Deal?

Looks like there's an emerging debt ceiling deal that will likely pass both houses. Here's the gist:

- Debt ceiling increase of up to $2.8 trillion

- Spending cuts of roughly $1 trillion

- Vote on the Balanced Budget Amendment

- Special committee to recommend cuts of $1.8 trillion (or whatever it takes to add up to the total of the debt ceiling increase)

- Committee must make recommendations before Thanksgiving recess

- If Congress does not approve those cuts by late December, automatic across-the-board cuts go into effect, including cuts to Defense and Medicare.

No new revenues, and the usual "not done deal yet" caveats apply. But assuming it passes this is a huge victory for Republicans. For everyone wondering why they were acting so crazy up until now... this is why they were acting so crazy up until now.

I hope the Fed responds with QE3.

Sometimes Voters Matter

UT-Austin professor of government Sean Theriault makes an important point about the debt ceiling miasma: this is happening because of political audiences, i.e. voters:

In 2005, I published a book called "The Power of the People." In it, I made the simple argument that, contrary to the opinion of a growing number of political pundits, members of Congress are still -- as they have always been -- responsive to their constituents. ...

The general election brought us race after race in which these tea party candidates were running against moderate Democrats, the so-called "Blue Dogs." Some of these Blue Dogs fought against Obama's health care plan. Others fought against cap-and-trade environmental legislation. In fighting these plans, the Blue Dogs frequently made them more moderate.

It didn't matter how hard they fought these plans or that they voted against them because, in November, their constituents voted them out of office. Why? Simply for being Democrats. And because of those decisions in November, the Tea Party Caucus in the House of Representatives now has 60 members -- 60 automatic votes against any type of compromise to preserve the full faith and credit of the United States.

The problem with our deficit crisis today is that the message the voters sent -- and that the winning candidates heard -- was "never compromise, never surrender." We may need such a mentality on the battlefield, but we cannot have such a mentality in politics. Politics, after all, is the art of compromise.

During the Krugman/Crooked Timber fiasco a few months back I tried to make the case that the voters really do play a role in the way politicians act. It's not just elites in the media or business that influence legislators. On this issue all of those groups are on the same side. The Very Serious People universally want a deal done. The rentier class is not interested in a debt default or downgrade, and don't particularly care how it's avoided. And yet here we are. Why? The best explanation has to be that the representatives care about political survival, and their constituents want them to hold the line. For the Republicans, especially those in districts vulnerable to Tea Party mobilization, this means tying a deal to deficit reduction that includes no new tax revenues. And Boehner couldn't unite his own party behind any moderate version of that. McConnell's attempted punt, which would put all of the political heat on Obama, similarly failed. McCain is now calling conservatives in his own party "foolish", "deceiving", and "bizarro". But the Tea Party isn't interested interested in the merely feasible. For the Democrats, it means opposing entitlement reform and especially a balanced budget amendment. This is why Obama went on national television practically begging voters to contact their congresspeople, and then spammed the internet with literally dozens of Tweets passing on the handles of representatives to his millions of followers.

There are a lot of political issues where politics is conducted mainly behind closed doors. The video below describing the experience of Dodd-Frank is one of them. Highly-technical policies are especially prone to "quiet politics". But high-profile political issues like the debt ceiling/deficit battle are anything but quiet, and voters find it fairly easy to take sides. That doesn't mean that voters are perfectly informed -- it seems many have broken the debate down to a more spending/less spending false choice -- but they don't have to be to put a lot of pressure on their representatives.

The Daily Show With Jon Stewart	Mon - Thurs 11p / 10c
Dodd-Frank Update
www.thedailyshow.com
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Recent European Economic Developments Are Probably Related to the Euro

Krugman:

Some people commenting here seem puzzled by what I write about Europe. How can I write favorable things about the performance of European welfare states, then turn around and write negative things about European monetary policy and developments?

Ahem. These are different questions. I can say that Mr. X is a fine musician and a lousy tennis player; I can praise his taste in music and despise his taste in food. Europe has a lot to teach us about health care and the virtues of a strong safety net; but the single currency project was ill-conceived and is going badly. In fact, at the moment it is going very, very badly.

A few days ago he posted the above graph and wrote:

I’ve written a number of times about the weird way American perceptions of Europe seem stuck in the past. It’s common — especially on the right, but more broadly too — to see Europe as a land of stagnant economies and lack of jobs. This vision had some truth in the 1990s, but was becoming less and less true even before the crisis, which hit US employment much harder than European employment.

The graph clearly shows convergence has come along two tracks: the weakening US labor market and the strengthening European labor market. As Krugman says, this has happened since the 1990s. So what have been the two biggest events in the US and Europe since the 1990s? The Lesser Depression in the US, and... the introduction of the euro in the EU in 1999.

In other words, these might not be two different questions analogous to taste in music and taste in food if the improved European employment picture is related to the adoption of the euro. The two are certainly correlated. And if we were to ask ourselves why European employment has improved over the past decade, wouldn't the single biggest policy change over that period be at the top of the list of potential explanations?*

This could also help explain why the EU is fighting so hard to keep the eurozone intact, despite increasing domestic political pressure in both creditor and debtor countries. The last decade was very good for both the Eurocore and Europeriphery. Some of that prosperity was predicated on a lie, as Krugman rightly notes, but not all of it.

*Other contenders could be neoliberalish reforms made in many European countries, some related to euro-adoption and some perhaps not, in an effort to boost competitiveness and economic growth in the EU. These include privatizations, deregulations, and a weakening of some of the welfare state. I doubt Krugman would favor those explanations either, but I'm not sure what is left.

Inequality and Fiscal Deficits

A newish paper from Martin Larch at the European Commission's research office:

Fiscal performance and income inequality: Are unequal societies more deficit-prone? Some cross-country evidence

A bias towards running deficits is an entrenched feature of fiscal policy making in most developed economies.

Our paper examines whether this tendency is in any way associated with the personal distribution of income of a country. It takes inspiration from theoretical work according to which distributional conflicts may give rise to deficit spending or to delayed fiscal adjustment. Although these theories have been around for years the empirical literature on the determinants of fiscal performance has so far paid little or no attention to the possible role played by different degrees of income inequality.

Our results suggest that this neglect was not justified. Using cross-country data we find evidence that a more unequal distribution of income can weigh on a country's fiscal performance. These findings can be relevant in the aftermath of the post-2007 global financial and economic crisis in particular when designing fiscal exist strategies. The success and sustainability of such strategies may inter alia depend on their distributional implications.

Bigger May Be Different

Social scientists are trained to conceptualize the world in terms of linear relationships between normally distributed variables. This paradigm underlies current discussion about the consequences of a US government default. Although the US has never defaulted, we can draw inferences about the likely consequence of a US default based on the consequences of sovereign defaults in other countries. Small defaults have small consequences, median defaults have median consequences. Larger defaults have larger consequences. Because the US would be an extremely large sovereign default, the consequences of its default would be extremely large too.

Although the inference that bigger is bigger might be correct, I want to posit a non-linear alternative: bigger is different. One sees evidence that bigger was different in 2008. As the US financial system teetered on the edge in 2008, foreign capital flowed in and the dollar strengthened. As one prominent student of global capital markets has noted, this is exactly the opposite of what happens every where else. “In most emerging-market countries…bursting of domestic financial bubbles was accompanied by capital flight, which only exacerbated these countries’ financial crises by generating exchange rate depreciation and higher interest rates. But foreign funding of the United States—both public and private—continued during the crisis, even as the United States lowered interest rates dramatically. Indeed, the dollar even strengthened as the crisis became more severe after mid-2008.”* In 2008, bigger wasn’t bigger--more capital flight, sharper currency depreciation, larger interest rate increase. In 2008, bigger was the opposite.

