Swiss Magic and Central Bank Price-Targeting

You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?

It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September -- most of which was after the announcement of the exchange rate minimum -- the SNB's foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB's foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB's purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.


But why would the SNB's promise of unlimited intervention in currency markets have led to a near total cessation of those interventions? Didn't they say they would intervene more, not less?

This is a beautiful demonstration of the almost magical power that central banks can sometimes have when they target prices instead of specifying a certain quantity of intervention. Market participants correctly believed that the SNB's promise to keep the CHF/EUR rate above 1.20 was perfectly credible. As such, no one was willing to try to accumulate CHF at a price inconsistent with that floor. In fact, there has been some sense in the market that this 1.20 rate was going to be increased, which would guarantee losses for anyone holding CHF assets. As a result, market demand for CHF has fallen dramatically and the exchange rate has drifted up above the 1.20 floor set by the SNB -- all with little or no actual intervention required by the central bank.


This should be a reminder to other central banks that when they target prices by promising unlimited intervention, the market will often do most of the work for them and respect that price target out of its own self-interest.

So let's apply this lesson to another situation: the doom loop that the market for Italian debt seems to have entered. Imagine that the ECB declared an interest rate ceiling and stated that it would not allow the rate on Italian bonds rise above some clearly specified spread over German interest rates. (Obviously this should be at an interest rate consistent with long-run Italian solvency.) And imagine that the ECB backed up that interest rate ceiling by promising unlimited intervention to support it. Since the ECB can make good on that promise by simply creating more euro -- which it can do in unlimited quantities -- market participants would understand that there is no way they could break the interest rate ceiling set by the ECB. And as a result, it is entirely possible that the ECB could achieve its price target on Italian debt with minimal intervention, just as the SNB achieved with its exchange rate floor.

What's preventing the ECB from doing that? Caution, conservatism, and politics, of course. But the Swiss Franc experience reminds us that, from an economic perspective, price targeting by a central bank can sometimes make very good sense.

Worrying Signs

I don't like seeing stories like this just a day after the eurozone's latest and greatest rescue plan was announced:

Italian borrowing costs surge in lacklustre auction

Italy issued 10-year debt on Friday but paid the highest price since joining the euro as investors demonstrated scepticism over the centre-right government’s economic reform programme in the first bond auction in the region since new steps were agreed to tackle the eurozone debt crisis.

...The yield on Italy’s March 2022 bond rose to 6.06 per cent from 5.86 per cent a month ago. The sale of the 10-year bonds was covered less than 1.3 times, but demand for the total sale of medium and long-term paper was sufficient for the Treasury to raise €7.94bn – at the top end of its target range. The yield on a three-year debt maturing in July 2014 rose to 4.93 per cent, at its highest since November 2000, compared to 4.68 per cent at an end-September sale.

“All in all, today’s auction was not very satisfying,” said Annalisa Piazza at Newedge Strategy. “Although the EU summit welcomed the new measures the Italian government is planning to implement in the next eight months to ‘change’ the economy, markets remain sceptical about the outcome.”

Officials recognise that yields at this level are unsustainable in the long term with Italy needing to roll over more than €250bn next year to finance its €1,900bn debt burden amounting to 120 per cent of gross domestic product...

Meanwhile, the ECB has apparently been forced to buy up more Italian debt on the secondary market since the new eurozone rescue plan was announced. But because of the ECB's obvious reluctance and the backwards way that they've structured their bond-buying program, such purchases probably have very little effect, other than to reinforce market skepticism about Italian debt.

I've argued repeatedly that the ECB can and should assume full responsibility for ending this crisis, and that it should be targeting interest rates on the secondary markets for Spanish and Italian debts. Paul De Grauwe articulates this reasoning perfectly in a column this week, and more generally expresses how painful it is to watch the ECB make mistake after mistake:

There is no sillier way to implement a bond purchase programme than the ECB way. By making it clear from the beginning that it does not trust its own programme, the ECB guaranteed its failure. By signalling that it distrusted the bonds it was buying, it also signalled to investors that they should distrust these too.

Surely once the ECB decided to buy government bonds, there was a better way to run the programme. The ECB should have announced that it was fully committed to using all its firepower to buy government bonds and that it would not allow the bond prices to drop below a given level. In doing so, it would create confidence. Investors know that the ECB has superior firepower, and when they get convinced that the ECB will not hesitate to use it, they will be holding on to their bonds. The beauty of this result is that the ECB won’t have to buy many bonds.

I am not impressed by the direction in which things have been heading in Europe this week. My sense is that, like me, many financial market participants have been suffering from so much 'crisis exhaustion' that they were willing to give this week's rescue package the benefit of the doubt and believe that it was in fact sufficient to permanently put things on a stable footing. Everyone wants this crisis to be over. But the inadequacies of the plan are real, and will only become more apparent over time. I hate to say it, but I fear that we haven't reached the final fix yet.

Liquidity, Solvency, and Competitiveness

Kantoos considers whether it is obvious that the eurozone debt crisis is, at least with respect to Spain and Italy, merely a liquidity crisis and not an issue of fundamental insolvency:

The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency – especially for countries as the future capacity to repay is not based on assets in a narrow sense but on the expectation of future economic growth.

...For Italy and Spain, there is a reasonable chance that it is in fact a self-fulfilling liquidity problem, but – and that was my main point – it is by no means certain. A backward-looking remark about Italy having a primary surplus is just not enough to make your case and Henry’s analysis is not encouraging.

A few points. First, take a look at the following chart that shows the debt/GDP ratios for a number of major European economies. See if you can tell which country is Spain. (All data is from Eurostat.)


If the markets believed that Spain (the blue line) is fundamentally insolvent -- or even at risk of becoming fundamentally insolvent in the foreseeable future -- then wouldn't such solvency concerns have also hit the debt of Germany, France, and the UK? (Those are the other three lines in the chart.) Given this, it seems overwhelmingly likely to me that the market's nervousness about Spanish debt is of the nature of a self-fulfilling "illiquid-but-solvent" crisis.

And what about Italy? Italy's debt/GDP ratio is indeed high -- over 100%. But that ratio has been over 100 percent for the past 20 years, so that's nothing new. And in recent years, Italy's budget deficit has been relatively small, as seen below.

Again, it seems far from obvious from this why market participants would have become worried about Italy's insolvency but not that of France or the UK.

There are two factors that Spain and Italy do have in common, however, that sharply distinguish them from France, Germany, and the UK. The first is that they do not have a central bank to provide unlimited liquidity to the government if necessary. The UK clearly does, by contrast, and I think most people would expect that the ECB would also perform that function for Germany if necessary. France is in a bit of a grey area there, which is exactly why the markets have inserted some additional risk premium into French government bond yields in recent months.

