The Damage to the US Brand
By John Mauldin 
 Oct 20, 2013
There is no doubt that the image – what I will refer to in this letter as the "brand" – of the United States has been damaged in the past month. But what are the actual costs? And what does it matter to the average citizen? Can the US recover its tarnished image and go on about business as usual? Is the recent dysfunction in Washington DC now behind us, or is it destined to become part of a bleaker landscape? In this week's letter we try to answer those questions and more, as I step firmly into politically incorrect territory and offer a little advice to my junior senator from Texas. If nothing else, we will look at the problems we face in a different light.
An Exorbitant Privilege
The term exorbitant privilege refers to the alleged benefit the United States receives due to the US dollar's being the international reserve currency. The term was coined in the 1960s by Valéry Giscard d'Estaing (not Charles de Gaulle, as many think), then the French Minister of Finance, later President of France, and an early and major proponent of a United States of Europe. This was prior to the gold window's being shut by Nixon. Giscard saw the Bretton Woods monetary system not simply as a way to balance international payments but as something that was giving the United States a significant advantage in the world. He was right.
Under Bretton Woods, the US would never face a balance of payments crisis, because it purchased imports in its own currency. That exorbitant privilege could not redound to a country whose currency had only a regional reserve currency role, but in the postwar era the US dollar reigned supreme around the world.
Academically, the exorbitant privilege literature analyzes two empiric puzzles, the position and the income puzzle. The position puzzle consists of the difference between the (negative) U.S. net international investment position (NIIP) and the accumulated U.S. current account deficits, the former being much smaller than the latter. The income puzzle consists of the fact that despite a deeply negative NIIP, the U.S. income balance is positive, i.e. despite having much more liabilities than assets, earned income is higher than interest expenses. (Wikipedia)
What that means in practical terms is that the United States can purchase more with its currency than it produces and sells. In theory those accounts should balance. But the world's reserve currency, for all intent and purposes, becomes a product. The world needs dollars in order to conduct its trade. Today, if someone in Peru wants to buy something from Thailand, they first convert their local currency into US dollars and then purchase the product with those dollars. Those dollars eventually wind up at the Central Bank of Thailand, which includes them in its reserve balance. When someone in Thailand wants to purchase an imported product, their bank accesses those dollars, which may go anywhere in the world that will take the US dollar, which is to say pretty much anywhere.
Other currencies can also function as reserve currencies if there is sufficient trade between countries. The euro, the Canadian dollar, the Aussie dollar, and the yen are examples; but the US dollar is the 800-pound gorilla.
There have been other global reserve currencies. The British pound sterling served as a global currency prior to the ascendance of the dollar. In most ways, we in the US act as if our dollar will always be the world's reserve currency. History suggests, however, that reserve currencies come and go. The US dollar will remain the dominant reserve currency only as long as we respect the responsibility that comes with our exorbitant privilege.
That privilege allows US citizens to purchase goods and services at prices somewhat lower than those people in the rest of the world must pay. We can produce electronic fiat dollars, and the rest of the world accepts them because they need them to in order to trade with each other. And they do so because they trust the dollar more than they do any other currency that is readily available. You can take those dollars and come to the United States and purchase all manner of goods, including real estate and stocks. Just this week a Chinese company spent $600 million to buy a building in New York City. Such transactions happen all the time.
And there is one other item those dollars are used to pay for: US Treasury bonds. We buy oil and all manner of goods with our electronic dollars, and those dollars typically end up on the reserve balance sheets of other central banks, which buy our government bonds. It's hard to quantify the exact amount, but these transactions significantly lower the cost of borrowing for the US government. On a $16 trillion debt, every basis point (1/10 of 1%) means a saving of $16 billion annually. So 5 basis points would be $80 billion a year. There are credible estimates that the savings are well in excess of $100 billion a year. Thus, as the debt grows, the savings also grow! That also means the total debt compounds at a lower rate.
Just as an aside, $80-$100 billion a year will buy a lot of healthcare. Hold that thought as we continue to look at currency trading and reserve currency status.
A Friction-Free World?
Let's return to our example of trade between Peru and Thailand. There is presumably little reason for a furniture manufacturer in Thailand to take Peruvian money (which is called the nuevo sol). Let's assume this piece of furniture sells for 32,300 Thai baht or about $1000. So the buyer in Peru takes 2,764 nuevo sols, buys 1,000 US dollars, sends them to Thailand, and voila! his teak table comes in on the next boat.
Except that it isn't quite that simple, as anyone who has done a substantial foreign transaction knows. You have to go to your local bank, which probably goes to its correspondent intermediary bank, which in turn deals with a large international investment bank, which then sends the money on to an intermediary in Thailand and then to a local Thai bank. At every step along the way there is a "toll" charged. While much smaller than it was a few decades ago, those tolls – that "friction" – can add up to a sizable sum. Depending on whom you ask and what you count, the total amount of currency traded per day is as much as $4 trillion, and just a few "pips" taken out to grease the skids tally up to a rather tidy sum.
(For the curious, a "pip" stands for "percentage in point" and is the smallest increment of trade in foreign exchange [FX] currency trading. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore is priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is equal to 1/100th of 1%.)
Currently, there are only about seven currencies that are traded in serious amounts, although theoretically every currency is trading in some manner. When I was traveling around Africa, I would often come across a street in a city where currencies were being traded. The rates were much better than you could get at the local bank. Going with an "official" rate often means suffering a real loss in local buying power, and thus the spreads on some currencies are much wider than on others. No one wants to get stuck with an Argentine peso for very long outside of Argentina, and even inside Argentina the locals exchange money into pesos only when they need local currency. When I was last there, using a credit card cost anywhere between 10-15% more (if a local establishment took credit cards at all), because the store would have to cash in at the official rate rather than the street rate.
