The Leaderless Economy (part 3)

February 6, 2013

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In Chapter 6, “Restoring International Balance in the World,” Temin and Vines use their model of internal and external economic balance to analyze the state of the global economy in the aftermath of the recent financial crisis. The main players in their story are East Asia (especially China), the United States, and Europe (especially the 17 nations of the European Monetary Union).

Since the 1980s, more countries in East Asia have adopted a path to growth similar to that of Britain, Germany and Japan before them, the model of rapid industrialization and expansion of exports. Rather than letting their currencies float in a way that might limit exports by making them more expensive, they pegged their currencies to the dollar at a low exchange rate, making exports cheap and imports expensive. The price they paid for that was relatively low wages and consumption for their own people, even as their export-based economies took off. Rather than spending the dollars they earned from their exports to boost their own standard of living, they lent them back to us to sustain our standard of living. They saved and lent more so that Americans could borrow and spend more.

Meanwhile, as I described in the previous post, the United States became relatively less competitive in world markets. It tried to keep its economy going by living beyond its means, importing more than it exported, having government spend more than it taxed and consumers spend more than they could afford. When the financial system collapsed under the burden of excessive and increasingly risky debt, the Great Recession ensued. Although a recovery is underway, the United States may now be forced to adjust to its uncompetitive position in another way, through fiscal austerity and high unemployment. The Federal Reserve is trying to reduce unemployment by keeping interest rates low, but it may be reaching the limit of what monetary policy alone can do. The dilemma of fiscal policy is that in the long run, spending has to fall and/or taxes have to rise to reduce debt, but in the short run, either of these measures can increase unemployment. “The US position is perhaps as bad as anywhere, in that there may be too-rapid removal of the stimulus in the short run but no coherent fiscal stabilization plan for the long run.”

The global situation is complicated by the economic condition of Europe. The European Monetary Union was formed in 1999 by twelve countries, later expanded to seventeen. Having monetary unity–a common currency–without political unity turned out to be tricky. It did promote cross-border economic activity by eliminating the confusion and risk of companies having to deal with many different floating currencies. It also seemed to provide some defense against inflation, a central preoccupation of policymakers at the time. “Gradually a view grew…that other European countries could latch themselves onto Germany by forming the European Monetary System, and that by doing so they could assume the anti-inflation credibility of the Bundesbank.” Economic policy in the Eurozone would have four main components: (1) the European Central Bank would pursue inflation control as its prime objective; (2) governments would try to maintain balanced budgets, as opposed to using fiscal policy to stimulate their economies; (3) those in a position to influence wages and prices would try to control them to maintain their country’s competitiveness; and (4) interest rates would be similar among countries. Only the first of these policies–fighting inflation–turned out to be very successful.

Differences in competitiveness among European countries undermined the system, especially the difference between Germany and the GIIPS countries–Greece, Ireland, Italy, Portugal and Spain. Having a common currency turned out to be very much like being on the gold standard before the Great Depression. The less competitive countries had trouble making their exports cheaper or imports more expensive to move toward external balance. With nominal exchange rates fixed, they could only reduce real exchange rates by reducing wages and prices, which would provoke internal resistance. As in the United States, it was easier to maintain demand by running up debt, enabled by global financial institutions seeking high returns while underestimating risks. “Capital inflows enabled increased expenditures, which strengthened the boom in these countries and made inflation worse. The opposite was true in Germany. High real interest rates and outflows of capital, organized by the German banking system, meant that German savings were not used at home but flowed to the European periphery.” So just as Chinese thrift financed American spending, German thrift financed GIIPS spending.

When the global financial crisis struck, the risks inherent in this situation became apparent, leading investors to demand a substantial risk premium–a higher interest rate–to continue lending to the indebted economies:

If a country earns less than it spends for many years because it is uncompetitive, it will be out of external balance, and it will accumulate foreign debts to pay for its imports. Tax revenues will shrink, and the government’s budgetary position will become difficult. There will be political pressures on the government to spend more to counteract the loss of activity caused by the loss of competitiveness, making the fiscal position worse. Financial markets will begin to fear that the country’s government might default on its debt, and a sovereign risk premium will emerge.

The indebted countries of Europe are now turning toward austerity, as is the United States, but the European countries are having it forced upon them suddenly as a condition of financial assistance from the rest of Europe. This has led to large reductions in spending and increases in unemployment. Temin and Vines argue that stronger economies, especially Germany, need some expansion of demand in order to compensate for austerity elsewhere. Otherwise, aggregate demand will fall for Europe as a whole, contributing to global recession. Germany has the potential to become the next hegemonic power, acting for the good of other countries, but so far has not embraced that role.

Germany is forcing a speedy and unprecedented degree of austerity adjustment on the GIIPS. But Germany is not ensuring a correspondingly rapid expansion of demand at home. Instead, it is using its competitive position to ensure that it grows rapidly by means of an export surplus. The external surplus of Germany, caused by an overly competitive position and inadequate internal demand, is making it impossible for the GIIPS to achieve either internal or external balance.

