US tax reform is vital but Trump’s plan is flawed

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Corporate tax reform has rightly been identified by both the President-elect and Congress as an immediate priority. There is no doubt that the status quo — where America has the highest statutory rate among major countries and companies hoard cash overseas — can be improved on. Unfortunately, the reforms identified by Paul Ryan, speaker of the House of Representatives, and Donald Trump appear set to damage the tax base and the US and global economies.

The central concept put forward by Mr Ryan, which appears to have the support of Mr Trump, is to turn corporate income tax from a tax on the return to capital into a tax only on extraordinary profits. This would be done by taxing corporate cash flows. In addition to the major reduction of the overall rate, the system would change in three fundamental ways. First, all investment outlays can be written off in the year they occur rather than over time. Second, interest payments to bondholders, banks and other creditors will no longer be deductible. Third, companies will be able to exclude receipts from exports in calculating their taxable income and will not be permitted to deduct payments to foreign suppliers or affiliates from income.

Unlike some of Mr Trump’s other economic ideas, the corporate cash flow tax is supported by some experts in both political parties. However, it has four major — probably fatal — flaws.

First, the tax change will exacerbate inequality, with more than half the benefits going to the top 1 per cent of Americans. Eliminating the corporate tax on the returns to capital and substantially scaling back the rate on extraordinary profits is a radical step that might be defensible on grounds of eliminating double taxation in a world where capital returns are effectively taxed at the individual level. But it is very hard to justify in the current world, where exclusions and preferences mean that most corporate income is not taxed at the individual level and where the estate tax, which could be a backstop, is easily avoided and may well be eliminated.

Second, the tax change will capriciously redistribute income, increase uncertainty and place punitive burdens on some sectors. Think of a retailer who imports goods from abroad for 60 cents, incurs 30 cents in labour and interest costs, and then earns a 5 cent margin. With a 20 per cent tax, and no ability to deduct import or interest costs, the taxes will substantially exceed 100 per cent of profits even if there is some offset from a stronger dollar. Businesses that invest heavily, hire extensively and export a large part of their product will have negative taxable income on a chronic basis. It is hard to imagine that the political process will allow annual multibillion-dollar refunds, so they too may be victimised. Then there are the still unresolved questions of what the rules will be on interest deductibility for banks and of the treatment of businesses organised as partnerships that do not pay corporate taxes.

Third, the tax change will harm the global economy in ways that reverberate back to America. It will be seen by other countries and the World Trade Organisation as a protectionist act that violates US treaty obligations. Proponents may argue that it should be legal because it is like a value added tax, but the WTO is very clear that income taxes cannot discriminate to favour exports. While the WTO process would grind on, protectionist acts by other nations would be licensed immediately.

Proponents of the plan anticipate a rise in the dollar by an amount equal to the 15 to 20 per cent tax rate. This would do huge damage to dollar debtors all over the world and provoke financial crises in some emerging markets. Since US foreign assets are mostly held in foreign currencies, whereas debts are largely in dollars, American losses with even a partial appreciation would be in the trillions. Ironically, China, with its huge reserve hoard, would be a winner.

Fourth, the combination of a sharply lower rate, new opportunities for tax arbitrage and the fact that any revenue gains from bringing overseas cash home are one-shot means the Federal revenue base would erode. The result would be cuts in entitlement payments to consumers who spend heavily, tax hikes on individuals and reductions in government spending. Over time, this will slow growth and burden the middle class.

There is no need to reinvent the corporate tax wheel. Let’s fix the tax we have by cutting rates, closing shelters, broadening the base and cracking down on tax havens. That would be an important step to making our economy grow faster. It would also be fairer.

Trump’s tax plans favour the rich and will hamper economic growth

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Just as Ronald Reagan’s landmark 1986 bipartisan tax reform increased simplicity, fairness and economic efficiency by broadening the tax base and reducing rates, today reform of the system has the potential to help American families and the economy.
Properly designed, revenue-neutral reforms could help to offset the dramatic increases in inequality that have taken place over a generation, repair a business tax system that globalisation has rendered dysfunctional, reduce uncertainty and promote growth.
Unfortunately, what we know of the intentions of the president-elect and congressional leadership suggest that they risk pushing through the most misguided set of tax changes in US history.
The proposals from the presidential campaign, reiterated last week by President-elect Donald Trump’s choice for Treasury secretary, will massively favour the top 1 per cent of income earners, threaten an explosive rise in federal debt, complicate the tax code and do little if anything to spur growth.
A core principle agreed to by all in 1986 was that reform would not reduce the tax burden on high-income taxpayers. Reagan achieved this objective while reducing top marginal rates because he raised capital gains rates, scaled back investment incentives, increased corporate tax collection, curtailed shelters and left estate and gift taxes alone. Unfortunately, neither the Trump plan, nor the one put forward by Paul Ryan, speaker of the House of Representatives, provides for nearly enough base-broadening to finance all the high-end tax cutting they include.
Steven Mnuchin, Treasury secretary-designate, asserts there will be no absolute tax cut for the upper class because deductions would be scaled back. The rub is that totally eliminating all deductions for those with incomes over $1m would not even raise enough revenue to cover reducing their marginal tax rates from 39 to 33 per cent, let alone offset their benefit from huge rate reductions on business and corporate income, and the elimination of estate and gift taxes.
Estimates of the Trump plan suggest that it will raise the average after-tax income of the 0.9 per cent of the population with incomes over $1m by 14 per cent, or more than $215,000. This contrasts with proposed tax cuts for those in the middle of the income distribution of $1,000, or about 2 per cent.
The repeal of estate and gift taxes is especially problematic because it would provide a window for the very rich to use gift and trust structures to ensure that their wealth passes without tax not just to their children but to their grandchildren and great grandchildren, regardless of subsequent legislation.
The Reagan tax reform simplified the code by eliminating the need for rules distinguishing ordinary and capital gains income, because these were taxed at the same rate, and by doing away with industry-specific shelter provisions. In contrast, the Trump proposal creates sheltering opportunities by reducing to 15 per cent the tax rate on any income that can be characterised as coming from an incorporated entity. Rather than reducing targeted subsidies, it would establish a highly dubious 82 per cent credit – the highest in the world – for financial equity investments in infrastructure.
This would mean not only disproportionate tax reductions for the upper-income group that has seen its incomes rise most rapidly over the past generation. It would also mean grave damage to federal budget projections. The envisioned Trump tax cut is about the same size relative to the economy as the 1981 Reagan tax cut. It is worth remembering that Reagan, hardly a fan of reversing course or raising taxes, found it necessary to propose significant tax increases in 1982 and 1984 (the equivalent in today’s economy of $3.5tn over a decade) due to concerns about federal debt.
Today’s budget situation is much more worrisome. The baseline involves much higher levels of debt and deficits. Then the economy was suffering from a deep recession; now it approaches full employment. If extreme tax cuts are legislated in the next months, uncertainty about the federal budget and about further tax adjustments is likely to rise. Finally, I can find no basis in either economic history or logic for Mr Mnuchin’s claim that the proposed reforms would increase the economy’s growth rate from its current 2 per cent rate to the historical 3 to 4 per cent norm. Adult population growth has slowed by nearly a percentage point, the gains generated by more women entering the workforce have been exhausted, and it is far from clear why tax reform will hugely spur productivity growth.
Indeed, because the Trump proposal would redistribute after-tax income towards those most likely to save it, push up long-term interest rates because of debt pressures, increase uncertainty and the advantages of overseas production, it is as likely to retard growth as to accelerate it.
In the 1980s, treasury secretary Don Regan said the first Reagan reform proposal was written on a word processor to signal the administration’s openness to negotiation and radical alteration. We should all hope the Trump administration follows Reagan’s approach on both tax policy principles and a commitment to bipartisan negotiation.

A badly designed US stimulus will only hurt the working class

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Not even US presidents with political mandates can repeal the laws of economics

November 13, 2016

Following a brief market plunge, the President-elect’s speech on Tuesday night was more conciliatory than many expected and emphasised his commitment to infrastructure investment. Investors have, on balance, concluded that the combination of a shift to very expansionary fiscal policy and major reductions in regulation in sectors ranging from energy to finance to drug pricing will raise demand and reflate the American economy.

The result has been a rise in real interest rates and inflation expectations, along with a strong stock market and a strong dollar. Experience suggests, however, that initial market responses to major political events are poor predictors of their ultimate impact.

The late MIT economist Rudiger Dornbusch made an extensive study of the results of populist economic programmes around the world, finding that while they sometimes had immediate positive results, over the medium- and long-term they were catastrophic for the working class in whose name they were launched. This could be the fate of the Trump programme given its design errors, implausible assumptions and reckless disregard for global economics.

I have long been a strong advocate of debt-financed public investment in the context of low interest rates and a decaying US infrastructure, so I was glad to see Mr Trump emphasise it. Unfortunately, the plan presented by his advisers, Peter Navarro and Wilbur Ross, suggests an approach based on tax credits for equity investment and total private sector participation that will not cover the most important projects, not reach many of the most important investors, and involve substantial mis-targeting of public resources.

Many of the highest return infrastructure investments — such as improving roads, repairing 60,000 structurally deficient bridges, upgrading schools or modernising the air traffic control system — do not generate a commercial return and so are excluded from his plan. Nor can the non-taxable pension funds, endowments and sovereign wealth funds that are the most promising sources of capital for infrastructure take advantage of the program.

