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Why We All Have to Worry about Cyprus

Wednesday, March 27th, 2013

With Europe’s brazen mismanagement this week of the banking collapse in Cyprus, the Euro crisis moved closer to farce and, potentially, closer to a serious problem for the rest of us. Over the past three years, as global investors have periodically fled the government bond markets of Greece, Portugal, Ireland, Spain and Italy, Eurozone leaders have grudgingly spent $650 billion bailing those countries out. The whole point of these bailouts has been to protect the solvency of the European banks that hold most of the bonds of those countries, including any of the leading banks in Germany and France. Yet, last week, when the two major banks in tiny Cyprus needed a modest bailout of $13 billion to hold the Eurozone together, European leaders proposed that all of the banks’ depositors help pay the bill. In short, they were prepared to tear up the EU pledge of deposit insurance, the last defense against nationwide bank runs.

Luckily, the people of Cyprus said no. Yet, this Tuesday, Eurozone finance ministers came up with a new way of restructuring the ailing Cypriot banks that will still mean large losses for their large depositors, as a condition of the latest bailout. So now, the next time global investors lose confidence in the bonds of, say, Italy or Spain, the banks across Europe that hold those bonds may face waves of withdrawals by their largest depositors. That could bring on the kind of far-reaching financial crisis which the bailouts were designed to head off.

From the vantage of Berlin or Paris, the new deal is certainly appealing in broad, if crude, political terms. European voters get the satisfaction of forcing the well-heeled depositors of the failing banks to pay a price, along with those banks’ investors. And many of those depositors aren’t even Eurozone citizens: Instead, they’re hyper-rich Russians, including at least 80 oligarchs who looted much of their country’s economy and then shifted their proceeds to foreign accounts. They didn’t choose Cypriot banks for their investment expertise, since the bankers sunk much of the deposits in Greek sovereign bonds, the world’s worst investment. They chose Cyprus because it’s a traditional tax haven with very low taxes and strict bank secrecy laws. Old times may also have played a role with many of the oligarchs, since Cyprus was once the KGB’s favorite listening post on the Middle East.

The global economics of the deal, however, are simply terrible. Large depositors account for a tiny fraction of all Cypriot bank accounts, but more than half of all Cypriot bank deposits. It’s a pattern seen almost everywhere, including the United States. Here, bank accounts of $250,000 or more account for less than one-half of one percent of all bank accounts, but nearly one-quarter of total bank deposits. In normal times, our own deposit insurance limits the amount subject to its guarantee at $250,000. But when confidence in banks is fragile or failing, the government always steps in to guarantee all deposits. That’s just what the Treasury and FDIC did in September 2008, to prevent a run on American banks by large depositors that would have spread the crisis across the U.S. banking system. That unlimited guarantee remained in place until our financial system was stable and healthy again, ending only at the end of last year.

Eurozone leaders have ignored these basic tenets of deposit insurance. Instead, they have sent a troubling message to large European depositors: Even in a financial crisis, large accounts are no longer safe. So, the next time that global investors begin selling off Italian or Spanish government bonds, threatening the solvency of the banks holding those bonds, we could see a run by large depositors not only in Italy and Spain, but also across Germany and France. And that would set off a new financial crisis that could trigger a downward spiral across much of world – including here in America.

Moreover, it seems that unnecessary economic mistakes have become the new norm. Austerity programs for economies struggling with weak recoveries, both here and across much of Europe, are the most common example. That’s why the Eurozone, taken together, has been in a recession for nine months; why Britain’s GDP has declined in four of the last five quarters; and why even the German economy has been contracting since at least last October. And an extended downturn in Europe only increases the likelihood of renewed government bond problems in Italy or Spain which, given this mismanagement of deposit insurance in Cyprus, could spiral out of control.

These are not the only examples of inane economic policy thinking these days.

Paul Krugman this week, for example, offered a defense of capital controls, citing how the movement of funds in and out of national markets can destabilize economies. But the issue is not the unfettered movement of funds across global markets. In fact, those capital flows have been a key factor in the strong performance of many developing economies, as well as our own economic stability. Rather, the problem lies in what financial institutions do with those funds and the willingness of governments to enforce sensible limits on what they do. In the end, the spectacular stupidity of Eurozone leaders this week may be just the most recent and dangerous example of how politicians manage to miss the most obvious and important economic point.

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Dark Thoughts on the Coming Sequester

Wednesday, February 27th, 2013

This week’s bout over federal spending pits Tea Party militants, conservative pundits and most Republican office holders against the President, his congressional allies and most economists who pay attention. But behind the politics, there is simply no economic basis for the immediate spending cuts that would follow the sequester — or immediate tax increases for that matter. The economy is still fragile enough that GDP went negative in the last quarter, when inventory purchases and federal spending both slowed more than usual. And just last weekend, Moody’s credit rating agency stripped the United Kingdom of its AAA rating — not because UK deficits are too high, but because Britain’s premature austerity policies are leaching away the growth required to make its deficits manageable. Moody’s decision only echoed recent warnings from the IMF and World Bank against just such precipitous moves to bring down cyclical deficits.

