Posts Tagged ‘The Point by Robert Shapiro’

The Cost of Playing Games with the Full Faith and Credit of the United States

Thursday, June 2nd, 2011

I spent last week in Rio attending a meeting of the IMF’s advisory board for the Western Hemisphere — and returned this week to Washington for the latest round of threats and charges over raising the U.S. debt limit. The contrast was, at once, disturbing and farcical. At the IMF meeting, former finance ministers, prime ministers and other ex-economic policy officials tried to unravel the grim implications for all of us if (when) Greece, Portugal or, in the worst case, Spain is forced to default on their sovereign debts. Back in Washington, congressional Republicans laid out their terms for not driving the United States into a voluntary default on its sovereign debt. Perhaps holding onto a child-like faith that bad things don’t happen to the United States, under God, they spelled out terms which everyone knows will never be accepted by President Obama and a Democratic Senate. The irony is that the GOP gambit of holding out a potential debt default if they don’t get their way could, in itself, make long-term control over deficits much harder.

The reason lies in the powerful influence of worldwide investors on our interest rates. Thankfully, global capital markets still have confidence that our two political parties can settle this dispute on reasonable terms, and that in time the United States will regain control over its deficits and debt. We know that confidence is still there, because the interest rates and yields on U.S. Treasury bills, notes and bonds all remain near historic lows. If there were real doubts about our capacity to control long-term deficits, those interest rates would be rising as investors demanded higher returns to offset the risk that we’ll fail. This confidence makes sense, because we succeeded at the same task twice before, in the 1980s and again in the 1990s. It took several years of squabbling and compromise, but President Reagan and a Democratic House agreed to raise taxes, cut defense and reduce Medicare and Medicaid spending in the 1980s — and the same pattern played out again a decade later with President Clinton and, first, a Democratic House and then a GOP one. That combination of revenues, defense and health care was, and remains today, inevitable, since those are the only pieces of fiscal policy big enough for cuts and reforms that can make a significant difference for deficits.

But neither Reagan nor Clinton faced opponents prepared to hold the full faith and credit of the United States hostage to their own partisan approach to the deficit. To make this gambit appear respectable, House Majority Leader Cantor even claimed last week that major players on Wall Street had assured him that a U.S. default would be a matter of economic indifference. The only explanation is that Mr. Cantor, without realizing it, was talking to short-sellers getting ready to bet billions that U.S. stocks and bonds might crash — as they will if we actually do default.

Happily, worldwide investors are probably correct that the likelihood of a U.S. debt default is still very, very small. If it ever came close to that, the real players on Wall Street would face down the U.S. Congress. But cutting it close may turn out to be very expensive, too.

Let’s perform a small thought experiment. A Tea-Party infused GOP takes us to the edge of default and then pulls back. A really close call, however, would almost certainly make worldwide investors nervous. They would begin to question whether our politics truly are up to the task of dealing with our deficits, so they add a small risk premium to our interest rates. Let’s say — and this would be optimistic in this scenario — that short-term rates on Treasury bills go up one-half of a percentage-point; medium-term rates on Treasury notes rise three-quarters of a percentage-point, and long-term rates on U.S. bonds increase by 1.25 percentage-points.

Now, let’s be optimistic again and assume that Congress and the President eventually agree to cut the 2012 deficit by 10 percent — $108 billion off of the current projection of $1.081 trillion. That will leave a 2012 deficit of $973 billion to be financed. The small increases to interest rates would add about $7 billion just to the first-year interest costs of the 2012 deficit. And that’s just the beginning: All publicly-held Treasury bills also have to be refinanced in 2012 — nearly $2 trillion worth at last count. The tiny 0.50 percentage-point increase in those rates would add another $10 billion to next year’s interest costs. That comes to $17 billion in extra interest costs in just the first year, and just on publically-held debt. Those premiums would become embedded in those interest rates, adding much more to our interest costs, year after year, as additional deficits have to be financed and some $7 trillion in publicly-held Treasury notes and bonds come due for refinancing. A single refinancing of that current stock of publicly-held Treasury notes and bonds, with the new risk premiums, would add more than $50 billion, per-year, to interest costs. And the actual risk premiums demanded by global investors could be significantly higher than we assume here, and so that much more expensive.

These incremental increases in interest rates also wouldn’t be confined to U.S. Treasury rates; they would be transmitted immediately to other interest rates, from mortgages to credit cards. That means the expansion would further slow, American incomes and the government’s revenues would grow less, and, lo and behold, the deficits would be even bigger.

That’s the math. Even if congressional Republicans don’t mean it, the political games they’re playing today with a U.S. debt default, purportedly in the name of fiscal responsibility, could make U.S. deficits and debt even more unmanageable, and U.S. prosperity more problematic.

The Economic After Shocks of the Disaster in Japan – Part 1

Monday, March 21st, 2011

Natural disasters can strike anywhere, but the heart-wrenching tragedy unfolding in Japan may be unique for modern times, at least economically. In today’s post, we focus on what makes last week’s earthquake and tsunami so different from other natural disasters and why they have put Japan’s economy at real risk. Later this week, we will lay out the implications for the rest of us, especially the economic aftershocks poised to hit the United States and China.

As a rule, natural disasters in advanced countries, like terrorist attacks, inflict enormous economic costs on the specific places where they occur, but with little if any serious damage to the nation’s economy as a whole. When Katrina crippled New Orleans in August 2005 and exacted $81 billion in property damages on Louisiana and Mississippi, it didn’t puncture investment or growth in the rest of the country. For a natural disaster to upend an economy, the damage has to touch most of the nation and endure for a considerable time. Those conditions normally occur only in small countries, especially small developing nations that depend heavily on foreign investment. What makes the terrible Japanese earthquake and tsunami uniquely destructive to that country’s large, advanced economy is that they could result in disabling a significant part of the nation’s power grid for months and, even worse, spread dangerous radiation across many of the country’s agricultural, industrial and population centers.

