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May 13, 2009

Economist's View - 6 new articles

"Where are the Largest Gains from Trade Liberalization?"

Time is scarce today, so staying in pass through mode: Here's one more from Dani Rodrik. He argues that the biggest gains within the US from further trade liberalization would come from liberalizing agricultural trade, and expanding visa quotas for highly skilled foreign workers:

Where are the largest gains from trade liberalization?, by Dani Rodrik: ...A society's gains from trade liberalization in different sectors depend on a lot of things, but as a rule of thumb, it is useful to focus on three things. (Here I will look at only U.S. policies, leaving aside the question of which initiatives should be pursued abroad.)

First, how large is the trade restriction (or subsidy) in question? Economic theory tells us that the gains from removing a tax or subsidy rise with the square of the wedge. So sectors where there are large policy interventions are particularly ripe for liberalization, everything else held constant.

Second, what is the likelihood that the liberalization will aggravate a pre-existing market imperfection? In the case of the U.S., the main imperfection I would worry about is technological externalities. These spillovers are likely to be associated with activities that employ lots of highly-skilled workers. My rule of thumb here would be that liberalization that results in the contraction of sectors that employ such workers is unlikely to generate much gains, and may even be harmful.

Third, is the liberalization likely to worsen income distribution at home? Many economists disregard distributional concerns (either because they do not think these are important, or else because they assume other policy instruments are available to deal with equity). But I do not find this a tenable position. So I would argue that any potential efficiency gains have to be traded off against potentially adverse movements in income distribution.

How do these considerations inform the question at hand, namely the nature of the initiatives the US should make a priority in its trade policy agenda? ... I can think of two areas of liberalization where existing barriers are high and do not face the objections that I have considered so far.

First, agriculture. Subsidies and other trade-distorting measures are rampant in agriculture, especially in crops like cotton and sugar. It is hard to argue that these activities generate externalities or that their contraction would be bad for income distribution as a whole. So this is clearly an area of priority. (Note that I am not considering the impacts on other countries, which is not my focus here. The positive impacts abroad are typically vastly exaggerated, but the domestic benefits are not in question.)

Second, visa restrictions on highly-skilled foreign workers. The barriers here are large, since we know the visa quotas bind severely. Allowing more foreign scientists and engineers in will reduce incentives to outsource technologically-advanced operations abroad, and will help expand sectors that are likely to generate positive spillovers. The distributional effects are unlikely to be adverse, as it is the top of the labor market that will be affected.

So the trade policy initiatives that deserve priority in the U.S. are: liberalize agricultural trade, and expand visa quotas for highly skilled foreign workers. Note that the U.S. can do both of these on its own, and does not need Doha or action on the part of the rest of the world to reap the gains from these reforms.

"The Truth Behind the Social Security and Medicare Alarm Bells"

Robert Reich reacts to yesterday's report on Social Security and Medicare finances:

The Truth Behind the Social Security and Medicare Alarm Bells, by Robert Reich: What are we to make of yesterday's report from the trustees of the Social Security and Medicare trust funds that Social Security will run out of assets in 2037, four years sooner than previously forecast, and Medicare's hospital fund will be exhausted by 2017, two years earlier than predicted a year ago?

Reports of these two funds' demise are not new. Fifteen years ago, when I was a trustee of the Social Security and the Medicare trust funds ... both funds were supposedly in trouble. But as I learned, the timing and magnitude of the trouble depended a great deal on what assumptions the actuary used in his models. As I recall, he then assumed that the economy would grow by about 2.6 percent a year over the next seventy-five years. But go back into American history all the way to the Civil War -- including the Great Depression and the severe depressions of the late 19th century -- and the economy's average annual growth is closer to 3 percent. Use a 3 percent assumption and Social Security is flush for the next seventy-five years. ...