Back home, President Obama’s odds of prevailing on the sequester would be greater, if those who have made careers out of fetishizing a balanced budget were not receiving quiet support from much of Washington’s split-the-difference political pros, including a clutch of Democrats.  Looking out a few weeks, a chorus of self-described centrists and a few liberals could nudge the President into accepting a “compromise package” of substantial, immediate spending cuts and what Ronald Reagan used to call “revenue enhancers.” If it stops there, the economic damage will be contained. But the scenario could turn worse if, as seems likely, such a compromise also becomes embedded in a Continuing Resolution that will cover the rest of the fiscal year and create a new, lower baseline for 2014.

This premature austerity inescapably will weaken the economy, raising deficits even more down the line. Worse, such a bipartisan agreement could reinforce both parties’ natural resistance to contain Medicare spending and build up the tax base, especially over the long-term. And that could finally convince global financial markets that the United States has lost its way economically. The result would be higher interest rates, which in turn would mean even slower growth and higher deficits. What the markets want and have long expected from us is just fiscal common sense. That means, first, sidestep the sequester trap and instead increase federal investments in infrastructure, basic R&D along our technological frontiers, and access for all adults to upgrade their skills. Then follow it up with serious steps to contain long-term Medicare spending and expand the national tax base.

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The New Nihilism in the Debate over the Debt Ceiling

Tuesday, January 8th, 2013

For decades, fiscal conservatives have used congressional debates over raising the debt limit to vent their frustrations with big government. But no one seriously questioned the need to do so, not until a band of Tea Party uber-conservatives in 2011 resolved to use the debt limit as a bargaining chip in budget talks. They ignored the fact that raising the debt ceiling does not in any way determine future spending or taxes. It simply allows the Treasury to borrow the funds to finance spending that past Congresses and Presidents already have undertaken. Raising the debt limit, in short, is a ministerial act that grants the government the technical legal authority to maintain the full faith and credit of the United States. And since the Treasury securities that comprise that credit underpin much of the operations of the American economy, withholding that technical authority could have devastating economic effects.

To understand how and why, start with the basics. When Washington runs a deficit, the Treasury has to borrow from investors not only to fund the deficit, but also to cover the interest on the government’s existing debt and to refinance much of that debt, all on a continuing basis. A failure to raise the debt limit, as many Tea Party denizens in Congress propose, therefore could force the Treasury to default on those obligations. Sovereign debt defaults have many well-known and very unpleasant consequences. Interest rates spike, stock and bond markets fall sharply, the value of the currency declines dramatically, and the country quickly falls into a deep recession. Given those consequences, no government with sane leadership would ever default voluntarily. Rather, the only reason any country has ever found itself unable to pay the interest on its bonds or issue new government debt is that domestic and foreign investors won’t lend it the funds to do so.

If, beyond all reason, Congress effectively forces our own government to default on our national debt, the results would be particularly nasty. Trillions of dollars in U.S. Treasury securities are held by financial institutions here and abroad, so the default would quickly freeze capital markets around the world. In other words, private lending to businesses and households here and in many other nations would halt. The reserves held by many of the world’s central banks include more trillions of dollars in U.S. Treasuries, so a U.S. default also would quickly bring on a global financial crisis that could dwarf the chaos of late-2008. In fact, even if the debt-limit debate merely increases the concerns of investors that a U.S. debt default somehow might occur, their heightened apprehension could have serious effects on interest rates, the dollar, and the stock and bond markets.

Even before a technical debt default could set in, however, the government would be forced to drastically cut current federal spending. Federal borrowing today covers between 35 and 40 percent of all federal spending. If Congress prevents the Treasury from legally borrowing any more funds, the government will be forced at once to slash spending by 35 percent to 40 percent. Such truly unimaginable cuts — more than ten times those contemplated under the sequester provisions of the 2011 budget Act — would force the President to shut down many parts of the federal government, including some national security operations, and even cut income support programs for tens of millions of retired Americans. And since the President and the Treasury would determine the distribution of these cuts, failure to raise the debt ceiling would effectively shift the power of appropriations from Congress to the Executive.