And while the "friction," or transaction cost, of trading a euro for a dollar and vice versa is a much smaller percentage, it is there. And thus the need for dollars to grease the wheels. To trade goods between Peru and Thailand, intermediaries usually have to find dollars.
But the key word in that sentence is usually. This week, London and Hong Kong agreed to begin trading in Chinese renminbi. The "extra" friction once incurred in converting to the US dollar will disappear, and the cost of doing direct transactions will fall. This absolutely makes sense for the two countries, and over time it will make sense on an ever-larger scale. Currencies are increasingly becoming mere electronic blips. For young traders, sitting at an FX desk is just another computer game, but if they are good at it, they get paid real money. Killing pips can be more profitable than killing zombies ever was.
The dollar is the world's reserve currency because it is a no-brainer trade. You don't have to think about your risk. If you take a ruble, you need to think about your risk and maybe buy some insurance. You ask yourself if you can trust Putin with your money. Even today, if you begin to stockpile renminbi, what can you do with them? You need to find something to import from China. There is risk to that trade. Not as large a risk as in the past, but more than if you deal in dollars.
Unless we damage our brand. Unless we start making that 27-year-old trader sitting at an investment bank in London think for a fraction of a second before he hits the button. He is in the business of killing pips, and if you increase his cost, even by 1/1000, the difference shows up in his bonus.
You scoff? Then why did credit default swaps on the US Treasury market rise over the last month? If you are buying US Treasury bonds, you are by definition seeking to avoid risk. You want zero risk, and last week the world markets decided – while watching CNN, CNBC, Bloomberg, and Al Jazeera, and reading the running commentary in the Wall Street Journal and the Financial Times, on Reuters, and in gods-know-how-many blogs – that there was indeed some small risk, and so they wanted to be paid more for holding Treasuries.
The world looked at the US, and unlike in the dozens of debt-ceiling games of chicken our politicians have played in the past, this time the fight at the edge of the cliff made the rest of the world nervous. In the past, you "knew" that the adults were playing a serious game over budgets, but there was always the sure sense that they would do the right thing and not risk the brand.
You can call it media spin or whatever you like, but this time there was a real sense that the adults had left the room. I totally understand why it happened, but the reaction from around the world was akin to watching your parents fighting and not being sure what would happen. I mean, you get used to your parents quarreling from time to time, but when they threaten to shut down the marriage and blow up the house, you might start to worry.
A Small Percentage of Americans
I read a note from my friend Barry Ritholtz about the recent events, which I found amusing in its viewpoint. I cut Barry a lot of slack, as he is one of only three or four Jacob Javits Republicans still in existence and should probably be preserved somewhere as a historical curiosity. (For those of a younger persuasion, or from outside the US, Jacob Javits, was a very liberal Republican Senator from New York. Yes, there was a day when the Republicans had a significant and decidedly liberal branch.) Barry wrote:
Amongst all of the background nonsense since October 1, the noise about the deficits was not really about budget deficits at all. Rather, it was about a decidedly narrow ideology held by a small percentage of Americans. Their belief is that government should be much smaller. This is a legitimate political ideology, one that has persisted over the centuries.
Actually, Barry, it is only a small percentage of the people on the island where you work (Manhattan). Out here in "flyover land," it can be a sizeable majority. And as Barry agreed in a conversation today, it really depends on how you frame the question.
If you asked people in 2008 whether they wanted access to more affordable healthcare, a majority said yes. A large majority also did not want to see their taxes raised. Sizeable majorities want smaller government and also want to preserve Social Security and receive more Medicare benefits. The fact that these desires are not consistent with one another is not a trivial issue. In fact, it is the source of our political divide.
The Republicans got into trouble when they made the recent debt-ceiling crisis about the trees rather than the forest. I would agree that Obamacare is a rather sizeable tree, but the forest is our unmanageable deficit and growing debt.
The questions the American people are ultimately going to have to answer are, "How much healthcare do we want, how much do we want to pay for it, and how will we pay for what we want?" Everything else in the national budget can be accommodated rather easily, as such things go, at least from a deficit perspective. Take a little here, give a little there. But with healthcare, there are no small gives and takes.
Barry cited a study by the IMF showing that we in the US pay lower taxes than people do in other OECD member countries. The study is both revealing and misleading. Here is the chart that suggests, according to Barry, that Americans are undertaxed:
The misleading part is that this chart does not include state and local taxes but rather focuses on top marginal federal income tax rates. But the top marginal rate in some states can be much higher, depending on local property taxes and whether there is a state (and even local!) income tax.
In general, the OECD countries have some form of universal healthcare. But most of them also assess a value-added tax, or VAT, which is basically a consumption tax. A VAT means that everyone pays a substantial tax on every purchased item. This is how these nations finance their large government budgets. Marginal rates in the US have been pushed about as high as they can be. The only remaining source of real revenue is the middle class, and raising taxes on them is a non-starter. The only other way to raise enough to pay for universal healthcare is with a VAT. But that approach brings on another whole set of problems, too many to get into today.
The Damage to the US Brand
Most everyone knows that the budget deficit cannot be sustained indefinitely. There must be significant entitlement cuts, significant tax increases, or some combination of the two. If we continue along the same path without some serious compromise, we will replay the debt-ceiling crisis again and again. It will not go away unless both sides are willing to compromise. Either that or the voters will have to make a firm decision one way or the other. Right now, the people we have elected to federal office do not appear to see compromise as their mandate. Until that dynamic changes, we are going to continue to put the brand of the US dollar at risk, something which must not be allowed. The cost in cold hard dollars of trashing that brand is a budget buster in and of itself.
