Fischer, the Fed, and US Growth

Jeffrey Frankel

DEC 23, 2013

Newsart for Fischer, the Fed, and US Growth

CAMBRIDGE Now that Janet Yellen is to be Chair of the US Federal Reserve Board, attention has turned to the candidate to succeed her as Vice Chair. Stanley Fischer would be the perfect choice, given his unique combination of skills, qualities, and experience.

During his academic career, Fischer was one of the most accomplished scholars of monetary economics. He then served as Chief Economist of the World Bank, First Deputy Managing Director at the International Monetary Fund, and, most recently, as Governor of the Bank of Israel. He starred in each of these positions. Indeed, one has trouble thinking of another economist (at least since John Maynard Keynes) who has done as well as Fischer at combining analytical skill, sound policy judgment, clear expression, selfless dedication to improving the world, and the ability to get things done – with imperturbable good humor.

Moreover, Fischer gained extensive crisis-management experience during his tenure at the IMF in the 1990’s and as Israel’s central banker during the 2008-2009 global financial crisis. That makes him an ideal match for Yellen, who is also an unusually accomplished academic and policymaker, but who is at her best when she has had a chance to prepare meticulously.

Fischer’s qualities were acclaimed last month at the IMF’s Annual Research Conference by, among others, outgoing Fed Chairman Ben Bernanke, who in the 1970’s was one of Fischer’s many MIT doctoral students (as was I).

The same conference has been much discussed for another reason: Larry Summers, Paul Krugman, and Fed officials each advanced provocative theses concerning the slow pace of economic growth in the United States and other advanced economies in recent years. These theses will be important influences on the Fed in 2014 and beyond.

Summers’s controversial explanation for slow growth has received the most attention. The economic crisis, he argued, is not over until it is over, which it is not yet. He boldly suggested that the reason for sub-par growth over the last ten years is a fundamental structural change, identified as “secular stagnation”: the natural, or equilibrium, real (inflation-adjusted) interest rate may have fallen below zeroperhaps as low as negative 2-3% – “forever.”

There are, according to Summers, two possible reasons for this: a saving glut coming from Asia or a long-term IT-induced decline in the relative price of capital goods that has reduced needed investment relative to saving. (Krugman offers more possible explanations: declining rates of population or productivity growth.)

Whatever the cause, if Summers is right, we are in deep trouble. As it is, central banks can have difficulty attaining a sufficiently low real interest rate in recessions, because the nominal interest rate cannot go below zero. In Summers’s scenario, the negative equilibrium rate would mean chronically slow growth.

Fischer himself expressed greater optimism at the conference that monetary policy can work, even under current conditions. Quantitative easing and forward guidance can push down the long-term interest rate. And there are other channels besides the real interest rate: the exchange rate, equity prices, the real-estate market, and the credit channel.

Fed staff members are less prone than professors to go out on a paradigm-shaking limb. But David Wilcox, Director of Research and Statistics at the Fed, and his co-authors argue that the severity and duration of the downturn that began in December 2007 has been steadily eroding the capital stock and the size and skills of the labor force. Thus, slow US output and employment growth in the last few years is a result of the financial crisis, not of exogenous structural change.

Without customers, firms do not build new factories, even when the cost of capital is low, while workers who have been unemployed for a long time may drop out of the labor force altogether. The result, as Wilcox and his colleagues persuasively argue, is that productive capacity and the effective labor force have moved onto diminished growth paths. The cumulative supply shortfall – the authors estimate that potential output is now 7% below the pre-2007 trajectorymay be larger than the current output shortfall attributable to the ongoing lack of aggregate demand.

This unfortunate recent history makes the Fed’s job even harder than it has been, because it further limits policymakers’ ability to stimulate growth without causing inflation. At the same time, given the potential for long-lasting damage to growth, it has become even more important to maintain adequate demand stimulus so long as unemployment remains high. The Wilcox paper thus supports continued monetary ease in 2014.

Krugman’s presentation at the IMF conference was as surprising as the others: concerns about US fiscal deficits and debt are misplaced even in the longer term. Deficit hawks worry that at some point global investors will lose their enthusiasm for holding ever-greater amounts of US debt, resulting in a sharp depreciation of the dollar. Krugman’s controversial claim is that, even if this were to happen, interest rates would not rise, while the depreciation’s effect on the US economy would be expansionary (via an increase in net exports). The policy implication is that there is less reason to worry about the long-term debt problem and more reason to worry that fiscal contraction over the last three years has been depriving the economy of needed demand.