Conservatives have serious and sincere differences with progressives over certain federal programs and functions. Whether Republican leaders recognize it or not, putting at risk the government’s legal authority to issue new bonds as a lever to press their policy preferences is a form of political nihilism. It easily dismisses the costs of wrecking the operations of government, because it places so little value on government itself. As such, the new political nihilism is as far from genuine conservatism, which seeks to preserve traditional political arrangements, as it is from a progressivism that uses government to reform those arrangements. Nevertheless, by vowing to block any increase in the debt limit until the administration accedes to their budget demands, congressional conservatives have embraced this new nihilism.

Nor, as some Tea Partiers would have it, should a failure to raise the debt limit be seen as a “preemptive default” intended to head off a real one. Global investors continue to lend the United States whatever funding we require — and judging by the low interest rates they accept, they are eager do so. We also are one of only two countries in the world (Denmark is the other) that places a legal limit on the debt its government can issue. So, now a handful of radical members would have the Congress refuse to raise that limit, knowing that the country will face another recession as government programs are slashed, followed by the chaos of a sovereign debt default. Republican leaders have no reasonable alternative but to join the President in rejecting such nihilism. 

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Modest Progress on the Deficit Is Just What the U.S. Economy Needs

Wednesday, January 2nd, 2013

One argument nearly entirely absent in the debate over the fiscal cliff issues is the effect on the economy. True, some diehard conservatives warn that without drastic steps to privatize part of Social Security and much of Medicare, our national debt will soon make us pariahs in global capital markets, on the Greek model. But there was never any economic evidence or reasoning behind their feverish scenario. In fact, throughout our long fiscal debate, worldwide investors have been eager to lend the Treasury virtually unlimited funds in 10-year tranches and accept annual yields of less than 2 percent.

Based on that, some diehard liberals insist that we do not have to cut spending at all, especially when there are plenty of well-heeled Americans around who can afford to pay higher income taxes. Their position ignores economic history — namely, that whenever our deficits have climbed and the national debt has threatened to soar, we earned the confidence of global investors by addressing those problems in measured ways. The only genuine economic imperative in this entire dismal fight is not that we should raise taxes on the wealthy or cut domestic spending, but simply that we once again have to take care of our fiscal business in a reasonable manner.

Despite the protestations of partisan economists, the economy is largely indifferent to whether we address these imbalances by cutting spending or raising taxes. The first stage of this effort, in 2011, brought $1.2 trillion in spending cuts over 10 years. The verdict of the markets was, “well done”; and, despite the heated rhetoric of last year’s campaign, the 2011 deal was followed by a generally strengthening economy. Stage two was resolved in this week’s agreement to raise nearly $700 billion in new revenues over 10 years, including substantially higher taxes on capital income. The markets are satisfied with that, too, and the economy almost certainly will continue to strengthen.

Stage three will come in a few months, when the President and Congress will likely agree to modest entitlement changes in exchange for additional revenues raised through some version of corporate tax reform. The economy will be fine with that resolution as well.

In fact, this process has been a quiet refutation of the slash-the-deficit chorus. That includes those of the Paul Ryan variety who would upend entitlements to finance more tax cuts, and “responsible budget” types who would hike taxes and slash spending as much as possible to reduce the cost of business borrowing in years to come. The truth is, the economy does not usually respond to drastic measures that confound the expectations of investors and consumers. For all of the complaints that rather than make a meal of the deficit, we take a nibble here, another nibble there and then a third nibble somewhere else, this tortured course allows businesses and households to adjust little by little. And that is the best course for the economy.

So, setting aside politics and social policy, the economic imperative remains that Washington must manage to take care of its fiscal business in measured and reasonable ways, whether through taxes or spending cuts of almost any variety. Looking ahead, this means that the debt limit can never again become a negotiating chip in fiscal politics. The last time that House and Senate hyper-conservatives went down that path, it cost the U.S. government its triple-A rating from one of the three major credit-rating agencies. A government capable of letting lapse its own legal authority to issue new debt and pay interest on its existing debts is one that, by definition, cannot take care of its basic business. And that is especially so in the current circumstances, when there are no market pressures on the government to default and when the government’s debt securities comprise much of the reserves of most of the world’s central banks.

Global investors would be anything but indifferent to such contempt for predictable economic consequences. A technical sovereign debt default triggered by a debt-ceiling stalemate would be a calamity for the U.S. and world economies. Any political leader or party that helps to bring about such a catastrophe will prove themselves unfit to govern for a very long time.

