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May 4, 2009

Economist's View - 5 new articles

Flu Pandemics, Financial Pandemics, and the Macroeconomy

Two from the WSJ. First, Barro and Ursua discuss the macroeconomic threat posed by flu pandemics:

Pandemics and Depressions, by Robert J. Barro and Jose F. Ursua, Commentary, WSJ: Here we are, struggling to find a way out of the worst financial crisis since the 1930s, when along comes the possibility of a global influenza epidemic. Though the first concern about the new strain of A/H1N1 virus involves health, we also have to worry that a full-blown flu pandemic would intensify the world's economic problems.

Our ongoing study of economic disasters for 36 countries since 1870 suggests that this concern is well founded. In this sample, we have isolated 158 depressions -- defined as declines in a country's real per capita gross domestic product (GDP) by at least 10%. The most prominent features of these depressions are wars and financial crises. But the fourth-worst global macroeconomic event since 1870 seems to be the Great Influenza Epidemic of 1918-20. This "health shock" accounts for 13 of the depression events. In contrast, World War II is associated with 25, World War I with 23, and the Great Depression of the early 1930s with 21. ...

Next, Richardson and Roubini on the state of the banking system:

We Can't Subsidize the Banks Forever, by Mathew Richardson and Nouriel Roubini, Commentary, WSJ: The results of the government's stress tests on banks, to be released in a few days, will not mark the beginning of the end of the financial crisis. If we are to believe the leaks, the results will show that there might be a few problems at some of the regional banks and Citigroup and Bank of America may need some more capital if things get worse. But the overall message is that the sector is in pretty good shape.

This would be good news if it were credible. But the International Monetary Fund has just released a study of estimated losses on U.S. loans and securities. It was very bleak -- $2.7 trillion, double the estimated losses of six months ago. Our estimates at RGE Monitor are even higher, at $3.6 trillion, implying that the financial system is currently near insolvency in the aggregate. With the U.S. banks and broker-dealers accounting for more than half these losses there is a huge disconnect between these estimated losses and the regulators' conclusions. ...

China and the Dollar

Andy Xie expects the dollar to collapse:

If China loses faith the dollar will collapse, by Andy Xie, Commentary, Financial Times: Emerging economies such as China and Russia are calling for alternatives to the dollar as a reserve currency. The trigger is the Federal Reserve's liberal policy of expanding the money supply to prop up America's banking system and its over-indebted households. ...[T]he Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyper-inflation and cause great damage to countries that hold dollar assets in their foreign exchange reserves.

The chatter over alternatives to the dollar mainly reflects the unhappiness with US monetary policy among the emerging economies that have amassed nearly $10,000bn in foreign exchange reserves, mostly in dollar assets. ...[T]he US situation is unique: it borrows in its own currency, and the dollar is the world's dominant reserve currency. The US can disregard its creditors' concerns for the time being without worrying about a dollar collapse. ...

The faith of the Chinese in America's power and responsibility, and the petrodollar holdings of the gulf countries that depend on US military protection, are the twin props for the dollar's global status. Ethnic Chinese ... may account for half of the foreign holdings of dollar assets. ...

The US could repair its balance sheet through asset sales and fiscal transfers instead of just printing money. ... The country's vast and unexplored natural resource holdings could be auctioned off. Americans may view these ideas as unthinkable. It is hard to imagine that a superpower needs to sell the family silver to stay solvent. Hence, printing money seems a less painful way out. ...

Other currencies are not safe havens either. ... Central banks are punishing savers to redeem the sins of debtors and speculators. Unfortunately, ethnic Chinese are the biggest savers.

Diluting Chinese savings to bail out America's failing banks and bankrupt households, though highly beneficial to the US national interest in the short term, will destroy the dollar's global status. Ethnic Chinese demand for the dollar has been waning already. ...

America's policy is pushing China towards developing an alternative financial system. ... Its recent decision to turn Shanghai into a financial centre by 2020 reflects China's anxiety over relying on the dollar system. The year 2020 seems remote... However, if global stagflation takes hold, as I expect it to, it will force China to accelerate its reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

Barry Eichengreen explains why using SDRs as a reserve currency, as has been suggested by the governor of the People's Bank of China, is not as easy as it might seem:

Commercialize the SDR now, by Barry Eichengreen, Commentary, Project Syndicate: Zhou Xiaochuan, the governor of the People's Bank of China, made a splash prior to the recent G-20 summit by arguing that the International Monetary Fund's Special Drawing Rights should replace the dollar as the world's reserve currency. ...

Sympathizers acknowledged the contradictions... Central banks understandably seek more reserves as their economies grow. But if those reserves mainly take the form of dollars, then their rising demand allows the United States to finance its external deficit at an artificially low cost. In turn, this allows unsustainable imbalances to build up, leading to an inevitable crash. ...

But skeptics question whether the SDR could ever replace the dollar as the world's leading reserve currency, for the simple reason that the SDR is not a currency. It is a composite accounting unit in which the IMF issues credits to its members. Those credits ... cannot be used in the other transactions in which central banks and governments engage. ... This means that the SDR is not an attractive unit for official reserves.