Now let’s combine the European story with the US-China story to see the three regions in combination. The US dollar and the European euro have a floating exchange rate, and that tends to avoid persistent external imbalances where either the US or Europe is unable to pay for its exports with its imports. (According to the Swan IB/EB model, weak demand for either’s products would push down its exchange rate, making its exports more attractive.) But in relation to the Chinese renminbi, both the dollar and the Euro are too strong, damaging the competitiveness of both the United States and Europe. That gives both Europe and the United States an incentive for fiscal caution, if they want to avoid a trade deficit and excessive debt. The northern European economies, especially Germany, have exercised that caution for a long time, while the Americans are just starting to. That’s why the Western trade deficit encouraged by the East Asia trade surplus and weak currency has become largely an American problem. “Low demand in China causes a current account surplus between China and the rest of the world. But Europe’s high savings means that Europe does not run a deficit. The surplus of China is mainly maintained at the expense of the United States. This is the story of the US deficit.”

So here’s the problem: Countries that have been running deficits, notably the United States and the GIIPS countries of Europe, need to pay down debt and move toward austerity, at least gradually. But countries with surpluses, notably Germany and China, cannot maintain their frugality at the same time. If all countries try to curb spending and import less than they export, aggregate demand cannot absorb productive capacity, global output will fall, and global recession will occur. No matter how sensible austerity seems to each country considered alone, global austerity will bring them all down together. The Chinese will need to raise wages and produce more for domestic consumption. The Germans will need to save less and spend more, risking inflation, and it will also need to take the risk of lending to troubled economies so that they can hold down unemployment while they make the transition to greater competitiveness. No other country is in a better position to take those risks. During the Great Depression, Germany made a bid for hegemonic power through military conflict and lost. Now it has an opportunity to assume hegemonic power through peaceful cooperation, resulting in a win-win.

By the way, I wish the authors had given more attention to the qualitative ways of increasing competitiveness. They focus primarily on quantitative adjustments–lowering the nominal exchange rate, lowering costs of production, and so forth. But if a debtor nation can invest in new activities that can find a global market, it may be able to increase exports without just weakening its currency or cutting costs. It can move away from living on credit without moving toward too much austerity. The authors seem to share that goal, but they don’t discuss that way of achieving it.

Although they see a significant risk of continuing global recession, Temin and Vines try to end on a hopeful note. They cite the collaborative process by which the G20 financial leaders (finance ministers and central bank governors from 20 nations representing about two-thirds of the world’s population) have formulated global economic objectives and engaged in an ongoing assessment of progress toward meeting them. In 2011, the G20 Mutual Assessment Process analyzed the policies of seven countries (US, Germany, France, UK, China, Japan and India) and made recommendations similar to those of this book. The authors also report that things are moving in the right direction in China, with expansion of domestic demand, rise in the real exchange rate, and decline in the trade surplus. They remain concerned about trends in the US and Europe, however:

The pressure for austerity, reducing domestic demand, echoes the policies of the early 1930s that led to the Great Depression. And the absence of a hegemon makes it harder to come out of these troubles into anything like the golden age of economic growth that followed the Second World War. We hope that our exposition will help national leaders adopt policies that point us toward the restoration of international economic balance and prosperity.

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The Leaderless Economy (part 2)

February 4, 2013

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My previous post described the Keynesian economic models that Temin and Vines use to explain the relationships between national economies and the global economy. The title of their book represents an overarching theme in their analysis: the need for some strong country to take the lead in fostering international cooperation and global economic growth.

Countries are economic competitors for export markets, but they are also trading partners. Each country benefits by having trading partners that can afford to buy its goods and pay for them with their own exports. Economic collapse in one country hurts other countries, and assistance to a struggling country may be in the long-run best interest of all countries. Such assistance carries risk, however, since it comes with no guarantee of a reciprocal benefit to the country providing the assistance. Temin and Vines believe that the global system works best when it contains one particularly strong country that can afford to take the risk of international leadership. Using the language of world systems theory, they refer to that country as the “hegemonic power.” The authors explain this further using the game-theory concept of the “prisoner’s dilemma,” but I don’t find those details essential.

The United States emerged as the hegemonic power after World War II, providing extensive assistance to Europe with the Marshall Plan and bringing nations together at Bretton Woods, New Hampshire to organize a new monetary system. Many of the ideas of what needed to be done came from John Maynard Keynes, whose thinking developed partly as a reaction against what Britain had failed to do to avoid the Great Depression and the war with Germany. Britain was the world’s strongest economy until the early 20th century, but its competitive position had weakened as the United States and Germany developed new industries like steel and chemicals, and even its established industries like textiles had failed to adopt more advanced methods. Not only did Britain’s weakened economic position undermine its international leadership, but British leaders made several policy blunders that contributed to the Depression, as Keynes saw it. Britain helped cripple the German economy and weaken its democracy by imposing crushing reparations after World War I, and it hurt itself by remaining on the gold standard throughout the 1920s. Fixing the value of the pound at too high a price in gold encouraged people to cash in pounds for gold or other currencies, leading Britain to defend the pound by keeping interest rates too high (trying to reward holders of pounds with a high return). These are contractionary policies that weaken aggregate demand and raise unemployment. (Recall that in the IS/LM model, the higher the interest rate, the lower the level of production at which demand balances supply; and in the IB/EB model, the higher the real exchange rate, the lower the level of domestic demand at which imports will balance exports.) At the onset of the Depression, Herbert Hoover was making the same mistakes in the US, maintaining the gold standard and raising interest rates. By the early 1930s, both countries had ended the gold standard and adopted more expansionary fiscal policies. Temin and Vines consider the Great Depression an “end-of-regime crisis” which brought Britain’s hegemonic power to an end and passed the mantle of leadership to the United States.

