This Was Inevitable

European domestic politics has been threatening the EMU since, well, its inception. But things may be coming to a head:

By insisting that it receive collateral from Greece in return for aid, Finland is threatening to upend an agreement that euro zone countries, led by France and Germany, made in July to expand the E.U. bailout fund. ...

“In countries like Finland the opposition to what are described as bailouts is huge,” said Philip Whyte, senior research fellow at the Center for European Reform in London. “Governments are politically constrained.”

In Finland, Prime Minister Jyrki Katainen faces discontent within his governing coalition as well as pressure from a nationalist opposition group, the True Finns, which rode euro-skepticism to big gains in April parliamentary elections.

Finland is just one of 17 euro zone countries whose parliamentary approval is needed for the expanded bailout fund and whose domestic politics could upset the process. ...

European government officials say they have to take Finland’s concerns seriously.

“We have to listen to the people of Finland,” said a government official, who requested anonymity because of the sensitivity of the issue. “Collateral is an absolute condition for Finland to be involved.”

US Stock Markets FOTD

From comments on this previous post on US equity values:

If the US wants more foreign inflows into stock, it should reduce the non-resident dividend tax rate from the very high 30% that it is today. Currently, foreign investors are encouraged to invest in US treasuries since the interest is tax-free but not in US stocks. Since my country of residence has no dividend or capital gains taxes, it generally makes more sense for me to invest in British, Brazilian and Indian stocks (0% tax) and to some extent in Chinese stocks (10% dividend tax).

The Fed Is Political, redux

Krugman's on the same page.

I will say that Krugman (and plenty of others from all along the ideological spectrum) are wrong to ridicule people who talk about "debasing the dollar" for not knowing what they're talking about. That's exactly what they (the expansionists eg Krugman) mean when they talk about currency devaluation and/or increased inflation for a sustained period, but they just call it "monetary stimulus". It might be good for the economy in aggregate, but it won't be good for everyone and those political cleavages obviously matter. They often make the case that monetary stimulus would be good in aggregate, but usually without recognizing that there is a group of people that genuinely wouldn't benefit from debasement, and this group is much broader than the "rentier class". It includes every consumer, eg. Ron Paul and Paul Ryan aren't loonies for noticing that, even if they're highly selective in their argument.

It's fine to ridicule Rick Perry as a loony detached from reality though, because no matter what the Fed does w/r/t QE3 it won't be treason and doesn't deserve the Texas special.

Links

Probably won't get to blog these properly, but they deserve attention.

-- Sad that this is necessary, but Barry Eichengreen discusses why a return to the gold standard is probably impossible, and not at all desirable anyway.

-- "The network of global corporate control", a very interesting research paper.

-- "The Convulsions of Political Economy", an application of Marx to the current environment from an unlikely source: a Senior Economic Advisor at UBS.

Will US Equity Values Decline Because of Demographics?

The SanFran Fed has published a research note on the value of US equities (with accompanying graph, above) that has attracted a fair bit of attention. Some key bits:

This evidence suggests that U.S. equity values are closely related to the age distribution of the population. Since demographic trends are largely predictable, we can forecast the path that the P/E ratio is likely to follow in the next few decades based on the predicted M/O ratio. ...

Despite theoretical ambiguities, U.S. equity values have been closely related to demographic trends in the past half century. There has been a tight correlation between population dependency ratios, such as the M/O ratio, and the P/E ratio of the U.S. stock market. In the context of the impending retirement of baby boomers over the next two decades, this correlation portends poorly for equity values. Moreover, the demographic changes related to the retirement of the baby boom generation are well known. This suggests that market participants may anticipate that equities will perform poorly in the future, an expectation that can potentially depress current stock prices. In that sense, these demographic shifts may present headwinds today for the stock market’s recovery from the financial crisis.