The one thing the US dollar has going for it right now is that other candidates for the world's major reserve currency all have even more serious problems than the dollar does in the near term. Most are just too small. If Canada were about ten times bigger, its dollar would be formidable. The euro is still an experiment. If Marie le Pen is France's answer, someone is asking the wrong question. Ditto for many other countries in Europe. The jury is still out; that said, if the euro still exists in five years, it will begin to take on a much larger role.
But the idea of some basket of currencies appearing on computers as tradable reserve currencies is not out of the question, technologically. It would not be convenient, at least at first – but if the dollar loses its luster? When that buyer in Peru wants a table made in Thailand, he does not care how the transaction is facilitated. He has neuvo sols and wants a table. And foreign exchange traders exist to make a few pips by helping him make that happen. They really just want the easiest and safest way to trade. In our own self-interest, we do not need to make the world look beyond the dollar.
An Open Letter to My Senator, Ted Cruz
While it is difficult to hide the fact that I am a Texas Republican, I try to keep politics out of this letter except as politics affect economics and investment; and generally I think I succeed. At one point in my life I was heavily involved in Texas politics; but that was well over ten years ago, and I have no intention of ever getting more than casually involved again. But that doesn't mean I do not have an interest in what is happening on the state and federal levels. I have sat down with many politicians over the years, and I still do, though I meet with more Democrats these days than I did in the past, in my current role as economic commentator. Politics is where the realm of ideas is fleshed out into legislation that we all have to live with. More and more, I wonder what sort of world my adult children and their children will be left with. And while longtime readers know I am optimistic about the future, the paths to get us there are many and twisting.
So, for those who want to forego my thoughts on Republican Party inside politics, I suggest you move on now, as this is going to be one Texas Republican talking to another. And I get that I risk being seen by many as someone who is willing to use the word compromise. I recently had dinner with my friend Ron Paul, who for years gave no quarter in Congress. I get the value of staking your reputation on a set of principles. But I also think I see the nature of the task in front of us, as well as the political realities that will pull us down if we don't meet the challenges they pose. So, with that, let me offer some unsolicited advice to Ted.
Dear Senator Cruz,
Congratulations on getting through a rough primary and on to the Senate. Not that it makes much difference now, but I did support you in the primary, not for the reasons most people reading this letter might think, but because your opponent committed an unforgiveable sin while in office. He raised taxes in a particularly offensive way (the corporate gross receipts tax), which I regarded as a barely legal fiction to get around our state constitution. That is something I do not think should be encouraged in Texas politics.
I should note that I met your wife Heidi last week and got to spend some time with her. She is your best asset. If you ever decide to go back to private life, there is another Cruz I might vote for in Texas.
As you might guess from the lead-in to this letter, I am quite concerned that your latest effort to roll back Obamacare might not have been as benign as you thought for the long-term "brand" of the US. Hopefully, there will be no real long-term damage. Perhaps, when the dust settles, your misguided tactics will amount to no more than a political version of New Coke. When Coca-Cola rolled out New Coke, the market rejected it, and the company recovered and moved on. New Coke is now merely an interesting footnote in the business school curriculum.
But that brings up the question of what to do now. Let me offer a few thoughts. First, you are right to be concerned about the effects of Obamacare on the public, and you have correctly gauged public angst. I totally get the polls that say something like 60% would like to see the law repealed or significantly changed.
But we need to remember that a majority in the country also want some type of better healthcare system. They are not for a return to what we had back in 2008. There was a reason Obamacare passed, and there was a reason Obama was re-elected even though his healthcare law was unpopular. The simple fact is that a majority (even if a small one) of the country did not trust Romney to manage a new healthcare system. Yes, I know there were lots of other reasons, but that was clearly a leading one.
While you can likely get broad agreement that the country should balance its budget and that the debt is a growing concern, the manner in which you go about dealing with Obamacare is critical. All the country heard during this last debt-ceiling fight was that a sizeable number of Republicans wanted to defund Obamacare. While most people might agree that Obamacare needs to be fixed, simply going back to where we were is not what they want either. They may not know what they want, but 2008 is definitely not it.
President Obama is never going to agree to a dismantling of the Affordable Care Act. It is just not in his DNA. I am convinced he will walk away from any deal if that is the price. And you should be walking away, too. Here's why.
We can see how Obamacare is rolling out. It's a train wreck in the making. It doesn't matter whether Obama throws (Health and Human Services Secretary Kathleen) Sebelius under the bus, the structure is fatally flawed, at least from our perspective. The program amounts to a huge middle class tax increase, and when healthcare rates go up – and you and I believe they will – the tax will be even more onerous. Hospitals are going to see their budgets cut and will be forced to lay off personnel even as their workload increases. The vast majority of people are going to be shocked at how much healthcare will still cost with Obamacare.
There is going to be a real opportunity to fix the problems in the future. If we are right about what will happen, the demand for change will be overwhelming. Even the Dems will be scrambling to make major changes to the program. But right now, in the wake of the recent congressional debacle, I wonder whether the public would be willing to trust us to manage that change. It's very possible, even likely, that the Dems will run on a strategy of "the problem with Obamacare is that the Republicans won't let us fix things." I would, in their place. Right now, they still think that they just have a programming problem and that a few software patches will make everyone happy – but a year from now? It is going to be all about whom voters trust to fix the problems.
Healthcare is a very personal issue. It is probably the most contentious topic I run into when I am out on the road talking to people. There is a sizeable contingent of the country that agrees with you, but it is unlikely to ever be a majority. The majority wants healthcare to change, not simply revert, but not until they feel they can trust the agents of that change.