I am optimistic regarding the efficacy of fiscal expansion. But any responsible economist has to recognise that, past a point, it can lead to some combination of excessive foreign borrowing, inflation and even financial crisis. As Dornbusch showed, in emerging markets this can happen quite quickly. In the US the process would take longer.

Even without taking account of the likely costs of the infrastructure plan (which the Trump team badly underestimates) or the proposed defense build-up, the Trump tax reform proposals are too expensive. Many, like the proposed abolition of the estate tax, will only benefit the high-saving wealthy.

While drastic changes in the proposed domestic programme are necessary for it to work, the general direction of increasing public investment, reforming taxes and adjusting regulation is appropriate. The same cannot be said of Mr Trump’s global plan, which rests on a misunderstanding of how the world economy operates.

Consider the immediate effects of Mr Trump’s victory. The Mexican peso has depreciated about 10 per cent relative to the dollar over fears of new protectionist policies, and many other emerging market currencies have also fallen sharply. The impact of this change is to raise the cost of anything the US exports to Mexico and to lower the cost of anything Mexico exports to the US.

It will also make Mexico and other emerging markets much cheaper relative to the US for global companies. So US workers, particularly in manufacturing, will see increased pressure.

The plan seems to assume that we can pressure countries not to let their currencies depreciate, as suggested by the intention to have the new treasury secretary name China as an exchange rate manipulator. This is ludicrous. While there are reasonable arguments that China manipulated its exchange rate for commercial advantage in the past, the reality is that for the past year the country has intervened to prop up its exchange rate. The same is true of most emerging markets. Not even US presidents with political mandates can repeal the laws of economics.

Populist economics will play out differently in the US than in emerging markets. But the results will be no better. All with a stake in the global economy must hope that now, as has happened often in the past, a US president faced with the responsibility of governing preserves the valid core of campaign economic plans while making major adjustments.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary

 

Voters sour on traditional economic policy

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It is hard to escape the conclusion that the world is seeing a renaissance of populist authoritarianism

October 9, 2016

As the world’s finance ministers and central bank governors came together in Washington last week for their annual global financial convocation, the mood was sombre. The spectre of secular stagnation and inadequate economic growth on the one hand and ascendant populism and global disintegration on the other led to widespread apprehension. Unlike in 2008 when the post-Lehman crisis was a preoccupation or 2011 and 2012 when the possibility of the collapse of the euro system concentrated minds, there was no imminent crisis.

Instead, the pervasive concern was that traditional ideas and leaders were losing their grip and the global economy was entering into unexplored and dangerous territory.

International Monetary Fund growth forecasts released before the meeting were again revised downwards. While recession does not impend in any large region, growth is expected at rates dangerously close to stall speed. Worse is the realisation that the central banks have little fuel left in their tanks.

Recessions come intermittently and unpredictably. Containing them generally requires 5 percentage points of rate cutting. Nowhere in the industrial world do central banks have anything like this kind of room even making allowance for the effects of unconventional policies like quantitative easing. Market expectations suggest that it is unlikely they will gain room for years to come.

After seven years of economic over-optimism there is a growing awareness that challenges are not so much a legacy of the financial crisis as of deep structural changes in the global economy. There is increasing reason to doubt that the industrial world is capable of simultaneously enjoying reasonable interest rates that support savers, financial stability and the current financial system and adequate economic growth at the same time. Saving has become overabundant, new investment insufficient and stagnation secular rather than transient.

It can hardly come as a great surprise that when economic growth falls short year after year and when its beneficiaries are a small subset of the population, electorates turn surly. They lose confidence in traditional policy approaches and their advocates.

Looking back at the political traumas of 1968 when there were people in the streets in many countries, it is clear that there was something going on beyond specific issues like Vietnam in the US.

In the same way as with Brexit, the rise of Donald Trump and Bernie Sanders, the strength of rightwing nationalists in many European countries, Vladimir Putin’s strength in Russia and the return of Mao worship in China, it is hard to escape the conclusion that the world is seeing a renaissance of populist authoritarianism.

These developments are mutually reinforcing. Weak economics promotes angry politics which raises uncertainty leading to even weaker economics. And so the cycle starts again. People have lost confidence both in the competence of economic leaders and in their commitment to serving the wider public rather than the global elite.

A number of traditional economic leaders in the public and private sector seemed to be making their way through the traditional grief cycle — starting with denial, moving to rage, then to bargaining and ultimately to acceptance of new realities.

It is untenable to ignore public sentiment. Nor, as 60 years of experience with populist policy cycles in Latin America demonstrates, is economic nationalism a viable strategy. Rather the challenge is to find a path forward in which international co-operation is supported and enhanced. This should focus on the concerns of a broad middle class rather than of global elites.

Concretely, this means rejecting austerity economics in favour of investment economics. At a time when markets are pointing to the problem over the next generation as being inadequate rather than excessive inflation, central bankers need to spur demand and co-operate with governments.

Enhancing infrastructure investment in the public and private sector should be a fiscal policy priority.

And the focus of international economic co-operation more generally needs to shift from opportunities for capital to better outcomes for labour. The achievement of this objective will require substantially enhanced co-
operation with respect to what might be thought of the as the dark side of capital mobility — money laundering, regulatory arbitrage, and tax avoidance and evasion.

These are a few ideas. The general point should be clear. Few things will be as important for the success of the next president as the restoration of confidence in the global economy.

 

Building the case for greater infrastructure investment

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September 12, 2016

The issue now is not whether the US should invest more but what the policy framework should be

There is a consensus that the US should substantially raise its level of infrastructure investment. Economists and politicians of all persuasions recognise that this can create quality jobs and provide economic stimulus without posing the risks of easy-money policies in the short run. They also see that such investment can expand the economy’s capacity in the medium term and mitigate the huge maintenance burden we would otherwise pass on to the next generation.

The case for infrastructure investment has been strong for a long time, but it gets stronger with each passing year, as government borrowing costs decline and ongoing neglect raises the return on incremental spending increases. As it becomes clearer that growth will not return to pre-financial-crisis levels on its own, the urgency of policy action rises. Just as the infrastructure failure at Chernobyl was a sign of malaise in the Soviet Union’s last years, profound questions about America’s future are raised by collapsing bridges, children losing IQ points because of lead in water and an air traffic control system that does not use GPS technology.

The issue now is not whether the US should invest more in infrastructure but what the policy framework should be. There are five key questions.

How much more do we need to invest? For the foreseeable future, there is no danger that the US will overinvest in infrastructure. An increase in investment of 1 per cent of gross domestic product over a decade would total $2.2tn and permit substantial steps both to catch up on deferred maintenance and embark on new projects.

What is the highest priority? The fastest, highest and safest returns are likely to be found where maintenance has been deferred. Maintenance outlays do not require extensive planning or regulatory approvals, so they can take place quickly. And they tend naturally to take place in areas where infrastructure is most heavily used.

How should investment be financed? There is a compelling case that infrastructure investments pay for themselves by expanding the economy and increasing the tax base. The McKinsey Global Institute has estimated a 20 per cent rate of return on such investments. If the return is only 6 per cent and the government collects about 25 cents on every dollar of GDP, it will earn 1.5 per cent on investments. This far exceeds the real cost of borrowing even over a horizon of 30 years. Debt financing of new infrastructure investment would be entirely reasonable. And if there is a desire to generate revenue to finance infrastructure investments, the best approaches would involve user fees. Thus, increased landing fees could help finance airports; tolls or taxes on miles driven could fund road improvements.

What about the private sector? Some infrastructure priorities, such as replacing coal-fired power plants with renewables, expanding broadband networks or building pipelines, are clearly the responsibility of the private sector. Policy frameworks that streamline regulatory decision-making and reduce uncertainty could spur investment in these sectors. There is a case for experimenting with mobilising private capital for use on infrastructure that has been a public-sector preserve, such as airports and roads. But, the reality that government borrowing costs are much lower than the returns demanded by private-sector infrastructure investors should lead to caution. It would be unfortunate if, in an effort to avoid deficits, large subsidies were given to private financial operators. Only when private-sector performance in building and operating infrastructure is likely to be better than what the public sector can do is there a compelling argument for privatisation.

How can we be sure investment is carried out efficiently? There is legitimate scepticism about this, and there is no silver bullet for this problem. Transparency of the type adopted for the Obama administration’s fiscal stimulus should become the norm. Additionally, progressive advocates of more investment should compromise with conservative sceptics and, in the context of increased spending, accept regulatory streamlining, as well as requirements that projects undergo cost-benefit analysis. Minimising cost should be the objective of infrastructure procurement.

Every year that we allow our infrastructure to decay raises the burden that our generation places on the next. We will not always be able to borrow for the long term at a near zero interest rate. However the election turns out, a major infrastructure investment programme should be adopted by the president and Congress in the spring of 2017.

 

The progressive case for championing pro-growth policies

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August 8, 2016

Issues of inequality, fairness, middle-class living standards and job creation have been central to the US presidential campaign.

Rightly so. For many years, the incomes of all groups tended to move together. Indeed, as a graduate student in the late 1970s, I was taught that it was a “stylised fact” that the shares of US total income going to profits and to wages, and to the rich and to the poor, was constant.
 