What this is basically saying is that stock market prices (relative to firm income per share) have tracked US demographics relatively closely over the past few decades. This is bad news for those invested in US equities because the US population is getting older, which means that there is likely to be more people seeking to sell equity investments to fund retirement than people looking to buy. If the supply of equities for sale shifts right, and the number of people with enough wealth to demand equities shifts left, then the price of equities is likely to fall. That's what the "model generated" portion of the graph above is showing.

But I don't buy it. As Ryan Avent notes, demographic trends are no secret, yet if supply is going to outstrip demand when retirees liquidate their equity portfolios the markets don't seem to have internalized the expectation.

More importantly, it's not clear to me that US demographic trends are the most relevant variable going forward. Capital is more internationalized now than at any point in history, and there are many more people in the global middle class than ever before, a trend that is expected to continue over the next 2-3 decades. For many of these people investing in US equities will be attractive, especially if the prices are low. Let's also remember that the US runs a very large current account deficit and is likely to continue doing so for the foreseeable future. That will have to be offset with financial transactions, and equities are one way to do that.

The authors mention the possibility of increased foreign ownership in passing, but it doesn't factor into their methodology. I think it probably should.

So Let Me Get This Straight

Political scientists can't predict political behaviors, sociologists can't predict social movements, economists can't predict economic crises, biologists have no idea how many species there are, and let's not even mention meteorologists.

We're a really dumb species.

The Fed Is Political

I meant to write about Rick Perry's idiotic "treasonous" comment but was occupied with other things. In any case, what Karl Smith said.

Perry's comments aren't completely out of the blue. Over the past few years we've increasingly seen how politicized the Federal Reserve is and how that can affect macroeconomic and regulatory policy. In mid-2009, polls showed the Fed was the least-popular major US agency, below even the IRS. Late last year a majority of Americans wanted the Fed audited or abolished.

Among elites, Fed-bashing is practically a cottage industry on both sides of the ideological spectrum. Obviously Ron Paul and the anti-inflationistas hit the Fed hard from the right for debasing/devaluing/inflating or something, while progressives like Yglesias and others advocate a Fed more dedicated to fighting unemployment. Part of this politicization comes from the Fed's dual mandate and the classic Phillips-curve inflation/unemployment tradeoff that tends to separate the right from the left*.

The Fed has also come under fire from both right and left over its role as regulator. The left finds the Fed completely derelict in its duty during the housing and derivates booms of the 2000s. The right accuses the Fed of regulating the banking system too much and favors various versions of free (or freer) banking. The left attacks Greenspan and Bernanke for being to laissez-faire. The right attacks Bernanke (a Republican and Bush appointee) for being too activist and trying to get Obama re-elected. International regulatory requirements such as the new Basel accord may not be fully implemented as pressures on American and European banks persist. Now Bank of America may be going down again.

These political battles have arguably hamstrung the institution. Peter Diamond, a Nobel Prize-winning economist, withdrew his nomination to the Fed when it became clear that he wouldn't receive approval in the Senate because he prioritized unemployment in his academic work. Obama has responded to the political climate by simply refusing to nominate anyone to fill key seats on the Board of Governors, despite the fact that the Fed is under greater pressures now than at any point in the past 30 or more years at least. Some on the right (eg Sumner) and left (eg Krugman) believe that Bernanke's prior academic work suggests that he would pursue a much different monetary policy were it not for opposite from the Board of Governors and, possibly, politicians.

Not all of these politics are clearly partisan. Both the far right and the far left strongly oppose the bank bailouts that heavily involved the Fed, and we found out yesterday that they were larger than previously thought. (Typical response: "[T]he Fed's secret bailout comes out to the same amount U.S. homeowners currently owe on 6.5 million delinquent and foreclosed mortgages. The progressive take on this story will be that the Fed has preferenced Wall Street over Main Street by using its exceptional authority to extend trillions in loans to banks without offering similar guarantees to underwater home owners.") Even worse for populists on both sides of the aisle is the fact that the Fed offered plenty of funds to non-American firms.

