Dirty Little Secret

I recommend a very fascinating article today by Ben Funnell in the Financial Times, where he tries to answer the basic question, "Why is there so much debt in the world today?"

"The answer is capitalism’s dirty little secret: excessive lending was the only way to maintain the living standards of the vast bulk of the population at a time when wealth was being concentrated in the hands of an elite."

Read the whole article and let me know what you think. Is debt the religion of the capitalist system, the opiate of the masses? Can capitalism function without highly leveraged middle classes?

I think it can, but I would be interesting in hearing the perspectives of others on this issue. What is the role of debt in modern society?

More than Meets the Eye?

I, like all young boys raised in the 1980s, had some transformers, the toys that changed from vehicles into robots and the subject of the upcoming blockbuster movie. The toys were a fun way to create, though not nearly as good as Legos which largely dominated my childhood. So you would think a movie about such toys would be fun and creative right?

Wrong. The first movie was a ridiculous bludgeoning of the senses, with little narrative and merciless marketing. And the sequel appears poised to be even worse. I have not seen the movie myself, and I do not plan on watching the movie. Reviews from Slate and the New York Times tell it all. Here is how the NYT describes the movie:

"The creative people behind the cretinous 'Transformers: Revenge of the Fallen,' the second blockbuster inspired by the popular Hasbro toys, have segmented their demographic into four discrete categories:

1. Young teenage boys who still play with Transformer toys (or keep them under the bed).2. Older teenage boys who identify with the professional doofus Shia LaBeouf.
3. Somewhat older teenage boys who would like to play with the professional hottie Megan Fox.
4. Boys of all ages who think it would be cool to go to war and run around the desert shooting guns."

Here is Slate's take on the movie:
"Michael Bay's latest bid to bludgeon audiences into dulled submission, is the reductio ad absurdum of a summer blockbuster. It is loud (boom!), long (two and a half hours!), incoherent (poorly explained intergalactic warfare!), leering (Megan Fox in short shorts!), racist (jive-talkin' robot twins!), and rife with product tie-ins (Chevy! Hasbro!). Transformers will also pack audiences into theaters with the ruthless efficiency of a Decepticon, one of the evil mega-robots who battle the good-guy Autobots for the length (let me repeat: 2.5 hours) of this nerve-crushing excruciation. John Yoo would not be able to draft a memo excusing the torment this movie inflicts on its audience, yet tens of millions of us will line up to shovel money at it this weekend. God bless America."

Good enough for me. I'm looking elsewhere for my summer entertainment.

You know it's bad when...

You know the economy is headed downwards when company executives are selling their own stock. According to the Financial Times yesterday, sales of stock by corporate insiders are 22 times greater than purchases during the past two months. Not a promising sign at all.

The 3 D's

Effective foreign policy requires three D's: Diplomacy, Defense, and Development.

I have heard this phrase a couple of times now at the Embassy, and I really like it. It seems to describe a comprehensive approach that is needed in US relations with other countries. It also seems like a helpful rubric to gauge our current engagement in various parts of the world. Here's my report card on four hotspots:

(1) Iraq: Diplomacy (B), Defense (A-), Development (B+) - We should not underestimate the successes we are having in Iraq on all three fronts. Our efforts with other countries in the region have been robust, we are working very hard and very effectively with politicians within the country, and I am hopeful for the transition. Our military has had remarkable success since the surge. And now, our European allies are even helping to pitch in with development work and training of local police forces. It is certainly still a sensitive time, but we are going about things in the right way.

(2) North Korea: Diplomacy (A), Defense (A), Development (NA) - Let's face it: Kim Jong-il is crazy. He is willing to go to extremes just to keep his grip on the country and show any possible dissidents his strength. Through the Bush presidency and into the Obama presidency, I feel the US has handled this situation as best as can be expected. Both administrations have worked with allies throughout the world, we have developed a robust counter to the North Korean threat, and we are continuing the pressure. It is just too bad that Jong-il won't let our development aid reach into the country. Perhaps that would be the decisive third prong to break the deadly impasse.

(3) Iran: Diplomacy (C+), Defense (B-), Development (C) - The current situation is particularly sensitive and we are not operating from a position of strength. The US is still recovering from President Bush's "Axis of Evil" speech and there remains deep distrust on both sides. Our recent attempts to invite Iranian diplomats to July 4th celebrations has been welcome but a lot more engagement is needed. Our missile defense system in Eastern Europe actually made things worse by alienating a key ally (Russia) of nonproliferation talks in Iran. And efforts to integrate Iran through development aid and assistance half been half-hearted, though that is largely the fault of Iran. A lot remains to be done here.