One sees suggestive indications that bigger might be different now too.

• "David Joy, chief market strategist at Ameriprise Financial, believes that US Treasury debt could even rally…"
• "Others say it is likely that big investors in Treasury bonds—particularly central banks—would still show up to buy Treasury securities even in a crisis. With Europe already struggling, the US Treasury might still have no rival as a place to invest money.”
• Deborah Cunningham of Federated Investors in Pittsburgh put plans in place to deal with a default several weeks ago. “The firm will convene a teleconference with the boards of affected funds…and she is considering arguing for holding onto the federal debt. “We have to justify to the board why we would want to continue to hold them, which might be because they are a high-quality, minimum-risk security…The question I think investors are going to have to face is, Where do they go? Do they go to foreign banks? U.S. commercial paper? U.S. agencies? Is there a safer haven than Treasury securities?"

Admittedly, a few quotes are not evidence. But these quotes hint at a causal mechanism that makes bigger different--mutually reinforcing individual (psychological) and social (network) characteristics. Individual participants seem to believe that US Treasuries remain safe in spite of a default or downgrade. These beliefs are reinforced by a global financial system that offers no better alternatives to US Treasuries (in large part because there has been no need for an alternative). Neither proposition applies to Greece (or to Spain, or to Portugal). No one believes that Greek debt is safe, even with an EU bailout. The global financial system provides plenty of alternatives that are far safer Greek debt. The psychology is different, the market structure is different. Bigger may be different.

I don’t know if bigger is different. Nor, if bigger is different, do I believe that it conveys immunity; different means that US sovereign default need not trigger an apocalypse—it does not imply that it cannot trigger one. What I am suggesting is that market participants might react differently to developments in the United States than they do to similar developments in other countries. Different reactions may generate fundamentally different outcomes. Bigger may be different.

*Eric Helleiner. 2011. "Understanding the 2007-2008 Global Financial Crisis: Lessons for International Political Economy."Annual Review of Political Science 14(1): 81.

Shifts

Dani Rodrik has a couple of posts [1, 2] and an op-ed describing how, for the first time, growth in developing countries is outpacing growth in developed countries. Arnold Kling links this to the current US economy:

Again, I want to suggest that there is a connection between this trend and the stagnation of median incomes in the United States, and even to the decade-long drop-off in employment here. New patterns of trade are developing that are reducing the advantage that a person enjoys merely for being located in the United States. There still are advantages, as evidenced by the excess supply of people who wish to immigrate herte. However, the Great Factor Price Equalization is underway, thanks to the fall of Communism, the rise of the Internet, and sporadic progress in institutional development in the emerging-market countries.

Remember that only 2% of jobs created in the US over the past 20 years have been in tradable sectors, and that while US manufacturing output has kept increasing, manufacturing employment has declined [1, 2, 3 and see comments]. Over the past 20 years, the global industrial labor force has increased by several billion in India, China, and Eastern Europe. How could there not be some convergence?

The two questions I'm most interested in are: 1. Will this convergence be sustained over a long period of time; 2. What will the effect be on politics? Regarding #1, as Rodrik mentions in his op-ed, if history is any guide there are good reasons to be doubtful. Sustained growth, particularly among low- and middle-income, has been rare. This is especially true for those that have grown via high commodity prices or other exports to developed countries that now suffer from depressed demand. Regarding #2, the effects will obviously be asymmetrical across countries, but we've seen interest groups pressure many governments over currencies, trade protection, investment policies, and growth concerns. I don't see those pressures lessening in the near term, especially if the global economy re-enters crisis mode.

The chart illustrates ownership of US government debt at the end of December 2010. US ownership is subdivided by category, foreign ownership by country. The foreign data are not broken down in to categories, but TIC indicates that 3/4 of foreign-owned US government debt is held by public authorities. The domestic data come from the June 2011 Treasury Bulletin and the foreign from the Treasury TIC. More recent data on foreign ownership exists. I could not find more recent data for US ownership. If I have mis-interpreted this data, someone please point this out.

By these figures, about 63% of US government debt is owned by central banks (foreign and domestic) and/sovereign wealth funds. Most of these entities are American friends and allies. Another 4% is owned by US state and local governments. That leaves 33%--about $4.8 trillion--in private hands. Of this, the financial institutions with the most restrictive regulations regarding asset ownership (depository institutions) own only 2% of the total ($290 billion). Mutual Funds, who may or may not have to dump downgraded debt, hold another 9% ($1.35 trillion).

What's the point? The discussion about the impact of US default revolves around the market response to default. Useful to recognize that most of the US government debt is held by public-sector agents who are much less sensitive to balance sheet pressures and regulatory constraints. These public sector agents are also substantially more sensitive to "moral suasion" and direct appeal than private financial institutions. The structure of ownership of US debt might dampen the negative impact of any default that does occur.

Hard Keynesianism Is Not Politically Sustainable

Alex Tabarrok comes out in support of Hard Keynesianism:

... I propose an unbalanced budget amendment.

The unbalanced budget amendment is a requirement that in good times the government must run a budget surplus. The virtues of such a rule are that it allows for counter-cylical fiscal policy during a recession. Indeed, it reduces the cost of counter-cyclical fiscal policy because it guarantees a reserve fund for just such emergencies. The unBBA is thus a type of automatic stabilizer of the kind I have argued for before (e.g. here).

A simple version of the unBBA requires surpluses but more generally the rule would be a surplus or a similarly sized reduction from the previous year’s deficit. The size of the required surplus/deficit reduction would be tied to a function of current and recent GDP growth rates.

John Quiggin and Henry Farrell argued in favor of this sort of thing for the member states of the eurozone, which I discussed previously here and here. I will just add that most of the US states have a version of this requirement, and it mostly didn't help cushion them from this recession. In other words, this kind of rule is unnecessary for dealing with small recessions, and impossible to uphold during large recessions.

One technocratic argument in favor of an unbalanced amendment would be to prevent the sort of deficit build-up that commonly prefigure financial crises and/or recessions. Thomas may wish to say more about that. In general, I think the answer is that such an amendment will never be passed de jure for the same reason that the policy is not implemented de facto: there is no constituency for it, and there are plenty of constituencies for higher spending and/or lower taxes. States face legal fiscal constraints because everyone understands that in the end the federal government is on the hook, so there's moral hazard. The same dynamic does not apply at the national level.

GOTD

Wow:



Via Uwe Reinhardt, who breaks it down:

Jobs in the tradable sector were added primarily in high-value services. They were lost in manufacturing, through outsourcing of the lower value-added components of the value chain to other countries.

The net effect has been that of the 27.3 million jobs created in the American economy from 1990 to 2008, only 662,000 new jobs were added by the tradable sector. That is only 2.3 percent of total job creation in the economy.

I assume that's gross, not net. This is in line with my view of (no) Great Stagnation, and see also this post from Will Wilkinson. Here's another worrying bit from Reinhardt:

Thus it is not surprising that ... close to 98 percent of the 27.3 million new jobs in the American economy in the last two decades were created in the nontradable sectors, led by government and health care in first and second place.