The second factor is the long run issue that Kantoos draws attention to: the competitiveness problem. The UK has no such problem, because its flexible exchange rate will automatically adjust its competitiveness to match the amount of financing it is able to attract; if investors become less willing to finance the UK's debt, the pound will lose value and the UK will start to gain competitiveness. Germany has no such problem, because it has undergone a steady improvement in its relative competitiveness ever since the adoption of the euro. And France is much closer to Germany than to Italy as far as competitiveness goes.

But where I would disagree with Kantoos is his assessment that Germany's improvement in competitiveness during the euro period was policy-driven, and that Italy and Spain's competitiveness problems are the result of their unwillingness to tackle the problem.

The changes in competitiveness in each of the eurozone countries during the years leading up to this crisis were driven by capital flows within the eurozone. Countries that received large capital inflows saw their prices rise in relative terms and their competitiveness worsen, which in turn helped to bring about the current account deficits that are the counterpart to those capital inflows. Conversely, countries that sent capital abroad saw their relative prices fall and competitiveness improve, for the same reason. Policy had little to do with competitiveness changes; they were a macroeconomic necessity entailed by the flow of capital from capital-rich countries like Germany to capital-poor countries like Spain.

The following table ranks the major eurozone countries in order of their current account balances between the adoption of the euro in 1999 and the onset of the financial crisis in 2008. Using total changes in the price level to provide a quick-and-dirty estimate of changes in competitiveness, it's clear that the relationship between the two is very strong -- countries that experienced capital inflows saw their price levels rise and their competitiveness worsen. The implication is that in the absence of policies to stem the inflow of capital, there was probably nothing they could have done to prevent that.


To summarize: Spain and Italy seem quite clearly to be the victims of a self-fulfilling illiquid-not-insolvent sort of crisis. They are in this situation because the markets have doubts about the willingness of a central bank to provide unlimited liquidity, unlike the case with Germany or the UK. And in addition they face a competitiveness gap with Germany that has arisen not out of any specific policies in Germany, Spain, or Italy, but that instead is the direct result of the massive capital flows from the northern eurozone to the southern eurozone that took place during the 2000s.

The eurozone therefore faces both a short run problem (the self-fulfilling liquidity crisis) and a long run problem (the competitiveness issue). There are fairly clear policy prescriptions for both. The primary question at this point is whether Europe's policy-makers will act on them.

The ECB: Unwilling Saviour

Joseph Cotterill at FT Alphaville reiterates an important theme today: the solution to the eurozone crisis really rests with the ECB.

The ECB is not here to save the world

...You might quibble with some parts of the plan [for much greater ECB support to eurozone sovereigns] but at least it is very clear about its starting point, the ECB. And of course many analysts have been calling for crisis solutions to move on from the EFSF’s finite balance sheet, to making use of the ECB’s omnipotent, effectively limitless balance sheet. Think of all the deep pockets of seigniorage, oodles of liquidity, et cetera. Only the ECB can absorb the quantum of sovereign losses, other analysts argue.

We definitely wouldn’t say this argument is wrong, or unworkable...

However... What we will say is that the ECB would never go along with it – based upon what the ECB has been doing so far.

...Frankly, at this point we’re open to theories on why the ECB has resisted the calls to provide sovereign liquidity.

The ECB is really the only institution that can establish a backstop in eurozone sovereign debt markets that is completely credible. This would be especially effective if the ECB targeted an interest rate for Spanish and Italian bonds rather than a quantity of intervention, as I've suggested previously.

But there's another reason that it would be appropriate for the ECB to be at the heart of the solution. In a recent paper (pdf) Paul DeGrauwe points out that an essential ingredient to the crisis is the fact that the adoption of the euro meant that sovereign nations in the eurozone could no longer borrow in their own currency. As he puts it, "in this sense member countries of a monetary union are downgraded to the status of emerging economies." The difficulty this creates is that since the central banks of these countries can no longer provide unlimited domestic currency liquidity to the government, default becomes a possibility in a way that it was not before euro adoption.

The solution to this flaw in the system is to have the new, joint central bank -- the ECB -- take up the role that individual central banks previously had of ensuring that their own government would never have to default on domestic currency debt simply due to liquidity problems. If the ECB were to assume that role today, default would be completely taken off the table as an option for investors to worry about in the markets for Spanish and Italian debt, which would guarantee that this crisis could no longer spin out of control as it is currently threatening to do.

Regardless of whether European leaders agree use the ECB as the immediate solution to the crisis, I would argue that if the eurozone is to survive in the long run, the ECB is going to have to be explicitly granted the authority -- and indeed the responsibility -- for doing just that. If they want to have a common currency and all of its benefits, the eurozone countries need to accept the drawbacks that come with it. And one of those drawbacks is that the ECB will have to not just be the guardian of the eurozone's inflation rate, but will also have to be an effective guardian of Europe's financial system, even at the potential cost of slightly higher inflation during certain limited episodes.

But as Cotterill points out, there is very little chance that the ECB will actually agree to take on this role. So do not expect this crisis to come to a neat conclusion this week.

Hoping that the Minimum is Enough in Europe

The headline of this New York Times story is somewhat at odds with the substance of what happened this weekend in Brussels regarding the eurozone debt crisis:

European Leaders Deal Directly With Debt Dilemma

BRUSSELS — With a new sense of urgency, the leaders of the 27 European Union nations grappled directly on Sunday with their thorniest financial and economic problems, and made progress that they promised could yield a complete package of measures within days.

The hope is that the seriousness of the leaders’ effort to finally solve the interrelated problems of Greek debt, weakened banks and a bailout fund in need of reinforcement will keep speculators at bay when the financial markets open on Monday morning. But now there is heavy pressure on the leaders to deliver the goods at their next meeting, set for Wednesday.

There are three reasons that I've gotten a slightly sinking feeling as I've been reading news reports about the progress that was made this weekend.

1. The EFSF. The heart of the matter to be decided is how to increase the resources available within the EFSF to support the sovereign debt markets for Spanish and Italian debt. That has always been the most difficult part of the puzzle to build, and based on reports from this weekend, we still seem to be no closer to knowing what approach they will agree on, or even if they will be able to agree in the first place. At least eurozone leaders did use impressively vigorous language to reiterate that they are indeed determined to reach an agreement. So that's something.

2. Bank recapitalization. Eurozone leaders have decided that EU banks will need a capital injection of €108bn:

Banks must find €108bn in new capital

Europe’s big banks will be forced to find €108bn of fresh capital over the next six to nine months under a deal to strengthen the banking system that is to be unveiled by European Union leaders.

This seems low to me. The IMF has estimated that the EU's banking system will take a hit of closer to €200bn as a result of the debt crisis, and I would have been somewhat relieved if the EU had agreed on a number closer to that. €108bn may be enough money, particularly if there's a robust and significantly large mechanism put in place to defend the Spanish and Italian sovereign debt markets, because in that case banks may actually realize relatively few losses on those bonds. But a larger bank recapitalization promise would have provided reassurance that eurozone policy-makers understand the scope of the problem and are willing to get ahead of it, rather than simply trying to fix things as cheaply as possible.

