Deal?

Looks like there's an emerging debt ceiling deal that will likely pass both houses. Here's the gist:

- Debt ceiling increase of up to $2.8 trillion

- Spending cuts of roughly $1 trillion

- Vote on the Balanced Budget Amendment

- Special committee to recommend cuts of $1.8 trillion (or whatever it takes to add up to the total of the debt ceiling increase)

- Committee must make recommendations before Thanksgiving recess

- If Congress does not approve those cuts by late December, automatic across-the-board cuts go into effect, including cuts to Defense and Medicare.

No new revenues, and the usual "not done deal yet" caveats apply. But assuming it passes this is a huge victory for Republicans. For everyone wondering why they were acting so crazy up until now... this is why they were acting so crazy up until now.

I hope the Fed responds with QE3.

Sometimes Voters Matter

UT-Austin professor of government Sean Theriault makes an important point about the debt ceiling miasma: this is happening because of political audiences, i.e. voters:

In 2005, I published a book called "The Power of the People." In it, I made the simple argument that, contrary to the opinion of a growing number of political pundits, members of Congress are still -- as they have always been -- responsive to their constituents. ...

The general election brought us race after race in which these tea party candidates were running against moderate Democrats, the so-called "Blue Dogs." Some of these Blue Dogs fought against Obama's health care plan. Others fought against cap-and-trade environmental legislation. In fighting these plans, the Blue Dogs frequently made them more moderate.

It didn't matter how hard they fought these plans or that they voted against them because, in November, their constituents voted them out of office. Why? Simply for being Democrats. And because of those decisions in November, the Tea Party Caucus in the House of Representatives now has 60 members -- 60 automatic votes against any type of compromise to preserve the full faith and credit of the United States.

The problem with our deficit crisis today is that the message the voters sent -- and that the winning candidates heard -- was "never compromise, never surrender." We may need such a mentality on the battlefield, but we cannot have such a mentality in politics. Politics, after all, is the art of compromise.

During the Krugman/Crooked Timber fiasco a few months back I tried to make the case that the voters really do play a role in the way politicians act. It's not just elites in the media or business that influence legislators. On this issue all of those groups are on the same side. The Very Serious People universally want a deal done. The rentier class is not interested in a debt default or downgrade, and don't particularly care how it's avoided. And yet here we are. Why? The best explanation has to be that the representatives care about political survival, and their constituents want them to hold the line. For the Republicans, especially those in districts vulnerable to Tea Party mobilization, this means tying a deal to deficit reduction that includes no new tax revenues. And Boehner couldn't unite his own party behind any moderate version of that. McConnell's attempted punt, which would put all of the political heat on Obama, similarly failed. McCain is now calling conservatives in his own party "foolish", "deceiving", and "bizarro". But the Tea Party isn't interested interested in the merely feasible. For the Democrats, it means opposing entitlement reform and especially a balanced budget amendment. This is why Obama went on national television practically begging voters to contact their congresspeople, and then spammed the internet with literally dozens of Tweets passing on the handles of representatives to his millions of followers.

There are a lot of political issues where politics is conducted mainly behind closed doors. The video below describing the experience of Dodd-Frank is one of them. Highly-technical policies are especially prone to "quiet politics". But high-profile political issues like the debt ceiling/deficit battle are anything but quiet, and voters find it fairly easy to take sides. That doesn't mean that voters are perfectly informed -- it seems many have broken the debate down to a more spending/less spending false choice -- but they don't have to be to put a lot of pressure on their representatives.

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Dodd-Frank Update
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Recent European Economic Developments Are Probably Related to the Euro

Krugman:

Some people commenting here seem puzzled by what I write about Europe. How can I write favorable things about the performance of European welfare states, then turn around and write negative things about European monetary policy and developments?

Ahem. These are different questions. I can say that Mr. X is a fine musician and a lousy tennis player; I can praise his taste in music and despise his taste in food. Europe has a lot to teach us about health care and the virtues of a strong safety net; but the single currency project was ill-conceived and is going badly. In fact, at the moment it is going very, very badly.

