Author: R.A. | WASHINGTON

MY COLLEAGUE at Democracy in America writes to clarify his view of an aggressive American approach to China’s renminbi policy, and I still am struggling to see things his way. I’ve been trying to pinpoint precisely where our views diverge, and I think there are actually several disagreements. He begins his reponse by saying:

I don’t buy the argument that China is hamstrung in its ability to make trade or currency policy by its citizens’ nationalism. Its citizens’ interests are a different matter.

The argument that retaliatory actions against another country are futile because they will only anger that country’s nationalist constituents is an argument with roots in fields like human rights and nuclear non-proliferation. In those contexts it’s a very strong argument. In fields like human rights, freedom of expression and rule of law, or on issues like Tibet, there is virtually nothing outsiders can do that will affect internal Chinese policy, and while America cannot be seen to condone gross abuses, taking aggressive stances is generally unproductive. The perception by both leaders and the general public is that outsiders have no business interfering in these issues. 

Trade disputes are different. They involve credible interests on the part of the importing countries, which the exporting countries must and do take seriously. Ultimately, it’s our money. There’s no way to pretend that the importing country has “no business” intervening in a trade issue. So trade disputes just don’t generate the same kinds of resentment against outside interference as human-rights or security disputes. Yes, the exporting country’s public generally sees trade actions as part of a scheme by foreigners to keep them down, but that resentment mostly gets filed away and doesn’t much affect government policy decisions.

Two points. First, I find the attempt to draw a distinction between the human rights case and the economic interest case to be entirely unconvincing. I fail to see how an America that can’t get China to agree to cease human rights violations can somehow get China to cease pegging its currency. It’s certainly clear that America doesn’t make as big a deal about human rights issues as economic issues because America sees that it has more of a domestic interest in intervention, but that has nothing to do with how effective intervention is likely to be. In either case, America has the leverage it has. What’s more, it’s inappropriate to pretend that negotiations on one issue are irrelevant to negotiations on other issues. Confrontations with China over economics should explicitly take into account the likely effect of those confrontations on other international problems, from China’s domestic human rights issues, to instability in North Korea and Iran, to climate change. America is involved in one, long, many-faceted negotiation with China, which is one reason the decision to push a hard line on the currency issue is so fraught.

Second, it is difficult, actually, to make the case that China is preserving the currency peg based on the interests of its citizenry. The case was stronger in late 2008, when global trade collapsed and China was looking to prevent a total industrial meltdown (and when appreciation against the dollar would have meant extremely rapid appreciation against most other currencies). At this point, the effect of appreciation on the Chinese would be somewhat ambiguous, but there is good reason to think that an orderly rise in the RMB would generate net benefits. Which is why China is hinting that revaluation is just a matter of time, and which is why it is silly to make it more difficult for China to revalue by roiling domestic political conversations with a newly aggressive approach.

Here’s where the disagreements really pile up:

But if America thinks the undervalued RMB really is a problem, both because of its effects on American workers, its effects on America’s macroeconomic imbalances, and its global contribution to instability; and if America thinks that blanket tariffs on Chinese imports would help correct those imbalances in the absence of revaluation, then absent some other convincing argument against them, America should implement such tariffs and seek agreement with other importing countries on harmonising them. That this will make a nationalist Chinese public angry is not much of an argument against doing so…

There is no world in which China refuses to revalue, America slaps tariffs on China, and then we all go on our merry way. China will either retaliate—with tariffs of its own or via new depreciation—in which case America’s bluff has been called and things can only get worse, or China will reluctantly agree, America’s current account deficit will not much change (since many Chinese exports will merely become exports from some other emerging market nation, and since America will still import gobs of petroleum), and America’s relationship with China will be decidedly more frosty—which could potentially be extremely costly. Which isn’t to say that revaluation wouldn’t be positive on net. It’s simply to say, as I have been saying, that revaluation cannot produce benefits large enough to be worth the potential downside risks of an aggressive strategy.

To get more deeply into the weeds, it’s clearly true that with China having re-prioritised growth over stability in the context of the global recession, local government officials and Party cadres are going to be opposed to RMB revaluation or anything else that interferes with their ability to report back high growth figures from their provinces, and forestall embarrassing factory closures and unrest. This is the clearest sense in which Beijing’s “freedom of movement” is likely limited. But if you accept that RMB undervaluation is a major problem and is indistinguishable from broad export subsidies, then to say that America should do nothing to respond to it is to say that we should run a trade deficit and put our own manufacturers at a disadvantage to help maintain political stability and the popularity of the government and Communist Party in industrial regions of China. That’s where it seems to me that we would be taking responsibility for something that is none of our business. China is responsible for its own internal politics, and is quite capable of handling them.

I don’t know what it means to say that china has re-prioritised growth over stability. Where China is concerned growth is stability. But the broader point is that America’s trade deficit has relatively little to do with the RMB peg. Revaluation would reduce it somewhat, but much of the imbalance in the Sino-American relationship stems from structural factors on both sides, which would persist. Meanwhile, America continues to run persistent current account deficits with plenty of other trading partners against whose currencies the dollar floats. Europe, for instance.

And I am absolutely not advocating that America do nothing in the face of the Chinese peg. There are mutually beneficial deals to be struck, and America should seek to strike them. And I think consistent but polite pressure with respect to the RMB peg is appropriate.

It seems to me that among economists, the get-tough approach is based on a naive view of American power, and among politicians, the get-tough approach is about the political possibilities of economic nationalism and populism. I have yet to see a clear case for why an agressive move toward more heated rhetoric and tariffs is the respectful, and most effective, way to get what America wants.

BRITAIN’s recession has been much more like America’s than Europe’s. Its recovery may follow that trend:

The budget deficit as a share of GDP may be on a par with Greece’s, but Britain’s public debt started much lower, at less than 50% of national output in 2007, compared with over 100% in Greece. Britain has always paid its debts; investors don’t yet doubt the ability of a British government to get a fiscal grip after the election; and Britons tend to pay their taxes.

