More on Cowen on Europe

In his op-ed, Tyler Cowen raises a concern about a euro-collapse that I haven't much seen previously:

We thus face the danger that the euro, the world’s No. 2 reserve currency, could implode. Such an event wouldn’t be just another depreciation or collapse of a currency peg; instead, it would mean that one of the world’s major economic units doesn’t work as currently constituted.

There are a lot of claims -- some implicit -- in here. I'll take them in turn.

1. Does an exit of several peripheral countries from the eurozone constitue an implosion of a reserve currency? I don't think so. The status of the euro as a reserve currency does not depend on Greece's membership, it depends on Germany's management of it. If the alternatives are to jettison Greece -- or even several of the GIPSIs -- or to devalue the currency to keep them in, the euro's status as a reserve currency might actually be improved by a smaller membership of weak countries.

2. How important is the euro as a reserve currency? Roughly as important as the German mark was pre-euro, perhaps in combination with the the franc. The euro has not advanced much above the mark+franc status as a global reserve currency, if any at all, since its introduction in 1999. So the global economy as a whole does not appear to be very dependent on the euro; it is dependent on the US and, to a lesser extent, Germany, Britain, and Japan.

3. Would a euro-exit be more severe than a collapse of a currency peg? It conceivably could, but again: what matters most is Germany, and markets' belief in Germany's credibility to maintain a valuable currency. Germany's economy is not on the verge of collapse, nor does it depend on Greece, and German policymakers have repeatedly chosen to maintain policy credibility over possibly saving peripheral members. How much do markets care about Greece? I'll return to that below.

4. Would a euro-exit signal that one of the world's major economic units doesn't work? No. Greece is not one of the world's major economic units. A euro-exit would signal that one of the world's major political units doesn't work, but I'm not sure that this is new information nor am I sure that markets care all that much. The the extent that markets prefer stability over instability any resolution may be preferable to continued uncertainty.

Let's look at some data. Has the euro has significantly weakened as the crisis has grown more severe?

A bit. But if we zoom out and look at a longer time series we see that the euro is now trading at historical levels:

If Greece leaves will the value of the euro hold? Considering that Greece is by far its weakest link I would think so. Indeed, the fewer non-German members in the euro the more credibility it has! Germany does not need to devalue.

Anyway, just how important is the euro? At the end of last year global dollar holdings were nearly 250% higher than euro holdings. Or consider the exchange market. The introduction of the euro did nothing to reduce the world's reliance on the dollar, as I discuss (and graph) here. The euro is used in roughly the same percentage of the world's Forex as was the mark + franc. The global economy survived the end of those currencies.

There is only one truly important global currency -- the dollar.

Perhaps most distressingly, Cowen seemingly misunderstands the arguments of Kindleberger that he references in the paragraph immediately following the quoted one above:

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences. For historical reasons, Germany isn’t up to playing the role formerly held by Britain and, to some extent, still held today by the United States. (But when it comes to the euro zone, the United States is on the sidelines.)

I said a bit about that in my post yesterday, and I'll say more about it in another post (this is plenty long already), but if the hegemon is most important than we should really only be concerned about the US (the global hegemon) and Germany (the regional hegemon), not Europe's southern periphery. And the role of the hegemon is to stabilize the system, not necessarily to guarantee good outcomes for every constituent within it.

Think about it this way: if Germany left the euro and re-issued the mark, do you think it would be stronger or weaker than the Germany-less euro? Do you think the new mark would be used more as a reserve currency than the euro or less?

So why should we think that a Greek exit would be much worse than "another depreciation or collapse of a currency peg"?

The World's Central Banker, Yet Again

Tyler Cowen summons his inner Kindleberger and gets pessimistic:

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences. For historical reasons, Germany isn’t up to playing the role formerly held by Britain and, to some extent, still held today by the United States. (But when it comes to the euro zone, the United States is on the sidelines.)

It depends on what he means by "on the sidelines". The US Congress is certainly not doing anything about Europe. Short of a Marshall Plan for the GIPSIs I'm not sure what they could do, and there's no way that's happening. But that doesn't mean that the US government as a whole is showing no hegemonic leadership. I've written a number of posts arguing that Bernanke has been acting as the world's central banker during the crisis -- opening swap lines with every major central bank in the world, extending liquidity financing to foreign firms, not provoking currency wars that lead to competitive devaluations, etc. -- and that this has stabilized the core of the global financial system.

I'm not going to re-write all those posts here, but please click through and read them. The Fed has been engaged in hegemonic leadership, and has done pretty well so far. Its job is not to put out every fire everywhere; its job is to keep the center of the system intact. So far, at least, its actions have been sufficient.

Note that in the op-ed Cowen more than once sounds a lot like an IPE scholar who has read no IPE literature. That is, he's asking the right questions but fumbles for answers to them. I have other things to write about the piece, but I'm going to break them up into pieces over the next day or two. Consider this a teaser.

More US Debt Needed?

So says David Andolfatto (via Mark Thoma):

I believe that the decline in real rates on U.S. treasuries reflects a steady change in how agents and agencies around the world want to structure their wealth portfolios. There has been a massive substitution away from many asset classes into U.S. treasuries; and it is this fundamental market force that is driving real interest rates lower. 

