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December 14, 2007

Economist's View - 5 new articles

"Don't Bet Against the Dollar"

Thomas Palley emails his latest with the message "I thought this piece might generate some argument":

Don't Bet Against the Dollar, by Thomas Palley: The global economy runs on the dollar, and that isn't about to change. Today the world's central banks hold about two thirds of their reserves in U.S. dollars. Most commodities are priced in American currency, and much of world's trade is invoiced in dollars as well. The dollar is the lifeblood of the international system.

Still, a growing number of observers, pointing to persistent U.S. trade deficits and the dollar's depreciation against the euro, have begun to speculate that the dollar's day is coming to an end. If they were right, this would be a worrisome development. First, an exit from the dollar would lead to its further depreciation, causing increased import prices that might trigger higher inflation. Second, a decline in demand for dollar assets would cause a fall in asset prices and raise interest rates, which could cause a recession and permanently slow U.S. economic growth.

Fortunately, these fears are misplaced.

Though the dollar is undergoing a correction, it is a healthy one and the dollar is likely to stay on top for years to come. The real matter for concern is the large U.S. trade deficit with the rest of the world, which causes jobs and demand to leak out of the economy. As a result, borrowing and spending that should create jobs in the United States end up creating jobs offshore, while the U.S. economy is left with a weakened manufacturing sector and burdened with the debts that finance this spending.

So why is the dollar here to stay? Put simply, it's still the best option. The world needs a currency for international transactions to facilitate pricing and payments, and what better than the dollar? With an annual GDP of more than $13 trillion and with efficient, liquid capital markets, the U.S. economy operates on a scale and with a vitality that is unmatched. (It also helps that the dollar is backed by the world's sole superpower.)

Another, complementary explanation for the dollar's preeminence is the "buyer of last resort" theory. Countries hold dollar assets because they want trade surpluses with the United States. According to this theory, many countries can't generate enough domestic consumption to spur growth and full employment, forcing them to rely on exports. As the United States is the world's largest consumer market, countries therefore have an incentive to make their goods cheaper and more competitive by undervaluing their currencies against the dollar. This obliges them to buy and hold dollars to maintain their undervalued exchange rates. The economic history of the past decade bears this theory out. Since the late 1990s, American consumers have powered a global boom, compensating for weak domestic demand in much of the world. But their massive spending on goods imported from abroad has also caused the U.S. trade deficit to balloon to $759 billion dollars in 2006, equal to 5.8 percent of U.S. GDP.

East Asian countries such as China have been especially reliant on exports, a policy that has earned them trade surpluses and a massive storehouse of dollars. According to the U.S. Treasury Department, China and Hong Kong have U.S. Treasury bond holdings of $455 billion, while Japan has holdings of $582 billion. Now, there is talk that some East Asian countries may diversify their foreign-exchange reserves by reducing their dollar holdings. Their options are limited, however. Because they want their exports to stay competitive, none of these countries wants its currency to appreciate against either the dollar or the currencies of its trading rivals. Nor do the two would-be competitors to the dollar offer an appealing alternative. Yen investments yield low returns. So do euro investments, and they may now be risky given the euro's large appreciation in recent years.

It's highly unlikely that any countries will abandon the dollar. Instead, some may choose to tweak the composition of their dollar holdings by moving some funds out of U.S. Treasury bonds and into commodities and U.S. equities. China has already said it plans to do just that through its new sovereign wealth fund, the China Investment Corporation. Moreover, now that the dollar has already depreciated significantly against the euro, U.S. assets are starting to look relatively more attractive. This suggests foreign capital worldwide will be looking to buy dollar assets, which promises to put a floor under the dollar and keep foreigners invested in the United States.

That said, there are two major scenarios under which the dollar could fall out of favor. One is if U.S. inflation were to accelerate sharply, thereby undermining the dollar's attractiveness as a store of value and unit of account. A second is if the United States alone undergoes a deep recession that the rest of the global economy avoids, thereby making investments denominated in other currencies more attractive. However, this last possibility is unlikely: The global economy is too closely intertwined, and a U.S. recession would likely affect everyone.