To be sure, major natural disasters always have significant local and distributional effects. Katrina depressed parts of the Gulf state economies for several years, and tens of thousands of people fled Louisiana for nearby states, especially Texas. In addition, the temporary closure of the port at New Orleans reduced U.S. exports for several months. But the real losses were confined to the immediate region. And while the terrible human and property costs shook most Americans, their empathy didn’t dampen investment or household spending anywhere else in the country. In fact, two months after Katrina struck, the fourth quarter of 2005 saw the strongest GDP gains of the entire decade.

The same dynamics were evident after the 9/11 attacks, which hit lower Manhattan like an earthquake. There were large, temporary distributional effects. For example, the attacks devastated real estate prices and rents in downtown Manhattan, but they boosted the real estate market for midtown. The attacks certainly shook most Americans psychologically; and when millions of people canceled planned trips for the coming months, it depressed airlines, hotels and other travel services. But the money that people saved by skipping their vacations went instead to buy large screen TVs and SUVs. And the Federal Reserve responded to the attacks by cutting interest rates, boosting interest-sensitive industries from capital equipment to housing. Just like Katrina, then, 9/11 had no adverse effects on the national economy. In fact, investment and consumer spending in the quarter following the attacks, October-November-December of 2001, were stronger than any quarter for two years before and after.

Unlike such localized catastrophes, the recent earthquake and tsunami will likely inflict enormous damages across Japan, and for some time to come. The issue here is not the terrible, immediate losses of life and property in the country’s northern shoreline towns and cities. The damage done to the country’s power grid will extend the economic costs far beyond the communities directly devastated by the disasters, slowing agricultural and industrial activity across up to one-third of the country. And for these losses, there will be no offsetting gains from reconstruction. Even more frightening, the radiation released by the ongoing meltdowns at nuclear power facilities could bring economic activity to a halt in much more of the country.

Other national economic effects are beginning to be felt across Japan’s already fragile economy. Japanese investors are cashing out much of their large holdings of dollar and Euro-denominated financial assets, converting them to yen, and bringing those yen back home. The result has been a large boost for the yen’s value, dealing an additional blow to Japan’s export companies. Those same companies also are beginning to cut back their foreign production, because many of critical parts for Japanese automobiles and electronics are still made in factories closed down by the disaster and electricity problems.

The disaster and its aftermath also are quickly driving up Japan’s budget deficit and national debt, which already were at dangerous levels following a decade of economic stagnation punctuated by the 2008 – 2009 financial meltdown and subsequent deep recession. As Japan’s economic outlook deteriorates, and its domestic savings fall with incomes and earnings, international investors will likely pull back. All of this could raise serious doubts about the viability of Japanese sovereign debt, pushing up interest rates and possibly triggering a run on the yen and a dangerous downward spiral.

As terrible as these dislocations will be for Japan, the world’s third largest economy, they’re not enough to derail the current global expansion. Even so, serious economic aftershocks will be felt soon beyond Japan, especially in the United States and China. Later this week, we will examine the potential damage to the American and Chinese economies from the horrific disaster in Japan.


The U.S. Economic Debate Gets a Failing Grade at the IMF

Wednesday, March 9th, 2011

At the private conference this week convened by the International Monetary Fund (IMF), 30 world-class economists talked for two days about “Macro and Growth Policies in the Wake of the Crisis.” Their discussions provided a reality test for the current economic debate in Washington, and the last decade of U.S. policymaking flunked. Economic ideology not only blinded American policymakers to the seeds of a financial crisis that never had to happen; it also has led to wrong-headed responses for both the short-run and the long-term.

While the United States and other advanced countries embraced large-scale stimulus in 2008 and 2009 to avoid a global depression, the panelists pointed out that the world’s advanced economies are now moving in the opposite direction, without regard for the consequences. Across a group of economists who normally argue over every assumption and decimal point, a genuine consensus emerged that the American and European economies remain too fragile today to successfully absorb major deficit cuts.

While congressional Republicans wield a meat axe over the budget, and many Democrats would apply a scalpel, nearly all of the economic notables gathered at the IMF concluded that additional spending and tax breaks would be much more sensible. The 2009 and 2010 stimulus programs came in for plenty of criticisms, especially for their emphasis on tax breaks for households:  The financial meltdown and deep recession left most households with so much debt relative to their incomes that much of the stimulus just went to reducing their debt loads. Household debt today is considerably lower; but it hasn’t fallen as far as most people’s assets, because the value of their principal asset, their homes, has kept on declining month after month. This time, the experts agreed, any stimulus should be better targeted, for example through investment tax breaks and spending on education and infrastructure.

To be sure, there were repeated calls for a long-term “fiscal consolidation” program, which is how economists describe entitlement reforms and other measures that can limit a nation’s public debt to a reasonable share of its GDP. But they weren’t encouraged by what they’re hearing out of Congress, where politicians regularly conflate the need for long-term deficit reduction with a short-term opportunity to roll back the size of government. Nowhere is this confusion more obvious, several noted, than in a misguided focus on cutting current discretionary appropriations. And particular scorn was heaped on calls for cuts in education and infrastructure investments, which economists have long promoted as the best way to support future expansion and provide a lifetime of healthy social returns.

