Can Europe Save Itself — and Avoid Pulling Down the U.S. Recovery?

Can Europe Save Itself — and Avoid Pulling Down the U.S. Recovery?

September 28, 2011

At last weekend’s IMF/World Bank annual meetings in Washington, the question on everyone’s minds was, what’s happened to Europe’s instinct for economic survival? While our Congress squabbles over bookkeeping for disaster assistance, the talk in the corridors of the IMF was that Europe is two to three weeks away from financial meltdown. It would start in the sinking market for Greek government debt, followed by turmoil in much-bigger markets for the public debt of Italy and Spain, as well as Portugal and Ireland. And if Europe’s leaders can’t head that off, it will likely take down most of Europe’s large banks. Angela Merkel, Nicholas Sarkozy and their counterparts across Europe get this. What they don’t want to face is that the only solutions ultimately lead to a radical rewriting of postwar social contracts across the Eurozone. 

The financial carnage wouldn’t stop at the continent’s shores. British banks have large holdings of Spanish, Italian and Irish government bonds, so they would be very vulnerable. Our own banks sold most of their portfolios of European government bonds over the last year. But U.S. officials worry privately that U.S. banks are holding unknown billions of dollars of credit-default swaps against both those bonds and the European banks that hold them. That puts them in a position that recalls AIG in late August 2008, as insurance providers for a catastrophe that now lies somewhere between the possible and the likely. Finally, a meltdown of European finance would mean horrendous recessions across Europe and an end to our own recovery.

The sober minded men and women at the IMF aren’t given to nightmare scenarios. They believe in data, and it’s the analysis of those data that now points to impending crisis. Over the last six months, for example, the shares of the largest banks of Greece, Italy, Spain and France have sunk 30 percent to 50 percent. Even scarier, the costs to insure against the failure of those banks reached the same levels last week as they did here for Lehman Brothers a few weeks before its collapse. And the costs to insure against the complete default of Greek, Italian and Spanish government debt — financial Armageddon — have risen 60 percent to 80 percent.

For months, financial analysts and global investors have tracked the perfect storm now taking shape across the Eurozone. But unlike the weather, European leaders know how to head off much of it and to contain most of the rest. Yet, like Henry Paulson’s Treasury throughout much of 2008, Germany’s Merkel and France’s Sarkozy have spent the last six months trying to ignore the undeniable. The bottom line this time: Monetary unions across states or countries, like the Eurozone, work only when the full faith and credit of the whole stands behind the full faith and credit of each part. 

The classic example of a successful monetary union was the United States in the late 1700s.  Under the Articles of Confederation, the southern states paid off their revolutionary debts, and their credit was sound — think of them as Germany, the Netherlands, and Northern Europe today. But profligate Massachusetts, Connecticut and most of the rest of the north let their debts, both old and new, just pile up — they were the Greece, Italy, Spain, Ireland and Portugal of their day. Resolving these debts hung up approval of the new U.S. Constitution, so the framers created a Bank of the United States which assumed the debts of the northern states. In return, by the way, the credit-worthy southern states got to take the national capital away from New York and relocate it in a swampy track on the border of Virginia. 

A similar task now faces Merkel, Sarkozy and the Dutch and Finnish members of the Eurozone — in effect, pledge their own good credit to guarantee the same for the Eurozone’s profligate southern countries. So far, they’ve thrown a lot of money at Greece, hoping it would satisfy global investors. We now know that hasn’t worked, and that much harder adjustments lay ahead.

In fact, Europe’s crisis is even more serious than our own in 2008. To begin, Europe’s banks hold the failing sovereign debts of the southern Eurozone countries as well as toxic assets left over from 2008. Moreover, no one doubted the U.S. Government’s capacity to step in and bail out our banks and provide massive stimulus for an economy spiraling downward. This time, it’s sovereign debt itself that’s under attack, so that option isn’t available for Greece, Spain, Italy, Portugal, or even France. Washington also could head off bank runs when Lehman, AIG and Merrill Lynch collapsed, by guaranteeing everyone’s money market balances. None of the Eurozone countries in such deep trouble today would have the credibility to take such a step. So, if everything begins to unravel, there’s very little they can do to save their banking systems. And such a banking crisis will hit Germany as well, since its private banks also hold many tens of billions of Euros in Greek, Spanish and Italian debt. 