All of this has changed. It is totally appropriate that widening inequality and the associated stalling of middle-class living standards should become an urgent political issue.
 
What is unfortunate is that many people, in their eagerness to focus on fairness, neglect the single most important determinant of almost every aspect of economic performance: the rate of growth of total income, as reflected in the gross domestic product.
 
Because those who champion strategies that centre on business tax-cutting and deregulation and favour the wealthy have placed the most emphasis on growth over the past 35 years, the objective of increasing growth has been discredited in the minds of too many progressives.
 
The reality is that more growth means more employment. And with the college-graduate unemployment rate only 2.5 per cent, the newly employed are disproportionately less educated and more disadvantaged.
 
It can hardly be an accident that the decades of maximum growth, the 1960s and 1990s, also saw the most rapid job growth and most rapid increase in middle-class living standards.
 
Growth provides the wherewithal for increased federal revenue and so encourages the protection of vital social insurance programmes such as Social Security and Medicare. It creates headroom for new initiatives such as expansions of the Earned Income Tax Credit.
 
Tight labour markets are the best social programme, as they force employers to hire and mentor inexperienced people in order to be adequately staffed. Some years ago, I estimated that for each 1 per cent point increase in adult male employment, the employment of young black men rose 7 per cent. More recent research confirms economic growth has an outsized benefit for younger people and minorities.
 
Rising growth has other benefits, as well. It strengthens the power of the American example in the world. It obviates the need for desperation monetary policies that risk future financial stability. Greater growth also has historically operated to reduce crime, encourage environmental protection and contributes to public optimism about the country that our children will inherit.
 
The reality is that if American growth continues to have a 2 per cent ceiling, it is doubtful that we will achieve any of our major national objectives.
 
If, on the other hand, we can boost growth to 3 per cent, interest rates will normalise, middle-class wages will rise faster than inflation, debt burdens will tend to melt away and the power of the American example will be greatly enhanced.
 
How, then, can growth be accelerated? In an economy like that of the US, the vast majority of job creation and income growth comes from the private sector. If the next president is lucky enough to oversee the creation of 10m jobs from 2017-20, more than 8m of them will surely come from businesses hiring in response to profit opportunities.
 
The question is not whether business success is desirable. The question is how it can best be achieved. At a moment when capital costs are close to zero, the stock market is at a record high and businesses are earning record profit margins, we do not need to bribe businesses to make investments that now do not seem worthwhile to them.
 
There is no case for reducing already low corporate taxes or removing regulations unless it can be shown that these have costs in excess of benefits.
 
What is needed is more demand for the product of business. This is the core of the case for policy approaches to raising public investment, increasing workers’ purchasing power and promoting competitiveness.
 
That such policies also contribute to fairness is not a reason to lose sight of the central objective of promoting growth.
 
Often in economics there are trade-offs. But not always. We can and must promote both fairness and growth.
 

Voters deserve responsible nationalism not reflex globalism

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July 10, 2016

It is clear after the Brexit vote and Donald Trump’s victory in the Republican presidential primaries that voters are revolting against the relatively open economic policies that have been the norm in the US and Britain since the second world war.

Populist opposition to international integration is on the rise in much of continental Europe and has always been the norm in Latin America. The question now is what should be the guiding principles of international economic policy? How should those of us — who believe that the vastly better performance of the global system after the second world war than after the first world war is largely due to more enlightened economic policies — make our case?

The mainstream approach starts with a combination of rational argument and inflated rhetoric about the economic consequences of international integration. Studies are produced about the jobs created by trade agreements, the benefits of immigration and the costs of restrictions. In most cases the overall economic merits are clear. But there is a kind of Gresham’s Law of advocacy whereby bolder claims drive out more prudent ones. Over time this has caught up with the advocates of integration.

While there is a strong case that the US is better off than it would have been if the North American Free Trade Agreement had been rejected, the most extravagant predicted benefits have not materialised. And it is fair to say that claims that China’s accession to the World Trade Organisation would propel political liberalisation have not been borne out. The willingness of people to be intimidated by experts into supporting cosmopolitan outcomes appears for the moment to have been exhausted.

The second plank of the mainstream approach is to push for stronger policies to resist inequality, cushion disruptions and support the poor and middle class, and then argue that if domestic policies are right, the pressure to resist globalisation will reduce. The logic is right and certainly measures like government assurance of mortgages and the interstate highway system were part of the political package that permitted the US to underwrite an open global system.

But the last eight years have seen America at last adopt universal health insurance, expand a variety of support programmes for the poor and bring unemployment below 5 per cent with trade becoming ever less popular. It is not that strong domestic policies are unnecessary to undergird global integration. It is that they are insufficient.

A new approach has to start from the idea that the basic responsibility of government is to maximise the welfare of citizens, not to pursue some abstract concept of the global good. People also want to feel that they are shaping the societies in which they live. It may be inevitable that impersonal forces of technology and changing global economic circumstances have profound effects, but it adds insult to injury when governments reach agreements that further cede control to international tribunals. This is especially the case when, for reasons of law or practicality, corporations have disproportionate influence in shaping global agreements.

If Italy’s banking system is badly undercapitalised and the country’s democratically elected government wants to use taxpayer money to recapitalise it, why should some international agreement prevent it from doing so? Why should not countries that think that genetically modified crops are dangerous get to shield people from them? Why should the international community seek to prevent countries that wish to limit capital inflows from doing so? The issue in all these cases is not the merits. It is the principle that intrusions into sovereignty exact a high cost.

What is needed is a responsible nationalism — an approach where it is understood that countries are expected to pursue their citizens’ economic welfare as a primary objective but where their ability to harm the interests of citizens elsewhere is circumscribed. International agreements would be judged not by how much is harmonised or by how many barriers are torn down but whether citizens are empowered.

This does not mean less scope for international co-operation. It may mean more. For example, tax burdens on workers around the world are a trillion dollars or more greater than they would be if we had a proper system of international co-ordination that identified capital income and prevented a race to the bottom in its taxation. Taxes are only the most obvious area where races to the bottom interfere with the achievement of national objectives. Others include labour and financial regulation and environmental standards.

Reflex internationalism needs to give way to responsible nationalism or else we will only see more distressing referendums and populist demagogues contending for high office.

 

The economic consequences of a Trump win would be severe

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On June 23, the UK will vote on whether to remain in the EU. On November 8, the US will vote on whether to elect Donald Trump as president. These elections have much in common. Both could lead to outcomes that would have seemed inconceivable not long ago. Both pit angry populists against the political establishment. And in both cases, polling suggests that the outcome is in doubt, with prediction markets suggesting a probability of between one in four and one in three of the radical outcome occurring.

It is interesting to contrast the way that financial markets are reacting to these uncertainties. The markets are highly sensitive to Brexit news: the pound and the British stock market move with every new opinion poll. Analysis of option pricing suggests that if Britain votes to leave the EU, sterling could easily fall by more than 10 per cent and the British stock market by almost as much. It is widely believed that the uncertainties associated with Brexit are consequential enough to affect the policies of the US Federal Reserve and other major central banks.

It would in all likelihood be economically very costly for Britain to leave the EU and would raise questions about the future cohesion of the UK. It would also threaten London’s role as a financial centre and curtail British exports to Europe.

What I find surprising is that US and global markets and financial policymakers seem much less sensitive to “Trump risk” than they are to “Brexit risk”. Options markets suggest only modestly elevated volatility in the period leading up to the presidential election. While every Fed watcher comments on the implications of Brexit for the central bank, few, if any, comment on the possible consequences of a victory for Mr Trump in November.

Yet, as great as the risks of Brexit are to the British economy, I believe the risks to the US and global economies of Mr Trump’s election as president are far greater. If he is elected, I would expect a protracted recession to begin within 18 months. The damage would be felt far beyond the United States.

First, there is a substantial risk of highly erratic policy. Mr Trump has raised the possibility of more than $10tn in tax cuts, which would threaten US fiscal stability. He has also raised the possibility of the US restructuring its debt in the manner of a failed real estate developer. Perhaps this is just campaign rhetoric. But historical research suggests that presidents tend to carry out their major campaign promises.

The shadow boxing over raising the debt limit in 2011 (where all participants recognised the danger of default) was central to the stock market falling by 17 per cent.

Second, in a world economy defined by global integration, Mr Trump’s economic nationalism is highly dangerous. Exports have been a major driver of the American economy in recent years. What would happen to exports if the US were to build a wall along its southern border and abrogate all its trade treaties? Withdrawal from trade agreements does not currently require congressional approval. If Mr Trump did even half of what he has promised, he would surely set off the worst trade war since the Great Depression.

Third, prosperity depends on a secure geopolitical environment. Requiring Japan and Korea to defend themselves and scaling back Nato is a prescription for emboldening China and Russia and promoting nuclear proliferation. A perception that the US is at war with Islam rather than with radical elements within Islam is an invitation to terrorism. In such an environment, investment and trade are unlikely to flourish.

Fourth, Mr Trump’s authoritarian style and cult of personality surely would take a toll on business confidence. He has proposed to bring back torture as a tool of US foreign policy and to change the law so he can sue and punish publications he does not like. The country was paralysed by Watergate and to a lesser extent the Iran-Contra scandal, both of which involved extralegal activity by the president’s staff and the abuse of power. Who will rest secure with President Trump controlling the Federal Bureau of Investigation and the Central Intelligence Agency?

