommodate international differences in monetary policy that arise in respond to differences in each country’s economic needs.

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China is Not Yet #1

Widespread recent reports have trumpeted: “China to overtake US as top economic power this year.”  The claim is basically wrong. The US remains the world’s largest economic power by a substantial margin.

The story was based on the April 29 release of a report from the ICP project of the World Bank: “2011 International Comparison Program Summary Results Release Compares the Real Size of the World Economies.”     The work of the International Comparison Program is extremely valuable.  I await eagerly their latest estimates every six years or so and I usethem, including to look at China.  (Before 2005, the data collection exercise used to appear in the Penn World Tables.)

The ICP numbers compare countries’ GDPs using PPP rates, rather than actual exchange rates.   This is the right thing to do if you are looking at real income per capita in order to measure people’s living standards.  But I would argue that it is the wrong thing to do if you are looking at national income in order to measure the country’s weight in the global economy.

The bottom line for China is that by both criteria, income per capita (at PPP rates) or aggregate GDP (at actual exchange rates), it still has a ways to go until the day when it surpasses the US.  This in no respect detracts from the country’s impressive growth record, which at about 10% per annum for three decades constitutes a historical miracle.


(click on the graph for larger image)

At current exchange rates, the American economy is still almost double China’s, 83% bigger to be precise.  But the cross-over day is not far off, as the graph shows.  If the Chinese real growth rate continues to exceed US growth by 5% per annum and the yuan appreciates at 3% a year in real terms (inflation is higher there), then China will pass the US by 2021. Soon, but not imminent.

The PPP-versus-exchange rate issue is familiar to international economists.   This annoying but unavoidable technical problem arises because China’s output is measured in its currency, the yuan, while US income is measured in dollars.  How should you translate the numbers so that they are comparable?  The obvious solution is to use the contemporaneous exchange rate.  (Multiply China’s yuan-measured GDP by the dollar-per-yuan exchange rate, so that is expressed in dollars.)

Someone then points out, however, that if you want to measure the standard of living of Chinese citizens, you have to take into account that many goods and services are cheaper there.   A yuan goes further if it is spent in China than if it is spent abroad.  Some internationally traded goods have similar prices.   T-shirts are virtually as cheap in the United States as in China, in part because we can buy them from there. (Oil is almost as cheap in China as abroad, because it can import oil.)   But haircuts, a service that cannot readily be traded internationally, are much cheaper in China than in the US.  For this reason, if you want to compare income per capita across countries, you need to measure local purchasing power, as the ICP does.

The PPP measure is useful for many purposes, like knowing which governments have been successful at raising their citizens’ standard of living.  A second application is estimatingwhether the country’s currency is “undervalued,” controlling for its productivity.  A third is judging whether it is reasonable to expect that the country has the means to start cutting pollution.   (The turning point for sulphur dioxide in international data has been estimatedat roughly $10,000 per capita in today’s dollars.  China is now there.)

Looking at income per capita, China is still a relatively poor country, even by the PPP measure and even though it has come very far in a short time.  Its income per capita is now about the same as Albania’s, in the middle of the distribution of 199 countries (99th).

But Albania doesn’t often get headlines.   Why are we so much more interested in China?  Partly because it is such a dynamic economy, but not just that.  China has the world’s largest population.  When you multiply a medium income per capita times 1.3 billion “capita,” you get a large number.  The combination of a very large population and a medium income gives it economic power, and also political power.

Why do we consider the United States the incumbent number 1 power?   Partly because it is rich, but not just that.  If income per capita were the criterion, then Monaco, Qatar, Luxembourg, Brunei, Liechtenstein, Kuwait, Norway and Singapore would all rank ahead of the US.  For purposes of that comparison, it does not much matter whether you use actual exchange rates to make the comparison or PPP rates.  Relative rankings for income per capita don’t depend on this technical choice as much as rankings of size do.  (The reason is that the PPP rates are highly correlated with income per capita, the phenomenon known as the Balassa-Samuelson relationship.)

If you are choosing what country to be a citizen of, you might want to consider one of these richest countries.   But we don’t consider Monaco, Brunei and Liechtenstein to be among the world’s “leading economic powers,” because they are so small.  What makes the US the #1 economic power is the combination of having one of the highest populations together with having one of the higher levels of income per capita.

So there is a widespread fascination with the question how China’s economic size or power compares to America’s, and especially whether the challenger has now displaced the reigning champ as #1.  It seems to me that PPP rates are not the best ones for making this comparison.  Why?