Right now, why not focus on the things you can get real agreement on? Reduce the deficit and make some entitlement reforms. If a chance for something like real tax reform offers itself, then take it. Forget the all-or-nothing strategy. It is all well and good to talk that way, but it is a terrible way to actually govern. Think back to Reagan and Tip O'Neil. Or Gingrich and Clinton. Few men could talk a better fight than those gentlemen did, but then they sat down together and talked and governed. And the country was better off for it.
Why not show that you can find solutions? Obama and Reid are going to need some help in the near future. Everyone knows there are some obvious fixes to the (so-called) Affordable Care Act that would make us all better off. So give them those fixes, and get some things we want in exchange. Show that you can govern. Show the country that you will do the right and necessary thing in the short term, even while keeping your eye on the long term.
If Obamacare becomes the political problem we both think it will, then we can get the votes to fix it, because the people will give us the votes if they think they can trust us to make the changes. If on the other hand Obamacare works well enough that a majority prefer it, then we will have to work on changing things gradually, as the Dems did for 50 years with regard to their desire for universal healthcare.
You are now the de facto leader of the Tea Party movement. The Republican Party needs those votes if they are going to promote change. But the Tea Party needs the rest of the Party's voters as well if they want to see change. You don’t want to chase the at-the-margin independent who normally leans Republican over to the other side by scaring them.We must create a strong coalition of people willing to work for change, or the Party will become a semi-permanent minority party that is unable to effect substantive change, however compelling its ideals. The GOP had been a minority in the House for 40 years when Gingrich was swept in on a wave of desire for change.
The big battle that will come later in this decade is not going to be over healthcare but over the debt and entitlements. If we don't deal with the deficit and run-away entitlement spending, we are going to be forced to make very unpleasant choices. We will face losing a great deal of what our forebears have bequeathed us in terms of our place in the world if we don't answer these big questions correctly. There will be no greater economic or political battle in our lifetimes. The challenge will require statesmen who are philosophically grounded and who understand the ramifications of the decisions that will be made. When that battle comes, we need to be a credible political force if we want to be able to determine the outcome and make sure the future is secure for our children and grandchildren. A minority party that knows it is right is still a minority party in a democracy.
The Dems are digging a very deep hole for themselves, but right now we're down in that hole with them: the approval rating of Congress is at an all-time low (which is really saying something), and the Republicans are taking the brunt of the public's displeasure. Only one party is going to climb out of the hole and fill it, and it will be the party the public thinks is credible and reasonable with its arguments and programs.
I want the winner of that battle to be the smaller-government team. So do you. But if we don't lay out a plan that can convincingly demonstrate how to fix the problems we face, then simply saying there is a problem won't be enough. We have to show that we can govern, and we have to demonstrate that we can keep our eyes on the whole forest rather than focusing solely on axing the ailing healthcare tree, if we don't have the votes to do it.
Yours for the long run, John
Code Red, Science Saves the Future, New York, Florida, Geneva, Saudi Arabia, and Canada
Next week I am off to NYC to do a week of media as we roll out my new book, Code Red. I will see my first copies when I get to the hotel on Monday, and it will be shipping to bookstores and Amazon during the week. I am truly excited about it, and the advance reviews are coming in even better than I expected. I always get nervous about these things.
I will be with Tom Keene Tuesday morning on his radio show and other outlets throughout the week, with more getting booked as I write. My co-author, Jonathan Tepper, and I will be speaking on Tuesday the 22nd for the World Policy Institute at 6 pm, in Manhattan, as part of their occasional World Economic Roundtable. There will be a wine reception. Space is limited, so if you wish to attend, please RSVP to Venue details will be included in your RSVP confirmation.
Then the next night, October 23rd, there will be a book-launch party from 5:30-7:30 at the Hyatt Union Square, 134 Fourth Ave., in The Fourth-Botequim restaurant. There will be light hors d'oeuvres and a cash bar. As one of my closest friends, you are of course invited.
Science Saves the Future – the "virtual conference" I recently hosted with my newest colleague,Transformational Technology Alert editor Patrick Cox – came together even better than I thought it would, and I had high hopes to begin with. If you watched the event, then you'll probably agree that while the ideas we discussed may seem shocking now, they're likely to be old hat in 15 or 20 years. What you witnessed during the event was akin to hearing Henry Ford lay out his vision for changing transportation before the first Model T rolled off the production line. Instead of transportation, though, the guests you heard were talking about the biggest potential transformation of all: life extension. Patrick did a wonderful job summing up all the arguments and explaining the opportunities in simple terms. And he has just released a report on three companies he thinks have the most near -term potential in this space. I urge you to read his report by clicking here.
I will be back in NYC on November 12 for a special event (details to come). I will then fly down to be with my good friend Cliff Draughn at Ponte Vedra, Florida (south of Jacksonville), on November 14. You can find out more by going to Cliff's website at And then it's back to NYC in early December and later that month to Geneva. In January I will visit sunny Saudi Arabia for the first time and am open to other speaking engagements in the region. I go from there to a speaking trip that will take me through three cities in Western Canada, where the weather will be quite the opposite.
Yesterday my doctor and good friend Mike Roizen was in town for a speaking event, and we got to spend some time together. I showed him my new apartment, which is under construction. They are putting in the floors, and admittedly there is a lot still to be done. When he asked when I would get to move in, I responded, "I am promised November 14." He laughed and said, "If you had told me December 14 I might have believed you, but I think November is a tad on the optimistic side." That has been the response of late, but if you can't trust your contractor's spreadsheet, what can you trust? You have to believe in the model, right? Don't tell my contractor, but just in case, I have not given up the lease on my temporary living quarters. I am sure that's an unnecessary precaution. Surely.
This has been a very difficult letter to write for some reason – perhaps because I think the issues are so very important – but now it's time to hit the send button. Have a great week.
Your nothing if not an optimist analyst,