These two sectors alone accounted for 40 percent of the total job growth over the last two decades. They were followed by retailing and construction, both of which grew on the back of heavy debt financing and a real-estate bubble.

The American people look to the president and Congress to create jobs — or, more precisely, to create the economic conditions in which job growth occurs.

At the same time, the American people now look to the president and Congress to rein in government spending in general and health-care spending in particular, at a time when a sizable deleveraging by consumers and business has sharply put the brakes also on retailing and construction.

So how can these desiderata –- creating jobs and, at the same time, cutting back on government and health care spending –- add up to a rosy future jobs picture? Can any government actually deliver on these conflicting goals?

I'm slowly being persuaded by Karl Smith's argument that a construction boom is looming, and Ryan Avent's general optimism about the economy. I still believe that trade is a large net plus for the US. But the US economy has been shifting over the past two decades, and it will continue to do so. I expect GDP growth to rebound from its current doldrums, but not necessarily in an especially egalitarian way. These shifts and changes lead to political shifts too, and we've been witnessing those as well. It may be awhile before we find the new equilibrium -- I suspect it involves a shift to more social democracy -- and in the meantime we may be in for some more pain.

Score One for the Oatley "Maybe No Big Deal" View

See this Krugman post on Japan's 2002 downgrade.

UNC Everywhere

UNC poli sci prof Frank Baumgartner and co-authors introduce a special issue of CPS:

Abstract: Major new understandings of policy change are emerging from a program to measure attention to policies across nations using the same instrument. Participants in this special issue have created new indicators of government activities in 11 countries over several decades. Each database is comprehensive in that it includes information about every activity of its type (e.g., laws, bills, parliamentary questions, prime ministerial speeches) for the time period covered, typically several decades. These databases are linked by a common policy topic classification system, which allows new types of analyses of public policy dynamics over time. The authors introduce the theoretical and practical questions addressed in the volume, explain the nature of the work completed, and suggest some of the ways that this new infrastructure may allow new types of comparative analyses of public policy, institutions, and outcomes. In particular, the authors challenge political scientists to incorporate policy variability into their analyses and to move far beyond the search for partisan and electoral explanations of policy change.

Dodd-Frank's First Birthday

Mike "Rortybomb" Konczal interviewed Economics of Contempt to discuss Dodd-Frank one year on. There's some good stuff in there. Most relevant for readers of this blog are these parts:

The big financial firms have been coordinating [lobbying efforts] well with each other on some issues and throwing each other under the bus on other issues. Due to the sheer range of issues being addressed in the Dodd-Frank rulemaking process, this was inevitable. Big foreign banks have different incentives than big US banks on some issues (e.g., extraterritoriality), but they’re aligned on other issues (e.g., clearinghouse ownership). To be honest, I’ve seen more coordination between the major banks than I expected, but I think that’s primarily because the trade associations (SIFMA, Financial Services Roundtable, ISDA, etc.) have been so eager to get paid and stay involved.

The fact that firms in the same sector would have different preferences (at least in some areas) is an area that political scientists haven't spent enough time on. I presented an early draft of a paper at ISA this spring that tried to get at some of that, but I haven't gotten very far just yet. The role of the trade associations in actively seeking to coordinate behavior would not surprise those who study institutions and institutional behavior.

As you say, the “Dodd-Frank didn’t go far enough” crowd tends to think that one of the main reasons why the major banks should be broken up is that they have a dangerous amount of political power. I think that the big banks’ political power, especially after the crisis, is massively overrated by pundits, and I think the interchange vote proved this. The big banks spared absolutely no expense in trying to roll back the Durbin Amendment (i.e., the interchange rules). The big banks mounted an all-out, eight-month lobbying campaign against the Durbin Amendment, and they even had the powerful community banks on their side. But they still lost the vote.

It's easy to come to the conclusion that Goldman Sachs is a vampire squid (or is it evil octopus?) whose tentacles rules the world. And the banks do have more influence in D.C. than most, and there are a whole host of programs and policies that benefit them. But that influence still has limits. In the past year or so, we've seen the enaction of Dodd-Frank, which is a significant re-regulation of the domestic financial system, and the agreement of the new Basel accord.

One of the problems with lamenting the “financialization” of the US economy is that no one ever explains what they would consider a successful de-financialization. Finance is a global industry and US financial institutions provide significant financial services to foreign investors. It’s also fair to say that the US has a comparative advantage in financial services. So given that comparative advantage, and the global nature of the financial industry, where is the line between a healthy US financial industry and the unhealthy “financialization” of the US economy?

This is true. The US does have a comparative advantage in finance (and other high-end services), and specializing in your comparative advantage is what every econ textbook says to do. This can lead to other problems -- including shifting political influence from labor to capital, increasing income inequality -- but any call for a definancialization of the US economy must include some argument about what can replace it and still be successful in a global marketplace. In other words, it has to make the case that the US has some other comparative advantage that it is not exploiting. And I don't know what that would be.

In another interview, Rob Johnson is less sanguine:

For Wall Street, [the year since Dodd-Frank passage] has gone swimmingly. They have the process tied in knots and at the same time can complain about the muddle to further weaken government. For the rest of us, a weak bill is getting diminished further. It is the fate of money/lobby-driven political machinations to make everyone disenchanted with government. ...

It will be compromised and weakened regardless of whether Democrats or Republicans hold power. ...

It will have been a reflection of how powerful the financial sector was. Finance is too strong in politics, bailouts, and corporate governance imperatives. They are like a tax that descends upon society, collected for the bonus pool and used to defray the losses from past carelessness. The social contract between the financial sector and society is a pendulum rocked very far to one side. This tepid set of reforms in the aftermath of a colossal crisis will underscore how far the power of finance dominates our political economy. Inside Job indeed!

Wall St. Is Worried About Default, But Still Expects a Deal

CDS on Treasuries have more than doubled in the past two months. And that's not all:

On Wall Street, Treasuries function like a currency, and investors often use these bonds, which are supposed to be virtually fail-proof, as security deposits in their trading in the markets. Now, banks are sifting through their holdings and their customers’ holdings to determine if these security deposits will retain their value. In addition, mutual funds — which own billions of dollars in Treasuries — are working on presentations to persuade their boards that they can hold the bonds even if the government debt is downgraded. And hedge funds are stockpiling cash so they can buy up United States debt if other investors flee. ...

Volatility in stocks has soared, and some investors say stock prices are falling because a United States default could severely raise companies’ costs of doing business.

In the Treasury market, investors are starting to sell, fearing that the government will not make good on some interest payments that will be due next month. And complex financial instruments that will pay out if the United States defaults have become twice as expensive to buy as they were at the start of the year. ...

“The metaphor is a pile of sand,” said Mark Zandi, the chief economist at Moody’s Analytics. “You keep putting one piece of sand on the pile, nothing happens, and then, all of the sudden it just caves.”

I will say that I'm surprised that the market reactions haven't been stronger. I still believe (mostly without evidence) that the markets expect a deal to get down, as do I. As I write this, the top headline on most news websites is that Obama and Boehner are close to a deal, and the markets are up big. Of course I don't want to read too much into that, but look at the betting markets. Right now, Intrade has the chance that Congress passes a deal before midnight on July 31 at only 39%, but the odds that Congress passes a deal before midnight on August 31 at 72%. Remember that the deadline for avoiding default is August 2. So betting markets seem to expect a deal in the 11th hour, which is also what I expect.

