Political Economy in Fiction QOTD

L. Frank Baum's book The Wonderful Wizard of Oz, which appeared in 1900, is widely recognized to be a parable for the Populist campaign of William Jennings Bryan, who twice ran for president on the Free Silver platform -- vowing to replace the gold standard with a bimetallic system that would allow the free creation of silver money alongside gold. ... According to the Populist reading, the Wicked Witches of the East and West represent the East and West Coast bankers (promoters of and benefactors from the tight money supply), the Scarecrow represented the farmers (who didn't have the brains to avoid the debt trap), the Tin Woodsman was the industrial proletariat (who didn't have the heart to act in solidarity with the farmers), the Cowardly Lion represented the political class (who didn't have the courage to intervene). ... "Oz" is of course the standard abbreviation for "ounce." (52)

That comes from David Graber's book Debt: The First 5,000 Years, an anthropological take on the evolution of the role of money and credit in the economy. Via Daniel Little who has an interesting take on the book and also adds this:

(This is roughly as startling to me as an interpretation of Star Wars as an extended allegory on Reaganism (intervention in Nicaragua, scary military officers in the background, etc.). This doesn't quite work, though, since Star Wars appeared in 1977, three years before Reagan's first election as president.)

Kindleberger Smiles

The banks announced that they would reduce by roughly half the cost of an existing program under which banks in foreign countries can borrow dollars from their own central banks, which in turn get those dollars from the Fed. The banks also said that loans will be available until February 2013, extending a previous endpoint of August 2012. 

“The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity,” the banks said in a statement. The participants in addition to the Fed were the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Canada and the Swiss National Bank.

More here. The title refers to the previous post.

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.

Is Job Creation Really Impossible?

This is a strong conclusion to a good post from Krugman:

My point, then, is that this claim — and the lionization of high earners as people who make a vast contribution to society [via job creation] — is not, in fact, something that comes out of the free-market economic principles these people claim to believe in. Even if you believe that the top 1% or better yet the top 0.1% are actually earning the money they make, what they contribute is what they get, and they deserve no special solicitude.

Here are his assumptions earlier in the post: "Yet textbook economics says that in a competitive economy, the contribution any individual (or for that matter any factor of production) makes to the economy at the margin is what that individual earns — period." The upshot being that the entire idea of a "job creator" is misguided. All of the value that factors of production add to the economy is recouped by those factors of production, and none "trickles down" to anyone else.

Correct me if I'm wrong, but doesn't the relevant "textbook economics" assume not only a competitive market but also constant returns to scale and no spillover effects? How often do we think all three of these things hold? Doesn't a Keynesian view of the world explicitly claim that in a depression there are often scale returns to be captured, as well as positive spillover effects from investment? How else could the Obama administration (like all administrations) claim that it has "saved or created" so many thousands of jobs via fiscal policy?

I Would Not Have Guessed This China-US FOTD

Another way to gauge China's problem is that its gross domestic product (GDP) quintupled over the decade through 2010, while its stock market doubled - so that market capitalization has fallen sharply relative to GDP. 

Via. I don't agree with everything else in the article, but this is another data point indicating that the rise of China may not yet be as impressive as many have thought.

Also this (which I would have guessed): "U.S. Leadership Approval Ratings Top China's in Asia". (ht: Phil Arena.)

Short Note on the Importance of History and Governance

This post by Yglesias, linked by a lot of folks, has a lot of good in it. But it's missing one thing: a conception of politics. Why is it that San Franciscans transfer so much money to Kentuckians? After all, California could surely use the cash to shore up local balance sheets. The answer is because Kentuckians (and Mississippians and Georgians and Iowans and Alabamans and etc.) get to elect the government that ultimately controls San Franciscans. And this privilege was gained -- well lost, technically, but such are the ironies of history* -- as the result of a brutal civil war.

If we're thinking in terms of parallels, Europe has had the civil wars. They just haven't had a winner. So they don't have a federal government, so they don't have a legitimate method of transfers, so they have fiscals crises in their periphery.