(4) Russia: Diplomacy (F), Defense (D-), Development (C) - In my mind, our foreign policy towards Russia during the last decade has been a huge failure. On nearly every major international issue since the Kosovo War in 1999, we have been on opposite sides. It did not have to be that way. Failed diplomacy and strong arm tactics in the 1990s disillusioned the fledgling democracy in Russia and they retreated to well-treaded authoritarian responses. The US has only provoked Russia further with its committment to further NATO expansion, placement of missiles and radar in Poland and the Czech Republic, and in our aggressive development support for Georgia. I would argue that we have been comprehensive in applying the three D's in the wrong way vis-a-vis Russia. I am grateful we are looking into a renewed relationship with Russia and particularly hopeful that nuclear arms reductions this fall will be successfull. But even our "reset" button backfired, and the way forward will be difficult. Still, I believe we can and should work to reengage with Russia and craft a revitalized foreign policy in this region of the world.

The Reality of Economic Green Shoots

Well the stock market is up, Goldman Sachs is issuing record bonuses, and unemployment figures are lessening their decline. This is all good news. But we are not out of the woods.

A number of analysts have noted some striking comparisons to the early 1930s when output increased slightly only to plunge yet again. I think the comparisons might be a little unfair to current policymakers as they have done a lot of work to counteract the effects. With that said, I think there are a number of big weeds that threaten to choke any green shoots emerging elsewhere:
(1) State finances - States are struggling, big time. They simply don't have the leverage to borrow their way out of this and so must take anti-Keynesian actions like cutting budgets and raising taxes. Already their actions are reducing the impact of federal spending (or alternatively, federal spending is reducing the worst of the state budgetary crisis). Rising taxes are stifling in an environment of uncertainty, particularly when they are so ad hoc and without any long-term vision. States still have a long way to go.
(2) National government finances - Here in Europe, things are not so pretty either. Latvia is getting bailed out only after taking drastic cuts to its budget. France, Germany, Ireland, Spain and others are running record deficits while most policymakers are laughing at the EU's rule of 3% deficits or less. The difference here though is there is no federal government that can engage in large Keynesian spending. Asia is not too much better, though China has done more to counteract this crisis than perhaps any other country. But again, I reiterate my warning that sovereign debt sales are in for a difficult summer and fall.
(3) Policy complacency - It seems that here in the US, we are nearly reaching the end of our tolerance with change and the future is uncertain. The suddenly acrimonious debate over health care and financial regulation has perhaps revealed the limits of how far we are willing to go to change our economic infrastructure. I suspect that businesses are looking for some stability in the policy realm before they go forward with long-term investments, and right now there is no certainty. Any vision of Obama or others is also clouded at the moment by bizarre events, like the death of flies, King Jong-il and his missiles, and the unrest in the Middle East (more on that later). Perhaps we just need to wait out the summer before things can really take hold again.

I do sincerely hope that this financial crisis compels us to seriously examine public policy choices. If we just patch things over, we will have to wait for the next period of economic uncertainty. But if we make real choices now (whatever they are), I believe optimism and economic growth will return.

Explaining Deficits

The New York Times has an excellent piece describing the US Federal debt that I highly recommend. One of my favorite parts of the piece is a multimedia chart on the left-hand side showing how deficit/surplus projections have changed since 2001. It seems a basic rule of thumb is to take the official surplus projection and cut it in half. Then take any deficit projection and double it.

Why are the official deficit/surplus projections so off? And why do we have such a propensity for deficits and an inability to raise credible surpluses. I believe a big part of the answer lies in our taxing structure.

Think of the United States government like your average Mr. Joe who goes out to get a job. He finds one where he is paid by commission. The problem is Mr. Joe thinks it is a salaried position. During the heydays of the company, he thinks his salary is, say, $150,000. So he plans accordingly. When all of a sudden the company hits a rough spot, his commission drops precipitously. Because Mr. Joe thinks he was living on salary, he keeps spending as he did before, thinking his company just delayed printing his check. When times are good again, he might be back up to his $150,000 commission but he now has all this debt. Mr. Joe will forget about it until the next time his company loses his check in the mail.

My point is, the US tax structure is too performance-based to be stable, yet we make projections and assumptions that it is relatively stable over time. First, it relies heavily on corporate taxes. Businesses, particularly small businesses are the first to encounter trouble in a financial crisis, so relying on businesses to help pay in rough times is foolish. Equally, trying to up their taxes in good times is difficult since they are wont to wander. Second, our progressive tax system relies on the rich who are extremely prone to cyclical swings. The reason is the rich put their assets in everything that goes down during recessions: property, equity, debt, and commodities. So the rich are very willing to file their taxes in a recession showing how much they have lost and how little taxes they owe relative to the good times.