3. Common purpose. Or more accurately, the lack of it. Everything I've read about the forthright but also acrimonious debate this weekend suggests to me that European leaders continue to be focused primarily on making sure that their own country pays the smallest share of the costs possible. No one has stepped up as an advocate for the common project of the euro. No country has taken on the leadership role of being willing to accept a higher burden of the costs for the common good. And now it is clear that no one is going to. Without any sign that the eurozone's political leaders are going to change their mindset and think first about the collective good and second about their own country, I am left with the feeling that the delays and inadequate responses to the crisis will continue. With each country narrowly focused on its own parochial interests, a resolution to the crisis is still certainly possible; but the brinksmanship that it will involve will make it difficult for financial markets to feel soothed by the process.

A crisis of confidence such as this can be resolved when financial markets are persuaded that policy-makers will do absolutely everything necessary to ensure that worst-case scenarios never come to pass. Unfortunately, this weekend's Brussels summit provides us with more evidence that instead of being willing to do whatever is necessary to avert catastrophe, Europe's political leaders are going to continue to try to do the minimum possible to contain the crisis.

So now we wait for their next meeting on Wednesday. And hope that their estimate of the mimimum possible will be enough.

Greece at its Limit

It seems that the ECB's thirst for austerity-punishment for Greece has not yet been fully slaked. From the FT:

Troika warns time running out for Greece

Greece should get its next €8bn in international aid, but its economic outlook is deteriorating so rapidly that the second bail-out plan, agreed just three months ago, is no longer adequate to keep Athens afloat, international lenders have determined.

The findings are part of a highly anticipated report by the so-called troika of Greek lenders – the European Commission, International Monetary Fund, and European Central Bank – and sent to eurozone countries on Thursday morning. The Financial Times obtained a copy of the report.

...Part of the reason for the delay is a standoff between two of the members of the troika – the IMF and ECB – over whether Greece can keep paying its debts without taking more stringent austerity measures. The ECB has taken a tougher line, while the IMF has urged more leniency.

The Greek parliament just passed the previously agreed-to package of tax increases and spending cuts. But I am willing to bet that it is the very last round of austerity measures that Greece will be able to enact. Here are excerpts from Gavin Hewitt's gripping column from yesterday:

Athens erupts over austerity cuts

Athens was expecting violence. The expectation of it hung in the air. It is all people have spoken of in recent days. Even tourist hotels some distance from the parliament were boarding up. As a 48-hour general strike took hold shopkeepers were hammering in place steel shutters. The fear that emerged in hushed conversations was that there could be serious casualties. Such is the rage, the frustration that has built over months.

...I joined some students heading for the parliament. They are outraged that schools have a shortage of books. One young man said to me that he was not prepared to see decades of social progress sacrificed to satisfy the European Union and the IMF. Some waved banners with Che Guevara's picture. Then the column stopped, and from the left marched builders, arms linked, carrying poles with red flags on top. They walked with purpose. They have seen the construction industry collapse.

Then metal workers and teachers. It seemed at times as if the whole city was on the move. ...Marches and skirmishes soon became running battles across the capital But the numbers kept coming; great rivers of protesters.

...And with the marchers came young men and women in black hoods and masks. They began tearing at a wire fence that the police had slung across the road at the side of the parliament.

When eventually the police lost patience and fired the first tear gas grenade, the sound echoed across Syntagma Square and the crowd cheered.

There is a sense here that this is the key battle if spending cuts and wage increases are to be defeated.

Then skirmishes became running battles. Some of the anarchists had petrol bombs that snaked through the air falling around the riot police. They replied with volleys of tear gas and stun grenades.

...Europe's leaders had insisted that in exchange for bailing Greece out, it had to slash its deficit. The Greek foreign minister told me on Tuesday that no European country had ever tried such cuts in such a short space of time.

But seeing the vast numbers on the street, the government ministries occupied, the violence, it has to be asked whether Greece can impose these new austerity measures.

And if it can't, will the EU and IMF go ahead with the next tranche of bailout money. The so-called troika (the EU, IMF, the ECB) is delivering its report this week. Without the next 8bn euros ($11bn; £7bn) Greece will be unable to pay its bills within weeks.

But the mood has hardened here. There is less fear of default.

The finance minister said on Wednesday that "what the country is going through is really tragic".

Greece will continue to miss the deficit targets set by the troika. The ECB can continue to demand that Greece raise taxes and cut spending by even more, but further austerity-punishment will not help. At some point very soon Germany is going to have to make a simple decision: does it, for its own self-interest, come up with the money needed to fix this crisis, irrespective of what's happening in Greece; or does it say no, and elevate the crisis by an order of magnitude. I wish I had confidence in the answer.


UPDATE: Lifted from the comments:

petercorner: I can't help but notice the parallels between the Versailles treaty reparations, and what the [ECB] wants from Greece - to quote Keynes:
"The policy of reducing Germany to servitude for a generation, of degrading the lives of millions of human beings, and of depriving a whole nation of happiness should be abhorrent and detestable -- abhorrent and detestable, even if it were possible, even if it enriched ourselves, even if it did not sow the decay of the whole civilised life of Europe."

Where Exactly Are Those Lazy Southern Europeans, Anyway?

The northern eurozone countries are facing the prospect of coming up with massive amounts of additional funds to avert the collapse of Europe's financial sector. There have been some hints from various sources that a major and decisive agreement will be reached this weekend... though if the eurozone crisis has taught us anything, it is that one should never underestimate the power of European policy-makers to dither and delay beyond all reasonable expectations.

At any rate, lots of people (primarily but not exclusively in northern Europe) are very angry about the massive cost of fixing the eurozone mess. Understandably so. But unfortunately, much of that anger has been specifically directed at those lazy, shiftless, irresponsible southern Europeans that are seen to have gotten the eurozone into this mess to begin with. It's not difficult to find such finger-pointing expressed in the statements of prominent European officials, or in commentary on blogs and news sites.

I've repeatedly argued that I strongly disagree with this placement of blame; the eurozone crisis was fundamentally caused by the massive flow of capital from the north to the south of Europe that was bound to happen once the euro was adopted, and the specific behavior of individual governments in southern Europe had little to do with it. But I realize that this is a relatively abstract economic argument -- albeit one with substantial theoretical and empirical support. Stories of impersonal capital flows somehow don't address the gut feeling that lots of people have that southern Europeans really are less hard-working and responsible than northern Europeans, and that those laid-back southern attitudes must have caused the crisis.

I understand that gut feeling. That's part of what people like about southern Europe, after all -- things there do tend to move more slowly than in the north. But sometimes that gets confused with inefficiency and laziness, and turned into a moral judgment.

