Why the supercommittee failed: The last best hope

With the deficit-reduction committee’s failure, American fiscal policy is drifting in a dangerous direction

[Greg Ip] Nov 26th 2011 | WASHINGTON, DC | from the print edition

THE failure by Congress’s joint select committee to produce a deficit plan was greeted with widespread disappointment, but little shock. Voters had long expected failure. Wall Street had predicted at best a small deal. Deprived of even that, stocks fell November 21st, the day the committee announced its failure, but soon turned their attention back to Europe.

Superficially the lack of alarm was understandable. The showdown between Republicans and President Barack Obama over the debt ceiling in August could have forced the federal government to renege immediately on its bills. In contrast, the law that established the “supercommittee” dictates that without a deficit plan, $1.2 trillion in spending cuts spread over domestic and defence programmes (a “sequester”) be triggered, but not until 2013.

However, the implications of the committee’s failure are more disturbing than the reaction of the markets has let on.

Two things to remember about Japan

Nov 14th 2011, 22:57 by G.I. | WASHINGTON

[Greg Ip] JAPANESE policymakers must watch Europe’s unfolding train wreck with mixed feelings. On the one hand, they take no joy in the economic and financial damage a vital trading partner is inflicting on itself. On the other hand, for a change they’re not the ones whose judgment is being dissected, debated and criticised.

That changes for one night, however. Tonight in my old stomping ground of Toronto, the following proposition will be debated: “Be it resolved that North America faces a Japan-style era of high unemployment and slow growth.” Paul Krugman and David Rosenberg take the “pro” side, while Larry Summers and Ian Bremmer represent the “con” side.

Japan has been studied so thoroughly that I may subtract rather than add value here. Nonetheless, there are two things I find get less attention than they deserve. They come in the form of a pop quiz:

1.     How much of the gap between Japanese and American economic performance since the mid-1990s can be explained by demographics?

2.     How much did fiscal tightening contribute to Japan’s steep recession of 1998?

The answer to (1) is “more than you think”, and the answer to (2) is “less than you think”. Okay, I don’t really know what you think. Still, when I learned the answers, I was surprised.

First, on demographics. Between 1994 and 2008 American GDP grew 3% a year while Japan’s grew 1.1%. That sounds dismal, but be sure you use the right benchmark. Japan’s potential growth slowed dramatically in the mid 1990s. As the chart at right illustrates, Japan’s working-age population at that time began a long decline, shrinking 0.4% per year over the period while America’s grew 1.2% according to the OECD. That 1.6 point differential can explain most of the difference in growth. Japanese productivity growth averaged a perfectly respectable 2.1% from 1994 to 2008, the same as America’s. At the time it was a disappointment because it was a sharp deceleration from prior decades. In retrospect, though, it may have been inevitable given that Japan had, technologically, almost caught up to America. (An overregulated and inefficient service sector made it difficult to close the remaining gap.)

It’s not about Berlusconi

Nov 11th 2011, 16:51 by G.I. | WASHINGTON

ASK any pundit why Italy is in crisis and they will mention some combination of Silvio Berlusconi, a towering national debt, and a moribund economy. The explanation resonates since all three have undeniably been enormous negatives for Italy. Today’s market action seems to vindicate the reasoning: with the prospect of a new government under Mario Monti and speedy implementation of a new budget, Italian bond yields have plummeted below 7%, and stocks around the world have rallied.

But these factors are not the root cause of the crisis and as long as Europeans behave as if they are, a resolution will elude them.

Italy has been burdened by Mr Berlusconi, a large national debt and a moribund economy for most of the past decade. As Daniel Gros points out, some of Italy’s key fundamentals—investment, R&D, educational attainment—have actually improved relative to Germany in that time. Yes, its debt remains a problem but, unlike Greece, it did not suddenly spiral out of control and was not, as far as we know, systematically underreported. As recently as 2009 Italy’s debt was 97% of GDP (it’s 100% now) and its deficit was 5% (compared to 4% this year, according to the IMF). Yet that year Italy could borrow at 4%, not much more than Germany, whereas now it must borrow at 6-7%, triple what Germany pays.