When we talk about size or power we are talking about such questions as the following.  From the viewpoint of multinational corporations, how big is the Chinese market?  From the standpoint of global financial markets, will the RMB challenge the dollar as an international currency?   From the viewpoint of the IMF and other multilateral agencies, how much money can China contribute and how much voting power should it get in return?   From the viewpoint of countries with rival claims in the South China Sea, how many ships can its military buy?   For these questions, and most others where the issue is total economic heft, you want to use GDP evaluated at current exchange rates.  It’s how much the yuan can buy on world markets that is of interest, not how many haircuts or other local goods it can buy back home.

It is sometimes objected that using the current exchange rate subjects the comparison to the substantial fluctuations that exchange rates often exhibit.   This is true.   But the large and variable measurement errors in the PPP adjustment are considerably worse.  There is a good case for using a five-year average of the exchange rate instead of the exchange rate in one particular year. It doesn’t make much difference for the US-China comparison during this period.  But even when exchange rate fluctuations seem large, the difference is relatively small compared to the other statistical issues at stake here.

[A shorter op-ed version of this article appeared at Project Syndicate. Comments can be posted there. A version at VoxEU will include references.]

Posted in China, Economic Development, Exchange Rates, Poverty | Tagged , , , | Leave a comment

How to Address Inequality

Inequality has received a lot of attention lately, particularly in two arenas where it had not previously received as much: American public debate and the International Monetary Fund.  A major driver is the observation in the United States that income inequality has now returned to the extreme levels of the Gilded Age.  (The share of income held by the top 1% rose from 8% in 1980 to 19% in 2012, a level last seen in 1928, and probably the highest among advanced countries.  The share held by the top 0.1% rose from 2% to almost 9% currently, a level least seen in 1916. And mobility remains as low as ever.)  Inequality remains high in Latin America and has increased in many other parts of the world as well.

The current discussion goes beyond the starting point that we should be concerned about the distribution of the pie, not just about the total size.  It tends to focus on one of several extra “wrinkles” — adverse effects of inequality beyond the obvious one of the welfare of those with lower income.  One such wrinkle is the hypothesis that inequality is bad for overall economic growth (for example, in times of inadequate demand, because the rich save more than others).  Another is that inequality leads to volatility and instability (for example, that it may have been responsible for the sub-prime mortgage crisis of 2007 and hence the global financial crisis of 2008).

A third is the proposition that inequality translates into envy and unhappiness:  someone who would have been happy at a given income is unhappy if he discovers that others are getting more.  One persuasive version of this latter claim holds that top executives demand and receive outlandish compensation, not because they value so much the money itself, but because they compete with each other for status.

A fourth concern appears to trump even the first three.   It is the fear that, because there is so much money in politics, the rich succeed in getting governments to adopt policies that favor them as a class. The system often goes under the name of oligarchy.  It generates extra hand-wringing because of the notion that it is self-perpetuating.  The first three concerns have the consolation that they might at some stage be self-correcting, at least in a democracy.  After all, the upper 1 per cent doesn’t have many votes.  Under oligarchy, however, the concentration of economic and political power is self-reinforcing.  Recent decisions by the US Supreme Court regarding campaign contributions suggest that the role of money in the electoral process will only get worse.   Hence the outpouring of opinion columns and editorials sounding the alarm on the political-economy ramifications of inequality.

Each of these four concerns carries a big element of truth.   To do any one of them justice would require diving into the details.

Two examples.  On the relationship between inequality and growth: The one-time land redistribution that took place in northeast Asian countries after World War II was probably good for growth; but a system where the hard-working, thrifty, and entrepreneurial fear that they will not be allowed to keep much of the fruits of their efforts is bad for growth.  On volatility:  Programs to “help” the poor by facilitating housing loans that they cannot afford are bad for them and for financial stability, not good.

But what is wrong with working from the premise that poverty in particular and inequality in general are undesirable for their own sakes, other things equal?  I question the rationale for writing opinion columns that focus overwhelmingly on the political economy dangers of the wealth of the upper 1 per cent.  Yes those dangers are important.   But how useful is it to pursue the argument?

