My preceding blogpost identified three mistakes made by leaders of the European Economic and Monetary Union in dealing with Greece.   But what is done is done.  The mistakes now lie in the past.  How can Europe’s fiscal regime be reformed to avoid future repeats of this crisis?  

The reforms that are now underway are not credible.  (”We are going to make the fiscal rules more explicit and make sure to monitor them more tightly next time.”)    Similarly, most proposals for how to put teeth into the rules are not credible — penalties such as monetary fines or loss of voting privileges. 

It is too late for Greece. But it is not too late for a euroland reform that would help avoid the re-emergence of unsustainable sovereign debt levels next time around by applying the lesson of mistake number two: to adjust the ECB policy of accepting the debt of all member states as collateral.  This is the policy that short-circuited warning signals that the private markets would otherwise have sent via interest rates during 2002-2007.  

My proposal:   The eurozone should in the future adopt a rule that whenever a country violates the fiscal criterion of the Stability and Growth Pact (say, a budget deficit in excess of 3% of GDP, structurally adjusted), the ECB must stop accepting that government’s debt as collateral.  This system would achieve the elusive objective of true automaticity.   If a country exceeded the threshold for justifiable reasons, such as natural disaster, the private markets could perceive that and impose little or no default risk premium.   No judgment of the merits by bureaucrats or politicians would be required.   More likely, for periphery countries, the result of such a re-classification would be the re-emergence of sovereign spreads of moderate magnitudes, in between the extremes of the 2002-07 lows and the 2009-11 highs (see chart).  The interest rate premium would send a message far more credibly, forcefully, and promptly than any warning that any Brussels bureaucracy will ever turn out.  

This is how it works among the U.S. states and municipalities.  Despite the absence of their own currencies, the recurrence of dysfunctional local politics and excessive deficits, and even a history of state defaults in the 19^th century, federal bailouts are not delivered and are not expected.   Without some such device, the new European Stability Mechanism is in danger of becoming a mechanism for instability.

[Niels Thygesen made the case in favor of the current reform track in "Governance in the Euro Area" at the Challenge of Europe session of INET's Annual Conference, Bretton Woods, NH, April 10, 2011. I gave my comment there as well. (Video)]

[Comments can be posted on the Vox.eu site (which has the copyright.)]

Politicians are often tempted to think that a policy to help one goal, say air quality, must also help lots of other goals, say economic growth.  Economists are more likely to presume tradeoffs, and to use the principle of targets and instruments.  That principle says that you cannot expect to hit more than one bird with one stone, except by coincidence.

At the American Economic Association meetings in San Francisco, January 3, I was on a panel titled “Energy and the Environment: Policy Advice for the New Administration” (along with some real energy experts; I am a relative latecomer to the area).  Within the framework of targets and instruments, I proposed a matrix such as the one that appears below. (more…)

I am sometimes asked, “Okay, we know that most of the economy is in the tank.   But what are one or two sectors where you see potential for growth in 2009?”   The conventional response would be “green technologies.”   But another sector occurs to me:   Intensive Care Units. (more…)

 These matters are not solely of interest to historians or economists.   The presidential campaign of Senator John McCain appears set to drive its wagon down the same road in which Reagan and Bush have already worn deep ruts.   The candidate is apparently selling the same snake oil:  he says he believes that tax cuts increase revenues.   His principle policy director disavows the Laffer Principle, just as the economists who advised Presidents Reagan and Bush did.   But the views of the economic advisers are not what determines what these presidents do. 

“The Queen in Alice in Wonderland  said that, with practice, she was able to believe as many as six impossible things before breakfast.   Most of us are more limited in our capacity for credulity.  If John McCain believes both the Laffer Proposition (tax cuts raise revenues) and Starve the Beast (higher revenues lead to higher spending, anathema to conservatives), then as a good conservative, his duty is clear.  He ought to run on a truly novel platform of higher tax rates!   Why?   Higher tax rates would reduce revenues (this is what Laffer says would happen) and thereby reduce spending (this is what Starve the Beast says would happen).   
    

Seriously folks.   If McCain continues to propose extending the Bush tax cuts, he should at least be forced to choose between the Lafferite defense and the “Starve the Beast” defense. Only then can the rest of us know which of the two mutually inconsistent propositions to refute. 