The most stinging critique, however, was reserved for the years of policy and business misjudgments which brought on the financial crisis and ultimately triggered the worst recession in 80 years. Starting with the opening remarks by Dominique Strauss-Kahn, the head of the IMF, a long line of economic luminaries laid out how policymakers here and in Europe misunderstand the very nature of modern financial capitalism. Again, there was rare unanimity for the view that markets today, which work so well in allocating resources, lack the means and the information to recognize bubbles and evaluate the economic risk of complex financial instruments.

Nor do policymakers have the excuse that this challenge represents something new. Hundreds of savings and loans went under in the 1980s, because financial markets couldn’t evaluate risk very well. Moreover, the 1990s saw three bubbles slowly take shape and then explode, first in Japan, then across much of East Asia, and finally in the Nasdaq tech sector. Yet, policymakers at the White House, the Federal Reserve, the Treasury and their counterparts across Europe sat by placidly, just a few years later, as leading financial institutions recklessly accumulated enormous leverage for financial instruments based on an obvious bubble and whose riskiness they couldn’t begin to assess.

Yet, these misjudgments weren’t universal: The financial meltdown was limited to the advanced economies, while much of the developing world learned the painful lessons of the 1997-1998 Asian financial crisis. So, their policymakers imposed new limits on leverage, and their financial institutions passed on investing in the toxic assets that brought down the U.S. and European economies. That’s why, at least for now, the developing economies have become the engine of global growth.

The Great Depression produced a large sheaf of institutional reforms which have helped the world avoid a repeat ever since. Yet, the Nobel Laureates and other experts gathered this week by the IMF also agreed that the United States and Europe have yet to undertake comparable reforms that would make another global financial crisis less likely. If we don’t, they warned, another financial crisis almost certainly will befall America and Europe in the foreseeable future.

What the Obama-Hu Meetings Can Mean for the U.S. Economy

Wednesday, January 19th, 2011

Barack Obama and China’s President Hu Jintao have genuinely important economic matters to talk about this week, even if there’s little prospect for any agreements that could materially improve our own economy anytime soon. But President Obama can –– and certainly will –– use these meetings to hammer home his long-term priorities for the U.S.-Sino relationship. And so long as Hu continues to see the United States as the “indispensable nation” for China’s economic development –– Hu’s own words –– a U.S. President’s priorities matter. And in acknowledging China’s increasing success in the global economy, the President can also remind Americans why they have to raise their own economic game –– and how his domestic policies can help them do just that.

A few of these discussions may produce quick benefits. For example, Obama will press Hu on China’s lax enforcement of the intellectual property (IP) rights of American companies in the Chinese market. A lot of Americans still see such enforcement as a parochial issue for a few big pharmaceutical and software outfits. It’s true that Chinese producers regularly try to rip off U.S. patented drugs, mainly for third-world markets; and until recently even the Beijing government used a pirated version of Windows. But there’s much more at stake here for us. The fact is, the only promising, long-term strategy that the global economy offers the United States today depends on our outsized national capacity for developing and adopting economic innovations –– from new products and technologies, to new ways of financing, marketing and distributing goods, and new ways of organizing a business and running a workplace. IP rights in the world’s second largest market, then, affect everything from movies, machine parts and genetically-enhanced foods, to computer slates, Internet business processes, and nanomachines.

China already is legally obliged to protect the IP rights of American companies inside China under the rules of the World Intellectual Property Organization. So, Obama will press Hu to actually meet those obligations; and since China has recently begun to build its own R&D establishment, it’s an area where China’s interests and ours are beginning to align. The truth is, this is ultimately non-negotiable for the United States. But it also should prove to be a small price for China to pay for a solid economic relationship with the country that is not only one of its largest markets, but also its leading source of foreign direct investment into China –– including new technologies and business methods that are at issue in IP enforcement.

There’s less prospect of real progress on nudging China to revalue its currency, a recent hot-button issue for some prominent members of Congress. A stronger renminbi certainly would appear to be in our interest, since it would cut the price of U.S. exports inside China and raise the price of their exports inside the United States. In practice, it probably would make little difference to our economy. A stronger renminbi mainly would help companies in places which produce the same things as domestic Chinese companies –– places like Bangladesh and Thailand, not Michigan or Alabama. Yes, it would shave the price of U.S. products inside China –– but it would do the same for the products of our Japanese and European competitors.

Anyway, Hu has no intention of taking major steps in this area. Chinese leaders have always approached the value of their country’s currency as a matter of national sovereignty –– and the truth is, we don’t react very well either when China or the government of any other country criticizes U.S. monetary policies. And even if Hu approached this matter less dogmatically, it wouldn’t change that fact that the cheap renminbi is a critical part of the country’s basic strategy for strong, export-led growth; or that Hu and his fellow leaders see the success of that strategy as a lynchpin of their own political legitimacy. And while it won’t be mentioned this week, China’s long-term goal in this area is to claim for the renminbi part of the U.S. dollar’s role as the world’s reserve currency, which at our expense would help insulate the renimbi itself from future pressures to revalue.

Obama may get a more receptive hearing when he presses Hu to engage with the United States –– and the rest of the world –– on climate change. Both men know very well that China is now the world’s largest greenhouse gas emitter. That’s mainly because China has the world’s most ambitious program for building new electricity-generating plants; and since its only significant domestic energy source is coal, that’s what those plants run on. Hu also knows that the world will address this threat sooner or later –– and when they do, China cannot afford to sit on its hands. Obama’s challenge is the same one he faces with many Americans –– come up with a strategy that will raise the price of fossil fuels without imposing serious costs on the economy. Here at home, the answer to that riddle is a carbon-based tax with the revenues recycled for tax cuts in other areas. For China, Obama’s approach will have to be more subtle –– for example, intimating about a future agreement to promote joint ventures by U.S. and Chinese companies to develop and sell new alternative fuels and climate-friendly technologies.