And yet we hear all the time about how the Fed is a technocratic institution, supposedly insulated from politics so it can set perfect policy from a dispassionate distance, thus correcting time inconsistency problems associated with the democratic election calendar. We hear it from academics who do empirical work on macroeconomics and politics, from government officials, and from our textbooks. We hear it from centrists who want to believe that it's true.

But it's not. The Fed is not only politicized; it is political. Every action taken benefits some group in society, often at the expense of another. Every policy choice has distributional consequences. Since the Fed is ultimately responsible for the health and well-being of the financial system, we can generally assume that the Fed will prioritize actions that benefit financial firms over other goals. And then they do. And then we claim to not understand what they're thinking. But that's the job that they've been given.

All of this is even more true of the European Central Bank.

*There's lots of work in political science and economics on this. See, eg, the classic Nordhaus (1975) article, Hibbs (1977), Alesina (1988), Milton Friedman's 1976 Nobel lecture, and plenty of others. There are some problems with this literature, but as a crude first-cut at monetary politics it's a good starting place.

This Is What Adjustment Looks Like (an ongoing series)

Martin Feldstein:

China’s government may be about to let the renminbi-dollar exchange rate rise more rapidly in the coming months than it did during the past year. The exchange rate was actually frozen during the financial crisis, but has been allowed to increase since the summer of 2010. In the past 12 months, the renminbi strengthened by 6% against the dollar, its reference currency. ...

There are two fundamental reasons why the Chinese government might choose such a policy: reducing its portfolio risk and containing domestic inflation.

Consider, first, the authorities’ concern about the risks implied by its portfolio of foreign securities. China’s existing portfolio of some $3 trillion worth of dollar bonds and other foreign securities exposes it to two distinct risks: inflation in the United States and Europe, and a rapid devaluation of the dollar relative to the euro and other currencies. ...

Looking back on the past year, the 6% rise in the renminbi-dollar exchange rate might understate the increase in the relative cost of Chinese goods to American buyers because of differences in domestic inflation rates. Chinese consumer prices rose about 6.5% over the past year, while US consumer prices rose only about 3.5%. The three-percentage-point difference implies that the “real” inflation-adjusted renminbi-dollar exchange rate rose 9% over the past year (i.e., 6% nominal appreciation plus the 3% inflation difference.)

There are obviously political interests in China for keeping the RMB's value low, but the most recent Five-Year Plan calls for increasing households' purchasing power above the rate of economic growth. We may start to see (more) political cleavages in China pitting consumers and against producers. Remember: politics exists even in authoritarian regimes.

New Economics Research

How Reliable are De Facto Exchange Rate Regime Classifications?
Barry Eichengreen, Raul Razo-Garcia
NBER Working Paper No. 17318

We analyze disagreements over de facto exchange-rate-regime classifications using three popular de facto regime data series. While there is a moderate degree of concurrence across classifications, disagreements are not uncommon, and they are not random. They are most prevalent in middle-income countries (emerging markets) and low-income (developing) countries as opposed to advanced economies. They are most prevalent for countries with well-developed financial markets, low reserves and open capital accounts. This suggests caution when attempting to relate the exchange rate regime to financial development, the openness of the financial account, and reserve management and accumulation decisions.

They do not cite this paper by Guisinger and Singer, which they should. Nor do they include the Aizenmann-Chinn-Ito "trilemma indexes" in the analysis, which they probably should. Still potentially interesting for those who do quantitative work involving exchange rates.