A few days ago he posted the above graph and wrote:

I’ve written a number of times about the weird way American perceptions of Europe seem stuck in the past. It’s common — especially on the right, but more broadly too — to see Europe as a land of stagnant economies and lack of jobs. This vision had some truth in the 1990s, but was becoming less and less true even before the crisis, which hit US employment much harder than European employment.

The graph clearly shows convergence has come along two tracks: the weakening US labor market and the strengthening European labor market. As Krugman says, this has happened since the 1990s. So what have been the two biggest events in the US and Europe since the 1990s? The Lesser Depression in the US, and... the introduction of the euro in the EU in 1999.

In other words, these might not be two different questions analogous to taste in music and taste in food if the improved European employment picture is related to the adoption of the euro. The two are certainly correlated. And if we were to ask ourselves why European employment has improved over the past decade, wouldn't the single biggest policy change over that period be at the top of the list of potential explanations?*

This could also help explain why the EU is fighting so hard to keep the eurozone intact, despite increasing domestic political pressure in both creditor and debtor countries. The last decade was very good for both the Eurocore and Europeriphery. Some of that prosperity was predicated on a lie, as Krugman rightly notes, but not all of it.

*Other contenders could be neoliberalish reforms made in many European countries, some related to euro-adoption and some perhaps not, in an effort to boost competitiveness and economic growth in the EU. These include privatizations, deregulations, and a weakening of some of the welfare state. I doubt Krugman would favor those explanations either, but I'm not sure what is left.

Inequality and Fiscal Deficits

A newish paper from Martin Larch at the European Commission's research office:

Fiscal performance and income inequality: Are unequal societies more deficit-prone? Some cross-country evidence

A bias towards running deficits is an entrenched feature of fiscal policy making in most developed economies.

Our paper examines whether this tendency is in any way associated with the personal distribution of income of a country. It takes inspiration from theoretical work according to which distributional conflicts may give rise to deficit spending or to delayed fiscal adjustment. Although these theories have been around for years the empirical literature on the determinants of fiscal performance has so far paid little or no attention to the possible role played by different degrees of income inequality.

Our results suggest that this neglect was not justified. Using cross-country data we find evidence that a more unequal distribution of income can weigh on a country's fiscal performance. These findings can be relevant in the aftermath of the post-2007 global financial and economic crisis in particular when designing fiscal exist strategies. The success and sustainability of such strategies may inter alia depend on their distributional implications.

Bigger May Be Different

Social scientists are trained to conceptualize the world in terms of linear relationships between normally distributed variables. This paradigm underlies current discussion about the consequences of a US government default. Although the US has never defaulted, we can draw inferences about the likely consequence of a US default based on the consequences of sovereign defaults in other countries. Small defaults have small consequences, median defaults have median consequences. Larger defaults have larger consequences. Because the US would be an extremely large sovereign default, the consequences of its default would be extremely large too.

Although the inference that bigger is bigger might be correct, I want to posit a non-linear alternative: bigger is different. One sees evidence that bigger was different in 2008. As the US financial system teetered on the edge in 2008, foreign capital flowed in and the dollar strengthened. As one prominent student of global capital markets has noted, this is exactly the opposite of what happens every where else. “In most emerging-market countries…bursting of domestic financial bubbles was accompanied by capital flight, which only exacerbated these countries’ financial crises by generating exchange rate depreciation and higher interest rates. But foreign funding of the United States—both public and private—continued during the crisis, even as the United States lowered interest rates dramatically. Indeed, the dollar even strengthened as the crisis became more severe after mid-2008.”* In 2008, bigger wasn’t bigger--more capital flight, sharper currency depreciation, larger interest rate increase. In 2008, bigger was the opposite.

One sees suggestive indications that bigger might be different now too.