These issues also give Obama the opportunity to drive home his case for new public investments at home –– in education and training, for example –– to expand America’s modest comparative advantage in fielding a workforce that can adapt easily to new technologies and business methods. This week’s meetings also could provide a platform to highlight his tax incentives for businesses, so they can make the investments required to better compete with Japanese and European companies in the Chinese market. And any meaningful U.S.-Sino discussions on climate change will dovetail nicely with the administration’s calls to expand R&D in this area, and so establish a more commanding position for the United States –– with or without China –– in global markets for green fuels and technologies.

Time for a Midcourse Correction in Economic Policy

Wednesday, September 8th, 2010

The economic proposals unveiled this week by the Administration suggest that the President’s determination to target his policies for the long-term has led the White House to misread the economy today.  Allowing firms to deduct their capital investments in the year they occur instead of slowly depreciating those costs, and expanding the R&D tax credit and making it permanent are measures that can help sustain growth once it returns, but they won’t lift the economy’s current faltering pace.  To do that, they need a midcourse correction aimed directly at the economic distortions which brought down the economy and produced today’s abnormally slow and halting recovery.  It’s time for presidential leadership and big initiatives, starting with the housing market.

 Since 2009, when the White House famously forecast that strong growth would return this year and unemployment would top out at 8 percent, their program has relied on models and analyses that see the current period as part of a normal business cycle.  If only that were so, because then the massive fiscal and monetary stimulus of the last 18 months would, indeed, have produced the robust V-shaped recovery they expected.  But that isn’t the economic hand we’ve been dealt.  Much like the sorry story of post-bubble Japan in the 1990s, the structural distortions in housing and finance which brought on our crisis remain largely unaffected by stimulus.  While all that stimulus stopped our slide towards a depression, it was neither sufficiently large nor long-lasting to offset the structural problems. 

So, the banking system, still saddled with hundreds of billions of dollars in shaky mortgage-backed assets  and fighting additional drag from falling values in commercial real estate and European debt, remains too weak and wary to resume normal lending to most businesses.  The problems with housing have even more far-reaching effects for the recovery.  With high unemployment dragging on — as it typically does following a financial crisis — housing foreclosures are stuck at three times normal levels, pulling down the value of most Americans’ homes.  This continuing decline in housing values not only has left 23 percent of households with mortgages under water.  It also continues to eat away at the net wealth of everyone who owns their own homes, producing a “negative wealth effect” that leaves most Americans, much like the banks, too financially weak and wary to resume normal spending.

Even if a second round of stimulus were possible politically, it wouldn’t cure these structural problems with any greater success than the first round.  Until the administration and Congress tackle the forces holding down consumption spending and business lending — or wait another half-decade for this dismal cycle to run its course — the American economy will remain weak and unemployment high. 

 A real opportunity here lies in a new approach to keep Americans in their homes and so help stabilize housing values.  Subsidies for banks to rewrite troubled mortgages haven’t worked, because the approach glosses over the weakness of the banks and the way they conduct business.  Even if these institutions were in better shape, very few bankers are willing to extend new credit to people who couldn’t keep up with their mortgages.  Only a government can assume such risks. 

The best approach for this would be a new two-part program aimed at housing and unemployment.  The first part is a loan program, modeled on student loans, to help Americans with troubled mortgages.  Those families could apply for five-to-ten year government loans to stave off foreclosures, with the repayment schedules linked to people’s incomes recovering.  With many fewer foreclosures, housing values could stabilize and staunch the negative wealth effect now holding down consumption.  The second part of the new program would reduce the cost to businesses of creating new jobs, by expanding and extending the administration’s modest cuts in an employer’s payroll taxes for new hires, the approach that CBO calls the most effective way to jumpstart job creation.  Every new job will enable another family to earn the income needed to help keep up with their mortgage, further stabilizing housing values and so ultimately supporting consumption.

If the economy were poised to take off, the Administration’s proposals for another $50 billion in infrastructure spending and $200 billion in tax breaks for small businesses might help.  Unhappily, that’s not the case.  But the President has time to seize the opportunity to make a mid-course correction, and put in place the foundation for a strong recovery in, say, 2012.

Why the Value of Your House Moved Global Markets This Week

Thursday, August 26th, 2010

This week’s housing news was a primer on globalization. U.S. existing home sales fell 27 percent in July, twice as sharp a drop as Wall Street analysts said to expect. (Of course, they’re the same geniuses who didn’t see their own meltdown coming; didn’t expect the long, deep recession that followed; and couldn’t figure out that the recovery would be slow and halting.) Right away, our stock markets sunk by one to two percent — no surprise there — but we weren’t alone. On Wednesday morning, the financial news led with “European Stocks Drop on Dismal U.S. Home Sales Data” and “Most (Asian) Stocks Fall Amid Speculation on U.S. Home Sales Report.”

Why does a bad report on American home sales rattle investors a half-world away? To be sure, housing is an important piece of every U.S. recovery. And the world pays close attention to ours, since we remain by far both the world’s largest market for imports and the place where most foreign multinationals maintain their subsidiaries. This time, however, there’s more at stake. Housing is both a lynchpin for a full recovery from the financial crisis that pushed most of the world to the brink of depression; and the key to something better than our current stumbling expansion.