I discussed my paper September 12, in a panel where Larry Summers and Gene Sperling also gave their thoughts on Supply Side Economics, at a joint meeting of the Center for American Progress  and the Economic Policy Institute.     

[Any readers wishing to comment on this blog post: I suggest you go to the RGE version.] 

(Incidentally, the July Snowmass presentations regarding Integrated Assessment models of the effects of such emission-reduction policy plans, which I plugged in my preceding blog post, are now accessible to the public.)

But issues of competitiveness and how to address it have risen to the top in the climate change policy debate among politicians.      The Lieberman-Warner bill - would have required the president to determine what countries have taken comparable action to limit GHG emissions;  for imports of covered goods from covered countries, the importer would then have had to buy international reserve allowances – equivalent to a tariff.  (The same with some of the bill’s competitors such as the Bingaman-Specter “Low Carbon Economy Act” of 2007.) 

In theory, there is a possible legitimate role for border adjustments in facilitating a multilateral regime such as the Kyoto Protocol.  One might think of penalties on carbon-intensive imports:

1.      as sanctions to apply pressure on non-participants,

2.      as a calibrated “countervailing duty” to equalize a distortion that will otherwise see carbon-intensive activities migrate to less-regulated countries (a phenomenon known as leakage)   or

3.      as political reassurance to domestic firms worried about their international competitiveness.

If designed properly, they need not necessarily be inconsistent with the WTO (World Trade Organization).    There are precedents, most importantly (and most ironically) the famous/infamous shrimp/turtle case.

But U.S. politicians are unlikely to do it properly.   They may be unaware that the US is more likely to end up as the target of such tariffs than as the enactor – to end up as the defendant, rather than as the prosecutor.   The European Union is way ahead of us in cutting back GHG emissions under the Kyoto protocol, and its EC Directive earlier this year had similar language calling for penalties aimed at shirking competitors.   That’s us.  The difference between their provisions for dealing with shirkers and ours is that their system is already in operation, while for the time being, we are the shirkers.  So US politicians had better look before they leap on this one.

The Brookings Institution had a conference in June that was well-focused on this set of policy issues, organized by Lael Brainard.  Interested readers can link to the papers at Climate Change, Trade and Competitiveness: Is a Collision Inevitable ?    Mine was titled  “Addressing the Leakage/Competitiveness Issue In Climate Change Policy Proposals,” in the panel on Proposals to Deal with Leakages.   

 The issues are reminiscent of larger fears on the part of anti-globalizers — that the WTO and free trade are obstacles to environmental regulation more generally — fears that I think are largely misplaced.   With well-designed multilateral policies, we can work to protect the global environment while simultaneously preserving the economic advantages of free trade.

I am also working on a broader project to address the design of climate change policy architecture as part of the HPICA initiative at Harvard directed by Joe Aldy and Rob Stavins.

[Any readers wishing to comment on this blog post: I suggest you go to the RGE version.] 

Menzie Chinn, Prof. of Economics at University of Wisconsin, is guest posting this week:

I want to thank Jeff Frankel for the opportunity to be a guest writer on his blog.

A lot of attention has been devoted to how oil price and food price shocks have affected the US economy, both along the output and price dimensions. A general presumption has been that as long as inflation expectations remain well anchored, then one need not worry about 1970’s style stagflation (recession is another matter).

However, there are many places in the world where inflation expectations are not well anchored. Or at least we can’t tell if they’re well anchored or not. Figure 1 presents data for several key groups (using the IMF classifications): Industrial countries, LDCs excluding oil exporters, oil exporters and developing Asia.

Figure 1: Inflation rates defined as 12 month changes in CPIs, in selected groupings: Industrial countries (blue), oil exporters (black), developing countries excluding oil exporters (red) and developing Asia (green). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

It’s clear that inflation is surging in the oil exporting countries. This is occurring as reserves balloon (see Brad Setser has diligently tabulated on a number of occasions; e.g., [1]), often under pegged-to-the-dollar exchange rate regimes, and the monetary authorities are unable to sterilize money base expansion. Here, I can’t resist writing the identity:

Money Base = Foreign Exchange Reserves + Net Domestic Assets

As foreign exchange reserves increase, money base must increase, unless the central bank can (and will) sterilize by making offsetting reductions in net domestic assets.

