Author: R.A. | WASHINGTON

THIS week’s Economist has a Leader on growing geopolitical tensions between China and America, which concludes:

It is in the economic field that perhaps the biggest danger lies. Already the Obama administration has shown itself too ready to resort to trade sanctions against China. If China now does the same using a political pretext, while the cheapness of its currency keeps its trade surplus large, it is easy to imagine a clamour in Congress for retaliation met by a further Chinese nationalist backlash. That is why the administration and China’s government need to work together to pre-empt trouble.

Some see confrontation as inevitable when a rising power elbows its way to the top table. But America and China are not just rivals for global influence, they are also mutually dependent economies with everything to gain from co-operation. Nobody will prosper if disagreements become conflicts.

The piece points out the difficulty American leaders face; it’s important not to be a pushover and to hold China to appropriate standards, but one has to recognise that America (and the world) can’t afford a falling out with China. Calculated Risk links to Reuters piece which quotes President Obama trying to navigate this narrow strait:

One of the challenges that we’ve got to address internationally is currency rates and how they match up to make sure that our goods are not artificially inflated in price and their goods are artificially deflated in price. That puts us at a huge competitive disadvantage.

Larry Summers similarly referenced the RMB peg in a recent speech at Davos. Meanwhile, Paul Krugman has been patting them, and himself, on the back for giving the currency issue “the heat it deserves”.

I think, though it’s impossible to be sure, that the administration’s rhetoric on this issue is primarily angled toward domestic audiences. But to the extent that it is directed at the Chinese, I think it is a bad idea. And I think the Krugman view is mistaken.

Why? Well, first, I disagree with Mr Risk that:

Getting the Chinese to revalue (or float) their currency is probably critical to the U.S. achieving Obama’s ambitious SOTU goal of doubling U.S. exports in the next five years.

It isn’t. Economic recovery and the use of a nominal baseline will get exports most of the way to Mr Obama’s goal. Reduced American consumption will help, as well (persistent American trade deficits over the past 25 years have had much more to do with internal imbalances than with China’s currency policies). And China isn’t the only emerging market out there that will be increasing its consumption of American exports in the years to come, and most of the others have allowed their currencies to appreciate against the dollar. This has also meant appreciation of their currencies against the RMB, which means that other countries are applying pressure on China’s leaders to do something about its currency. There’s therefore no need for America to provoke a geopolitical crisis by taking the lead on the issue.

China will also be facing increased internal pressure to appreciate the RMB, as inflation takes off with economic recovery. Markets are betting that the Chinese currency will rise in the near term. Given this, American rhetoric on the issue is counterproductive. China would probably like to adjust the RMB’s valuation, but while American politicians make a fuss over the issue policy shifts will look like deference to American wishes.

I also think that Scott Sumner’s point—that a weak RMB has been highly stimulative for China, which has benefitted the world as a whole—has some real merit. From this perspective, America would be far better off focusing on domestic monetary expansion than whining about the RMB peg.

But the biggest point is that there is a real geopolitical risk here that must be recognised. Relations between China and America haven’t turned ugly yet, but they have grown increasingly testy. A real trade war between the two would be devastating to a fragile world economy. If America is going to pick a fight with China, it had better make sure it’s one with a minimal risk of escalation and with a great deal of potential upside. The RMB peg fails on both of these counts; disputes over trade imbalances could rapidly escalate into dangerous territory given the unemployment situation in America, and even an immediate move to a floating RMB wouldn’t make America’s internal imbalances or its trade deficits with China and the world disappear. Best to shut up about this and move on.

SCOTT SUMNER writes:

In February I said fiscal stimulus wouldn’t work, as the Fed had some sort of nominal aggregate target in mind, and was going to simply offset the fiscal stimulus. And that is what happened. In March when things looked scary, like a Depression was possible, the Fed announced its big program of buying Treasuries and MBSs. Later in the year when things picked up a bit, and we were clearly going to avoid a depression, the Fed started furiously back-peddling. They started talking about ending the bond buying program and “exit strategies.” Ask yourself this; what does that back and forth behavior tell you? It tells me the Fed has some sort of implicit nominal target, and if the economy seems to fall short they’ll pull out all the stops and flood the economy with liquidity. That’s why the $800 billion dollar fiscal stimulus was a complete waste of money; the Fed wasn’t going to allow NGDP to fall much further than the actual 2.5% it fell. Shame on us for not figuring that out, and shame on the Fed for not explaining that to us.

Matt Yglesias adds:

I think maybe you need an academic’s confidence in his own theories to accept this as a reason to have avoided stimulus back in early 2009. As either a blogger or a policymaker, I’m more comfortable with the idea of joint fiscal and monetary measures to fight a downturn. But the most important point here is that fiscal policy can’t swim against the monetary tide. If the FOMC doesn’t want aggressive stimulus to aggregate demand to fight unemployment, then it just doesn’t happen. Voters hold elected officials responsible for macroeconomic performance, but this is mainly determined by the Fed. And the Fed has given every indication since autumn 2009 or so that it’s very comfortable with a slow recovery.

In a follow-up post, Mr Sumner seems to challenge Mr Yglesias’ contention that fiscal stimulus was a good idea. I think Mr Yglesias’ point stands. Monetary policy is not an exact science. If we believe the Fed is in complete control, we need to ask why they allowed such a significant decline in output to occur in the first place. If we instead argue that the Fed had the ability to prevent a decline in output of more than 2.5%, but it was powerless to close the gap beyond that, well, fiscal expansion was a good idea. Remember that the Fed’s own forecasts are for weak growth in 2010—growth in nominal output of 3.5% to 5%, which is pretty low considering the size of the output gap. The Congressional Budget Office is predicting growth in nominal GDP of 3.2% this year and 2.8% next year. That’s very, very slow. If the Fed has been entirely offsetting fiscal stimulus in this environment, then perhaps Ron “End the Fed” Paul has a point after all.