• "David Joy, chief market strategist at Ameriprise Financial, believes that US Treasury debt could even rally…"
• "Others say it is likely that big investors in Treasury bonds—particularly central banks—would still show up to buy Treasury securities even in a crisis. With Europe already struggling, the US Treasury might still have no rival as a place to invest money.”
• Deborah Cunningham of Federated Investors in Pittsburgh put plans in place to deal with a default several weeks ago. “The firm will convene a teleconference with the boards of affected funds…and she is considering arguing for holding onto the federal debt. “We have to justify to the board why we would want to continue to hold them, which might be because they are a high-quality, minimum-risk security…The question I think investors are going to have to face is, Where do they go? Do they go to foreign banks? U.S. commercial paper? U.S. agencies? Is there a safer haven than Treasury securities?"

Admittedly, a few quotes are not evidence. But these quotes hint at a causal mechanism that makes bigger different--mutually reinforcing individual (psychological) and social (network) characteristics. Individual participants seem to believe that US Treasuries remain safe in spite of a default or downgrade. These beliefs are reinforced by a global financial system that offers no better alternatives to US Treasuries (in large part because there has been no need for an alternative). Neither proposition applies to Greece (or to Spain, or to Portugal). No one believes that Greek debt is safe, even with an EU bailout. The global financial system provides plenty of alternatives that are far safer Greek debt. The psychology is different, the market structure is different. Bigger may be different.

I don’t know if bigger is different. Nor, if bigger is different, do I believe that it conveys immunity; different means that US sovereign default need not trigger an apocalypse—it does not imply that it cannot trigger one. What I am suggesting is that market participants might react differently to developments in the United States than they do to similar developments in other countries. Different reactions may generate fundamentally different outcomes. Bigger may be different.

*Eric Helleiner. 2011. "Understanding the 2007-2008 Global Financial Crisis: Lessons for International Political Economy."Annual Review of Political Science 14(1): 81.

Shifts

Dani Rodrik has a couple of posts [1, 2] and an op-ed describing how, for the first time, growth in developing countries is outpacing growth in developed countries. Arnold Kling links this to the current US economy:

Again, I want to suggest that there is a connection between this trend and the stagnation of median incomes in the United States, and even to the decade-long drop-off in employment here. New patterns of trade are developing that are reducing the advantage that a person enjoys merely for being located in the United States. There still are advantages, as evidenced by the excess supply of people who wish to immigrate herte. However, the Great Factor Price Equalization is underway, thanks to the fall of Communism, the rise of the Internet, and sporadic progress in institutional development in the emerging-market countries.

Remember that only 2% of jobs created in the US over the past 20 years have been in tradable sectors, and that while US manufacturing output has kept increasing, manufacturing employment has declined [1, 2, 3 and see comments]. Over the past 20 years, the global industrial labor force has increased by several billion in India, China, and Eastern Europe. How could there not be some convergence?

The two questions I'm most interested in are: 1. Will this convergence be sustained over a long period of time; 2. What will the effect be on politics? Regarding #1, as Rodrik mentions in his op-ed, if history is any guide there are good reasons to be doubtful. Sustained growth, particularly among low- and middle-income, has been rare. This is especially true for those that have grown via high commodity prices or other exports to developed countries that now suffer from depressed demand. Regarding #2, the effects will obviously be asymmetrical across countries, but we've seen interest groups pressure many governments over currencies, trade protection, investment policies, and growth concerns. I don't see those pressures lessening in the near term, especially if the global economy re-enters crisis mode.

The chart illustrates ownership of US government debt at the end of December 2010. US ownership is subdivided by category, foreign ownership by country. The foreign data are not broken down in to categories, but TIC indicates that 3/4 of foreign-owned US government debt is held by public authorities. The domestic data come from the June 2011 Treasury Bulletin and the foreign from the Treasury TIC. More recent data on foreign ownership exists. I could not find more recent data for US ownership. If I have mis-interpreted this data, someone please point this out.

By these figures, about 63% of US government debt is owned by central banks (foreign and domestic) and/sovereign wealth funds. Most of these entities are American friends and allies. Another 4% is owned by US state and local governments. That leaves 33%--about $4.8 trillion--in private hands. Of this, the financial institutions with the most restrictive regulations regarding asset ownership (depository institutions) own only 2% of the total ($290 billion). Mutual Funds, who may or may not have to dump downgraded debt, hold another 9% ($1.35 trillion).