Despite the reverses of the past couple of years, the British economy retains important strengths, not least its openness to trade, capital flows and, more recently, migration. There is much talk of rebalancing the economy, of finding new sources of growth now that financial services and the housing market have taken a hit. Yet Britain’s economy is already surprisingly varied. It is still the world’s sixth-biggest manufacturer. The outlook for financial services may have darkened but London’s streets are no less thronged with lawyers, management consultants, accountants and ubiquitous marketing types. Cultural output is strong, with films and video games and edgy fashion pouring forth. Foreigners still want to buy British businesses—and Britain usually does well by it…

Delivering his pre-election budget on March 24th…the chancellor, Alistair Darling, said he expected growth to accelerate from 1.25% this year to 3.25% next year, then to 3.5% over subsequent years. That smacks of wishful thinking. Britain’s banks are reluctant to lend. Consumers owe too much and will have to pay more in taxes whoever wins power in May. The economy has long-standing weaknesses, including congested transport, unreformed schools and patchy skills.

Nevertheless, the prospects for growth look reasonable.

Earlier in the crisis, sterling was seen as a potential burden for Britain—as a vulnerability that could lead to currency runs and additional pain. These days, being outside the euro looks like a blessing, for having avoided recent troubles associated with sovereign debt problems and for the boost flexible sterling will give to rebalancing.

VOX has posted a piece by Yiping Huang an economics professor at the China Center for Economic Research at Peking University, who takes aim at Paul Krugman’s arguments for confronting China over its currency peg. It isn’t the most persuasive case I’ve seen made for the play-it-cool approach. In particular, the argument that a Chinese revaluation would cut global growth by 1.5% seems as unsupported as the suggestion that the RMB peg is costing the world a similar amount of growth (unless we’re talking about a sudden, massive, disorderly revaluation, which China would obviously not accept). I do think this is right, however:

So what would happen were the Obama administration to follow Krugman’s advice? First of all, it would delay, not accelerate China’s exchange rate policy reform. On 6 March, the People’s Bank of China Governor Zhou Xiaochuan made it clear that the current soft peg of the renminbi to the dollar was a temporary response to the global financial crisis and that this would have to end. These statements clearly suggest that the Chinese authorities are searching for an appropriate time to exit from the soft peg and I think this could happen at any moment.

But finding the appropriate time is not always easy. The China-US policy game on the renminbi exchange rate can be best characterised as a “prisoners’ dilemma”. It is important to keep in mind that, like American politicians, Chinese leaders also have to entertain domestic political pressure. And to be seen as giving in to American pressure can substantially weaken the leaders’ political standing and capacity to act in everyone’s best interests. China is more likely to move ahead quickly if the US maintains a calm and rational stance. This was largely what happened in the lead up to the July 2005 exchange rate reform.

Those advocating strongly for a Chinese revaluation seem to approach the peg as if it is an immutable part of Chinese economic policy. It isn’t. China was steadily appreciating its currency during the three years preceding the crisis. Its decision to halt this process was a countercyclical one. Chinese officials have repeatedly made this point, and have repeatedly said that a return to appreciation is just a matter of time. As Mr Huang notes, a week before Mr Krugman’s latest firebreathing column on the issue People’s Bank of China Governor Zhou Xiaochuan said that the peg was among the interventions that would end as recovery solidified. And today, we read this:

China may allow the yuan to trade more freely against the dollar, while avoiding an abrupt revaluation that would wreck its exports, according to Fan Gang, an adviser to the country’s central bank.

“China may resume a managed float of its exchange rate, particularly if the uncertainty of the overall post-crisis economic situation diminishes,” Fan wrote in an opinion piece published today in China Daily, a government-backed English language newspaper. “If the adjustment came abruptly, Chinese companies would suffer a sudden loss of competitiveness.”

This is the direction in which China is moving. It might be worth giving them a little breathing space to begin the adjustment, rather than rushing forward to impose tariffs before they have the opportunity to do what America wants them to do without looking like they’re caving in to American pressure.

A FEW weeks ago, I noted that one explanation for weaker than expected employment performance might be that the GDP measure of output is simply not the best indicator of economic activity;

GDP—the total market value of output produced each year—is the most commonly used indicator of the “true” state of an economy. A theoretically equivalent but less commonly-cited indicator is Gross Domestic Income, which adds up wages, profits and taxes. In practice, the two numbers often move slightly out of step with each other, and a growing body of research hints that GDI, rather than GDP, should be given more weight in computing an estimate of the economy’s true direction.

By the light of GDI, the American economy looks a bit more pallid. According to the income measure, activity slowed at a 7.3% annual rate in the fourth quarter of 2008. GDP, meanwhile, recorded a 5.4% drop. And in the third quarter of 2009 (the most recent for which income data are available), GDI continued to contract while GDP notched up the increase that led many economists to announce the end of the recession.

This was based in part on research put together by Fed economist Jeremy Nalewaik, who has investigated this topic over the course of several years. Mr Nalewaik recently presented a new paper on GDI as one of the Brookings Papers on Economic Activity. He writes:

Considerable evidence suggests that the growth rates of [GDI] better represent the business cycle fluctuations in “true” output growth than do the growth rates of GDP…For the initial growth rates, the revisions evidence over the past 15 years, the correlations with other business cycle indicators, and the recent behavior of the estimates around cyclical turning points all point to this conclusion. For the latest estimates that have passed through their cycle of revisions, careful consideration of the nature of the source data, statistical analysis of the information added by the revisions, and statistical tests as well as informal comparisons with other businesss cycle indicators, again all suggest [GDI] growth is better than GDP…growth.

