Gaming US Fiscal Reform

Mohamed A. El-Erian

01 October 2012

NEWPORT BEACHIt sounded like a really clever idea: Use a very public and sizeable threat to get bickering politicians to collaborate and compromise. Well, it has not worked so far, and the already-sizeable stakes just got bigger.
No, I am not talking here about Europe’s debt crisis, decisive resolution of which still requires greater cooperation and shared responsibility, both within individual eurozone member states and between creditor and debtor countries. I am referring to the complex fiscal situation in the United States – a fluid problem that has just been rendered more consequential by the recent warning from the ratings agency Moody’s that the US could lose its top credit rating next year if Congress fails to make progress on medium-term fiscal reforms.
Hobbled by the self-inflicted wounds of the debt-ceiling debacle in the summer of 2011 – which undermined economic growth and job creation, and further damaged Americans’ confidence in their political system – the US Congress and President Barack Obama’s administration recognized the need for a measured and rational approach to fiscal reform. To increase the likelihood of this, they agreed on immediate spending cuts and tax increases that would automatically kick in (the “fiscal cliff”) if agreement on a comprehensive set of fiscal reforms eluded them.
On paper, at least, this sizeable threat – involving blunt fiscal contraction amounting to some 4% of GDP – should have properly aligned incentives in Washington, DC. After all, no politician would wish to go down in history as being responsible for pushing the country back into recession at a time when unemployment is already too high, income and wealth inequalities are increasing, and a record number of Americans live in relative poverty.
Yet, so far, the threat has not worked. To understand why, we can appeal to game theory, which provides economists and others a powerful framework with which to explain the dynamics of both simple and complex interactions.
The objective of threatening a fiscal cliff was to force a “cooperative outcome” on an increasinglynon-cooperative game.” But, in the absence of a credible enforcer (and lacking sufficient mutual assurances), participants felt that they had more to gain from continuing their non-cooperative behavior.
Politicians on both sides of America’s political divide have generally felt that compromise would be viewed as a sign of weakness. Moreover, too many have made prior commitments – for example, promising never to increase taxes – that they find hard to break, especially ahead of elections that both sides deem to be of defining significance for the country’s future, reflected in the candidates’ campaigns, which are getting nastier by the day.
The cost-benefit calculations will likely evolve after the election in November. At that point, the cost of being singled out as collaborating with members of the other side – and thus the risk of being unseated by more extreme forces in one’s partymay well decline. Moreover, since early September, the potential benefits of cooperation now include avoiding an embarrassing credit-rating downgrade next year if medium-term fiscal reform does not materialize.
I suspect that some will be quick to dismiss the consequences of a Moody’s downgrade. And it certainly is tempting to do so.

After all, the global financial crisis badly damaged the credibility of ratings agencies as a whole. Moreover, one would be hard pressed to identify any meaningful hit to the US from the decision by another major agency, Standard & Poor’s, to downgrade America’s sovereign rating in August 2011.
On the contrary, rather than spiking higher following S&P’s unprecedented move, US market interest rates continued to fall, reaching record-low levels. This seemingly contradictory fall in financing costs reflected an abundance of foreign capital seeking to invest in the US, including money fleeing from Europe. The absence of any adverse impact on government finances may thus lead some to dismiss the impact of a potential Moody’s downgrade in 2013.
Yet, those of us who are exposed on a daily basis to the inner workings of financial markets would caution against too upbeat an attitude toward a second downgrade by a major ratings agency. Moreover, the potential impact certainly is not linear.
Owing to the way that investment contracts are written and guidelines specified, there is a meaningful difference between a single and multiple rating downgrades. Were Moody’s to follow S&P in stripping the US of its triple-A rating, the most likely outcome is that the universe of global investors who are both able and willing to increase their holdings of US government securities would shrink over time.
Fortunately for the US, the immediate adverse impact on borrowing costs would be alleviated, if not nullified, by investors’ lack of readily available alternatives to US government bonds, as well as a Federal Reserve that has been buying large volumes of US Treasuries. But this is not a long-term risk worth taking.
Historically, it has taken countries many years of difficult fiscal-policy efforts to regain a triple-A status. And, while no one can be certain about where the limits lie, there are both theoretical and operational bounds to how many government bonds can (and should) be placed on the balance sheet of a modern, well-functioning central bank.
All of this suggests that, whether in the lame-duck congressional session following the elections or in the first few months of the new Congress, US politicians will likely dismantle the fiscal cliff. Based on an assessment of potential commonality among the political parties, such a compromise would limit the contractionary fiscal impact to some 1.5% of GDP.
Such a mini-bargain would go a long way toward reducing the risk of a serious US recession. But it would fall short of the type of fiscal reforms that would satisfy Moody’s. Such reforms require a grand bargain between America’s political parties, which in turn presupposes visionary leadership by both of them.

Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment company PIMCO, with approximately $1.8 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, and 2011. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by the Economist. 

October 2, 2012 6:41 pm
Is unlimited growth a thing of the past?
Ingram Pinn cartoon©Ingram Pinn

Might growth be ending? This is a heretical question. Yet an expert on productivity, Robert Gordon of Northwestern university, has raised it in a provocative paper. In this, he challenges the conventional view of economists that “economic growth ... will continue indefinitely.”

Yet unlimited growth is a heroic assumption. For most of history, next to no measurable growth in output per person occurred. What growth did occur came from rising population. Then, in the middle of the 18th century, something began to stir. Output per head in the world’s most productive economies – the UK until around 1900 and the US, thereafter began to accelerate. Growth in productivity reached a peak in the two and a half decades after World War II.

Thereafter growth decelerated again, despite an upward blip between 1996 and 2004. In 2011 – according to the Conference Board’s databaseUS output per hour was a third lower than it would have been if the 1950-72 trend had continued (see charts). Prof Gordon goes further. He argues that productivity growth might continue to decelerate over the next century, reaching negligible levels.

Click to enlarge
The future is unknowable. But the past is revealing. The core of Prof Gordon’s argument is that growth is driven by the discovery and subsequent exploitation of specific technologies and – above all – by “general purpose technologies”, which transform life in ways both deep and broad.

The implementation of a range of general purpose technologies discovered in the late 19th century drove the mid-20th century productivity explosion, Prof Gordon argues. These included electricity, the internal combustion engine, domestic running water and sewerage, communications (radio and telephone), chemicals and petroleum. These constitute “the second industrial revolution”. The first, between 1750 and 1830, started in the UK. That was the age of steam, which culminated with the railway. Today, we are living in a third, already some 50 years old: the age of information, whose leading technologies are the computer, the semiconductor and the internet.

Prof Gordon argues, to my mind persuasively, that in its impact on the economy and society, the second industrial revolution was far more profound than the first or the third. Motor power replaced animal power, across the board, removing animal waste from the roads and revolutionising speed.

Running water replaced the manual hauling of water and domestic waste. Oil and gas replaced the hauling of coal and wood. Electric lights replaced candles. Electric appliances revolutionised communications, entertainment and, above all, domestic labour. Society industrialised and urbanised.

Life expectancy soared. Prof Gordon notes that “little known is the fact that the annual rate of improvement in life expectancy in the first half of the 20th century was three times as fast as in the last half.” The second industrial revolution transformed far more than productivity. The lives of Americans, Europeans and, later on, Japanese, were changed utterly.

Many of these changes were one-offs. The speed of travel went from the horse to the jet plane.

Then, some fifty years ago, it stuck. Urbanisation is a one-off. So, too, is the collapse in child mortality and the tripling of life expectancy. So, too, is control over domestic temperatures. So, too, is liberation of women from domestic drudgery.

By such standards, today’s information age is full of sound and fury signifying little. Many of the labour-saving benefits of computers occurred decades ago. There was an upsurge in productivity growth in the 1990s. But the effect petered out.

In the 2000s, the impact of the information revolution has come largely via enthralling entertainment and communication devices. How important is this?

Prof Gordon proposes a thought-experiment. You may keep either the brilliant devices invented since 2002 or running water and inside lavatories. I will throw in Facebook. Does that make you change your mind? I thought not. I would not keep everything invented since 1970 if the alternative were losing running water.

What we are now living through is an intense, but narrow, set of innovations in one important area of technology. Does it matter?

Yes. We can, after all, see that a decade or two from now every human being will have access to all of the world’s information. But the view that overall innovation is now slower than a century ago is compelling.

What does this analysis tell us? First, the US remains the global productivity frontier. If the rate of advance of the frontier has slowed, catch-up should now be easier. Second, catch-up could still drive global growth at a high rate for a long time (resources permitting). After all, the average gross domestic product per head of developing countries is still only a seventh of that of the US (at purchasing power parity). Third, growth is not just a product of incentives. It depends even more on opportunities. Rapid increases in productivity at the frontier are possible only if the right innovations occur. Transport and energy technologies have barely changed in half a century. Lower taxes are not going to change this.

Prof Gordon notes further obstacles to rising standards of living for ordinary Americans. These include: the reversal of the demographic dividend that came from the baby boomers and movement of women into the labour force; the levelling-off of educational attainment; and obstacles to the living standards of the bottom 99 per cent. These hurdles include globalisation, rising resource costs and high fiscal deficits and private debts. In brief, he expects the rise in the real disposable incomes of those outside the elite to slow to a crawl. Indeed, it appears to have already done so. Similar developments are occurring in other high-income countries.