What's the point? The discussion about the impact of US default revolves around the market response to default. Useful to recognize that most of the US government debt is held by public-sector agents who are much less sensitive to balance sheet pressures and regulatory constraints. These public sector agents are also substantially more sensitive to "moral suasion" and direct appeal than private financial institutions. The structure of ownership of US debt might dampen the negative impact of any default that does occur.

Hard Keynesianism Is Not Politically Sustainable

Alex Tabarrok comes out in support of Hard Keynesianism:

... I propose an unbalanced budget amendment.

The unbalanced budget amendment is a requirement that in good times the government must run a budget surplus. The virtues of such a rule are that it allows for counter-cylical fiscal policy during a recession. Indeed, it reduces the cost of counter-cyclical fiscal policy because it guarantees a reserve fund for just such emergencies. The unBBA is thus a type of automatic stabilizer of the kind I have argued for before (e.g. here).

A simple version of the unBBA requires surpluses but more generally the rule would be a surplus or a similarly sized reduction from the previous year’s deficit. The size of the required surplus/deficit reduction would be tied to a function of current and recent GDP growth rates.

John Quiggin and Henry Farrell argued in favor of this sort of thing for the member states of the eurozone, which I discussed previously here and here. I will just add that most of the US states have a version of this requirement, and it mostly didn't help cushion them from this recession. In other words, this kind of rule is unnecessary for dealing with small recessions, and impossible to uphold during large recessions.

One technocratic argument in favor of an unbalanced amendment would be to prevent the sort of deficit build-up that commonly prefigure financial crises and/or recessions. Thomas may wish to say more about that. In general, I think the answer is that such an amendment will never be passed de jure for the same reason that the policy is not implemented de facto: there is no constituency for it, and there are plenty of constituencies for higher spending and/or lower taxes. States face legal fiscal constraints because everyone understands that in the end the federal government is on the hook, so there's moral hazard. The same dynamic does not apply at the national level.

GOTD

Wow:



Via Uwe Reinhardt, who breaks it down:

Jobs in the tradable sector were added primarily in high-value services. They were lost in manufacturing, through outsourcing of the lower value-added components of the value chain to other countries.

The net effect has been that of the 27.3 million jobs created in the American economy from 1990 to 2008, only 662,000 new jobs were added by the tradable sector. That is only 2.3 percent of total job creation in the economy.

I assume that's gross, not net. This is in line with my view of (no) Great Stagnation, and see also this post from Will Wilkinson. Here's another worrying bit from Reinhardt:

Thus it is not surprising that ... close to 98 percent of the 27.3 million new jobs in the American economy in the last two decades were created in the nontradable sectors, led by government and health care in first and second place.

These two sectors alone accounted for 40 percent of the total job growth over the last two decades. They were followed by retailing and construction, both of which grew on the back of heavy debt financing and a real-estate bubble.

The American people look to the president and Congress to create jobs — or, more precisely, to create the economic conditions in which job growth occurs.

At the same time, the American people now look to the president and Congress to rein in government spending in general and health-care spending in particular, at a time when a sizable deleveraging by consumers and business has sharply put the brakes also on retailing and construction.

So how can these desiderata –- creating jobs and, at the same time, cutting back on government and health care spending –- add up to a rosy future jobs picture? Can any government actually deliver on these conflicting goals?

I'm slowly being persuaded by Karl Smith's argument that a construction boom is looming, and Ryan Avent's general optimism about the economy. I still believe that trade is a large net plus for the US. But the US economy has been shifting over the past two decades, and it will continue to do so. I expect GDP growth to rebound from its current doldrums, but not necessarily in an especially egalitarian way. These shifts and changes lead to political shifts too, and we've been witnessing those as well. It may be awhile before we find the new equilibrium -- I suspect it involves a shift to more social democracy -- and in the meantime we may be in for some more pain.

Score One for the Oatley "Maybe No Big Deal" View

See this Krugman post on Japan's 2002 downgrade.