The policy failures have indeed been remarkable. Though prompt action halted the 2008 financial meltdown, and initial monetary and fiscal stimulus helped to end the recession itself in 2009, the recovery since then has been painfully slow, owing mainly to destructive fiscal policy: misguided drag in 2010-13; repeated self-inflicted crises in 2011-13; and no progress on the genuine longer-term fiscal problem. Together, these fiscal failures have probably subtracted more than a percentage point from US growth in each of the last three years.

But there are grounds for optimism in 2014. For the first time in four years, fiscal policy probably will not have a negative effect on growth. True, it would be better if fiscal policy could make a positive contribution. But ending the negative contributions is cause for celebration.
Meanwhile, monetary policy will be in good hands, especially if Fischer joins the team.

Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

Rescuing Europe from the Ground Up

Hans-Werner Sinn

DEC 21, 2013

Newsart for Rescuing Europe from the Ground Up

MUNICHThe European Union has earned its place as an instrument for peace in Europe. Free trade has brought prosperity to its peoples, and the freedom to choose a place of residence guards against the resurgence of totalitarian regimes. The Acquis Communautaire protects all member states’ citizens under the rule of law. Anyone who doubts the existence of these benefits need only look to Kyiv’sEuromaidan,” where hundreds of thousands of people have been gathered for weeks to demonstrate their support for closer ties with Europe, rather than an alliance with Vladimir Putin’s Russia.

The paradox is that the same enthusiasm and benefits do not apply when it comes to Europe’s common currency. On the contrary, the euro has plunged southern Europe and France into a deep economic crisis that is fraying the nerves of all involved. I have never seen so many swastikas and hateful slogans directed at Germany. The ex-head of the Eurogroup, Luxembourg’s longtime Prime Minister Jean-Claude Juncker, has said that 2013 makes him think of 1913, when no one could imagine what would happen a year later. That may be stretching things a bit, but a statement like this by such a distinguished politician is chilling.

Unfortunately, the crisis is far from over. While the insurance that the European Central Bank has offered, free of charge, to buyers of EU members’ government bonds has temporarily calmed financial markets, ordinary workers fretting about their jobs look to the future with trepidation. In Greece and Spain, half of all young people not studying are unemployed, as is a quarter of the adult workforce. Particularly worrying is the continuing rise in unemployment in France and Italy, where industrial production has been shrinking and price competitiveness continues to deteriorate.

The euro itself is responsible for this debacle. During the first several years after the EU’s Madrid Summit in 1995 officially launched the move toward a common currency, too much capital was steered into southern Europe, creating an inflationary credit bubble there. An inordinately lax regulatory environment proved lethal, encouraging northern European banks to pad their balance sheets with southern European government and bank bonds. When the bubble burst, it left in its wake woefully expensive economies that had lost their competitiveness.

Europe should now use the calm between the storm fronts to rethink the European currency union from the ground up. The effort to create a European equivalent of the dollar and impose a fiscal union on top of it, despite the absence of a common European state, is bound to fail. It will turn member countries into debtors and creditors to each other, stoking even more animosity.

The fundamental requirement for functioning monetary and fiscal unions in Europe is the establishment of a United States of Europe, with a real parliament that gives all citizens equal representation, together with a common legal system. Above all, the success of the European peace project requires a common army and a common foreign policythat is, a genuine, long-lasting mutual-insurance union based on reciprocity in ensuring security and stability. Those who try to anticipate such a common state with a fiscal union will never achieve their goal.

Because France is not yet willing to accept a common European state, we need an intermediate stage to preserve and stabilize the eurozone. This requires sorting out the current mess and introducing a flexible membership system based on hard budget constraints. Four measures are needed to achieve this.

First, a debt conference is needed, with creditors of the southern European governments and banks forgiving part of the debt. The creditors relinquishing part of their claims must include public entities, first and foremost the ECB, that have now largely replaced private lenders.

Second, eurozone members whose path to regaining competitiveness through price and wage reductions is too long and grueling, and whose societies risk being rent asunder by the necessary imposition of austerity, must temporarily exit the monetary union. The pain of exiting should be cushioned with communal financial help, which would not be necessary for long, because a devaluation of the new currency would quickly restore competitiveness. In fact, a “breathing eurozone” that permits – and regulates exit and re-accession should be clearly stipulated. Europe needs a system that is halfway between the dollar and a fixed-exchange-rate system like Bretton Woods.

Third, this breathing currency union must include hard budget constraints on its members’ national central banks. Specifically, a ceiling must be set on local money creation by establishing the obligation to settle balance-of-payments imbalances with gold or other comparably safe means of payment.

Finally, bankruptcy regulation for countries is essential in order to make it clear to investors from the outset that they are taking on risk. This is the only way to avoid the destabilizing credit flows that drove southern Europe to ruin.

If we are serious about deepening European integration, we must recognize that there is no credible alternative to reforming the euro from the ground up. Otherwise, Europe’s admirers and aspirants, like those in Ukraine, will eventually look elsewhere.