For almost two centuries, today’s high-income countries enjoyed waves of innovation that made them both far more prosperous than before and far more powerful than everybody else. This was the world of the American dream and American exceptionalism. Now innovation is slow and economic catch-up fast.

The elites of the high-income countries quite like this new world. The rest of their population like it vastly less. Get used to this. It will not change.

Copyright The Financial Times Limited 2012.

The Federal Reserve and the Currency Wars

Jose Antonio Ocampo

02 October 2012


NEW YORKThe United States Federal Reserve’s recent decision to launch a third round of “quantitative easing” has revived accusations by Brazil’s finance minister, Guido Mantega, that the US has unleashed a “currency war.” In emerging-market countries that are already struggling with the impact of rapid currency appreciation on their competitiveness, expansionary measures announced in recent weeks by the European Central Bank and the Bank of Japan have heightened the sense of alarm at the Fed’s decision.
My sense is that both sides are right. The Fed was right to adopt new expansionary monetary measures in the face of a weak US recovery. Furthermore, tying it to improvements in the labor market was a particularly important step one that other central banks, especially the ECB, should follow.
Of course, monetary expansion should be accompanied by a less contractionary fiscal stance in industrial countries. But the advanced economies’ room for fiscal maneuver is more limited than it was in 2007-2008, and America’s political gridlock has deepened, all but ruling out further stimulus through budgetary channels. Although the effectiveness of a new round of quantitative easing will be limited, as Mantega argues, the Fed had no choice but to act.
But Mantega is also right. Given the role of the US dollar as the dominant global currency, the Fed’s expansionary monetary policy generates significant externalities for the rest of the worldeffects that the Fed is certainly not taking into account. The basic problem is that there are essential imperfections in an international monetary system that is based on the use of a national currency as the world’s main reserve currency.
This problem was highlighted as far back as the 1960’s by the Belgian economist Robert Triffin, and, more recently, by the late Italian economist Tommaso Padoa-Schioppa. “The stability requirements of the system as a whole,” Padoa-Schioppa argued, “are inconsistent with the pursuit of economic and monetary policy forged solely on the basis of domestic rationales.”
In particular, expansionary monetary policies in the US (indeed, in all advanced countries) are generating high risks for emerging economies. Because interest rates must remain very low in developed countries at least for the next several years, there are now strong incentives to export capital to higher-yielding emerging economies. But such capital inflows threaten exchange-rate overvaluation, rising current-account deficits, and asset-price bubbles, all of which have in the past led to crises in these economies.
In short, the medium-term benefits that emerging economies could receive from faster growth in the US are now being swamped by short-term risks generated by the “capital tsunami,” as Brazilian President Dilma Rousseff has called it.
The basic problem is the lack of a broader agenda that would make the Fed’s position consistent with that of Mantega and other emerging-country officials. That agenda must include two issues of global monetary reform that remain unaddressed: coordinated global regulation of capital flows in the short term, and a long-term shift toward a new international monetary system based on a true global reserve currency (possibly based on the International Monetary Fund’s Special Drawing Rights).
The US could benefit from such policies, as capital-account regulation would force investors to find opportunities at home, while a true global reserve currency would free the US from concerns – and harsh rebukes – about the implications of its monetary policy on the global economy. At the same time, emerging markets would gain the full benefits of expansionary monetary policy in the US, to the extent that it boosts demand for their exports.
IMF Managing Director Christine Lagarde has called for coordinated action to sustain the global recovery. Moreover, in October, the IMF is set to release officialrules of the road” for the use of capital-account regulations. The IMF/World Bank meetings in Tokyo on October 12-13 thus might be the ideal opportunity to begin broadening the international monetary agenda – by giving the green light to coordinated regulation of cross-border capital flows, and launching a discussion about the future of the international monetary system.

José Antonio Ocampo, former United Nations Under-Secretary-General for Economic and Social Affairs and former Finance Minister of Colombia, is Professor and Member of the Committee on Global Thought at Columbia University.