In the next several decades, there will be a slow shift toward other currencies as other economies catch up with the United States, but that process will be gradual and will leave the current system essentially intact. That does not mean there is nothing to worry about, but being preoccupied with the dollar's dominance is the wrong goal in the first place. Indeed, the policy of a "strong dollar" contributed to creating the overvalued dollar, and has always been misguided.

Instead, the target should be sustainable prosperity, one requirement for which is exchange rates that prevent excessive trade deficits. This will automatically deliver a "sound dollar," which is a better basis for a dollar standard that works. From this perspective, far from being a strike against the dollar, the appreciation of the euro is a welcome development. The Chinese yuan and Japanese yen should be allowed to appreciate as well. The next step is for U.S. policymakers to set up international arrangements to prevent future damaging exchange rate misalignments—such as the ones now being corrected. The bottom line is that the dollar is down, but it's not out.

The Widening Gap

Jared Bernstein reviews the latest data from the CBO on the distribution of income:

Boy, Have We Got an Inequality Problem, by Jared Bernstein: The Congressional Budget Office (CBO) just updated their invaluable data series on income inequality and the results are startling. Income inequality among households, both before and after Federal taxes, grew more quickly over the last two years of the series, 2003-05, than over any other two-year period on record, back to 1979.

Over those two years, the growth of inequality transferred $400 billion dollars from the bottom 95% to the top 5%. That is, had the income distribution remained as it was in 2003, the income of each of the 109 million households in the bottom 95% would have been $3,660 higher in 2005.

If this is the ownership society at work, I think we need to have a serious talk with the owners.

EPI will post our analysis later in the day (the Center on Budget and Policy Priorities will also post their nifty analysis), but I wanted to share a few of our findings with you right away:

  • If we break households in groups of 20% each by income, well over half of household income (55%) was held by the richest fifth in 2005, the highest such share on record;
  • The share of income held by the top 1% has climbed from 9% in 1979 to 18% in 2005.
  • After-tax income of the bottom 20% grew 6%, or $1,800 over these years (1979-2005, in 2005 dollars); the middle-class gained $11,000, up 21%, over these 26 years. The average income of the top 1%, more than tripled, up 228%, for a gain $781,000.
  • By 2005, the average post-tax income of the bottom fifth was $15,300, the middle fifth: $50,200, and the top 1%: $1.1 million.

These hugely different growth rates have led to much greater economic distance between income classes over the years. Back in 1979, the post-tax income of the top 1% was 8 times higher than that of middle-income families and 23 times higher than the lowest fifth. In 2005, those ratios grew to 21 (top compared to middle) and 70 (top to bottom), a vast increase in the distance between income classes. ...

Such concentration of income is unsustainable in a democratic society. The distributional mechanisms that have historically worked to ensure much more equitable outcomes appear to be wholly inoperative. Fixing them must be at the heart of any serious economic policy discussion.

Public Goods and Public Bads

"Twentieth-century government was all about public goods. This century will be all about public bads." Here's part of the longer article:

Badlands, by Thomas Schaller, Democracy Journal: I live in Northwest Washington, D.C., but one need not reside in the nation's capital to sympathize with the experience I have endured several times at the intersection of Florida Avenue, 18th Street, and U Street. The six-way intersection is convoluted enough, but it is made even more hectic by several take-out restaurants, a mini-mart, and a check-cashing concern on its southeast corner. Invariably, some driver–a person who, based on my non-scientific sample, is almost always a man–adds to the mess by temporarily turning the intersection into his private parking lot.

He double-parks in front of one of the restaurants and puts on his flashers. Smoking a cigarette, he disappears inside while talking on his cell phone so loudly he disturbs the sit-down customers. Traffic outside is bottling up ... when another driver inadvertently brushes the double-parked car's bumper, setting off its alarm and waking a midnight-shift worker in her nearby apartment. Eventually, the man exits with his Styrofoam takeout box, flicks his cigarette butt to the curb, and drives away.