*Some well-regarded conservative -- I believe it's Walter Williams, tho I can't recall with certainty -- is often quoted as saying that the best thing that happened to Africans was the Atlantic slave trade, because despite its ills the children and grandchildren of slaves grew up in America rather than colonial or post-colonial Africa. Even given the abominable record of the US w/r/t minorities, this view contends that the lot of Africans is better here than there. Perhaps this is another irony of history. Perhaps it's completely specious. Whether one thinks that claim contains truth or not, it would be hard to argue that the American South did not benefit, in the long run, by losing their bid for independence. Without it, they could not rely on the transfers from rich San Franciscans to poor Alabamans.

Why Is the US Doing So Well?

So asks Ezra Klein:

Not in absolute terms, of course. Unemployment remains high. Growth remains anemic. Markets remain shaky. But Europe has been doing something very close to imploding for months now. So just as our financial crisis sent Europe into a tailspin three years ago, you might expect that the possibility of a partial or complete break-up of the Eurozone would have American businesses taking a chainsaw to their workforces and households stuffing their paychecks under the mattress in the expectation that 2012 will be a lot like 2009. And yet none of that is happening.

He then runs down some data and has some quotes from macroeconomists. I think the answer is given by this interactive graph from the BBC. In short, Europe is much more highly exposed to weakness in the US (Above picture) than the US is exposed to weakness from Europe. Click on a few of those European countries; almost none of them expose the US. The ones that do -- mostly the UK -- are in decent enough shape. Even the biggest exposures, from France and Germany, are much smaller than exposures of European countries to the US, and of course the US has a much larger economy and banking system than any one of those countries.

Thomas, Sarah, Andy, and I have some joint research that we've posted about before that visualizes the same data in a different way. Ours includes more countries as well as cross-time developments, shown in an animation. (We posted it nine months ago, so the BBC is way behind.) The point is the same: the world is much more susceptible to contagion emanating from the US than the US is to contagion from the rest of the world. This includes even Europe.

In other words, it's not enough to simply say that interlinkages in the global economy are important, and conclude from that developments in the EU will automatically determine the US's economic performance. The patterns of interdependence are even more important, and these give us reasons to be optimistic that the US may be relatively okay even if Europe goes belly-up.

The World is Hierarchical

Will links to a WAPO piece on the apparent US resilience to EU difficulties. As Ezra summarizes, "Nevertheless, the fact remains that the American economy has been curiously resilient over the past few months. Things are getting better when you could imagine them getting worse."

This isn't curious; this is how the global economy functions. Financial and economic shocks that originate in the United States have global consequences, while shocks that originate in other parts of the system have consequences that are primarily local.* Empirical research conducted over the past ten years finds clear and consistent evidence of this asymmetry Consider the asymmetric impact of news—unexpected economic outcomes--on asset prices. When US economic performance is stronger than expected or if US monetary policy tightens unexpectedly, interest rates rise in the UK and euro areas and the dollar appreciates. Stronger-than-expected US growth raises foreign equity prices during US recessions, and reduces them during expansions. In contrast, foreign economic news has little impact on markets in the US and elsewhere. German economic news has little impact on euro-dollar exchange rate; euro-area news has little impact on US bond yields. British news has no impact on US equity prices.

Similar asymmetries characterize spillovers through financial linkages. Changes in American interest rates affect interest rates in Australia, Canada, and the euro area. US equity market movements affect equity prices in overseas markets. Yet, US interest rates, exchange rates, and equity prices are affected modestly if at all by foreign developments. For instance, one study finds that the share of euro area variance in equity and bond prices accounted for by US market developments is three times as large as the impact of euro market movements impact on US bond and equity prices. Others find robust evidence that real interest rates in the United States affect real interest rates in the euro area but no evidence that euro rates affect rates in the US.

There is a broader point, here. Although we typically realize that the global economy is defined by connectedness, we pay little attention to the structure of connectedness. And even when we give some thought to this structure, we rarely consider how the structure shapes performance. We seem willing to accept Friedman's claim that the world is flat. Well, the world isn't flat. The world is hierarchical. This hierarchical structure shapes performance in ways that are important and remain under-appreciated. We need to pay it greater attention.