And:

These two measures have shown markedly different business cycle fluctuations over the past twenty-five years, with GDI showing a more-pronounced cycle than GDP…GDI currently shows the 2007-2009 downturn was considerably worse than is reflected in GDP.

One of the concluding thoughts in Mr Nalewaik’s paper concerns the delay with which GDI data is published. The advance estimate of fourth quarter GDP was made available in late January. Meanwhile, the first report on fourth quarter GDI has only just come out, two months later. As it happens, GDI finally showed expansion during the last three months of the year:

A bit hard to see, but what you’re looking at there is GDP (the blue line) and GDI (the red line) from the beginning of 2007 through the end of 2009. Obviously, GDI performance has been worse than GDP performance, and in the third quarter the latter rose while the former did not. But while the gap between the two remains large, the income measure of output actually rose faster during the fourth quarter than did the expenditure measure. So perhaps we can say with a little more confidence that the recession had, as of late 2009, finally ended.

THIS morning, the Bureau of Economics Analysis released its third estimate of American output growth for the fourth quarter of last year. The newspaper headlines are focusing on the least newsy aspect of the latest report; “U.S. Economy Expands the Most in Six Years”, reads the link on Bloomberg’s homepage. But it’s been the best quarter in six years since the advance estimate came out in late January. That’s not the news.

The interesting new information is, first, that output growth was revised down slightly, from a 5.9% second estimate to a 5.6% third estimate. Secondly, each revision has reduced the contribution of personal consumption expenditures and residential investment to quarterly output, and each revision has increased the contribution of equipment and software investment, suggesting a larger role for inventory changes.

The upshot of all of this is that underlying growth in the economy—excluding one-time, transitional factors like inventory adjustment—was weaker than initially estimated. This makes sense in light of the fourth quarter employment experience. But it’s also a little worrying.

THE American recovery is now three quarters old, and yet in only one month since the onset of recession in 2007 has payroll employment increased. That was last November, when non-farm employment ticked up by 64,000. The Obama administration has estimated that the economy will add an average of 95,000 jobs per month in 2010—barely enough to prevent additional increases in the unemployment rate—but the first two months of the year turned in employment declines.

But perhaps March will be different. And maybe, just maybe, it will be very different. Some economists are anticipating an increase in payrolls of greater than 200,000, still somewhat modest for recovery from a deep recession but a huge reversal from recent figures. Simon Constable explains the possibility:

In the first place, the government has started hiring large numbers of temporary workers for the census. That number should peak at around 635,000 in May, according to the Commerce Department. The jobs will be temporary, but they are still jobs and that will likely mean increased spending in the economy and hence likely more hiring.

Even without the census-related boost, Brusuelas said the private sector should add about 50,000 permanent jobs a month if the economy stays on its current trend. That trend-growth rate should edge higher towards the end of the year, with even more jobs being added each month, he said.

Add to that further evidence hidden deep with other data series. Even though the Institute for Supply Management’s Manufacturing Index, which tracks growth in the factory sector, slowed in February, the sub-index for employment was more bullish, showing three months of steady increases.

The employment sub-index within ISM’s Services Index, which tracks the non-manufacturing economy, also showed consistent gains over the same period. The two ISM data points augur improved hiring going forward.

A bounce-back from the snow-ridden performance in February could also contribute. But is that big a number really in the cards?

Probably. Underlying employment growth is still very weak. The ISM manufacturing employment index has been strong, but the service sector improvements Mr Constable cites are actually just declines in the rate of contraction. Absent extenuating circumstances, payrolls in March would probably be flat, more or less. But census hiring could add 100,000 jobs or more, and bounce-back from February could tack on 50,000 more. A 200,000 job month isn’t unreasonable.

The interesting question is whether this somewhat artificial gain might push the economy past a turning point an on to self-sustaining recovery. So far, renewed growth hasn’t produced job gains, and so growth in spending has been constrained. Lack of customers has in turn limited the willingness of firms to add (or permanently add) new employees. New demand has been met with greater labour productivity rather than hiring, and the concern has been that as stimulus and housing market supports fall away, demand will flag and the economy will stall out.

But if a banner employment report or two convinces employers on the brink of hiring to pull the trigger, then a virtuous cycle might begin. Optimism might lead to hiring and investment, which will bring new customers, which will lead to more hiring and investment. Even if the initial impetus is illusory, the long-term effect could be real. In that case, thank goodness for the census. It couldn’t have been better timed.

I MAY have been wrong, this is perhaps the least surprising lede of all time:

North Koreans who recently fled to China say many of their fellow citizens are losing faith in the regime of Kim Jong Il…

But it goes on:

…after a disastrous currency revaluation that wiped out savings and left food scarcer than at any time since the famine of the mid-1990s, when as many as 2 million people died.

This is not a post about China; it’s not the revaluation itself that caused the trouble. North Korea’s government aimed to tame inflation by introducing a new Won that basically chopped several zeroes off the old one. The problem was this:

It entailed the destruction of what counted in North Korea for private wealth. A 100,000 old-won limit was placed on what households could convert from old to new, equivalent to one or two years’ state wages. But households’ meagre state incomes were boosted by market activities. At the prevailing black-market rate, the sum represented just $30, barely enough to buy a 50kg sack of rice. It is not just traders, petty or great, who need cash for inventories. Households riding out the vagaries of harvests and the public-distribution system need plenty too. And so a remarkable thing happened in this repressive state. The public angrily protested, putting the state’s resolve in doubt. It announced a flurry of revisions to soften the impact. In a new-year fanfare of achievements by the state media, no mention was made of the reform.

North Korea destroyed private savings, aiming to punish those who had accumulated cash hoards through black market activities. The Los Angeles Times reports today on the latest conditions:

Food remains in such short supply that a single egg costs a full week’s salary for many. Rice remains largely unavailable at state stores and can be purchased only illegally at about the equivalent of more than two weeks’ salary.