domingo, octubre 20, 2013



Ted J. Kaptchuk, John M. Kelley

Inside the Placebo Effect

18 October 2013
BOSTON – For many medical researchers and followers of science, few things are more unsettling than the placebo effect. How can an inert sugar pill have therapeutic value?
The answer requires understanding the context that surrounds medical treatment – a setting in which the symbols and rituals of health care combine with the charged emotional reactions that arise when patients encounter healers. The importance of trust, empathy, hope, fear, trepidation, and uncertainty in the therapeutic encounter should not be disregarded.
By using sugar pills, saline injections, or even sham surgery, placebo research isolates provision of care from the direct effects of genuine medications or procedures. Recent research on the placebo effect has demonstrated that the clinical encounter alone – without the provision of any “real” medicine – can alleviate pain, improve sleep, relieve depression, and ameliorate the symptoms of a wide variety of conditions, including irritable bowel syndrome, asthma, Parkinson’s disease, heart ailments, and migraine.
Placebos mainly influence patient self-appraisal. They cannot shrink tumors; but they can help patients experience less of the fatigue, nausea, pain, and anxiety that are associated with cancer and its treatment. They cannot lower cholesterol or reduce high blood pressure, but they may alter mood or pain sufficiently to promote more healthful behaviors.
Placebos can behave like drugs; and the placebo effect can also make drugs more effective.
Research shows that various components of the placebo effect – for example, the paraphernalia of care (pills and syringes) and the patient-provider relationship – can be added incrementally in a manner analogous to dose dependence (the higher the dose, the greater the effect).
Indeed, these components have been shown to boost the efficacy of many powerful medications.
For example, when morphine is administered by injection in full view of the patient, it is significantly stronger than when it is given through an intravenous line without the patient’s knowledge.
Many psychosocial mechanisms have been implicated in placebo responses. Increased hope, positive expectations, and reduced anxiety can all modify “mindsets” that guide how patients respond to noxious sensations. Evidence strongly suggests that the support and empathy of a thoughtful and attentive physician can improve clinical outcomes. Indeed, it has been demonstrated that non-conscious environmental cues and symbols – the white coat or the diploma on the wall – can “prime” a patient to experience improvement.
Until recently, it was assumed that the effects of placebo pills depended on concealment or deception. The patient had to believe that the treatment was “real” for placebos to work. But new researchindicates the potential for significant clinical improvement even if patients are told that they are ingesting an inactive substance. This suggests that the simple enactment of a treatment ritual may, like conscious expectations, have a powerful impact.
In fact, the power of imagination, it seems, has a basis in neurobiology. Recent evidence shows that when placebos have salubrious effects, they engage the same neurological pathways as active medications. For example, when patients experience pain relief from placebos, the brain releases endogenous opioids and/or CB1 cannabinoids – the very same mechanisms that mediate pain relief derived from pharmaceutical treatments.
Likewise, neuroimaging studies show that placebo treatment activates specific brain structures such as the prefrontal cortex and the rostral anterior cingulate cortex. Experiments on patients with Parkinson’s disease have shown that placebo treatment releases endogenous dopamine in the striatum region of the brain. Moreover, intriguing pilot research suggests that there may be genetic factors that predispose one to have greater placebo responses.
The effects of placebos are not always beneficial. The placebo effect has a dark twin called the nocebo effect. Although placebos are biologically inert, as many as 26% of placebo-treated patients drop out of clinical trials after suffering intolerable side effects, which are usually the same as the possible side effects of the drug being tested. For example, in a trial of anti-migraine medication, if the active ingredient is an anticonvulsant, the nocebo effect (the placebo’s side effect) will disproportionally relate to anorexia or memory; but if the active ingredient is a non-steroidal anti-inflammatory drug, the nocebo effect will more likely be gastrointestinal symptoms and thirst.
This underscores the importance of placebo effects in the development of new drugs. To approve new pharmaceuticals, the US Food and Drug Administration requires two well-designed randomized controlled trials in which the drug demonstrates superiority over placebo treatment.
However, evidence suggests that for some illnesses, placebo effects have grown progressively larger over the last several decades. This “placebo drift” poses significant challenges to detecting drug-placebo differences.
And that highlights a more fundamental point: In our rush to embrace high-tech medicine, we tend to forget the enormous potential for healing that can arise from a good therapeutic relationship. Placebo research has demonstrated that the context within which treatment takes place and the patient-clinician relationship have huge potential to improve health outcomes.
We need to learn more about the placebo effect’s power and limitations. We also need to learn how to translate this scientific knowledge into ethical and effective methods that physicians can use to improve medical outcomes. And we need to know more about the placebo effect in clinical trials. In short, we need to stop thinking in terms of the “art of medicine” and start exploring a new science of healing.

October 20, 2013

American Debt, Chinese Anxiety

Madison, Wisconson — Last week, the United States once again walked up to the precipice of a debt default, and once again the world wonders why any country, much less the world’s largest economy, would endanger its financial reputation and thus its ability to borrow.
Though a potential global financial crisis was averted at the last minute, one notable development has been a string of warnings by Chinese officials. Prime Minister Li Keqiang told Secretary of State John Kerry that he was “highly concerned” about a possible default. Yi Gang, deputy governor of China’s central bank, warned that America “should have the wisdom to solve this problem as soon as possible.” An opinion essay in Xinhua, the state-run media agency, called “ for the befuddled world to start considering building a de-Americanized world.”
These statements, unusually blunt coming from the Chinese, show that repeated, avoidable crises threaten the privileged position of the U.S. as issuer of the world’s main reserve currency and (until now) risk-free debt.
It is unlikely that China would provoke a sudden, international financial calamity — for instance, by unloading U.S. Treasury securities and other government debt. Nonetheless, the process of repeated crises and temporary reprieves will only solidify the Chinese government’s determination to diversify its holdings away from dollar-denominated assets. Moreover, these crises provide ammunition to advocates within the Chinese government for expanding the role of the renminbi in international markets. Both of these trends will erode the ability of the United States to issue debt at super-low interest rates, and accelerate the ascent of China’s currency.
Foreign entities — governments, companies and individuals — hold nearly half of the publicly held debt owed by the United States. Of China’s $3.6 trillion in foreign exchange reserves, about 60 percent is estimated to be held in U.S. government securities.
As foreign exchange reserves have soared over the last decade, Chinese monetary authorities have attempted to diversify away from dollar-denominated assets, with limited success. The motivation for diversification is understandable: Since July 2005, the Chinese currency has been appreciating against the U.S. dollar, so that in terms of local purchasing power, dollar-denominated holdings have been losing value.
In addition, the fiscal battles in Washington have made the Chinese authorities more anxious. The overarching problem is that over the longer term, U.S. government finances are not sustainable, in the absence of enhanced tax revenues and restrained spending.
However, Chinese policy makers have fairly limited room for maneuver. First, they are locked into a development model that relies heavily on exports as a source of growth. It’s well recognized that adjustment to a new, more domestically oriented growth model is required. But that process will take a long time, and progress thus far has been halting. Hence, it’s likely that China will continue to accumulate large foreign exchange reserves.
Second, most of the earnings received by Chinese exporters are in dollars, so that currency is what the People’s Bank of China accumulates. In principle, the dollars could be exchanged for other convertible currencies, like the euro or the Swiss franc. But any move to sell dollars in large-enough amounts to make a dent in dollar-denominated holdings would likely drive down the value of the dollar in such a way as to diminish the value of the securities held by the central bank.
Third, even if the Chinese could diversify their holdings away from dollars without realizing capital losses, the question would be — as always — what is the alternative? Government bonds issued by Germany, Switzerland and Britain are safe, but there just aren’t sufficiently large amounts of those securities available for purchase.
China can move away from the dollar in other ways — namely by way of its sovereign wealth fund, the China Investment Corporation (with over $500 billion under management). But again, the question is what can be purchased, and how much. Political resistance to Chinese acquisition of foreign-owned companies, particularly when issues of national security are at stake, have highlighted the dilemma.
Does that mean we Americans can rest easy? The answer is no.
To begin with, the fact that fiscal policy is partly in the hands of individuals who don’t believe that debt default is a serious issue understandably makes foreign investors uneasy. Within China, advocates of economic reform have a big argument for accelerating the policy shift that de-emphasizes exports and promotes domestic private consumption to shrink China’s trade surplus.
Moreover, China has been encouraging the invoicing of trade in renminbi, with some success (albeit starting from very low levels). In addition, China is loosening restrictions on renminbi-related financial transactions, with an eye to increasing the Chinese currency’s role in international finance. Eventually, this will mean a reduced demand for the dollar.
Over the longer term, both of these outcomes might be positive from China’s — and the world’s — perspective. However, if timed poorly, they would mean that demand for U.S. Treasury securities would decline at exactly the moment when interest rates on U.S. government debts rose. The resulting strain on government finances is not not be an outcome that patriotic Americans of any stripe should welcome.
Menzie D. Chinn, a professor of public affairs and economics at the University of Wisconsin, Madison, is the author, with Jeffry A. Frieden, of “Lost Decades: The Making of America’s Debt Crisis and the Long Recovery.”