*For an entry to this research, see Bayoumi, Tamim, and Andrew Swiston. 2010. "The Ties that Bind: Measuring International Bond Spillovers Using Inflation-Indexed Bond Yields." IMF Staff Papers 57 (2):366–406. (An ungated pre-pub version here).

Weekend Links

-- A long, excellent interview with Patrick Thaddeus Jackson at Theory Talks (a generally excellent site; it's easy to lose hours in there), concerning IR and the philosophy of science. I haven't yet had the chance to read PTJ's newest book, but it's in the pile and I look forward to it.

-- The Economist enlists Larry Summers and Donald Kohn in a role-play, asking them to deal with the imminent collapse of a major bank using the new tools provided by Dodd-Frank.

-- Matthias Matthijs and Mark Blyth read Kindleberger in Berlin. I hope to have more to say about this later.

-- Is it surprising that the US's financial troubles had a larger effect on Europe than Europe's financial troubles have had on the US? Not to me, as regular readers would expect.

-- Weber, "Science as a Vocation". I find it somewhat odd that "Politics as a Vocation" ends up on many social science syllabi while "Science" does not, given that social scientists want to be scientists not politicians. Or maybe my experience has been unique.

-- "The Women's Petition Against Coffee, 1674". One of my favorite historical documents, brought to memory by this article on rising global coffee pries.

-- The Piedmont (which includes my town) has a local currency, in operation since 2002. I've never seen it used.    

Review: Exorbitant Privilege

I read Barry Eichengreen's Exorbitant Privilege last night, whose subject is found in the subtitle "the Rise and Fall of the Dollar and the Future of the International Monetary System". From this, one might expect the bulk of the book to be a current discussion of the imminent fall of the dollar as the world's reserve currency, as well as predictions regarding what sort of system will replace it. This expectation is not well met.

As always, Eichengreen does best when he sticks to a narrative of economic history. There are two predominant strands here: chapters two and three, tracing the origins of the US as an international currency, from before the Revolutionary War until the collapse of the Bretton Woods system of fixed exchange rates in the 1970s; and chapter four, which recounts the series of economic and monetary integration regimes in Europe that culminated in the introduction of the European monetary union in 1999. Those two histories make up roughly the first two-thirds of this short book, the rest of which is dedicated to a discussion of the subprime crisis and other contemporary events.

The problem with the book is that there is no conceptual frame shaping Eichengreen's discussion. From the subtitle and many of the chapter titles (the euro's "Rivalry" with the dollar; the greenback's "Monopoly No More"; the specter of a "Dollar Crash") you might expect Eichengreen to be pessimistic about the future role of the dollar in the international monetary system. In the introduction Eichengreen sets the book up in this way, arguing on page 6 that "The conventional wisdom about the historical processes resulting in the current state of affairs – that incumbency is an overwhelming advantage in the competition for reserve currency status – is wrong". But the core of the book actually makes the opposite case: the role of the dollar as the pre-eminent global currency is likely to remain for the foreseeable future, both because of the attributes of the US as the world's largest economy, and because of the deficiencies of the only conceivable challengers.

Concerning the latter, Eichengreen spends the majority of the time on the EU. He also discusses Japan (no desire for the yen to be a reserve currency), China (no capability for the yuan to be without major reforms which would likely be destabilizing), other currencies like the Brazilian real and Indian rupee (not big enough, or global enough, economies or financial systems), and the IMF "special drawing rights" (SDRs, which among other criticisms are only used as accounting devices, and are not accepted by any private actors as a medium of exchange), but dismisses them in short order. He dedicates a long chapter to European postwar monetary history, some of which may be interesting to those approaching this subject for the first time, but all of which has been dealt with in more detail, and with more theoretical and empirical care, elsewhere.