One North Korean woman interviewed said common laborers under the new system were making about 2,500 won per month, barely more than $1 at the new exchange rates prevailing on the black market. Cooking oil is a luxury, so unaffordable that people buy only a few grams at a time in small plastic bags.

The direct action taken by the state has prevented North Korean leadership from blaming the disaster on foreign sanctions. The policy moves have been unfortunate for poor North Koreans, but it’s also an interesting turn of events given the approaching hand-over of power from Kim Jong Il to his son Kim Jong Un. Of course, even without the pressure of this currency crisis one suspects that increasing wealth in China, North Korea’s closest foreign ally, has made rising frustration among North Koreans an inevitability.

MY COLLEAGUE at Democracy in America covers the same China story I mentioned this morning. He specifically addresses the argument that America shouldn’t push China to revalue, since China’s domestic political constraints ensure that such a strategy is likely to backfire.

This argument may well be correct. But there’s no way it would ever have been made in such terms when speaking of Japan. The Japanese were presumed to be equals who were capable of handling their own internal political affairs; tariffs were either a good idea or a bad one, but it was not considered to be the responsibility of Americans to manage a foreign government’s relationship with its nationalist constituents. China’s leadership, too, has become quite sophisticated in its understanding of foreign countries’ internal political affairs over the past 30 years, and recognises that America’s government operates within constraints imposed by constituent demands. With unemployment running at 10%, it is hard to tell laid-off manufacturing workers that America must tolerate Chinese currency manipulation that is effectively indistinguishable from export subsidies. The Chinese did not lose their cool over the (much less justifiable) tariffs on tyres that Barack Obama imposed last year; they are perfectly capable of recognising that America’s tolerance for undervaluing the yuan has limits. But in any case, putting the crucial American-Chinese relationship on a sound footing requires that we treat them as equals, not as restive primitives easily swept away by their hatred of the “gwai lo” [western devils].

I have to say, I don’t understand this. America has no control over China’s domestic politics, and it should therefore take them as given and design its policy response accordingly. It seems to me that the assumption that America could apply enough pressure on China to change its internal political dynamics isn’t actually indicative of a respectful attitude. To put it another way, if the argument is that America should treat China with respect by saying, “Your internal politics is your business, just find a way to do what we want, or else,” well, you see what I’m saying.

At any rate, American leaders have been very forthcoming about their view on the RMB peg. It’s no secret that American officials think RMB appreciation is important to rebalancing. Whether those officials have refrained from chest pounding over the issue because they feel they’ve made themselves clear or because they’re considering China’s domestic politics, their response still strikes me as more respectful than chest pounding.

If we’re willing to attribute sophistication to China’s leaders, which we should be, then we should assume that:

– They understand the argument in favour of a stronger RMB

– They understand the impact of China’s currency policy on political attitudes in America

– They understand how such attitudes could generate a trade backlash against China

The fact that they’re reluctant to revalue given the above should tell us something about the freedom of movement that Beijing has. And respect aside, I’m not sure what pushing aggressively for something China is this reluctant to do is supposed to accomplish.

EUROPEAN finance ministers, led by Germany, have embraced a conditionality-based approach to the sovereign debt crisis in Greece. To obtain emergency financing from Europe, Greece must adopt a credible austerity package, sufficient to put the country on a path toward eventual budget balance. The IMF uses a similar tit-for-tat approach when it assists troubled economies around the world.

So far, Germany has not been satisfied with the deals it has been able to strike. Despite Greek efforts to cut its deficit this year by about 4 percentage points, to 8% of GDP, Germany has refused any explicit offer of aid. Its leaders pulled back on the promise of direct financial assistance, then attempted to steer the aid discussion toward creation of a European Monetary Fund, then advocated for IMF intervention. The soap opera has roiled markets and frustrated Greece, whose borrowing costs will remain elevated until some source of emergency financing is identified.

Now, Germany once more seems willing to agree to some aid for Greece, specifically, a dual approach that would combine IMF financing with bilateral assistance from within Europe. But Germany is again making its agreement conditional:

Ms Merkel said Greece’s crisis had revealed shortcomings in the eurozone: without “an orderly process” to deal with debt crises, the stability of the euro could be “damaged”.

“That’s why I am in addition going to push for the necessary [EU] treaty changes” to toughen monitoring and sanction of government budgets, she told the Bundestag.

In doing so, the German chancellor for the first time outlined Berlin’s willingness to help Greece only if its 26 EU partners agree to what could be a rocky path of rule changes.

It’s understandable that Germany would want this. Clearly some institutional changes are needed, and Germany likely believes that its bargaining power is highest now, when its aid is needed most. But this will be a difficult time to strike a deal. For one thing, major institutional changes cannot easily be negotiated amid crisis. For another, the desperate situation may actually undermine Germany’s bargaining strength:

Ms Merkel told the Bundestag that she was aware of the “grave risks” the Greek crisis posed, as it could lead to ”a chain reaction” that would hit Germany and the EU.

Playing hardball would be like holding oneself hostage; it’s difficult to convince your negotiating partners of your seriousness. And Germany has already committed, more or less, to offering some assistance.

But the request may serve to begin the formal process of institutional reform (starting with an EU summit taking place today and tomorrow). That’s all well and good then, so long as Germany doesn’t leave markets twisting amid uncertainty over Greece for too long.

THIS is one of the least surprising lede’s I can recall reading:

Despite mounting pressure in Congress for the Obama administration to declare China a currency manipulator, the Chinese government is giving no indication that it will change its exchange rate policy.

One might be tempted to assign some causation between the “mounting pressure” and the “no indication”. I don’t know why anyone in Washington or elsewhere would think that China would like to be seen as succumbing to American demands. If everyone agrees that revaluation is in China’s interest, the smart thing to do would be to sit back quietly and allow them come to this on their own terms.