The Nobel Laureates on equity bubbles

By Gavyn Davies

October 20, 2013 2:41 pm

It is also of relevance to the likely next Chair of the Fed, Janet Yellen, who will be closely examined about bubbles in her confirmation process. In the past, she has strongly argued that the Fed should not use standard monetary policy to deal with bubbles [1].
Many people have commented that two of the Nobel Laureates, Eugene Fama and Robert Shiller have polar opposite views about the theoretical possibility of bubbles [2]. Fed Governor Jeremy Stein said on Friday that this debate is “paradigm-versus-paradigm stuff”. One is right, the other is wrong, and the Fed needs to know which is which.
Professor Fama, the founder of efficient market theory, has said that he does not really understand what bubbles are, or how bubbles can exist, even after the implosion of the housing and credit markets in 2005-08 [3]. He is probably being deliberately provocative about this, but it is important to understand what he means.
Fama acknowledges that economists have a widely-accepted definition of a “bubble”, which is that the asset price has deviated sharply from the level justified by fundamentals. For the equity market, the price justified by fundamentals is given by the expected future flow of dividend payments, discounted by the required future return on the asset. The required return is equal to the risk free rate, plus the equity risk premium. Obviously, an increase in the expected flow of dividends raises the equity price, while a rise in the required rate of return reduces it.
We know from the work of Robert Shiller that asset prices, notably equity and house prices, are far more volatile than can be explained by variations in the future flow of dividends and rents, or in the risk free rate. This is also accepted by the Chicago School, as explainedhere by John Cochrane, Fama’s son-in-law and also his intellectual heir. This means, by process of elimination, that the large variations in asset prices, which might be called bubbles, stem from changes in the equity risk premium, or in a residual factor which is not identified. This is where the difference between Fama and Shiller arises.
Fama basically thinks that most of the variation in asset prices (almost by definition in his world) is determined by changes in risk appetite. When risk appetite is high, the future return required is low, so the equity risk premium is low. This means that the discount rate applied to future dividends will be low, and the equity market will be at a high level [4].
In Fama’s approach, the market almost always remains at equilibrium, given the risk appetite prevailing at any given time, even though the market level fluctuates much more than fundamentals like dividends would suggest. There is no irrationality involved in this, no opportunity to “beat the market” (except by accepting a different level of risk from the market as a whole), and therefore no case for the Fed to intervene to smooth a “bubble”.
Shiller’s approach is very different. He believes that it is implausible that the risk appetite in the financial markets changes in a manner which can explain the over-reaction of equities (and house prices) to the relevant economic fundamentals. (In fact, he was the first person to establish that prices behave like this, and the first to point out that this is a major problem for efficient markets.) In the absence of a plausible explanation based on risk appetite, he suggests that the explanation must lie in behavioural factors, including the possibility of irrational bubbles in the asset price.
John Cochrane says that empirical work has so far failed to determine conclusively whether Fama or Shiller is right. However, recent work has, in my opinion, been supportive of Shiller’s interpretation. It is certainly a strong positive that the medium term predictions for asset prices derived from his model have been successful (see Brad DeLong here). But the decisive factor is what actual investors say about their expectations of future returns at different points of the cycle in asset prices. Recall that, in the Fama explanation, investors are supposed to be pessimistic about future returns when prices are high, and optimistic when prices are low. Shiller, in contrast, expects investors to be bullish at the top of the market, and vice versa.
Most practising investors would have little doubt, based on experience, that Shiller’s view on this sounds a lot more plausible than Fama’s: when markets are near their peaks, investor opinion is often at its most bullish, because people tend to extrapolate the recent rise in prices into the future. At the bottom of the market, by contrast, gloom is all-pervasive.
And this is exactly what has been found in recent empirical work, notably by Robin Greenwood and Andrei Shleifer at Harvard. They show that a collection of different surveys of investor opinion strongly suggest that markets do indeed extrapolate the recent direction of asset prices when they form their expectations, which implies that they expect the highest future returns when prices are near their cyclical peaks.
In Fama’s world, this represents inefficient bubble-like behaviour, which should be eliminated by an influx of rational investors taking the opposite point of view. But in practice this does not seem to happen. Instead, investors behave in herd like fashion in the short term, driving asset prices higher and higher [5]. Only in the medium or long term do these anomalies correct themselves.
In Jeremy Stein’s battle of the paradigms, it therefore seems that the Fed should be paying more attention to the warnings of Shiller than to the reassurance of Fama. Bubbles can happen, but of course that does not automatically mean that we are in one now. Shiller’s market valuation measures for equities and housing are not yet abnormally high, and new econometric techniques for detecting bubbles (recent results from which will be outlined in a forthcoming blog) are mostly reassuring.
So the Fed should certainly be on the look-out for bubbles, but not necessarily taking action yet.
[1] In 2005, Ms Yellen, in an unfortunate quote, said:
First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, “no,” “no,” and “no.”
At the time, the San Francisco Fed was in the forefront of Fed research arguing that the control of bubbles should not be a matter for standard monetary policy. This has changed, as this excellent speech by San Francisco Fed Chairman John Williams demonstrates. (It also develops many of the points in this blog in greater depth.) It remains to be seen whether Ms Yellen has joined her former colleagues in changing her approach on this.
[2] The work of the third winner, Lars Peter Hansen, is summarised by John Cochrane here. For a more straightforward piece on the contribution of all three winners, see this accessible essay by Daniel Davies at Crooked Timber. See also Paul Krugman on why the prizes were merited, Tim Harford on why the efficient market theory merited the Nobel, Mark Thoma on why efficient markets theory is useful, and Mark’s compendium of other web entries on the Nobel this week.
[3] Fama, in reply to a question from John Cassidy, said: “I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
[4] John Williams neatly explains this as follows: “If rational investors discount future dividends by less, perhaps owing to a reduction in risk aversion, then the price-to-dividend ratio rises and we see a boom in the asset price. And the expected future rate of return on the now higher-priced asset will be correspondingly lower.”
[5] This does not mean that it is easy to make money in the short term by betting against the crowd, because it is hard to time the top and bottom of bubbles accurately. The weak or semi-strong form of Fama’s efficient market hypothesis (EMH), states that public information is fully reflected in asset prices. It can be true that it is difficult to beat markets in the short term, without believing that market prices are always economically optimal. Active investors attempt to find anomalies and exceptions to the EMH, or repackage risks differently from other investors.