Without making too much of a case, Eichengreen seems to suggest that the subprime crisis may be a catalyst for a shift in the global monetary architecture. His discussion of the crisis is not strong, either as a standalone discussion or as a means of linking it to the potential for a change in the global reserve currency. For example, near the beginning of this chapter he claims "At the root of the crisis lay financial irregularities unchecked by adequate regulation" (p. 98). At this point most observers acknowledge that this was the manifestation of the crisis, perhaps even the proximate cause, but not the root cause. Eichengreen seems to understand this a bit later on, when he discussions macroeconomic imbalances in the global system, the global savings glut, the US domestic political economy that led to low national savings and persistent budget deficits, loose Fed policy and the "Greenspan put", etc. All of these are deeper causes than the inability of banks or regulators to judge the extent of risk embedded in asset-backed securities, which, in this context, appear to be more leaf than root.

The end of Eichengreen's discussion of the crisis leads him to marvel that the strength of the dollar was reinforced as a result of the crisis, not weakened. This may also surprise a reader not already aware of this phenomenon, since all of the book until that point has set the stage for a rapid move away from the dollar following a crisis, similar in speed and precedent to the rise of the dollar in the immediate aftermath of World War I. The rest of the book is dedicated to a discussion of why that is unlikely to happen.

As a part of that explication Eichengreen reverses what he wrote earlier about the incumbency advantage. In the first chapter he wrote that arguing that the status quo is durable precisely because it is the status quo is "wrong". But later, on pages 124-126, he argues that the "advantage of incumbency" is "not to be dismissed". Then he hedges again, writing of China on p. 146:

That said, Chinese policymakers are serious about transforming Shanghai into an international financial center by 2020. Doing so will require deeper and more liquid markets. It will require liberalizing the access of foreign investors to those markets, which in turn imply other changes in the country's tried-and-true growth model. Liberalizing the access of foreign investors to China's financial markets will in turn require a more flexible exchange rate to accommodate a larger volume of capital inflows and outflows. While these are not changes that can occur overnight, it is worth recalling how the United States moved in less than 10 ears from a position where the dollar played no international role to one where it was the leading international currency. There is precedent, in other words, for the schedule that the Chinese authorities aspire to meet.

This should lead us to a comparison of the the world in the 2010s to that of the 1910s, and the relative positions of the US and China within those worlds. In the earlier period the largest economy (the US) was not the issuer of the global reserve currency as it is now. Despite that, it took at least one World War, and the subsequent collapse of the global economy during the interwar period, for the dollar to supplant the pound sterling. To reach undisputed dollar pre-eminence took another World War. The rapid shift in the dollar was therefore a consequence of the rapid shifts in the organization of global security and economic apparatus. As bad as the subprime crisis has been, it has not been anywhere near that scale.

Perhaps because Eichengreen does not have a clear conceptual framework with which to make sense of his history, his views about the future are wishy-washy: the "fall of the dollar" mentioned in the subtitle is not inevitable, nor even likely; then again, the rise of the dollar was rapid, and China's economic rise is rapid, so who knows?

A better approach, I think, would be to try to understand monetary dynamics in a network context. Eichengreen considers this briefly, in footnote 50 on page 151, only to dismiss it just as briefly. This is a shame. If he better understood network dynamics he might not write things like this, from page 8:

There may have been only one country with sufficiently deep financial markets in the second half of the twentieth century, but not because this exclusivity is an intrinsic feature of the global financial system.

But what if it is? What if the distribution of financial liquidity is power-law distributed? What if this introduces scale-free dynamics into the global financial network? This would imply that there is only room for one reserve currency at a time, and that currency is likely to remain in place until there is such a large shock that the network itself is destroyed, at which point a new network is constructed with a new currency at the center of it.

Such a shock occurred from 1914-1945. It has not occurred since, which is why the dollar's pre-eminence has survived less-major shocks like the collapse of Bretton Woods, the rise of emerging market economies, the monetary unification of Europe, the end of the Cold War, and the subprime crisis. Such a history might lead us to expect more stasis than change in the coming years, barring a systemic collapse on a level not seen since the interwar period.

Eichengreen does not spend much time in this short book on theoretical explanations for the nature of the global monetary system, instead choosing to trace several historical developments. This is fine, but it leaves us with more description than explanation, and so teaches us little about what to expect from the future.