What changed is not Italy’s political or economic fundamentals but how investors perceive Italian debt.

Too big to fail: Fright simulator

How to deal with a collapsing bank under the Dodd-Frank rules

Nov 12th 2011 | NEW YORK | from the print edition

[Greg Ip] OF ALL the questions unleashed by the bankruptcy of MF Global, a broker, the most important is whether America is prepared to deal with a bigger collapse, on the scale of another Lehman Brothers. The Dodd-Frank reform law creates an alternative to letting a systemically important firm go bankrupt, known as “resolution”. But it also prohibits bail-outs: shareholders and creditors must bear losses.

The Economist simulated the failure of a global bank at its Buttonwood Gathering on October 27th in New York (a video can be seen here). Larry Summers, a former treasury secretary and once Barack Obama’s top economic adviser, was joined by five other ex-officials and a prominent bank lawyer to play the parts of officials at the Treasury, the White House and regulatory agencies on a Friday afternoon in April 2013. The group was confronted with a teetering, $1 trillion bank-holding company called New Jefferson. Without their intervention, it would not open on Monday, an event guaranteed to send markets into free fall.

Economics focus: Pulling for the home team

Central-bank lending to government serves a valuable, though risky, purpose

Nov 5th 2011 | from the print edition

[Greg Ip] IT CANNOT be pleasant to start a new job with a continent’s fate resting on your shoulders. On November 1st, Mario Draghi’s first day as president of the European Central Bank (ECB), peripheral-government bond yields shot up and stockmarkets sank on fears that Greeks might reject a rescue plan agreed days earlier. On November 3rd, as The Economist went to press, Mr Draghi was presiding over his first policy meeting. Much is riding on what the ECB decides then and in coming weeks because it alone currently has the means to stem the intensifying crisis. It has bought Greek, Portuguese and Irish debt; since early August, it has also purchased Spanish and Italian bonds. But its purchases have been intermittent and begrudging. Without a firm commitment to buy as much as needed to prevent yields on Italian and Spanish bonds rising so high that both countries become insolvent, investors have less incentive to return. The ECB’s reluctance to make such a commitment is understandable: its legal mandate and doctrinal persuasion bar it from directly supporting governments. Yet throughout history central banks have been lenders of last resort to their governments. In 1694 the English monarchy was broke and in need of a loan so that it could wage war with France. A group of financiers agreed to lend the crown £1.2m in return for a partial monopoly on the issue of currency. Thus was born the Bank of England.

Nominal GDP targeting will not provide a Volcker moment

Nov 1st 2011, 10:28 by G.I. | WASHINGTON

[Greg Ip] Early in his tenure as Fed chairman, Paul Volcker declared his intention to drive inflation lower. Soon after, he met with a group of businessmen. One told him, “’I listened carefully to you Mr Volcker, but I completed a wage agreement with my workers last week for 13% a year for each of the next 3 years. That’s what I think of prospects for inflation.’” Mr Volcker recalled the conversation last year, adding, “I always wondered what happened to that guy.”Mr Volcker’s anecdote exposes the flawed reasoning behind the newborn infatuation with nominal GDP targeting. Its advocates, which include my colleague, R.A. and Goldman Sachs, now include Christina Romer. In the New York Times she says just as Mr Volcker adopted money supply targeting to defeat inflation, Ben Bernanke should adopt NGDP targeting to restore full employment. She writes:

[Volcker] believed that by backing up his commitment to lower inflation with a new policy framework, he would break people’s inflationary expectations. So the Fed began to explicitly target the rate of money growth. Like the Volcker money target, [an NGDP target] would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth. Such expectations could increase spending and growth today

The problem with her argument is that as the story of the hapless businessman, and studies such as this one, illustrate, Mr Volcker’s policy did not succeed by changing people’s expectations of inflation. It succeeded by crushing demand.