I still worry about the trembling hand, however.

This Can't Be True

Hannah Kuchler at FT Tilt:

China is celebrating its first ever victory at the World Trade Organisation after the European Union was found to be discriminating against Chinese nuts and bolts.

China has won WTO cases before. Perhaps the author means that this is the first victory for China against the EU:

And it marks a victory for China -- the main target of anti-dumping measures, or duties on imports judged to be sold for less than they cost at home -- in its first trade dispute against the European Union since joining the WTO in 2001.

But even that can't be true... China and the EU have had numerous trade disputes.

I'm confused. Is this the first time that China has won an anti-dumping case against the EU? Is this a first anything? I have no idea what these articles are trying to say.

This Isn't Hyperbole

In a post below, Dr. Oatley makes the case that a US debt default won't be earth-shattering. It's a good post, and notes that previous debt ceiling line-toeing -- including one instance of accidental default -- hasn't had catastrophic effects. I agree completely with his point that as a bargaining strategy it makes sense for the House GOP to take an extreme position. I've made similar points before. But I think Oatley is discounting the downside of a US default quite heavily. There are a number of reasons for this.

First, the US has to rollover $500bn of debt in August alone. Suppose that interest rates go up by 60 basis points, as a study Oatley cites argues occurred following the 1979 technical default. That would cost the US $3bn in borrowing costs next month. But there is no reason to think that this would be the only cost. The 1979 default was an accident caused by a technological mistake. A default today would be an intentional choice made by a recalcitrant legislature. The reason why everyone expects a much bigger market response is because this time really is different. Oatley doesn't think so:

In other words, markets might distinguish between a sovereign default caused by massive over-borrowing and collapsing export revenues (where the likelihood of being made whole is zero) and a technical default by the United States (where the likelihood of not being made whole is zero).

Perhaps, but in this case the likelihood of not being made whole is not zero. It's much higher than that. And while interest rates haven't jumped in anticipation of default risk, that doesn't mean the effects would be slight. If the "catastrophe" view is correct, there may not be a way to price in that sort of risk. Or perhaps markets are convinced that a deal will eventually get done, despite the brinksmanship. In any case, I'm not quite as ready as Oatley to accept that just because interest rates haven't spiked financial markets don't think a default would be a big deal. That's not what financiers are telling legislators. They're scared and getting angry.

As I wrote before, the financial system could be devastated by a debt downgrade. The financial system depends on having a lot of liquid, high-quality collateral. If Treasuries can't serve that function it wreak havoc on balance sheets and cause another panic. I'm actually less concerned about the effect of default/downgrade on government borrowing costs as on the financial system, and a newly-disrupted financial system is not what the economy needs right now. Nothing in Oatley's post reassures me on that front.

Beyond Hyperbole

First a little history.

April 3, 1979

The House of Representatives today approved an increase in the national debt's ceiling to $830 billion...ending a threat that the nation would default on its bills for the first time in history.

There have been previous crises over the debt ceiling...This time, the situation was more serious because the technical elements of debt management became more embroiled in the political controversy over a balanced budget...

The bill approved today did not go as far as Republicans had wanted in legislating a balanced budget...Representative Barber B. Conable of upstate New York...said, "All we want is to create a little presumption in favor of a balanced budget."

" U.S. Debt Ceiling Raised; Threats of Default Ended," By CLYDE H. FARNSWORTH New York Times Apr 3, 1979; pg. A12

March 29, 1996

After the Republican leadership threatened for six months to prevent the United States from borrowing billions of dollars more to keep the Government running, today's votes to raise the Federal debt ceiling were a strategic victory for Treasury Secretary Rubin. Mr. Rubin had warned for months that the Republicans were threatening the Government's credit rating. Several of the...leading credit-rating agencies agreed with him, warning investors that the political gridlock could interfere with the Government's ability to repay them.

Initially, Republican leaders dismissed Mr. Rubin's warnings as scare tactics. Some freshman Republican members even talked about impeaching the Treasury Secretary for taking a number of extraordinary steps...to keep the government afloat while Republicans tried to force President Clinton to make concessions.

"Brinksmanship to Victory," By DAVID E. SANGER New York Times Mar 29, 1996; pg. B11

It seems, therefore, that the contemporary standoff over the debt ceiling isn't novel. Bargaining theory suggest that both sides in these discussions have incentive to commit to extreme positions. The Republicans need to convince the administration that someone is willing to push the U.S. into default. The Republican leadership thus has strong incentive to push people with extreme views to center stage. The administration needs to convince the Republican leadership that defaulting would be far, far worse for them than a tax increase. The administration thus has incentive to paint the consequences of a technical default as financial apocalypse. Pegging yourself to the extreme is the only way to avoid being driven to your least preferred outcome.

In the past, both sides have found a way to walk back from the extremes and find agreement somewhere in between. Typically this agreement occurs at the zero hour. Why would it come earlier? Of course, past performance in no way guarantees future results, as they say, so things may turn out different this time around. But even if agreement proves elusive, financial apocalypse need not be the result. Indeed, I am puzzled by how people can be so certain about the consequences of an event that has never occurred. Moreover, these doomsday scenarios are hard to reconcile with the little bit of evidence that we do have.

The two observation we have to draw on suggest a more moderate conclusion. In late March and early April 1979, technical problems caused the Treasury to default on a few T-bills. According to the only published paper (gated) to have studied this episode, interest rates on T-bills rose by 60 basis points. The authors assert that this increase was permanent (or at least persistent). This sounds big; in fact it constituted a six percent increase in borrowing costs--rates on T-bills rose from 9.1 to 9.7 percent. Were this to occur today, a six percent increase of the current 3-month T-bill rate would raise borrowing costs by... nothing (.06 x 0 = 0). This seems anti-apocalyptic.

A similar analysis of the 1995-96 standoff (ungated) reached a very similar conclusion. This study explored whether bond markets anticipated default in the spring of 1996 and thus imposed a risk premium. They find evidence of such a risk premium, but find also that the premium was largest for 3-month bills, smaller for 6-month bills, and non-existent for 12-month bills. The authors concluded that these findings might suggest that although "the market is concerned about the budget crisis in the near future, it also believes the standoff will not stretch out into the distant future" (page 262). In other words, markets might distinguish between a sovereign default caused by massive over-borrowing and collapsing export revenues (where the likelihood of being made whole is zero) and a technical default by the United States (where the likelihood of not being made whole is zero).

What seems to have happened in the past, then, is that political deadlock in debt ceiling negotiations leads markets to charge slightly higher interest rates when they lend to the US government. This seems reasonable. It also seems quite far from a doomsday scenario. Does this very slender evidence speak directly to current affairs? One can't know. However, markets don't seem to be spooked, at least not by the American situation. One would think that we would see some sign of impending doom. Higher interest rates at auctions? Sharply falling bond prices in secondary markets? No, instead we see negative yields on US T-bills of less than 3 months. Markets are so concerned about US default that they are willing to pay the US government for the privilege of holding US debt. Perhaps we are still too far from the event to expect a market reaction. Perhaps as Treasury's cash runs down and agreement remains elusive, markets will begin to stir and the world will collapse. Only time will tell.

In the meantime, we might contemplate the purpose of a reputation. The US can borrow at negative interest rates not because it never faces obstacles to repayment, but because it makes its creditors whole in spite of any obstacles it faces. And it might well be precisely this determination to make its creditors whole that prevents a bargaining stalemate over the debt ceiling from precipitating financial doomsday.