The unstoppable force of the world’s dimmest deliberative body disagrees:

Lindsey Graham, Republican of South Carolina, and Charles E. Schumer, Democrat of New York, have introduced legislation that would effectively compel the Treasury to cite the Chinese currency for “misalignment.”…

“We’re fed up,” Mr. Graham said on Tuesday. “China’s mercantilist policies are hurting the rest of the world, not just America. It helped create the global recession that we’re in. The Chinese want to be treated as a developing country, but they’re a global giant, the leading exporter in the world.”

The Senate bill would let the Commerce Department retaliate against currency misalignment by imposing duties or tariffs. “The only thing that will make China move is tough legislation,” Mr. Schumer said.

Evidence, please! What indication do we have that imposing tariffs on China will lead to something other than Chinese retaliation?

Fortunately, in the House of Representatives, cooler heads are in front of the mic:

At a Ways and Means Committee hearing Wednesday, its chairman, Representative Sander M. Levin, Democrat of Michigan, said of the currency policy: “Like so many other trade issues, it gets caught up in the polarization that grips trade issues — free trade vs. protectionism — a grip that I have believed harmful and reject.”

Similarly, the top Republican on the committee, Representative Dave Camp of Michigan, said it would be better for the United States to work through the Group of 20 meetings and the International Monetary Fund to persuade China to reform its banking and financial sectors, open its markets and improve protection of intellectual property.

“Focusing on the currency valuation issue to the exclusion of the others is more likely to lead to collective frustration than to any improvement in the health of the critical U.S.-Chinese economic relationship,” Mr. Camp said.

Indeed. The way to approach a recalcitrant state is not to steadily turn up the heat, even as no progress is made. It’s to evaluate costs and benefits, and proceed to build the institutional capacity and support to address the dispute. Trying to get tough and back China into a corner will not end well.

OUTGOING Vice Chairman of the Fed Board of Governors gave a speech yesterday at Davidson College, in which he assigned his colleagues some homework. Calculated Risk summarises Mr Kohn’s four short-answer questions:

1) “One assignment is to evaluate the implications of the changing character of financial markets for the design of the liquidity tools the Federal Reserve has at its disposal when panic-driven runs on banks and other key financial intermediaries and markets threaten financial stability and the economy.”

2) “In addition to providing liquidity on an unprecedented scale, we reduced our policy interest rate (the target for the rate on overnight loans between banks) effectively to zero, and then we continued to ease financial conditions and cushion the effect of the financial shock on the economy by making large-scale purchases of several types of securities. My second assignment involves improving our understanding of the effects of those purchases and the associated massive increase in bank reserves.”

3) “Number three involves considering whether central banks should use their conventional monetary policy tool–adjusting the level of a short-term interest rate–to try to rein in asset prices that seem to be moving well away from sustainable values, in addition to seeking to achieve the macroeconomic objectives of full employment and price stability.”

4) “The fourth and final assignment concerns whether central banks should adjust their inflation targets to reduce the odds of getting into a situation again where the policy interest rate reaches zero.”

Central bankers would also do well to compare and contrast approaches and outcomes around the world. The upside to any crisis is that it provides an opportunity to test policy hypotheses. The upside to a global crisis is that you get to test more than one at a time.

KEVIN DRUM reads environmental journalist David Roberts, who has written an open letter to senators crafting a climate bill:

For at least the next five to ten years, no politically palatable price on carbon is going to serve as a primary driver of change. Anything that can pass simply won’t be high enough and its effects will be too diffuse. The main goal with your bill should be to establish a framework whereby a carbon price is implemented and steadily raised. The initial price can be low — low enough to avoid the kind of political backlash that has poisoned previous efforts — and phase in over time so affected industries have time to prepare. At least in the short term, we should think of carbon pricing as a funding mechanism for clean energy policies. It’s a form of responsible budgeting, nothing more, nothing less.

….In exchange for reducing the role of carbon pricing, you should push to strengthen and expand the clean energy and efficiency provisions in your bill. Without a substantial price on carbon those policies will have to be that much more robust if they are to meet the goal President Obama promised in Copenhagen: 17 percent from 2005 levels by 2020.

And Mr Drum says:

Actually, this isn’t really an “exchange.” It’s more like two pieces of a puzzle fitting neatly together.

The price of carbon created by a cap depends on how much carbon emitters are required to cut. If they have to cut a lot, the price is high. If they only have to cut a little, the price is low. And as many, many people have pointed out already, there’s a lot of low-hanging fruit available on the carbon front. This stuff is mostly within the realm of the efficiency and clean energy provisions that Dave talks about, and it has a lot of potential to reduce carbon considerably all on its own. If these provisions are implemented, a carbon cap would most likely require only a small additional carbon reduction, which means that a cap that moved steadily toward a 17% reduction over the next decade would probably produce a pretty modest price for carbon. It’s only in the decade after that, when the cuts become larger, that the declining cap would start to produce a really significant carbon price.

Let’s summarise. Both writers are interested in generating large reductions in carbon. Mr Roberts argues that if politics dictates the enactment of a too-low carbon price, then the bill should make up for that by doing more to encourage efficiency by other means (like fuel efficiency standards for automobiles). Mr Drum is saying that improved efficiency will reduce the carbon price needed to achieve a given carbon reduction.

I think it’s worth looking at this economically to clarify a bit. Underlying the function of cap-and-trade or a carbon tax is the relationship between price and quantity, which economists call elasticity. Sometimes, a given change in price doesn’t produce much of a change in quantity. When petrol prices rise, consumers buy just a little less petrol. Other times, price changes produce big quantity swings. If one of many makers of generic ibuprofen increases its price, quantity demanded will fall to almost zero.

Key to this relationship is the availability of substitutes. More and better substitutes lead to more of a quantity response. Someone dependent on an automobile to get to work has few alternatives when the price of petrol rises, and so his driving doesn’t fall by much. A commuter who typically drives but who lives within walking distance of a commuter rail station, by contrast, may respond more strongly to rising petrol prices. And given a range of near-perfect substitutes, as in the generic ibuprofen example, a price increase for one brand leads to an almost complete drop in quantity demanded.

