How a New Jobless Era Will Transform America

The above mentioned article appeared in The Atlantic issue of March 2010. I would like each of you to take the time (20-30 minutes) to read the 4 pages.

Remember that the reward is in the journey :-)

http://www.theatlantic.com/doc/201003/jobless-america-future

Federal Deficit and Carbon Taxex

Sovereign debt , as a potentially crippling fiscal problem world wide, has risen to the forefront over the past few months. Whether it is the US, Europe, Japan or many other developed and developing countries the sovereign debt watch is on.

The major metrics of a pending sovereign debt crisis that have been in vogue for decades used to be applied only to developing countries. Unfortunately this is no longer the case. The Herculian efforts by governments all over the world; the developed in particular; to avoid a repeat of the debilitating depression of the 1930's has forced these countries to increase substantially their fiscal stimulus programs. In a sense the monetary and fiscal policies adopted by the officials of all of these countries have been very successful. A worst case scenario has been avoided.

But as economics has always taught us, There Ain't No Such Thing AS A Free Lunch; TANSTAAFL. Yes we avoided a deep recession and the top officials can pat themselves on the back for this. But maybe not. Is the cure at least as expensive or maybe even more so than the ailment that it saved us from? That is , currently, the $64,000 question or maybe I should say the $64 billion question?:-)

Often, our efforts at prescribing remedies are counter productive because of what is inherent in problem solving. We always seem to target the symptom rather than the disease. As a result we inevitably move from one crisis to the next as a result of the law of unintended consequences.

In our efforts to save the system and to prevent a major economic depression we proceeded to throw money at the problem in order to generate more final demand and thus put more people to work. What we did not stop to consider is the major question of how are we going to pay back all of these funds that we have borrowed? It seems that we did what we always do, shift the burden onto the future generations. The debt will not come due for some decades ,right? Wrong.Well informed individuals know that more debt implies more taxes in the future and so they take corrective by refusing to own the highly risky debt. Once we find out that the debt service is too large and that we cannot keep on rolling the debt unto the future then we will have no choice but to become deadbeats. That is where we are at the moment. The question is which country is going to go under first? Would it be Greece or would it be one of the other PIIGS? How about the UK, or evn Japan or the US? If any of these countries default would they set up a contagion that will devastate all the current international financial sytem as we know it?

Believe it or not there is a potential mechanism that if adopted could go a long way towards addressing the real cause of this issue and not only the surface phenomenon. The solution that I am about to propose is not new, actually,N.G Mankiw wrote about it in 2007.

"The scientists tell us that world temperatures are rising because humans are emitting carbon into the atmosphere. Basic economics tells us that when you tax something, you normally get less of it. So if we want to reduce global emissions of carbon, we need a global carbon tax. ...

The idea of using taxes to fix problems, rather than merely raise government revenue, has a long history. The British economist Arthur Pigou advocated such corrective taxes to deal with pollution in the early 20th century. In his honor, economics textbooks now call them “Pigovian taxes.”...some taxes align private incentives with social costs and move us toward better outcomes."


I would love to see a carbon tax levied not only in the major industrial countries but all over the globe with all the proceeds dedicated to lowering the sovereign debt. Such a tax could be a first step towards internalizing the negative externalities of all the production inthe world economy. If that leads to less and more efficient production then all of us will be winners.

Bernanke : Exit Strategy

I am sure that all of you recall the discussion that we had a few weeks ago about the balance sheet of the Federal Reserve and the potential exit strategy that is likely to be employed.

Well, if ,for any reason,you failed to appreciate the importance of the issue or if the discussion was not clear then here is your second chance:-) Mr. Bernanke released today a 10 page paper in which he detailed what the Fed intends to do And the following is the NYT coverage. Please read.
***************************************************************************************