By the Bretton Woods meeting in 1944, Keynes had formulated the economic policies he believed necessary for postwar prosperity.

Keynes aimed to establish a policy framework in which individual countries like Britain would be able to promote high levels of employment and output by means of demand-management policies, mainly in the form of fiscal policy. This would, it was hoped, avert slumps in growth and would prevent the reemergence of the kind of global depression that had occurred in the 1930s. Each country would pursue internal balance.

But Keynes saw that such policies would need global support, because they would have to be reconciled with the need for each country to be sufficiently competitive. That is, each country would need to be able to export enough to pay for the imports that would be purchased at full employment.

The specific policies he recommended included management of domestic demand to maintain full employment, pegged but adjustable exchange rates to maintain the balance-of-payments between countries, reductions in tariffs to increase free trade, and international lending to foster economic development. He foresaw international institutions such as the International Monetary Fund, The World Bank and the World Trade Organization. The Bretton Woods agreement set up a system of exchange rates along the lines Keynes recommended:

The IMF oversaw a global system of pegged-but-adjustable exchange rates. A deficit country was declared to be in “fundamental disequilibrium” if it wished to import more at full employment than it was able to cover from its exports. Exchange-rate pegs were not to be adjusted (unless there was a fundamental disequilibrium) to prevent countries from stealing jobs from one another by beggar-thy-neighbor devaluations. But deficit countries in fundamental disequilibria were required to adjust their exchange rates. Lending from the IMF was available to cover liquidity problems during the adjustment period. Surplus countries in fundamental disequilibrium—that is to say, countries exporting more than the amount required to pay for what would be imported at full employment—were also required to adjust.

Under this system, a country whose exports were in much less demand than its imports could restore balance by lowering its exchange rate, making its exports cheaper and its imports more expensive. Anchoring the system of adjustable exchange rates was the stable US dollar, which once again was given a fixed price in gold. This made the dollar the world’s strongest currency, but that was okay as long as the United States was clearly the world’s strongest economy. The system worked well from 1945 until 1971, helping to make that period “the most remarkable period of economic expansion that the world had ever known.”

In the late 20th century, it was the United States that became the faltering hegemonic power. The story is in some ways similar to Britain’s earlier story, involving a combination of declining global competitiveness and domestic policy blunders. The country’s competitive position after World War II was exceptionally strong, since it was producing over one-fourth of all the goods and services in the world. Challenges were inevitable sooner or later, especially from European recovery and Asian development. The transition to a less dominant economic position was complicated by the expansionary fiscal policies of the Johnson administration, especially the failure to raise taxes to pay for the unpopular Vietnam War. With the economy already operating at high capacity, the additional fiscal stimulus pumped up consumer demand, generating both inflation and an excess of imports over exports. The combination of the dollar’s fixed price in gold but declining buying power threatened a run on the dollar, which the Nixon administration avoided by taking the US off the gold standard and letting the dollar float like other currencies. “The resulting devaluation corrected the external imbalance, but it made the internal balance worse by intensifying American inflation.” “Supply shocks” such as the higher price of oil contributed as well. President Carter’s new Federal Reserve Chairman, Paul Volcker, adopted a monetary policy so strict that it not only brought down inflation, but threw the economy into recession. When it recovered in the 1980s and after, it seemed for a time that internal equilibrium had been re-established, and by 2000 economists were speaking favorably of the “Great Moderation.” What was overlooked by many was that a worsening external imbalance was enabling the internal balance. Americans were increasingly living beyond their means, exporting too little, importing too much, and sustaining domestic consumption by accumulating government and household debt.

Why wasn’t the US trade deficit mitigated by a decline in the value of the dollar, which is what’s supposed to happen in a system of floating exchange rates? The main reason is that other countries, especially China and other East Asian countries, prevented that in order to protect their export-led economies. Instead of letting their currencies float upward, they pegged exchange rates at a level that kept their currencies cheap and the dollar strong. Then they took many of the dollars they earned with their exports and lent them back to the US, making us the world’s biggest debtor.  This arrangement made imports to the US cheap and exports more expensive, hurting US manufacturing on world markets. It also encouraged borrowing and spending by Americans enabled by saving and lending by foreigners. Our economy could remain strong only if government and consumer spending were high enough to compensate for the lack of foreign demand for our products. The Reagan-Bush reductions in taxes and increases in military spending helped fuel domestic demand, as did looser monetary policy by the Federal Reserve under Alan Greenspan, especially after 2001. Remarkably, foreign countries continued to finance our deficits even as lower interest rates diminished their returns.