 

 

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The State of the Union and the Power of Technological Change

Wednesday, January 25th, 2012

President Obama made inequality a major theme of his State of the Union address last night, an unsurprising choice as he prepares to face Mitt Romney. Everyone now knows that just last year Mr. Romney paid a smaller share of his $21 million income in taxes than the average American paid on a $50,000 salary. But if inequality was the President’s theme, his main subject was jobs. For Obama, faster job growth depends on more government. We need Washington, for example, to retrain workers, reduce college costs, and provide special supports for manufacturers. For Romney, the answer for job creation is, what else, less government: Washington needs only to cut regulation and reduce taxes, especially for the wealthy people and corporations who, in the Romney worldview, create the jobs. But not so fast — there are other options as well. A new report from the NDN think tank suggests that certain kinds of new technologies can spur job creation more effectively than most government programs or tax cuts. The new study, conducted by Kevin Hassett of the American Enterprise Institute and myself, found that the rapid spread of new 3G wireless devices from 2007 to 2011 led directly to the creation of nearly 1.6 million new jobs. And those job gains occurred even as the overall economy was shedding 5.3 million other jobs.

Our analysis tracked shifts by consumers and businesses from 2G wireless phones to 3G smart phones and tablets, quarter by quarter and state by state, from July 2007 to December 2011. We then analyzed the links between the shift to the more powerful 3G devices and changes in employment, quarter to quarter and state by state. We did the math and found that every 10 percentage point increase in the use of those devices generated more than 231,000 new jobs within a year.

It makes clear and compelling economic sense. As a growing share of Internet use shifts to wireless devices, the people and businesses that use them become more efficient and productive. Those gains, in turn, create new value which ultimately leads to more job creation. The spread of 3G wireless devices also created a platform for new services — for example, in mobile e-commerce, mobile social networking, and location-based services. The growth of those new services also led to more job creation.

And the best news for jobs is that another technological shift is occurring right now, from 3G to 4G wireless devices. 4G wireless networks and the Internet infrastructure that supports them have the potential to drive significant new efficiencies and innovations across the economy. Jobs already are being created in 4G-dependent areas such as cloud-based services and mobile health applications. According to industry analysts, 4G wireless networks in the near future could be used to create a Smart Electricity Grid and a national public safety system.

This analysis, then, can provide a new direction for job creation efforts: Adopt spectrum and other policies that will promote the broad and rapid deployment of 4G

Still, there are also kernels of economic truth in the Romney and Obama positions. Romney is not wrong, for example, when he says that lower taxes are usually better for the economy than higher taxes. But there’s no evidence that lower taxes on wealthy people or corporations would produce many jobs. And in a period of trillion-dollar budget deficits, calls for tax cuts seem at best irrelevant, and at worst politically cynical and misleading.

The President is on firmer ground. Greater access to higher education and retraining should increase productivity and growth, at least over the long haul. Since the direct benefits from those efforts would presumably go to people from modest or middle-income households, Obama’s approach also could help address inequality. And since the President seems prepared to raise the revenues to finance his proposals, they could be more than political window dressing.

For all of these good points, these approaches are not the answer to slow job creation. For that, President Obama and Mr. Romney have to directly address the forces that actually create and destroy private-sector jobs. One such force is technology, and our new analysis shows that the 3G and 4G wireless technologies can create many more jobs than they may destroy, and do so quickly. Another approach could focus on reducing the additional costs that businesses bear directly when they create new jobs. That could mean cuts on the employer side of the payroll tax or new measures to slow increases in the health care costs that businesses bear for their employees. At a minimum, any of these approaches would produce more economic benefits for more people than all of the tax cuts promoted by Obama’s opponents.

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The Bankruptcy of Austerity Economics

Thursday, January 12th, 2012

Conservative conventional wisdom collided this week with a dose of economic reality, and the winner is reality. For two years, every Republican congressional leader and presidential hopeful has proudly insisted these days that austerity is the cure for a sluggish economy like ours. It is an approach embraced most memorably, of course, by Herbert Hoover, although Angela Merkel also pushes it today for the faltering Eurozone. In fact, austerity in the face of high unemployment, slow investment and weak demand has been decisively refuted by a half-century of economic analysis and policy. The best medicine for a slow economy is usually measures to jump-start investment and consumption funded by more private or public debt.

Congress has refused to let Washington play that role since the 2010 elections, so finally American households are stepping into the breach. Last week, we learned that employment rose sharply in November, and this week we found out why: Borrowing by American households jumped $20.4 billion in November. That’s the largest increase in ten years. This new willingness by Americans to take on new debt is the main reason why consumer spending is finally picking up, which in turn is the main reason why the jobless rate keeps on falling.

It would be rash to read too much into these new data, but they could be a powerful signal of stronger growth ahead. For three years, Americans have saved in order to reduce the burden of their outstanding debts. New Federal Reserve data show that it is working. In 2007, payments on mortgage, consumer and auto debts claimed a larger share of the incomes of an average household than at any time since 1980. But by the third quarter of last year, this household indebtedness had fallen to the lowest levels since 1994, providing a reasonable basis to begin borrowing again.