As a group, middle class Americans have less income fluctuation: in the good times, they don't do hugely better but in the bad times they don't do hugely worse. Yes, there are layoffs, but those who keep their jobs don't see their income falling precipitously. But more and more, middle class America is not sharing the taxing burden. For obvious reasons, politicians are loathe to tax their voters and voters are loathe to be taxed. A smaller and smaller percentage of the population is bearing the larger and larger burden of America's taxing. That makes the US budget very prone to economic conditions.

Now some "commission" pay structure is good: it motivates politicians and government to create and promote a good business environment. But it has to be balanced with consistency. For that reason, I feel a broader tax base is necessary. I like the idea of a graduated progressive flat tax wherein everybody has to pay taxes, albeit at increasing levels of income. In the same manner, there needs to be a simplified corporate tax structure that applies across the board and severely punishes tax evaders.

Politically, the idea is perhaps not very viable. But we will surely need to move in that direction if we are to solve our fiscal challenges.

Back in Business

Again, my apologies for the lack of posts recently. It certainly has not been due to the lack of newsworthy events. Indeed, here's some important stuff that I have missed:

1) Latvia had a failed debt auction. This is not the first failed auction in Europe - I already wrote about Germany and UK debt auctions here. But the size of this failure and it coming even as the economy improves suggests selling government debt is going to be somewhat difficult in coming months. Indeed, the Financial Times reports the calendar for selling debt is becoming so crowded, traders are going to have to cancel their summer vacations.

2) There has been a rowdy and fun debate between economists Paul Krugman and Niall Ferguson about the implications of the rising Federal bond yields and the growing spread between short term and long term yields. (See here and here for the original two articles that sparked the debate.) I highly recommend reading both articles and making your own conclusions. For me, Krugman's article reinforces what I have been writing for the past four months, namely Bernanke's quantitative easing is working but only at the cost of long-term inflation. The best recent analysis I have seen on this situation comes from Martin Wolf here.

3) There have been a number of very interesting elections lately. First, the European Parliament elections showed that Europeans are not simply a stereotypical bunch of socialists who are prone to communism at every economic downturn. Instead, they are regular citizens who vote based on the performance of their elected representatives. A hearty congratulations to the Green party who were most successful in increasing their clout in the Parliament. (Disclaimer: I interned with the Greens in the EP in 2007.) And we'll have to wait and see what the rise in extremist parties in the Parliament mean.

Second, the Lebanese elections are an early hopeful sign of a stronger American position in the Middle East. The American-backed coalition won strongly against Iranian-backed Hezbollah. A stable, western-looking Lebanon is a crucial precondition for peace in the Middle East. Combine that with a peaceful Syria willing to reconcile with the West, and one can feel downright positive about the Middle East.

Third, the Iranian election is coming up shortly and there are increasing signs that the reformers are making dramatic gains there. Ahmadinejad is increasingly desperate in his attacks and the youth appear dissatisfied with the lack of economic progress and the regression in women's rights. This is the one election that really, really matters this summer. If Ahmadinejad is out, we could see real progress on world peace.

4) Almost as if all this good news had created a dearth of really bad guys, North Korea has taken upon itself to be the world's big villain. Launching missiles, detonating a second nuclear bomb, condemning foreign journalists to decades of hard labor and threatening, well, everyone is North Korea's new national sport. Hopefully, the world will be able to work together to compel North Korea to accept reality, namely that it is a pathetically small country with a woefully underdeveloped population and a madman for a leader. China is the key on this issue.

Alas, there are more issues but I am out of time. I will just have to start from where we are now. My blogging will be somewhat different this summer though, as I am interning with the State Department. As a consequence, I cannot blog about the issues I am working with in State so I will be focusing more on economic news in the upcoming weeks. This summer will be an important phase of our economic recovery, and the next few months should be exciting!

Moving Hiatus

I apologize for the lack of posts lately. I have been in the midst of finishing up my year here in Bologna and preparing for our move to Brussels. After we get settled this week, I'll have more from the heart of Europe!

The Long-Term Picture

One of the great difficulties in public policy is balancing between immediate needs and democratic pressure and planning for the long run. People-both policymakers and citizens-want results when decisions have been taken. Everyone wants to see the causal connection between choice A and outcome B. On the other hand, both policymakers and citizens want permanent fixes to challenges. Returning to the same problematic issue only a few years down the roads leads people to decry decisions taken in the past for lacking vision. So if you are the president of the United States, do you go for the quick fix or the long term perspective?