The Coming Unnecessary Disaster

I've recently had a few people ask me what the big deal is about the debt ceiling. A little default couldn't be that big of deal, right? And who cares what the ratings agencies think? I've found it distressingly difficult to get across just how serious this is. So let's start with this excellent primer from Ezra Klein:

It all comes back to U.S. Treasury bonds, which are the foundation of almost all other financial products — the base of the global financial pyramid.

If the federal government’s borrowing costs rise, so will everyone else’s. Mortgages rates will jump, car loans will be harder to come by, universities won’t be able to float bonds, cities won’t be able to fund themselves.

Treasuries are supposed to set the rate of “riskless return” — the price of loaning someone money and knowing, with perfect certainty, that they’ll pay you back, with interest. So when lenders decide how much to charge, they start with the riskless rate and then add to it to cover the risk that you won’t pay them back, and the inconvenience of having to wait for you to pay them back.

It’s a practice called benchmarking, and it’s everywhere: in your mortgage, your credit card, your car payments, the loan you took out to hire three new employees at your business. It’s even common internationally. The fact that Brazilian loans tie themselves to the American government’s debt just shows the high esteem in which the world holds us.

The most basic financial pricing formulas, the ones you learn about in Finance 101 like CAPM and Black-Scholes, depend in large part on a riskless, liquid baseline financial asset, which has long been understood to be US Treasuries. In other words, if T-bills are no longer "riskless", then the value of basically every financial instrument in the world comes into question. As I've mentioned previously, a Treasury default will make current financial regulations, which rely on risk-weighting to determine capital requirements where Treasury debt has a 0% risk weight, more or less meaningless. And because all of this is networked together, it can lead to big problems.

“There’s a whole credit structure,” says Pete Davis, president of Davis Capital Investment Ideas. “Think of it as roads and bridges, but it’s finance, it’s all connected, and it’s all on top of Treasuries. . . . So when you shake the basis of it, everything on top of it shakes, too.”

Or let's put this another way. If you thought things were bad when investors became convinced that Lehman Brothers and AIG were not as safe as they'd thought, what do you think will happen when people think the same about the US government? This has the potential to be very devastating. Klein puts it well:

Running in the background of every day’s trading is the accumulated wisdom of an almost endless number of calculations: How much money does J.P. Morgan Chase have? How likely is Des Moines, Iowa, to pay its bills? What will interest rates be next year? How many people will buy homes in 2013?

These calculations undergo incremental updates almost constantly. That’s fine. Occasionally, they need to be dramatically updated. That’s manageable. But if they all need to be updated at once, and if no one really has the information to update them because Treasuries are suddenly unreliable? That’s catastrophe.

And it's a catastrophe that doesn't need to happen. The ratings agencies appear to be more spooked about the US political process than real pressures on sovereign debt. And for good reason. The US government can borrow for the next five years at negative real interest rates. Literally. Other people will pay us to take their money:



Moreover, unlike other countries the US can borrow -- again, at negative real interest rates -- in its own currency. We don't have to worry about exchange rates or some technocrats in Frankfurt. This could be due to the dynamics I discussed earlier, in which there appears to be a shortage in high-quality investment assets. Regardless of the cause, we are flirting with a disaster the severity of which very few people seem to understand for no good reason at all.

The Bond Vigilantes are no longer invisible... they're just in the form of ratings agencies rather than bond markets. And we need to take them seriously. There's a reason why other countries are trying everything, including dispatching riot police to combat thousands of protesters, in order to avoid default. It's a very bad thing. It's a big mistake to treat it so flippantly.

We're Missing A Mechanism

Felix Salmon:

The big-picture thing to remember when looking at this chart is something which I’ve said many times before — that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. On a micro level, triple-A securities are safer than any other securities. But on a macro level, they’re much more dangerous, precisely because they’re considered risk-free. They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage.

Much more at the link including the mentioned chart. Brad DeLong has made similar points in the past, and Tyler Cowen links to related discussion of how demand for AAA assets shifted to sovereign debt when it became clear that much AAA-rated ABS wasn't in fact AAA. Now of course there is a lot of trouble with sovereigns.

What we don't have a clear sense of is the mechanisms driving all of this. Is it a global movement towards safety beginning in the 1990s? Is it regulatory response, since both high-quality securities and OECD sovereign debt are privileged in the Basel accords?

From an IPE perspective, there appears to be insufficient supply of risk-free assets, which the US Treasury used to be able to provide. Unfortunately, the debt ceiling political theater has reduced that capability, which could have an adverse effect on the global economy and financial, not just the US economy and financial system. I'm very nervous about the state of the world right now.

Politics of Default for the Cynical

John Sides Joshua Tucker has a post on whether political science literature would/could predict that the Republicans would intentionally sabotage the economy in order to increase the chances that Obama loses the 2012 election. It's a fine discussion, but I'd like to add a few things related to the whole idea of economic voting, while acknowledging that this is not my area of expertise so it could all be wrong.

1. There's a fundamental assumption embedded in the economic voting literature that representatives are trying to manage the economy well, or at least well enough. When one party fails at that task, voters give another party a turn. In a situation in which the opposite is happening -- in which one party is openly trying to destroy the economy while the other is trying to save it -- the economic voting literature gives no reason to expect voters to reward the saboteurs. It violates the most core assumption of the basic model, which is that voters reward good governance (or at least good outcomes that are attributed to good governance). Tucker kind of gets at this in his last paragraph, but fails to drive home the point.

2. This may depend on how obvious the sabotage strategy is, and the particular frames voters use to interpret it. In this case I think it's pretty obvious. If Congress doesn't raise the debt limit, and the economy collapses, it'll be hard for Republicans to run and hide. McConnell's quote that his #1 task was to defeat Obama in 2012 rather than govern well will be in every Democratic advert. Cantor's short position on US debt will be shouted from the rooftops, and possibly investigated. Limbaugh's quote that he hopes Obama fails would be oft-repeated. Obama can say "I wanted to keep the Social Security checks flowing, I wanted to to not blow up the financial system and increase the costs of servicing our debt, but the GOP Congress wouldn't pass a bill allowing me to do it."

3. As Tucker says, many interest groups in the GOP camp are opposed to a shutdown/default. If the Chamber of Commerce and American Bankers Association as well as every economist in the world tell the GOP leadership that default is a bad idea, and the GOP goes against them anyway, well then that could be explosive.

4. This is where the McConnell gambit comes in. The GOP may decide that kicking the can down the road, with plausible deniability ("we voted against it!"), might be their best strategy. Obama opposes this strategy. Neither Obama nor the GOP is acting like a shutdown/default -- as opposed to signaling and theater -- is in the best interests of the GOP.

5. Tucker cites the Clinton shutdown in 1995 as Tucker's co-blogger John Sides has done before, but I think a few things need to be said about that. For one thing, the economy is in a very different place. For another, while Sides has presented evidence that the shutdown didn't benefit Clinton (see the graph at the link) what I see from that time series is a relatively minor downtick in Clinton's approval that quickly reversed after the shutdown ended, after which his approval continued to grow leading up to the election. To the extent that the Republicans are less concerned about Obama's approval in August, 2011 than November, 2012, Sides' previous analysis doesn't tell us all that much. In 1996 Clinton won re-election easily, while the House GOP lost some seats. That isn't proof of anything, but while the shutdown might not have helped Clinton it doesn't seem to have hurt him either. It certainly doesn't seem to have helped Gingrich or Dole.