Finally, there is the question of uncertainty and confidence. Improving business confidence is the cheapest form of stimulus. Creating an environment where every tenet of the rule of law, internationalism and consistency in policy is up for grabs would be the best way to damage a still fragile US economy. In no election in my lifetime has a major party candidate for president been so dangerous for the economy.

Markets are discounting the possibility of a Trump presidency. Let us all pray they are right.

Europe is right to kill off the criminal’s favourite banknote

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So-called Bin Ladens have an important role facilitating illicit activity
 
Most of the time I use this column to recommend policy changes that I believe would make the world a better place. This time I am saluting a policy change I believe will have significant benefits – one that carries with it important lessons.
The decision of the European Central Bank last week to stop producing €500 notes permanently is a triumph of reasonable judgment over shameless fearmongering. As Peter Sands, the former chief executive of Standard Chartered bank, wrote with several Harvard academics in a paper published this year, the ECB’s action will make the world a safer, fairer place and offers lessons for the future.
 
Almost everything in life, and in public policy, has both good and bad aspects. Cars provide great transport services but sometimes have devastating accidents. Liquid financial markets provide worthwhile benefits to savers and investors but can be driven to speculative excess. High denomination currency notes stand out as a case in which the good uses are dwarfed by the bad ones, and that is why they should be eliminated. Britain’s Serious Organised Crime Agency has estimated that, before their availability was curtailed in 2010, more than 90 per cent of demand in the UK for €500 notes came from criminals.
There is little if any legitimate use for €500 notes. Carrying out a transaction with 20 €50 notes hardly seems burdensome – and this would represent more than $1,000 in purchasing power. Meanwhile, 20 €200 notes would represent close to $5,000 in purchasing power.
Who in today’s world needs cash for a legitimate $5,000 transaction? Indeed, the ECB found in a study that 56 per cent of the EU public had never laid eyes on a €500 note. Cash transactions of more than €3,000 have, in fact, been made illegal in Italy; in France, the maximum is €1,000. Anyone who thinks that abolishing a high denomination note damages a country’s currency or its citizenry should note that the US and Canada have phased out the $1,000 note – and, in the case of the US, the $500 note – without noticeable complaint.
The ECB policy is at the gentle end of the reasonable spectrum of possible policies. Unlike in the US, no effort is being made to stop the use of existing notes as legal tender and the policy is being implemented only at the end of 2018.
Even after this measure, the ECB will continue to issue notes more than twice as valuable as the highest denomination notes issued anywhere else in the Group of Seven leading industrialised nations. And certainly there is no suggestion that eliminating cash would be desirable or is in conceivable prospect.
By contrast with normal commerce, €500 notes have an important role facilitating illicit activity, as suggested by their nickname: Bin Ladens. Measurement is obviously difficult but estimates by Friedrich Schneider of Johannes Kepler University Linz suggest that physical cash is used in 80 per cent of the global drug trade, 70 per cent of small arms trades, 50 per cent of human trafficking transactions and 50 per cent of transactions for human organs. Estimates by the International Monetary Fund and others of total money laundering consistently exceed $1tn a year. High denomination notes also have a substantial role in facilitating tax evasion and capital flight.
To be sure, it is hard to estimate how much crime will be prevented by the halt in production of €500 notes. It will surely impose some burdens on criminals and might interfere with some transactions. The main point is that even a small reduction in crime would more than justify the loss of any possible benefit that comes from the €500 note.
In this instance, Europe has taken the lead on a significant security issue. But its action should be seen as a beginning rather than an end in itself.
First, the world should demand that Switzerland stops issuing SFr1,000 franc notes. After Europe’s bold step, these notes will stand out as the hard-currency world’s highest denomination note by a wide margin. Switzerland has a long and unfortunate history with illicit finance. It would be tragic if it were to profit from criminal currency substitution.
Second, the question of the facilitation of criminal activity should be placed prominently on the agenda of the Group of 20 leading nations. There would be a strong case for stopping the production of notes with value greater than, perhaps, $50, and also for greater co-operation to assure that new financial technologies, such as bitcoin, do not become vehicles for facilitating illicit transactions.

Global trade should be remade from the bottom up

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Since the end of the second world war, a broad consensus in support of global economic integration as a force for peace and prosperity has been a pillar of the international order. From global trade agreements to the EU project; from the Bretton Woods institutions to the removal of pervasive capital controls; from ex­panded foreign direct investment to increased flows of peoples across borders, the overall direction has been clear. Driven by domestic economic progress, by technologies such as containerised shipping and the internet that promote integration, and by legislative changes within and between nations, the world has grown smaller and more closely connected.

This has proved more successful than could reasonably have been hoped. We have not seen a war between leading powers. Global living standards have risen faster than at any point in history. And material progress has coincided with even more rapid progress in combating hunger, empowering women, promoting literacy and extending life. A world that will have more smartphones than adults within a few years is a world in which more is possible for more people than ever before.

Yet a revolt against global integration is under way in the west. The four leading candidates for president of the US — Hillary Clinton, Bernie Sanders, Donald Trump and Ted Cruz — all oppose the principal free-trade initiative of this period: the Trans-Pacific Partnership. Proposals by Mr Trump, the Republican frontrunner, to wall off Mexico, abrogate trade agreements and persecute Muslims are far more popular than he is. The movement for a British exit from the EU commands substantial support. Under pressure from an influx of refugees, Europe’s commitment to open borders appears to be crumbling. In large part because of political constraints, the growth of the international financial institutions has not kept pace with the growth of the global economy.

Certainly a substantial part of what is behind the resistance is lack of knowledge. No one thanks global trade for the fact that their pay cheque buys twice as much in clothes, toys and other goods as it otherwise would. Those who succeed as exporters tend to credit their own prowess, not international agreements. So there is certainly a case for our leaders and business communities to educate people about the benefits of global integration. But at this late date, with the trends moving the wrong way, it is hard to be optimistic about such efforts.

The core of the revolt against global integration, though, is not ignorance. It is a sense, not wholly unwarranted, that it is a project carried out by elites for elites with little consideration for the interests of ordinary people — who see the globalisation agenda as being set by big companies playing off one country against another. They read the revelations in the Panama Papers and conclude that globalisation offers a fortunate few the opportunities to avoid taxes and regulations that are not available to the rest. And they see the disintegration that accompanies global integration, as communities suffer when big employers lose to foreign competitors.

What will happen next — and what should happen? Elites can continue pursuing and defending integration, hoping to win sufficient popular support — but, on the evidence of the US presidential campaign and the Brexit debate, this strategy may have run its course. This is likely to result in a hiatus in new global integration and efforts to preserve what is in place while relying on technology and growth in the developing world to drive further integration.

The precedents, notably the period between the first and second world wars, are hardly encouraging about unmanaged globalisation succeeding with neither a strong underwriter of the system nor strong global institutions.

Much more promising is this idea: the promotion of global integration can become a bottom-up rather than a top-down project. The emphasis can shift from promoting integration to managing its consequences.

This would mean a shift from international trade agreements to international harmonisation agreements, where issues such as labour rights and environmental protection would take precedence over issues related to empowering foreign producers. It would also mean devoting as much political capital to the trillions that escape tax or evade regulation through cross-border capital flows as we now devote to trade agreements. And it would mean an emphasis on the challenges of middle-class parents everywhere who doubt, but still hope desperately, that their kids can have better lives than they did.

A world stumped by stubbornly low inflation

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Here is a thought experiment that illuminates the challenges currently facing macroeconomic policymakers in the US and the rest of the industrial world.

Imagine that in a brief period inflation expectations around the industrial world, as inferred from both the markets for indexed bonds or inflation swaps, rose by nearly 50 basis points to a level well above the 2 per cent target with larger increases foreseen at longer horizons.

Imagine that at the same time survey measures of inflation expectations, such as those calculated by the University of Michigan and New York Federal Reserve in the US, were rising sharply.

Imagine also that commodity prices were soaring and that the dollar experienced a decline seen once every 15 years.

Imagine that the market estimate of future monetary policy in the US was far tighter than the Federal Reserve’s own policy projections.

Imagine that measures of gross domestic product growth were accelerating with increasing signs of a worldwide boom.

Imagine too that no serious efforts were under way to reduce deficits.

Finally, suppose that officials were comfortable with current policy settings based on the argument that Phillips curve models predicted that inflation would revert over time to target due to the supposed relationship between unemployment and price increases.

I think it is fair to assert that in this hypothetical circumstance there would be pervasive concern that policy was behind the curve. There would be fears that much was at risk as inflation expectations were becoming unanchored and that a substantial set of policy adjustments were appropriate.

The key point is that allowing not just a temporary increase in inflation but a shift to abovetarget inflation expectations could be very costly.

At present we are living in a world that is the mirror image of the hypothetical one just described. Market measures of inflation expectations have been collapsing and on the Fed’s preferred inflation measure are now in the range of 1-1.25 per cent over the next decade.

Inflation expectations are even lower in Europe and Japan. Survey measures have shown sharp declines in recent months. Commodity prices are at multi-decade lows and the dollar has only risen as rapidly as in the past 18 months twice during the past 40 years when it has fluctuated widely.