Even in the United States, most voters believe that inequality matters in addition to total national income. This is true even recognizing that the poor are less heavily represented among those who vote.  Even among the upper 1 per cent, approximately two-thirds believe that US differences in income are too large and support progressive taxation.  Most Americans believe in helping the less fortunate, provided it can be done without government intervening so intrusively or distorting incentives so much as to seriously damage economic efficiency.  The problem is that they often vote for politicians who enact laws inconsistent with those goals.  For example, someone hoodwinked the median  voter 10 years ago – most of whom themselves leave negligible estates – into believing that to protect small family-owned farms it was necessary to eliminate taxes on $ 5 million estates.

In other words, the problem isn’t that the median voter is unwilling to trade off any growth in return for more equality.  The problem is that the political process produces outcomes that deliver both less growth and less equality than we could get under the optimal tradeoff.

For the US, the most sensible measures include expansion of the Earned Income Tax Credit, elimination of payroll taxes for low-income workers, cutting deductions for high-income taxpayers and restoring higher inheritance taxes.  These are policies that reduce inequality efficiently, at relatively low cost to aggregate income.   Some further policies are “win-win” in that they may even promote overall economic growth while reducing inequality – such as universal pre-school education and universal health care — especially if these programs are financed out of efficiency-enhancing measures such as eliminating fossil fuel subsidies (and, preferably, taxing fossil fuels instead).   I’d also eliminate the carried interest loophole in the corporate tax code and deductions for stock options (while lowering the statutory tax rate).   Most of these proposals are supported by most independent economists, but it is hard to get the message across.

Meanwhile, there exist many government programs that are sold on the basis of improving income distribution but in fact impair economic efficiency severely with relatively little benefit for the poor or, on some cases, none at all.  The original rationale for wasteful agricultural supports was largely to help small farmers who were less well-off; but it has been a long time since they were positive for the income distribution.  Mortgage subsidies contributed to the sub-prime mortgage crisis, but the benefits go overwhelmingly to higher–income families.  Many Americans are persuaded to support such policies, not because it is in their interest, but because they don’t understand the economics.

Other countries also have similar programs that are sold as pro-equality but are inefficient or even harmful for that goal. In developing countries, measures that tax, subsidize or price-regulate food and energy tend to be highly inefficient tools for improving the income distribution, and frequently even have the opposite effect.  Of the $400-plus billion that countries spend on fossil fuel subsidies each year, for example, far less than 20% of the benefits go to the poorest 20 % of the population.  In general, a disproportionately small share of social spending goes to the poorest 40 % of the population.  Conditional Cash Transfers, on the other hand, have proven highly effective; they reach the poor and promote education and health.

How to nudge the political process toward delivering better policies?   Some believe that the appropriate stragegy is to sound the alarm about inequality and oligarchy.

The argument against oligarchy is not a perfect fit with the reality in the United States.  In the first place, most of the income of the upper 0.1% is still “earned” income, not inherited wealth (though Thomas Piketty’s best-seller argues that this is about to change).  In the second place, lots of single-issue groups are able to distort the political process severely, not just the rich.  In the third place, the opposition among the rich to measures helping the less unfortunate is far from unanimous.  Think of all the Bill Gates and George Soroses.  On the other side, think of all the unskilled workers who vote against their self-interest.

The anti-oligarchy logic for writing a column on inequality is that the rich have too much money, which they use to get the politicians elected and the bills passed that will favor them, the rich.  But how is that money weapon used?  Not often by outright bribery, at least not in the United States.  Politicians need money so badly for only two reasons: to get elected and to stay elected.  They buy advertising to persuade people to vote for them.  Hypothetically, if we could persuade people to stop watching the advertisements, that would solve the problem.

More constructively, if we could persuade the poor to vote, that might solve the problem.   But op-eds are probably not an effective means of achieving this, because those who are not civically engaged enough to vote are probably not civically engaged enough to read op-eds.  The same goes for unskilled workers.  (If we thought they were reading, we wouldn’t be using such an insulting term as “unskilled” to describe them.)

It seems to me that op-eds are better used to argue out which are the best policies to improve income distribution efficiently, and to point out who are the politicians who support them.  “Yes” to the EITC and pre-school education; “no” to subsidies for oil, agriculture and mortgage debt.

Too difficult, you say.  One must always apologize for the “policy-wonkery” of engaging in substantive discussion.  But think, what is the alternative?

Apparently the alternative is the very roundabout strategy of achieving more enlightened policies by trying to reduce the ability of the rich to buy votes, which is to be accomplished by reducing the share of income that goes to the rich, by reducing inequality, by… what?  Pursuing pro-equality policies, like the EITC and pre-school education!   How can complaining about inequality be a more effective strategy for achieving these policies than arguing the case directly for the policies themselves?