Update: I got posts by Tucker and Sides confused. I think they're straightened out now.

More on US Manufacturing and Productivity

Continuing the discussion from here and here (see comments) of US productivity, manufacturing capacity/activity, and what that means for both the domestic and global economy, David Steinberg pointed out that while total US manufacturing output has gone up, and US share of global manufacturing output has stayed surprisingly high, there's something else to consider:

I agree that the US's share of global manufactured production is the relevant measure regarding American control over global production. But, from what I can tell, the main reason why most people worry about the decline of manufacturing is the belief that the manufacturing sector has higher productivity than services (e.g. Rodrik's stuff). And if that is what worries you, then the manufacturing sector's share of GDP is the "better" measure. Maybe that's just my bias though.

If the worry is about productivity, then the data we're looking at should encourage us. After all, it shows that we're producing a lot more with a lot fewer workers... that's the definition of a productivity increase. But, as Steinberg says, we could be beneath our potential if we aren't using our workers in the most productive mixes. So take a look at this chart:



From the BLS via the Fed, which has a nice interactive tool at the link allowing you to compare sectors. I'm guessing the straight line for manufacturing pre-1986 means that these type of data weren't collected before then by the BLS, but in case the trend is pretty clear. Per-worker output has been going up for both manufacturing workers and those in services. Manufacturing productivity has risen fastest, which is I think part of what Steinberg is referring to (via Rodrik) but it's not clear that productivity in those industries is much higher than in non-manufacturing industries. Productivity growth has been faster there, but remember that we've been shedding workers during this period; those are likely the least productive workers. It's not immediately obvious that we could add a bunch more workers to that sector and keep productivity levels the same. There's some evidence and argument that quite a lot of these potential manufacturing workers generate very low marginal product. Meanwhile the marginal cost of hiring them remains relatively high. Automating a lot of simple tasks has made some workers's skills surplus to requirements, and offshoring to lower marginal cost workers for low-productivity tasks has further hurt those with few skills.

One (possible) way to think of these dynamics is as follows: the US economy is left with a high-skills, high-productivity economy in tradable industries. Those with lower skills get pushed into non-tradable sectors that are not easily automated, where their lack of productivity doesn't make them uncompetitive. Maybe that's okay if there are lots of jobs in construction or services, but it tamps down middle class wage growth while boosting high-skill wage growth, thus leading to more inequality.

If this is close to true, then we ought to see some political organization across sectoral lines, and some across factoral lines. Across sectors, we should see support for trade openness in nontradables and high-productivity sectors. Across factors, we ought to see a lot of opposition to immigration of low-skill workers from workers in nontradable sectors, but support for immigration for capital in those sectors. We should see more of the economy shift to high-skill services. We might expect a stronger social safety net too. To greater or lesser extent all of those have been present in the politics of the US over the past 10-15 years.

Has there been any research done on the politics of productivity?

No One Could Have Predicted This

Today we see that banks are worried about their exposures to sovereign debt from Europe, especially now that Italy is wavering.

Yesterday, we saw that banks owned so much sovereign debt because it was well-rewarded in the regulatory code. Of course that happened because governments write the regulatory rules, and governments want to stack the deck to make sure they have access to plenty of cheap funds with which to fund spending programs. They do that by privileging sovereign debt in the regulatory requirements, specifically the risk-weights given to debt assets in the capital adequacy standards.

This is no surprise, but it's worth taking a step back every now and then to consider what's going on.

Would A Yuan Appreciation Narrow the Trade Imbalance?

Probably not:

Moreover, the impact of higher dollar prices for Chinese goods might well be to raise the U.S. import bill. In particular, U.S. spending on Chinese goods would rise unless higher prices induced a proportionately larger decline in import volumes. For example, if a 10 percent rise in the price of Chinese products resulted in only a 7 percent decline in the volume purchased, spending would rise by roughly 3 percent. Significantly, empirical studies have been as likely to find that higher prices raise U.S. import spending as lower it. Regardless of the direction of the spending impact, these offsetting price and volume effects imply that the impact of a Chinese currency appreciation on U.S. import spending would be small.

Finally, the impact of a stronger renminbi on U.S. imports would be limited by the fact that most goods purchased from China come from industries in which U.S. producers no longer have a substantial presence. Indeed, out of more than 400 detailed production categories, 60 categories account for some 80 percent of U.S. purchases from China. The same 60 categories account for less than 15 percent of U.S. manufacturing shipments. With little U.S. capacity at the ready, higher Chinese import prices might be more likely to spur increased imports from Korea or Vietnam than increased U.S. production. If so, a smaller U.S. trade deficit with China would be offset by larger deficits with other countries.

The last point is key, I think. I'm not as concerned about the short-run elasticities as the long-run structural issues.

"Ohhh Buh-yam!" of the Day

Stephen Williamson, on the Krugman-Cochrane rivalry:

It's likely that, in the absence of his Krugman-critique, Cochrane would never have appeared on Krugman's radar screen, much like the rest of the the economics profession or, indeed, economics in general. However, Cochrane now has a place of honor on Krugman's list of bad guys, and serves as a convenient foil, particularly given his University of Chicago affiliation.

I still think this is basically theater.

OT: Does Yadier Molina Hurt the Cardinals By Being Awesome?

Note: While watching the All-Star game, I grabbed some data and wrote this post for Viva El Birdos, the best blog covering my favorite sports team, the St. Louis Cardinals. Since it's kinda-sorta rat choicey I thought I'd toss it up here too. Oh who am I kidding... I'm putting it here because I don't feel like writing another post tonight. If I thought hard enough I'm sure I could squeeze out some relevance for IPE, but I'm not going to bother. Skip it if you like.

It's generally accepted that in terms of preventing other teams from stealing bases Yadier Molina is one of the best, if not the best, catchers in MLB. Al Hrabosky is fond of saying that Yadi is so good that teams just don't steal on him anymore (and Al's not the only one). Which always made me wonder... Given that base-stealers must be successful at least 75% of the time to benefit their team, is it really a good thing if Yadi's excellence at throwing out stealers prevents teams from running? After all, if teams ran on him more, he'd generate more outs. Perhaps it would be better for the team is Yadi was worse, thus generating more attempts, thus generating more outs.

I had a few hours to kill tonight, so I thought I'd plot some data, all of which comes from Baseball Reference. The first graph shows the percentage of would-be stealers that Yadi has caught in his career, as well as the National League average.

As expected, Yadi has been very good over the course of his career, well better than the league average, although so far this year has been his worst. But has his success had an effect on other teams? In other words, do teams run on Yadi much less than other catchers? This next graph shows the stolen attempts for Yadi (per 162 games) compared to the NL average. (Formulas: (SB+CS)*(162/GP) for Yadi; ((SB/G)+(CS/G))*162 for NL.)

Okay, so teams really don't run on Yadi: he routinely has 50-60 fewer attempts against than the NL average catcher -- or would have, if he played all 162 games. So Yadi has fewer attempts against but more outs per attempt than the average catcher. We might think that the team would benefit if we could maximize the number of outs made (so long as the percentage of caught stealing remains above 25%). How does this translate into outs over the course of a season? (Formulas: CS*(162/GP) for Yadi; (CS/G)*162 for NL. Again this is normalized as if Yadi played in every game.)