The phenomenon began in the early 1990s, with the collapse of the Japanese stock market. Then Mexico in 1994, the Asian crisis 1997-98, Russia in 1998, and Brazil in 1999; see Bernanke (2005). Investors became rationally pessimistic about the returns to investing in these countries, as well as similar countries that had not yet experienced crisis. The natural effect of this would be capital outflows from these countries into relative safe havens, like the United States.

The basic thesis here is very much related to what Ricardo Caballero calls a "global asset shortage."

I wrote about this over a year ago, in response to a similar argument by Brad DeLong. You can read that post for more details, but the gist is that Kindleberger argued that in a crisis a hegemon is needed to stabilize the international system by providing five public goods: a market for distress (unsalable) goods, lender of last resort and provider of liquidity into the global financial system, a stable system of exchange rates, macroeconomic coordination, and countercyclical lending.

But what if there's a 6th? What if the hegemon should also create large amounts of highly-rated financial assets that firms can keep on their books without worrying about default?

In a sense, such a role is already encapsulated in Kindleberger's five. It would, in a sense, provide a market for distress goods, which in this case is speculative finance. If these assets are heavily-traded enough an increase in their supply could also constitute a form of liquidity. And they could be used to fund a program of countercyclical lending, by borrowing funds from skittish investors and channeling them to needy borrowers.

As Mark Blyth and Matthias Matthijs argue in a recent issue of Foreign Affairs, Germany is either incapable or unwilling to play this role in Europe. (I'd argue both.) In which case the U.S. should step in and be more aggressive. The Federal Reserve has taken some steps in that direction, opening up swap lines with most major central banks worldwide, and lending directly to foreign banks. But many of those programs have ended. It's not clear that the Fed is doing much to stabilize Europe now. Meanwhile, the federal government has no appetite for such a role.

Put all this together and it's hard to escape the belief that things are going to get worse before they get better. The U.S. may be relatively insulated from a European collapse, but that doesn't mean we're perfectly insulated. And plenty of other places are much more exposed. As the systems level, then, unless the U.S. steps up instability is likely to worsen.

We Are Not in the 1930s

It's easy to draw parallels between these days and the 1930s, especially for an IPE scholar. Drezner does it here, I've done it before, and so has practically anybody with any sense of the international or temporal dimensions of political economy. Here's DeLong:

I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria--that the great fiscal crisis is about to erupt and send us lurching down toward Great Depression II. Well, right now guess what? The time is 1931, and we are Austria. The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip. The Federal Reserve Needs to do so now.

Is this 1931? Here's a partial list of similarities: an system of prosperous globalization is threatening to unravel as Europe's fixed exchange rate regime crumbles; macroeconomic imbalances presage a significant financial crisis; European governments respond to large fiscal burdens by attempting to devalue internally through austerity rather than devaluing externally through the exchange rate; movements towards trade protectionism and beggar-thy-neighbor policies (outside of Europe); etc.

But I don't think we're in the 1930s. I think the world is different now than it was then in a number of important ways, and that leaves me more optimistic than I otherwise might be.

First, I think the international economic system has been transformed from the way it was during the interwar period in a number of key areas. Unlike then, international politics is now highly institutionalized. We have a series of durable trade relationships that have been legally formalized, but which provide flexibility for national governments to address pressing short-run concerns. We have a credible international organization that monitors trade and provides a mechanism for dispute adjudication. Europe has a common trade market that is likely to remain even if the monetary union dissolves. A collapse in world trade -- and thus global output -- equivalent to that in the 1930s thus seems highly unlikely.

Perhaps more importantly, the present international monetary system is not dedicated to the orthodoxy of currency values fixed to a specific quantity of a sparkly metal. This has allowed central banks, especially the central bank of the global reserve currency, to inject liquidity into the global financial system at key points over the past few years. Even the ECB, which has rightly come under criticism for not doing enough to manage the crisis despite having no legal authority to take the necessary measures, has pursued a far more expansionary policy than it would if it were trying to maintain a gold standard. Indeed it has almost certainly already acted beyond the parameters set out for it under the Lisbon Treaty. In at least some key respects, the US Fed has followed Kindleberger's advice and acted as the World's Central Bank, a role left unfulfilled in the 1930s. While the monetary authorities may not have been expansionary enough, they have done much more than anyone did during the 1930s.

Countries within the eurozone, while not bound by "Golden Fetters", are certainly bound by Euro Shackles. This load is may be too great to bear for some, but there is little doubt that at the regional level this yoke is easier and the burden lighter than the gold standard restraint of the 1930s.

There are other reasons to expect better results than the 1930s. Unlike then, Europe is not the central pivot point in the global economy. Major exporters such as China are not financially exposed to Europe, and have stockpiled foreign exchange reserves sufficiently large to keep their economy moving forward, even if the pace slows somewhat. Even the US is not exposed to European financial markets in sufficiently large way likely to be exceptionally destabilizing, especially when compared to Europe's exposure to the US in 2008 or the US's exposure to Europe in the 1930s. While contagion is a real concern, it's not much of a concern in a European crisis as it was during the US crisis. If you don't live in Europe, that is.

Finally, unlike the 1930s, nearly all of the world's major economies are consolidated democracies. While this can place some unfortunate, even tragic, constraints on short-term policymaking, in the medium run geopolitical and economic stability is likely to benefit from democratic solidarity. Factor in close security ties and the sort of security dilemmas (including economic security dilemmas) that were operating in the 1930s just don't seem to apply today.