Still, it remains the case that monetary tightening will undermine fiscal expansion. Given that, American workers should be very worried indeed. Many analysts have been saying that while the Fed will end its asset purchases this year, it’s unlikely to actually raise interest rates until 2011. Markets don’t agree. Fed fund futures indicate that a change in the target from “0% to 0.25%” to 0.25% could occur by late summer, with an increase to 0.5% by the fall. Even with the additional stimulus measures proposed in the president’s budget, Fiscal 2011, which begins in October, is going to bring with it some significant fiscal retrenchment. The original stimulus will shift from a net boost to growth to a net drag by mid-year. The economy had better get its feet under it by the summer, because the rug will be pulled out from under it thereafter.

But not according to Mr Sumner, who says the Fed will jump back in if necessary. Maybe so, but again, markets are anticipating rate increases in 2010.

Here is Mr Sumner’s latest post, defending the efficient-markets hypothesis.

WEEKLY jobless claims, seasonally adjusted, had fallen as low as 432,000 at the very end of 2009, but the trend over the last few weeks has been upward. Last week, according to the latest Labour Department data, jobless claims ticked upward to 480,000. The four-week moving average of claims has risen by 28,000 since early January:

Tomorrow, data on January payroll employment will be released, and expectations are for a gain in employment of about 15,000. Against a backdrop of 10% unemployment, that increase is hardly worth mentioning. But so long as these figures continue to come in like this, it’s the best the American economy will manage.

PAUL KEDROSKY links to the chart below, courtesy of the Financial Times:

At his blog, Mr Kedrosky puts up only the bottom half of the graphic, containing world output shares. And indeed, I suspect that most residents of developed nations would be more likely to focus on the bottom half, and more likely to worry about it. In fact, the only part of the above image developed nations ought to care about is its top left quadrant. Growth in 2010 is looking to be very disappointing for developed nations, which will make for slower recovery in labour markets and generally more human suffering.

The bottom, realistically, is good news for practically everyone. What we see is that countries that are home to about 740 million people, or about 11% of world population, are producing 40% of world output, down from over 50% 30 years ago. It would be bizarre if that state of affairs persisted, and it would be extremely unfortunate, as it would mean that most of the world’s population was continued to languish in poverty.

I realise that I make this point about population repeatedly, but I feel it’s both important and something that’s often neglected in discussions about relative American decline, or relative Western decline.

I’M SURE this sounded lovely rattling around in Tom Friedman‘s head:

First, a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves.

Felix Salmon pounces:

In fact, if you decided to short only countries whose foreign exchange reserves reached some large proportion of gross world product, you’d be batting 2 for 2 right now as you started shorting China. First you would have shorted the USA in the 1920s, and then you would have shorted Japan in the 1980s.

Sounds damning, but he proceeds to quote Michael Pettis, who writes:

It was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.

It is at this point that the needle slides off the record. Excess capacity caused lost decades in Japan and America? Not according to any of the prevailing stories of their respective crises. Japan’s doldrums are generally attributed to three main factors: massive overindebtedness, government reluctance to reorganise zombie banks and zombie industries, and the foolish conservatism of the Bank of Japan. And America? Most agree the problem was four years of intense monetary contraction, followed up with another dose of premature tightening in 1937.

It’s easy to argue that rapid credit expansion fueled bubbles and poor resource allocation. But that doesn’t get you a depression or a lost decade. Whatever excess capacity problem America had going into the Depression, it evaporated when the government abandoned gold, taking the pressure of adjustment off domestic prices. Japan’s lost decade looks a lot more like America’s current predicament than America in the 1920s or present day China in that the primary threat was a paralysing debt burden.

Tyler Cowen has a more coherent critique of the trouble-with-reserves argument:

You can make a lot of mistakes by analogizing governments to countries, but every now and then it is worth doing.  If I were a major investor, I would get nervous each time I saw a company with massive cash reserves on its balance sheet.  That’s often a sign that discipline is headed out the window.

In other words, it isn’t what China has done, it’s what it’s about to do with all of that scratch burning a hole in its pocket. But this still doesn’t make that much sense to me. Maybe Chinese property markets are beginning to overheat. So what? China has hundreds of millions of citizens who need upgraded housing. The Chinese economy couldn’t overbuild housing if it wanted to. And while China will absolutely misallocate some of its resources, it’s channeling others into can’t miss sectors like infrastructure, energy, and education. Certainly imbalances breed instability, but that instability didn’t much throw China off its stride during this latest recession, not least because Chinese economic policy through the crisis was the exact opposite of American policy circa 1931.

There are risk factors to Chinese growth, and I think Mr Friedman is mistaken to argue that Chinese reserves are a major source of strength. All the same, I can think of a lot of places I’d sooner short than China.

KAUFFMAN, a foundation supporting entrepreneurship, has once again surveyed a large group of economics bloggers (including yours truly) on the outlook for the American economy. It goes something like this:

As you can see, economists are most bullish on the budget deficit. Here’s what they’d like to do about it:

Less tax on income, and more on consumption, particularly of energy and emissions. Sadly, the public doesn’t seem too keen on the concept. I have to say, I was a little surprised to see the extent of the deficit hawkishness among the bloggers. Around a third felt that the debt was an “unacceptable risk” to the economy when sitting at levels between 50% and 75% of GDP. Note that the current debt-to-GDP ratio is above 75%, and yet markets are basically untroubled by this. Meanwhile, nearly half of surveyed bloggers listed as one of their top three priorities for deficit reduction adoption of constitutional amendments forcing balanced budgets or a spending cap. And this, when asked to take into account what solutions might or might not be politically achievable. Economists note: it is more difficult to get an amendment passed than it is to get a bill through the Senate. Think about that, and reprioritise.

OVER at the American, Vaclav Smil has a piece explaining that clean technology transitions have been predicted for ages but have yet to materialise. Coal power remains the workhorse of the energy world. Mr Smil suggests that this is because energy transitions historically take a very long time—half a century, typically—and so it’s unreasonable to expect that renewables can occupy a much larger share of power generation within a short time frame:

These are the realities of 2008: coal-fired power plants produce half of all U.S. electricity, nuclear stations 20 percent, and there is not a single commercial breeder reactor operating anywhere in the world; in 2007 the United States derives about 1.7 percent of its energy from new renewable conversions (corn-based ethanol, wind, photovoltaic solar, geothermal); natural gas supplies about 24 percent of the world’s commercial energy—less than half the share predicted in the early 1980s and still less than coal with nearly 29 percent; and there are no fuel-cell cars.