Hans-Werner Sinn, Professor of Economics at the University of Munich, is President of the Ifo Institute for Economic Research and serves on the German economy ministry’s Advisory Council. He is the author of Can Germany be Saved?

December 22, 2013 6:36 pm

An exercise in prolonging a banking credit crunch

The lousy agreement on banking union will produce the financial sector equivalent of austerity

The agreement on a eurozone banking union is neither a glass half full, nor half empty. As many commentators are saying, last week’s deal is hideously complex, and a common resolution mechanism without a fiscal backstop for failed banks is pointless.

Those technical deficiencies apart, the agreement raises two broader, more important questions: why do countries keep on accepting such lousy deals in the first place? (Or to use a seasonal metaphor, why do turkeys keep on voting for Christmas?) And what are the long-term consequences of their actions?

To answer the first question, it is worth looking at how the debate evolved. Ahead of the negotiations several finance ministers called for a common fiscal backstop that could provide a credit line to the resolution fund. It was a reasonable request. Yet that is precisely what they did not get

All they got were some warm words from Germany that there would be further talks about a backstop within 10 years. Some of the finance ministers tried to put a brave face on this humiliating defeat, pretending that Wolfgang Schäuble, the German finance minister, had given ground on an important principle.

But that is not the case at all. The banking union that was agreed was the banking union Mr Schäuble always wanted. He does not want German taxpayers to pay for the restructuring of banks in other countries. And he does not want the European Commission, or anybody else, to close down a German bank. If ever there was a game, set, match victory in EU history, this was it.

So why did the others accept it? Recall the previous discussion on fiscal integration. These culminated in the fiscal compact, a vehicle to deliver permanent austerity by forcing countries to pay down their excessive debt for 20 years. The periphery countries accepted austerity but failed to secure Berlin’s commitment to debt mutualisation as a quid pro quo. Berlin got an all-for-nothing deal: more eurozone fiscal discipline, at no cost to Germany.

One explanation is that Mr Schäuble is a formidable lawyer and better prepared than his negotiating counterparts. The fundamental reason is that the periphery countries were never able or willing to form an effective coalition against Germany, let alone willing to make a credible threat that they would leave the eurozone without such guarantees. Perhaps they did not trust each other. I am convinced Germany would have budged on some of these issues if confronted with such an existential choice. But it never happened, and now probably never will.

When it became clear none of the periphery countries would risk such a confrontation, Germany’s position became unassailable. The periphery governments were happy to support whatever Berlin demanded as long as sovereign bond yields were not too high. Their crisis resolution policy consisted of keeping their heads down. And so they kept on voting in favour of successively lousy deals.

But that policy is very short-sighted, with severe economic consequences, which brings us to the second question. The fiscal compact and its predecessors brought austerity, which had a devastating and lasting impact on gross domestic product. This banking union will produce the financial sector equivalent of austerity – a secular credit crunch.

To see this, one needs to understand how banking union is going to work. The European Central Bank, in its role as supervisor, has started a comprehensive assessment of the banking sector. As part of this exercise, it assesses financial risks, takes an in-depth look at balance sheets, and subjects banks to stress tests. This exercise is going to end with a demand that some banks raise their capital.

But without a common fiscal backstop, it lacks credibility. The ECB will be in no position to demand that banks raise capital if there is no backstop. It would risk financial instability if it exposed a bank as undercapitalised that has no access to outside capital. The resolution fund will not be able to help because it will not be fully mutualised for a decade. At the start all risks will remain within the member states.

Unlike the Federal Deposit and Insurance Corporation of the US, the eurozone’s resolution fund will have no credit line.

The ECB thus has every incentive to fudge the exercise. This is possible because reviewing a bank balance sheet or a stress test is no exact science. The key variable is the assumption made about the future.

Unfortunately, a fudge does not change the dire economic reality. An exercise in ending the credit crunch in the banking sector will actually prolong it because the recapitalising banks in the periphery will be put on ice due to a lack of funds.

Economically, this is 1990s Japan all over again, probably worse given the periphery’s dire economic state. The banking system in the eurozone will not be able to supply the economy with sufficient credit, except in creditor countries. The economic consequences of what finance ministers hailed as a “historicdecision will be substantially negative.

The periphery finance ministers who accepted this deal know all this. They are not stupid. And still they are not acting in their best interest. If your policy consists of keeping your head down, then perhaps this is the banking union you deserve.