None of which is meant to imply that the current troubles are not serious. I remain concerned that the coordinating institutions that now exist do not have sufficient authority to operate effectively. The biggest problem in Europe over the past two years has not been macroeconomic fundamentals, or a currency zone that is not optimal, or even a central bank -- solely concerned with price stability -- that fiddles while Rome burns. The biggest problem is the deficit in governance by which the Euro-level coordinating institutions cannot act without unanimous approval of member states, many of which have preferences that are diametrically opposed. At the global level the problem is both better and worse. Better because the shackles are much looser than in Europe; worse because the coordinating mechanisms are weaker than in Europe. The only game in Governance Town seems to be the G-20, which has been... underwhelming in their policy responses since 2008. The IMF seems to be caught in limbo over the euro-crisis. But in the 1930s there wasn't even a G-20. There wasn't an IMF. There wasn't a central bank at the center of the monetary system willing to take the globally-minded actions that the Fed has taken. There wasn't a US Treasury Security like Geithner who, for all his faults, can never be accused of underestimating the downside risk of financial contagion.

It's difficult to draw perfect parallels to the current situation in Europe. But if I had to pick one, it would be closer to Latin America in the 1980-1990s than Europe in the 1930s. I expect the harshest effects to remain at the regional level. The US, Japan, China, Brazil, India, and other major economies will be affected, but not severely.

The next few years, like the last few years, will be a test of the resiliency of the global economic and political architecture. So far we've done fairly well all things considered. Hopefully that will continue.  

The Great Crash 2008, Part Three

In the last chapter of The Great Crash 1929, "Cause and Consequences", JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed from the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the third.


The third cause Galbraith gives for the length and depth of the 1930s depression was that there was a bad banking structure. His words: 

[M]any of these [banking] practices were made ludicrous only by the depression. Loans which would have been perfectly good were made perfectly foolish by the collapse of the borrower's prices or the markets for his goods or the value of the collateral he had posted. The most responsible bankers -- those who saw that their debtors were victims of circumstances far beyond their control and sought to help -- were often made to look the worst. The banks yielded, as did others, to the blithe, optimistic, and immoral mood of times but probably not more so. ...

However, although the bankers were not unusually foolish in 1929, the banking structure was inherently weak. The weakness was implicit in the large numbers of independent units. When one bank failed, the assets of others were frozen while depositors elsewhere had a pregnant warning to go and ask for their money. Thus one failure led to other failures, and these spread with a domino effect.

The banking structure in 2008 is often characterized as being dominated by the concentration of market share in a few "too big to fail" firms that were able to exploit an implicit government guarantee and thus secure rents. This led these firms to engage in more risk-taking than they would have done absent a guarantee, so the best way to promote future financial stability is to reduce the size of these firms, thus eliminating the implicit government guarantee, thus forcing firms to internalize their risk-taking, thus leading to less risk-taking and more stability. But this was more or less the state of affairs in 1929, according to Galbraith. There were many small firms and no government guarantee. But that led to instability for the opposite reason as 2008: market share was too dispersed throughout the banking sector, with no financial institutions large enough to halt the spread of contagion.

I've blogged similar arguments to Galbraith's before (and before having read the book). A big part of the resolution of the 2008 crisis involved selling illiquid and/or insolvent firms (Bear Stearns, Merrill Lynch, Washington Mutual, Lehman Brothers, Countrywide, etc.). The only possible buyers for firms that large and with that many problems on their balance sheets was to find other large firms that could absorb them, like JP Morgan and Bank of America. This option was mostly not available in 1907 or 1929 but, combined with strong action from the Fed and Treasury, allowed the resolution of the financial crisis much more quickly and comfortably than in those previous crises. Indeed, the actual financial shock in 2008 was worse than in 1929, and possible worse than any in previous history. The fact that since that shock we've merely had a period of slowed growth and a fairly moderate increase in unemployment rather than a Great Depression is perhaps partially attributable to the fact that we dealt with this crisis much better than previous crises.

This line of thinking should give us pause when we consider whether having more small banks rather than fewer large banks would really be a good idea*. One way we might conceptualize this is to think in terms of patterns of financial integration. A financial system in which a relatively small number of firms are central to the system will generally react differently to crises than a system in which the distribution of links is more dispersed. Specifically, according to research on the spread of viruses and other crises through networks, highly-unequal systems are "robust but fragile": they are resilient to shocks in the periphery of the network, but fragile to shocks in the core. In 2008 we had a shock to the core, so the gut reaction is to reduce the importance of the institutions that comprise the core to the broader system. But that may only leave us susceptible to shocks anywhere in the financial system. This, warns Galbraith, is a very real possibility.

That doesn't seem to leave us with many good options. But here we may take some good news from the 2008 crisis: despite being a more severe financial crisis than 1929, the fallout was much less severe. This is obviously due to a number of reasons including the safety net and automatic stabilizers, as well as pretty drastic actions taken by the Fed and other central banks. But the Fed's actions were likely made more effective by the fact that they had to concentrate their efforts towards only a handful of firms at the center of the system. Once those firms were stabilized, the entire system was stabilized. The 1929 Fed didn't have that option.