This list of contrasts could be greatly extended, but the point is made: all of these forecasts and anticipations failed miserably because their authors and promoters ignored one of the most important realities ruling the behavior of complex energy systems—the inherently slow pace of energy transitions.

For very mundane, logistical reasons, a major energy transition is sure to take some time. You can’t build any sort of power plant overnight, and new generation sources require new investments in physical infrastructure, like transmission lines. That aside, I think it’s way to easy to oversell the crucial importance of coal. Consider this chart:

That’s real coal prices over time (source, PDF). There’s no real magic going on here; coal is just a simple technology, and firms have gotten very good at blasting the stuff out of the ground. As a result, real coal prices have fallen, which means that it hasn’t been enough for alternative energy technologies to get cheaper (and they have gotten much cheaper); they would have needed to have gotten cheaper faster than coal in order to take a lot of market share from coal technologies.

Of course, what you’re not seeing in the above chart are many of the other costs associated with coal energy generation. The practice of blowing the top off of mountains to mine coal produces cheap power, but causes a lot of damage to local environments and a lot of health problems for people near mining operations. Similarly, people living in close to coal power stations suffer deleterious health effects. And of course, there is the cost of carbon emissions associated with coal power.

In other words, coal dependence has continued largely because coal has remained so cheap, and coal has remained cheap because society has not forced mining operations and power companies to internalise the costs of the environmental, economic, and health damage associated with coal into the price. Coal continues to dominate simply because the market doesn’t reflect social costs. That’s not a problem with renewables. That’s a problem of economics and of governance.

CHECK out this nice World Bank chart, from Paul Kedrosky:

Qatar is a bit of an outlier, though there is a clump of energy producing states, including Iceland, UAE, and Kuwait, that stand head and shoulders above the rest of the world. The next tier includes large former British colonies (Australia uses energy much like Canada and America), as well as Northern European countries like Norway, which both produce energy and use a lot of it in the winter.

Next you have the rest of the developed world. Then emerging markets pulling away from the destitute bottom. But what should stand out is that most of the world’s population is squished into that broad bottom tier, which includes emerging markets and undeveloped countries. Really, something like 85% of the people living on this planet consume below the world’s average energy use. Either those people need to quit aspiring to developed nation lifestyles, or the world needs to make output far less energy-intensive, or we should all prepare ourselves for a nasty time of things, in geopolitical and environmental terms, as emerging markets continue to develop economically.

I THOUGHT Ezra Klein made a nice point a few days ago when he wrote:

We talk about the budget as the president’s budget, and that makes sense, as the president is the one proposing it. But this is also the country’s budget. It reflects not just what the president is proposing, but what’s actually happening, and what’s been happening. It reflects the creation of Medicare (Lyndon Johnson) and Medicare Part D (George W. Bush), Social Security (FDR) and lower marginal tax rates (Ronald Reagan). It reflects economic growth, which can’t be traced to any one president, and financial crises, which are similarly diffuse.

This is something Barack Obama has been at pains to point out, as Republicans have attacked him as a profligate spender and runner of deficits. Most of today’s borrowing, he has said, is attributable to factors beyond his control. He is essentially pointing people to charts like the one at right.

That’s a damning chart. It implicates a lot of people, including some of the same Congressional Democrats who are now joining Republicans in assailing the president for budgeted deficits, but who voted for the Bush tax cuts and the wars in Iraq and Afghanistan. Politically, this is a pretty important chart.

But economically speaking, it’s all but irrelevant. To understand why, have a look at the chart below (of debt held by the public as a share of GDP), which is taken from the Congressional Budget Office’s report on the long-term budget outlook.

That massive increase there at the end is due to two things: growth in spending on Medicare and Medicaid, and growth in interest payments on the debt. But the real problem is Medicare and Medicaid. By about 2070, spending on Social Security, Medicare, and Medicaid alone will outstrip revenues.

In the end, who caused what deficits when isn’t important. What is important is finding some way to avoid that spike. And both parties seem to be a long way away from having anything like a serious discussion about that challenge.

HERE’S your latest budget factoid. The freeze on non-defence discretionary spending, should it come to pass, will trim $250 billion off the cumulative deficit over the next ten years. Over that same period, defence discretionary spending will add $284 billion to the deficit.

Spencer Ackerman has been providing some nice graphics over the last few days, illustrating the size and relevance of defence spending. Here‘s another good one:

Reductions in spending associated with the end of activity in Iraq reduced total defence below the levels it reached during the Bush administration. But the base Defence Department budget continues to grow in a more or less uninterrupted fashion. It’s hard to say how this increase is making Americans safer.

And it might ultimately be counterproductive to the growth of liberalism. Here‘s Real Time Economics’ Bob Davis:

[A] January paper by economists Daron Acemoglu of Massachusetts Institute of Technology and Pierre Yared of Columbia University, published by the National Bureau of Economic Research, is a reminder that peace is the soil that nourishes trade. The two economists compared the growth of trade between 1988 and 2007 and the growth of militarism over roughly the same time frame and found that countries that experience an above-average increase in military spending are likely to experience a below-average increase in trade.

“Militarism is negatively associated with trade,” the two authors argue.

The economists use an increase in military spending or an increase in the size of the military as proxies for “militarism.” Even when they remove from the sample countries actively at war, the findings are the same: more militarism equals less trade growth.

It’s the difference between global politics as a zero sum game and as a positive sum game. Americans need to be asking hard questions about the growth of the defence sector. So far, they’re refusing to do so, even in the face of a looming budget crisis.