For some people, such judgments can be traced back to their own experiences... such as that day on vacation somewhere in southern Europe when they suffered through terrible service at a restaurant, got food poisoning, found that every pharmacy was closed for an extended lunch break in the middle of the afternoon, and then attempted navigate an incredible amount of paperwork and government bureaucracy to register a simple complaint. (No, I'm not speaking from personal experience at all. Why do you ask?)

In other cases the moral judgment of the south is probably more abstract and theoretical, and is simply following in the tradition of Weber's Protestant Ethic and the Spirit of Capitalism. Suspicion of the character of southern Europeans is not at all new.

But either way, being the economist that I am, I've been looking for some data to provide more insight into what lies behind this notion that southern Europeans are indeed a bunch of lazy free-loaders. Here's what I've found so far. Note that each table shows four northern eurozone countries and then four southern eurozone countries. Data is from the OECD.

Southern Europeans tend to work more hours each year than northern Europeans. But perhaps this is made up for in the north by greater participation in the labor force...

No, with the exception of Italy, it appears that the percentage of the population that is an active part of the labor force is generally similar to labor force participation rates in northern Europe. Germany appears to compensate for the few hours that its people work by having more people working in the first place.

So let's turn to the productivity of that labor. We know that labor in southern Europe has always been less productive than in northern Europe (for the past few centuries, anyway)... but have they been falling even further behind?

Labor productivity grew incredibly rapidly in Greece in the years leading up to the crisis. Even much-maligned Portugal enjoyed improvements in labor productivity roughly equal to northern Europe. Interestingly, it was Spain and Italy -- two southern European countries that did not run particularly large budget deficits (Spain even ran a budget surplus), and for which capital flows from northern Europe financed private investment rather than government spending -- that lagged in productivity growth. This again calls into question the common notion that large budget deficits in southern Europe are to blame for the crisis.

Now let's look at the social welfare system. In addition to being lazy, southern Europeans are accused of simply living off the state. So here's the amount of social welfare spending per capita:

Northern European countries give their people considerably more state assistance than do southern European countries. Greece and Portugal give by far the least, though we must recognize that incomes in those countries are much lower in general. But even Italy provides less social support to its citizens on a per capita basis than any of the northern European countries, and in 2007 Italy's per capita GDP was about the same as France's.

Just to be sure, though, let's take a look at a specific kind of public assistance expressed as a percentage of GDP: state pensions.

With this measure Italy does indeed appear to spend more on pensions than northern European countries. Of course, Italy also has one of the oldest populations in the world on average, which might explain that difference. Regardless, pensions in the rest of southern Europe are not particularly generous, even relative to income, when compared to northern Europe.

Putting it all together, it's hard to see much empirical support in this data for the notion that southern Europeans are a bunch of lazy free-loaders. That's not to say that there aren't obvious cases of gross inefficiencies in southern European countries -- of course there are. And there are probably other types of data that I haven't thought of that should be examined as well. Feel free to offer suggestions. I've focused on the types of data that, to me, most obviously and directly speak to the common criticisms of southern Europeans, but perhaps I've missed something.

Alternatively, maybe there really isn't a systematic difference in how hard-working, responsible, or self-reliant southern and northern Europeans are. After all, it is also possible to find plenty of examples of opaque government bureaucracies, entrenched unions, and extremely generous state assistance in the northern eurozone countries. So the next time someone asserts that southern European irresponsibility is what lead to this crisis, I would simply ask to see the data they have to support that claim.

China's Inflation Rates: Signs of Market Imperfections

Ryan Avent points out that if one uses a different measure of inflation in China to convert its nominal exchange rate into a real exchange rate, the Chinese yuan (CNY) has actually appreciated quite a bit in real terms in recent years. Using China's GDP deflator instead of the CPI, in fact, the CNY has appreciated in real terms by close to 50% since 2005. Using the CPI the other day I had calculated the real appreciation to be much smaller.

The larger figure obtained using the GPD deflator provides a reassuring confirmation of our priors, but it raises a very interesting question: why are the two measures of China's inflation rate so different? As seen in the chart to the right, the GDP deflator has been consistently rising much faster than the CPI in China. Why?

While there are many differences in how the two measures of inflation are calculated, the biggest and most relevant distinction in this case is that the CPI only measures the prices of things that consumers buy, while the GDP deflator also measures the prices of things that non-consumers -- i.e. businesses, the government, and the foreign sector -- buy.

Let's make the (reasonable, I hope) assumption that consumers buy more services than goods, while non-consumers buy far more goods than services. Combining this assumption with the distinction noted above tells us that the prices of tradable goods have been rising much faster than the prices of locally-provided services in China. And this has three important implications.

1. Manufacturing wage growth in China outpaces productivity growth.
For simplicity, let's think of China's economy as producing two types of goods: tradables (i.e. manufactured products) and non-tradables (i.e. services). We typically think of wages as being equal to the marginal revenue provided by labor, that is:

(1) w^t = p^t * MPL^t

where 'w' stands for wages, 'p' is the price level, 'MPL' stands for the marginal product of labor, and the 't' superscripts indicate that variables pertain to the 'tradable' sector of the economy. If w and MPL in the tradable sector both rise at the same rate, then p^t should remain constant. The fact that p^t has been rising indicates that wages are rising faster than productivity in this sector of the economy.

This in turn raises its own interesting question: why are wages rising faster than productivity in China's manufacturing sector? This apparently violates classical labor market assumptions. While I don't pretend to be an expert in China's labor market, I suspect that this is a form of catch-up. Prior to China's great economic growth of the past 15-20 years, wages in the manufacturing sector were far below what worker productivity would normally have warranted in the absence of market imperfections. (My guess is that this was due to the communist, command-economy system that dominated in China prior to the 1990s, which kept wages artificially depressed.) And what we've been seeing over the past 10-15 years is the process of that discrepancy being corrected.

This ties back to an argument I have previously made that the incredible movement of manufacturing to China that has happened over the past two decades was a once-in-a-lifetime event, in which multinational firms could essentially take advantage of an arbitrage opportunity in China that existed because labor in China was cheaper than its marginal product. That difference between wages and productivity in China is now rapidly being arbitraged away.

2. There is poor intersectoral labor mobility in China.
The fact that the prices of manufactured goods in China are rising faster than the prices of services also tells us that there must be poor labor mobility between China's manufacturing sector and its services sector. How can we infer that? Take a look at an equation similar to (1) above, but for the non-tradables sector of the economy:

(2) wⁿ = pⁿ * MPLⁿ

We know that pⁿ is rising more slowly than p^t. There's a mountain of empirical evidence that tells us that MPLⁿ almost always rises more slowly than MPL^t, i.e. that labor productivity grows faster in manufacturing than in services. Putting those together, it must be the case that wⁿ is growing more slowly -- much more slowly, in fact -- than w^t.