At the same time, the distribution of American income was changing, with more going to the richest 1% and less to the bottom 80%.  (This is partly a result of globalization too, because of the loss or outsourcing of good manufacturing jobs.) After-tax income was becoming even more skewed, since the Reagan and Bush tax cuts were directed especially at the wealthy. The wealthy had more money to lend, while the less wealthy had more reason to borrow in order to achieve their financial goals, such as home ownership. With interest rates low, investors had an incentive to seek higher returns in riskier investments, such as sub-prime loans and the even riskier derivative securities based on those loans. While the manufacturing sector declined, the financial sector boomed, and financial institutions created new instruments like collateralized mortgage obligations, pools of mortgages that offered high returns while disguising risks. Rating agencies overrated these instruments by assuming that they were diversified enough to minimize risk, overlooking the possibility that a general decline in home prices or incomes would cause many borrowers to default simultaneously. Under-regulation of the financial industry, including a refusal to regulate derivative securities at all, made it even easier to engage in risky behavior.

In short, the choices the United States made in the face of its declining international strength were crucial. The tax cuts, financial deregulation, and choice of a low level of interest rates— instead of ensuring that the dollar devalued— are fundamental to our story. They left the United States in internal balance but with an external imbalance. The United States encouraged expenditure through financial deregulation and a low level of interest rates. This unhappy combination caused the financial bubble, which led in turn to the crash.

The internal balance in which demand absorbed productive capacity turned out to be unsustainable, since it depended ultimately on spending in excess of income by government, by consumers, and by the country as a whole. The bubble had to burst when prices fell in the overheated housing market, borrowers began defaulting on loans that were larger than their homes were worth, investors began panic-selling the overvalued mortgage-backed securities, and large investment banks failed when they were caught holding too many toxic assets themselves.

Temin and Vines regard the recent global financial crisis as another “end-of-regime crisis,” this time marking the end of American hegemonic power and global leadership.

How do we know that this is the end? We know because of the lack of leadership from the United States to revolve the crisis. The United States turned belligerent after the suicide attacks on September 11, 2001, echoing the frustrated policies of Germany between the world wars and leaving the world economy leaderless. The United States set the example for bank bail-outs during the crisis itself, but then vanished as a world leader….The country has become part of the problem rather than a leader orchestrating the search for a solution to it.

Continued

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The Leaderless Economy

February 1, 2013

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Peter Temin and David Vines. The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It (Princeton University Press, 2013)

This is a work of both Keynesian macroeconomic theory and economic history, emphasizing the connections between the internal workings of national economies and the external relations among them in the global economy. “Economic theory provides a framework for understanding the relations between internal and external balances, and economic history shows the context in which these relations assume importance.” Since the book is directed at noneconomists as well as economists, the authors seem to assume that readers want more history than theory. They refrain from discussing their economic models very directly, providing only a sketchy introduction in the first chapter and then a somewhat more logical presentation in the Appendix. I would have preferred they explain their models more fully at the outset. As it is, they tell the story of “The British Century and the Great Depression” in Ch. 2, and then describe Keynes’s evolution as a theorist and a policymaker in Ch. 3, before going on to “The American Century and the Global Financial Crisis” in Ch. 4. Given the wealth of historical detail, the reader is hard-pressed to understand the events described without yet having a firm grasp of the theory that’s supposed to explain them!

For that reason, I will attempt to describe the economic models first, and then rely on them to illuminate the economic developments.

Temin and Vines summarize their perspective this way: “The aim of policy in a well-managed economy must be to ensure both external balance–which requires that exports are sufficient to pay for imports–and internal balance–which requires that resources be fully utilized. It is clear that to achieve both objectives at the same time requires a difficult balancing act.” Economists have long seen economic processes as balancing acts, especially the reconciling of supply and demand in a particular market through a pricing mechanism. The British economist John Maynard Keynes made great advances in understanding balancing processes involving two markets at once. This is the tradition the authors draw on to understand the connections between domestic and international markets.

Temin and Vines present two models of bi-market relationships in the Appendix, both of which derive from the work of Keynes, as interpreted and developed by James Meade.

The Hicks IS/LM Model

This model describes the simultaneous balancing of supply and demand in two markets within the same economy, the market for goods and the market for money.

The market for goods is balanced when the supply (Gross Domestic Product) is equal to all the forms of demand: Consumption, Investment, Government Spending and Net Exports. GDP is also equivalent to national income, and the forms of demand can be thought of as allocations of income.

In the Hicks model, the balance of supply and demand is expressed as the balance of Savings and Investment. That works because some income is saved rather than spent on consumption, government or imports, and the same amount must show up as investment in order for the supply-demand equation to balance.

The second market, the market for money, is balanced when the Real Money Supply equals the Liquidity Preference (the demand for cash). Liquidity preference includes the demand for cash for transactions as well as the demand for cash savings. Liquidity preference is closely tied to the Interest Rate (the price of money). The demand for cash pushes interest rates up, but on the other hand, high interest rates encourage people to lend money rather than keeping it in cash.

A change within either market triggers balancing processes in both markets. The possible system states are displayed in a graph with GDP on the horizontal axis and Interest Rate on the vertical axis. A change in either variable creates a new point of “general equilibrium,” the point at which supply would balance demand in both markets simultaneously. The relationships between the two variables are described by two curves, the LM curve and the IS curve, and the point of equilibrium is where they cross.