There are still a few precious weeks left to head off this Euro-catastrophe. The Eurozone’s rescue fund so far has focused on delaying Greece’s default. In the next two weeks, it will have to, at once, inject capital into unknown numbers of large banks and buy massive amounts of Greek, Spanish, Italian and Portuguese debt on the open market. The politics of pulling that off are daunting, because it will require the unanimous support of 17 Eurozone governments. So far, only six have agreed, and they’re mainly the ones that would be rescued. Of the others, Finland, for one, has put up impossible demands that will have to be dialed back. And while Merkel now says she’s prepared to do what she said a month ago she’d never do, it’s unclear if her own party will go along in a vote scheduled for later this week. 

One reason for their opposition is that most of the bill will fall to Germany and the five other Eurozone countries that still have sound credit. There are ways to stretch the bail-out capital, however. The European Central Bank could underwrite it — it still says no to that — or the rescue mechanism could guarantee losses of up to 20 percent on sovereign bonds. But such moves are immensely complicated matters to work out in just a few weeks, especially when everything requires the unanimous consent of the Eurozone governments. When Henry Paulson had to come up with a bailout plan quickly as Wall Street melted down, he managed to pull together three pages of general principles saying the Treasury could do whatever it wanted. That won’t wash this time. 

The second reason will be even harder to handle. If the Eurozone can find its way to guaranteeing the sovereign debts of all of its members, their future debts will have to be centrally and uniformly constrained.  In short, the solution to the crisis could spell the end of each government’s autonomous right to conduct its own spending and tax policies, since that’s what generates sovereign debt. That would require fundamental revisions of the long-time social contracts these governments have with their peoples, including provision for the world’s most extensive public pensions and health care coverage. That’s the real reason Merkel, Sarkozy and the rest have spent so long denying the emerging crisis. The next two to three weeks will tell whether they have the courage and vision to finally address it.

Protectionism Remains a Danger to Economic Recovery

September 20, 2011

Tough times almost always raise the pressure for trade protection, and the current global economic troubles are no exception. President Obama has generally resisted this impulse, asking Congress to approve new free-trade agreements with Colombia, Panama and South Korea. Still, Congress has yet to act. And here and around the world, new duties or other restrictions have been applied on a range of imports. More broadly, protectionist demands from India, Brazil and other large developing nations have stalled the completion of the Doha multilateral trade round. Even so, a renewed commitment by Congress and the Administration to expand trade may be the best way currently available to help support a faltering U.S. recovery.

Such a push will have to confront the strong temptation in times like these to turn to measures which would reduce trade, most notably anti-dumping and countervailing duties against imports from developing countries. The futility of this approach has been demonstrated time after time, perhaps most recently in the decision by the International Trade Commission (ITC) to slap anti-dumping and anti-subsidy duties on imports of coated paper products from China and Indonesia. I won’t argue about whether or not that decision was consistent with U.S. law. My focus is entirely on whether or not it will help or harm American consumers, paper companies and their employees. So I conducted a case study to find out: The conclusion is, those duties harm American consumers without providing any assistance to American paper companies and their workers.

This issue is especially timely, because September 21 of this year is the one-year anniversary of the Department of Commerce decision to impose the new anti-dumping and countervailing duties on coated paper imports from China and Indonesia. The ITC reaffirmed the duties last October with the final vote in November 2010.

The case began in September 2009, when three large U.S. paper companies and the United Steel Workers, which represents 6,000 of their employees, filed for relief from the ITC under the anti-dumping and countervailing duty laws. They won their case: The ITC imposed duties of between about 8 percent and 135 percent on coated-paper imports from China and duties of 18 percent to 20 percent on imports of those products from Indonesia. These duties, of course, raise the prices for those imports here, wiping out most or all of the difference between the prices that Americans businesses and consumers paid for those imports and the prices they paid for coated-paper products made here. And without that price competition, the result is higher prices not only for the imports, but also for U.S. and European paper products.