Country Size, International Trade, and Aggregate Fluctuations in Granular Economies
Julian di Giovanni, Andrei A. Levchenko
NBER Working Paper No. 17335

This paper proposes a new mechanism by which country size and international trade affect macroeconomic volatility. We study a multi-country, multi-sector model with heterogeneous firms that are subject to idiosyncratic firm-specific shocks. When the distribution of firm sizes follows a power law with an exponent close to -1, the idiosyncratic shocks to large firms have an impact on aggregate output volatility. We explore the quantitative properties of the model calibrated to data for the 50 largest economies in the world. Smaller countries have fewer firms, and thus higher volatility. The model performs well in matching this pattern both qualitatively and quantitatively: the rate at which macroeconomic volatility decreases in country size in the model is very close to what is found in the data. Opening to trade increases the importance of large firms to the economy, thus raising macroeconomic volatility. Our simulation exercise shows that the contribution of trade to aggregate fluctuations depends strongly on country size: in the largest economies in the world, such as the U.S. or Japan, international trade increases volatility by only 1.5-3.5%. By contrast, trade increases aggregate volatility by some 15-20% in a small open economy, such as Denmark or Romania.

Does this contradict the PSST story in the case of the stagnating US economy?

Realism, Internationalism, and Networks

Henry Farrell characterizes the debate between Drezner and Slaughter as over "whether realism or networked internationalism best describes the basic contours of international politics" and thinks they're both wrong, preferring instead a view in which networks are important but that joint-gains functionalism is the wrong way to approach them: "If the kinds of international networked cooperation we see are all about struggles for resources, rather than achieving functionalist imperatives, then we may expect a very different international networked society than if these forms of cooperation are aimed at pursuing functionalist goals and Pareto-improvements". I read the debate, even more simply, as so:

Slaughter: Transnational networks are changing international politics by weakening or changing the role of the state, and this mostly leads to Pareto-improvements.

Drezner: Yeah, maybe, but states are still by far the most important actors in global politics and on many big-ticket items transnational advocacy networks have had little discernable effect. To the extent that non-state networks matter, it's largely because they change state preferences, not that they make states less relevant.

Farrell: Networks form for distributional reasons and states often cannot control them. In fact, states themselves are networks of politicians and bureaucrats. Networks transform politics via a complex process of contagion which is very difficult to predict ex ante.

Obviously some nuance is missing in these characterizations, but I think that's the gist of the argument. I have sympathy for all three views, but my own belief is that international politics operates somewhere in the space between Drezner and Farrell. That is, I think that networks play important roles in shaping international politics, but I think that their influence is best understood within the context of the state system. And despite the fact that international politics is comprised of a series of complex networks that interact, I don't necessarily think that "contagion" is the best way of thinking about these processes in all cases, nor that network behavior is a fundamentally mysterious phenomena.

Farrell and others cite the Arab Spring as a good contemporary example. According to one view, the "Arab Spring" is a "black swan" -- a rare event that is essentially unpredictable. I think Farrell would modify the Blyth-Taleb story about probability distributions into a network context, where "black swans" are now viewed as shocks to networks that diffuse through the system in idiosyncratic ways. In some cases the network may be transparent enough that we can predict how extreme shocks might affect the network, but in other cases we won't have that information, and anyway we can't know when or how the shocks will occur. In this view the Arab Spring is a phenomena that cascaded across state borders in a way that states could not understand much less control. Factor in social media and other coordinating devices -- which are networks themselves -- and it gets messy very quickly.

But the alternative view of the Arab Spring, which I believe is more or less the dominant view of those who study contentious politics, is that diffusion dynamics themselves are not enough to explain when revolutions succeed or fail.* Quite often it is the decisions of centrally-located actors that play the most significant role. For example, the Egyptian revolution succeeded because the military chose to protect the protesters in Tahrir Square rather than killing them, and because key international allies pulled support from the Mubarak regime. The attempted revolution in Bahrain failed because the state, with support from foreign allies, was able to mobilize the military to put the insurrection down. This story isn't about cascading network spillovers infecting international politics in chaotic ways, but about the ability of governments to do what is necessary to keep elites on their side. In Libya, the revolution was likely to fail without international intervention. In Egypt, international intervention was almost non-existent. But in each case there are clearly-identifiable actors operating within the network that are having an important effect on outcomes. In at least some cases their behavior may be predictable by either interest-based or ideational approaches.