Israel versus America versus Iran

Shlomo Ben-Ami

03 October 2012


TEL AVIVIsrael’s concern about the specter of a nuclear Iran has now degenerated into a crisis of confidence concerning the United States. Prime Minister Binyamin Netanyahu has embarked on a campaign to force President Barack Obama to set a red line that Iran must not cross, lest it risk unleashing an American military response. Implicit threats of a unilateral Israeli attack, together with conspicuous meddling in the US presidential election campaign, have compounded Netanyahu’s effort to twist Obama’s arm.
The controversy between the two allies partly reflects their divergent timelines: for Israel, the red line is Iran’s imminent burial deep underground of its uranium-enrichment facilities; for the US, it is the start of a dedicated weapons program. But, equally important, the dispute underscores their different objectives.
For Israel, war with Iran is not about neutralizing an existential threat; it is about reasserting its regional status. Israel’s leaders see their country’s standing in the region being seriously threatened by the emergence of a hostile Islamist regime in Egypt; the possibility that a similarly hostile regime will eventually emerge in Syria; the fragility of traditionally friendly Jordan; and the dangerous boost that the regional Islamist awakening has given to Israel’s sworn enemies, Hamas and Hezbollah.
Both Netanyahu and Defense Minister Ehud Barak thus regard an attack on Iran as a major strategic move aimed at the broader Middle East, which implies that they would not discount a military campaign that goes well beyond surgical air strikes. Indeed, they probably contemplate land incursions into Iran, and possibly a decisive – and, from their perspective, long overdueshowdown with Hamas in Gaza and Hezbollah in Lebanon.
Though determined to prevent a Iran from acquiring nuclear weapons, even if doing so requires military action, the US weighs the consequences of a military showdown in very different terms. A superpower that has earned only frustration in its abortive efforts – whether war or regional diplomacy – in the dysfunctional Middle East, the US faces the Iran crisis in the midst of its epochal strategic shift to Asia and the Pacific. The fallout from a war in Iran would pin down the US in the Middle East for years to come, undermining its new strategic priorities.
As a result, the US, though certainly better equipped than Israel for a war to ensure that Iran forever abandons its nuclear ambitions, could nonetheless conclude that that objective is simply too costly. The recent report by The Iran Project, whose signatories include the former US national security advisers Brent Scowcroft and Zbigniew Brzezinski, concluded that an American military attack on Iran could only delay its nuclear program for up to four years.
To guarantee that Iran never acquires a nuclear bomb, the US would need to maintain military pressure on Iran for several years. And, if forced to impose regime change as the ultimate solution to the dilemma, the report assumes that this would require military occupation, which would entail a commitment of resources and personnel greater than what the US invested in the Iraq and Afghanistan wars combined.
Moreover, the conventional assumption that the region’s Sunni Arab regimes would give tacit approval to a military attack on Iran’s nuclear installations must be revisited in the wake of the Arab Spring – particularly in the aftermath of the recent, sudden upsurge in anti-American violence throughout the Muslim world. The pre-Arab Spring paradigm that framed the Middle East as being divided between “moderates” and “extremists” has become obsolete.
The Islamist governments that have emerged from the downfall of America’s puppet regimes are no friends of an Iranian nuclear empire. But, in their struggle to survive, they must channel popular anti-Americanism. For Egyptian President Mohamed Morsi, that imperative meant placating the angry mob that recently attacked the US embassy rather than merely condemning the violence.
An attack on Iran, especially if it develops into a longer war involving regional proxies, is bound to become the trigger for mass anti-Israel and anti-US hysteria, which might draw the Islamist regimes in the region into a dynamic of escalation. It would be impossible to rule out a regional war.
The main problem facing a military operation in Iran is the need to ensure its legitimacy. China and Russia would never allow the US to secure a United Nations mandate for an attack. Moreover, while Iranian provocations that clearly reveal the regime’s intentions to develop a nuclear-weapons capability might help build support for American military action, it is far from certain that Europeans, or others, would rush to join another US-ledcoalition of the willing.” The dire legacy of Iraq and Afghanistan weighs heavily on the Western democracies.
The saddest part of the story is Israel’s utter indifference to the need to build international legitimacy for its drive to stop Iran’s nuclear program. Netanyahu thinks in bold military terms, not in terms of geopolitical strategy.

His careless Palestine policy has left Israel with few friends in the international community, let alone in the Arab Middle East. Indeed, many regard Netanyahu’s Iran obsession as nothing more than a successful ploy to divert attention from the Palestinian issue.
Only a generous, bold peace initiative that would genuinely revive the two-state solution, accompanied by a freeze on construction and enlargement of West Bank settlements, would help to recover the good will of the Palestinians and their brethren throughout the Arab world. And only that outcome can secure the international goodwill that both Israel and the US will need for a showdown with Iran.

Shlomo Ben-Ami, a former Israeli foreign minister and internal security minister, is Vice-President of the Toledo International Center for Peace. He is the author of Scars of War, Wounds of Peace: The Israeli-Arab Tragedy.

Copyright Project Syndicate -