It is perhaps no surprise that democracies all too frequently err on the side of the "quick fix." The bailout, the stimulus package, and central bank quantitative easing are all excellent policies that have helped stabilize the temporal world. I frankly support all three. But are they the best long-run policy? Bailouts create moral hazard that might encourage risky borrowing in the future, the stimulus package will inevitably require higher taxes in the future, and central banks will have to drastically restrict the money supply through very high interest rates once the economy starts back up. So it sounds like a catch-22: do nothing and everything collapses, do everything and you will have to come back to the issue in another crisis in the future.

I believe there is an alternative. It requires a consistent and engaged public debate. It requires a populace able to focus on difficult issues for longer than five minutes. It requires a voting citizenry willing to take action and then watch it through to its ultimate conclusion. In short, we need greater policy endurance.

This week, there were a number of stories and news items that have nothing to do with economics that reinforced this point to me:

(1) David Brooks wrote about the fascinating Grant Study. It is a longitudinal study of 268 Harvard sophomores that began in 1937. Researchers have been following the men for over eighty years, trying to understand what makes people happy. This is extremely impressive research because it captures the big picture while remaining statistically rigorous. (I am a big fan of longitudinal studies because it helps control for so much of the statistical error term that plagues "random samples.") The researcher's conclusions? "That the only thing that really matters in life are your relationships to other people." Oh, and exercise, no smoking, no alcohol abuse, and the ability to tackle challenges maturely. So much for those flashy ads or self-help books promising to turn your life around overnight. (I highly recommend reading the full Atlantic article here.) The study itself emphasizes the value of enduring, of seeing an idea through to its conclusion.

(2) Slate highlighted a new, longer-term study that suggests that Ritalin has no positive effect for children with Ritalin. The same researchers that published a study in 1999 suggested that Ritalin was effective in helping children with developmental challenges focus and perform better in social environments. At the time (1999), the children had undergone treatment for 14 months. Now, eight years later, there is little discernible benefit. Perhaps some of the decline in effectiveness could be due to patients not taking their medication. But more disturbing, perhaps the medication is not effective in the long run. The fact is, our medication testing system is based on short-term studies. We really do not know the true long-term effects of so many drugs. After all, pharmaceutical companies are largely concerned with getting the drug to market. Once it is there, public relations becomes the big spender, not researchers.

(3) A number of Republicans are completely going hyperbolic about a proposed tax on carbonated beverages to pay for rising health care costs. Sean Hannity describes it as a war on America's institutions. Stephen Colbert also seems to feel there are dangerous undertones in this sugar war.

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I do not mind a public debate about taxes, but what are the long term implications of creating such fear and hysteria about increased taxes? Thankfully, Colbert helps lighten the mood a bit. But make no mistake, taxes will rise in the future. And make no mistake, government expenditures will decline. Both will be required after the financial crisis to rebalance the books. These are difficult and painful policies and no politician likes to take them. So why raise the political stakes so high? Republicans (and libertarians) are setting themselves up for a fall if they insist on no new taxes (See Bush, George H.W.).

We need greater endurance in all facets of society. We need to be willing to implement policies and see them through. We need to be willing to take action, but then continue to observe the consequences. Just because we have made a choice does not mean the debate is over; rather, it means we move to a new phase of the debate. We have to say, "Look, we made the choice now let us see what happens." Policy endurance requires a citizenry willing to engage in long, complex dialogue rather than lurching from one crisis to the next.

I am hopeful. I believe that Americans today are more able to engage in political and policy debate than ever before. I believe technology is a key ingredient in this mix. And frankly, I think the financial crisis will persist for a while and its consequences even longer. That will perhaps force us to think more longer term.

I will certainly admit I need greater endurance in my own personal life. That is perhaps a good place to start. I am faltering right now in my resolve to train for my upcoming marathon, and other good habits have drifted somewhat too. So, I am renewing my drive to take the long-term perspective. Hopefully America can too.

Adjusting in the Post-Lehman Era

Bank libor rates are down to levels not seen since the collapse of Lehman Brothers in September. This is good news indeed. I particularly like how the article talks of "pre-Lehman levels." I wonder if we will start talking about financial variables as BL (before Lehman) and AL (after Lehman).

Or maybe that would just confuse baseball fans.