The link to finance is straightforward. Everybody remembers how Wall Street’s largest institutions swooned or crashed when the end of the housing bubble brought down hundreds of billions of dollars in mortgage-backed securities and the credit default swaps that backed them up. But when Washington stepped in to rescue most of them, it took out its own risky bet that a housing recovery would quickly stop the bleeding. So we never seriously considered what Sweden did so successfully in the early 1990s — and what we did ourselves to resolve the S&L crisis: Take over an insolvent Bear Stearns, AIG or Merrill Lynch, pull out the weak and failed assets, and sell the still-healthy stuff to new investors who would promptly reopen the institution under a new name. And the bailouts didn’t even require that these institutions put their books back in order by getting rid of the most risky housing-based assets which they still held.

The catch is that if the housing market continued to deteriorate — as it did — more of those assets would decline in value or fail outright. Those losses, current and prospective, leave finance much less willing to lend to most other companies. And that means that strong business investment, which is a critical part of all healthy expansions, this time will follow a housing recovery, not lead it.

There’s more at stake in the current housing market than the pace of business investment. Some 70 percent of U.S. households are homeowners, which makes housing values the most important piece, by far, of most Americans’ wealth and economic security. So, the sharp drop in those values has made most of Americans poorer than they had been; and, unsurprisingly, people who feel poorer tend to spend much less. The health of the housing market, in short, now directly affects both business investment and consumer spending, and with them the outlook for the entire U.S. recovery.

It’s little wonder that world markets reacted badly to this week’s dismal U.S. housing report. Beyond the 27 percent drop in existing home sales — and one day later, sales of new homes also fell sharply — nearly one-third of the houses that did sell were “distressed” properties. That means they were either in foreclosure or sold for less than their outstanding mortgages. Average home prices did inch up a little bit, but the only reason was that the end of the temporary tax credit for first-time homebuyers led to a particularly sharp fall in their purchases, which normally involve lower-priced homes.

Nor are there signs of a real housing recovery anytime soon. Foreclosures are still running at four times their normal levels — and nothing drives down a neighborhood’s housing prices and slows down sales more than nearby homes in foreclosure. On top of that, supply continues to way outpace demand: At current rates of home sales, it would take over a year to clear all of the homes already on the market today.

If we don’t take serious steps to finally turn around these conditions, the United States and much of the rest of the world will be looking at a weak expansion, or worse, for several more years. One measure that could have a powerful effect would be steps to bring foreclosure rates down to normal levels. For example, congressional Democrats could advance a new program modeled on student loans for homeowners with mortgages in trouble. Homeowners who qualify could borrow the funds they need to stay in their homes, at a low interest rate, with no interest due the first year so long as they stay in the homes for at least two more years.

Most Republicans will denounce it as just another “big government program.” Yet, without a housing recovery, the alternative is not only smaller government but also a smaller economy, because businesses can’t find loans, people can’t find jobs, and most consumers can’t spend like they used to.

The Importance of Blaming the Right People for the Wall Street and Gulf Disasters

Wednesday, June 16th, 2010

This year’s notorious Supreme Court decision on campaign finance found that corporations have the full rights of individuals, at least in the area of campaign finance. While that ruling may have serious consequences for how we conduct elections, most of us already approach big companies as if they were people — and then, when those companies wreak havoc on the economy, no one can be found to hold accountable. Congress may pass new regulations, but that’s little consolation to the victims. Anyway, both the Wall Street meltdown and the Gulf spill unfolded not only because regulation was weak or lacking, but because enforcement was lax where regulations did exist. In both cases, then, we see signs of “regulatory capture,” with the SEC and the Minerals Management Service applying their existing regulations in ways which, at a minimum, permitted the persistent risks that eventually led to disaster. In the quest for accountability, there also will inevitably be lawsuits. But the companies may not survive to pay any judgments; and when they do, the costs fall to shareholders. The executives whose decisions brought on the crisis are left unaccountable — a moral hazard of the first degree — and the rest of us are left unsatisfied. In fact, very similar dynamics are at the heart of the Tea Party movement, only with unaccountable public officials in the place of unaccountable CEOs.

Some of the public’s outrage about both crises probably stems from people’s assumption that large companies do operate like people, at least in respecting broad social norms. So, we expect our bank to be concerned about our personal finances, a view implicitly encouraged by the sketchy form of the neoclassical economics that dominates public discourse. In an abstract world of the perfectly efficient market, that market constrains banks to offer us goods and services that serve our interest; in the real world, our banker’s retail job is simply to sell us his bank’s products based on how profitable they are to that bank. And even when we recognize the difference, we assume our bank won’t abuse our trust, because the law will prevent it and, anyway, educated people just don’t act that way.

Similarly, whether or not Gulf residents expected oil companies to share their concerns about their regional environment — and many certainly did have those expectations — the market was supposed to ensure that the risk of incurring $20 billion or more in liability costs would prevent reckless operations of deep-water rigs. For how this works in the real world, think of Toyota: Like Toyota, BP adopted a calculus in which cost-saving measures outweighed those risks; and in deep-water drilling, that often involves less stringent safety systems and standards. So, even as BP was fined much more often than its rivals for deep-water rig safety violations, BP shareholders enjoyed years of higher returns.

If we can’t depend on regulation or potential liability to stop reckless corporate decisions, it’s time to focus less on the corporate “person” and more on the actual people who make those reckless decisions. The laws of corporations have long shielded a company’s decision makers from personal liability for corporate decisions, based once again on the idealized view that market competition will reliably drive executives to make decisions based on their shareholders’ best interest. But economists have long recognized — it’s called the “agent-principal problem” — that the interests of executive decision makers (the agents) can diverge sharply from those of the shareholders (the principals). And how those executives are rewarded for their decisions can make that divergence very wide and deep if, as with both Wall Street and BP, they can earn huge bonuses for steps that boost short-term earnings even when the decisions that generate those earnings eventually bring down the company. While Paul Volcker and a few others have called for a ban on such compensation schemes, Congress has bowed to Wall Street protests, in a form of “legislative capture” as dangerous as its regulatory counterpart.