[A shorter version of this column appears at Project Syndicate.  Comments can be posted there.]

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ECB QE via FX: Plan B

My post last month was a proposal for the European monetary authorities to pursue Quantitative Easing, not by buying euro bonds, but by buying dollar bonds.   I also presented this idea in a speech at a conference sponsored by the Dallas Fed, April 4, “Why the ECB Should Buy US Treasuries.”

But what if the ECB is told by the international community, especially the US, that it doesn’t want them to push the euro down against the dollar, that it fears a re-ignition of the currency wars?   And what if the ECB concludes that it can’t buy US treasuries without US agreement?   After all, it was only February of last year that the G-7 Ministers and Governors agreed not to try to influence exchange rates.

I have a Plan B to propose in that case, a version of the idea that need not put downward pressure on the foreign exchange value of the euro.   The ECB still pursues QE by buying US bonds; but it buys them from the Fed rather than on the open market.

Recall that the goal is for the ECB to expand its monetary base, without flirting with illegality.  And that the Fed’s goal is to taper and then reduce its holdings of Treasury bonds and Mortgage Backed Securities, without yet forcing up long-term interest rates.

The argument is that everybody gets what he wants.  The Eurozone expands its monetary base.   The Fed gets to reduce the bonds on its balance sheet.  By selling them to the ECB rather than on the private market it avoids upward pressure on interest rates. (And what central bank doesn’t want more foreign exchange reserves, other things equal?)  If the ECB buys its dollar assets from the Fed instead of on the private market it avoids downward pressure on the euro.

The counter-argument from the viewpoint of the ECB is that, even though this is a way to expand its monetary base, it probably doesn’t achieve the objective of lowering Euro interest rates, if the Fed holds the euros as deposits at the ECB.  It would work if the Fed used them to buy longer-term euro bonds, which lots of central banks do these days.  But that idea would not go over well with the American public.  So maybe it has to be Plan A.

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Considering QE, Mario? Buy US Bonds, Not Eurozone Bonds

The ECB should further ease monetary policy.  Inflation at 0.8% across the eurozone is below the target of “close to 2%.”  Unemployment in most countries is still high and their economiesweak.  Under current conditions it is hard for the periphery countries to bring their costs the rest of the way back down to internationally competitive levels as they need to do.  If inflation is below 1% euro-wide, then the periphery countries have to suffer painful deflation.

The question is how the ECB can ease, since short-term interest rates are already close to zero.   Most of the talk in Europe is around proposals for the ECB to undertake Quantitative Easing (QE), following the path of the Fed and the Bank of Japan, expanding the money supply by buying the government bonds of member countries.  This would be a realization of Mario Draghi’s idea of Outright Monetary Transactions, which was announced in August 2012 but never had to be used.

QE would present a problem for the ECB that the Fed and other central banks do not face.  The eurozone has no centrally issued and traded Eurobond that the central bank could buy.   (And the time to create such a bond has not yet come.)   That would mean that the ECB would have to buy bonds of member countries, which in turn means taking implicit positions on the creditworthiness of their individual finances.   Germans tend to feel that ECB purchases of bonds issued by Greece and other periphery countries constitute monetary financing of profligate governments and violate the laws under which the ECB was established.  The German Constitutional Court believes that OMTs would exceed the ECBs mandate, though last month it temporarily handed the hot potato to the European Court of Justice.   The legal obstacle is not merely an inconvenience but also represents a valid economic concern with the moral hazard that ECB bailouts present for members’ fiscal policies in the long term.  That moral hazard was among the origins of the Greek crisis in the first place.

Fortunately, interest rates on the debt of Greece and other periphery countries have come down a lot over the last two years.    Since he took the helm at the ECB, Mario Draghi has brilliantly walked the fine line required for “doing what it takes” to keep the eurozone together.  (After all, there would be little point in preserving pristine principles in the eurozone if the result were that it broke up.  And fiscal austerity by itself was never going to put the periphery countries back on sustainable debt paths.)  At the moment, there is no need to support periphery bonds, especially if it would flirt with unconstitutionality.

What, then, should the ECB buy, if it is to expand the monetary base?   It should not buy Euro securities, but rather US treasury securities.  In other words, it should go back to intervening in the foreign exchange market.   Here are several reasons why.