But if workers could move between the tradable and non-tradable sectors of the economy, they would equalize wages between them. So we can reasonably conclude that workers can NOT move between the two sectors of the economy. This corresponds with casual observation in China (manufacturing jobs are highly prized in China, but not available to everyone), but it is a sign of an important labor market imperfection that we must keep in mind.

3. The real appreciation of the CNY may be near an end.
We've now established that wages are growing faster than productivity in the manufacturing sector in China, and that workers can not easily move between the manufacturing and service sectors of China's economy. This has an important implication for China's real exchange rate.

Developing countries typically experience trend appreciations in their currencies as they become more developed. This is explained by what's widely referred to as the Harrod-Balassa-Samuelson (HBS) effect. The HBS effect can be summed up like this: relatively low productivity gains in the services sector compared to the manufacturing sector means that the relative price of services in the developing economy rises. This raises the overall price level in the developing economy relative to where it used to be (and relative to its trading partners), causing a real appreciation of the currency. The Economist article that Ryan refers to in yesterday's post cites the HBS effect as one reason why inflation in China has been and should be higher than inflation in other countries.

But inferences #1 and #2 above directly contradict the underpinnings of the HBS effect. Instead of experiencing faster inflation in the services sector as the HBS story predicts, China is experiencing faster inflation in the manufacturing sector. And instead of labor mobility equalizing wages between the two sectors of the economy, there are clearly barriers that prevent that in China.

This means that the HBS effect does not apply to China, and can not be expected to drive a continued real appreciation of the CNY. China's currency has indeed undergone a real appreciation in recent years, though as Ryan correctly pointed out, exactly how much depends greatly on which inflation measure you use. (Please see this paper by Menzie Chinn for an excellent primer on which inflation rate to use when calculating real exchange rates. In short: there's no single right answer.)

But the real appreciation of the CNY over the past several years seems to have been driven by the catch-up of manufacturing wages with manufacturing productivity. And that means that once that catch-up process is complete -- i.e. once the difference between labor's productivity and wages has been arbitraged away -- this mechanism for real appreciation will go away. Given the various distortions and imperfections in China's labor markets that this simple analysis can illuminate, I hesitate to have faith that market forces will solve the problems of China's massive imbalances, either internal or external.

Does the euro need Greece more than Greece needs the euro?

Gavin Hewitt puts it another way in his most recent column, but that's basically the question he's asking:

Eurozone debt crisis: Greece's wild card

When the G20 finance ministers gather in Paris they face a stark fact: that nearly a year and a half since Greece received its first bailout, the crisis remains unresolved. Europe's leaders will be asked yet again what they are going to do with Greece.

...But there is another factor in all this, a wild card: the Greek people. It is just possible that the Greek people will have their say, that they will simply refuse to go along with austerity plans demanded by outsiders, their creditors.

What happens if a people simply says "no"? What happens if, through many small and not-so-small actions, they sabotage the plan?

I think of it like this: Greece and the core eurozone countries (Germany, France, etc.) are in the process of trying to apportion the additional costs of fixing the crisis. Is local austerity ("punishment" is a more accurate term in my opinion) going to be the main mechanism to pay for the solution, or will the crisis mainly be solved through direct assistance from Germany and France? So far the costs of this crisis have been mainly borne by the Greeks through austerity-punishment, but there's a limit to how much of that can be imposed. To better understand who will pay the additional costs of resolving this crisis, it's helpful to think about the incentives each side has to voluntarily shoulder the burden.


Greece

Yes, of course Greece has some awfully compelling reasons to try to avoid a unilateral default on its debt, and to shoulder some of the cost of avoiding that outcome. If at some point Greece is forced into unilateral default, it will face the prospect of losing all further financial assistance from the rest of the EU, a run on domestic banks and complete shutdown of its financial system, an immediate inability for the Greek government to pay all of its bills (even excluding interest payments), and a wave of Greek corporate bankruptcies. As I've argued before, I think that this would very quickly lead to Greece issuing its own domestic currency (which would probably operate in parallel with the euro rather than replacing it). And that would lead to rapid inflation, depreciation, and a drop in Greece's purchasing power. In a nutshell, the outcome for Greece would be very bad. So Greece undeniably has a strong incentive to comply with Germany's demands for continued austerity-punishment.

But keep in mind that once the trauma of unilateral default and the introduction of a new local currency has faded a bit, Greece could be in a very good position to stage a strong economic recovery. Argentina has pointed the way as far as that goes. So while that prospect doesn't mean that unilateral default would be a good outcome for Greece, it does mean that it's a dark cloud with a silver lining, and therefore a slightly less-bad option than it would otherwise be.


The Eurozone

But the outcome for the rest of the eurozone countries could be equally devastating. The main problem they face is that markets are looking to Greece for information about what the core eurozone countries are willing to do to keep the eurozone together. If Greece is allowed to unilaterally default, the markets will have their worst fears confirmed -- that the core countries are willing to allow other eurozone countries default and effectively exit. European financial markets will immediately be devastated by contagion as a massive selloff in Spanish and Italian debt quickly pushes weak eurozone banks to the brink of collapse. The eurozone will face the prospect of having to come up with perhaps in excess of a trillion euro to support the Spanish and Italian government debt markets and to rescue the entire European banking system from collapse.

It is difficult to overstate the seriousness of the crisis that would hit European financial markets in the wake of a unilateral Greek default, I think. This gives France and Germany an enormous incentive to bail out Greece -- for their own pure self interest.

If on the other hand the core eurozone countries actually do come through with sufficient funds to finally resolve the Greece issue, then all of a sudden markets will have important evidence that the core countries are indeed determined to do whatever is necessary to keep the eurozone whole. Put simply: if Germany is willing to pay up to keep Greece in the system, then it's pretty likely that it will also do what is necessary to keep Spain and Italy in the system. Investors' fears are soothed, and contagion largely goes away.


When Greece Hits its Limit

Given this, I would actually argue that the eurozone needs a Greek rescue more than Greece does. At some point soon -- if it hasn't already -- Greece is going to reach its limit regarding the austerity-punishment it is willing to accept. The Greek government will continue to miss deficit reduction goals set by the ECB and Germany, and will be unable to raise additional taxes or cut government spending further without the Greek people triggering the government's complete collapse. And given that this crisis is largely the result of forces beyond Greece's control, I wouldn't really blame them.

When that happens, Germany and France are going to have to think very, very carefully about their response. The immediate reaction of a lot of people at that point will be to throw Greece to the wolves. But if more sober heads prevail, the sort of reasoning I've outlined here suggests that it will be in the eurozone's own interest to swallow its pride and hand over whatever amount of money it takes to keep Greece in the system.