February 11, 2010
Bernanke’s How-To on Rate Increase Lacks a When
By SEWELL CHAN
WASHINGTON — “At some point.” “At the appropriate time.” “When the time comes.”
On Wednesday, the Federal Reserve’s chairman, Ben S. Bernanke, outlined a strategy – but not a timetable – for scaling back the extraordinary measures it began taking in 2007 to prop up the economy as financial markets teetered on collapse.
The Federal Reserve has eased borrowing by lowering short-term interest rates to nearly zero and built up a $2.2 trillion balance sheet by scooping up assets like mortgage-backed securities and even credit card and auto loans.
Eventually, to avoid inflation, both actions will have to be reined in. But Mr. Bernanke, in a 10-page statement, provided few hints as to how long that period will be.
“Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding,” he wrote. “We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively.”
However, Mr. Bernanke did provide new details a major concern: how, as the recovery proceeds, to gradually shrink the balance sheet, which along with a vast array of assets also includes $1.1 trillion that banks are holding with the Fed.
Mr. Bernanke suggested that a new policy tool – the interest rate on excess reserves, which the Fed began paying in October 2008 – would be a vital part of the Fed’s strategy.
Increasing that interest rate, he said, will have the effect of pushing up other short-term interest rates, including the benchmark fed funds rate – the rate at which banks lend to each overnight.
It is even possible, Mr. Bernanke said, that the Fed “could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities,” to communicate its policy stance to the markets. Since 1994, the fed funds rate has been the much-watched centerpiece of statements by the Federal Open Market Committee, the Fed’s key policy-making arm.
For days, economists have been trying to forecast what Mr. Bernanke would say about the sequence of steps and the combination of tools the Fed will use to tighten credit. On that subject, Mr. Bernanke offered only hints of his thinking.
“One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation,” he wrote. “As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves.”
But Mr. Bernanke suggested that “if economic and financial developments were to require a more rapid exit from the current highly accommodative policy” – that is, if fears emerge about inflation – the Fed “could increase the interest rate paid on reserves at about the same time it commences significant draining operations.”
Along with raising the interest rate on reserves, Mr. Bernanke discussed three other options for draining reserves. The first involves reverse repurchase agreements, in which the Fed would sell securities from its portfolio with an agreement to repurchase them at a later date.
The second involves term deposits – similar to certificates of deposit – to banks. That would convert part of the banks’ reserves into deposits that could not be used for short-term liquidity needs and would not be counted as reserves.
A third tool involves redeeming or selling securities. That strategy could carry risk, as the Fed’s large portfolio of mortgage-backed securities is helping to prop up the housing market and keep mortgage-interest rates low.
Mr. Bernanke did note that the balance sheet would shrink a bit on its own, over time, as assets like mortgage-backed securities and debt guaranteed by Fannie Mae and Freddie Mac are prepaid or mature. “In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities,” he wrote.
Mr. Bernanke also reviewed the controversial lending assistance it extended to “help avoid the disorderly failure” of Bear Stearns, which was sold to JPMorgan Chase, and the American International Group, which was bailed out by the government. Mr. Bernanke said that the credit extended under those arrangements totaled about $116 billion, or about 5 percent of the balance sheet.
“These loans were made with great reluctance under extreme conditions and in the absence of an appropriate alternative legal framework,” he said, emphasizing that he did not believe that the loans would result in any losses to taxpayers.
The statement was prepared for a House committee hearing that had been scheduled for Wednesday but was postponed because of snow. Mr. Bernanke decided to release the statement anyway.

Deficits and Power

February 2, 2010
News Analysis
Huge Deficits May Alter U.S. Politics and Global Power
By DAVID E. SANGER

WASHINGTON — In a federal budget filled with mind-boggling statistics, two numbers stand out as particularly stunning, for the way they may change American politics and American power.

The first is the projected deficit in the coming year, nearly 11 percent of the country’s entire economic output. That is not unprecedented: During the Civil War, World War I and World War II, the United States ran soaring deficits, but usually with the expectation that they would come back down once peace was restored and war spending abated.

But the second number, buried deeper in the budget’s projections, is the one that really commands attention: By President Obama’s own optimistic projections, American deficits will not return to what are widely considered sustainable levels over the next 10 years. In fact, in 2019 and 2020 — years after Mr. Obama has left the political scene, even if he serves two terms — they start rising again sharply, to more than 5 percent of gross domestic product. His budget draws a picture of a nation that like many American homeowners simply cannot get above water.

For Mr. Obama and his successors, the effect of those projections is clear: Unless miraculous growth, or miraculous political compromises, creates some unforeseen change over the next decade, there is virtually no room for new domestic initiatives for Mr. Obama or his successors. Beyond that lies the possibility that the United States could begin to suffer the same disease that has afflicted Japan over the past decade. As debt grew more rapidly than income, that country’s influence around the world eroded.