This is why Feldstein has called for de-pegging from the dollar for oil exporter currencies [2] (for contrasting recommendations, see Paulson’s comments [3]).

Of course, this mechanism does not apply in all instances, there are oil exporting countries not under fixed exchange rates, but reserve accumulation nonetheless is making its way into money base creation. As government revenues increase, spending is also pushing up prices.

So, no surprise that inflation is rising in this group. But what is surprising is how much inflation has risen in the non-oil-exporting LDCs, and in Developing Asia (this group excludes NICs like Korea).

Figure 2: Inflation rates defined as 12 month changes in CPIs, in selected East Asian countries: China (red), Malaysia (blue), Philippines (green), Thailand (black), Vietnam (teal). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

Inflation has risen as food and energy prices have risen. Vietnam is the most striking example. And China, of course, has been in the spotlight, largely because of its economic mass. But note how Thailand and the Phillipines inflation rates have accelerated.

Now one might say this is all obvious - - but in several of these countries (e.g., China), energy prices were heavily subsidized. Raising these subsidized prices will - - in a mechanical fashion - - raise the recorded CPI. If prices were perfectly flexible, higher energy and food prices only represent a higher relative price for these goods. I’ll let the reader determine for him or herself whether that’s a plausible assumption. In any case, the net effect over the longer term is uncertain. Raising the subsidized prices means higher prices on those specific goods (possibly feeding into wages). But the lower government outlays for subsidies means smaller deficits (holding all else constant) and hence lower money base creation.

Is there hope to be derived from the fact that there are more inflation targeters now than there were during the previous episode of inflationary pressures, three decades ago? In a paper written two and a half years ago, Andy Rose documented the fact that inflation targeting has proven to be a relatively durable form of monetary regime. That is, compared to the “fixed” exchange rates, an average duration of an inflation targeting regime is longer. One observation I would make is that most of those inflation targeting regimes were implemented in a relatively benign global economic environment - - at least benign from the inflationary standpoint. While oil prices have been rising since 2002, it appears that the surge in food prices, on top of oil and non-food commodity prices - - is what has changed matters (Figure 3 recaps a graph from this post).

Figure 3: Log indices. NBER defined recession shaded gray. Source:.
(Of course, these oil and food price shocks may end a lot of exchange rate reimges as well).

By the way, Thailand and Philippines are classified as inflation targeters by Rose. Korea, also classified as an inflation targeter, has also experienced accelerating, but nonetheless lower, inflation (at about 4 percent). So, the jury is still out on the question whether the commitment to inflation targeting during this episode will result in a substantive difference in how matters play out.

On a more speculative note, one idea that has struck me is that, as inflation rates rise, it may become more difficult for the East Asian countries to maintain their exchange rates against the dollar at their current levels. Recalling (in logs):

q^j = s – p^j + p ^US

In words, the real exchange rate for country j against the USD (defined as up is weaker) will strengthen as the domestic price level rises, holding all else constant. That may in turn a be a harbinger of the end of the tendency for the East Asian countries to export capital to the US (although the overall US current account balance will tend to remain driven largely by domestically driven by the saving/investment balance in the US, and we know where the current trajectory of the US budget deficit is going…[4]).

Figure 4: Trade weighted broad real currency values, in logs. NBER defined recession shaded gray. Dashed line is at June 2005, the month before the CNY revaluation. Source: BIS accessed June 23, 2008.

So far, this remains speculation. However, over the past couple months, China’s real currency value has appreciated in trade weighted terms, which is remarkable when one keeps in mind the dollar’s depreciation over this same period. It remains to be seen whether the other currencies follow suit. That may hinge upon how these countries respond to inflationary pressures.

Since I started this blog, my comment section has been inundated with spam. (I am not talking about bona fide comments, most of which have been intelligent and useful.) The spam has reached 35 per night, and it is time-consuming to go through and delete it all. For some reason, my software can’t filter it out, even though other bloggers don’t seem to have this problem.

Hence, reluctantly, I am turning off the comment function on my blog site. I am sorry about this. Most of my posts will be carried by RGE Monitor, SeekingAlpha or the BCSIA site (though with a delay). Readers may post comments there.