An important point is that this relationship isn’t static. If petrol prices rise a great deal today, there is very little a commuter can do about that immediately. Within a week or so, however, the commuter may have arranged a carpool. Within several months, the commuter may have opted to trade in an old gas-guzzler for a more efficient automobile. And within a year or more, if prices remain high, the commuter may change the location of his job or residence to reduce the need to drive at all. As time passes, responses to price changes become more complete.

The economy is heavily dependent on carbon fuels at present, and so to reduce carbon output by a lot and quickly would require a high carbon price, which would be extremely painful for consumers (as it would be high precisely because no good substitutes are available). An initial low price, on the other hand, would not produce much of a demand response at all, but it good generate the incentive to begin developing carbon substitutes, particularly if carbon prices are expected to rise. Then, later, when prices do rise, the availability of substitutes—electric cars, transit lines, efficient appliances, and so on—will mean that more carbon can be eliminated with less of a price increase.

So when we talk about things like efficiency requirements and their impacts on prices and carbon output, what we’re really trying to get at is the development of alternatives to carbon-intensive activity. A carbon price is likely to be the most efficient way to develop substitutes for carbon-intensive activities and technologies. From a political economy standpoint, however, it’s worth noting that government investments in substitutes or government efficiency regulations can make demand for carbon more elastic, clearing the way for adoption of an appropriate carbon price.

Michael Kinsley has responded to my post addressing his “inflation nightmare”—the spectre of hyperinflation:

I should have made clearer in my original piece that, at least to me, 13 percent inflation would be a catastrophe (just ask Jimmy Carter) even if it didn’t spiral even further. The cost of climbing down from 13 percent was the worst recession since the Great Depression until the current one. So imagine having the double-dip 1980-82 recession on top of the 2008 – 2010 (?) recession, with a federal deficit running far higher than Paul or almost anyone else could have imagined back in 2003. Some day I will look up the Economist leaders of the time and see if they shrugged off 13 percent inflation with a “File under things not to worry about”…

He’s misunderstanding me here. “File under things not to worry about” refers to hyperinflation. Concerning hyperinflation, I wrote:

To get from America’s current situation to one in which hyperinflation is a realistic possibility, one must pass through an intervening step in which America’s political institutions utterly collapse. And I submit that if Mr Kinsley has reason to believe that such a collapse is imminent, he should be writing columns warning about that rather than the economic messes which might follow.

That is, don’t worry about hyperinflation. About 13% inflation, I merely said:

To point number two, well, this gets at Mr Kinsley’s big error, which, in his defence, is fairly common—misunderstanding the economic significance of hyperinflation. In his initial piece, Mr Kinsley claimed that America “peered into this abyss” in the 1970s and pulled back just in time. But as he notes, annual inflation rates in the 1970s peaked at around 13%. In a real hyperinflation, inflation proceeds at a much, much faster clip. Inflation in Zimbabwe, for example, may have touched an annual rate of nearly 90 sextillion percent.

I didn’t say not to worry about 13% inflation. I pointed out that hyperinflation, with which America has no experience, is a much different animal than 13% annual inflation, with which America does have experience. In fact, double-digit inflation is costly, a point I made repeatedly when discussing Olivier Blanchard’s recommendation that central banks consider raising inflation targets to 4%.

IF America were facing 13% inflation, I would be worried. But another, fairly important, point is that America is not facing 13% inflation. Recall the image of the 12-month percentage change in core producer prices:

Given low levels of capacity utilisation, 9.7% unemployment, and continuing weakness in housing markets, it is very difficult to see from where sustained upward price pressure might originate.

Mr Kinsley seems to want to argue for the risk of hyperinflation by political economy, saying that there is no other painless way to reduce the debt. But hyperinflation is by far the most painful of all of the options. It is the equivalent of holding a gun to the head of the legislature and saying, “balance the budget or I’ll shoot”. However painful balancing the budget may be, it’s better than the alternative.

SO, THE Dodd financial regulation bill is out and out of committee, and financial writers are having a look at what it contains. Mike Konczal is one of them; here he is on resolution authority for failing, systemically important banks—key to reining in the behaviour of too-big-to-fail firms:

It’s not meaningless – regulators at the Federal Reserve will have resolution authority over large financial firms, with a prompt corrective action regime applied to them…it’ll require a lot for regulators to detect problems and show the political will to pull the plug while the company is still net positive value if they are allowed to write the rules themselves, for them to actually do the resolution authority well. We are putting a lot of stress on the Federal Reserve and resolution authority, and giving it a fair amount of discretion.

Here‘s The Economist on resolution authority:

It may prove unworkable, of course. The threat of being wiped out in bankruptcy could cause creditors to flee both the troubled firm and any firms like it, precisely the sort of panic the resolution regime is meant to avoid. “In a severe financial crisis it will be too terrifying for politicians and bureaucrats to use” the new process, predicts Douglas Elliott of the Brookings Institution. Instead, he says, they will resort to ad hoc measures as they did in 2008.

This is not good. To address TBTF concerns, the bill is relying very heavily on resolution authority, as opposed to measures limiting firm size or leverage or interconnectedness through direct means or the use of strong incentives. So you ensure that some firms will be really big and systemically risky, and then you give regulators discretion to use or not use resolution authority. Discretion, under these circumstances, is exactly what you don’t want. It creates doubt in markets that regulators will actually pull the trigger, which will lead to greater risktaking by firms, which will make it more difficult for regulators to pull the trigger in times of crisis.