The result are nearly perfect conditions of moral hazard for America’s top executives, especially in critical areas like finance and energy, where their moral hazard can be most dangerous to the rest of us. Since moral hazard affects the top decision makers, perhaps more than their institutions more generally, the Wall Street and Gulf disasters suggest that it’s time to revise the limited personal liability provisions of the corporate form: The government should be able to sue executives personally for decisions that turn very bad for the rest of us — involving costs of, say, at least $25 billion — when those decisions entail risks that rise to a standard of negligence. This change could even be part of broader tort liability reform. But whether it is or not, it’s time to pierce the veil of the corporate “person” and get to the real people whose personal interests repeatedly lead them to embrace risks that end up harming tens of millions of others.

Deciphering the Crisis in Greece and Its Significance for America

Wednesday, May 12th, 2010

With the world’s stock and bond markets thoroughly roiled by Greece’s sovereign debt problems, it’s only natural to ask the perennial question, how does it affect us? The outlines of the crisis are certainly familiar. As I’ve been warning in this space for more than a year, governments around the world would inevitably face serious fiscal problems, dealing with the daunting debts accumulated from the huge bailouts for the financial meltdown and the large stimulus programs for the subsequent deep recession. In countries that began with large deficits and national debts, such as Greece, Portugal, Spain and Italy, those fiscal stresses have become very serious. Here, in the United States, we’re just beginning to hear calls for deficit reductions. If recent history is any guide, we will ignore the problem for several more years, until voters finally demand that Washington take real action.

Greece can’t wait, despite the recent violent protests there against budget austerity. Greece is also burdened with a relatively weak and uncompetitive economy, so it cannot generate strong growth to help ease the problem. Moreover, the organization of the Eurozone denies Greece, along with other member-nations with high and fast-rising public debts, two standards measures to boost competitiveness and help countries grow out of their mess. Greece can’t depreciate its currency to make its exports cheaper in foreign markets, since it shares the Euro with many other countries uninterested in a sharp depreciation that would leave them poorer. Greece also can’t cut its interest rates to spur domestic investment and attract capital from other EU countries, since the European Central Bank (ECB) sets the interest rates for everyone in the Euro Area.

That’s why Greece has been headed for a default on its government bonds. The hitch is that a Greek default would shatter the EU’s grand myth, that their (partial) economic union enhances the efficiency and competitiveness of its members enough to protect them from such crises. Moreover, if the EU stood by as Greece sank, international investors would dump the public bonds of other debt-burdened EU countries, starting with Portugal, Spain and Ireland. All of this would drive down the value of the Euro, especially relative to the currencies of the EU’s two major trading partners, the United States and China. By the way, that would be both bad and good news for us. A stronger dollar would make our exports more expensive in Europe, undermining the President’s hopes of relying on exports to help drive growth at home. But a stronger dollar, along with the threat of a sudden crisis for the Euro, also draws more foreign capital to the United States, which helps keep our interest rates low.

So far, the EU and the IMF (prodded by us with promises of a larger U.S. financial contribution) have headed off a Greek default, by unveiling a $1 trillion bailout plan consisting mainly of loans and a pledge by the European Central Bank to accept Greek bonds as collateral for loans to the European banks that buy those bonds from the Greek government. The fund is big enough to rescue Portugal and Spain as well, a smart move since serial debt defaults pose the greatest danger of all.

The announcement of the plan strongly recalls the original TARP bailout. Both plans were pulled together hastily to signal government’s determination to head off a collapse. In both cases, the signal is more important than the actual plan, since neither makes much economic sense. The EU plan depends, first, on taxpayers across northern Europe agreeing to shoulder much of the costs to rescue Greece and, second, on Athens following through with deep spending cuts and sharp tax increases that are bitterly opposed by most Greeks. Even if all of that came to pass, the plan has more fundamental flaws. It purports to respond to Greece’s public debt crisis by expanding the debts of Greek and other European banks as well as other EU governments — as if international investors will generously overlook Europe piling up even more debt than today. And if Greece does follow through on the draconian austerity measures contemplated in the plan, its economy will sink further, requiring even more public debt. In short, the bailout plan is a fantasy; and Greece and Europe will face another round of this debt crisis not long from now.

The improbable shape of the EU bailout does recall our own, original TARP plan. Just as the EU bailout does nothing to address Greece’s lack of competitiveness, the TARP in its various versions has never addressed the forces and factors that drove our financial crisis. So, 20 months later, our large banks are still not strong enough to resume normal lending to American businesses. Their continuing vulnerability also makes Europe’s current debt problems even more serious for us. Greek bonds — along with the bonds of Spain, Portugal, Ireland and Italy — are held mainly by financial institutions. German and French banks are the most exposed, but ours are well in the mix, too. Those bonds have been declining in value for weeks, taking their toll on bank balance sheets. A formal default by Greece would hit all of them; and serial defaults by Greece, Portugal and then Spain — and possibly Italy — would trigger another worldwide financial crisis.

This time, we would have few policy tools left to stop a downward spiral — and Congress almost certainly would fiercely oppose another huge taxpayer bailout, especially Republicans in the midst of a populist purification process that already has purged Bob Bennett in Utah and Charlie Crist in Florida. This is all speculative — thank goodness — but we could find ourselves with very few options to address a crisis that ultimately could lead to another Depression. Our best hope for now is that Greece and the Eurozone will somehow muddle through, much as we did in 2009.