The Liquidity Preference-Money Supply (LM) Curve describes a direct relationship between GDP and Interest rate. The higher the GDP, the higher the interest rate needed to balance the supply and demand of money. A higher GDP increases the demand for money for transactions, putting upward pressure on the interest rate. But rising interest rates reduce the speculative demand for money; the desire to keep savings in cash declines because of the high interest available to lenders. So a change in GDP results in a new equilibrium in the money market, where money demand once again equals money supply, but cash for spending has increased relative to cash for lending, other things being equal (money supply assumed to be unchanged).

The Investment-Savings (IS) Curve describes an inverse relationship between Interest Rate and GDP. The higher the interest rate, the lower the level of production at which demand balances supply. Higher interest rates discourage people from borrowing in order to spend on either capital or consumer goods. The economy contracts and a new equilibrium is established at a lower level of both supply and demand. Similarly, lower interest rates encourage borrowing, spending, and a higher level of supply and demand.

The point at which the two curves cross is the point of general equilibrium. Other points represent situations of excess supply or demand in either the goods market or the money market, or both.

How can there be two different relationships—one direct and one inverse—between the same two variables, GDP and Interest Rate? Think of it like the relationship between a predator and its prey, such as foxes and rabbits. A larger rabbit population can support a larger fox population (direct relationship), but a larger fox population trims the rabbit population (inverse relationship). The result is a balance of nature in which neither population can become too large relative to the other. Similarly, rising interest rates both result from GDP growth and place limits on it.

That doesn’t mean that the economy tends toward a steady state, however. The equilibrium can be a moving equilibrium, where variables remain in some balance while moving together. In a growing economy, supply and demand can increase together in both the goods market and the money market. GDP and national income grow, but interest rates can remain stable if the increasing demand for money is offset by a steadily increasing money supply. For that to happen, however, the markets for goods and money must sustain a delicate mutual balancing act. Since some of the growth in income is saved rather than spent, growth in the aggregate demand for goods requires increases in investment as well as consumption.  (Recall that Savings must equal Investment for supply and demand to balance.) But GDP growth encourages higher interest rates because of the increasing demand for money, and high interest rates discourage borrowing for investment and consumption. So economic growth requires the money supply to increase just fast enough to balance GDP growth and money demand; if not, the GDP growth won’t be sustained and the economy will have to contract. On the other hand, if money supply outruns GDP growth, interest rates fall, consumers borrow and spend too freely, and that results in inflation. A delicate mutual balancing act indeed!

The Hicks model helps clarify the role of government, which is a central feature of Keynesian economics. If the economy were self-regulating and always near general equilibrium, there wouldn’t be much for government to do, except balance the budget and slowly increase the money supply to accommodate growth. Increasing government spending would just raise interest rates, discouraging producers and consumers from borrowing and spending. (This is the basis for the old idea, criticized by Keynes, that government spending just crowds out private investment.) And increasing the money supply too quickly would just be inflationary (too many dollars chasing too few goods). But Keynes was interested in policies to repair economies that are not in equilibrium. If the economy is in recession, with interest rates too high, money too tight and aggregate demand insufficient to absorb productive capacity, a more expansionary fiscal policy or looser monetary policy may provide needed stimulus. Writing during the Great Depression, Keynes was well aware that economies could get seriously out of balance, and that public policy made a difference for better or for worse.

The Swan IB/EB Model

This model relates internal balancing within the domestic market for goods to external balancing of imports and exports in international trade. It is the model most directly relevant to the authors’ discussion of the global economic crisis.

As in the Hicks model, the internal goods market is balanced when demand matches productive capacity, maintaining full employment without inflation. The external goods market is balanced when exports are just large enough to pay for imports, with neither a trade surplus nor a deficit.

Once again, a change within either market triggers balancing processes in both markets. Graphic presentations differ, but the Temin and Vines version plots Domestic Demand on the horizontal axis and Real Exchange Rate on the vertical axis. (Since at equilibrium output equals demand, it is not a big change to plot Domestic Demand where GDP was in the Hicks model. It’s still equal to Consumption, Investment, Government Spending, and Net Exports.) The Real Exchange Rate is the price of the country’s currency on world markets. (Technically that is the nominal–stated–rate of exchange adjusted for the ratio of domestic prices to foreign prices, since either a higher nominal rate of exchange or higher domestic prices make a country’s goods more expensive on world markets.) The exchange rate is inversely related to global competitiveness, since a high exchange rate makes it harder to sell goods abroad.

The Internal Balance (IB) Curve describes a direct relationship between Domestic Demand and Real Exchange Rate. The higher the domestic demand, the higher the exchange rate at which demand will balance supply. Higher domestic demand tends to push up prices, making the real exchange rate higher even if the nominal rate remains the same. The nominal rate would also go up if a lot of the demand is coming from foreign buyers, pushing up net exports and the price of the currency foreigners need to buy them. But a higher exchange rate makes exports more expensive and imports cheaper, which brings the demand for domestic goods back down toward supply.

The External Balance (EB) Curve describes an inverse relationship between Real Exchange Rate and Domestic Demand. The higher the real exchange rate, the lower the level of domestic demand at which imports will balance exports. At equilibrium, the income earned from exports provides the means to buy imports. If a country’s currency is very strong (high exchange rate), that encourages a trade deficit by making exports expensive and imports cheap. But that trade deficit lowers the national income, depressing the demand for imports. Lower demand offsets the higher exchange rate and restores the balance of trade.