LAST week, I wrote:

In a conference call that just concluded, Deputy Director of Office of Management and Budget Rob Nabors responded to a question on how the freeze might conflict with efforts to return the economy to full employment. Mr Nabors noted that in 2010, the adminstration was focused on putting Americans back to work. Then in 2011, when the economy is on a more stable footing, the president will turn his attention to working toward a sustainable budget situation.

This is utter foolishness. Fiscal 2011 begins in October of this year. At that point, according to CBO, unemployment will be above 9.5%. At the beginning of fiscal 2012, according to CBO, unemployment will still be at or near 9%. This is an important point; one of the primary factors causing current high deficits is the revenue-reducing effect of a weak economy combined with the automatic increase in spending on social programmes associated with the weak economy. It’s very difficult to balance a budget while the economy is weak, because every contractionary policy move further reduces economic activity, thereby trimming revenues and putting upward pressure on automatic stabiliser spending.

OMB head Peter Orszag is giving a press conference just now with Christina Romer, head of the Council of Economic Advisors, on the president’s Fiscal Year 2011 budget. Ms Romer explained the economic assumptions underlining the budget forecasts. She noted that expected fourth quarter-over-fourth quarter real GDP growth would be 3% in 2010, 4.3% in 2011 and 2012, and would average 3.8% in the five years thereafter. These figures are in line with Fed projections.

She then gave the unemployment forecast. At the end of 2010, the unemployment rate, according to the administration’s forecast, will be 9.8%. At the end of 2011, the rate will be at 8.9%. And at the end of 2012, after the next presidential election, the unemployment rate will be 7.9%.

Meanwhile, here‘s the historical context from Carmen Reinhart and Kenneth Rogoff:

As government debt levels explode in the aftermath of the financial crisis, there is  growing uncertainty about how quickly to exit from today’s extraordinary fiscal stimulus. Our research on the long history of financial crises suggests that choices are not easy, no matter how much one wants to believe the present illusion of normalcy in markets. Unless this time is different – which so far has not been the case – yesterday’s financial crisis could easily morph into tomorrow’s government debt crisis…

We do not anticipate outright defaults in the largest crisis-hit countries, certainly nothing like the dramatic de facto defaults of the 1930s when the US and Britain abandoned the gold standard. Monetary institutions are more stable (assuming the US Congress leaves them that way). Fundamentally, the size of the shock is less. But debt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.

While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. We suspect that growth also slows as governments turn to financial repression to place debts at sub-market interest rates.

The problem here is that budget balancing amid a weak economy is a bit like pushing on a string. The more you increase taxes and reduce spending, the weaker is the economy, which leads in turn to reduced revenues and increased spending on things like unemployment insurance. But as Ms Reinhart and Mr Rogoff point out, if you don’t address the deficit at all, then markets eventually get worried and interest rates rise, choking off recovery.

The way you get around this is by taking credible steps to address long-term deficit issues while maintaining government support for the economy in the short run. This is what Mr Nabors claimed the Obama adminstration was after, but his statement is clearly undermined by adminstration forecasts suggesting the unemployment rate will be above 9.8% at the point at which the discretionary spending freeze sets in. Meanwhile, the freeze itself will do nothing to convince markets of the administration’s deficit-cutting resolve, given that it will result in only $250 billion in savings over the next ten years—a drop in the debt bucket.

We can look at this another way. Currently, America is looking at a budget deficit around 10% of output. Mr Orszag noted in the press conference that the administration would like to cut that to 3%. But their expectations are that the bulk of the improvement in the near-term deficit—producing a decline in the deficit from 10% of GDP to 5% by 2015—will come from economic recovery, and the resulting increase in tax revenues and decline in automatic stabiliser spending.

Near-term deficit reduction is almost entirely about the strength of the economy. And nothing anywhere in the president’s policies will do anything meaningful about the long-term deficit, which is almost entirely about growth in spending on health care.

The president has looked at the problem, correctly identified its nature, and proposed solutions which are irrelevant to harmful. I don’t doubt that they perceive political advantages, which may lead to policy improvements, to this strategy. But having sacrificed a narrative that makes sense, I struggle to understand what they’re gunning for.

CAROL GRAHAM has a nice column up at Vox explaining recent research on happiness. It reads in part:

My more recent research on happiness around the world throws another monkey wrench into the equation…While the research confirms the stable patterns in the determinants of happiness worldwide, it also shows that there is a remarkable human capacity to adapt to both prosperity and adversity. Thus, people in Afghanistan are as happy as Latin Americans – above the world average – and Kenyans are as satisfied with their healthcare as Americans. Crime makes people unhappy, but it matters less to happiness when there is more of it; the same goes for both corruption and obesity. Freedom and democracy make people happy, but they matter less when these goods are less common. The bottom line is that people can adapt to tremendous adversity and retain their natural cheerfulness, while they can also have virtually everything – including good health – and be miserable.

One thing that people do have a hard time adapting to is uncertainty. For example, my latest research, with Soumya Chattopadhyay and Mario Picon based on daily records of around 1,000 Americans from January 2008, shows that average happiness in the US declined significantly as the Dow fell with the onset of the crisis. Average happiness fell 11% from 6.94 (on an 11 point scale) prior to the onset of the crisis, to a low of 6.19 on November 16, 2008. Yet when the market stopped bottoming out and some semblance of stability was restored in late March 2009, average happiness recovered much faster than the Dow. By June 2009 it was higher than its pre-crisis level: 7.15 on June 21 – even though living standards and reported satisfaction with those standards remained markedly lower than they were prior to the crisis. Once the period of uncertainty ended, people seemed to be able to return to previous happiness levels, while making do with less income or wealth…

It’s interesting to note the difference in happiness and confidence. On Saturday, the New York Times published a piece by Robert Shiller which read:

Among students of history, there are fears that we will suffer the type of chronic economic malaise that afflicted the world after the 1929 stock market crash, or that weakened Japan after the puncturing of twin stock and housing market bubbles around 1990. The post-1929 depression did not end for about a decade, and Japan has still not emerged from its post-1990 slowdown.