How Toyota and Goldman Sachs Stumbled — and We Could, Too

Tuesday, May 4th, 2010

Powerful and wildly-successful institutions sometimes act like teenagers and addicts, unable to recognize their own self-destructive behavior. This year’s top two examples are Toyota and Goldman Sachs. After investing decades to develop a sterling reputation for safety and quality, Toyota squandered its brand not by accident, but by myopic design: In a benighted chase for higher profits, Toyota’s top brass demoted vehicle safety from its long-time perch as the firm’s number one operational measure, to number four. Everyone inside the firm got the message — and now consumers around the world have as well. So, Toyota will spend years working to reclaim part of the worldwide market share it threw away.

Goldman Sachs may pay an even dearer price. It, too, spent a very long time building a world class reputation that married extraordinary market acuity with honest dealing. The self-immolation of that brand probably began with its principals’ decision to jettison their partnership and become a publicly-held company. This shift in the firm’s legal organization not only allowed them to cash in; it also transformed Goldman’s business and culture. Its flagship business of investment banking — giving advice and assembling financing for mergers, buyouts and takeover — receded so sharply that in recent years, it has accounted for just 10 percent of the firm’s revenues. In its place, Goldman became a giant hedge fund that creates and trades exotic financial products for both its clients and itself. What we know now is that once the top brass’s financial positions were no longer tied to the firm’s long-term value, as it would be under a partnership, a seemingly insatiable drive for huge, short-term profits led them to create products which they simultaneously hawked to their largely institutional clients of pension funds, endowments, banks and other financial institutions, even as they took financial positions against the very same products.

Coming back will be harder for Goldman Sachs than for Toyota. Toyota has to reengineer its operations — a serious challenge — in order to restore the core position of safety and quality. But automobile recalls are routine, even if the extent and reasons in Toyota’s case were not; and several years from now, a reconfigured Toyota could be back on top. But Goldman faces years of civil suits by government regulators, their own shareholders and their former clients, as well as possible criminal charges — and not just in the United States. Goldman faces the same treatment in other countries — starting with Greece, whose fiscal problems Goldman allegedly helped to hide using financial maneuvers like those employed by Enron in its final, desperate year. Based on what has happened to other firms that found themselves caught up in extended legal problems, the most important costs to Goldman will not be the legal fees, fines and settlements, but the “distraction factor.” For years, its top executives will find themselves absorbed in defensive moves and stratagems to beat their various raps — while their rivals at other firms focus on the subtle shifts in markets and the economy that can presage large changes. And this doesn’t even count the herculean task of rebuilding a brand that now stands for both self-dealing and double-dealing.

Without realizing it, administrations, congresses and political parties also can turn self-destructive. The GOP brand in economic stewardship, for example, certainly suffered serious damage from the policies of a Republican President and Congress that ultimately culminated in the worst economic crisis since the 1930s. Yet, even with 60 percent of the country still blaming the Bush administration for the bad economic times, and the public directing the worst of their outrage at Wall Street, Washington Republicans remained committed to a “strategy” of stopping the Obama administration from reforming Wall Street.

Then there’s the matter of the national debt. Eighteen months ago, in this blog, I warned that Wall Street’s meltdown was only the first stage. Stage two was the deep recession triggered by the financial meltdown; and stage three would be the fiscal crises created by the bailouts and stimulus used to address the first two stages. That all has come to pass; the open question is how self-destructive our response will be. We pulled the financial system back from a collapse that would have ushered in another Great Depression, with only a normal quota of self-inflicted wounds — like letting Goldman and JP Morgan Chase claim full payment on deals with AIG which the taxpayers rescued, and not forcing them and other bailed-out institutions to use their new, taxpayer-financed capital to expand lending to businesses. The American brand is successful pragmatism: Figure out what needs to be done, and then go do it. But what needs to be done here is to reconfigure the tax system so it produces more revenues while leaving the economy more efficient — think of tax simplification that jettisons lots of special interest tax breaks — and to reshape current “entitlement” spending for not only elderly people, but also for influential industries and for districts and states whose members of Congress have risen to the leadership.

If we cannot get past the partisan warfare, the United States in a few years could find itself in Toyota’s place, with a tainted brand and smaller political market share. Our Treasury bills and bonds are very unlikely to ever default, as Greece nearly did this week (and still could do, if the bailout fails in any significant way). But the normal politics-of-least-resistance will never reconfigure taxes or reshape spending. Instead, it will lead us to a place where we have to pay out more and more to attract foreign investors, and those higher interest rates could consign the American economy to years of very slow growth. That’s what can happen to a great nation that insists on acting like a child or addict, blind to its own self-destructive behaviors.

Read Dr. Shapiro’s related Huffington Post piece: Goldman Scandal Erodes Case for Cap and Trade, April 28, 2010.

A New Progressive Economic Strategy, Part 4: The Global Economy

Thursday, April 29th, 2010

In a global economy, even the world’s largest economy by a factor of three (that’s us, compared to Japan and China) cannot by itself ensure job opportunities for everyone and healthy incomes gains for everyone who works hard and well. We may wish it were otherwise, but the United States and the forces of globalization now share control over America’s economic path. The challenge is to work with those forces to benefit average Americans, and to exercise the global leadership required to ensure that other countries work with us to promote the growth and stability of the global system. This part of the progressive agenda has many elements, including efforts to advance open trade in ways that help average workers, steps to promote innovation and protect the rights of American innovators around the world, and responsible regulation of finance while promoting free flows of global capital.