Then there is the consumer protection agency. Here is The Economist:

Less important but much more controversial is the issue of consumer protection. Democrats want to take that job away from bank regulators and give it to an independent agency. Republicans fear such an agency would kill off legitimate products and circumscribe banks’ financial health. Mr Dodd’s clunking compromise is to place a Consumer Financial Protection Bureau inside the Fed (where it gets a chunk of the Fed’s budget), make its director a presidential appointee and allow the oversight council to overrule its decisions.

The “clunking compromise” is necessary, the piece points out, because the Democrats no longer have 60 votes in the Senate and therefore need Republican support. The compromise also manages to neuter the agency, by allowing the Financial Stability Oversight Council to veto its rulings. Mike Konczal points out that the composition of the FSOC will tend to make it bank friendly. Surveying the officials who would have been members in 2005 and considering their stated positions on regulation of subprime mortgages produces the conclusion that in 2005, the FOSC would have vetoed consumer protections for subprime mortgages.

In other words, things don’t look good. And this is before the legislative wringer of full Senate consideration.

RECENTLY, Michael Kinsley wrote a pretty misguided column warning that America should maybe be worried about looming hyperinflation. Paul Krugman responded to this column by, essentially, calling it nonsense. And now Mr Kinsley has written back:

(1) Krugman should stop bullying people with accusations of economic ignorance. I would never pretend to know a tenth of economics Paul knows. But if he means, in calling this distinction a matter of “textbook economics [subtext: you idiot],” that economic textbooks make this distinction, he is wrong. Or at least no such distinction between inflation and hyperinflation is made, despite an extensive discussion of inflation, in the leading economics textbook, by Harvard Professor Gregory Mankiw.

(2) Krugman’s definition of hyperinflation—“when governments can’t either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press”—is more or less precisely what I wrote that I was afraid of. I suppose there’s a difference between the government printing money to pay off its debts (Krugman’s definition) and the government printing money to reduce the real value of its debts (my fear). But not much of one.

To point one, that “leading economics textbook” is an intro textbook. So, you know, it might leave some important stuff out.

To point number two, well, this gets at Mr Kinsley’s big error, which, in his defence, is fairly common—misunderstanding the economic significance of hyperinflation. In his initial piece, Mr Kinsley claimed that America “peered into this abyss” in the 1970s and pulled back just in time. But as he notes, annual inflation rates in the 1970s peaked at around 13%. In a real hyperinflation, inflation proceeds at a much, much faster clip. Inflation in Zimbabwe, for example, may have touched an annual rate of nearly 90 sextillion percent.

Contra Mr Kinsley, there is a massive difference between printing money to pay off debts and printing money to erode the real value of debt. In the immediate postwar period, America experienced annual rates of inflation up to 10%, which eroded the value of America’s war debt by some 40%. Hyperinflation was never a problem. And there is a big difference between governments that are reluctant to opt for painful budget fixes and governments that absolutely cannot do it. Moreover, the pain of hyperinflation is every bit as bad as and worse than the pain of tax increases, or spending cuts, or default. No politician would risk it, and even if the politicians were willing to, America’s independent Fed wouldn’t let them.

The truth about hyperinflation is that it isn’t so much an economic phenomenon as a political one; it corresponds to the complete breakdown of a country’s political institutions. It is no coincidence that episodes of hyperinflation are typically associated with very poor developing nations, those exiting major conflicts, and those suffering from other major economic dislocations (like the end of Communism).

To get from America’s current situation to one in which hyperinflation is a realistic possibility, one must pass through an intervening step in which America’s political institutions utterly collapse. And I submit that if Mr Kinsley has reason to believe that such a collapse is imminent, he should be writing columns warning about that rather than the economic messes which might follow.

TWO pieces of housing data are out this morning, and neither is very comforting. First, we have existing home sales, which fell in February for a third consecutive month. Home sales hit their lowest level in eight months. Weak sales have had the expected effect on inventory and months of housing supply:

Bloated inventories place downward pressure on prices. Right on schedule, we have the latest data release from the Federal Housing Finance Agency, which reported a second consecutive montly price decline, of 0.6%, in January. December’s decline was larger than originally reported at 2.0%. For the big picture, have a look at this:

What you see there is decline, arrested last year with some significant help from the Federal Reserve and Congress’ homebuyer tax credit, now resuming. The FHFA index is subject to some composition bias, as it doesn’t follow the Case-Shiller methodology of using sale pairs, but the general trend for Case-Shiller has been similar: decline, followed by a period of increases, and then a leveling off (and, in some markets, a return to decline).

It’s a little disconcerting. Fed purchases of mortgage-backed securities are basically over with, and the housing tax credit will expire at the end of April. There is a real question as to whether housing markets can avoid another round of decline without government help. And there is another question: whether broader recovery can survive a new period of declining home prices.

OVER at Real Time Economics, Justin Lahart writes up new research sponsored by MetLife, on the effect of retiring Boomers on the American labour force:

[B]y 2018 there will be 14.6 million new nonfarm payroll jobs, plus some additional jobs in farming, family businesses and so on. Meantime, with no change in immigration policy or labor force participation rates, there will only be about 9.6 million workers available to fill those positions, leaving a gap of more than 5 million jobs that are vacant.

Mr Lahart notes that diminished wealth levels among older workers have delayed some retirements (and, therefore, new job openings). That’s true, but it appears that the net effect of the downturn is likely to be an acceleration in Boomer retirement, rather than a slowdown.

Even so, it’s not clear that retiring workers will magically solve America’s labour market problems. Retirement of skilled workers may simply exacerbate income inequality, if younger generations are unable to produce workers with appropriate training. This is already an issue, as many of the workers shed from manufacturing and construction sectors are a poor fit for new openings in health and education, or professional and business services.

Meanwhile, retirements will increase the strain on the budget, which will eventually have to be addressed. If budget balancing involves spending cuts and tax increases (as it typically does) then broader economic growth may slow, leading to reduced job growth. Which will offset some of the openings generated by Boomer exits.