Moreover, the renewed willingness of average Americans to take on new consumer debt may also signal that housing values have finally bottomed out. Falling housing values — and Washington’s inability to do anything to help stabilize them — have been the single largest obstacle to a strong recovery. When home prices fall month after month, that not only increases the net debt of most homeowners; it also makes American homeowners poorer, month after month. And people who see their assets shrink, month after month and year after year, cut back on their spending. So, recent signs that consumer borrowing and spending are heating up again suggest that housing values may have finally stabilized. If that’s the case, the recovery may finally accelerate.

America’s new acolytes of austerity could still screw this up. In the last year, they tried to block payroll tax relief and extended unemployment benefits, and the truest believers among them even hoped to block an increase in the legal debt limit. All three of these matters will come back to Congress in coming months. The political landscape has shifted, however. The public now holds Congress in such low esteem — and especially House conservatives — that even fervent advocates of austerity may hesitate to repeat their wildly unpopular 2011 performance in an election year.

A stronger U.S. recovery could still fall victim to the European austerity caucus. Merkel continues to press austerity on the Eurozone governments, even as Europe slides into recession. Moreover, piling yet more austerity on economies in recession can only worsen the sovereign debt crisis which already threatens to pull down the Euro and major banks across Europe. Sometime next week or in the next few months, global investors may conclude that Merkel’s attachment to austerity will finally preclude meaningful steps to stabilize Italian and Spanish government debt. If that comes to pass, the ensuing financial crisis almost certainly would short circuit a strong American recovery.

For now, that recovery is in the hands of America’s households. Thankfully, they display more economic sense than many members of Congress or leaders of the Eurozone.

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Obama Channels Clinton on the Economy, But Will it Work the Second Time?

Wednesday, December 14th, 2011

In Kansas last week, President Obama laid out the economic brief for his reelection. Its substance plainly recalls the program Bill Clinton offered in 1992. Both plans are built around new public commitments to education, R&D and infrastructure, some fiscal restraint to finance the public investments and unleash more private investment, plus some modest redistribution of the tax burden from working families to the wealthy. This formula still strikes the right notes politically, at least for those who aren’t diehard, pre-New Deal conservatives. But economically, this mainstream approach will face much greater hurdles today.

Most of the President’s conservative critics have focused on his call for more revenues from affluent Americans, starting with a surtax on millionaires. In fact, congressional Republicans not only have rejected the surtax; they’ve also suggested that they might hold payroll tax relief hostage until Obama agrees to make the Bush upper-end tax cuts permanent. It’s a bluff, and not a very good one: The GOP will stop the surtax on the rich, but they cannot be seen at the same time as raising taxes on everyone else. Whether or not Bush’s largesse for upper-income Americans survives will turn on who is inaugurated in January 2013.

This tax debate may pack a good political punch for Obama; but in the end, it doesn’t have much economic significance. Yes, a higher marginal rate, in itself, would have negative effects. But in the real world, a higher rate never operates by itself. The additional revenues may help bring down interest rates by reducing deficits and so spur business investment, as they did under Clinton. Or the same revenues could help finance public investments that make businesses more efficient and productive. And the truth is, the adverse effects of a higher tax rate on the wealthy, by itself, fall somewhere between quite weak and very weak. What else can an economist infer from strong growth in the 1950s when the top rate exceeded 90 percent, quickening growth in the 1990s after Clinton hiked the top rate, and more tepid growth after Bush cut the top rate?

The harder and more important issue is whether the combination of more public investment and smaller deficits, which worked so well for Clinton, will make much difference today. Like Clinton in 1992, Obama last week called for more federal dollars in the three specific areas that can boost productivity and growth in every industry, and which businesses tend to shortchange. This covers worker education and training, basic research and development, and transportation infrastructure. The theory, confirmed by the boom of the latter 1990s, is that these factors help make businesses more efficient and their workers more productive. Together, those gains translate into higher incomes and stronger business investment, especially if businesses don’t have to compete with Washington for capital to invest. And all of that should produce stronger growth, more jobs, and a much-sought-for virtuous circle.

The catch lies in jobs and wages. If the public investments allow businesses to become more efficient and productive, but those investments do not lead to higher incomes and more jobs, the only result will be higher profit margins. The whole virtuous circle will slow down or even stall out, much like what happened once the 2009 stimulus ran its course. In the 1990s, the strategy worked like a charm, because U.S. companies still responded to higher growth and productivity with strong job creation and wage increases. But those connections have weakened badly since then.