This would not be easy to change. Despite the trials and tribulations of the American economy, dollar securities remain the dominant form of reserves because of the unparalleled depth and liquidity of US markets. Central banks can buy and sell dollar securities without moving those markets. There is also the convenience factor: dollars are widely used in a variety of other transactions. As a result, not even the euro has seriously challenged the dollar as the dominant reserve currency. ...

If China is serious about elevating the SDR to reserve-currency status, it should take steps to create a liquid market in SDR claims. It could issue its own SDR-denominated bonds. ... Of course, an earlier attempt was made to create a commercial market in SDR-denominated claims ... in the 1970's... But these efforts ultimately went nowhere. The dollar being more liquid, its first-mover advantage proved impossible to surmount.

Overcoming that advantage now would require someone to act as market-maker ... and subsidise the market in its start-up phase. The obvious someone is the IMF. The Fund could stand ready to buy and sell SDR claims to all comers, ... at narrow bid/ask spreads competitive with those for dollars. ...

Transforming the SDR into a true international currency would require surmounting other obstacles. The IMF would have to be able to issue additional SDRs in periods of shortage... The IMF's management would also have to be empowered to decide on SDR issuance, just as the Fed can decide to offer currency swaps. For the SDR to become a true international currency, in other words, the IMF would have to become more like a global central bank and international lender of last resort.

For worries about inflation, see Inflation Nation by Alan Meltzer (and also see Krugman's response, A History Lesson for Alan Meltzer).

[Note: A lot of people have noted the apparent contradiction in the concern from Krugman over deflation, and from Meltzer over inflation, e.g. Mankiw for one, but here's an example of this from Mankiw's colleague, Martin Feldstein, within the same article. It's simply a short-run, long-run distinction.]

Tax Increases and Revenue: Curbing Offshore Tax Havens

One of the arguments you hear against tax increases at the upper end of the income distribution is that this group will simply find a way to avoid the taxes, legally or illegally, and therefore the revenue collected as a result of the tax increase will fall far short of what is predicted. The "tax cuts increase revenue" crowd will even argue that a tax increase can decrease revenues for this reason.

I always thought the problem was simply the will to enforce the tax increases, i.e. to take the time and effort to close whatever loopholes exist that allow this tax avoidance behavior to be rewarded, and to crack down on illegal behavior. The excuse that it's too hard, they'll just outsmart us, so why try at all always seemed like an unsatisfactory answer to me.

So it's nice to see the administration moving to make tax avoidance more difficult for both individuals and corporations, and to see efforts to broaden the tax base. This will complement their plan to raise taxes on the upper end of the income distribution. I don't know if they will be successful in the end, whether the will to clamp down on evasion and illegal activity and to broaden the base can withstand the intense pressure and resistance that is sure to come, but, unlike the previous administration, at least they are trying:

Obama Calls for New Curbs on Offshore Tax Havens, NY Times: President Obama presented a far-reaching set of proposals on Monday that are aimed at the tax benefits enjoyed by companies and wealthy individuals harboring cash in offshore accounts.

These steps, he said, would be the first in a much broader effort to fix a "broken tax system." ... His remarks echoed the sentiment he voiced again and again during the presidential campaign, when he pledged to crack down on "illegal overseas tax evasion."

The proposed tax overhaul, which will be fully unveiled later this week..., could help raise $210 billion in revenues over 10 years...

While most Americans paid their fair share of taxes, Mr. Obama said, "there are others who are shirking theirs, and many are aided and abetted by a broken tax system." Multinationals, he said, paid an average tax rate of just 2 percent on their foreign revenues. And some wealthy individuals hid their fortunes in foreign tax havens.

The president thus set up a frontal clash with big business over the tax advantages enjoyed by companies with extensive overseas operations. ... The president hopes to remove the competitive advantage for companies that invest and create jobs overseas, working to replace their tax advantages with incentives to produce jobs in the United States. ...

But several large businesses have opposed the proposal. About 200 companies and trade associations, including Microsoft, General Electric and the United States Chamber of Commerce, signed a letter stating that the proposed tax changes would put them at a disadvantage with their rivals. ...

Many of the tax proposals will require Congressional approval and, if passed, none would take force before 2011.

It's a start, but more is needed.

There should not be a tax advantage to moving jobs offshore, but I'm not a big fan of using tax incentives to induce firms to create jobs here either. That can quickly turn into a downward protectionist spiral as other countries follow suit. To me, this is a matter of equity. Wealth should not allow individuals or corporations to escape paying their assigned share of the tax burden.