Once again, the point of general equilibrium is the point at which the two curves cross. In this graphic presentation, points to the right of the upwardly sloping IB curve represent inflation, and to the left unemployment. Points above the downwardly sloping EB curve represent trade deficit, and points below the curve represent surplus. The one point that is on both curves is the equilibrium.

In the Hicks model of internal markets, GDP growth stimulates a higher interest rate, which in turn limits GDP growth. In the Swan model of internal and external markets, domestic demand stimulates a higher exchange rate for the domestic currency, which in turn limits domestic demand. That doesn’t mean that demand for a country’s products can’t grow at all; it just means that growth is constrained by certain “other things being equal” conditions, in this case the success of competing economies in creating demand for their products. If all countries are increasing their production of desirable goods by the same amount, demand can rise everywhere and exchange rates don’t have to change to anyone’s disadvantage.

Now consider two trading partners, one whose goods are more in demand than the other. The one whose goods are more in demand is a net exporter with a trade surplus, and the other is a net importer with a trade deficit. The balancing processes should go like this: High demand for the exporter’s goods should increase its real exchange rate, making its exports more expensive and bringing the demand back down. In the other country, low demand for its goods should reduce its real exchange rate, making its exports cheaper and bringing demand up. Where exchange rates are free to adjust, trade imbalances should be self-limiting.

However, countries often resist adjustments to exchange rates. Some countries, like China, deliberately maintain a cheap currency to make it easy for other countries to buy their exports. Other countries, like the US, enjoy the buying power that a strong currency provides. And countries in the European Monetary Union share a common currency whose exchange rate may be set too high or too low for the economic health of a particular member state. In theory, real exchange rates can change through price inflation or deflation, even if nominal rates remain the same, but those changes may not be welcome either. Wage or price cuts that would make American goods more competitive may be resisted by labor or business.

Without appropriate currency adjustments, trade imbalances may persist, turning a net importer into a debtor nation and a net exporter into a creditor nation. Temin and Vines are especially interested in how these persistent external imbalances affect the internal balancing acts of nations, often resulting in economic crises. How would a country with a persistent trade deficit maintain internal balance, that is, full employment without inflation? How would it keep its industries operating at full capacity if foreigners aren’t buying its goods and its own citizens are buying a lot of imports? It could offset the low global demand for its products by increasing other components of aggregate demand. It could direct a larger proportion of its national income toward spending rather than saving. Its consumers could buy domestic as well as foreign goods by saving less, borrowing more and spending more. Government could encourage consumer spending by cutting taxes and holding interest rates low, as well as by keeping its own spending in excess of government revenue. Foreign saving and lending could help finance borrowing by consumers and government, as well as provide investment capital to compensate for the low rate of domestic saving. In this way, a debtor nation could grow its economy for a time. But when economic growth based on increasing indebtedness proved unsustainable, a severe contraction would occur. (Does any of this sound familiar?)

Temin and Vines argue that internal balance and external balance must be considered together. The story they tell about the global economy is largely a story of international trade imbalances perpetuated by unwise policy responses, which greatly complicate and ultimately overwhelm efforts to maintain balanced economies running at full capacity. I think that their perspective adds an important dimension to discussions of the recent financial crisis.

Continued

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The New New Deal (part 2)

September 5, 2012

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In my last post, I described the American Recovery and Reinvestment Act, as reported by Michael Grunwald in The New New Deal: The Hidden Story of Change in the Obama Era. Today I want to talk about the bill’s economic impact and political fallout.

The Recovery Act was first and foremost a short-term stimulus bill, so the biggest issue is its impact on job creation. President Obama signed the bill in February 2009, and the jobs outlook changed dramatically beginning in May. Net job losses had averaged 750,000 per month for the previous six months, but in the six months starting in May they averaged only about 300,000 per month. The economy didn’t actually start adding net jobs until early in 2010, but at least things were getting better instead of getting worse. More layoffs were being avoided or offset by new hires. The unemployment rate peaked at 10% in October 2009 and slowly began to fall. Economists generally credit the stimulus with saving or creating about 2.5 million jobs. In a labor force of about 150 million, that represents a reduction of about 1.7% in the unemployment rate, suggesting that it would have risen closer to 12% without the legislation.

Technically, the recession ended in June 2009, when the GDP began expanding again. The expansion was greatest in the states and industries that received the most stimulus money. The Center for Budget and Policy Priorities estimated that without the tax credits and other assistance to the poor, the poverty rate would have increased five times as much as it actually did. Grunwald says, “The leading independent economic forecasters…all agree that the stimulus helped stop the bleeding, averting a second depression and ending a brutal recession.”

The reinvestment side of the Act is also paying off, although the full benefits may not be seen for some time. The clean energy industry was struggling to get started in this country, since potential investors were put off by the high risks, the hefty startup costs, and the potentially long wait for results. The many projects funded by the Dept. of Energy allowed many promising ideas to be implemented. A company named Solazyme was now making and selling jet fuel produced by genetically engineered algae. By the end of 2010, the wind and solar industries employed almost 200,000 workers, more than the coal industry. Republicans maintained that federal investment would crowd out private investment, preferring instead low taxes on corporations and the wealthy to enable more entrepreneurship and job creation. (I think their argument would be more convincing if so much private capital weren’t already sitting idle.) Mitt Romney went so far as to accuse Obama of “killing solar energy by having the government play the role of venture capitalist.” Grunwald says that the truth is just the opposite: “The U.S. solar industry was on the brink of death before the Recovery Act, but it has expanded sixfold over the last three years.” The Act also had matching requirements that drew private capital into new industries rather than crowding it out.