Consider the following. The Bush expansion from 2002 to 2007 saw GDP grow by an average of 2.7 percent a year, 30 percent slower than the 3.5 percent annual gains for a comparable period in the 1990s, say 1993 to 1998. But while the number of private sector jobs grew by more than 18 percent from 1993 to 1998, this rate fell to less than 6 percent from 2002 to 2007, a two-thirds decline from the earlier period . Even worse, the connection between productivity and wage gains broke down even more. In the 1990s, productivity grew 2.5 percent per-year, and average wages increased nearly in lock-step, by 2.2 percent a year. In grim contrast, productivity grew 3 percent a year from 2002 to 2007 while the average wage didn’t go up at all.

Clinton’s program could take strong job creation and wage gains virtually for granted. President Obama’s program will have to address these issues head on, and in ways that might attract some bipartisan support. Obama will also have to contend with additional hurdles, including the persistent economic drag from the financial crisis and, perhaps, from another round triggered by Europe’s faltering sovereign debt.

Here are three ways to begin.

First, while the President’s temporary payroll tax cut for workers provides some welcome stimulus, reducing the tax burden that falls directly on job creation on a permanent basis — the employer side of the payroll tax — would be more powerful economically.  We could cut employer payroll taxes in half, for example, and replace the revenues with a new carbon fee on greenhouse gases. In the bargain, the United States also would become the world’s leading nation in fighting climate change.

To address stagnating wages as well as slow job growth, the President should recast his training agenda as a new right. Most jobs today — and virtually all positions very soon — require some real skills with computers and other information technologies. All working Americans should have the opportunity to upgrade their IT skills, year after year. They could have that, and at modest cost to taxpayers, if Washington will give community colleges new grants to keep their computer labs open and staffed at night and on weekends, so any American can walk in and receive additional IT training for free.

Finally, U.S. multinationals have lobbied furiously, without success, for a temporary tax cut on profits they bring back from abroad. Give them what they want, if they will give the economy what it needs. We could let U.S. multinationals bring back, say, 50 percent of their foreign profits at a lower tax rate if, and only if, they expand their U.S. work forces by 5 percent. A 6 percent increase in a company’s U.S. workers would entitle them to bring back 60 percent of those profits at a lower tax rate, and on up to a 10 percent job increase and 100 percent of foreign profits.

That’s what it will take, just to begin, for an economically-powerful program of public investment and fiscal restraint to work its magic this time.

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Will Europe Step Back from the Brink this Week?

Tuesday, December 6th, 2011

On the edge and the eve of a financial market meltdown, Germany seems to now accept that the Eurozone sovereign debt crisis poses the greatest danger to the European, American and global economies since the early 1930s. Yet, the world still is far from out of the Euro-woods. Yes, Angela Merkel’s Chancellery has finally signaled that she and her government will permit the European Central Bank (ECB) to stabilize the value of Italy’s public debt. But first, Italy, France and 14 other Eurozone nations have to prove themselves worthy by accepting German rules for fiscal policy. The clock is ticking: If they don’t agree to those conditions at the European summit later this week, Merkel will nix ECB intervention, and the meltdown will begin.

The gravity of this crisis is genuinely unique. When the U.S. financial market seized up in 2008, the systemic dangers were largely limited to institutions which had used reckless leverage to invest in securities or credit default swaps based on a housing bubble, like Lehman Brothers and AIG. This time, the systemic threat extends to everyone who has trusted in what has long been considered one of the safest assets in the world, the governments bonds of large, advanced European nations. That covers almost all large European banks and companies.

Furthermore, in the 2008 – 2009 crisis, governments had powerful tools — bailouts, new guarantees, stimulus, and interest rates cuts — to contain the worst of the crisis to those reckless financial institutions. For this second round, coming out of the first meltdown, governments everywhere have very few tools left to prevent the crisis from badly damaging entire economies.

So, if the ECB and Eurozone governments fail to act in the next few days and weeks, the results will be devastating. Most of the huge sovereign debt of Italy, the epicenter of the systemic threat, is held by German, French, Italian, and Spanish banks. The value of Italian bonds already has fallen sharply, eating away at the capital of those banks. That’s why lending by large Eurozone banks has virtually stopped, pushing most of Europe back into recession. That’s also why “interbank loans” in Europe — the billions of Euros or dollars in overnight loans that keep the banking system there liquid from day to day — also dried up.

To ease these liquidity pressures, the Federal Reserve and the ECB, along with the central banks of England, Japan, Switzerland and Canada, joined hands and stepped in last week. They cut by half the price they charge banks in their own countries to borrow dollars from their central banks, which the Fed has agreed to supply as required. Stock markets everywhere rallied, hoping this move would buy the Eurozone enough time to put in place a real solution. But the new loans cannot do more than that. The liquidity squeeze they address is only a symptom of the real problem, which is that the holdings of Italian government bonds by Europe’s big banks could bankrupt them. If those bonds fall in value much more, it will wipe out their capital.