The Fed’s most recent forecasts call for interest rates to rise almost 2 per cent in the next two years, while the market foresees an increase of only about 0.5 per cent.

Consensus forecasts are for US growth of only about 1.5 per cent for the six months from last October to March. And the Fed is forecasting a return to its 2 per cent inflation target on the basis of models that are not convincing to most outside observers.

Despite the apparent symmetry, the current mood is nothing like the one posited in my hypothetical example.

While there is certainly substantial anxiety about the macroeconomic environment, as judged from the meeting of the Group of 20 big economies in Shanghai last week, there is no evidence that policymakers are acting strongly to restore their credibility as inflation expectations fall below target.

In a world that is one major adverse shock away from a global recession, little if anything directed at spurring demand was agreed. Central bankers communicated a sense that there was relatively little left that they can do to strengthen growth or even to raise inflation. This message was reinforced by the highly negative market reaction to Japan’s move to negative interest rates. No significant announcements regarding non-monetary measures to stimulate growth or a return to target inflation were forthcoming, either.

Perhaps this should not be surprising. In the 1970s it took years for policymakers to recognise how far behind the curve they were on inflation and to make strong policy adjustments.

Policymakers continued to worry about a supposed lack of demand long after it was an important problem. The first attempts to contain inflation were too timid to be effective and success was achieved only with highly determined policy. A crucial step was the abandonment of the idea that the problem was structural in nature rather than driven by macroeconomic policy.

Today’s risks of embedded low inflation tilting towards deflation and of secular stagnation in output growth are at least as serious as the inflation problem of the 1970s. They too will require shifts in policy paradigms if they are to be resolved.

In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and, in extremis, further experimentation with unconventional monetary policies.

No free lunches but plenty of cheap ones

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February 7, 2016

Trade-offs have long been at the center of economics. The aphorism “there is no such thing as a free lunch” captures a central economic idea: You cannot get something for nothing. Among the many trade-offs emphasized in economics courses are guns vs. butter, public vs. private, efficiency vs. equity, environmental protection vs. economic growth, consumption vs. investment, inflation vs. unemployment, quality vs. quantity or cost and short-term vs. long-term performance.

Just as families with limited incomes have to make decisions about what they will and will not buy, societies face trade-offs. Economists are right when they emphasize the need to choose between competing objectives in designing policies.

Trade-off economics helps explain political gridlock. If all change produces winners and losers, and if democratic safeguards mean that veto power is promiscuously distributed, it is hardly surprising that relatively little change takes place.

Yet I am increasingly convinced that “no free lunch” oversimplifies matters and makes economics too dismal a science. It would be true in a world where all opportunities to make things better had been fully exploited — where, to use another cliché, there were no $100 bills lying on the street. But recent experience suggests that by improving incentives or making strategic investments, we can achieve apparently conflicting objectives to a greater extent than conventional wisdom would suggest.

Take U.S. health care. The traditional view was that policymakers had to weigh major trade-offs between cost, quantity and quality. The argument was that measures to reduce cost would also reduce quality of care, as hospitals and doctors denied expensive treatments to patients, were starved of resources and were spread thinner as demand for care rose.

Experience since 2010, when Obamacare was passed, shows how wrong the traditional view is. Coverage has been substantially expanded. Yet costs, which grew far more rapidly than gross domestic product for a half-century, have now moved into line with GDP growth, resulting in large savings to Medicare and private health insurance. No one fully understands why the health-care cost curve has bent, but most experts believe new approaches to reimbursement that reward success and penalize failure have played an important role. Such measures have, for example, led to dramatic reductions in the share of hospital patients who are readmitted soon after discharge.

Likewise, hospice-type approaches to end-of-life care, where the focus was shifted from cure to patient comfort, were expected to improve the patient experience and reduce costs by eliminating costly, unproductive interventions. There is now substantial evidence that they extend life expectancy as well. The moral of the story is not that there is never a trade-off between cost and quality. Rather, it is that innovations can greatly improve the terms of the trade by reducing costs and increasing quality.

A quite different example involves the alleged trade-off between equity and efficiency — specifically, the concern that redistribution hurts economic performance and stymies growth. It is true that tax increases produce at least some adverse incentives and that providing income-based government benefits involves implicit taxes. But matters are much more complex than a simple trade-off. Antitrust laws that attack rent-seeking promote both equity and efficiency, as do measures that increase educational opportunity. The rational strengthening of financial regulation reduces the incidence of financial crises, thus improving economic performance while promoting fairness by helping consumers. In demand-short economies, the greater equity achieved through more progressive taxation means more spending and fuller employment of resources. These examples do not deny trade-offs between equity and efficiency. They do, however, suggest that there is nothing ineluctable about them. Both can be enhanced through proper policy.

The idea that it is possible to achieve apparently conflicting objectives is not confined to public policy. Henry Ford, with his famous $5 workday, both made his workers better off and raised his profits. Ford’s example has been followed by Aetna , Walmart and others in recent months. Many companies report that an increased commitment to social responsibility makes them more profitable by increasing their attractiveness to workers and customers. Others have found that investments in energy efficiency are among the most profitable they can make. More generally, successful entrepreneurs provide a new, previously unavailable benefit to consumers, create opportunities for workers and earn profits for themselves.

Trade-offs should be seen not as constraints but challenges. There are plenty of very cheap lunches out there for those with the will to find them. Economics has much to contribute and much to gain from this search as well. It can become a cheerful science.

Heed the fears of the financial markets

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Often markets are volatile at the end of the year – as many traders go on holiday and those with losses unload them – and then settle down as a new year begins. Not this year. U.S. and European markets closed significantly lower on Friday after a very rough week despite a very strong U.S. jobs report. The week’s economic news was dominated by dramatic declines in China’s stock market and currency; the week also saw a further plunge in oil prices even in the face of major tension between Iran and Saudi Arabia.

A week when bad market news repeatedly makes the front page raises the general question of how much forecasters and policymakers should look to speculative markets as indicators regarding future prospects. And it raises the more specific question of how alarmed policymakers should be about the prospect of a global slowdown, especially in light of the financial dramas playing out in China.

There is little question that markets are highly volatile relative to the fundamentals they seek to assess. Economist Paul Samuelson famously quipped 50 years ago, “the stock market has predicted nine of the last five recessions.” Former Treasury secretary Robert Rubin was right when he would regularly reassure anxious politicos in the Clinton White House that “markets go up, and markets go down” on days when a market move created either joy or anxiety. The best executives manage their company with an eye to long-run profitability, not daily stock price. And policymakers do best when they concentrate on strengthening economic fundamentals rather than on daily market fluctuations.

At the same time, because markets aggregate the views of a huge number of participants, and because they are constantly assessing the future (unlike economic statistics, which only reflect the past), they are like canaries in coal mines: very valuable in giving warning when conditions change. That is why several studies have shown that prediction markets do a better job of forecasting elections than pollsters and why Hollywood studios use such markets to judge the likely success of movies.

Policymakers who dismiss market moves as reflecting mere speculation often make a serious mistake. Markets were on to the gravity of the 2008 crisis well before the Federal Reserve was; to the unsustainability of fixed exchange rates in Britain, Mexico and Brazil while the authorities were still in denial; and to the onset of a slowdown or recession well before forecasters in countless downturns.

While markets do sometimes send false alarms and should not be slavishly followed, the conventional wisdom essentially never recognizes gathering storms. The Economist reports this week that, looking across all major countries over the past several decades, there were 220 instances in which a year of positive growth was followed by one of contraction. In its April forecasts during the growth year, the International Monetary Fund did not anticipate a coming recession on a single occasion!

Market signals should be taken especially seriously when they are long-lasting and coming from many markets, as is the case with current indications that inflation will not reach target levels within a decade in the United States, Europe or Japan. Especially ominous are moments when news fails to rally markets as would be expected such as with the U.S. stock market and Friday’s strong employment report or the decline of oil prices in the face of heightened Middle East tensions.

Last week we saw huge negative movements in Chinese markets and a large foreign market response. While it certainly could be the case that the Chinese developments reflect a combination of market psychology and clumsy policy responses, and that the strong response of world markets is an example of transient contagion, I doubt it.

Over the past year, about 20 percent of China’s growth as reported in its official statistics has come from its financial-services sector, which has mushroomed to the point where it is about as large relative to national GDP as in Britain, and Chinese debt levels are extraordinarily high. This is hardly a case of healthy or sustainable growth.

In recent years, China’s growth has come heavily from massive infrastructure investment; indeed, China put in place more cement and concrete between 2011 and 2013 than the United States did in the whole of the 20th century. This growth, too, is unsustainable, and even if it is replaced by domestic services, China’s contribution to demand for global commodities will fall way off.

Experience suggests that the best indicators of a country’s economic prospects are the decisions that its citizens make about keeping capital at home or exporting it abroad. The reason the renminbi is under pressure is that Chinese citizens are extremely eager to move their money overseas. But for the substantial recent depletion of China’s reserves, the renminbi would already have substantially depreciated.

Traditionally, international developments have had only a limited impact on the U.S. and European economies because their impact could be offset by monetary policy actions. Thus, the U.S. economy grew robustly through the Asian financial crisis as the Fed brought interest rates down. With rates essentially at zero in the industrial countries, however, this option is no longer available, and foreign economic problems are likely to have much more direct effects on economic performance.