The answer is... there's not a huge effect, but Yadi's prodigious ability to catch potential base stealers probably doesn't help the team, and might even hurt it a bit. In four years (2004, 2008, 2009, 2011), Yadi generated fewer outs on the bases than the NL average. In two years (2007, 2010), he generated more. In two years (2005, 2006), he generated almost exactly the same. In no year is the difference all that large. For the stats-minded: I doubt the effect is statistically significant, but in this case a failure to reject the null hypothesis is very interesting, since it contradicts the Hrabosky-esque conventional wisdom. Obviously this is a crude analysis, but often simple stats are the most illustrative. 

The broader point that I'm interested in making is that baseball, like all games, is strategic. If a player is really, really good (or bad) at one thing, then other teams will respond by changing their approach to the game in order to neutralize that advantage. Think of NBA teams fouling Shaq intentionally to make him shoot free throws. Or MLB teams walking Barry Bonds 232 times (!) in 2004. In some cases, it might benefit the team if the individual player were a little bit worse, so that their opponents didn't focus so much attention on them. 

In other words, Yadi probably hasn't hurt the team with his cannon arm, at least not much. But he hasn't helped the team much either. It would probably be better for the team if he was slightly above average (say, 30-35% caught-stealing rate rather than 40-50%) but not enough for teams to drastically alter their base-running patterns. 

Why Doesn't Anybody Use Slopegraphs?

I'm going to start. This is a slopegraph, from Tufte (p. 158):



(click for bigger, less blurry, image)

Lot of information, conveyed elegantly and simply. Discussion here. R code here. Via Kottke.

US: Still a Global Leader in Manufacturing

As part of a back-and-forth in comments to this post, LFC (of the excellent Howl at Pluto) wrote:

But on US mfg not having declined in raw terms: are you saying e.g. that roughly as much steel is produced today in Youngstown, Pittsburgh, etc. as was produced in, say, 1968, just with many fewer workers and fewer plants? That would surprise me.

Surprise!



Via. I'm not sure about steel in Youngstown per se, but overall the US manufactures more now than it ever has. As a percentage of global manufacturing output the US hasn't declined too much either. Until the subprime crisis/Great Recession the US had stayed around 25% of global manufacturing output since 1975.



Despite that downtick, the US was still the largest manufacturer in the world in 2009 (more graphs and discussion at that link). The view that the US just doesn't produce anything anymore is common, but it's wrong. We still produce quite a lot, in both raw terms and as a share of global output, and we do it with fewer workers than ever before. That's bad for the unneeded workers in the Rust Belt, but not for the broader economy.

The Glorious Revolution and the Industrial Revolution

Some new research from Pincus and Robinson:

The English Glorious Revolution of 1688-89 is one of the most famous instances of ‘institutional’ change in world history which has fascinated scholars because of the role it may have played in creating an environment conducive to making England the first industrial nation. This claim was most forcefully advanced by North and Weingast yet the existing literature in history and economic history dismisses their arguments. In this paper we argue that North and Weingast were entirely correct in arguing that the Glorious Revolution represented a critical change in institutions. In addition, and contrary to the claims of many historians, most of the things they claimed happened, for example parliamentary sovereignty, did happen. However, we argue that they happened for reasons different from those put forward by North and Weingast. We show that rather than being an instance of a de jure ‘re-writing the rules’, as North and Weingast argued, the Glorious Revolution was actually an interlinked series of de facto institutional changes which came from a change in the balance of power and authority and was part of a broader reorientation in the political equilibrium of England. Moreover, it was significant for the economy not because it solved a problem of credible commitment, but for two other reasons. First, because the institutional changes it led to meant that party political ministries, rather than the king’s private advisors, now initiated policy. Second, because these ministries were dominated by Whigs with a specific program of economic modernization.

The World's Central Banker, Again

Foreign banks are arbitraging the Fed:

Up until April this year, US banks had a nice little earner.

As Freakonomics explained, big banks were able to borrow cash from the Fed funds or repo market for say, 15 basis points, posting US Treasuries as collateral, and then deposit the cash received with the Federal Reserve overnight at 25bps, earning some 10bps. The FT has estimated that since late 2008, this risk-free arbitrage may have netted America’s banks as much as $200m in profits.

The arbitrage-opp came to an end in April, however, when the US Federal Deposit Insurance Corporation’s (FDIC) introduced a new fee on banks, essentially eliminating the 25bps-grab.

Small problem. It seems the new FDIC rules don’t apply to many non-American banks. And foreign banks, we should all know by know, also have access to the repo markets and federal funds.

Moreover, this is a good thing. The Eurocrisis may have been more destabilizing than it has been if foreign banks didn't have an easy way to recapitalize. And it doesn't hurt the US. Well, it hurts US banks, which don't have the same opportunity, but that provides an incentive for them to lend to the real economy, which is needed.

Also note this:

... the reported assets of US branches of foreign banks are up 250 per cent since the end of last year, now making up a whopping 48 per cent of their total assets. Basically, foreign banks have absorbed all of the growth in reserve balances in 2011.

The Atypicality of U.S. Power and Influence, Again

Can you guess the source?

I shall argue that it is high time indeed that we pay much more attention to the sociology of international studies, and especially to the reasons why one particular myth -- that of America's lost hegemony -- took root so strongly in the United States academic community about fifteen years ago and why it has been so generally and unquestioningly accepted since-so much so that it has even gained credence in the world beyond North America. ...

In its extreme form, the myth that the United States today is just a little old country much like any other and has, in some sudden and miraculous way, lost its hegemonic power may seem more plausible than do some of these other myths. But when it is subjected to close and searching scrutiny, it is just as far from truth. And unless cool and rational analysis undermines its power to move minds and shape attitudes, it can be every bit as dangerous. In living memory, the optimism of the United States gave Americans and others a vision of a new, better and attainable future for the world; today, the myth of lost hegemony is apt to induce in everybody only pessimism, despair, and the conviction that, in these inauspicious circumstances, the only thing to do is to ignore everyone else and look after your own individual or national interest. Thus, some of the same American contributors to International Organization who are personally persuaded of the benefits of more international cooperation and conflict resolution, may paradoxically be contributing to a less cooperative environment by subscribing to and perpetuating the myth of lost American power.

That is Susan Strange, in her 1987 IO article "The Persistent Myth of Lost Hegemony" (ungated), which I just read for the first time. It's very good, and certainly still relevant twenty-five years on.

She argued (contra Krasner, Keohane, and others) that the U.S. in the mid-1980s was still a hegemonic state, because it controlled the four elements of structural power (which she distinguishes from relational power):

1. The ability to deny or increase other peoples' security from violence.

2. The ability to control the system of production of goods and services.

3. The ability to determine the structure of finance and credit, and therefore acquire purchasing power without producing or trading for it.

4. The ability to influence knowledge creation, whether technical or ideological, and the ability to acquire, communicate, and store that knowledge and information.

Strange argued that by those four metrics, the US was clearly a hegemonic power in the mid-1980s. Here's what she wrote about the US's persistent current account deficit:

Indeed, to run a persistent deficit for a quarter of a century with impunity indicates not American weakness, but rather American power in the system. To decide one August morning that dollars can no longer be converted into gold was a progression from exorbitant privilege to super-exorbitant privilege; the U.S. government was exercising the unconstrained right to print money that others could not (save at unacceptable cost) refuse to accept in payment.