If that weren’t bad enough, European governments may find themselves unable to contain the meltdown to banks with large holdings of Italian bonds. In 2008, the U.S. and European governments averted bank runs by quickly guaranteeing the money market accounts where most corporations keep their operating funds. But when the problem is the credit of governments themselves, who will believe them if they pledge to guarantee money market or other accounts — and where would they find the funds to do so if investors won’t buy their debt?

The good news for the United States is that American banks and companies got rid of most of their investments in Italian and other Eurozone government bonds over the last year. The bad news is that no one knows how many credit default swaps they hold against the default of those Italian bonds, or against the default of the corporate bonds of the Eurozone banks that actually hold most of Italy’s debt, or the corporate bonds of Eurozone companies that depend on those banks.

Europe sidestepped the danger of the credit default swaps against Greek debt by convincing the large institutions that held most of Greece’s bonds to voluntarily accept a 50 percent write-down. This 50 percent “haircut” is comparable to what usually happens when a government formally defaults. But because the write down of Greek bonds was technically voluntary, it didn’t trigger the credit default swaps.

The same approach won’t work for Italy, because its outstanding debts are just too large: Eurozone banks could not accept a 50 percent write-down on Italian bonds without becoming insolvent. And if the big financial institutions outside Europe — Goldman Sachs, Bank of America, Barclays and Bank of Tokyo-Mitsubishi, for example — have substantial European based credit default swaps, the fallout will threaten the global financial system. The sudden insolvency of European banks could damage the American economy in other ways as well. For instance, American banks and corporations are engaged in hundreds and perhaps thousands of deals today with large European banks. If those banks go down, all of the existing deals will be thrown into doubt.

If the crisis does hit the Eurozone and then spreads to the United States, most of the steps that policymakers took to contain the damage in 2008 – 2009 will not be available. Voters are very unlikely to tolerate another big bank bailout or large stimulus. And with interest rates already near zero, the Fed won’t be able to cut those rates enough to meaningfully support a sinking economy. The only move left will be to print money. To be sure, that’s what Europe faces today in an ECB intervention. Yes, it may lead to a steep devaluation of the Euro, which ultimately could unravel the currency union.

In a world in which better options are no longer available, the only course left is to address crises, one at a time.

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

Monday, September 12th, 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.

 

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For a Strong Economy, Keep Europe Afloat and Keep Americans in Their Homes

Monday, August 29th, 2011

The persistent sluggishness of the recovery here in the United States and in most of the world’s advanced economies should underscore a stark lesson from economic history: Systemic financial crises are the products of deep economic problems, and they can’t be solved by simply treating the after-effects of slow growth. It’s long overdue that the United States and Europe directly address the deep market distortions that brought about the crisis of 2008 and 2009.

So far, all we’ve done is substitute large doses of fiscal and monetary stimulus for the hard work.  That pulled us back from the brink of a Depression. We also shouldn’t have been surprised that once the stimulus played out, the same distortions reasserted themselves. We may technically be experiencing a recovery. But unless we’re more forthright in our interventions into both the housing and financial markets — on both the international and domestic stage — we’ll remain exposed to the possibility of a renewed crisis, one even more severe than the one that began three years ago.

These considerations don’t drive policy, in part because so many economists still see the crisis as an anomaly, one that will be followed in due course by markets reasserting their natural optimality. This view, of course, ignores or slights the overwhelming evidence of how inefficiently and “sub-optimally” the financial and housing markets have performed for years. U.S. and European financial markets have systematically failed to reasonably price the risks of trillions of dollars of derivative securities; housing markets here and across much of Europe have sustained a classic speculative bubble and equally classic crash.  

Our current predicament has as much to do with our own lame responses to the consequent crisis, as it does with the original crisis itself. Washington provided bailouts and virtually-free credit for financial institutions without applying requirements as to how that new-found money ought to be used. There also were new housing initiatives, but based on a fanciful view that a little federal money would be enough to convince bankers to extend new credit to people already on the brink of default. Finally, there was a substantial fiscal stimulus — a good and necessary move — but one cobbled together from the wish lists of hundreds of members of Congress.

The results are now clear in the data. Financial institutions amassed trillions of dollars without expanding business lending, mainly because the financial-market distortions that brought on the crisis are still with us. These institutions are still holding trillions of dollars in wobbly asset-based securities, whose risks even now they cannot reasonably price. So they sit on most of their new capital (after paying out their bonuses), in hopes of avoiding another bout of bankruptcy from those assets, should another crisis erupt. Yet, the prospect of new legislation to sustainably resolve those weak assets by pulling them off the books — as Sweden did in its early-1990s banking crisis, and we did in the S&L crisis of 1989-1990 — is nonexistent.