Health and education also benefitted. The money that went into health information technology made it the fastest growing occupation, with over 50,000 jobs created. Comparative effectiveness research did identify more cost-effective treatments, such as a $50 drug that was just as effective as a $2,000 drug for treating macular degneration. Three million more low-income students got Pell Grants to go to college, and overall tuition aid more than doubled.

The Recovery and Reinvestment Act was not without its failures, the most publicized of which was the bankruptcy of Solyndra, a solar energy company that received a $500 million federal loan. It was a bipartisan failure in that the loan had first been proposed by the Bush administration before being approved by the Obama administration. One of Solyndra’s problems was that competition was bringing down the price of solar panels, and its panels were too costly. Another was that its Chinese competitors were getting even more government support than it was. Republicans charged but were never able to demonstrate undue political influence in the awarding of the Solyndra loan, but they did their best to characterize the entire loan program as an example of crony capitalism. To the contrary, Grunwald describes the stimulus program as a model of transparency and accountability, with a new independent oversight board and an online site where the public could follow the disbursements. The Office of Management and Budget was surprised by the nearly total absence of fraud in such a large spending bill. Knowing that loans to support risky new businesses wouldn’t all be repaid, Congress set aside $2.5 billion to cover losses, but less than that was needed.

Although Grunwald is largely supportive of the Recovery and Reinvestment Act, he is candid about its limitations. Recessions that are accompanied by severe shocks to the financial system take a long time to get over. Some of the fiscal stimulus was offset by spending reductions at the state and local level. Many projects took longer to get going than originally planned. For example, the home weatherization project was delayed by six months because Congressional Democrats wanted it covered by the Davis-Bacon law requiring federal projects to pay “prevailing wages,” although prevailing wages hadn’t yet been determined for such work. Other projects were long-term by their very nature, especially high-speed rail lines. I would add that some of the Obama administration’s “strategic investments” will have even more distant, less tangible and more controversial outcomes than commuter trains. Although the kinds of educational reform represented by Obama’s “Race to the Top” have a lot of bipartisan support, my hunch is that it will take a lot more than standardized testing and merit-based teacher pay to create environments in which disadvantaged children can learn.

Some of the limitations on stimulus were simply fiscal. At the end of George W. Bush’s presidency, forecasters projected a 10-year deficit of $5.6 trillion, in contrast to the $8 trillion surplus that had been projected when he took office. Running up more debt for the sake of fiscal stimulus was a tough sell. President Obama decided not to fight for a $450 billion transportation bill that could have helped revive the construction industry. He did fight for the American Jobs Act, known as “son of stimulus,” but by that time the Republicans controlled the House of Representatives and could easily block it.

The Recovery and Reinvestment Act itself was passed almost entirely without Republican support (no votes in the House and three in the Senate), despite the widespread calls for fiscal stimulus from groups like the Chamber of Commerce, Association of Manufacturers, the U.S. Conference of Mayors and the National Governors Association. The Republican caucus had become more conservative as swing-state moderates were defeated in the 2006 and 2008 elections. Republican leaders decided at the outset of the Obama administration not to accept the role of junior partner in any Democratic effort to improve the economy, even one that included almost as much in tax cuts as in new spending. They would condemn the stimulus as a waste of taxpayer money, hope it wasn’t too successful, and then run against the President’s “failed policies.” This strategy worked pretty well. Obama’s opponents ignored evidence of economic improvement and seized on any suggestion of waste. They made Solyndra the poster child for the entire bill. They ridiculed a study of primates undertaken to understand cocaine’s effects on the brain as “Monkeys Get High for Science.” (On the other hand, many Republicans who condemned the bill sought stimulus money for their own districts and took credit for the jobs that it created.)  The prospect that the government might help homeowners behind on their mortgage payments touched off an angry rant by CNBC commentator Rick Santelli, who called for a new Tea Party to oppose taxing the responsible to aid the irresponsible. With the election of many Tea Party candidates in 2010, further stimulation of the economy became impossible. Grunwald’s assessment: “The first two years of the Obama presidency were two of the most productive years in modern political history. Then in 2011, nothing happened….The recovery stalled while Washington was obsessing over spending and debt.”

Public perceptions of the “New New Deal” have not been based on very accurate or complete information. The economic benefits have been subtle, complex and poorly reported, while the opposition has been loud and simplistic. Obama himself said that the bill was “easy to caricature as a big-spending liberal agenda.” When he took office, the country was being engulfed by such a huge wave of layoffs that the stimulus could only reduce the damage, not reverse the trend right away. As Barney Frank says, “It would’ve been worse without me” doesn’t make a very good reelection bumper sticker. Before he took office, the President’s advisors projected that unemployment would reach 9% without a stimulus but remain under 8% with it. The truth turned out to be much worse: unemployment peaked at 10% with the stimulus but probably would have approached 12% without it. Critics could accuse the President of breaking his “promise” to hold unemployment below 8%, but that would have been quite an accomplishment considering that it was already at 8.3% in his second month in office, and rising rapidly. The President was unable to overcome the resistance to helping homeowners with their mortgages, and so he was blamed both by conservatives for trying and by liberals for not succeeding. He was also blamed for not singlehandedly achieving bipartisanship (I think that’s an oxymoron), since he was the one who had promised to change Washington. He didn’t even get credit for cutting taxes, since Republicans kept the debate focused on his proposal to raise rates for the wealthy rather than on his actual cuts for the working poor. The Making Work Pay tax credits were often unnoticed and underappreciated, since they came in the form of small differences in withholding (about $16 per week) instead of in a lump sum.