Even if you assume Social Security is a problem, it's ... a tiny problem, as these things go. Medicare is entirely different. It's a monster. But fixing it has everything to do with slowing the rate of growth of medical costs -- including, let's not forget, having a public option when it comes to choosing insurance plans under the emerging universal health insurance bill. With a public option, the government can use its bargaining power with drug companies and suppliers of medical services to reduce prices. And, as I've noted, keep pressure on private insurers to trim costs yet provide effective medical outcomes.

Don't be confused by these alarms from the Social Security and Medicare trustees. Social Security is a tiny problem. Medicare is a terrible one, but the problem is not really Medicare; it's quickly rising health-care costs. Look more closely and the real problem isn't even health-care costs; it's a system that pushes up costs by rewarding inefficiency, causing unbelievable waste, pushing over-medication, providing inadequate prevention, over-using emergency rooms because many uninsured people can't afford regular doctor checkups, and spending billions on advertising and marketing seeking to enroll healthy people and avoid sick ones.

De-globalization and Development

Dani Rodrik says growth in international trade is likely to slow down, but that doesn't have to "spell doom for developing countries":

A De-Globalized World?, by Dani Rodrik, Project Syndicate: It may take a few months or a couple of years, but one way or another the United States and other advanced economies will eventually recover from today's crisis. The world economy, however, is unlikely to look the same.

Even with the worst of the crisis over, we are likely to find ourselves in a somewhat de-globalized world, one in which international trade grows at a slower pace, there is less external finance, and rich countries' appetite for running large current-account deficits is significantly diminished. Will this spell doom for developing countries? Not necessarily. ...

[I]t is no surprise that the countries that have produced steady, long-term growth during the last six decades are those that relied on ... promoting diversification into manufactured and other "modern" goods. By capturing a growing share of world markets for manufactures and other non-primary products, these countries increased their domestic employment opportunities in high-productivity activities. ...

China exemplified this approach. Its growth was fueled by an extraordinarily rapid structural transformation toward an increasingly sophisticated set of industrial goods. In recent years, China also got hooked on a large trade surplus vis-a-vis the U.S. ― the counterpart of its undervalued currency. But it wasn't just China. ...

It is now part of conventional wisdom that large external balances ― typified by the bilateral U.S.-China trade relationship ― played a major contributing role in the great crash. Global macroeconomic stability requires that we avoid such large current-account imbalances in the future.

But a return to high growth in developing countries requires that they resume their push into tradable goods and services. In the past, this push was accommodated by the willingness of the U.S. and a few other developed nations to run large trade deficits. This is no longer a feasible strategy for large or middle-income developing countries.

So, are the requirements of global macroeconomic stability and of growth for developing countries at odds with each other? ... There is in fact no inherent conflict, once we understand that what matters for growth in developing countries is not the size of their trade surpluses, nor even the volume of their exports. What matters is their output of modern industrial goods (and services), which can expand without limit as long as domestic demand expands simultaneously.

Maintaining an undervalued currency has the upside that it subsidizes the production of such goods; but it also has the downside that it taxes domestic consumption ― which is why it generates a trade surplus. By encouraging industrial production directly, it is possible to have the upside without the downside.

There are many ways that this can be done, including reducing the cost of domestic inputs and services through targeted investments in infrastructure. Explicit industrial policies can be an even more potent instrument.

The key point is that developing countries that are concerned about the competitiveness of their modern sectors can afford to allow their currencies to appreciate (in real terms) as long as they have access to alternative policies that promote industrial activities more directly.

So the good news is that developing countries ... growth potential need not be severely affected as long as ... developing countries ... substitute real industrial policies for those that operate through the exchange rate. ...

"How Realistic Were the Economic Forecasts Used in the Stress Tests?"

I, along with many others, have "suggested that the economic forecasts used in the tests are not severe enough." (See also Breathing easier after bank stress tests? You shouldn't.) Here's an opposing view from Ken Beauchemin and Brent Meyer of the Cleveland Fed:

How Realistic Were the Economic Forecasts Used in the Stress Tests?, by Ken Beauchemin and Brent Meyer, FRB Cleveland: The results of the "stress tests" came out last Thursday, and we can now see what three months of intense scrutiny of 19 of the countries largest bank holding companies has revealed about the amount of capital they are likely to need to withstand a worse-than-expected recession. Since the April 24 release of the Federal Reserve white paper describing the process, a number of observers have suggested that the economic forecasts used in the tests are not severe enough, and may result in insufficient capital requirements.