Inflation and Real Exchange Rates in China

China's exchange rate policy has been in the news quite a bit recently, thanks to the US Senate's action this week to try to punish China for it. Putting aside the legal issues for a moment, it has been noted by various observers (e.g. Matt Yglesias) that the problem of China's undervalued exchange rate is at least partially resolving itself over time. This week's Economist picks up this theme:

And now, protectionism
America’s latest anti-China bill tackles a problem already being solved

...The problems this bill purports to address are already being resolved. The Economist has long argued that a flexible yuan is in the interests of both China and its trading partners. It would hasten the reorientation of China’s economy from exports to consumer spending, give its central bank more freedom to fight inflation, and divert demand to depressed Europe and America, catalysing an essential rebalancing of the global economy.

Belatedly, China recognises this. Since June last year the yuan has appreciated 7% against the dollar. The rise in China’s relative costs has been even greater given its higher inflation rate. With stimulative fiscal and monetary policy bolstering domestic demand, China’s current-account surplus has shrunk by two-thirds, from 10% of GDP in 2007. Meanwhile America’s trade deficit has narrowed, and manufacturing employment has stopped falling. All this means the yuan is far less undervalued than it was a few years ago—if at all.

If you had asked me yesterday how much the yuan (CNY) had appreciated against the dollar since China released the yuan from its long-standing peg of 8.28 CNY/USD back in 2005, I could have told you that the CNY is now about 20% stronger in nominal terms. But then I would have been quick to add that since inflation in China has been considerably higher than in the US, in real terms -- i.e., in terms of actual purchasing power once inflation is accounted for -- the CNY has probably appreciated by more like 30% to 40%.

It turns out I would have been pretty badly wrong. Last night I pulled data from Principal Global Indicators (an excellent multi-country data site, by the way) on actual inflation in China and the US over the past few years, and this is what the consumer price index looks like in each country (try to look past the terrible seasonal fluctuations in the Chinese data):


It turns out that, at least according to official statistics (and yes, we probably need to take them with a large grain of salt), consumer prices in China have risen only by a total of only 6.7% more than prices in the US since 2005. The inflation differential that had loomed large in my mind is not so great after all.

In addition to the possible unreliability of Chinese inflation statistics, there may be a second explanation for the fact that Chinese inflation has been less different from US inflation than I imagined: changes in consumer prices in both countries since 2005 have been largely driven by changing energy prices. So for example, the US CPI is currently up almost 4% over a year ago thanks to higher energy prices (excluding energy prices, US inflation remains very modest) -- and China has experienced a bulge in its own inflation rate at the same time, in part for exactly the same reason. Similarly, the collapse in energy prices in late 2008 and early 2009 caused inflation rates in both countries to plummet at the same time. In short, the role that energy costs play in consumer price inflation in both countries may explain why inflation rates in the US and China have tracked each other surprisingly closely in recent years, as shown below.


The result is that when the consumer price index is used to measure inflation differentials between China and the US (and yes, I know that the CPI is not the ideal inflation measure to use for that, but Chinese inflation data is woefully limited, and as economists we're forced to look where there's light), the Chinese currency's real exchange rate has only appreciated a little bit more than the nominal exchange rate. The final picture below shows both series, setting January 2007 = 100.


So clearly my guess that China's currency has appreciated against the dollar in real terms by 30% to 40% would have been pretty far off. The real answer is that the real appreciation of the yuan is only a few percent more than the nominal appreciation. Put another way, almost all of the movement in China's real exchange rate has been due to movements in the nominal exchange rate.

So if you're looking for China's undervalued yuan to correct itself over time, you can't count on inflation differentials to do much of the work, at least based on the experience of the past few years. Any significant changes in China's real exchange rate are probably going to have to come from further changes in the nominal CNY/USD rate.

Europe's Farm Subsidies

It seems that the European Commission wants to change how its Common Agricultural Policy (CAP) is run. Or at least how it's marketed. From the BBC:

EU plans CAP reforms for 'greener' farm subsidies

The European Union has announced plans to reform its Common Agricultural Policy - its most expensive scheme, and one of the most controversial. The CAP cost 58bn euros (£51bn; $80bn) last year - 47% of the whole EU budget.

The European Commission does not want to cut the budget, but change its priorities - including linking direct payments to environmental measures.

I find this fascinating, for a couple of reasons. First, amidst all of the current discussion about the merits of additional fiscal federalism in the EU -- i.e. whether increasing the independent taxation and spending power of the EU might be the best way to deal with the ongoing eurozone crisis -- this serves as an important reminder of the current state of affairs in that regard. The EU does have its own budget, and does get to spend money on EU-wide priorities. The problem is that its budget is very small: only about €140 billion in 2011 for the entire 500 million people in the EU -- roughly the same as government spending in Denmark alone (population 5 million). And of that tiny budget, almost half is devoted to agricultural subsidies.

Given such a small budget to begin with, it has always seemed very odd that so much of it is consumed by subsidies to farmers. And the EU is apparently a bit self-conscious about that fact: farm subsidies are described as spending for the "preservation and management of natural resources" in the EU's budget planning documents. (Note the reassuring green color on the pie chart.) And they rather defensively note in their FAQs that the share of the EU's budget that has been devoted to farm subsidies has been steadily falling.

Why have such large agricultural subsidies, then? There are several possible explanations, but I think that there are two that are the most important. First, they served as an important lubricant in the political process of getting everyone on board with the EU project. As economists say, they were an important side-payment made from some members of the EU to others to faciliate other agreements.

Second, I think it's reasonable to believe that there's a genuine value placed by many Europeans and their governments on farming villages, lifestyles, and countrysides. In other words, I think that many non-farmers in Europe reap positive externalities from the existence of their farming communities. So for better or worse, they're willing to pay subsidies to maintain them.

But that doesn't mean that the EU can't try to do a better job of marketing them. And I think that's what's going on here; the EU realizes that if it more explicitly ties these farm subsidies to environmental protection, they will be more defensible. And they're probably right. So whether you like this idea or not will probably depend largely on what you think "environmental protection" is really all about.

What Smaller Government Looks Like in the US

Last week's employment report in the US contained a familiar story: the private sector continues to add jobs, albeit at a modest pace, while government layoffs continue to undo a portion of those job gains. In the absence of the current mania to reduce the size of government, the US labor market would have gained closer to 2 million jobs instead of the roughly 1.5 million actually created over the past year.

But it's informative to take a look at exactly which sort of government jobs are being cut. The following table tells the story.


Over the past two years, government employment in the US at all levels (federal, state, and local) has fallen by a bit over half a million. Total federal employment has remained roughly constant (increased defense department jobs have made up for job losses elsewhere in the federal government), and employment by state governments has fallen by a bit. But local government employment has seen by far the largest change over the past two years, with local governments alone accounting for about 90% of all government job losses in the US. And of that, the majority of job losses are education jobs.