This makes no economic sense: At a time when overall demand by American consumers and businesses is flagging, forcing them to pay more for these products only leaves less for them to spend on everything else.

Nor are there benefits for our own paper producers and workers to offset these higher costs. The reason lies in the fact that our producers compete with Indonesian and Chinese paper makers not only here, but around the world. So, as the new duties contract their share of the U.S. market, the Indonesian and Chinese paper producers have more product to sell in third-country markets. We found that this increase in the available supply of these products will drive down the prices of Chinese and Indonesian coated paper in those countries between 7 percent and nearly 19 percent. The predictable effect is that their market share in those countries will increase at the expense of American producers. That’s how global markets work.

In addition, our new duties may trigger retaliation by China and Indonesia, targeting U.S. exports of the same products to their own markets. That’s precisely what happened in other cases of U.S. anti-dumping and anti-subsidy duties. Since China is the third largest market for U.S. coated paper products, such retaliation could further harm our own producers.

The irony is that coated paper is an example of an unusually well-functioning market. From 2007 to 2009, when this particular case was filed, coated-paper imports to the United States had actually contracted by more than 30 percent. Imports from China and Indonesia had increased, but imports from European countries had declined even more, so the domestic market share of American producers had increased from 61 percent to 66 percent. In addition, the prices paid for these products by American consumers and businesses had fallen by between 2 percent and 6 percent. This was not a market than needed to be “fixed” by new duties.

Further, the U.S. market for these products was segmented quite efficiently. An ITC survey had found that business customers for these products judged American, Chinese and Indonesian products comparable in terms of quality, product consistency, packaging, discounts, and credit terms. Business customers also found Chinese and Indonesian products superior for their lower prices. The survey also reported that American customers preferred the American-made products for the range and availability of product, reliability of supply, delivery terms and delivery time, and technical support. Various advantages and disadvantages, then, produced a market in which buyers choose based on what is most important to them.

The emergence of China and Indonesia as major paper producers also has followed a very powerful and natural dynamic in the global paper industry; namely, that paper production follows paper consumption. In nearly all cases, a country’s capacity to produce paper products has expanded or contracted with its share of worldwide consumption of the products. For example, as the U.S. share of worldwide consumption of paper products fell from 41 percent in 1970 to 19.4 percent in 2009, our share of worldwide production of the same products fell from 40 percent to 20.5 percent. Similarly, China and Indonesia’s combined share of worldwide consumption of paper products went from just over 2 percent in 1970 to 25.3 percent in 2009. Over the same years, their combined share of worldwide production of those products rose from just under 2 percent to 25.6 percent.

It is also only natural that companies like to see their competitors hobbled. Laws and regulations in the United States, as in most other countries, still contain hundreds of instances in which a special burden is imposed on certain companies or a special benefit is conferred on other companies, all to the detriment of their rivals. Consumers almost never win from such special grants. And as this case study shows, when the special burdens involve protectionism targeted to an industry’s foreign rivals, the American firms and workers that called for the protection also lose in the end.

Grading Obama and the GOP Hopefuls on their Plans for Jobs and the Economy

September 12, 2011

Last week’s GOP debate at the Reagan Library, followed the next night by the President’s address to Congress, threw into stark relief the strengths and weaknesses of each side’s understanding of jobs and the economy. The Republican hopefuls get a gentleman’s C on the impact of regulation on economic activity. But their approaches to the overall economy and job creation ranged from silly to dangerous, and earn them all F’s. The President has to produce results, and his ideas aren’t constrained by primary challengers. This may help explain why his approaches are broader and more thoughtful, earning him a solid B on the overall economy and an A-minus on job creation.

All of the Republican hopefuls — the two leaders Rick Perry and Mitt Romney, the so-serious minded Jon Huntsman and Ron Paul, and the media-infatuated Michelle Bachmann and the rest — agreed on one economic prescription: Apply deep and immediate budget cuts to an economy generating little growth and no jobs. This common position not only defies the basic dynamics of supply and demand in a slow economy. It also rejects the policies of the last five GOP presidents. After all, it was true-blue conservatives Ronald Reagan and George W. Bush who justified big spending increases for defense and big tax cuts to boost the flagging economies of their own times.   