Regulators tested the banks against two sets of assumptions for GDP, unemployment, and housing prices. The "baseline" scenario averaged the February forecasts of real GDP and the unemployment rate from the Blue Chip Survey, Consensus Forecasts, and the Survey of Professional Forecasters. The assumptions for house prices followed a path implied by futures on the Case-Shiller Housing Price Index. The second, "more adverse" scenario represented a longer and deeper recession than the baseline scenario.

In the baseline case, real GDP falls by 2.0 percent in 2009 before rebounding to 2.1 percent in 2010; the unemployment rate averages 8.4 percent in 2009 and 8.8 percent in 2010. House prices decline 14.0 percent in 2009 and fall an additional 4.0 percent in 2010.

The more adverse (but not necessarily "worst-case" scenario) assumes a sharp 3.3 percent real GDP contraction in 2009 followed by scant 0.5 percent growth in 2010; the unemployment rate averages 8.9 percent in 2009 and 10.3 percent in 2010. House prices drop 22.0 percent in 2009 and 7.0 percent in 2010.

At the time the assumptions were determined, the advance estimate on fourth-quarter 2009 real GDP growth was −3.8 percent (annualized), and the February employment figures were not known. Subsequently, the Bureau of Economic Analysis slashed the fourth-quarter growth estimate by a stunning 2.5 percentage points, to −6.3 percent. Given the large downward GDP revision, an exceptionally rapid deterioration in the labor market, and yet another large GDP decline (in the first quarter), it is, of course, natural to question the validity of the bank stress tests. It turns out, however, that the most recent forecasts remain in line with the two stress-test scenarios.

First, the most recent GDP growth forecasts still lie within the range covered by the stress-test scenarios. While both the Blue Chip consensus and Macroeconomic Advisors forecasts dip below the baseline-scenario projection for 2009 growth of −2.0 percent, they are quite close to the 2010 baseline and remain firmly within the range between the baseline and more adverse scenarios in both years. Furthermore, only the Blue Chip pessimists' forecast hits the lower bound of the stress-test scenarios in 2009, and it is 0.4 percentage point above the more adverse scenario for 2010.

Second, while rapid deterioration in the labor market has led to a near-term path for the unemployment rate that will most likely generate a 2009 average in excess of the 8.4 percent rate assumed by the baseline scenario, both the most recent Macroeconomic Advisors and Blue Chip forecasts predict an unemployment rate slightly lower than the 8.9 percent rate assumed by the more adverse scenario. The forecasts for 2010 are also less dire than assumed by the more adverse scenario. As the Federal Reserve noted in its April 24 white paper, "Although the likelihood that unemployment could average 10.3 percent in 2010 is now higher than had been anticipated when the scenarios were specified, that outcome still exceeds a more recent consensus projection by professional forecasters for an average unemployment rate of 9.3 percent in 2010."

Finally, recent forecasts for house prices remain consistent with those of the stress-test scenarios and even hold out some hope that house prices may rise faster than the baseline forecast. This result is particularly encouraging since further declines in house prices will be a leading cause of any additional losses. Home prices are an important indicator to consider because the troubled assets that could potentially threaten the 19 tested financial institutions are largely related to residential real estate. The ultimate performance of these assets is partly a function of what happens to home prices in the future.

In summary, notwithstanding further unexpected and dramatic declines in the economy, recent projections by professional forecasters indicate that the stress-test scenarios remain viable and relevant to the task of assessing the potential losses faced by nation's largest bank holding companies. While the adverse scenario may seem more likely than when it was first drawn up, it is only the near-term outlook for unemployment that has significantly strayed from baseline assumptions. Furthermore, the alternatively adverse scenario looks to be plenty adverse, and exposes the wisdom of planning for a more stressful outcome in the first place.