This "solution" isn't much of one, admittedly. For one thing, it means that we may remain susceptible to types of crises similar to the one in 2008. That's little comfort. Additionally, it maintains the system of rents that these large firms are able to exploit, and that's unfortunate. But there may be ways of using the regulatory code, tax code, or criminal code to eliminate these rents in other ways. It may be possible to use the same tools or others to promote financial stability in other ways. In any case, it isn't obviously clear that a more decentralized financial system would be any more stable. It wasn't in 1929.

*Keep in mind that a stated goal of regulatory policy at both the domestic and international levels is to reduce the size and number of "systemically important financial institutions". These firms are likely to have higher capital requirements under Basel III, and Obama proposed a special tax for these firms. As far as I can tell these policies have had no effect at all on bank behaviors.

The Great Crash 2008, Part Two

In the last chapter of The Great Crash 1929, "Cause and Consequences", JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed from the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the second.

Galbraith's second possible reason for why the 1930s depression was so great was that the corporate structure in the US economy was poor:

The fact was that American enterprise in the twenties had opened its hospitable arms to an exceptional number of promoters, grafters, swindlers, impostors, and frauds. This, in the long history of such activities, was a kind of flood tide of corporate larceny. 

The most important corporate weakness was inherent in the vast new structure of holding companies and investment trusts. ... dividends from the operating companies paid the interest on the bonds of the upstream holding companies. The interruption of the dividends meant default on the bonds, bankruptcy, and the collapse of the structure.

There are really two things here. First, Galbraith claims that the 1920s were prone to a widespread prevalence of fraud. Second, that corporations were structured in such a way that a disruption in finance would batter the real economy because financial firms owned many of the most important firms in the real economy. Throughout the book he offers a lot of evidence that fraud and other shenanigans were prevalent in the 1920s, although he does nothing to establish the claim that the 1920s were somehow worse in this regard than decades before or since. He does more throughout the book to show how the corporate structure was organized with productive firms downstream that were owned by financial firms upstream. The two were tightly linked, so that a major perturbation to one sector could have adverse effects on the others.

Some of these charges have been levied about the corporate system in the run-up to the 2008 crash. While I think claims that the financial crisis is a result of fraud or other criminal activity are generally over-stated, and I know of no reason to believe that criminal activity in the financial sector was more prevalent during the 2000s than other periods, there certainly was some of that going on. Perhaps more plausible is the argument that compensation schemes in major financial firms were skewed towards excessive risk-taking and boosting the short-run value of firms, not long-run stability. That may be true as well, although the only piece of research I've seen that directly examines that question finds the opposite (although another study shows that executives of large banks sold their companies stock more than they bought it, perhaps indicating that they didn't have much confidence in their firms' activities).

The second part of Galbraith's claim is more interesting to me, and potentially much more important. Was there was a shift in the underlying structure of the economy that altered the pattern of corporate organization? I don't know of any research showing the specific dynamic that Galbraith describes -- dividends from downstream productive firms paying for activities of upstream financial holding companies -- but something else happened:

From this analysis came two striking figures. The first is a map [above; click for larger version] of links between companies in five key economic sectors: technology, oil, other basic materials, finance linked to real estate and other finance. As of 2003, the sectors are relatively distinct, with real estate isolated. By 2008, they’re a tightly linked jumble, with finance at the center. 

I wrote about this research last year:

To me, there are two ways of looking at this. The first is the conclusion reached by Keim, that interdependence on its own can be stabilizing, until it reaches a critical mass, at which point increased interdependence destabilizes the system. Interdependence obviously went up throughout the 2000s. But another way to look at it is to examine the pattern of interdependence, rather than the occurrence of interdependence. 

It is clear that the financial sector became much more central to the economy, so the economy as a whole became much more susceptible to trouble in the financial sector. In this way, the U.S. economy appears to display a feature of non-random, hierarchical networks, which is that they are robust to shocks in peripheral parts of the network, but fragile to shocks at the center. In other words, if a shock had hit the peripheral oil sector (as happened, in fact, in the middle part of the decade), the increased interlinkages with finance would make the economy more resilient. But once a shock hit finance, the central sector, everything else was prone to collapse as well.

In other words, the major American industries -- tech, energy, real estate, etc. -- all became very strongly linked to finance. This generated lots of profits during the 2000s, but also left the entire economy more susceptible to a shock to the financial system. So the tightly-linked corporate structure that emerged in the 2000s may indeed have had quite a lot to do with why the financial panic had such a devastating (and persistent) effect on the real economy.

The Great Crash 2008, Part One

In "Cause and Consequences", the last chapter of The Great Crash 1929, JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash that led to a prolonged slump. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the first.

Galbraith's first reason given for why the stock market collapse plunged the real economy into deep depression is the large amount of income inequality. Galbraith writes:

This highly unequal income distribution meant that the economy was dependent on a high level of investment or a high level of luxury consumer spending or both. The rich cannot buy great quantities of bread. ... Both investment and luxury spending are subject, inevitably, to more erratic influences and to wider fluctuations that the bread and rent outlays of the $25-a-week workman. This high-bracket spending and investment was especially susceptible, one may assume, to the crushing news from the stock market in October of 1929.