Grabbing lunch is hardly a capital crime, and even double-parking is barely a traffic misdemeanor. The man's behavior is inconsiderate at best, rude at worst. But clearly he is a public nuisance. Through actions both direct and indirect, he has created a series of small but not insignificant "public bads"–or "negative externalities," as economists call them... Specifically, our "public baddie" has created the following externalities: traffic congestion that ripples in all directions for several blocks; sidewalk litter from his cigarette butt; second-hand smoke inhaled by restaurant customers; noise pollution from his phone chatter inside the restaurant and car alarm outside it; ozone depletion from the CFC-laden Styrofoam box destined for the local landfill; and, yes, even space junk, in the form of the satellite carrying his cellular transmission which, when obsolete, will remain in orbit, colliding with other trash presently circling the planet.

What happens next? Most likely, nothing. Drivers may lean on their horns. Diners may cast scornful looks. The poor woman in bed will probably pull the pillow over her head in disgust. Inaction is perfectly rational because the costs of doing something–anything–exceed any potential benefits. ...

But that is changing. ...[V]oters are using the electoral process to express their demand for solutions to public bads. Some are rather obvious, minor, or widely agreed upon, such as anti-littering laws; other responses are more controversial, like highway surveillance cameras to catch speeders. Somewhere in between is the growing number of restrictions or punitive taxes (the so-called "sin taxes") on a variety of individual behaviors deemed harmful to the general public or some significant portion of it. ... Call it the coming era of the public-bads government, analogous to the public-goods government that dominated policymaking in the twentieth century. ...

Public-goods governance certainly had its moment. ... Today, however, a new frontier of public policy, characterized by the mitigation of public bads, has emerged. Governments have shifted their attention away from building highways ... to protecting us from harming one another... More than ever, governments supervise and referee a variety of interpersonal behaviors and public transactions that were once governed solely by the self-restraint of personal courtesy and social mores. ... In fact, the increased public demand for reducing negative externalities ... is altering the role of government and the public's understanding of that role. ...

Arguments about regulating public bads stand to dominate our politics in the twenty-first century much as arguments over public goods did in the twentieth. It is therefore incumbent on policy thinkers to begin to consider what principles guide public-bads legislation. They should address (at least) four questions: How do we determine the point at which the government must step in to correct for a public bad? What is the proper level of government to address that bad? What types of government solutions are best suited for reducing public bads? And how do we weigh civil liberties against the benefits of reducing public bads? ...

Why Government Action Is Needed ...Coase's Theorem essentially posits that, in the absence of transaction costs, there is no need for government assignment of property rights because individual parties can voluntarily negotiate or contract these rights. Though often cited by economic and political conservatives to validate calls for limited government, the rub in Coase's Theorem are those pesky transaction costs, which are often unavoidable in public life–and particularly when a contracted relationship simply does not or cannot exist. A farmer can contract with the owner of the neighboring field for grazing rights, but the suburban homeowner cannot send a bill to the neighbor whose unmowed, unkempt lawn is driving local property values down. At the most rudimentary level, the public court system provides a latent governmental solution to the transaction costs which arise naturally from disputes over property rights...

That said, what Coase's Theorem cannot account for are the informal contracts between and among persons going about their daily lives ... in densely crowded, modern societies. A person who talks during the key part of a film at a movie theater or cuts off other drivers with an aggressive maneuver on the highway has no contractual relationship with those he or she has harmed; indeed, it's impossible to imagine a situation in which a preexisting, enforceable private contract between these parties could exist. And since the type of "rights" at issue in such situations are often not literal, physical properties but rather loosely defined commodities that are difficult to contract legally, even if there were no transactional costs, the government would still need to ... resolve ... disputes...

Asking the question in a different way, how much and what parts of the public sphere do we need to regulate? At its most abstract level, what individuals in modern societies need–if not crave–is something that our premodern ancestors often enjoyed in surplus: space and silence. ...

Of course, space and silence are commodities for which robust markets exist. The rich can buy larger and more remote homes, ... and travel in ways that reduce the inconvenient hurly-burly of interacting with their fellow citizens. The separate lines for boarding planes, the private skyboxes for watching sporting events and concerts, the remote vacation spots... One of the great luxuries of wealth today is ... the ability to eliminate or at least severely reduce the harm and nuisance caused by a world full of public baddies, which is often the same as saying a world full of fellow citizens less wealthy or connected than oneself.