Because of China’s scale, its potential volatility and the limited room for conventional monetary maneuvers, the global risk to domestic economic performance in the United States, Europe and many emerging markets is as great as any time I can remember. It is time for policymakers to hope for the best and plan for the worst.

Central bankers do not have as many tools as they think

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December 6, 2015

The unresolved question is how policy can delay and ultimately contain the next recession

While debate about the relevance of the secular stagnation idea to current economic conditions continues to rage, there is now almost universal acceptance of a crucial part of the argument. It is agreed that the “neutral” interest rate, which neither boosts nor constrains growth, has declined substantially and is likely to be lower in the future than in the past throughout the industrial world because of a growing relative abundance of savings relative to investment.

The idea that real interest rates – that is, adjusted for inflation – will be lower than they have been historically is reflected in the pronouncements of policymakers such as Federal Reserve chair Janet Yellen, the medium-term forecasts of official agencies such as the Congressional Budget Office and the International Monetary Fund and the pricing of government bonds whose payments are tied to inflation.

This is important progress and has contributed to more prudent monetary policies than otherwise would have been made and the avoidance of a deflationary psychology taking hold particularly in Europe and Japan. Policymakers, despite having adjusted their views, still overestimate the extent to which neutral real interest rates will rise.

Neutral real interest rates may well rise over the next few years as the American economy creates jobs at a rapid rate and the effects of the financial crisis diminish. This is what many expect, though the fact that an imminent return towards historically normal interest has been widely expected for the past six years should invite scepticism.

A number of considerations make me doubt the US economy’s capacity to absorb significant increases in real rates over the next few years. First, they were trending down for 20 years before the crisis started and have continued that path since. Second, there is at least a significant risk that as the rest of the world struggles there will be substantial inflows of capital into the US leading to downward pressure on rates and upward pressure on the dollar, which in turn reduces demand for traded goods.

Third, the increases in demand achieved through low rates in recent years have come from pulling demand forward, resulting in lower levels of demand for the future. For example, lower rates have accelerated purchases of cars and other consumer durables and created apparent increases in wealth as asset prices inflate. In a sense, monetary easing has a narcotic aspect. To maintain a given level of stimulus requires continuing cuts in rates.

Fourth, profits are starting to turn down and regulatory pressure is inhibiting lending to small and medium sized businesses. Fifth, inflation mismeasurement may be growing as the share in the economy of items such as heathcare, where quality is hard to adjust for, grows. If so, apparent neutral real interest rates will decline even if there is no change in properly measured rates.

All of this leaves me far from confident that there is substantial scope for tightening in the US and there is probably even less scope in other parts of the industrialised world. The fact that central banks in countries, including Europe, Sweden and Israel, where rates were zero found themselves reversing course after raising rates adds to the cause for concern.

But there is a more profound worry. The experience of the US and others suggests that once a recovery is mature the odds of it ending within two years are about half and of it ending in less than three years over two-thirds. As normal growth is below 2 per cent rather than the historical near 3 per cent, the risk may even be greater. While recession risks may seem remote given rapid growth, no postwar recession has been predicted a year ahead by the Fed, the administration or the consensus forecast.

History suggests that when recession comes it is necessary to cut rates more than 300 basis points. I agree with the market that the odds are the Fed will not be able to raise rates 100 basis points a year without threatening to undermine recovery. Even if this were possible, the chances are very high that recession will come before there is room to cut rates enough to offset it. The knowledge that this is the case must surely reduce confidence and inhibit demand.

Central bankers bravely assert that they can always use unconventional tools. But there may be less in the cupboard than they suppose. The efficacy of further quantitative easing in an environment of well-functioning markets and already very low medium-term rates is highly questionable. There are severe limits on how negative rates can become. A central bank forced back to the zero lower bound is not likely to have great credibility if it engages in forward guidance.

The Fed will in all likelihood raise rates this month. Markets will focus on the pace of its tightening. I hope their response will involve no great turbulence. But the unresolved question that will hang over the economy is how policy can delay and ultimately contain the next recession. It demands urgent attention from fiscal as well as monetary policymakers.

Grasp the reality of China’s rise

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November 8, 2015

For the first time in centuries, China affects the global economy as much as it is affected by the global economy. In the years ahead, China is likely to account for between one-third and one-half of growth in global incomes, trade and commodity demand, and its significance will only increase as its share of the world economy rises.

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The case for expansion

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Policymakers must abandon structural reform rhetoric and embrace fiscal stimulus

October 7, 2015

As the world’s financial policymakers convene for their annual meeting on Friday in Peru, the dangers facing the global economy are more severe than at any time since the bankruptcy of Lehman Brothers in 2008.

The problem of secular stagnation – the inability of the industrial world to grow at satisfactory rates even with very loose monetary policies – is growing worse in the wake of problems in most big emerging markets, starting with China.

This raises the spectre of a vicious global cycle in which slow growth in industrial countries hurts emerging markets which export capital, thereby slowing western growth further. Industrialised economies that are barely running above stall speed can ill-afford a negative global shock.

Policymakers badly underestimate the risks of both a return to recession in the west and of a global growth recession. If a recession were to occur, monetary policymakers lack the tools to respond.

There is essentially no room left for easing in the industrial world. Interest rates are expected to remain very low almost permanently in Japan and Europe and to rise only very slowly in the US.

Today’s challenges call for a clear global commitment to the acceleration of growth as the main goal of macroeconomic policy. Action cannot be confined to monetary policy.

There is an old proverb: “You do not want to know the things you can get used to.” It is all too applicable to the global economy in recent years. While the talk has been of recovery from the crisis, forecasts of future gross domestic product have been revised sharply downwards almost everywhere.

Relative to its 2012 forecasts, the International Monetary Fund has revised its estimate for the level of US GDP for 2020 downwards by 6 per cent, Europe by 3 per cent, China by 14 per cent, emerging markets by 10 per cent and 6 per cent for the world as a whole.

These dismal results assume no recessions in the industrial world and the absence of systemic crises in the developing world. Neither can be taken for granted.

We are in a new macroeconomic epoch where the risk of deflation is higher than that of inflation and we cannot rely on the self-restoring features of market economies. The effects of hysteresis – where recessions are not just costly but stunt the growth of future output – appear far stronger than anyone imagined a few years ago.

Western bond markets are sending a strong signal that there is too little, rather than too much, government debt. As always, when things go badly there is a great debate between those who believe in staying the course and those who urge a serious correction. I am convinced of the urgent need for substantial changes in the world’s economic strategy.

History tells us that markets are inefficient and often wrong in their judgments about economic fundamentals. It also teaches us that policymakers who ignore adverse market signals because they are inconsistent with their preconceptions risk serious error.

This is one of the most important lessons of the onset of the financial crisis in 2008. Had policymakers heeded the pricing signal on the US housing market from mortgage securities, or on the health of the financial system from bank stock prices, they would have reacted far more quickly to the gathering storm. There is also a lesson from Europe. Policymakers who dismissed market signals that Greek debt would not be repaid in full delayed necessary adjustments – at great cost.

Lessons from the bond market

It is instructive to consider what government bond markets in the industrialised world are implying today. These are the most liquid financial markets in the world and reflect the judgments of a very large group of highly informed traders. Two conclusions stand out.

First, the risks tilt heavily towards inflation rates that are below official targets. Nowhere in the industrial world is there an expectation that central banks will hit their 2 per cent targets in the foreseeable future. Inflation expectations are highest in the US – and even there it expects inflation of barely 1.5 per cent for the five-year period starting in 2020.

This is despite the fact that the market indicates that monetary policy will remain looser than the Federal Reserve expects: the Fed funds futures market predicts a rate around 1 per cent at the end of 2017 compared to the Fed’s most recent median forecast of 2.6 per cent. If the market believed the Fed on monetary policy it would expect even lower inflation and a risk of deflation.

Second, the prevailing expectation is of extraordinarily low real interest rates. Real rates have been on a downward trend for nearly 25 years.

The average real rate in the industrialised world over the next 10 years is expected to be zero. Even this presumably reflects some probability that it will be artificially increased by nominal rates at a zero bound and deflation. In the presence of such low real rates there is no sign that economies would overheat.

Many will argue that bond yields are artificially depressed by quantitative easing and so it is wrong to use them to draw inferences about future inflation and real rates. This cannot be ruled out. But it is noteworthy that rates are now lower in the US than their average during the period ofQE and that forecasters have been confidently – but wrongly – expecting them to rise for years.

The strongest explanation for this combination of slow growth, expected low inflation and zero real rates is the secular stagnation hypothesis.

It holds that a combination of high rates of saving, lower investment and increased risk aversion depresses the real interest rates that accompany full employment. The result is that the zero lower bound on nominal rates becomes constraining.

There are four contributing factors that lead to much lower normal real rates. First, increases in inequality – the share of income going to capital and in corporate retained earnings – raise the propensity to save.

Second, an expectation that growth will slow due to smaller labour force growth and slower increases in productivity reduces investment and boosts the incentives to save.

Third, increased friction in financial intermediation caused by more extensive regulation and increased uncertainty discourages investment.

Fourth, reductions in the price of capital goods and in the quantity of physical capital needed to operate a business – think of Facebook having over five times the market value of GM.