The prospect of another imminent crisis on the horizon ought to put the necessary policies into relief. One initiative that cannot wait: President Obama should call an emergency G-8 meeting to help head off a new financial meltdown in Europe. The sobering fact is that many of Europe’s largest banks are nearly insolvent. It’s a legacy from not only the 2008 – 2009 meltdown, but also the EU’s decision in 2007 to reduce bank capital requirements under the level set by the “Basel 2” accords. Americans benefited from the fact that our own banking regulators dawdled in making similar changes desired by the Bush administration, by which time even the Bush Treasury had doubts about cutting capital requirements. The result today is that the German and French banking systems in particular are in much worse shape than Wall Street.

Now these weak banks face additional, large-scale losses from the falling values of Italian and Spanish government bonds, a contagion from the now-anticipated defaults of Greek and Portuguese public sovereign debt.  If this turmoil intensifies, it will probably pull down some of Europe’s largest banks. And if institutions such as BNP Paribas and Deutsche Bank (the world’s two largest banks) fail, the U.S. and global economies would probably follow. Moreover, this time, the consequences would be even more dire than in 2008 – 2009, since governments have already exhausted their fiscal and monetary policy options.

We can still head off a 1931 scenario if Germany and France will accept the inevitable and obvious: A common Euro currency requires that every member pledge its full faith and credit for Eurobonds to support the full faith and credit of everybody else. Otherwise, the failure of a small member (today, Greece and/or Portugal) can destroy confidence in the economic sustainability of much larger members (Italy and Spain). And then, everybody’s goose is cooked.

The political catch is that the solution puts French and German taxpayers on the hook to bail out fiscally-inept Greece and Portugal. Chancellor Merkel and President Sarkozy have tried to avoid the political blowback from introducing Eurobonds by trotting out smaller options. It is a decision that hearkens to the Bush administration’s misguided attempts to avoid bailing out Lehman Brothers. Investors aren’t buying it. So if Greece goes down now, Sarkozy and Merkel will be forced to rescue Italy and Spain — and perhaps France itself — at incalculably greater cost to everyone.

President Obama should not delay to call for a G8 meeting: Europe needs to hear that the United States considers its current course unacceptable, and that Washington would be ready to help fund IMF support for a broader solution that can head off another full-blown crisis.

If we intervene to put Europe back on course and avoid a replay of 1931, we still will be facing the prospect of a persistently slow economy. Preventing that kind of long-term stagnation would require that we finally address the distortions in the housing market by stabilizing housing prices. Policymakers’ most promising avenue to that end would be to focus on bringing down foreclosure rates and keeping American families in their homes.

There is no doubt that housing prices are central to our current growth dilemma. People spend freely when their incomes are rising or their wealth is increasing. During the last expansion and leading up to the current crisis, the incomes of most Americans stagnated. Instead, growth and business investment were driven mainly by the “wealth effect” created by fast-rising housing values. Now, the economy is caught in the flip-side, as four years of sliding housing prices drive a powerful negative wealth effect that continues to hold down consumption.

The broad reach of these effects reflects how wealth is now distributed in the United States: According to Fed data for 2007, the bottom 80 percent of American households held 40 percent of the value of all real estate assets, compared to a miserable seven percent of the total value of all financial assets (and yes, that includes pensions). Home equity, in short, is very nearly the only real asset for more than half of all Americans. The decision to allow housing values to fall for four straight years—in contrast to the equity and bonds of large financial institutions—leaves the majority of American consumers growing poorer month after month. Just as people who grow richer spend more, people who find themselves poorer spend less. So, consumer demand and with it business investment will not recover until housing values stabilize.

To help make that happen, policymakers could establish a temporary loan program for homeowners whose mortgages are in trouble, to help bring down foreclosure rates and so begin to stabilize housing prices and stem the negative wealth effect. The program should not be a giveaway; if it were, it would create enormous moral hazard and enrage everyone who works hard to keep up their own mortgages. So, the loans would carry an interest rate above current 30-year mortgage rates, and those who take advantage of them would have to turn back to taxpayers a share of any capital gains earned later from selling their homes.

It’s very important that we get this right. Unfortunately, the signs from Washington right now aren’t promising. The Obama administration reportedly is considering a program to promote large-scale mortgage refinancings at the current, low fixed rates. If it worked, lower mortgage payments could free up an estimated $85 billion for consumers. But since those whose mortgages are in trouble probably wouldn’t qualify, the refinancing program would inject a little stimulus without affecting housing values. That means it would leave intact the current, negative wealth effect.

We don’t have time to wait for the markets to begin operating rationally again. The economy will only right itself when housing values stabilize and distortions in Wall Street’s and Europe’s financial systems have been addressed. We will need to intervene on both domestic and international fronts, to restore consumer demand and business investment — and with them, President Obama’s prospects for reelection.

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