It's well-established that US income inequality increased dramatically over the two decades prior to the 2008 crash. Here's a snapshot of the share of national income going to the top 10% of income earners from the famous Piketty/Saez historical study of the American income distribution (labelled and discussed by Krugman here)



The graph ends a few years before 2008 but the trend didn't reverse in that time. What I like about Galbraith's explanation of the role of income inequality in the Great Depression is that there is a plausible causal story: with increased inequality the economy becomes more dependent on the fortunes of the high-bracket folks to maintain demand and investment; a shock to their finances via a financial crash thus hurts more than it otherwise would. This can link up with demand-side and structural explanations of the sclerotic US recovery. Too often discussions of contemporary income inequality lacks such a mechanism, and are much more normatively framed and politically charged. That's fine, but it doesn't really help us understand how income distribution affects the broader economy.

The question is whether Gailbaith's causal story matches the present. Let's look at some data on private investment. We know that there was a slump in housing, so let's check that first:




It drops off a cliff, but notice that that begins in late-2005. This is in line with the usual story that the housing collapse preceded and perhaps caused the financial collapse by deteriorating the value of the underlying assets on which securities were backed. For Galbraith's story to be true, we'd need to see investment drop off after the financial collapse destroyed the wealth of those at the top of the income distribution. And we do:



Note that in percentage terms, the dropoff post-2008 is more severe than what occurred during the 2001 recession. My back of the envelope estimate is that investment at the trough post-2001 was ~ 88% of the pre-2001 peak; In 2008 it was 78%. Moreover, investment fell more steeply more quickly post-2008 than post-2001. But it also rebounded in a sharper V-pattern than in 2001. If Galbraith's logic held, we might expect to see the opposite: a deeper, longer investment drought. Sometime like an 'L'- or 'U'-shaped pattern of recovery.

Let's look at some consumption data:



Here we see a much bigger dropoff post-2008 than post-2001, and it persists for much longer. While we've gotten back to pre-2008 levels, we haven't yet caught back up to trend. But is this slack enough to explain the persistent malaise in labor and financial markets? And is the slack in spending and investment attributable to income inequality rather than high unemployment? Is high unemployment attributable to income inequality? There's no obvious mechanism that explains it. At least not that I can think of.

It may be that increased inequality was a symptom of structural shifts in the global economy that pre-dated the crash. An effect rather than a cause. Post-crash inequality becomes a cause of ongoing economic weakness. However as a first explanation for the Lesser Depression I'd look elsewhere.

In any case, the major political battles in the US since the financial crisis have been on issues related to income distribution: health care, financial regulation, and progressive taxation vs. expenditure austerity. Maybe we could add classic Phillips-curve battles over unemployment/inflation tradeoffs.* This suggests that the cleavages in the economy break down along at least some of these lines. But this could be a consequence of the weak economy rather than a cause of it, especially since the political scene has shifted from fire-fighting to deficit-cutting.

*Krugman and others argue that right now there isn't much of a tradeoff and I tend to agree, but neither the political leadership of the GOP nor most pundits seem to believe him.

The World's Central Banker

I've written about this in terms of lender of last resort, but Edward Hugh says the Fed's importance goes well beyond that:

If the global economy has been growing reasonably well over the last six months it is because what Nouriel Roubini once called a “wall of liquidity” is seeping out of the United States, where solvent domestic demand for credit is flat and will remain flat due to the private indebtedness problem (remember US “over consumption” (the high proportion of GDP which has been consumption driven) has only been the mirror image of Chinese “over investment” and we that live in a world which badly needs to rebalance).

This “wall of liquidity” has been force feeding strong growth in a number of key emerging markets, and this growth has been generating strong demand for exports from a number of developed economies, and most particularly from Germany. Thus the German boom is no mystery, and has been intimately tied to the implementation of QE2 in the US. Note, in the chart below, how the German manufacturing PMI was slowing in the summer of 2010, how it surged in the autumn (QE2) and how it is now swooning again. There is no mystery to these “soft spots”, all you need to ask yourself is where the demand is coming from. ...

Maybe it seems peculiar to be arguing that policy in the Federal Reserve should be partially conditioned by policy failures in countries like Italy, Spain and Greece, but such is the nature of the inter-connected world we live in.

This is Kindleberger's Decession Politics.

Actually, Let's Not Start a Trade War With China Just Now

(click for larger image)

Brad DeLong links to Jared Bernstein, who suggests some policies that Obama could pursue (without deficit spending) to help the U.S. employment malaise. Many of them are fine, but this one isn't:

Currency Management: this would be a very bad time to let up on countries who subsidize their exports by suppressing their currency values in foreign exchange markets, most notably China. I’d push the Levin bill on this. And it’s bipartisan: the darn thing got 99 R votes in the last Congress!

The Levin bill proposes slapping tariffs on goods coming from countries that manipulate their exchange rates to boost exports. Levin has proposed a variant of it for years (here's one from 2006), but finally got traction during the recession. Krugman agrees that this is a good idea, but I think there are a number of problems with it.

1. It's most likely illegal. If China is violating trade rules with its exchange rate policies, then the USTR should take them to the WTO. The fact that that hasn't been done at any point over the past decade, despite the fact that it would have been politically popular, indicates to me that the USTR believes it would lose such a case. There's a reason why exchange rate policy has been referred to the IMF (which conducts monitoring and surveillance but has no authority) rather than the WTO. It's also not clear that China is violating any WTO rules. For one thing, the WTO doesn't have a lot to say about which exchange rate regimes are legal and which aren't. And although using the exchange rate to subsidize exports could be illegal, there's a fairly high bar to clear. This (several years old) thread on the excellent International Economic Law and Policy blog describes the three simultaneous conditions under which currency manipulation could be WTO-illegal: 1. It must entail a "financial contribution"; 2. It must be specific; 3. It must confer a benefit on exporters. The comments to that post get into specifics, but according to IELP, "If [currency policy] is contingent in law or de facto upon export performance, it is then prohibited and deemed specific automatically".