Or, as Mr. Obama’s chief economic adviser, Lawrence H. Summers, used to ask before he entered government a year ago, “How long can the world’s biggest borrower remain the world’s biggest power?”

The Chinese leadership, which is lending much of the money to finance the American government’s spending, and which asked pointed questions about Mr. Obama’s budget when members visited Washington last summer, says it thinks the long-term answer to Mr. Summers’s question is self-evident. The Europeans will also tell you that this is a big worry about the next decade.

Mr. Obama himself hinted at his own concern when he announced in early December that he planned to send 30,000 American troops to Afghanistan, but insisted that the United States could not afford to stay for long.

“Our prosperity provides a foundation for our power,” he told cadets at West Point. “It pays for our military. It underwrites our diplomacy. It taps the potential of our people, and allows investment in new industry.”

And then he explained why even a “war of necessity,” as he called Afghanistan last summer, could not last for long.

“That’s why our troop commitment in Afghanistan cannot be open-ended,” he said then, “because the nation that I’m most interested in building is our own.”

Mr. Obama’s budget deserves credit for its candor. It does not sugarcoat, at least excessively, the potential magnitude of the problem. President George W. Bush kept claiming, until near the end of his presidency, that he would leave office with a balanced budget. He never got close; in fact, the deficits soared in his last years.

Mr. Obama has published the 10-year numbers in part, it seems, to make the point that the political gridlock of the past few years, in which most Republicans refuse to talk about tax increases and Democrats refuse to talk about cutting entitlement programs, is unsustainable. His prescription is that the problem has to be made worse, with intense deficit spending to lower the unemployment rate, before the deficits can come down.

Mr. Summers, in an interview on Monday afternoon, said, “The budget recognizes the imperatives of job creation and growth in the short run, and takes significant measures to increase confidence in the medium term.”

He was referring to the freeze on domestic, non-national-security-related spending, the troubled effort to cut health care costs, and the decision to let expire Bush-era tax cuts for corporations and families earning more than $250,000.

But Mr. Summers said that “through the budget and fiscal commission, the president has sought to provide maximum room for making further adjustments as necessary before any kind of crisis arrives.”

Turning that thought into political action, however, has proved harder and harder for the Washington establishment. Republicans stayed largely silent about the debt during the Bush years. Democrats have described it as a necessary evil during the economic crisis that defined Mr. Obama’s first year. Interest in a long-term solution seems limited. Or, as Isabel V. Sawhill of the Brookings Institution put it Monday on MSNBC, “The problem here is not honesty, but political will.”

One source of that absence of will is that the political warnings are contradicted by the market signals. The Treasury has borrowed money to finance the government’s deficits at remarkably low rates, the strongest indicator that the markets believe they will be paid back on time and in full.

The absence of political will is also facilitated by the fact that, as Prof. James K. Galbraith of the University of Texas puts it, “Forecasts 10 years out have no credibility.”

He is right. In the early years of the Clinton administration, government projections indicated huge deficits — over the “sustainable” level of 3 percent — by 2000. But by then, Mr. Clinton was running a modest surplus of about $200 billion, a point Mr. Obama made Monday as he tried anew to remind the country that the moment was squandered when “the previous administration and previous Congresses created an expensive new drug program, passed massive tax cuts for the wealthy, and funded two wars without paying for any of it.”

But with this budget, Mr. Obama now owns this deficit. And as Mr. Galbraith pointed out, it is possible that the gloomy projections for 2020 are equally flawed.

Simply projecting that health care costs will rise unabated is dangerous business.

“Much may depend on whether we put in place the financial reforms that can rebuild a functional financial system,” Mr. Galbraith said, to finance growth in the private sector — the kind of growth that ultimately saved Mr. Clinton from his own deficit projections.

His greatest hope, Mr. Galbraith said, was Stein’s law, named for Herbert Stein, chairman of the Council of Economic Advisers under Presidents Richard M. Nixon and Gerald R. Ford.

Stein’s law has been recited in many different versions. But all have a common theme: If a trend cannot continue, it will stop.