Lucrative Career: Mothers

In honor of Mother's Day, Salon.com does an economic estimate of the median salary of mothers, given their significant responsibilities in the home. This year's median salary? $122,732. Despite some estimation issues (Economix blog has a good review of them here), the salary figure is impressive.

Now if only there were someone in the world who would pay mothers this amount... At the very least, happy mother's day!

UK Malaise

If ever you start getting worried about the American economy, just say quietly to yourself: "At least I am not in the United Kingdom."

I know that is cruel, but look at some of the key facts:

(1) UK Government finances are in tatters. Not only are they spending more than ever before to bail out their bloated financial system, they are earning very little in tax revenue. The major reason is they depended disproportionately on the financial corporate sector for taxes, thereby preventing everyday Brits from bearing a larger tax burden. It was great political policy and led to a great run for the Labour party. But with the great implosion of the City, the UK has nowhere to turn for money. Its current solution is to raise the highest tax rates to a whopping 61%, but that will only make things worse. A good Economist article on this point can be found here.

(2) The UK manufacturing industry is in tatters. You would think the plunging sterling/dollar rate would be a good thing for domestic manufacturers since it makes their goods more competitive on world markets. Unfortunately, the vast majority of firms chose a one-way bet that deprives them of these gains. When the sterling was incredible strong against both the euro and the dollar, firms purchased inputs from the continent and then sold them to the US. Now, with the sterling low against both the euro and dollar (but particularly the euro), input prices are significantly higher and sale prices are necessarily lower. So manufacturing is a no-go, at least as currently constituted. So without manufacturing and without financial services, what does the UK have left as an industry? Fishing? Tourism? Windmills?

(3) Morale is in tatters. Most Brits I think recognize that they are in for some tough times in the future. They are wise enough to see the enormous budget deficits and start preparing for higher taxes in the future. But this only exacerbates the "paradox of thrift" that is current in the world. Citizens save to prepare for tough times ahead and pay down debt-government assumes more debt to make up the loss in consumption-citizens save more to prepare for higher taxes due to the government debt-government assumes more debt to make up the loss in consumption...you get the idea.

We are truly entering the next phase of the financial crisis: the government-finance phase. With the more-or-less successful conclusion of the bank stress tests, markets are now looking to democratic political systems to see if they are up to the next difficult challenge.

I have hope. More on that later...

Stress Tests

$50 billion needed for Citi and $34 billion for Bank of America. Ironically, stocks are up on the news because it is not as bad as they feared. Geithner's comments notwithstanding, I think the main reason is investors know that government will be there to recapitalize the banks that cannot raise money on their own.

How do you think the American public will react to news of more bailouts?

Green Shoots

Ben Bernanke is smiling, the stock market has been going up since March (I am taking credit for calling this early on), LIBOR rates have plummeted, and numerous analysts are speaking of green shoots of economic growth. All of this is incredibly promising on the "financial crisis" front. Hurray!

The only remaining bogey out there is also the biggest one: bank capitalization. The Fed's "stress tests" of major US banks are due tomorrow and the world is holding its breath. I am already pretty sure the major banks are severely undercapitalized though. Instead, I am saving my breath-holding for the moment when governments throughout the world (and especially in Europe) acknowledge the need to pump more money into the banking sector by assuming even more public debt.

First, no country will let their major banks fail; the lesson of the Lehman Brothers debacle destroyed all conviction of the importance of fighting moral hazard. Under current rules of global finance, every bank is simply too connected to every other bank. The political consensus seems pretty strong on this point, regardless of the public costs of further bailouts.

Second, few countries are in a position to pay for these bailouts. Most vulnerable on this count is the United Kingdom and Spain. All countries will have to take out additional debt. And I hate to keep beating the same drum, but such a universal increase in public debt will flood the market even as demand declines.

Besides the issues I have mentioned previously, there is another consequence of this debt glut. Because goverment bonds often act as a floor of national interest rates, any failed bond auctions or declining investor demand will drive up interest rates across the economy. Thus, at a time of emerging economic growth, interest rates could climb very quickly, snubbing out the growth before it has a chance to really flourish. Inflation pressure will only drive this yield curve even higher.

The future is a very difficult tightrope walk for governments. They must continue to bail out the banking system and keep up their countercyclical Keynesian spending. But at the very moment when growth starts to emerge, they must quickly and credibly reduce budget deficits and debt. For the US, this includes the additional challenge of reducing the current acount deficit, a difficult task at the current strong exchange rate for the dollar. Fiscal policy reform is never easy, but the emergence of green shoots makes it imperative.

Wish our elected leaders good luck.