In one way or another, just about every economic activity in America is touched by global forces, whether it’s the operations of foreign companies, investors, innovators, consumers, or governments. We’re still the world’s largest economic actor by a long shot; but the global economy has grown too large, complex and fast-changing for even us to dominate, much less direct. Let’s start with trade. Twenty years ago, 18 percent of all the goods and services produced in the world were traded across national borders — today, in a global economy two-thirds larger (adjusted for inflation), one-third of everything produced anywhere is traded — some $20 trillion worth per-year. Most of this rapid increase is tied to the explosive modernization of China and other large developing countries, and the fast-expanding consumption of their people.

America can generate good jobs and rising incomes for average families only by working with this historic expansion of worldwide trade. Progressives should be committed not only to equip American workers and companies with what they need to compete in a global trading system, but also to open markets here and around the world, especially in services and agriculture. The first commitment involves many of the initiatives described in earlier essays, including access to free IT training, health care reforms to reduce business costs, and tax reforms to make American companies more competitive.

In exchange, progressives should push to conclude the Doha trade round to open foreign markets to services, where U.S. companies excel, to negotiate fair, free trade status with burgeoning economies such as Korea and, in time, with Japan; and to hold China and other fast-growing emerging markets to their WTO promises to open their markets. In all of these cases, American firms and workers would gain, because our markets already are far more open than most others in the world. And there’s no one else who can lead effectively here, since no other country has as much leverage with the holdouts in the EU and the developing world.

America’s greatest exports are its new ideas, whether they’re embodied in new software code, breakthrough pharmaceuticals and medical devices, new business services, genetically-enhanced foods, new forms of entertainment, or the latest-generation equipment. In fact, America’s unique role in globalization is being the world’s largest source of economic innovations and the testing grounds for adopting them on a large scale. To be sure, innovators come from every part of the globe; but for the last generation, American inventors, entrepreneurs and companies have dominated the development of most (not all) critical new technologies and new ways of doing business. And the effective application of new ideas is the principal source of most of the competitive edge American companies retain in many global markets.

To help keep all of this going, our new economic plan has to actively spur continuing economic innovation through tax reforms, a larger federal commitment to basic research, and by maintaining the healthy competitive pressures that spur innovation and their broad adoption. In this context, too, American workers need access to the skills required to use these innovations and perform effectively in workplaces dense with advanced technologies. These steps not only can help average families succeed as new ideas unfold; they also support America’s place as the world’s largest domestic market for innovations, which in turn will spur additional investments to develop their next generation.

A progressive economic program should include two initiatives in this area. First, since innovation is the essence of our competitive advantage in the world, we need a no-holds-barred campaign to cajole or coerce every other nation to respect the intellectual property rights of American innovators and companies. In addition, we need to reclaim the global leadership we exercised in the 1990s in addressing climate change by enacting measure to fix a strict and environmentally-appropriate price on carbon emissions, preferably with a carbon-based tax that recycles its revenues in other tax cuts. This would not only be part of America’s responsibility for broad economic leadership, it also could spur to a dramatic degree American companies to develop new, climate-friendly fuels and technologies, and then broadly adopt them.

A progressive economic plan also has to take serious account of the global financial system. American companies are the world’s largest foreign direct and portfolio investors, with operations and other investments spread across the developing and advanced world. The United States is also the world’s largest single recipient of direct investments by foreign companies and portfolio investments by foreign funds and governments. So, we have an enormous stake in a healthy and stable financial system, here and around the world. And in the wake of the recent meltdowns, the central issue here is how best to regulate finance, here and around the world.

Based on the recent crisis, the basic terms of regulation seem clear. First, require that all financial institutions hold more capital, relative to their investments, and adjust those stricter capital requirements for the riskiness of a bank or fund’s portfolio. That should help end their risky practice of making huge wagers, for example in asset derivative or interest rate futures, using almost entirely borrowed funds. Second, make sure that every transaction in finance, involving any kind of instrument, occurs on a public exchange or through a publicly-chartered clearinghouse. That can ensure that every trade or purchase is transparent and subject to the same disclosure and soundness rules. Third, end self-dealing compensation practices that just encourage the most risky wagers, for example by paying out bonuses long before anyone knows whether the transaction will actually work out. And none of these sensible changes would impede the free flow of investment and money — in fact, they should enhance America’s premier position in the global capital system.

The good news here is that the regulatory plans passed by the House and being considered this week in the Senate both contain versions of these three basic changes. The bad news is that they’re all weaker than needed — so, it’s up to progressives to strengthen them.

That leaves the sticky matter of “Too Big to Fail,” or what to do about funds or banks whose failure could trigger another broad crisis. We have two alternatives: Break them up, so no bank or fund can jeopardize the stability of the entire financial system. In its’ favor, there’s little evidence of real economic benefits derived from the huge size of the institutions that dominated the sector before the crisis, much less the even greater size of the behemoths that dominate it now. Many conservatives like this approach, from Alan Greenspan to Mervyn King (he runs the Bank of England), because it avoids the alternative, which would be a new process to take over the investment activities of any large player at the first sign of trouble. Either way, the plan should reject out-of-hand the current, reckless GOP position:No prophylactic break-ups, no new process to take them over when they’re in trouble, and no future bailouts. That would be a formula for a global depression the next time that big finance implodes.

There’s more to consider as well for a progressive plan to help Americans make the best of globalization, from sensible immigration reforms to measures to help recognize asset bubbles before they get out of hand. In one way or another, we will return to those issues later, along with some others. For now, we conclude this four-part series hopeful that somewhere out there, in Washington or beyond, there is a growing recognition that now is the time for progressives to rethink our national economic approach and reconfigure the economic agenda.