How much of this remains true? Arguably the US is at a greater security advantage now than in 1987, and still controls quite a lot of the globe's system of production. The ability to determine the structure of finance and credit is certainly still in the US's hands, and the US is still a global leader in knowledge creation and dissemination. While some countries have narrowed the gap in one or two of these categories, none can challenge across all of them.

Has the subprime crisis changed any of this? It's certainly illustrated aspects of it. It remains to be seen whether the crisis was a transformative event.

But, as Strange noted, previous "transformative events" (such as the collapse of the Bretton Woods system and 1970s economic malaise) ended up not being nearly so transformative as many thought they would be. According to Strange, that's because the structural conditions didn't change.

Strange also argues, prefiguring folks like Zakaria, that international disorder stems from US political instability rather than a decline in capability, which itself is a result of constitutional design (separation of powers, checks and balances), the role of interest groups in coalition-building, and a tendency to suddenly reverse course mid-stream. As Strange put it: "It is not easy for [American academics and policymakers] to admit that the conduct of American policy towards the rest of the world has been inconsistent, fickle, and unpredictable, and that United States administrations have often acted in flat contradiction to their own rhetoric."

It's a very good article.

We Are All Mostly Irrelevant QOTD

Tim Harford:

Approximately 3,000 scientific articles are published per day – roughly one every 10 seconds of a working day. We can now expect that these papers will, each year, cite around five million previous publications. And the rate of production of scientific papers is quadrupling every generation. (All these estimates are based on data from the Institute for Scientific Information.) The percentage of human knowledge that one scientist can absorb is rapidly heading towards zero. This side of a new Dark Age, there will never be another Da Vinci.

Whenever Tom Coburn proposes cutting NSF funding and everyone squeals something like this comes to my mind. And, like Harford, I support public (and private!) research funding, but we need to be realistic about what exactly the return to that investment is. The old romantic ideal of scholar-polymath is over, and that was inevitable. Moreover, it's a good thing; it means that knowledge has progressed massively, to the point where no single person can absorb it all. We all have to fill our niches, and then try to make our niche-work known so it has some relevance for the outside world. So let's just recognize that we're working on the margins and try to do the best with that that we can.

Meanwhile human progress marches on.

Minimum Wage 101

Kevin Drum and Karl Smith are having a go-around about the effect of minimum wages on employment. There is the famous Card/Krueger study (and others) showing that increases in the minimum wage do not adversely affect employment rates, and a bunch of other studies plus basic economic reasoning suggesting that they do. Drum weights the former more heavily, Smith weights the latter more heavily, but they can both be right. The effect of a price floor of any kind depends on where the floor is set relative to the competitive equilibrium. In the graph above (originally used to depict a basic relationship between capital ratio regulations and bank behavior, but the same principle works here), a floor below the equilibrium has no effect on behavior. Think of this as a minimum wage below the market wage, or (perhaps) the Card/Krueger finding. In the graph below, the floor is above the market equilibrium, so behavior is altered.



The point is that the effect of a minimum wage change will depend on many factors besides the minimum wage itself. In a depressed labor market, with many potential low (or zero) marginal product workers, the demand curve for labor shifts left, the equilibrium price falls, and a minimum wage increase is more likely to retard employment rates than it would in a robust labor market where the demand curve shifts right and equilibrium price rises.

Many people argue that a relaxation of payroll taxes would help boost employment. If that is true, then a minimum wage increase would decrease employment, at least for workers at the margin where any of this is relevant. That may not be many workers (as Drum claims), but given the depressed labor market today it is probably a lot more than it would have been in 2005.

Also keep this in mind: if a minimum wage is successful it must set a floor above the competitive equilibrium, and therefore must reduce employment. Maybe that shows up in hours worked or price increases rather than crude employment rates but it has to be there somewhere. A wage floor below the equilibrium doesn't change anything, and is therefore unsuccessful.

Salam on the US Economy

QOTD:

This is why it is so damn frustrating when people say, “Hey, Barack Obama has been great for the private sector economy. Check out those huge corporate profits!” Huge corporate profits reflect product markets that are not sufficiently competitive. Product markets become less competitive in economies defined by high barriers to entry, including costly labor market regulations. This isn’t about President Obama. Rather, it is about the accretions that happen in any stable, affluent society.

And this:

I really want to live in a world in which center-right types would say, “Yes, enormous corporate profits are a bad thing — they’re bad because they’re a symptom of crony capitalism. The solution isn’t to tax away profits and use them to expand an inefficient public sector. Rather, it is to facilitate exploratory innovation by reducing barriers to firm entry.”

This is something that center-left folks (and progressives) also do not understand. The TBTF problem and huge profits in finance are reinforced by regulations. Regulations, even the well-crafted and necessary, will tend to support large incumbent firms almost all the time. And not just because they can lobby more effectively, but because they have the resources and market base to comply more easily than new competitors would. The fact that our financial sector is so profitable and so top-heavy is a strong sign that our regulatory code is seriously screwed up. As is the rise of the shadow banking system.

Although perhaps desirable for other reasons, raising taxes does not solve this problem and could even exacerbate it, by reducing the gains to entry even further.

I would like to see a program along the lines that Salam suggests later in the post, including an overhaul of the tax code using Simpson-Bowles as a starting point. The swiss cheese system of deductions, depreciation write-downs, loopholes, and credits is distortionary and generally benefits those who don't need much help rather than those that do. I would like to see policies designed to reward innovators rather than incumbents, and that will mean less regulation in some areas. I would like to see a program of work supports similar to what Salam describes, which sounds (to me) like something similar to the German system. I do not want to see major cuts in entitlement programs, as Salam does, as I believe a stronger safety net is more important in a more-competitive and more skills-driven economic system.

In short, at the same time the US worked to make the global economy more open and competitive, it did not enact policies that made itself more open and competitive. For a long time, our dominant global position meant that we could collect rents from the rest of the world, which we then distributed according to political demand. But those rents are now being competed away while the political demands have not. It's a fixable problem*, I think, but not until we recognize what the problem is. Right now it doesn't appear that either major political party does.

*And, at the global level, it isn't a problem at all. Competing away US rents is a good thing for the world.

The Case for Kicking the Can in Greece

It's been my operating assumption for quite some time that this was the intended endgame:

In other words, new net lending to Greece, from the EU, IMF and/or EFSF to finance the current deficit, is just pushing down the eventual recovery rate on all debt. The marginal rate of writedown on new credit extended to Greece is one hundred per cent. ...

The Greek government should be trying to borrow as much as anyone will lend them, since the repayment terms don’t matter if you’re planning to default. It is analogous to the practice of “trading while insolvent” for a company; this is an illegal thing to do for a corporation, but countries aren’t corporations.

With that in mind, we realise we are under no time constraint at all, and we can organise the eventual bailout at our leisure and for our political convenience. Particularly, we can stick it out past 2013, by which time the German Presidential elections will be out of the way, and a raft of new European legislation will be in place with respect to sovereign and bank debt restructuring, allowing the whole business to be carried out on a more civilised basis.

There's much more here about how the situation can be resolved in a relatively painless way. The conclusion:

The idea is so simple (as JK Galbraith said about the creation of money in a fractional reserve banking system) that it repels the mind. To repeat – all we need is the existing Euro, the existing EFSF, and a legal opinion that this would not constitute monetisation of the Greek national debt, which as far as I can see it wouldn’t. But there is no rush.