But, at least in democracies, those who cannot purchase spatial or aural relief may seek solutions through the political process. Consequently, we can expect that responsive and responsible governments will continue to dedicate more time and greater resources toward regulating public bads. As Munger has argued, however, government involvement is not without its tradeoffs: "The chief problem faced by people who would design political institutions is ... to make government powerful enough to be able to control 'private-coercive' actions such as pollution, theft, or violence, without endowing it with so much power, or placing so many decisions under government control, that individual freedoms are lost to 'collective-coercive' rules and regulations." In other words, regulating public bads is not without trade-offs. In the same way that twentieth-century public-goods policymaking was predicated on new debates over the role of the states, so too today must we reconsider the nature of government before we can design effective and fair public-bads legislation. ...

Kenneth Arrow: The Case for Cutting Emissions

Kenneth Arrow argues that cutting greenhouse gas emissions now makes economic sense "even if ... one heavily discounts uncertainty and the future." Thus, "there can be little serious argument about the importance of a policy aimed at avoiding major further increases in carbon dioxide emissions":

The case for cutting emissions, by Kenneth Arrow, Commentary, Project Syndicate: Last fall, the UK issued a major government report on global climate change directed by Sir Nicholas Stern, a top-flight economist. The Stern Review ... argues that huge future costs of global warming can be avoided by incurring relatively modest cost today.

Critics of the report don't think serious action to limit carbon dioxide emissions is justified, because there remains substantial uncertainty about the extent of the costs of global climate change, and because these costs will be incurred far in the future.

However, I believe that Stern's fundamental conclusion is justified: We are much better off reducing carbon dioxide emissions substantially than risking the consequences of failing to act, even if, unlike Stern, one heavily discounts uncertainty and the future. ...

Cost-benefit analysis is a principal tool for deciding whether altering it through mitigation policy is warranted. Two aspects of that calculation are critical. First, it has to be assumed that individuals prefer to avoid risk. ...

The second critical aspect is how one treats future outcomes relative to current ones -- an issue that has aroused much attention among philosophers as well as economists. At what rate should future impacts -- particularly losses of future consumption -- be discounted to the present?

The consumption discount rate should account for the possibility that, as consumption grows, the marginal unit of consumption may be considered to have less social value. This is analogous to the idea of diminishing marginal private utility of private consumption, and is relatively uncontroversial, although researchers disagree on its magnitude.

There is greater disagreement about how much to discount the future simply because it is the future, even if future generations are no better off than us. Whereas the Stern Review follows a tradition among British economists and many philosophers against discounting for pure futurity, most economists take pure time preference as obvious.

However, the case for intervention to keep carbon dioxide levels within bounds (say, aiming to stabilize them at about 550 ppm) is sufficiently strong to be insensitive to this dispute. Consider some numbers from the Stern Review concerning the future benefits of preventing greenhouse gas concentrations from exceeding 550 ppm, as well as the costs of accomplishing this. The ... benefit of mitigating greenhouse gas emissions can be represented as the increase in the annual growth rate from today to 2200 from 1.2 percent to 1.3 percent.

As for the cost of stabilization... Let's assume that costs to prevent additional accumulation of carbon dioxide (and equivalents) come to 1 percent of GNP every year forever, and, in accordance with a fair amount of empirical evidence, that the component of the discount rate attributable to the declining marginal utility of consumption is equal to twice the rate of growth of consumption.

A straightforward calculation shows that mitigation is better than business as usual -- that is, the present value of the benefits exceeds the present value of the costs -- for any social rate of time preference less than 8.5 percent. No estimate of the pure rate of time preference, even by those who believe in relatively strong discounting of the future, has ever approached 8.5 percent.

These calculations indicate that, even with higher discounting, the Stern Review estimates of future benefits and costs imply that mitigation makes economic sense. These calculations rely on the report's projected time profiles for benefits and its estimate of annual costs, about which there is much disagreement. Still, I believe there can be little serious argument about the importance of a policy aimed at avoiding major further increases in carbon dioxide emissions.

links for 2007-12-13

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