The End of OPEC

Forty years after the Arab oil embargo, new technologies are dramatically reshaping the geopolitics of the Middle East.


Forty years have passed since the Arab oil embargo went into effect on Oct. 16, 1973, triggering a period of incredible change and turmoil. After the United States provided support to Israel during the Yom Kippur War, a cartel of developing-world countries (via the Organization of the Petroleum Exporting Countries, or OPEC) banned the sale of their oil to Israel's allies and thereby set in motion geopolitical circumstances that eventually allowed them to wrest control over global oil production and pricing from the giant international oil companies -- ushering in an era of significantly higher oil prices. The event was hailed at the time as the first major victory of "Third World" powers to bring the West to its knees. Designed in part to bring Arab populations their due after decades of colonialism, the embargo opened the floodgates for an unprecedented transfer of wealth out of America and Europe to the Middle East. Overnight, the largest segment of the global economy, the oil market, became politicized as never before in history.
But four decades later, the shoe may finally be on the other foot. Now, on the 40th anniversary of the 1973 embargo, the United States has a historic opportunity to lead a counterrevolution against the energy world created by OPEC as innovation in the U.S. energy industry looks poised to end the decades-long, precarious "dependence on foreign oil." Washington should seize the opportunity and push to democratize energy globally, just as its Silicon Valley giants have democratized information.
In the run-up to 1973, two-thirds of global ownership of oil moved from the private sector of American and European companies to public-sector national oil companies. Rather than let the forces of supply and demand determine prices, post-1973, the lowest-cost oil producers, such as Saudi Arabia, Iraq, and Iran, artificially shut production and discouraged capital investment, creating a lasting wedge of rents or financial profitability that market conditions never warranted. (Today, oil prices in real terms are more than four times higher than in 1972.) A massive industrial restructuring occurred over the course of a half-decade, as state-owned enterprises, with limited project-management skills and bloated workforces, surpassed the oil majors like Chevron and Shell in both capitalization and size.
The 1970s witnessed a profound and unprecedented transfer of wealth to the Middle East that continues to have significant repercussions today -- from democracy movements to terrorism to civil warsThe region's leaders failed to set up long-term mechanisms to distribute the benefits of that wealth transfer broadly to their populations and to establish an equitable stake in governance of resource proceeds that would have brought a newfound stability to the region. Instead, they bought lavishly, gilding their palaces and buying fleets of luxury autos. For decades, they squandered the opportunity to use oil wealth to modernize their societies and train their populations for future global economic competition. The result -- unfolding not just in the Middle East but in other oil-producing countries as well -- is a crisis of governance that is itself triggering a round of oil-supply disruptions.
Massive petrodollar inflows brought with them a new political paradigm of "rentier" patronage, characterized by financial excesses, corruption, repression, and billions of dollars in accumulated weapons purchases. Populations of oil-producing states, for the most part, are little better off today than in 1973. Many of the countries have been war-ravaged or riven by sectarian hatreds. And, even with decades of relatively high oil prices and associated worker remittances, most countries of the Middle East still see modest GDP per capita, below $30,000 person on a purchasing-power-parity basis.
Deep income inequality means that much of the region's population is in fact still living in poverty, even in places like Saudi Arabia. So it should be no surprise that 40 years after the 1973 embargo, citizens of the region are rising up against those who squandered their futures. Tired of waiting for the day when rising oil revenues would somehow magically bring back the promise of prosperity, youth are taking to the streetsport and oil workers are mounting strikes; and jihadists are taking up arms to end the oil curse once and for all. Their frustrations do not unfold in a vacuum. High oil prices associated with all this unrest is propelling energy investment elsewhere to great success. Energy efficiency is also getting a boost, shrinking the long-term market for Middle East oil. The upshot will be that it will be harder and harder over time for Arab rulers to count on oil money to keep them in power. And that has a trickle-down effect to the populations they've been keeping quiescent with handouts for decades.
Ironically, just when political revolutions were gaining momentum across the Middle East, a different kind of revolution was emerging that looks likely to bring a new epoch of dislocation and distortion to prevailing oil and gas structures. This second energy revolution is also ameliorating the impact of the first.
Since January 2011, at the dawn of the rebellions against dictatorial governments in North Africa, the amount of oil "offline" or being blocked from production by either domestic turmoil (in Iraq, Nigeria, Sudan, Syria, Yemen) or international sanctions (in Iran) has generally been above 2 million barrels per day (m b/d), four times the average level of supply outages before the so-called Arab Spring. Then Libya erupted once again this past summer, taking another 1.2 m b/d, or more, offline. But the impact of these disruptions has been relatively mild, given that over the same period, production in North America, the heartland of the three revolutionary changes in unconventional hydrocarbon production (shale, deep water, and oil sands), has grown by more than 2.5 m b/d. And more is on the way.
Growth in renewable energy has also been significant in recent years in the United States and beyond, and rising fossil fuel costs and strong government intervention have created new market opportunities. World biofuels production has doubled to over 1.2 m b/d since 2006, but wind power has grown in oil-equivalent terms from 1 m b/d to 2 m b/d since 2008 (and is accelerating at about a 20 percent annualized clip). Solar power, meanwhile, grew from 20,000 b/d of oil-equivalent energy in 2008 to 400,000 b/d last year.
But the impact of all this change in the energy world will go far beyond just replacing continuing Arab Spring outages. Unconventional oil and gas and the clean-tech booms are spawning a host of new, smaller oil and gas exploration companies committed to innovation and willing to take on risk. They have no stake in the multibillion-dollar megaproject world of the international majors and national oil companies, and as such, they have fewer concerns about sustaining high profits from giant assets found decades ago. They are enabling the United States the opportunity to take a lead in changing the way energy is bought and sold -- not just in the United States, but globally.