The graph above shows the nominal dollar-yuan exchange rate over the past five years. Does it look like the exchange rate is contingent upon export performance? The yuan has appreciated against the dollar by nearly 25% over the past five years, and I'm not sure the trend clearly indicates responsiveness to changes in Chinese export performance.

2. There are growing concerns about inflation in the U.S. These concerns may be misguided, but they play well in Republican circles and among certain Governors at the Federal Reserve. Slapping an import tariff on China would cause immediate price spikes across a wide range of consumer goods, which would likely lead to increased calls for the Fed to tighten monetary policy. That, of course, would not be good for economic recovery. Nor would it be good for standards of living. A Chinese undervaluation of the yuan is equivalent to the Chinese giving us free money. Let me say that again: a Chinese undervaluation of the yuan is equivalent to them giving us free money. It's not clear to me that trading lower standards of living for more jobs is a net win. Jobs are certainly important, but they're not the only important thing.

Moreover, as we've discussed on this blog repeatedly, the nominal exchange rate is less significant than the real exchange rate, and the real exchange rate is shifting faster than the nominal rate as inflation in China out-paces inflation in the U.S.

3. It's not at all clear that a tariff targeted specifically at China's exchange rates would have any effect on U.S. jobs. Not only would importers suffer, but there is no reason to believe that manufacturing jobs would come back to the U.S. en masse. Manufacturing employment was collapsing before the recession (see also here), and even if China lost some jobs via a U.S. tariff those jobs would likely go to Vietnam and Taiwan and South Korea and any number of other places before coming back here. A tariff would make U.S.-produced goods cheaper relative to Chinese goods (in U.S. markets), but would not affect the price of Vietnamese goods at all. The magnitude of this shift, and the timing of it, isn't obvious to me, and to some extent it offsets #2 above, but the world is dynamic.

4. Those dynamics are not limited to economics; they also involve politics. The Chinese would not simply accept tariffs as the new cost of doing business. They would fight back. First, they would take the U.S. to the WTO. Second, they would likely enact retaliatory tariffs. The WTO cases would take years to be resolved (i.e. hopefully after the recovery from the recession), but the tariffs would immediately damage U.S. exporters. Obama's stated policy goal is to double American exports over the next several years. It's going to be hard to do that if you can't sell into the world's fastest-growing major market, now the second-largest economy on the globe.

5. The U.S. runs the risk of pot-meets-kettle reactions from the rest of the globe. The world already believes that U.S. monetary policy, with interest rates at 0% and two rounds of quantitative easing already conducted, constitute "currency manipulation" of a different sort. Putin called it "hooliganism", Brazil imposed capital controls, S. Korea has expressed concern about exchange rates at the G20, etc. I agree with Krugman and others that this criticism is over-blown; the U.S. is in a deep recession and should be using monetary expansion to help get out of it. But a round of tariffs targeting exchange rate policy will leave the U.S. open to a dose of its own medicine. Other countries are already wary of U.S. policy, and more aggressive measures could quickly lead to a cycle of more prevalent beggar-thy-neighbor policies. Right now it is critical that international economic cooperation move forward, not back. We've seen from the Japan crisis how badly economies are damaged when global supply chains are disrupted.

6. The U.S. needs to know its role. The global economy is still terribly damaged. 1937 isn't the worst analogue. Right now the U.S. needs to do everything it can to keep markets open, maintain international cooperation, provide liquidity into the global system, and maintain a market for goods. In other words, it needs to live up to Kindleberger's charge. That involves allowing some free-riding. It involves setting policy based on global, not domestic, circumstances. Myopically trying to get back every lost job as quickly as possible runs the risk of damaging global economic relations over the medium- and long-run, which could easily have adverse effects on growth and prosperity. Letting China sell us goods at below-market prices seems like a very small price to pay for averting a seriously negative outcome.

The World's Central Banker

More information (via Felix Salmon) about how the Fed acted as the lender of last resort for foreign firms during the 2008 crisis:

File under “things you never knew the Fed did during the financial crisis”: an $80 billion loan scheme known as ST OMO, which was so obscure that even Barney Frank had no idea it existed when he required the Fed to turn over its lending data in his Dodd-Frank bill. ...

Why was the Fed so reluctant to discuss this program? After all, Fed spokesman Jeffrey Smith had nothing but great stuff to say about it to Ivry, gushing about how it “helped alleviate strains in financial markets and support the flow of credit to U.S. households and businesses”. You’d think if it was so great, the Fed wouldn’t be so quiet about it.

One possible reason is hinted at in the charts above. They cover four banks: Credit Suisse, Deutsche Bank, BofA, and RBS. (RBS is still referred to, quaintly, under its old name of Greenwich Capital, the shop bought by NatWest before NatWest was bought by RBS.) The three European banks all borrowed 11-figure sums from the facility, while the one American bank barely used it. ...