Currency Reform

Reflections on Currency and the Euro
Steve H. Hanke1

Lars Jonung and Eoin Drea (2010) conclude that the pessimistic stance
taken by most American economists toward the euro in the 1989-2002 period
“was probably fostered by the propensity of U.S. economists to view the euro as a
political project driven by murky motivations and based on an insufficient
institutional foundation.” If most American economists thought the euro was
largely a political project, they were right on target. As one reads thorough
accounts of the birth of the euro, it is clear that politics, not economics, ruled the roost (Brown 2004; Marsh 2009).

This realistic view—that “politics” dominates—does not suggest that one
would take either a pessimistic or an optimistic stance toward the euro, however.
In my experience as an adviser on currency reforms in Europe in the 1990s, I
observed first-hand that politics, and on occasion personal pique, not the
economics of optimum currency areas, dominated, and that this state of affairs
could still produce good reforms.

In Estonia, which established an independent currency in 1992, the
overriding national objective was to exit the ruble zone, and more broadly,
Moscow’s sphere of influence. A currency board was the most effective way to
rapidly accomplish the goal. The driving force behind Lithuania’s similar 1994
currency reform was Prime Minister Adolfas Slezevicius. A currency board
appealed to him because it was a means to move the governor of the central bank
to the sidelines and to impose fiscal discipline on his own Democratic Labor
Party, which controlled parliament. A hyperinflation in Bulgaria in 1997 sparked a
popular outcry for sound money and a currency board, an idea that had been
circulating in professional circles since 1991. Indeed, a Bulgarian-language
knockoff of an old monograph I had written in 1991 (Hanke and Schuler 1991)
made the bestseller list in Sofia during the hyperinflation. Bosnia and Herzegovina
also installed a currency board in 1997. It was mandated by the Dayton/Paris
Peace Agreement of November 21, 1995—an international treaty. Montenegro,
while still part of the Federal Republic of Yugoslavia along with Serbia, dumped
the Yugoslav dinar and replaced it with the German mark in November 1999. This
bold move by then-President Milo Djukanovic; was part of a political strategy to
establish Montenegro’s independence. Like the establishment of the euro,
Montenegro’s embrace of the German mark had politics, not economics, as its
hallmark.

That there was a political rationale and popular support for the currency
reforms that I was advocating made my day. That the finer economic points took a
back seat failed to move me.2 All of the above-mentioned countries continue
today with the monetary policies they established in the 1990s. (Montenegro
switched to the euro when euro notes and coins replaced the German mark.) The
policies were adopted in large part for political reasons, but they have persisted
because they have produced what was anticipated: strong economic results.
My views on exchange rates are based on the distinction between strictly
fixed, strictly floating and pegged regimes. Fixed and floating rates are regimes in
which the monetary authority is aiming for only one target at a time. Although
floating and fixed rates appear dissimilar, they are members of the same freemarket
family. Both operate without exchange controls and are free-market
mechanisms for balance-of-payments adjustments. With a floating rate, a central
bank sets a monetary policy but the exchange rate is on autopilot. In consequence,
the monetary base is determined domestically by a central bank. With a fixed rate,
there are two possibilities: either a currency board sets the exchange rate, and the
money supply is on autopilot, or a country is “dollarized” and uses the U.S. dollar
or another foreign currency as its own, and the money supply is again on autopilot.
From the perspective of an individual country, a monetary union such as the
eurozone is similar to dollarization. In consequence, under a fixed-rate regime, a
country’s monetary base is determined by the balance of payments, moving in a
one-to-one correspondence with changes in its foreign reserves. With either a
floating or a fixed rate, there cannot be conflicts between monetary and exchange
rate policies, and balance-of-payments crises cannot rear their ugly heads.
Floating- and fixed-rate regimes are inherently equilibrium systems in which
market forces act to automatically rebalance financial flows and avert balance-of payments crises.

Most economists use “fixed” and “pegged” as interchangeable or nearly
interchangeable terms for exchange rates. For me, they are very different
exchange-rate arrangements. Pegged-rate systems are those where the monetary
authority is aiming for more than one target at a time. They often employ
exchange controls and are not free-market mechanisms for international balanceof-
payments adjustments. Pegged exchange rates are inherently disequilibrium
systems, lacking an automatic mechanism to produce balance-of-payments
adjustments. Pegged rates require a central bank to manage both the exchange rate
and monetary policy. With a pegged rate, the monetary base contains both
domestic and foreign components.