Copyright The Financial Times Limited 2013

martes, diciembre 24, 2013


Xi’s Recipe

Anne-Marie Slaughter

DEC 23, 2013

Newsart for Xi’s Recipe

WASHINGTON, DCChina’s government is cracking down hard on Western journalists, threatening not to renew visas for reporters from the New York Times and Bloomberg in retaliation for their reporting on the corruption of senior Chinese officials. Times columnist Thomas Friedman recently penned an open letter to the Chinese government telling them that, because the topcause of death of Chinese regimes in history is greed and corruption,” a free press is more likely to help than hurt.

Anyone who holds freedom of the press and freedom of expression to be universal human rights will agree with Friedman’s position. But, in China, politicsincluding the politics of rights – is always intertwined with economics.

Last month, President Xi Jinping announced a set of sweeping economic reforms at the Central Committee’s Third Plenum, setting forth his vision of “the great rejuvenation of the Chinese nation.” His 60-point plan included reforms of fiscal policy and the financial sector that would set market interest rates on loans and deposits, permit some private-investor participation in state-owned enterprises, increase the role of small and medium-size enterprises, loosen labor restrictions, and introduce property taxes to boost revenue for local authorities.

This renewed embrace of the market, reminiscent of Deng Xiaoping’s original turn to capitalism in 1979, will be hard medicine for China’s entrenched business and government elites to swallow. If Xi’s administration is successful – a big if its reforms may enable China to negotiate the necessary transition from an economy driven by exports and government investment to a more sustainable growth model based on domestic consumption.

The stakes are high. A country that has lifted hundreds of millions of people out of poverty over the last two decades must now find a way to safeguard and gradually increase those gains while engineering the same miracle for the hundreds of millions still left behind. The world has a significant economic, political, and moral interest in the success of China’s reform agenda.

In this context, it is important to understand that Xi’s economic reforms are only one ingredient of a carefully crafted cocktail. The rest of the recipe includes two parts popular social reforms – an end to the one-child policy for many Chinese parents and the abolition of “reeducation through labor” – and one part political crackdown. Increased censorship and intimidation of foreign journalists, together with the imprisonment of dissidents and tighter restrictions on dissent, are an effort to ensure that economic disruption does not give rise to political rebellion.

To implement his ambitious reform agenda, Xi has taken several steps to consolidate his personal and bureaucratic power. He has reduced the membership of the Politburo from nine to seven, making it easier to obtain agreement in a system designed to institutionalize collective leadership. He has increased the power of the Central Committee, which he chairs. And he has created a new State Security Council.

To understand how the State Security Council could serve Xi’s interest in centralizing power, consider the United States. Without the National Security Council and the Domestic Policy Council, the US president would have no routine way to control and coordinate different bureaucracies. White House staff working for the National Security Council call meetings at which officials from the State Department, Defense Department, Treasury, Justice Department, and other key agencies hash out their views on a given policy. But it is the president’s staff who guide the outcome and determines the next steps.

Xi’s moves to strengthen his hand have helped to convince observers that he means business with the reform agenda. Since the Third Plenum ended and the scope of Xi’s reforms has become clear, many China watchers have hailed him as the most transformative leader since Deng. Time will tell, but a key difference between 2014 and 1979 is that today the Chinese cocktail is spiked with fear.

Evan Osnos, writing in The New Yorker, reports that two years ago, in the midst of the Arab uprisings, a senior official told a meeting in Beijing that if the Chinese governmentwaver[ed]” in the midst of social-media-fueled global dissidence, “the state could sink into the abyss.” Recently, Osnos writes, a high-level Chinese diplomat explained the threatened expulsion of New York Times and Bloomberg journalists on the grounds that “the Times and Bloomberg were seeking nothing short of removing the Communist Party from power, and that they must not be allowed to continue.”

That fear is one of the principal forces driving Xi’s reform agenda. The Communist Party must keep the Chinese economy growing (even if more slowly), while fighting rampant corruption and responding to citizens’ demands. Chinese citizens cannot vote, but they canand domake their displeasure known, which places a premium on what Chinese bureaucrats callstability maintenance.”

Will Dobson, author of The Dictator’s Learning Curve, describes the Chinese government as a technocracy whose legitimacy is founded on efficient problem-solving. When a regime’s legitimacy is derived from its performance,” he argues, “any crisis – and how the party responds to it – can raise existential questions about the regime’s right to rule.”

China’s leaders apparently worry that Western-style investigative journalism inside China could trigger just such a crisis. In any case, they are taking no chances. They are placing their faith in their ability to wash their own dirty laundry and drive economic, social, and political change from the top down. And they are less and less willing to play by Western rules.

Anne-Marie Slaughter, a former director of policy planning in the US State Department (2009-2011), is President and CEO of the New America Foundation and Professor Emerita of Politics and International Affairs at Princeton University. She is the author of The Idea That Is America: Keeping Faith with Our Values in a Dangerous World.