But it does seem that the governments of Switzerland, Germany, France, and the UK should all be sending thank-you letters to 33 Liberty Street if they haven’t already done so: it’s entirely possible that the New York Fed bailed out their banks without those governments even knowing about it. That’s just how generous we are, in this country.

I've written about similar actions here and here. The Fed has been criticized for not doing more to stimulate the economy since 2008, but the actions it took to stabilize the international financial system would make Kindleberger smile.

1937

(click here for animation)

I agree with Krugman again:

How bad will it be if we don’t manage to raise the debt ceiling? ...

First, US government debt plays a special role in the financial system: T-bills are the universal safe asset, the ultimate collateral. That’s why, during moments of financial stress, the interest rate on T-bills has actually gone negative. Make that safe asset suddenly unsafe, and it might cause vast disruption.

Krugman should make the point much stronger. It will cause vast disruption. And not just for the U.S. financial system, although that would be bad enough. The effect on the global financial system would be far worse. There's a reason why, following the biggest financial crisis since the Great Depression, capital actually flowed into the U.S. banking system, which was the epicenter of the storm. It's because the U.S. was at the epicenter of the storm. Stabilizing the U.S. was necessary to stabilize the global financial and economic system. If you click on the link above and watch the animation, you'll notice that the U.S. becomes more central to the global banking system over the period 1999-2010. And you'll even notice that, while the network wobbles after the shock in late-2008, it reinforces itself pretty quickly. Why? Because if the U.S. went under, then all those thick black lines would disappear, and everyone else would go under too.

What does this mean? It means that the rest of the world is heavily invested in the U.S. Which means that if the U.S. has a downturn, the global economic system has a downtown. If the U.S. refuses to raise the debt ceiling, there are two possible outcomes, which are not mutually exclusive: quick, harsh austerity that will crush what little recovery we've had; some form of default on debt. In truth, one implies the other. Both of them involve a massive collapse in global aggregate demand, as well as the mother of all bank runs. This is important because U.S. Treasury bills are considered "riskless" by financial institutions around the world. If the "riskless" assets become risky overnight, the effects on bank balance sheets will be catastrophic. Global regulatory structures will effectively cease to exist (since enforcing capital requirements would make every bank insolvent), and runs on financial institutions will occur almost immediately. The U.S. won't be able to intervene to stabilize the banking sector since its debt-spending capacity has been eliminated, so the banks all melt down. If that happens, not only would the U.S. economy crash the world economy would crash as well. There are few countries immune from an American virus. This would be a pandemic.

Moreover, it's just not necessary. The U.S. can currently borrow for five years at negative real interest rates (i.e. adjusted for future inflation). That means that other people will currently pay us to take their money. Let me repeat: Other people will pay us to take their money for the next five years. Instead, we're considering blowing up the global economy. Bad deal.



What happens when global economies blow up? Well, all of the examples we have are pretty bad. They tend to lead to long depressions, world wars, nuclear bombs being dropped, that sort of thing. I'm trying not to be too hyperbolic, but the major thing separating this crisis from the 1930s is a series of global institutions that are buttressed by economic stability in the U.S., integrated Europe, and Asia. If we blow that apart, then things can get ugly very quickly. Quite frankly, I'd rather not conduct a natural experiment to see how well various IR theories hold up.

For these reasons, I don't think it will happen. I don't want to put anything past the current Congress, which is as petty and short-sighted as every other Congress, but the stakes here are just too high. Then again, we've been in similar situations before, and they didn't always end well. If Congress is engaged in a game of chicken, then I hope they're ready to jump. This isn't worth toeing the line.

The Decline

Consider the never-ending narrative of American decline. My historical knowledge isn't super-deep, but I know for certain that that drum has been kicked at least since Sputnik ('50s), continuing through the Vietnam War ('60s), the closing of the gold window and the oil embargo/stagflation ('70s), the rise of Japan ('80s), European integration ('90s), and now the rise of the BRICs, especially China. During this entire period critics of the U.S. have focused on its sclerotic political system and messy "laissez-faire" capitalism (ha!), which was clearly inferior to the svelte technocratic industrial policies of the USSR OPEC Japan NICs E.U. China. The U.S. is becoming more and more irrelevant, I keep hearing. The quick rebound of China, Brazil, and Germany is proof that the world is decoupling from the U.S. The world is becoming more multipolar, the U.S. needs to learn how to shift into obsolescence and be just another state among states.

And yet when the U.S. announces that it is going to reduce some of the maturity of its sovereign debt in order to boost domestic demand -- an equivalent action to normal monetary policy operations, except on 5-year T-bills rather than shorter maturities, at a time when markets expect deflation (see graph above) -- the world goes ballistic. Huh? If the U.S. was as vulnerable as folks make it out to be, and the rest as powerful and resilient, this shouldn't even register. Instead the Chinese complain about "currency manipulation" as if QE2 wasn't a demand-side domestic monetary policy. Brazil complains about capital inflows creating bubbles, and institutes capital controls to counteract them, as if protecting local capital owners and commodity exporters in one of the most inegalitarian countries on earth had nothing to do with it. Japan enacts its own QE, and South Korea is pushing for, er, something to deal with exchange rates at the upcoming G20 meeting it hosts. The entire industrialized world is concerned that a relatively small program in the U.S. is going to threaten their entire economies.