Unlike floating and fixed rates, pegged rates invariably result in conflicts
between monetary and exchange rate policies. For example, when capital inflows
become “excessive” under a pegged system, a central bank often attempts to
sterilize the ensuing increase in the foreign component of the monetary base by
selling bonds, reducing the domestic component of the base. And when outflows
become “excessive,” a central bank often attempts to offset the decrease in the
foreign component of the monetary base by buying bonds, increasing the
domestic component of the monetary base. Balance-of-payments crises erupt as a
central bank begins to offset more and more of the reduction in the foreign
component of the monetary base with domestically created base money. When
this occurs, it is only a matter of time before currency speculators spot the
contradictions between exchange rate and monetary policies and force a
devaluation, interest-rate increases, the imposition of exchange controls, or all
three.

During the ramp-up to the launch of the euro, I served, among other things,
as an officer of a hedge fund. Given my views on exchange-rate regimes, the
period provided many profitable trading opportunities. After all, the Exchange
Rate Mechanism (ERM) was a system of pegged exchange rates. When a pegged
system experiences trouble, typically a country’s interest rates rise, its currency
slumps, or both. With this in mind, I was either selling deposits in a “weak”
currency country or shorting other European currencies against the German
mark. As an example of my thinking (and trading), in January 1992 I wrote:

Within the next month, the market will push sterling to its lowest point
in the ERM band. Facing that eventuality, there are four possible British
policy responses: 1) allow sterling to be devalued to about DM2.5 and
eventually allow interest rates to come down a bit; 2) defend sterling and
restore a central rate of DM2.95 by increasing interest rates a full
percentage point to 11.5%; 3) negotiate a realignment of the ERM along
the lines we suggest; or 4) bring back (God forbid) exchange controls.
Rational as options 1) and 3) might be, we believe that the Brits have
invested so much political capital in the ERM and the ridiculous DM
2.95 that they will grudgingly choose option 2) and raise interest rates.
Sell March three-month sterling deposits. Place stop at 90, good
anytime. (Hanke 1992)

As it turned out, that was a profitable trade. But my judgment about what
the United Kingdom would do with the pound caused me to miss the big trade on
Black Wednesday, September 16, 1992, when the government floated the exchange
rate, in effect devaluing, rather than raising interest rates further.
That said, there were paydays associated with bets against the ERM pegs.
The most notable one occurred at the end of July 1993, when France’s pegged
rate, dubbed the franc fort, came a-cropper (Sulitzer 1993). In consequence, the
ERM’s narrow band was widened from 2.25% to 15% around the central rates.
I considered the euro sound from a technical perspective, because it
requires a fixed exchange rate rather than pegged rates among member countries,
but my policy views concerning the euro were generally skeptical during the euro’s
ramp-up phase. The basis for my skepticism was the idea that a strong euro would
in the long run require a strong central state, as Robert Mundell (2000) has
suggested. While I agree with Mundell’s diagnosis, I did not, and do not, consider a
strong central state desirable. For me, the European Union and the European
Commission represent additional political and bureaucratic layers that will impede
much-needed European economic liberalization.

While I was skeptical of a common currency for Europe, I favored European
currency unification via currency boards (Hanke and Walters 1990). And I
was not alone. During a May 1990 meeting in East Berlin with Karl Otto Pöhl,
President of the Bundesbank, he confirmed that we shared the same vision (Marsh
2009, 131) and encouraged me to press ahead. Such a unified currency approach,
with the German mark as the anchor, would have given Europe monetary
stability, while at the same time it would have avoided the ratcheting up of the
state and bureaucratic powers that have accompanied the euro.

References
Bogetic, Zeljko, and Steve H. Hanke. 1999. Cronogorska Marka. Podgorica,
Montenegro: Antena M.
Brown, Brendan. 2004. Euro on Trial: To Reform or Split Up? New York: Palgrave
Macmillan.
Hanke, Steve H. 1992. The Walters Critique. Friedberg’s Commodity and Currency
Comments, 26 January.
Hanke, Steve H. 1996/7. A Field Report from Sarajevo and Pale. Central Banking
7(3).
Hanke, Steve H., Lars Jonung and Kurt Schuler. 1992. Monetary Reform for a
Free Estonia: A Currency Board Solution. Stockholm: SNS Förlag.