The fears themselves are an integral part of the problem. Economists have a tendency to assume that everyone’s behavior is rational. But post-boom pessimism is a factor driving the economy, and it is likely to be associated with attitudes that may be enduring.

In reality, business recessions are caused by a curious mix of rational and irrational behavior. Negative feedback cycles, in which pessimism inhibits economic activity, are hard to stop and can stretch the financial system past its breaking point.

But as Ms Graham notes, happiness reset fairly quickly after the decline stabilised. Where animal spirits are concerned, there is clearly some trickier set of emotions at work.

Ms Graham also includes this chart:

The level of variation in satisfaction across similar wealth strata is remarkable. And who would have guessed the Irish are so happy?

MANCUR OLSON wrote that over time, interest groups accumulate within a power stucture, making the political system more corrupt and the economy more sclerotic. In the absence of some sort of disruptive event—an invasion, say—to destabilise the existing political system, the economy would fall behind its peers. I think this is a little too pessimistic, in that it discounts the ability of technological innovation to perpetually challenge power structures, but the idea that disruptive events which destabilise existing institutions can be viewed as opportunities is a good one.

Tyler Cowen writes:

I’m not suggesting that the future gains will, in moral terms, outweigh the massive loss of life and destruction, but still the future Haiti might have a higher growth rate and a higher level of gdp per capita.  Here’s how.

In the previous Haitian political equilibrium, the major interest groups were five or six wealthy families and also the drug trade, plus of course the government officials themselves.  None had much to gain from market-oriented, competitive economic development…

Enter the rebuilding of Haiti.  Contract money will be everywhere.  From the World Bank, from the U.S., from the IADB, even from the DR.  That contract money will be significant, relative to the financial influence of either the main families or the drug trade.

There exists (ha!) a new equilibrium.  The government is still corrupt, but it is ruled by the desire to take a cut on the contracts.  Ten or twenty percent on all those contracts will be more money than either the families or the drug runners can muster.  The new government will want to bring in as many of these contracts as possible and it will (maybe) bypass the old interest groups.  Alternatively, the old interest groups will capture the rents on these contracts but will be bought off to allow further growth and openness…

You will see this in how the port of Port-Au-Prince is treated.  Previously the rate of corruption was so high that the port was hardly used.  If the port becomes a true open gateway into Haiti (if only to maximize contracts and returns from corruption), that means this scenario is coming true.

The surviving Haitians, in time, might be much better off.

One way or another, things will work differently, post-earthquake. I wonder, though, whether the new government will have the wherewithal to capture rents from these contracts. Maintaining the post as a “true open gateway into Haiti” may well be beyond its abilities for years to come.

This week’s Economics focus is a guest article by Paul Calello, the head of Credit Suisse’s investment bank, and Wilson Ervin, its former chief risk officer. In it they propose a new process for recapitalising failing banks with shareholders’ and creditors’ money. We asked them a number of follow-up questions on the detail of their proposal.

Your goal is to make creditors and shareholders bear the pain of recapitalising a failing bank. Why aren’t ideas such as contingent capital, a new form of subordinated debt that turns into equity when capital levels fall to a certain point, enough to achieve this aim?

We support the idea of contingent capital, and think it could work in concert with the Bail-in concept.  A well designed contingent capital instrument can create good management incentives – for example, encouraging more capital to be raised early in a crisis, and focusing boards and managers on risk management.  And the extra capital it provides directly might be sufficient for moderately sized stress events.

However, contingent capital instruments alone may not provide sufficient equity to solve a really serious crisis, or work for “outlier” institutions. For example, would $5 billion of contingent capital really have been enough to stem the tide in the case of Lehman?  Unless the layer of contingent capital was very thick, the final result might have been the same for many banks.

In essence, the Bail-in process taps all layers of existing unsecured debt capital to provide contingent capital in a crisis.  By doing that, it makes the layer of potential new equity capital very thick, so it maximizes the chance that the institution can avoid failure and a disorderly liquidation.  And it’s also more efficient to ask existing creditors to accept their responsibility for bearing an appropriate portion of losses, than to engineer an entirely new layer of capital to do so.

You seem to stress the importance of keeping troubled institutions as “going concerns”, whereas many regulatory proposals are about enabling more orderly liquidations. Is this just another way of ensuring that big financial institutions cannot fail?

The Bail-in concept is designed to avoid a disorderly failure where possible – without compromising responsibility or market discipline.  A key objective of this plan is to keep institutions viable as going concerns where possible, because liquidation is costly and can multiply the size of the problem.  In the case of Lehman, we estimate that liquidation added more than $100 billion of deadweight losses onto investors, above and beyond the $25bn of losses that market participants estimated were present on a going concern basis.  It’s much better for investors if we can solve the problem as cheaply as possible.  If costs can be kept in proportion, we dramatically reduce the risk that a problem at one bank can escalates into a crisis that threatens the overall financial system and the economies it supports.

But while we want to avoid liquidation-style failure because of the high cost, it doesn’t mean that Bail-ins give banks a “get out of jail free” card.  Far from it:  Shareholders can be wiped out.  Management can be fired.  And bondholders do their part by exchanging their obligations into equity capital.  Owners and mangers bear appropriate responsibility, which should incentive good management behavior and market discipline.

Why does your proposal exempt secured creditors from taking a haircut if a bank gets into trouble? Shouldn’t everyone bear the pain?

Secured creditors should be treated differently because they are investing in a different instrument.  Secured investors accept a lower yield on their loans because they are lending against collateral.  This is different from unsecured creditors who agree – in advance – to take the credit risk of the bank directly.  For markets to function well, we think it’s best that the outcomes are related to the nature and intent of the product.

In addition, compromising the efficiency of the secured funding market could impair the ability of companies to fund themselves in times of stress.  We frequently see companies use secured funding as an additional source of liquidity at a time of difficulty.  Many companies have used this market to avoid bankruptcy, gaining time to work down their assets or consider strategic options.  Given the importance of liquidity in the recent crisis, it seems unwise to make this funding option more difficult.