First, it solves the problem of what to buy without raising legal obstacles.  Operations in the foreign exchange market are well within the remit of the ECB.    Second, they also do not pose moral hazard issues (unless one thinks of the long-term moral hazard that the “exorbitant privilege” of printing the world’s international currency creates for US fiscal policy).

Third, ECB purchases of dollars would help push the foreign exchange value of the euro down against the dollar.  Such foreign exchange operations among G-7 central banks have fallen into disuse in recent years, in part because of the theory that they don’t affect exchange rates except when they change money supplies. There is some evidence that even sterilized intervention can be effective, including for the euro.  But in any case we are talking here about an ECB purchase of dollars that would change the euro money supply.  The increased supply of euros would naturally lower their foreign exchange value.

Monetary expansion that depreciates the currency is effective.  It is more effective than monetary expansion that does not, especially when, as at present, there is very little scope for pushing short-term interest rates much lower.

Depreciation of the euro would be the best medicine for restoring international price competitiveness to the periphery countries and bringing their export sectors back to health.  Of course they would devalue on their own, if they had not given up their currencies for the euro ten years before the crisis (and if it were not for their euro-denominated debt).   Depreciation of the euro bloc as a whole is the answer.

The strength of the euro has held up remarkably during the four years of crisis.  Indeed the currency appreciated further when the ECB declined to undertake any monetary stimulus at its March 6 meeting.  The euro could afford to weaken substantially.  Even Germans might warm up to easy money if it meant more exports rather than less.

Central banks should and do choose their monetary policies primarily to serve the interests of their own economies.  The interests of those who live in other parts of the world come second.  But proposals to coordinate policies internationally for mutual benefit are reasonable.   Raghuram Rajan, head of the Reserve Bank of India, has recently called for the central banks in industrialized countries to take the interests of emerging markets into account by coordinating internationally.

How would ECB foreign exchange intervention fare by the lights of G20 cooperation?  Very well.  This year the emerging markets are worried about tightening of global monetary policy.  The fears are no longer monetary loosening as in the “Currency Wars” talk of three years ago.  As the Fed tapers back on its purchases of US treasury securities, it is a perfect time for the ECB to step in and buy some itself.


         Jeffrey Anderson and Jessica Stallings, “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Feb. 13, 2014.
Kathryn Dominguez and Jeffrey Frankel, 1993, Does Foreign Exchange Intervention Work?(Institute for International Economics, Washington, D.C.).
—”Does Foreign Exchange Intervention Matter? The Portfolio Effect,”1993, American Economic Review 83, no. 5, December, 1356-69.
Rasmus Fatum and Michael Hutchison, 2002,  ”ECB Foreign Exchange Intervention and the Euro: Institutional Framework, News, and Intervention,” Open Economies Review, 13, issue 4, 413-425.
Marcel Fratzscher, 2004, “Exchange Rate Policy Strategies in G3 Economies,” in C. Fred Bergsten, John Williamson, eds., Dollar Adjustment: How Far? Against What?  (Institute for International Economics, Washington, DC).
Stefan Reitz and Mark P. Taylor, 2008, “The Coordination Channel of Foreign Exchange Intervention: A Nonlinear Microstructural Analysis,” European Economic Reviewvol. 52, issue 1, January, 55-76.
Lucio Sarno and Mark P. Taylor, 2001, “Official Intervention in the Foreign Exchange Market: Is It Effective and, If So, How Does It Work?” Journal of Economic Literature, 39(3), 839-868.

[A shortened version of this column appears as my March Project Syndicate op-ed.  Comments can be posted there.]

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The Fiscal Stimulus and Market Turnaround: 5-Year Anniversary

Commentators are taking note of the five-year anniversary of the fiscal stimulus that President Obama enacted during his first month in office.   Those who don’t like Obama are still asking “if the  fiscal stimulus was so great, why didn’t it work?”    What is the appropriate response?

Those who think that the spending increases and tax cuts were the right thing to do have given a number of responses, which sound a bit weak to me.  The first is that the stimulus wasn’t big enough.  The second was that the Great Recession would have been much worse in the absence of the stimulus, perhaps a replay of the Great Depression of the 1930s.  (The media are fond of this line of reasoning because it allows them to escape making a judgment.  They can just say “nobody knows what would have happened otherwise.”)    The third response is that the fiscal stimulus was short-lived, and in fact was reversed by the Congress by 2010.

I believe that each of these three statements is true.   But they sound weak because they look like attempts to explain away the absence of a visible positive impact.  Listening to these arguments,  one would think that no effect of the Obama stimulus could be seen by the naked eye in the U.S. economic statistics of 2009.    Nothing could be further from the truth.