(Either that or they're using it as cover to justify policies that they wish to enact anyway. I actually think this is more likely, since they can always continue to devalue against the dollar without retribution if they wish, and anything that boosts American demand is good for Chinese, Japanese, Brazilian, and South Korean exporters. But I don't know that for certain; maybe these leaders really are freaked out.)

Of course all of this follows a financial crisis that originated in the U.S. but was not contained within it. Forgive me for thinking that at this point the importance of the U.S. to the global economy almost cannot be overstated. At this point I wouldn't be terribly surprised if the replacement of Bretton Woods II is a variant of Bretton Woods I. The U.S. needs to recognize its place in the world, and act like a hegemon should. There's not chance the G-20 is capable of doing it.

So far I think we've done a reasonably good job -- the trading system has remained intact, warnings of competitive currency depreciations have been all smoke and no fire, countercyclical lending has gotten to states (like Greece) that have needed it, international institutions have held together remarkably well -- but we can do even better. Now is the time to finish the Korea FTA and give fast-track negotiating authority to Obama. Doha isn't going anywhere right now, but in a few years time there could be a window for movement, and it would be good to have the tracks laid ahead of time. Now is the time to let other countries devalue against the dollar if they need to, while still pursuing policies that will boost domestic demand, including demand for imports. Yes that hurt employment in tradable sectors, but mostly in the sort of less-skilled manufacturing that will not yield new jobs anyway. In the meantime, it will boost employment in importing sectors, and provide low-cost goods for struggling households. I wish it were possible to push for immigration reform too, since it's the time for that as well, but I'm pretty sure the sort of immigration reform we'd be likely to see right now isn't the sort I'd support.

Now is emphatically not the time to "get tough" with other countries that also pursue policies in their domestic interest, even if they have some short-run negative consequences for the U.S. There is a lot of low-hanging positive-sum fruit hanging out there. There's no need to take an axe to the trunk.

After all, if the Federal Reserve can't get the U.S. economy moving, the Bank of Japan won't be able to either.

The U.S. should not set policy out of fear of decline.

Hegemony and Currency Wars

Apologies for the lack of posts lately. Real work has gotten in the way.

Over the past few weeks I've been thinking about the Fed's actions over the past few years. At the height of the crisis the Fed moved to shore up the integrity of the banking sector and immediately lowered the funds rate to practically 0%. It also engaged in a first round of quantitative easing -- by increasing the size of its balance sheet -- and qualitative easing -- by increasing the riskiness of its balance sheet. Most observers agree that these actions prevented the Great Decession from becoming another Great Depression.

Since early-2009, the recession has worsened but the Fed has mostly kept policy stable. This has led to complaints from many ideological corners; Scott Sumner and Paul Krugman don't agree on much, but they do agree that the Fed isn't doing enough. Some have expressed bemusement that "Helicopter Ben" Bernanke, student of the Great Depression, hasn't done more to prevent the worsening of the recession. After all, he famously said of the Fed's role in abetting the Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton [Friedman] and Anna [Schwartz]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

So why has he let the U.S. economy stagnate? Why has he let other countries devalue their currencies with no U.S. response? Why hasn't he learned from history?

Perhaps he has. I have no reason to think this is true, but perhaps Bernanke is influenced by another scholar of the Depression - Charles Kindleberger. Kindleberger argued that the Great Depression became a cataclysmic international event because of the unwillingness of the U.S. and inability of the U.K. to supply public goods to stabilize the international system. Those public goods include maintenance of a system of stable exchange rates and open markets:

"As with exchange depreciation to raise domestic prices, the gain for one country was a loss for all," Kindleberger writes. "With tariff retaliation and competitive depreciation, mutual losses were certain."

In other words, perhaps Bernanke is acting as the world's central banker. If Bernanke believes that a U.S.-led currency war would have adverse consequences for the global economy, then perhaps he is willing to prolong the U.S. recovery in order to prevent a large global downturn. Such a deterioration of the global economy would also affect the negatively affect the U.S. of course. So while, ceteris paribus, a dollar devaluation would help the U.S., ceteris is not paribus. A U.S. devaluation would prompt a series of actions in Frankfurt, Tokyo, and Beijing. The resulting exchange rate instability would spook financial markets and hamper trade. Cries for protectionism would grow louder, and the net effect would be sharply negative.

Faced with that scenario, perhaps Bernanke has opted instead to try to stabilize markets and defuse an explosive global political economy by allowing other countries to beggar the U.S. some in the short run. Again, I don't know if this is the case, but it seems more persuasive to me than "Bernanke doesn't understand the monetarist lessons from the Depression".

It should be noted that Barry Eichengreen disagrees with Kindleberger about devaluations. Eichengreen argues that while competitive devaluations in the 1930s did beggar neighbors in the short run, they also constituted a large international monetary stimulus that helped pull the global economy out of the depression (after several years). More recently, Eichengreen has argued that this process is best done through multilateral policy coordination so as to avoid swings in exchange rates. Unfortunately this sort of coordination is basically impossible right now. The Prisoner's Dilemma that incentivizes beggar-thy-neighbor devaluations also incentivizes defection from a coordinated monetary policy.

Given that, perhaps Bernanke has chosen to follow Kindleberger's advice: provide as much liquidity as he can, work to maintain an open trading system and relatively-stable exchange rates, and allow other countries to devalue without U.S. reprisal. Perhaps that will cost the U.S. in the short run, but it can benefit the global economy over the longer run.