Finally, we believe that it is important to avoid mechanisms that could create a ‘rush to the exits’, which can destabilize the funding of a bank.  By changing a portion of their credit profile from secured to unsecured, we could actually add risk to the system – by creating an additional class of short term creditors who would run to the exits at the first whiff of danger.

For a regulator to be able to impose a recapitalisation within a matter of hours, wouldn’t they need a clearer grasp of institutions’ balance-sheets than they apparently did during this crisis? And when those institutions run across international borders, wouldn’t they need to act in concert with other regulators?

We think regulators had sufficient balance sheet knowledge to execute a Bail-in recapitalization, even under the stressed conditions of late 2008.  What they didn’t have was the clear authority to execute one.  If new laws providing for Bail-ins are set out with clarity, the necessary steps are fairly simple and could be executed with a reasonable amount of preparation, even in the severe time constraints of a crisis.

There are operational elements that could be considered to make implementation work more smoothly – it is critical that a Bail-in be executed quickly and decisively for the institution to regain market confidence and continue to operate.  For example, a holding company structure could be used to isolate recapitalizations, and keep them separate from operating entities and customer relationships.  To handle inter-creditor issues, regulators could retain an experienced bankruptcy judge, who is skilled in balancing the claims of different classes of creditors.

In addition, case studies could be published to provide the market with examples of how regulators would have structured a Bail-in for the various resolution events encountered in 2008.  This could aid regulators in future crises – when time is short, and when precedents would be extremely helpful to both policymakers and investors.  There are, no doubt, many operational and legal issues that would need to be confronted and addressed but we believe that these should be manageable – especially considering the importance of this issue and the drawbacks of the alternatives.

Lastly, it should be possible to execute a Bail-in framework in a single country, though broad international acceptance would make implementation simpler.  The main international consideration is that some minimum level of cooperation from offshore regulators would be needed, so that local regulators refrained from pre-emptive actions to seize assets or block normal activities, while the overall institution was being recapitalized.  But as long as offshore regulators allowed the primary home market regulator some reasonable deference, we believe international coordination issues should also be manageable.

You say that investors would continue to invest in big banks despite the risk of a forced recapitalisation since they put their money into other securities with a similar risk. But other industries do not expose them to the risk of regulator-imposed losses within the space of a weekend. Surely this implies a significantly higher cost of capital for the banks?

Our view is that the net cost impact will actually be relatively neutral for well-run institutions.

The riskiness and cost of a loan depends on two things:  the likelihood of a loss and the severity of a loss.  The Bail-in event should only occur when an institution has exhausted all other avenues – so the likelihood of trouble is the same.  So the only question is whether the severity will be greater or less.  In the recent crisis, some investors in troubled institutions suffered harsh losses – as in the Lehman case – while others got bailed out with taxpayer money.  While a cynical investor might like to take his chances and hope for a government bailout, he is exposed to significant political uncertainty that one may occur, and devastating losses if it doesn’t.

In contrast, a Bail-in event would impose some losses, but they would be much less severe.  In the Lehman liquidation, for example, recovery values for unsecured holding company debt securities have traded in the 15% – 25% area, implying huge losses from par.  In contrast, a Bail-in would allow creditors to keep 85% of their debt whole, and this debt would now be a claim on well-capitalized bank. Moreover, the debt investor would also receive significant new equity in exchange for 15% discount.  The package should be worth something over 90%, a vastly better outcome than the current result.

Debt investors understand these types of tradeoffs.  They also tend to dislike highly unpredictable outcomes, which were a feature of the various resolution events seen in the recent crisis.  We think that the net cost impact of a predictable, well-structured Bail-in alternative should be relatively modest for well run banks.

If an institution appears to be getting into trouble, won’t the threat of a forced recapitalisation encourage investors to offload their holdings as fast as they can, increasing the fragility of the institution and the instability of the system?

Institutions in trouble always see some price declines in their securities – this is a natural result of a normal market process.  The different – and highly de-stabilizing – element of the recent crisis was the risk of counterparty and customer runs, and the loss of short term funding, such as repo.  This affected the core business of the institutions, depleting their customer franchise and funding support, and making it more difficult for them to survive.

In the Bail-in structure, the customers and business relationships would be kept whole.  In our Lehman example, the operating divisions of the institution would be protected, so transactional counterparties should feel comfortable staying with the bank.  The risk of a liquidation type bankruptcy would be more remote, so you shouldn’t see customers or short term repo investors fleeing at the 11th hour.  You could still see heavy equity selling – as with any firm under stress.  But shorting stocks will be less profitable as it will be more difficult to push the institution into a fear-driven collapse.

The politics of forcing losses onto wholesale creditors are relatively simple. But we have seen in this crisis that it is politically untenable to let retail depositors lose money. Could this scheme work for a bank funded predominantly or entirely by retail deposits?

A Bail-in would not help regulators resolve an entity that is funded entirely by retail deposits.  Our proposal would not force depositors to participate in the debt-for-equity exchange that is central to a Bail-in.  Retail deposits enjoy special government protections in most financial systems, which help avoid the risk of de-stabilizing bank runs, and we do not propose to change this approach.

However, few large institutions are funded fully by retail deposits.  Almost all of the larger institutions have a significant portion of long term debt funding in preferred stock, subordinated debt and unsecured senior debt.  This debt is typically owned by sophisticated creditors, who understand they are investing in the credit risk of the institution.  This means that, as a practical matter, most of the systemically important banks at the center of the recent debates could be handled via the Bail-in process.

ONE might have thought that by January of 2010, proposals to improve the ability of regulators to resolve large and failing financial institutions would be hopelessly behind the times. Surely, the government would have adopted needed policy changes by now, some 15 months after Lehman’s collapse?

Hardly. Financial reform legislation continues to putter its way through Congress, and authorities are unable to agree how best to handle large failing institutions. The policy debate over strategies is as relevant as ever.