Update: Robert Reich:

Why Obama is Taking on Corporate Tax Havens, by Robert Reich: Why, one may ask, is Obama taking on yet another huge fight by taking aim at foreign tax havens? Yes, it's unfair that multinationals pay an average tax rate of only 2 percent on their foreign revenues, and it's unfair that some wealthy Americans are avoiding taxes altogether by parking their fortunes abroad. But, hey, these have been true for decades. So why take them on now, when the President is also taking on universal health insurance and global warming, and trying to get the economy going again? The White House says that some jobs go abroad because American companies are lured there by tax loopholes... True. But a crackdown on tax havens might also cost American jobs if companies decided that a higher tax burden here required them to cut payrolls in order to stay competitive or to simply leave the United States altogether. Another possible explanation is that it was a campaign promise. ... But this can't be it, either. He criticized several other things as well -- such as the North American Free Trade Agreement -- which he now seems comfortable with. So again: why this, and why now? Two reasons, both strategic. The President needs the cooperation of many big corporations if he's going to get universal health insurance enacted... Many of these companies would benefit from lower health costs but they're reluctant to take on Big Pharma, big health insurance companies, and major health providers, all of whom are dead set against a ... government health plan. How does it help for him to take on corporate tax havens? Because the President needs as many bargaining chips with the rest of corporate America as possible. The proposed crackdown on foreign tax avoidance is one such chip. He might be willing to take it off the table if big corporations lend him active support on health insurance. The second reason has to do with revenues. Originally the White House had planned to pay for universal health insurance by limiting tax deductions for wealthier Americans. But the Democratic leadership nixed that source. The rich Americans who take the deductions ... had enough political leverage to make it a non-starter. That means the White House has to find other sources of money. ...

The Administration figures it could raise over $100 billion over ten years by preventing companies from taking immediate deductions for overseas expenses... It could raise another $95 billion by making it harder for individuals to hide their income in offshore accounts, and harder for companies to shift income ... to ... the lowest-tax jurisdiction. The White House is preparing to release a more detailed budget blueprint later this week. That blueprint has to contain some credible ways to pay for universal health insurance. Otherwise the measure could become vulnerable to deficit hawks who, like vultures over road kill, continue to circle ominously.

Paul Krugman: Falling Wage Syndrome

Are we doing enough to reduce the risk that we'll face a sustained period of deflation and stagnation?:

Falling Wage Syndrome, by Paul Krugman, Commentary, NY Times: Wages are falling all across America. Some of the wage cuts, like the givebacks by Chrysler workers, are the price of federal aid. Others, like the tentative agreement on a salary cut here at The Times, are the result of discussions between employers and their union employees. Still others reflect the brute fact of a weak labor market: workers don't dare protest when their wages are cut, because they don't think they can find other jobs.

Whatever the specifics, however, falling wages are a symptom of a sick economy. And they're a symptom that can make the economy even sicker.

First things first: anecdotes about falling wages are proliferating, but how broad is the phenomenon? The answer is, very.

It's true that many workers are still getting pay increases. But there are enough pay cuts out there that, according to the Bureau of Labor Statistics, the average cost of employing workers ... rose only two-tenths of a percent in the first quarter of this year — the lowest increase on record. Since the job market is still getting worse, it wouldn't be at all surprising if overall wages started falling later this year.

But why is that a bad thing? After all, many workers are accepting pay cuts in order to save jobs. What's wrong with that?

The answer lies in one of those paradoxes...: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment. ... So there's no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy's problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don't go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more ... but as wages fall, they're chasing a moving target. ... Things get even worse if businesses and consumers expect wages to fall further in the future. ...

Concern about falling wages isn't just theory. Japan ... is an object lesson in how wage deflation can contribute to economic stagnation.

So what should we conclude from the growing evidence of sagging wages in America? Mainly that stabilizing the economy isn't enough: we need a real recovery.

There has been a lot of talk lately about green shoots and all that, and there are indeed indications that the economic plunge that began last fall may be leveling off. The National Bureau of Economic Research might even declare the recession over later this year.

But the unemployment rate is almost certainly still rising. And all signs point to a terrible job market for many months if not years to come — which is a recipe for continuing wage cuts, which will in turn keep the economy weak.

To break that vicious circle, we basically need more: more stimulus, more decisive action on the banks, more job creation.

Credit where credit is due: President Obama and his economic advisers seem to have steered the economy away from the abyss. But the risk that America will turn into Japan — that we'll face years of deflation and stagnation — seems, if anything, to be rising.

Here's a graph of the Phillips curve over the last two and a half years (2006:Q3 - 2008Q4) as measured by the year over year percentage change in the employment cost index (total compensation) versus the civilian unemployment rate:


Artificially restraining wages from falling is not the correct response, the key is to drive the unemployment rate down so that the labor market tightens and wages rise in response. That is why it's essential that stimulus programs provide a boost to employment, and I've wondered from the start if the stimulus programs we enacted have focused enough on providing employment opportunities. Building new infrastructure does provide long-term benefits, and that gives political cover to the large government expenditure and tax cuts that were enacted, but infrastructure projects alone do not give the maximum possible boost to employment. Providing jobs - some of which may not directly boost long-run productivity - is an essential component of short-run stabilization policy, and there is more that we could do to give unemployed workers opportunities for employment until jobs begin to reappear in the private sector.

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