Perhaps most significantly, to my knowledge there is no evidence that the Arab Spring is an internationalist movement rather than a series of local movements that have arisen somewhat idiosyncratically. Networks played an important role in organizing protesters domestically, but there didn't seem to be any similar network coordinating actors at the regional level, and not all Arab countries have experienced prolonged protest periods. This is what I was referring to above when I said that contagion stories can only take us so far. A contagion story would have to be able to explain why protests spread from Tunisia to Egypt and elsewhere in 2011, but not from Iran in 2009. Or why protests spread from Tunisia to Egypt to Syria but not to Jordan or Lebanon. Or why reforms in Morocco appear to have been accepted by the populace, while they were rejected in Syria. In other words, there appears to be plenty of room for some sort of two-step analysis when determining how, when, and why social movements diffuse through the system.

Which actors are the most important may be a function of network characteristics, but quite often the relative importance of different actors is knowable ex ante. As a critical central node in Egyptian society, no one was surprised when the defection of the Egyptian military tipped the scales in the revolutionaries' favor, and it seems that protesters believed early on that such a defection was likely if the crowds could sustain momentum for awhile. This belief provided just the motivation needed to sustain that momentum. Similarly, if we think about why the US financial crisis led to a global recession while the Swedish crisis in the 1990s did not, we can look to network characteristics of the global financial system and immediately see that the US is a much more important node than Sweden. We could then consult network theory that suggests that in highly unequal systems that are tightly inter-connected, networks are robust to shocks in the periphery but fragile to shocks in the core. Contra Farrell then, having a grasp of how networks behave and what the financial network looks like thus makes even complex phenomena like the financial crisis much easier to understand.

So on a fundamental level I'd argue that Farrell's claim that the international political system is best understood as "space for contagion" is missing something, at least under most common definitions of network contagion which tend to influence structure over agency. For one thing, as an empirical matter "contagion" often doesn't operate in ways we might expect. Revolutions are not viruses. Neither are neoliberal economic reforms or most other policies/outcomes that are often described in terms of diffusion or contagion. I'd rather say that we can use networks to understand the bargaining space within which strategic political actors interact. And if we understand how network dynamics confer power to some actors over others, then outcomes in international politics can be more easily understood.** The pattern of interdependence in networks is thus an important causal variable, but is not determinate on its own. Like Farrell (and Drezner), I do not assume that these interactions are necessarily Pareto-improving, or that they ordinarily will be. Unlike Farrell, I think that the role of states within these networks is likely to be substantial for all definitions of "state".***

Despite all of that, I think Farrell is much more right than wrong in emphasizing the ways in which networks affect international politics in ways not expected by most realist theory. And I think he's right to argue that Slaughter's focus on joint-gains functionalism is misplaced optimism in many cases. But I think the lesson from these corrections is not necessarily that international politics is a space for contagion to spread in unknowable ways, but rather that we need to situate political actors within a structural context to understand how they shape policy and respond to events.

*I'm heavily influenced in this by the research and teaching of UNC prof Graeme Robertson, who has written about and discussed the Arab Spring here and here. His current research is on contentious politics in post-Communist states.

**For one example of this see Charli Carpenter's recent IO article on gatekeepers in advocacy networks.

***In other words, depending on the analysis, we may need to complicate states along lines that Farrell suggests. Sometimes the subtle two-step that Drezner advocates will be fine. As Bear Braumoeller notes in comments to Farrell's post, endogeneity problems quickly emerge when you try to internalize everything into network analyses. Nevertheless Farrell is correct in saying that if we think of world politics as a complex adaptive system (and we should), then problems quickly emerge when we "black-box" any one level of analysis. Unfortunately there's no simple solution for this, but there are ways to gain tractability by shifting focus from one level of analysis to another without completely losing sight of the other levels.