This week, The Economist features a perspective on dangerously undercapitalised banks from two veterans of the crisis of September of 2008. Paul Calello (above, at left), the head of Credit Suisse’s investment bank, and Wilson Ervin, its former chief risk officer, have written a guest Economics focus column proposing that regulators push for a “bail-in” strategy to recapitalise banks quickly and simply, and at minimal cost to taxpayers and the financial system. They write:

According to market estimates at the time, Lehman’s balance-sheet was under pressure from perhaps $25 billion of unrealised losses on illiquid assets. But bankruptcy expanded that shortfall to roughly $150 billion of shareholder and creditor losses, based on recent market prices. In effect, the company’s bankruptcy acted as a loss amplifier, multiplying the scale of the problem by a factor of six. This escalated the impact elsewhere in the financial system. For example, the Reserve Primary Fund, a large money-market fund, “broke the buck” the next day, leading to severe pressure on other funds. A bail-in during the course of that weekend could have allowed Lehman to continue operating and forestalled much of the investor panic that froze markets and deepened the recession.

How would it have worked? Regulators would be given the legal authority to dictate the terms of a recapitalisation, subject to an agreed framework. The details will vary from case to case, but for Lehman, officials could have proceeded as follows. First, the concerns over valuation could have been addressed by writing assets down by $25 billion, roughly wiping out existing shareholders. Second, to recapitalise the bank, preferred-stock and subordinated-debt investors would have converted their approximately $25 billion of existing holdings in return for 50% of the equity in the new Lehman. Holders of Lehman’s $120 billion of senior unsecured debt would have converted 15% of their positions, and received the other 50% of the new equity.

The remaining 85% of senior unsecured debt would have been unaffected, as would the bank’s secured creditors and its customers and counterparties. The bank’s previous shareholders would have received warrants that would have value only if the new company rebounded. Existing management would have been replaced after a brief transition period.

The equity of this reinforced Lehman would have been $43 billion, roughly double the size of its old capital base. To shore up liquidity and confidence further, a consortium of big banks would have been asked to provide a voluntary, multi-billion-dollar funding facility for Lehman, ranking ahead of existing senior debt. The capital and liquidity ratios of the new Lehman would have been rock-solid. A bail-in like this would have allowed Lehman to open for business on Monday.

Today and tomorrow, Free exchange will host a roundtable discussion, featuring responses to the piece from financial experts. We hope you will follow along, and offer your thoughts on the matter in comments.

I THOUGHT it was a good speech, politically speaking. Barack Obama came off as relaxed and optimistic and presidential. He was able to make the opposition squirm a few times (“do we clap for tax cuts or not?”). And early polling suggests the public overwhelmingly responded well to the speech.

I would say that it’s unlikely to change anything. Mr Obama’s numbers will rebound when the economy rebounds, and not much sooner. I was impressed at the forcefulness with which he urged Congress to get its act together and pass some legislation, and his oblique reference to the inappropriate use of the 60-vote cloture rule surely cheered many of his supporters. But if stonewalling senators were the sort to be swayed by a speech, they wouldn’t be stonewalling in the first place. Business as usual will continue, as usual.

As for content, there was little in the speech, economically-speaking, that we hadn’t already heard about. He mentioned the contents of the House jobs bill. He briefly discussed his deficit plans. And he made reference to some aspirational goals on things like energy efficiency. Two points did stand out. One was a proposal for changing funding for higher education:

To make college more affordable, this bill will finally end the unwarranted taxpayer subsidies that go to banks for student loans. Instead, let’s take that money and give families a $10,000 tax credit for four years of college and increase Pell Grants. And let’s tell another one million students that when they graduate, they will be required to pay only 10 percent of their income on student loans, and all of their debt will be forgiven after 20 years –- and forgiven after 10 years if they choose a career in public service, because in the United States of America, no one should go broke because they chose to go to college.

An adjustment to student loan rules in long overdue; as it stands, the government guarantees the loans and yet allows private companies to make them, granting them a nice profit for no particular reason. The tax credit is potentially a good idea. I’m curious to see how the debt forgiveness would work. Is it the case that a borrower could make the minimum payment (or less) for twenty years and then get the debt forgiven? And more importantly, will this be retroactive applied? Please?

And then there was this:

Third, we need to export more of our goods. Because the more products we make and sell to other countries, the more jobs we support right here in America. So tonight, we set a new goal: We will double our exports over the next five years, an increase that will support two million jobs in America. To help meet this goal, we’re launching a National Export Initiative that will help farmers and small businesses increase their exports, and reform export controls consistent with national security.

This seems to me to be a somewhat more mercantilist use of language than is customary in these speeches. Every president talks about competitiveness, but Mr Obama’s connection of more exports with more jobs seems to up the zero sum quotient.

The good news, is that he doesn’t follow that up with anything too stiff. An initiative to help American firms access export markets is pretty benign, and the next paragraph promotes the signing of trade deals and the Doha round of trade talks.

As for that doubling of exports, well, it’s not quite as tough a task as it might sound. If we take the likely 2009 number, return it to the 2008 level and count on 2% inflation, then in nominal terms the goal is almost halfway met. Presumably, Mr Obama is counting on some help from a declining dollar and continued growth in emerging markets. It’s not the most audacious goal in the world, in other words, which is a probably a good thing.

But the bottom line is this: for all the sunniness in the speech, conditions remain as they are. The economy will limp through 2010, and unemployment will likely be near 9% the next time Mr Obama stands at the podium to deliver one of these things. If he wasn’t fully on the defensive this time around, he will be then.

I AM generally not a fan of the sort of op-ed columnist who writes piece after piece saying, “why don’t politicians just do this simple policy thing that I like, which is very simple,” without stopping to consider the political realities that make said policy thing outlandishly unrealistic. And I’m very much not a fan of those wonks who argue that cap-and-trade should be abandoned in favour of a carbon tax, as cap-and-trade isn’t as good a policy (they’re functionally quite similar, and the quality of both policies depends on implementation) and as cap-and-trade is way too complicated (a carbon tax would get complicated in a hurry if it had to spend a few months making its way through Congress). And so I’m a little reluctant to say what I’m about to say.