Energy Update

This is the Dallas Fed's Quarterly Energy Update:

Petroleum Products Rebound as Natural Gas Continues to Slide, by Jackson Thies and Mine YĆ¼cel, FRB Dallas: Although demand for oil remains weak, prices have rebounded from the lows of the first quarter (Chart 1). As of early May, the spot price for West Texas Intermediate crude (WTI) was near $54 per barrel, over 25 percent higher than the first quarter average of $42.88. If economic activity picks up in the latter half of the year, we can expect further firming in oil prices.

Gasoline Prices Rising Following oil prices, gasoline prices are off their recent lows on declining refinery utilization and signs of stabilization in vehicle miles traveled (Chart 2). The onset of the summer driving season and increased travel will put upward pressure on prices. As of early May, prices are slightly over $2.10 per gallon, about 9.3 percent higher than the first quarter average, but over 40 percent below year-ago prices.

Chart 2: As gasoline prices fall, miles traveled stabilizes

OPEC Production Held Steady At the March 15 meeting, OPEC opted to hold production constant but encouraged member countries to further adhere to quotas. The International Energy Agency estimates compliance at 83 percent, and with the exception of Nigeria, all producers exceeding their quotas trimmed production in March (Chart 3). If OPEC reaches full compliance, it will trim an additional 700,000 barrels per day from the market.

Chart 3: OPEC quota compliance

OPEC Excess Capacity Increases Reductions in output have brought supply and demand closer to alignment but have also increased excess production capacity. The Energy Information Administration (EIA) estimates OPEC has 5 million barrels per day of excess capacity, its highest level since 2002 (Chart 4). This provides a substantial cushion against a rebound in demand, but without continuing investment, excess capacity will diminish.

Reduced expectations for global growth have led to spending cuts at oil companies, leading to decreased maintenance and increased decline rates for many mature oil fields. Higher-cost non-OPEC fields look more vulnerable, but OPEC is not immune—over 30 OPEC expansion projects have been put on hold amid the economic turmoil.

Chart 4: OPEC excess capacity increases

Demand Expectations Looking at vintage EIA forecasts, we can see that petroleum consumption estimates for 2009 have fallen drastically since mid-2008 (Chart 5). As recently as September, demand forecasts incorporated only minimal effects from the economic downturn. Demand is now expected to bottom out in June at just over 83 million barrels per day, before rising through the end of 2010.

The expected rebound in demand is relatively strong, though average consumption in 2009 is projected to drop to 84.1 million barrels per day—3.3 million barrels lower than was expected in September of 2008, and 1.3 million barrels below the 2008 average.

Chart 5: Vintage EIA consumption forecasts revised downward

Natural Gas Prices Continue Fall As oil prices recover ground, natural gas prices continue to hover near multiyear lows (Chart 6). Decreased consumption due to the economic malaise and increased supply are the culprits.

Chart 6: Natural gas at lowest level since 2002

Within the past few years, abundant new supplies of natural gas became available in the Barnett and Haynesville shales. Shale plays began serious production in 2004 and increased significantly over the following years. Reaching its highest level since 1974, natural gas production peaked in 2008 just as the economy—and industrial activity—slid into decline.

As the economy deteriorated in the latter part of 2008, natural gas consumption in industrial activities followed suit. Natural gas use in the industrial sector fell to 1.6 trillion cubic feet (Tcf) in fourth quarter 2008, down 5 percent from 1.7 Tcf in the final quarter of 2007. As consumption declined, supply continued to increase (Chart 7), pushing prices lower.

Chart 7: Natural Gas consumption declines as production rises

Natural gas has now traded under $4 since March 26. Lower prices have led to a sharp decline in the natural gas rig count, which is down to 775 from its high of 1,585 in September 2008, a 51.1 percent drop over the past seven months. In February, year-over-year production was flat compared with the high-single-digit increases seen throughout 2008. Given the decline in the rig count, gas production could decrease in the coming months as compared with year-ago levels. The extent of demand deterioration remains to be seen.

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