The US (along with many countries around the world right now) is currently going through a deeply unfortunate and harmful bout of fiscal contraction, right when it should be doing exactly the opposite. And by acheiving that fiscal contraction primarily by laying off teachers, it appears to have decided to do so on the backs of its schoolchildren.

Drawing the Line for Italy and Spain

Greg Ip at Free Exchange directs us to a very helpful graph (helpful to those who think about the world in terms of supply and demand curves, anyway) that illustrates how the current situation with eurozone debt can benefit from some non-traditional thinking.

The idea is that the fear currently endemic in eurozone sovereign debt markets means that investors look to the price of bonds for two very different pieces of information. First, as is always the case, the price of bonds tells investors what return they will earn from holding those bonds. So when the price of bonds falls, they look like a better deal and investors can expect to earn a correspondingly higher rate of return, which tends to make the demand for those bonds goes up. That's the normal, downward-sloping demand curve at the top of the graph.

But right now investors also extract a second piece of information from the price of those bonds: they see it as a signal about how worried the rest of the bond market is about the probability of default. So once the price gets too low, then even though investors know they will get a good rate of return, they also start to worry that they'll never get repaid, so a lower price can actually cause demand to fall. That's the backward bending part of the demand curve noted in the graph as the "zone of vulnerability". (There are other mechanisms at work to reinforce this negative feedback loop as well, but you get the idea.) The result is that once the price of bonds falls too far, this vicious cycle takes over until a new equilibrium is reached at a very, very low price - the "distressed" price.


This is a helpful way to look at what's happening in the eurozone bond markets right now, I think. (Note that while this illustration uses Italy as an example, the logic applies equally well to Spain, which is also fundamentally solvent.) But there's a very clear policy prescription that follows from this analysis, as noted by BCA Research: The ECB has the ability to influence which equilibrium the market settles on.

How can the ECB make sure that the "good" equilibrium is the one that actually pertains? They somehow need to change this picture so the price can never drop below a certain level -- the level I've added to the picture in red. If the ECB can credibly establish that red line and restrict the market to the upper portion of the graph, then the only possible equilibrium will be the good one. Interest rates stay low, panic is avoided, and minimal additional intervention is required.

So how can the area below the red line be rendered off-limits? There are a couple of ways. First, policy-makers could simply state, repeatedly and loudly, that there is absolutely no possibility of Italy defaulting. If market participants are convinced, then they will no longer look at the price of the bonds as providing information about the probability of default. That's basically the approach that has been followed by European policy-makers (both within and outside the ECB) to date.

If that doesn't work, though (and clearly it hasn't worked very well so far, as investors seem unimpressed by such statements), then more credible statements are needed. The simplest would be for the ECB to make a formal promise that it will simply never let the price fall below the red line. In other words, they could commit to always buying Italian bonds at a price equal to the red line.

Note that this would be very much like an exchange rate floor, in which a central bank states that it will not let a currency fall below a certain limit. That's exactly what the Swiss central bank promised last month with regard to the euro vis-à-vis the Swiss Franc, for example. Only in this case instead of making a commitment to buy currency at a certain price, the promise would be to buy bonds at a certain price.

For this to work, the ECB's promise would have to be credible, of course - investors would have to believe that the ECB will actually put its money where its mouth is. But if it is indeed credible, and if the red line (i.e. the bond price floor) is below the good equilibrium price, then it's very possible that the ECB would not actually have to buy many Italian bonds. The bond market would do most of the work for it, and keep the price of Italian bonds at the good equilibrium. It's a perfect example of how targeting a price can be a far more effective -- and less costly -- for a central bank than targeting a certain quantity of intervention.

Of course, it's unlikely that the ECB would ever follow this economic logic and actually commit to supporting such a bond price floor. The fear among European policy-makers would be that the ECB would have to buy an uncomfortably large amount of Spanish and Italian bonds before the market became convinced that the price floor was indeed binding.

But if the ECB were able to take a deep breath and take this step, it would almost certainly bring about a quick end to the contagion of the eurozone crisis to Italy and Spain. I think it's a good example of how bold and unconventional economic policy actions could go a long way toward resolving the crisis. And since actual policy responses to the eurozone crisis have been neither bold nor unconventional, it also illustrates why the crisis never seems to end.

Retaliating Against Currency Manipulation: A Primer

You've probably heard that this week the US Congress has been addressing the issue of how China controls its exchange rate with the US dollar. In particular, many have argued that China's policy of only allowing the yuan (CNY) to appreciate very gradually against the dollar has kept Chinese products unreasonably cheap to American consumers, and American products unreasonably expensive to Chinese consumers. (See for example Paul Krugman's column on Monday.)

So this week the US Senate voted to consider a bill that would impose tariffs on countries that are judged to have misaligned exchange rates. But China has reacted by very explicitly threatening to retaliate against the US. And now Boehner and other Republicans in Washington seem to be ready to stop this bill, so it's unclear to me whether it actually has a realistic chance of becoming law.

But this is an issue that is not going away any time soon, so it bears thinking about. In general I tend to focus much more on the economics than the legal aspects of international trade and financial issues, but in this case the legal implications could have some important economic effects that we need to consider.


The WTO

The first thing to recognize is that the WTO has a substantial amount of jurisdiction over the tariffs that the US can impose. Why is that? Think of the WTO as a club. Like all clubs, it has certain rules that members must adhere to, and in exchange the members get certain benefits. For the WTO, the primary benefit is that all other members of the club must be nice to you when it comes to trade, meaning that they can not arbitrarily impose tariffs on your products. On the flip side, the rules of the club (naturally) include a prohibition against arbitrarily imposing tariffs on your fellow club members.

So if the US unilaterally imposes tariffs on China, then the US may be breaking club rules. This would mean that the injured party (in this case China) would probably receive official WTO sanction to retaliate. And that is exactly what China has promised to do.

Such a 'trade war' (I've seen the term in the business press a lot this week) could possibly have some negative implications for the US economy. But it's hard to quantify how much China's retaliation would hurt the US, because I suspect that it would be much more informal than formal. For example, I would guess that China will start selecting Airbus over Boeing airplanes for a while. US multinationals could be shut out of lucrative joint ventures in China. And it wouldn't surprise me if China takes a bit of a breather on trying to enforce copyrights and patents owned by US companies. In addition, China might impose some tariffs on US products, but those would almost be secondary to the informal measures that China could take.

None of these steps would be disastrous to the US, but they might be enough to undo some of the benefit that the US could gain through a stronger CNY. Of course, the US could complain to the WTO about any informal retaliation -- the WTO would only sanction formal, tariff-based retaliation. But if the US has unilaterally imposed tariffs on China itself and been found to be in violation of WTO rules, it will not be in a particularly good position (legal or moral) to act as the injured party.