But wouldn’t it be something if Barack Obama came out and proposed a carbon tax tonight in his State of the Union address?

The energy bill strategy pursued so far, which includes a cap-and-trade system along with a lot of other stuff, seems to be nearly if not quite entirely dead. So the risk of endangering its passage by advocating a different approach is somewhat minimal. Second, if the American public is sick of anything, it would seem to be the sort of horsetrading associated with the crafting of both the health care and energy bills. Voters are unhappy with perceived giveaways to health insurers and to Ben Nelson’s Nebraska, and voters are likely sceptical about the perceived giveaways associated with the distribution of carbon allowances and offsets. Now, as Robert Stavins has argued, the fact that allowances can be given out to satisfy political interests without compromising the integrity of the carbon cap is one of the virtues of the cap-and-trade strategy. But I think that the benefit to the president to be derived from distancing himself from cap-and-trade may be worth the loss of flexibility.

Next, the carbon tax could represent a meaningful bone thrown to deficit hawks, able to raise tens of billions of dollars per year. And it would allow Mr Obama to appeal to Americans’ desire for righteous sacrifice (trust me, it’s buried in there somewhere). Voters might well respect a policy that would facilitate a move toward a healthier, cleaner environment and a debt-free future.

To pull off the move, he’d need to allay concerns about harm to lower-income families. This could be done by including in the proposal a simple refund of carbon tax revenues to families below a certain income level. He would also have to allay concerns about the contractionary impact of the measure. To do that he could simply propose that the tax take effect in the first fiscal year after unemployment drops beneath 6%. And he would have to try and prevent Congress from churning the policy into something complicated and unpopular. To do this, he could capitalise on Congress’ unpopularity by calling them out and daring them to muddle up the bill, and by declaring that he simply would not sign any bill with unnecessary Congressional amendments.

And finally, he would have to figure out how to address distributional concerns—that is, how to get legislators in states that stand to lose from a tax on dirty energy to sign on (enough of them, anyway, to pass the bill). This would be the trickiest part. I think the president’s best bet would be to offer affected lawmakers assurances that in a follow-up bill addressing other energy questions, from research grants to infrastructure to the inevitable aid to alternative energy sources, their states would receive ample transition assistance and investment.

It would be simple, substantive, and the Washington press corps would eat it up. Would it fly? Maybe. Mr Obama hasn’t really tried to harness public anger behind a major initiative yet. And even if it didn’t, the simple act of making the proposal would probably reflect better on the adminstration and do more to improve the tone in Washington than proposed renewal of an accelerated depreciation measure for purchases of business equipment.

It’s a horribly unrealistic suggestion. But the electorate is angry, frustrated, disillusioned, and bored with the president and his do-nothing Congress. A laundry list of tax credits isn’t going to generate much in the way of new energy or enthusiasm. May as well take a little risk, I say.

MIGHT a handshake get you hired?

The authors examined how an applicant’s handshake influences hiring recommendations formed during the employment interview. A sample of 98 undergraduate students provided personality measures and participated in mock interviews during which the students received ratings of employment suitability. Five trained raters independently evaluated the quality of the handshake for each participant. Quality of handshake was related to interviewer hiring recommendations. Path analysis supported the handshake as mediating the effect of applicant extraversion on interviewer hiring recommendations, even after controlling for differences in candidate physical appearance and dress. Although women received lower ratings for the handshake, they did not on average receive lower assessments of employment suitability. Exploratory analysis suggested that the relationship between a firm handshake and interview ratings may be stronger for women than for men.

I like that the raters tasked with evaluating handshakes were “trained”. How does one become a trained handshake evaluator?

TO FOLLOW up a bit on yesterday’s complaint about the exemption of discretionary “security” spending from the president’s proposed spending freeze, on the grounds that every last dollar spent at Defence, State, Homeland Security, and Veterans Affairs is apparently necessary to prevent attacks on Americans, have a look at this chart, courtesy of Spencer Ackerman.

As you can see, America is spending nearly $20 billion per year, or a little less than the estimated savings from the president’s spending freeze, on procurement of combat aircraft. Those would be the fancy jets that America would deploy in a conventional war against a fellow superpower. Considering that America’s existing stock of combat aircraft is overwhelmingly dominant relative to any potential adversary’s air force, this seems like the kind of category of spending that might fruitfully be frozen, or hey, dialed back to 2000 levels.

Roughly half of all discretionary spending (which is itself about 40% of the total budget) is defence spending. It’s ridiculous to perpetuate the false idea that the whole of that budget is necessary and must keep growing in order to keep Americans safe.

THE way legislators were running away from Ben Bernanke late last week, you’d have thought he was the most hated man in Washington. But as Sudeep Reddy notes, most Americans feel about the chairman they way they feel about, you know, things about which they’re unsure:

About 18% of those surveyed said they were “positive” about Mr. Bernanke, the same share that said they were “negative.” Of the rest, 19% called themselves “neutral” and 45% said they were unsure. That puts Mr. Bernanke’s ratings slightly ahead of those of Treasury Secretary Timothy Geithner, who had a smaller “positive” share.

Of course, one imagines that those who feel positive about Ben Bernanke are sort of meekly positive, while those who feel negatively about him are quite passionate in their distaste. Other interesting numbers include:

Of those who have investments, 38% supported his reappointment and 35% were opposed. Those with $50,000 or more in investments favor a second term by 42% to 37%. Of those without investments, 28% supported reappointment while 40% were opposed…

The poll found that Mr. Bernanke has a gender gap. Men favor a second term, 40% to 36%; women oppose, 39% to 28%.

People with a high school education or less opposed Mr. Bernanke 43% to 22%, while those with at least some college supported him 39% to 32%. People with a postgraduate education supported Mr. Bernanke 41% to 33%.

I’d be curious to see how significantly the breakdown by education departs from past Fed leaders. Obviously, less educated workers have fared worst during the recession and benefitted least from the rebound in asset prices, so their opposition isn’t a shock. Still, I’d guess that Fed chairman is not a position that inspires a lot of working class love even at the best of times.