Emerging markets hit reverse

Until recently, a major bright spot has been the strength of emerging markets. They have been substantial recipients of capital from developed countries that could not be invested productively at home.

The result has been higher interest rates than they would otherwise obtain, greater export demand for industrial countries’ products and more competitive exchange rates for developed economies.

Gross flows of capital from industrial countries to developing countries rose from $240bn in 2002 to $1.1tn in 2014. Of particular relevance for the discussion of interest rates is that foreign currency borrowing by the private sector of developing countries rose from $1.7tn in 2008 to $4.3tn in 2015.

Developing country net capital flows fell sharply this year – marking the first such decline in almost 30 years, according to the Institute of International Finance, with the amount of private capital leaving developing countries eclipsing $1tn.

Any discussion has to start with China, which poured more concrete between 2010 and 2013 than the US did in the entire 20th century. A reading of the recent history of investment-driven economies – whether in Japan before the oil shock of the 1970s and 1980s or the Asian tigers in the late 1990s – tells us that growth does not fall off gently.

China faces many other challenges, ranging from the most rapid population ageing in the history of the planet to a slowdown in rural to urban migration. It also faces issues of political legitimacy and how to cope with unproductive investment.

Even taking an optimistic view – where China shifts smoothly to a consumption-led growth model led by services – its production mix will be much lighter, so the days when it could sustain commodity markets are over.

The problems are hardly confined to China. Russia is struggling with low oil prices, a breakdown in the rule of law and harsh sanctions. Brazil has been hit by the decline in commodity prices but even more by political dysfunction. India is a rare exception. But from central Europe to Mexico to Turkey to Southeast Asia, the combination of slowdowns in industrialised countries and dysfunctional politics is hurting growth by discouraging capital inflows and encouraging capital outflows.

Assertive stance

What does all this mean for the world’s policymakers gathered in Lima for the IMF and World Bank meetings? This is no time for complacency. The idea that slow growth is only a temporary consequence of the 2008 financial crisis is absurd. The latest data suggest growth is slowing in the US and it is already slow in Europe and Japan. A global economy near stall speed – and slowing – is one where the primary danger is recession.
The most successful recent assertion of growth policy was Mario Draghi’s famous vow that “the European Central Bank will do whatever it takes to preserve the euro”, uttered at a moment when the single currency appeared to be on the brink.

By making an unconditional commitment to providing liquidity and supporting growth, the ECB president prevented an incipient panic and helped lift European growth rates – albeit not by enough.

What is needed now is something equivalent but on a global scale – a signal that the authorities recognise that secular stagnation and its spread to the world is the dominant risk we face. After last Friday’s dismal US jobs report, the Fed must recognise what should already have been clear: that the risks to the US economy are two-sided. Rates should be increased only if there are clear and direct signs of inflation or of financial euphoria breaking out. The Fed must also state its readiness to help prevent global financial fragility from leading to a global recession.

The central banks of Europe and Japan need to be clear that their biggest risk is a further slowdown. They must indicate a willingness to be creative in the use of the tools at their disposal. With bond yields well below 1 per cent it is very doubtful that traditional QE will have much stimulative effect. They must be prepared to consider support for assets that carry risk premiums that can be meaningfully reduced. They could achieve even more by absorbing bonds to finance fiscal expansion.

Long-term low interest rates radically alter how we should think about fiscal policy. Just as homeowners can afford larger mortgages when rates are low, government can also sustain higher deficits. If the Maastricht criteria of a debt-to-GDP ratio of 60 per cent was appropriate when governments faced real borrowing costs of five percentage points, then a far higher figure is surely appropriate today when real borrowing costs are negative.

The case for more expansionary fiscal policy is especially strong when it is spent on investment or maintenance. Wherever countries print their own currency and interest rates are constrained by the zero bound there is a compelling case for fiscal expansion until demand accelerates. While the problem before 2008 was too much lending, many more of today’s problems have to do with too little lending for productive investment.

Inevitably, there will be discussion of the need for structural reform at the Lima meetings – there always is. But to emphasise it now would be to embrace the status quo. The world’s markets are telling us with increasing force that we are in a very different world now.

Traditional approaches of focusing on sound government finance, increased supply potential and the avoidance of inflation court disaster. Moreover, the world’s principal tool for dealing with contraction – monetary policy – is largely played out. It follows that policies aimed at lifting global demand are imperative.

If I am wrong about expansionary fiscal policy, the risks are that inflation will accelerate too rapidly, economies will overheat and too much capital will flow to developing countries. These outcomes seem remote. But even if they materialise, standard approaches can be used to combat them.

If I am right and policy proceeds along the current path, the risk is that the global economy will fall into a trap not unlike the one Japan has been in for 25 years where growth stagnates but little can be done to fix it. It is an irony of today’s secular stagnation that what is conventionally regarded as imprudent offers the only prudent way forward.

The Fed looks set to make a dangerous mistake

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August 23, 2015

Raising rates this year will threaten all of the central bank’s major objectives

Will the Federal Reserve’s September meeting see US interest rates go up for the first time since 2006? Officials have held out the prospect that it might, and have suggested that — barring major unforeseen developments — rates will probably be increased by the end of the year. Conditions could change, and the Fed has been careful to avoid outright commitments. But a reasonable assessment of current conditions suggest that raising rates in the near future would be a serious error that would threaten all three of the Fed’s major objectives — price stability, full employment and financial stability.

Like most major central banks, the Fed has put its price stability objective into practice by adopting a 2 per cent inflation target. The biggest risk is that inflation will be lower than this — a risk that would be exacerbated by tightening policy. More than half the components of the consumer price index have declined in the past six months — the first time this has happened in more than a decade. CPI inflation, which excludes volatile energy and food prices and difficult-to-measure housing, is less than 1 per cent. Market-based measures of expectations suggest that, over the next 10 years, inflation will be well under 2 per cent. If the currencies of China and other emerging markets depreciate further, US inflation will be even more subdued.

Tightening policy will adversely affect employment levels because higher interest rates make holding on to cash more attractive than investing it. Higher interest rates will also increase the value of the dollar, making US producers less competitive and pressuring the economies of our trading partners.

This is especially troubling at a time of rising inequality. Studies of periods of tight labour markets like the late 1990s and 1960s make it clear that the best social programme for disadvantaged workers is an economy where employers are struggling to fill vacancies.

There may have been a financial stability case for raising rates six or nine months ago, as low interest rates were encouraging investors to take more risks and businesses to borrow money and engage in financial engineering. At the time, I believed that the economic costs of a rate increase exceeded the financial stability benefits, but there were grounds for concern. That debate is now moot. With credit becoming more expensive, the outlook for the Chinese economy clouded at best, emerging markets submerging, the US stock market in a correction, widespread concerns about liquidity, and expected volatility having increased at a near-record rate, markets are themselves dampening any euphoria or overconfidence. The Fed does not have to do the job. At this moment of fragility, raising rates risks tipping some part of the financial system into crisis, with unpredictable and dangerous results.

Why, then, do so many believe that a rate increase is necessary? I doubt that, if rates were now 4 per cent, there would be much pressure to raise them. That pressure comes from a sense that the economy has substantially normalised during six years of recovery, and so the extraordinary stimulus of zero interest rates should be withdrawn. There has been much talk of “headwinds” that require low interest rates now but this will abate before long, allowing for normal growth and normal interest rates.

Whatever merit this view had a few years ago, it is much less plausible as we approach the seventh anniversary of the collapse of Lehman Brothers. It is no longer easy to think of economic conditions that can plausibly be seen as temporary headwinds. Fiscal drag is over. Banks are well capitalised. Corporations are flush with cash. Household balance sheets are substantially repaired.

Much more plausible is the view that, for reasons rooted in technological and demographic change and reinforced by greater regulation of the financial sector, the global economy has difficulty generating demand for all that can be produced. This is the “secular stagnation” diagnosis, or the very similar idea that Ben Bernanke, former Fed chairman, has urged of a “savings glut”. Satisfactory growth, if it can be achieved, requires very low interest rates that historically we have only seen during economic crises. This is why long term bond markets are telling us that real interest rates are expected to be close to zero in the industrialised world over the next decade.

New conditions require new policies. There is much that should be done, such as steps to promote public and private investment so as to raise the level of real interest rates consistent with full employment. Unless these new policies are implemented, inflation sharply accelerates, or euphoria in markets breaks out, there is no case for the Fed to adjust policy interest rates.

The writer is the Charles W Eliot university professor at Harvard and a former US Treasury secretary

Corporate long-termism is no panacea — but it is a start

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The real need is for a cadre of trusted, tough-minded investors that will support strong management teams

August 9, 2015

There are not many wholly new areas to open up in economic policy. But in recent months there has been a wave of innovative proposals directed at improving economic performance in general, and middle-class incomes in particular — not through government actions but through mandates or incentives to change business decision-making. The goal is for companies and shareholders to operate with longer horizons and to more generously share the fruits of their corporate success with their workers, customers and other stakeholders.

There are strong grounds for interest in such approaches. After the crises of recent years, the case for relying on speculative markets to drive the real economy — to whatever extent it had validity — is surely attenuated. Instances where successful companies with strong management teams and records of investment have been forced to curtail investment plans are a cause of concern. And we would all like to see middle-class incomes do a better job of keeping up with productivity than they have in recent years.