Energy innovation is taking many forms in the United States, creating major export opportunities and giving Washington the tools it needs to ensure that the conditions of a 1973-style oil embargo will not repeat themselves. The oil embargo was so devastating because strong economic growth throughout the 1960s had taken up the margin of spare oil-productive capacity in the United States and across the world, leaving the Middle East's oil producers with undue monopoly power. Similar razor-thin extra productive capacity left markets highly vulnerable in 2006 and 2007, when OPEC made contraseasonal cuts in output to increase prices, instead of considering the risks to global economic growth. But as oil and gas production from U.S. and Canadian shale formations rises, the ability of oil producers like Russia to use an "energy weapon" to gain extra benefits from consuming countries is diminishing.
U.S.-led innovation in alternative fuels (including natural gas-vehicle fueling technology and electric vehicles), energy-efficiency technologies, battery storage, and smart-grid solutions, working together with and complementing the supply surge in unconventional oil and gas, should also change the face of demand, giving consumers around the world more freedom of choice. And as the United States becomes an energy exporter -- at competitive prices -- that should seal the deal. By providing ready alternatives to politicized energy supplies, the United States can use its influence to democratize global energy markets, much the way smartphone and social media technologies have ended the lock on information and communications by repressive governments and large multinational or state-run corporations.
Abundant U.S. natural gas is just the first step. Booming domestic natural gas supplies have already displaced and defanged Russia's and Iran's grip on natural gas buyers. By significantly reducing American domestic requirements for imported liquefied natural gas (LNG), rising U.S. shale gas production has had the knock-on effect of increasing alternative LNG supplies to Europe, breaking down fixed pricing from entrenched monopolies. But this is just the beginning: Over the coming decade, the United States looks likely to overtake Russia and rival Qatar as a leading supplier of natural gas to international markets.
The geopolitical role of U.S. natural gas surpluses in constraining Russia's ability to use its energy as a wedge between the United States and its European and Asian allies should strengthen over time, to the extent that Barack Obama's administration stays the course with approving the construction of LNG export terminals. American unconventional oil and gas plays from Texas to Pennsylvania are also generating new surpluses of natural gas liquids, which are increasingly exported as transportation fuel or petrochemical feedstock to Europe, Asia, and elsewhere -- reducing demand growth for oil from the Middle East. And U.S. crude oil exports might also be possible some day, strengthening America's lead in market-related pricing for kingpin crude oil, much the way rising North Sea production did in the 1980s.
As an increasing number of companies and investors flock to North America to develop prolific unconventional resources, Middle East heavyweights like Saudi Arabia, Kuwait, and Iran are losing their lock on remaining exploitable reserves, reducing their ability to band together and create artificial shortages. Already, Mexico and Argentina are reading the tea leaves and reversing protectionist resource nationalism policies, instead pushing through reforms to attract capital investment to their doorsteps.
Abundant U.S. natural gas is also spawning new American-designed engine and modular fueling station technologies to readily use natural gas as a fuel in trucks, trains, and ships, ending oil's monopoly in transport. Some 40 m b/d of the global 85 m b/d oil market is open for competition from natural gas -- in the form of compressed natural gas for cars and buses, and LNG for heavy-duty vehicles and marine transportation. We conservatively expect at least 2 m b/d of currently projected oil demand to cede to natural gas by 2020, further weakening perspectives on future global oil-demand growth and once again chipping away at Middle Eastern influence.
American innovation and exports of energy supply and technology will open global energy markets to competitive investments and consumer choice. But Washington needs to embrace this choice by resisting the call to continue to ban energy exports to protect vested business interests or for resource nationalistic reasons. Indeed, we need to reverse the mindset of the oil embargo years -- a mindset of supply shortages and husbanding of resources -- and move back to a more traditional promotion of free markets. The energy sector has done this in the trade of petroleum products, where the United States is simultaneously the world's largest importer and exporter. The United States is heading in this same direction for trade in natural gas, whether by pipeline to Mexico and eastern Canada or the export of LNG. And it should move in the same direction with crude oil exports as pressures mount from growing surpluses midcontinent and on the U.S. Gulf Coast.
The expanding wind and solar businesses in California and Texas are encouraging new complementary battery-storage options and smarter networks, laying the groundwork for greater consumer choice and control. The move to distributed energy, right now focused mainly on affluent customers who can afford private backup generation, may spread to broader applications. Some day soon, it will enable increased remote energy solutions for villages in sub-Saharan Africa or Southeast Asia. 
The U.S. government needs to support the reform of the electricity utilities to enable this transition, which will entail more-efficient technologies, locally produced and distributed generation, time-of-day pricing and peak-demand shaving. Such reforms are critical to the integration of renewable energy whose output varies widely over the course of a day. By leading the charge to these new energy technologies, the United States can fashion a global energy world more to its liking, where petropowers can no longer hold car owners hostage or turn off the heat and lights to millions of consumers to further geopolitical ends.
Just as it was difficult to predict the impact of Apple computers on future global social trends, it may now seem hard to depict the exact time and place that America's unconventional resources and smart-grid innovation will democratize energy markets. But Apple did reset the way we think about computing and changed the world. Similarly, the dislocations currently unfolding in the energy sector are pointing to markets taking back pride of place over government control and consumer choice winning over supplier monopolies. The pace of change may be slow in coming at first, but eventually it will be no less stunning than Oct. 16, 1973, a day that sent shock waves into the global economy, the ripples of which are still visible today.

Amy Myers Jaffe is the executive director for energy and sustainability at University of California, Davis.

Ed Morse is global head of commodities research at Citigroup.