Recall the timing.  Obama was sworn in on January 20, 2009. The economy and financial markets had been in freefall ever since the Lehman Brothers failure four months earlier (September 15).   The President quickly proposed the American Recovery and Reinvestment Act, got it through Congress despite strong Republican opposition, and signed it into law on February 17.

If one judges by the economic statistics, the effect could not have been much more immediate, whether the crierion is job loss, GDP, or financial market indicators.   Look at the graphs below.

The stock market, which had been falling steeply since September, hit bottom on March 9, 2009, and then started a 5-year upward trend.   The index shown in Figure 1 is the S&P 500.  The turnaround can’t be missed.  Wall Street should get ready to celebrate the anniversary on March 9.

The much-maligned TARP and bank stress-tests also played important roles, unfreezing financial markets.  Bank interest rate spreads were back to pre-Lehman levels by February 2009 and back to pre-subprime-crisis levels by June.

What about the real economy?  That is what matters, after all.   Economic  output was in veritable freefall in the last quarter of 2008: a shattering 8.3 % p.a. rate of decline (BEA).  More specifically, the maximum rate of contraction came in December 2008, according to the monthly GDP estimates from the highly respected MacroAdvisers.   (For charts in the form of growth rates, see Figures 1 and 2 ofmy post on the 3-year anniversary.)  The free-fall stopped in the first quarter of 2009.   As the GDP graph below shows, economic activity was flat, scraping along the bottom until June, after which growth resumed.   The official end  of the recession thus came in June.   Visible to the naked eye.

The rate of job loss bottomed out in March 2009.  It is there for anyone to see.   The graph shows private sector employment changes.  Thus the turnaround does not count government jobs directly created by the fiscal stimulus.  Job creation turned positive after the end of the year.  Since then, though employment gains have been much too slow, they have on average exceeded the rate during the corresponding period under George W. Bush.

Of course there are always a lot of things going on. One cannot say for sure what was the effect of the Obama stimulus. And one can debate why the pace of the expansion slowed after 2010. (My own prime culprit is the switch to fiscal austerity.)

But whether looking at indicators of economic activity, the labor market, or the financial markets, the idea that the fiscal stimulus of February 2009 had no apparent impact in the numbers is wrong.

[Comments can be posted at the Econbrowser version or in the always-lively debate at Economist’s View.]

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What Do Obamacare and the EITC Have in Common with Cap-and-Trade?

My preceding blog post described how market-oriented mechanisms to address environmentally damaging emissions, particularly the cap-and-trade system for SO2 in the United States, have recently been overtaken by less efficient regulatory approaches such as renewables mandates.   One reason is that Republicans — who originally were supporters of cap-and-trade — turned against it, even demonized it.

One can draw an interesting analogy between the evolution of Republican political attitudes toward market mechanisms in the area of federal environmental regulation and hostility to the Affordable Care Act, also known as Obamacare.   The linchpin of the program is the attempt to make sure that all Americans have health insurance, via the individual mandate.  But Obamacare is a market mechanism, in that health insurers and health care providers remain private and compete against each other.

As has been pointed out countless times, this was originally a conservative approach, designed to work via the marketplace:  The alternative is to have the government either (i) directly provide the health insurance (a “single payer” system, as in Canada; or under US Medicare for that matter) or (ii) directly provide the health care itself (”socialized medicine,” as in the UK; or the US Veterans Administration hospitals).  The new approach was proposed in conservative think tanks such as the Heritage Foundation. It was enacted in Massachusetts by Republican Governor Mitt Romney. By the time President Obama adopted it, however, it had become anathema to Republicans, most of whom forgot that it had ever been their policy.

One can trace through the parallels between clean air and health care.  The market failure in the case of the environment is that pollution is what economists call an externality:  In an unregulated market, those who pollute don’t bear the cost. The market failure in the case of health care is what economists call adverse selection:  Insurers may not provide insurance, especially to patients with pre-existing conditions, if they have reason to fear that the healthy customers have already taken themselves out of the risk pool.

Government attempts to address the market failure can themselves fail.  In the case of the environment, command-and-control regulation is inefficient, discourages innovation, and can have unintended consequences.   For example, CAFÉ standards (Corporate Average Fuel Economy) were partly responsible for the rise of the SUV.  Corn ethanol mandates raised food prices and accomplished nothing for the environment.  When “New Source Review” requires that American power companies adopt the most stringent available control technology if they build a new power plant, they respond by keeping dirty old plants running as long as possible (Stavins, 2006).