Nor are the Republican wanna-be’s chastened by the current examples of Germany, France and Britain, which all embarked on austerity programs this year while the European Central Bank (ECB) raised EU interest rates. The results have been even more anemic growth than our own. In fact, the two GOP frontrunners along with the inimitable Mr. Paul not only demanded deep spending cuts, but also sided with the ECB by denouncing Fed chairman Ben Bernanke as an inveterate inflationist. The markets they all claim to worship don’t see it that way, since our long-term interest rates remain near record lows. For their determined contempt of introductory macroeconomics, all of the GOP putative presidents flunk.

The current President at least appreciates that this economy needs a boost, not more headwinds. His package adds $450 billion over 12 months, in theory adding new demand equal to 3 percentage points of GDP. In practice, it would work out to be less than that, since people will save some of the money they gain from lower payroll taxes, and some of the tax cuts for businesses won’t be taken up. The administration also gets credit for recognizing that the sick housing market is a critical piece of the puzzle behind the slow economy. Their answer, however, misses the most basic point: Mr. Obama called for expediting Fannie Mae refinancings to put more money in the pockets of some homeowners. But that won’t affect the more economically consequential, high foreclosure rates that have been pushing down housing values, and so dampening people’s willingness to spend. On balance, give the President’s economic team a solid B on the overall economy.

Both sides also call for tax cuts to spur job creation. All of the GOP candidates, however, would focus on cutting corporate taxes. Now, most economists agree that the corporate tax cries out for reforms, especially a lower marginal rate tied to ending distorting tax breaks for favored industries.  But no reputable economist who doesn’t aspire to a top position in the next GOP administration has found that those reforms would have noticeable effects on jobs in any short or medium-term. With large U.S. businesses already holding some $1 trillion in banked profits, by what economic logic would additional tax cuts move them to create jobs?

The only route from this GOP position to new jobs depends on lower corporate taxes translating into higher dividends, mainly for the very affluent, which they would then spend, boosting demand. Even so, much of those additional dividends probably would be saved, which wouldn’t create any jobs under today’s conditions. Moreover, the GOP hopefuls also insist on spending cuts to offset any lower corporate tax revenues — and that would mean job losses. For their resolute ignorance of labor economics and public finance, these hopefuls score another F.

President Obama’s tax plan is both more detailed and better targeted to creating jobs — which should be unsurprising, given how much he has riding on near-term results. He would reduce the cost to businesses of creating new jobs and maintaining their current workers. To do this, he would temporarily suspend the employer side of the payroll tax for new hires by firms with about 1,000 employees or less, and temporarily cut by half all employer-side payroll taxes for firms with about 100 workers or less. This strategy is eminently sensible — and downright brilliant compared to the broad corporate tax cut championed by the Republican hopefuls. Full disclosure: I’ve urged the administration to propose cutting the employer side of the payroll tax since December 2009, including eleven times in these blog essays.

The decision to limit these new tax incentives to small and medium-size companies is less than ideal, since big businesses employ nearly half of all workers. On the other hand, big businesses are sitting on hundreds of billions of dollars in banked profits, so they clearly have the means to hire more workers. On balance, these proposals deserve an A-minus.

The same score goes to the President’s call for more direct, job-related spending. This includes new funds for the states to prevent more layoffs of teachers, police and firefighters; new support for school construction; and additional investments in infrastructure (through a National Infrastructure Bank). More problematic are the jobs benefits from other parts of the plan, including support for expanded access to high-speed wireless and public-private partnerships to rehab homes and businesses. There’s also little direct jobs benefit in the administration’s otherwise-laudable plans to reform the unemployment insurance system and bar employers from discriminating in hiring against long-term jobless people. All told, another A-minus.

The Republican hopefuls have time to develop better strategies for growth and jobs, especially compared to their current dismal positions. They’ll have to play catch-up, however, because President Obama has proposed a sound new jobs agenda. And if congressional Republicans refuse to work with him on it, the public will know whom to blame.