No magic bullets waiting out there to solve these labour market issues, I’m afraid.

TWO weeks ago, China released trade data for the month of February. Where monthly trade surpluses during the pre-crisis boom years had been in the $20 billion to $30 billion range, China recorded a $14 billion surplus in January, and just an $8 billion surplus in the month of February—results, China’s government used to argue that currency adjustment isn’t necessary. Now, we learn this:

The country will probably see a “record trade deficit” in March thanks to surging imports, Minister of Commerce Chen Deming said on Sunday, while warning that Beijing will “fight back” if Washington labels China a currency manipulator.

Speaking at the three-day China Development Forum that ends on Monday, Chen said: “I believe there will be a trade deficit in March” – which will be the first since May 2004.

That would certainly complicate the arguments of those demanding a revaluation. Amid heated rhetoric on the issue, the stakes have been steadily climbing:

The US business community can no longer resist political pressure for Washington to take a tougher stand against China on trade issues, according to a senior figure from the US Chamber of Commerce.

Myron Brilliant, senior vice-president for international affairs, who has previously helped to protect Beijing from hawkish trade policies, told the Financial Times: “I don’t think the Chinese government can count on the American business community to be able to push back and block action [on Capitol Hill].” …

Mr Brilliant said corporate America’s attitude had changed in response to a range of “industrial policies” pursued by Beijing, including the undervaluation of the renminbi, which made it harder for US companies to do business and compete with China. He also cited the tough economic times in the US – particularly the near 10 per cent jobless rate – as making it more difficult to argue against tough action on China.

Who knows how much stock to put in the deficit projection. What seems clear is that the possibility for an orderly and amicable resolution of this dispute is slipping somewhat, which is quite troubling. There is little to be gained from turning up the heat on this conversation and much to fear, including a round of damaging economic nationalism. The likelihood of sensible policy changes emerging from that is quite slim.

TO READ more about the landmark passage of America’s health reform bill, simply visit any site on the internet. Including this one. A brief health care link round-up:

At the White House, Peter Orszag rebutted some of the fiscal arguments leveled at the Senate bill. Meanwhile, Ezra Klein detailed five of the more promising cost control features in the bill.

Democracy in America cautions Republicans against running on repeal of the bill, saying that should instead opt for reform. James Surowiecki agrees, writing:

Now that the bill has passed, repealing it (which I presume is what Republicans campaigning in the fall will call for) will mean, literally, voting for allowing insurance companies to deny coverage to people with pre-existing conditions, voting to permit rescissions, and voting to make it much harder for people who lose their jobs to stay insured. I have a hard time believing that advocating these things will be a political winner.

Meanwhile, surveying market movements as a gauge of a policy’s likely effect is a fool’s game (albeit one we’re all likely to play when the correlation works in our favour), but some are noting that markets are up today. And indeed, since the current Intrade contract on health reform first moved above 50 on March 4, the S&P index has risen nearly 4% (including a rise of about 0.5% today). Interpret as you will.

And for exhaustive, high quality coverage of the bill, the progress of the reconciliation measure, and all related impacts visit The Economist‘s United States channel page.

AMONG some economics writers (including, at times, me) there is a real disappointment that the Ben Bernanke who stood in front of Milton Friedman and said of the central bank’s response to the Great Depression:

You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Does not seem to be the same Ben Bernanke who ran America’s monetary policy during this recession. Scott Sumner has argued that monetary policy was far too tight in 2008, and Mr Bernanke feels confident ending his unconventional interventions while unemployment is still near 10%, citing the threat of inflation. For some reason or another, the chairman hasn’t been ready to act as he almost certainly would have recommended the Fed act while he was merely a highly regarded academic.

Joe Gagnon explains what more might be done:

A new study in which I participated has been posted on the website of the Federal Reserve Bank of New York. It documents how the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. The study reinforces an argument I have previously made: that the Federal Reserve and other central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero…

As I argued last December, the Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt…

Does additional Fed action mean that inflation is going to come roaring back? Not unless the Fed forgets everything it learned from the 1970s. But right now, inflation is below the Fed’s target of 2 percent and heading lower.

Mr Gagnon hints at an important point. There are risks to stimulative actions by the government (debt concerns) and the Fed (inflation), and there is a risk to inaction (continued high unemployment, and consequent debt concerns). Of all the potential threats, inflation appears to be the most dormant and least troublesome. It’s also the easiest to lick; there are no difficult political choices needed to rein in inflation, just the will of the FOMC to raise rates.

But Mr Bernanke seems to have made up his mind on this front. That’s unfortunate, but I think is probably a silver lining to the dark cloud of inaction and unemployment—our policymakers are learning, or they will eventually.

Mr Bernanke did not behave in this crisis as if he’d learned nothing at all from the Depression. He did ease policy, if insufficiently, and he worked hard with the Treasury to avoid the cascading bank failures that did so much to damage economies in the 1930s. The difference is evident; America avoided another Depression. Lessons were learned. And they may be learned again. Here‘s Mark Thoma:

Whether or not the Fed embraces more aggressive quantitative easing the next time a crisis hits depends critically upon how gracefully the Fed can exit from the policies implemented during this crisis. If, as I believe, the Fed can exit without an outbreak of inflation, then one conclusion that will most likely be drawn is that the Fed was way too timid with its quantitative easing policy. However, if inflation does turn out to be a problem, it will call the whole policy procedure used during the crisis into question.

How easily the Fed exits from its interventions will obviously impact how readily future Fed actors use such tools during severe downturns. Meanwhile, the Fed will also have gotten some important data on the relationship between unemployment and inflation during deep crises. The next time around, policymakers will feel more confident using the unconventional tools at their disposal.

That may be cold comfort to Americans currently without jobs, but it is an important point. Economists can’t generate their own macroeconomic experiments but must wait for events to provide them with natural ones, and this means that intellectual progress is often slow. But there is still progress.