In the case of health care, a national health service monopoly can forestall innovation and provide inadequate care with long waits.  In general, the best government interventions are designed to target the failure precisely – using cap-and-trade to put a price on air pollution or using the individual mandate to curtail adverse selection in health insurance — and otherwise let market forces do the rest more efficiently than bureaucrats can.

American conservatives often talk as if the alternative they would prefer is no regulation at all.  But few in fact would want to go back to the unbreathable pre-1970 air of Los Angeles, London, or Tokyo.  Even those few who might want to should recognize that most of their fellow citizens feel differently.  Political reality shows that the alternative in practice is an inefficient rent-seeking system in which solar power, corn-based ethanol, and fossil fuels all get subsidies or mandates.  Analogously, few conservatives in fact will say that they want hospital emergency rooms to turn away critically ill patients who lack health insurance.  Even for those who might want this, reality shows that the alternative in practice is hospitals that give emergency care to those who lack insurance, whether because of personal irresponsibility or for reasons beyond their control, and then pass the charges on to the rest of us.

A third example is the Earned-Income Tax Credit.  It was originally considered a conservative idea: an implementation of Milton Friedman’s proposed negative income tax, it was championed by Ronald Reagan as a pro-work market-friendly way of addressing income inequality.   President Obama proposedexpanding the EITC in his State of the Union address last month.  But conservatives, again forgetting that it was their own creation, have opposed expansion of the EITC as verboten redistribution.   So proposals to increase the minimum wage get more political traction as a way to address income inequality, even though that approach is more interventionist and less efficient.

[This is the second of a two-part post, which in turn is the extended version of an op-ed published atProject Syndicate.  Comments may be posted there; or join the debate at Economist’s View.]

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The Rise and Fall of Cap-and-Trade

Markets can fail.  But market mechanisms are often the best way for governments to address such failures.  This has been demonstrated in areas from air pollution to traffic congestion to spectrum allocation to cigarette consumption.    Markets for emission allowances – in which those firms that can cheaply cut pollution trade with those that cannot – achieve desired environmental goals at relatively low economic costs.   As of a decade ago, that long-standing economic proposition had become widely recognized and put into action. Yet the political tide on both sides of the Atlantic has been against “cap and trade” over the last five years.

In the United States, the highly successful trading system for allowances in emissions of SO2 (sulfur dioxide) has all but died since 2012.  In the European Union as well, the Emissions Trading System was in effect overtaken by other kinds of regulation in 2013.

Cap-and-trade was originally considered a Republican idea.  Market-friendly regulation was pushed by those who thought of themselves as pro-market, rather than by those who thought of themselves as pro-regulation.  Most environmental organizations were opposed to the novel approach;  many of them thought it immoral for corporations to be able to pay for the right to pollute. The pioneering use of the cap-and-trade approach to phase out lead from gasoline in the 1980s was a policy of Ronald Reagan’s Administration.  Its successful use to reduce SO2 emissions from power plants in the 1990s was a policy of George H.W. Bush’s administration.  The proposal to use cap-and-trade to reduce SO2 and other emissions further was a policy of George W. Bush’s administration ten years ago under, first, the Clear Skies Act proposed in 2002 and then the Clean Air Interstate Rule of 2005. (See Schmalensee and Stavins, 2013, pp.103-113.)

The problem is not that cap and trade is a theoretical proposal from ivory-tower economists that cannot survive application in the real world.   To the contrary, its performance in action surpassed expectations.  The mechanism in the 1980s allowed lead to be phased out more rapidly than predicted and at an estimate savings of $250 million per year compared to the old-fashioned approach that did not permit trade.  (Stavins, 2003.)   SO2 emissions were curbed at a much lower cost than even the proponents of cap-and-trade had predicted before 1995, let alone what the cost would have been under the old command-and-control approach.   As expected, the electric power sector chose to close down those plants where it was cheapest to achieve pollution cuts. The flexibility of the cap-and-trade system also allowed the industry to take advantage of unexpected developments such as new scrubber technology and newly accessible low-sulfur coal, to a much greater extent than would have been possible without the market mechanism. (Among those explaining why costs came in so low are Ellerman, et al, 2000.)