Options

Given this, what are the US's options for retaliating against China's weak-CNY policy?

1. Ignore the WTO. First of all, the US could simply go ahead and break the club's rules, allow the WTO to sanction retaliation by China, and take a chance that China either can't or won't punish the US severely enough to make a difference. There are plenty of cases where the WTO has determined that a member has violated the rules, sanctioned retaliation, and the violator has just ignored or put up with the consequences. It's arguably not very good for the health of the club, but it's an option.

Note that this is effectively what the legislation currently being considered by the US Congress would do - it would unilaterally impose tariffs on China without trying to get official WTO sanction. And while I'm not entirely clear on all of the reasons for Republican opposition to the bill, this does seem to be one of their concerns; Orrin Hatch has proposed an amendment that would have the US work with the WTO rather than take unilateral action. (Of course, this does then raise the question of why Republicans, who generally despise most international institutions, are more interested than Democrats in respecting them on this issue...)


2. Use the IMF. Another option would be for the US to try to get the IMF on its side. The IMF (another club, with different membership rules and benefits that relate to financial matters rather than tariffs and trade) has rules that specifically prohibit its members from manipulating currencies to gain unfair competitive advantage. And it doesn't hurt that voting shares in the IMF, unlike with the WTO, depend on how much money each country contributes. Needless to say, this means that the US has a lot more influence there.

The problem is that the IMF rules don't contain any enforcement or retaliation mechanism. So tariffs by the US would not be sanctioned by the IMF even if the US argues that China is breaking IMF rules.


3. Work the System. But what if the US can make the argument that China is actually the party that first violated WTO rules, so that the US's tariffs are actually a justified retaliation? Then the WTO would have to sanction the US's tariffs, and China would be breaking the club rules if it tried to retaliate. Everything would be flipped on its head.

As part of this strategy, the US could cite IMF rules, along with reference to an agreement that the IMF and WTO have signed in which they promised to help each other, respect each other, and coordinate as much as possible. With that legal foundation the US could, through the WTO's adjudication process, ask the WTO to sanction tariffs on China. If the US wins the adjudication then China must allow its currency to appreciate or face retaliatory US tariffs -- which China would then be disallowed from retaliating against. But if China wins the adjudication, then the US must go back to option #1. The primary disadvantage of this strategy, however, is that it's very, very slow; even if the process started today, it would probably take a year or more before a decision was made. That's a long time to wait if you think that this policy is important to helping the US out of its current economic slump.


What About the Economics?

I realize that I haven't yet provided any insight here into what I think should happen from an economic perspective. The short answer on that is that I do think that international clubs like the IMF and WTO serve very useful functions, and that the US generally should avoid undermining them whenever possible. It's really in the US's own long-term interest for those institutions to be robust and respected.

But the China issue is a real one. I'm doubtful that a stronger CNY would make a noticeable difference to the US economy over the next year or two -- I think the trade effects of exchange rate movements are simply too slow for that -- but there's pretty convincing evidence (see Menzie Chinn, for example) that it would slowly push things in the right direction. So while we shouldn't think that a different CNY/USD exchange rate would suddenly pull the US out of its economic slump, it might help a bit over time. And that's worth something.


Additional reading: if you're interested in more details regarding the legal options and implications of possible US retaliation against Chinese currency manipulation, you can't do better than this paper by Jonathan Sanford of the Congressional Research Service: "Currency Manipulation: The IMF and WTO".

Magical Thinking

This is what policy paralysis looks like. From the FT's ongoing coverage of the eurozone crisis:

8.40: Another day, another fudge. Or so cynics might think following the latest eurozone finance ministers’ decision on Greece. After meeting until late into the night, ministers from the 17-member common currency area agreed to – yup you guessed it – wait a bit longer before deciding what to do.

Sometimes bad policy-making takes the form of enacting bad policies. But sometimes it takes the form of doing nothing.

What do the EU's finance ministers think will be different one month from now? Do they expect that between now and then Greece will find a secret treasure chest that will enable the Greeks to miraculously reduce their budget deficit? Or that investors will just get bored of the whole eurozone debt crisis, go on a nice holiday for the rest of the year, and stop applying pressure to fix anything?

I realize that this will probably sound like a truly horrible insult (particularly to European policy-makers themselves) but I can't help but be reminded of the magical thinking that characterized so much of George W. Bush's policy-making, who regularly avoided making difficult policy choices due to the apparent belief that things would just get better on their own. It seems that many European policy-makers are hoping for such a similar magical resolution to the eurozone debt crisis.

Either that, or it's nothing more than simple procrastination.


UPDATE: Oops, I hadn't remembered that Paul Krugman had used the term magical thinking in the context of European policy-making more than a year ago. Sorry for missing the citation, Paul.

Macro 101 Validated Yet Again

I wish I could take more comfort in the fact that we are regularly provided with evidence that the macroeconomics of fiscal policy that we teach first-year university students is a pretty good guide to the real world. Here's the Macro 101 lesson:

Suppose we are in a country that is running a large budget deficit but, for whatever reason, decides that it needs to dramatically reduce it. Take your pick of examples, because there are plenty to choose from: Greece, the UK, the US...

Suppose that the country – let’s call it Austerityland – has a GDP of $100/year, and a budget deficit of $10/yr, or 10% of GDP. And suppose that the government decides it wants to get the deficit down to 5% of GDP. How can it get there?

No, the answer is not “cut spending by $5/yr”. Nor is it “raise taxes by $5/yr”. And last but not least, it is also not “enact a combination of tax increases and spending cuts that total $5/yr”. To see why, let’s do just a bit of arithmetic...

...[With a $5 cut in spending] the new deficit is now $6.875, which is 7.4% of the new level of GDP. Wait, I thought we were trying to get the deficit down to 5% of GDP? What happened?

What happened is that we’ve missed our target, by quite a bit, due to the multiplier effect and the fall in tax revenues that resulted from the shrinking economy. In fact, just a bit of simple algebra allows us to figure out that government spending in Austerityland will have to be cut by about $9 in order to reach a budget deficit target of 5% of GDP. In other words, the government will have to cut spending by almost twice as much as it initially thought it would in order to reach its deficit target.

(When that happens, by the way, GDP will fall from $100 to around $86. Yes, that’s a 14% drop in output. But hey, at least we’ve hit our deficit reduction target!)

And here's today's news out of Greece:

Greece to miss budget deficit targets in 2011 and 2012

Greece has said its budget deficit will be cut in 2011 and 2012 but will still miss targets set by the EU and IMF. The 2011 deficit is projected to be 8.5% of GDP, down from 10.5% in 2010 but short of the 7.6% target.

The government, which on Sunday adopted its 2012 draft budget, blamed the shortfall on deepening recession... It blamed an economic contraction this year of 5.5% - rather than May's 3.8% estimate - for the failure to meet deficit targets.