In the end, the President succeeded in improving the economy by getting a large stimulus bill passed, but he lost the battle for public opinion. The irony in this is that Barack Obama was thought of more as a “words guy” than a “deeds guy.” In office, he turned out to be better at legislating than selling his legislation to a skeptical public. Grunwald says, “Obama has the facts on his side, but so far, he doesn’t have the public on his side.”

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Posted by Ed Steffes

The New New Deal

September 4, 2012

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Michael Grunwald. The New New Deal: The Hidden Story of Change in the Obama Era (Simon & Schuster, 2012).

In this book, Time senior national correspondent Michael Grunwald provides the most comprehensive account to date of the 2009 American Recovery and Reinvestment Act, commonly known as the “stimulus” package. He calls attention to the large gap between what the legislation actually does and how it has been perceived by the American people. I’ll say more about that in my next post, but here I’ll start with the economic situation the bill was intended to address.

When Barack Obama took office in January 2009, the country was experiencing the worst economic contraction since the 1930s. Since the economy began shedding jobs in February 2008, 3.6 million jobs had been lost, and the unemployment rate had risen from 4.9% to 7.8%. In the first four months of Obama’s presidency, another 3 million jobs would vanish. Even before his inauguration, his economic team rushed to prepare legislation to counteract the downturn and put the country back to work. Congress passed the $787 billion American Recovery and Reinvestment Act in February 2009.

The Obama administration based its economic plan on the widely held “Keynesian” assumption that the federal government can stimulate aggregate demand for goods and services by temporarily spending more than it receives in revenue. Economists still debate how much Franklin Roosevelt’s New Deal saved the economy, but even if World War II spending did more to end the Depression, that’s still evidence in favor of a fiscal stimulus of some kind. Obama’s Recovery Act was more than 50% larger, in constant dollars, than the entire New Deal.

Obama’s advisors wanted the stimulus to be “timely, targeted, and temporary.” The money should go to those who were most likely to spend it quickly. So assistance to low-income people, such as tax breaks, extended unemployment benefits and food stamps, was a higher priority than extending the Bush tax cuts, which had returned more cash to the top 1% than the bottom 80%. Obama proposed the “Making Work Pay” credit for low-income workers, a “refundable” credit that gave money even to those too poor to have any income tax liability. Aid to state governments was also high on the agenda, since they could immediately use it to save the jobs of public employees. These fairly obvious forms of stimulus accounted for about three-fourths of the spending.

The President also wanted to use the economic crisis as an opportunity to make some “strategic investments” to improve American competitiveness in the global economy. The investment side of the Recovery and Reinvestment Act included a wide variety of initiatives in the areas of energy, health care, education and infrastructure.

The administration wanted to shift energy policy away from just using up our fossil fuels as fast as possible (we are using 25% of the oil being consumed in the world, but have less than 3% of the world’s oil reserves), and toward conservation, cleaner energy and less environmental damage. The Recovery and Reinvestment Act raised fuel efficiency standards, provided support for developing electric vehicles, set efficiency standards for light bulbs and major appliances, and financed the weatherization of hundreds of thousands of homes. The Department of Energy funded thousands of clean energy projects to help develop the solar, wind and biofuel industries, areas where the U.S. had been falling behind.

Initiatives in the health care area included a big push for electronic medical records to bring health information technology into the 21st century, and comparative effectiveness research to identify the treatments most worth spending money on. The President’s biggest health goal, making health insurance available to all Americans, was addressed in the Affordable Care Act of 2010.

Educational spending was based on the assumption that every child could learn if schools set high standards, adopted evidence-based innovations, and related teacher compensation to measurable results. The Act included money for the President’s “Race to the Top,” a competition among states to qualify for funding by showing how actively they were pursuing such reforms.

Finally, the Act funded improvements in infrastructure, many of which also advanced the cause of energy conservation. These included high-speed rail projects in several metropolitan areas, a more efficient energy grid, and greater access to broadband communications.

After his first year in office, President Obama was able to get only some small additional stimulus measures through Congress. The Republicans were calling for major spending cuts to trim the deficit, and Obama accepted a three-year freeze in discretionary spending. He was able to get a small bill to prevent teacher layoffs, and another to give tax breaks to small businesses. In the lame duck session after the 2010 election, he cut payroll taxes, extended unemployment benefits again, and got extensions to some of the other stimulus measures that were due to expire.

In my next post, I’ll talk about the impact of the “New New Deal” on the economy and on the political situation. Spoiler alert: It turned out to be pretty decent economics but pretty bad politics, at least in the short run.

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Posted by Ed Steffes

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