The Republican candidate for president in 2008, Senator John McCain, had sponsored US legislative proposals to use cap-and-trade to address emissions of carbon dioxide and other greenhouse gases responsible for global warming.  (He had co-sponsored the Climate Stewardship Act with Senator Joe Lieberman in 2003.  It was defeated in the Senate by 55 votes to 43.   They tried again as recently as 2007, but got no further.  McCain continued to advocate a cap-and-trade approach to climate change during the 2008 presidential campaign; Washington Post, May 13, 2008, p. A14; and Financial Times,May 13, 2008, p.4.)

Republican politicians have now forgotten that this approach was ever their policy.  To defeat the last major climate bill in 2009, they worked themselves into a frenzy of anti-regulation rhetoric.  (The American Clean-Energy and Security Act, sponsored by Congressmen Ed Markey and Henry Waxman, was passed by the House of Representatives that year, but not the Senate.) The Republican rhetoric successfully stigmatized cap-and-trade.  Schmalensee and Stavins (p.113) sum it up: “It is ironic that conservatives chose to demonize their own market-based creation.”

This stance left in its place alternative approaches that are less market-friendly (Stavins, 2011) — especially after court cases pointed out that the 1970 Clean Air Act and its 1990 Amendmentswere still the law of the land (originally signed into law by Republican Presidents Richard Nixon and George H.W. Bush, respectively, with heavy bi-partisan congressional majorities both times).

The non-market alternatives, such as “command and control” regulation requiring that particular energy sources or particular technologies be used, are less efficient.    Nonetheless they are again the dominant regime.   The number of SO2 allowances specified by the cap-and-trade regime has not been adjusted since 2000. As a result, emissions have since 2006 been steadily declining below the ceiling. The cap is no longer binding.  People aren’t willing to pay for something if they already have more of it than they need.  So the price of emission allowances has fallen steeply, essentially hitting zero since 2012, which indicates that it no longer affects behavior in the electric power sector.  (Schmalensee and Stavins, p.106-07; 114.)

*                            *                      *

In Europe, the peak of cap-and-trade came 10 years ago.   The European Union adopted the Emissions Trading System (ETS) in 2003, as a cost-effective way to achieve the commitments it had made under the Kyoto Protocol on Global Climate Change.  It rapidly became the world’s biggest market in the trading of carbon allowances.  But ETS has in recent years been pushed aside by older “command-and-control” approaches, in which the government dictates who should use which technologies, in what amounts, to reduce which emissions.

European directives say that 20% of energy must come from renewables by 2020.  Renewable energy has been promoted by mandates and subsidies.  These policies along with excessive allocations havecollapsed the price of emissions permits in the ETS, because demand for the permits now falls short of any binding constraint.    The price of carbon fell below 3 euros a ton in April 2013, rendering the market almost irrelevant.   It remains very low (5 euros a ton).  This in turn contributes to the burning of coal – the worst energy source, from the viewpoint of global warming or local pollution – which would not have happened if the central policy to address these problems were still a mechanism to put a price on carbon.

On top of that, the EU methods of encouraging renewables have proven ruinously expensive.  This has been giving pause to European officials as they decide how to extend the 2020 framework to goals for 2030.  The European Council will discuss this at a meeting scheduled for March 2014.    The EU should abandon its numerical targets for renewables and go back to relying on the ETS, with whatever limits on permit quantities are  necessary to keep the price up.  This route can achieve greater progress at reducing Greenhouse Gas emissions at lower cost to the European economies.
*          *          *

There is nothing inevitable or irreversible about the recent trend away from cap-and-trade.   Indeed in some parts of the world, such as China, governments seem to be moving in the direction of emissions trading as an efficient way to address global climate change.

Even in the US, where it began, there is still grounds for hope.  The Environmental Protection Agency is currently developing federal guidelines for state programs to reduce CO2 emissions from power plants under the Clean Air Act [Section 111(d)].   As a good model for putting a price on carbon, the EPAshould consider the cap and trade schemes that have been developed by the northeastern RGGI, California, and some Canadian provinces. The Regional Greenhouse Gas Initiative (RGGI) began trading permits among large power plants in 2008 and continues to operate among nine northeastern statesCalifornia recently started an important new emissions trading system.  But the Golden State is another example where policies to set standards for particular fuels or particular modes of power generation are in danger of undermining the emissions trading plan [“Assembly Bill 32“].

*          *          *

[This is the first of a two-part post, which is the extended version of an op-ed published at Project Syndicate.  Comments may be posted there — or at Economist’s View where there is a lively debate. The full version is also to appear at VoxEU.]

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