Such proposals for corporate reform are responding to legitimate policy imperatives, but they also tap into the zeitgeist in another way. At the same time as there is widespread unhappiness with market outcomes, confidence in government has reached a low ebb. So the idea of achieving reform through altered business behaviour, rather than government programmes, is appealing.

The corporate behaviour debate recently taken up by investors, management consultants and even presidential candidates is a very valuable one, which speaks fundamentally to the way in which American capitalism functions. In many aspects it is an overdue recognition of basic market principles.

Businesses will raise wages to a point where the cost is just balanced by the reduced bill for recruiting and motivating workers. At that point, a further increase in wages does not appreciably change their total costs but higher wages certainly makes their workers better off. So there is a strong case for robust minimum wages.

There is also a strong reason for regulating aspects of pay. Usually competition drives desirable economic arrangements. But not always — especially when there is a risk of a race to the bottom. A company that tries to stand out by offering especially attractive family leave benefits , or job security, or egalitarian wage structures faces the prospect of attracting a disproportionately risk-averse work force. So there is an argument for using mandates to level the playing field.

Profit sharing, too, is an area where there are demonstrable benefits in terms of increased productivity — but an individual company that stands out by offering it may encounter difficulties in recruitment because workers are too risk averse. So there is a strong case for tax incentives to spur profit sharing.

At the same time scepticism about whether all horizons should be lengthened is appropriate. A generation ago, the Japanese keiretsu system of cross ownership of corporate shares — which insulated corporate managements from share price pressure — was seen as a strength. Yet, Japan’s manifest macroeconomic difficulties aside, companies lacking market discipline have squandered leads in sectors from electronics to automobiles to IT.

Managements of companies that are dissipating the most value, such as General Motors before it was bailed out by the US government in 2009, have often been the most enthusiastic champions of long-termism. Market participants who are willingly placing high valuations on Silicon Valley start-ups that lack any profits and have little revenue may be putting too much, not too little, weight on the distant future. That, at least, is the implication of those who see the inflation of a “technology bubble”.

Corporations hoarding cash that is earning zero in the bank or in Treasury bills would be cheered not jeered by the market if they could be convinced that the companies were putting it to productive use. Many corporations are in this situation of having cash piles but often do not have productive uses for the money. Either that or they cannot convince investors of their projects’ validity. Pushing corporations without good projects to invest is wasteful. Stopping or discouraging them from distributing funds to shareholders is dangerous if it encourages mindless takeovers as an alternative.

The real need is for a cadre of trusted, tough-minded investors in any given company who can credibly commit to support strong management teams and to provide assurances to a broader investment community so that productive investments are made. Accomplishing that, while maintaining market discipline, is the crucial challenge.

 

Complacency and incrementalism are traps to avoid

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July 12, 2015

Clear-eyed, bold action is what the world requires if the financial drama is to subside.

Against a backdrop of slow and diminishing growth forecasts, recent months and especially recent weeks have seen an extraordinary level of financial drama. While not rising to the level of the systemic global crisis of 2008, or the period of great uncertainty in the late 1990s around the Asia-Russia-Brazil-Long-Term Capital Management crises, markets everywhere seem to be thwarting political aspirations.

Greece’s relationship with the euro area has been a financial soap opera for months, and it is one that is unlikely to end anytime soon. Concerns about German dominance of Europe are now more salient than they have been at any time in the past 70 years.

China’s stock market has been a rollercoaster despite – or perhaps because of – a remarkable (even for China) level of government involvement. And the ability of the Chinese government to deliver the rapid growth on which its legitimacy increasingly depends is very much open to question.

In the US, while the fiscal picture at the federal level appears healthier than it has in a long time, thanks to a marked slowdown in healthcare costs, Puerto Rico is on the brink of the largest municipal bond default in American history.

Tolstoy observed that all happy families are alike but each unhappy family is miserable in its own way. In the same way, each of these situations is driven by its own dynamics. But their concatenation does warrant reflection on some common lessons for financial policymakers and their political masters. Two stand out.

First, there are economic laws like there are physical laws and, as with physical laws, economic laws do not yield to political will. The financial crisis, the great recession and sharp increases in inequality have all properly led to a negative reassessment of the functionality of unfettered free markets. It does not follow, however, that governments can bring about economic outcomes they prefer by fiat. Greece’s problems, of course, relate to the failings of Greek economic policy. But it should come as no surprise that a fiscal contraction in excess of 20 per cent of gross domestic product in an economy that does not have the freedom to loosen monetary policy or to devalue its currency leads to depression, even if policymakers wish otherwise.

Famously, while you can fool all of the people some of the time and some of the people all of the time, you cannot fool all of the people all of the time. In the same way, markets may well be inefficient and diverge from fundamental value, and they may well be subject to government manipulation for significant intervals, but it is a foolish government that supposes it can indefinitely maintain speculative prices at politically convenient levels, as the Chinese authorities may soon discover.

Likewise, if a default cannot be managed, it is tempting to assume that it cannot occur. This is an obvious fallacy demonstrated most recently by European insistence in 2010 that Greek debt would never be restructured. It dangerously invites complacency on the part of creditors and leaves debtors with such large overhangs that they have little motivation to carry out constructive reform.

Second, fundamental imbalances and problems require fundamental solutions. In all spheres, the temptation to incremental policymaking is enormous. Incrementalism is less politically jarring; it preserves flexibility for the future in an uncertain world; it usually requires less admission of past error; and it gives the appearance of prudence. Yet the American experience in Vietnam should be cautionary to those inclined to yield to the temptation of incrementalism. At every step, policymakers did enough to avoid disaster but not enough to offer a prospect of success – until the moment when helicopters left the Saigon embassy and US policy ended in failure.

Financial problems are in some combination always about two things – arithmetic that does not add up and a loss of confidence. Incremental steps that provide some but not large sums of assistance, that postpone but do not reduce scheduled debt payments, and that defer decisions about the future to the future run the constant risk that they will not bring convincing arithmetic into view and will be insufficient to restore market confidence.

There are dozens of examples in financial history when an exchange-rate peg was maintained too long, or debt was restructured too late, or forbearance was carried out for too long. I can think of none where strong action came too soon. Clear-eyed, bold action is what the world requires if the financial drama is to subside. Let us hope against much of the experience of recent years that it will be forthcoming.

Greece is Europe’s failed state in waiting

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June 20, 2015

When, as now appears likely, Greece financially separates from Europe it will at one level be no one’s fault.

The Greek leaders will rightly explain that having imposed more austerity on themselves than any industrialised country has suffered since the Depression, they could not have done more without light at the end of tunnel in the form of a clear commitment to debt relief. European leaders will rightly explain that they adjusted their positions repeatedly to accommodate the Greeks. They will stress that their citizens would not permit Greece to play by different rules to the rest of Europe. And the IMF will rightly explain that it would have blessed any plan agreed by Greece and Europe that added up.

The trouble is that all the parties are going to get much more of what they fear from a breakdown than they would even from what they regard as an unacceptable compromise. Historians understand how the first world war was allowed to start but are still, a century later, incredulous that it happened. Financial historians may look back at the events of next week and wonder how Europe’s financial unravelling was permitted.

Make no mistake about the consequence of a breakdown. With an end to European support and consequent bank closures and credit problems, austerity in Greece will get far worse than it is today and it will probably become a failed state to the great detriment of all its people and their leadership.

When Greece fails as a state, Europe will collect far less debt than it would with an orderly debt restructuring. And a massive northern out-migration of Greeks will strain national budgets throughout Europe — not to mention the challenges that will, come as Russia achieves a presence in Greece.

The IMF is looking at by far the largest non-payment by a borrower in its history. True, there are good reasons to think enough foam has been placed on the runway to prevent financial contagion. Yet, this was asserted with respect to LTCM, subprime and the fall of Lehman.

Diplomacy fails and catastrophes happen when nations are preoccupied with their own concerns and fail to consider the political needs of their counterparts and become convinced that their counterparts will not take yes for an answer.

Here is an informed outsider’s judgment as to what needs to happen if disaster is to be averted.

The Greek prime minister Alexis Tsipras needs to do what is necessary to make reaching an agreement politically feasible for his fellow Europeans.

That means dropping ideological rhetoric about a new European approach. He must recognise that Greece’s problems are significantly of its own making and make clear that he is absolutely committed to doing what is necessary to keep Greece in the euro area. He needs to be clear that he will accept further VAT and pension reforms to achieve primary surplus targets this year and next, but that he expects a clear recognition that if Greece does its part, debt will be written off on a large scale.

German chancellor Angela Merkel and the European authorities must do what is necessary to make policy adjustments politically tenable in Greece.

That means acknowledging that the vast majority of the financial support given to Greece has gone to pay back banks rather than to support the Greek budget. They must agree on debt relief and recognise the degree of adjustment in Greek spending that has taken place: with nearly 30 per cent of government workers laid off. It also means announcing their intention to accelerate economic growth throughout Europe.

The IMF needs to recognise that this is now not about the numbers. It is about the high politics of Europe. Its job is to stand behind any deal that avoids breakdown.

The hour is late. But it’s often darkest before dawn. Let us all hope that Greece and Germany use this weekend to work back from the brink before Monday’s summit.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary.