The great political challenge of the moment is how to update the 20th century entitlement state so that it is affordable. This challenge manifests itself in two main forms. The primary problem is the cost, or growth in cost, of health care in our country. The second problem is the current excess of spending over and above revenue in both discretionary and non discretionary spending.
Republican's like to say that "this country has a spending problem." In actuality, this country has a revenue and a spending problem, and addressing one without the other offers an overly simple and incomplete solution to this challenge.
In the recent past, both Mr. Ryan and President Obama have offered largely partisan proposals on how to solve this challenge. They are both drastically lacking in a comprehensive solution to this challenge. Mr Ryan health care proposals are incomplete and the rest of his budget is laughable in bad assumptions. Mr. Obama's health care proposal is enlarged government largesse, and the rest of his budget depends on politically favorable tax hikes which will result in sub optimum outcomes.
Mr. Ryan's health care proposal is to increase competition by giving "consumers" more control.
Friday, April 22, 2011
Wednesday, April 20, 2011
The Great Depression
This post draws significantly on M. Pettis
Countries that left the gold standard quickest, and thus were able loosen credit sufficiently to counteract the banking collapse, had the mildest economic contraction. Countries with the largest balance of payment surpluses (the U.S.) were in the strongest position to hang onto gold, and thus the last to leave the gold standard, and suffered the most painful economic contraction (it took 18 year for SP500 earnings to reach their pre-great depression peak, by comparison, it took the SP500 to 19 months to reach its pre-credit crisis peak). Countries with the strongest balance of payments were also those with the largest trade surpluses, and thus most exposed to collapse of net demand.
Besides the standard impact of the stock market crash of 1929 on consumer confidence, consumption, and cost of capital, economist agree that:
1. Significant industrial overcapacity in the United States was exported abroad, financed through massive foreign borrowing in the U.S. The 1929 crash not only crushed domestic demand, but eliminated the ability of foreign borrowers to finance imports from the U.S.
As international trade collapsed (and US tried to force the adjustment abroad through import tariffs), domestic demand was not nearly enough to absorb what U.S. factories produced. Government did not respond by spending, so so overcapacity was resolved through unemployment and factory closings. Government action (Smoot Hawley, mercantilism) invited retaliation and made the process more difficult.
2. Excess monetary creation caused by massive expansion of gold reserves in the 1920s lead to over investment and risky lending. The stock market crash set off the de-leveraging cycle, bank assets collapsed, and a sudden collapse in the money supply. The Fed failed to intervene with liquidity and the sharp contraction in economic activity became a depression. This is widely believed (Friedman, others) to be the biggest policy blunder that ensured the contraction turned into a depression.
Some comparison's to China:
China's trade surplus is about the same size in terms of Global GDP as the U.S. in 1929 - about .5% Though China's economy today is one fifth the relative size of the U.S. So, overcapacity, and domestic demand are likely to be much smaller than the U.S. in 1929.
Unlike in the 1920s, authorities recognize the importance of forceful monetary and fiscal response to sustain demand and provide liquidity. On the other hand, China most certainly has had excessively low interest rates, excessive monetary expansion (excess of savings), risky lending, and over investment.
A sharp reversal in China's trade surplus will result in a decline in foreign currency, and with it a decline in the money supply (effectively those savings leaving the country). This is because so long as the PBoC main job is to fix the value of its currency, it has limited ability to manage the money domestic money supply. In 2009, China did a fantastic job managing a contracting money supply with an explosion of loan growth.
Countries that left the gold standard quickest, and thus were able loosen credit sufficiently to counteract the banking collapse, had the mildest economic contraction. Countries with the largest balance of payment surpluses (the U.S.) were in the strongest position to hang onto gold, and thus the last to leave the gold standard, and suffered the most painful economic contraction (it took 18 year for SP500 earnings to reach their pre-great depression peak, by comparison, it took the SP500 to 19 months to reach its pre-credit crisis peak). Countries with the strongest balance of payments were also those with the largest trade surpluses, and thus most exposed to collapse of net demand.
Besides the standard impact of the stock market crash of 1929 on consumer confidence, consumption, and cost of capital, economist agree that:
1. Significant industrial overcapacity in the United States was exported abroad, financed through massive foreign borrowing in the U.S. The 1929 crash not only crushed domestic demand, but eliminated the ability of foreign borrowers to finance imports from the U.S.
As international trade collapsed (and US tried to force the adjustment abroad through import tariffs), domestic demand was not nearly enough to absorb what U.S. factories produced. Government did not respond by spending, so so overcapacity was resolved through unemployment and factory closings. Government action (Smoot Hawley, mercantilism) invited retaliation and made the process more difficult.
2. Excess monetary creation caused by massive expansion of gold reserves in the 1920s lead to over investment and risky lending. The stock market crash set off the de-leveraging cycle, bank assets collapsed, and a sudden collapse in the money supply. The Fed failed to intervene with liquidity and the sharp contraction in economic activity became a depression. This is widely believed (Friedman, others) to be the biggest policy blunder that ensured the contraction turned into a depression.
Some comparison's to China:
China's trade surplus is about the same size in terms of Global GDP as the U.S. in 1929 - about .5% Though China's economy today is one fifth the relative size of the U.S. So, overcapacity, and domestic demand are likely to be much smaller than the U.S. in 1929.
Unlike in the 1920s, authorities recognize the importance of forceful monetary and fiscal response to sustain demand and provide liquidity. On the other hand, China most certainly has had excessively low interest rates, excessive monetary expansion (excess of savings), risky lending, and over investment.
A sharp reversal in China's trade surplus will result in a decline in foreign currency, and with it a decline in the money supply (effectively those savings leaving the country). This is because so long as the PBoC main job is to fix the value of its currency, it has limited ability to manage the money domestic money supply. In 2009, China did a fantastic job managing a contracting money supply with an explosion of loan growth.
Factors Affect Trade
This post draws significantly on M. Pettis.
Any policy that explicitly or implicitly affects the balance of production and consumption.
So currency policy affects trade through diverting production and consumption (devalue = raise cost of imports, reduce real wages, opposite for production - which raises employment but does not improve living conditions). Tariffs work the same way.
Taxes - reduce income which reduces consumption (income and sales taxes) and corp taxes raise cost of production so reduces production. Taxes are transfer mechanism - so increasing income tax and reducing corp tax can have a bigger combined effect on trade balance.
Wages - low wages reduce household income, reduces consumption and increases production - relative to productivity.
Subsidies to producers - input costs, cost of capital (which is especially dangerous if the subsidy lowers the hurdle rate of an otherwise unprofitable enterprise)- subsidizing increases production relative to consumption, but also increases employment which has a slightly offsetting impact on consumption. Remember the net impact on trade surplus from rising production is offset by consumption through employment.
Costs to consumer - low deposit rates - which is the subsidy to producers in the form of cost of capital - reduces income, especially in economies where households do not own diversified portfolios of assets, i.e. dependent on savings rates. Wide lending margins (i.e. in China where there is a cap on deposit rates and a floor on lending rates) also reduce consumption.
Other Credit Intervention/Repressed Financial System: lending guarantees, directed lending, etc. This raises production (again, while raising consumption also through employment and increased wages, though longer term if that capital is misallocated the result is reduction of production, employment/wages and consumption. This is also tied to "regulated" interest rates - where interest rates are much lower than comparable growth equilibrium rates.
Any policy that explicitly or implicitly affects the balance of production and consumption.
So currency policy affects trade through diverting production and consumption (devalue = raise cost of imports, reduce real wages, opposite for production - which raises employment but does not improve living conditions). Tariffs work the same way.
Taxes - reduce income which reduces consumption (income and sales taxes) and corp taxes raise cost of production so reduces production. Taxes are transfer mechanism - so increasing income tax and reducing corp tax can have a bigger combined effect on trade balance.
Wages - low wages reduce household income, reduces consumption and increases production - relative to productivity.
Subsidies to producers - input costs, cost of capital (which is especially dangerous if the subsidy lowers the hurdle rate of an otherwise unprofitable enterprise)- subsidizing increases production relative to consumption, but also increases employment which has a slightly offsetting impact on consumption. Remember the net impact on trade surplus from rising production is offset by consumption through employment.
Costs to consumer - low deposit rates - which is the subsidy to producers in the form of cost of capital - reduces income, especially in economies where households do not own diversified portfolios of assets, i.e. dependent on savings rates. Wide lending margins (i.e. in China where there is a cap on deposit rates and a floor on lending rates) also reduce consumption.
Other Credit Intervention/Repressed Financial System: lending guarantees, directed lending, etc. This raises production (again, while raising consumption also through employment and increased wages, though longer term if that capital is misallocated the result is reduction of production, employment/wages and consumption. This is also tied to "regulated" interest rates - where interest rates are much lower than comparable growth equilibrium rates.
The Arithmatic of Chinese Consumption
This post draws heavily on M. Pettis.
First - Chinese consumption is not depressed by the "investment model" - which is an effect - it is depressed by trade policies, monetary policies, distorted credit allocation, and rigid financial system. Second, Chinese consumption in the 35% area in 2008 compares to 55%-65% in Europe, Latam 65%-70% and above 70% in the U.S. Other Asian consumption figures are mid 50% - India is an example at 57%.
The flip side is the savings rate in China. From 12-15% in early 1990s, the savings rate rose steadily to 25% in 1998 and only rose to 26% recently. The increase in national savings in the 2000s occurred at the corporate level - though this is due to transfer from households to producers.
China's last trade deficit was in 1996. After that trade surpluses grew to around 5% of GDP in 2003 and then surged to a high of 10% in 2007. Investment grew as a share of GDP, from 23% in 1990, jumped to 31% in 1992-94 where it stabilized, then grew at steadily to 40% by 2008.
The Asian growth model forces households to subsidize investment and production, which generates employment and growth which at the expense of household income and consumption.
In 1992 household income peaked at 72% of GDP, then erratically declined to 66% in 2002, and subsequently plunged to 55%.
Rebalancing is not just a rise in consumption, it is a expansion in Chinese net demand so that China can adjust to dropping net demand in the US in a way that doesn't harm trade partners and escalate trade tensions. Rebalancing is not consumption growing (which is the critical mistake analysts make everywhere), it is consumption growing relative to GDP. In fact, this can occur by GDP dropping below current consumption rates, which would be the worst outcome. The best outcome is for GDP to grow and for consumption to grow more quickly.
If consumption continues to grow more slowly than GDP imbalances get worse, while the trade numbers can be temporarily disguised by surging investment. This only makes rebalancing more difficult and increases the cost if capital is missallocated.
The arithmetic is very difficult. If China grows at 8%, consumption must grow at 11% to raise consumption as a share of GDP from 35% to 36% in a year. To return consumption to 40% of GDP in the next five years (40% is still well below any global consumption rate), at 8% GDP rate, consumption has to grow at 11%; at 7% GDP, consumption growth is 10%. To bring consumption to 50% of GDP in twenty years (the low end of other Asian high savings economies) if GDP grows at 7%, consumption must grow at 9%.
So, if Chinese GDP slows from 14% over the past decade, consumption none the less must surge in excess of 8-9% growth rates of recent years for any rebalancing to take place.
First - Chinese consumption is not depressed by the "investment model" - which is an effect - it is depressed by trade policies, monetary policies, distorted credit allocation, and rigid financial system. Second, Chinese consumption in the 35% area in 2008 compares to 55%-65% in Europe, Latam 65%-70% and above 70% in the U.S. Other Asian consumption figures are mid 50% - India is an example at 57%.
The flip side is the savings rate in China. From 12-15% in early 1990s, the savings rate rose steadily to 25% in 1998 and only rose to 26% recently. The increase in national savings in the 2000s occurred at the corporate level - though this is due to transfer from households to producers.
China's last trade deficit was in 1996. After that trade surpluses grew to around 5% of GDP in 2003 and then surged to a high of 10% in 2007. Investment grew as a share of GDP, from 23% in 1990, jumped to 31% in 1992-94 where it stabilized, then grew at steadily to 40% by 2008.
The Asian growth model forces households to subsidize investment and production, which generates employment and growth which at the expense of household income and consumption.
In 1992 household income peaked at 72% of GDP, then erratically declined to 66% in 2002, and subsequently plunged to 55%.
Rebalancing is not just a rise in consumption, it is a expansion in Chinese net demand so that China can adjust to dropping net demand in the US in a way that doesn't harm trade partners and escalate trade tensions. Rebalancing is not consumption growing (which is the critical mistake analysts make everywhere), it is consumption growing relative to GDP. In fact, this can occur by GDP dropping below current consumption rates, which would be the worst outcome. The best outcome is for GDP to grow and for consumption to grow more quickly.
If consumption continues to grow more slowly than GDP imbalances get worse, while the trade numbers can be temporarily disguised by surging investment. This only makes rebalancing more difficult and increases the cost if capital is missallocated.
The arithmetic is very difficult. If China grows at 8%, consumption must grow at 11% to raise consumption as a share of GDP from 35% to 36% in a year. To return consumption to 40% of GDP in the next five years (40% is still well below any global consumption rate), at 8% GDP rate, consumption has to grow at 11%; at 7% GDP, consumption growth is 10%. To bring consumption to 50% of GDP in twenty years (the low end of other Asian high savings economies) if GDP grows at 7%, consumption must grow at 9%.
So, if Chinese GDP slows from 14% over the past decade, consumption none the less must surge in excess of 8-9% growth rates of recent years for any rebalancing to take place.
Asian Developement Model
This post draws significantly from M. Pettis
Beginning in 2009 - the massive expansion of credit and investment is an extension of the same policies observed in China since 2004 - driven by the Ministry of Commerce, export constituencies, and provincial and municipal leaders focused on short term growth targets and unemployment.
In late 2009 - it appeared that the US consumption binge could not continue - though it has. We have seen a dress rehearsal of this in the 1987 crash - when the trade deficit reached 3.5% before reversing over the 1990s. That period also marked the end of the Japanese miracle, though party didn't end for several years.
Quick note on Japan - following the Plaza Accord, as the Yen appreciated versus the dollar, Japan's surplus with the U.S. expanded, driven by a surge in credit (and informally guaranteeing borrowers, so profitability did not affect lending decisions) which allowed producers to expand production while consumers subsidized this production - trade surplus.
The Asian Development model then involves policies that directly/indirectly boost savings and channel huge subsidies (usually provided by the savers, thus depressing consumption) into investment and manufacturing. Consumer restraint and surging production inevitably lead to large and consistent trade surpluses and equal capital exports.
When large countries, or groups of large countries have policies aimed at creating trade surpluses, they face a binding constraint - a country or group of countries willing to run the concurrent deficit. Without deficit countries, the Asian growth model would run into 19th century cycle of rapid production and overinvestment. There must be an importer of last resort.
In the lasts decade, the U.S. trade deficit grew from 1% of GDP to 7%. When consumption growth is faster than GDP growth - necessary when a country builds a trade deficit -there is a necessary build up in debt. When households repair their balance sheets - we would expect a decline in consumption relative to GDP and a decline in the deficit.
Declines in deficit countries will force concurrent declines in trade surpluses from growing. The Asian growth model is dependent on growing deficits, particularly the US with the largest market for consumers and deep financial markets. The end of U.S. trade deficits will likely be the end of the Asian Growth model.
This is why the surge of lending and investment in 2009, 2010, and 2011 is so disturbing. This investment will lead to even more overcapacity, NPLs, misallocation of capital, and suppression of consumption (through an implicit tax on household by lowering interest rates to reduce debt burdens and recapitalize insolvent banks). Instance after instance of wealth transfer from households to producers.
Beginning in 2009 - the massive expansion of credit and investment is an extension of the same policies observed in China since 2004 - driven by the Ministry of Commerce, export constituencies, and provincial and municipal leaders focused on short term growth targets and unemployment.
In late 2009 - it appeared that the US consumption binge could not continue - though it has. We have seen a dress rehearsal of this in the 1987 crash - when the trade deficit reached 3.5% before reversing over the 1990s. That period also marked the end of the Japanese miracle, though party didn't end for several years.
Quick note on Japan - following the Plaza Accord, as the Yen appreciated versus the dollar, Japan's surplus with the U.S. expanded, driven by a surge in credit (and informally guaranteeing borrowers, so profitability did not affect lending decisions) which allowed producers to expand production while consumers subsidized this production - trade surplus.
The Asian Development model then involves policies that directly/indirectly boost savings and channel huge subsidies (usually provided by the savers, thus depressing consumption) into investment and manufacturing. Consumer restraint and surging production inevitably lead to large and consistent trade surpluses and equal capital exports.
When large countries, or groups of large countries have policies aimed at creating trade surpluses, they face a binding constraint - a country or group of countries willing to run the concurrent deficit. Without deficit countries, the Asian growth model would run into 19th century cycle of rapid production and overinvestment. There must be an importer of last resort.
In the lasts decade, the U.S. trade deficit grew from 1% of GDP to 7%. When consumption growth is faster than GDP growth - necessary when a country builds a trade deficit -there is a necessary build up in debt. When households repair their balance sheets - we would expect a decline in consumption relative to GDP and a decline in the deficit.
Declines in deficit countries will force concurrent declines in trade surpluses from growing. The Asian growth model is dependent on growing deficits, particularly the US with the largest market for consumers and deep financial markets. The end of U.S. trade deficits will likely be the end of the Asian Growth model.
This is why the surge of lending and investment in 2009, 2010, and 2011 is so disturbing. This investment will lead to even more overcapacity, NPLs, misallocation of capital, and suppression of consumption (through an implicit tax on household by lowering interest rates to reduce debt burdens and recapitalize insolvent banks). Instance after instance of wealth transfer from households to producers.
Tuesday, April 19, 2011
Consumption, Savings, Investment, Surplus, Deficit
This post draws significantly on M. Pettis, P. Krugman, S. Roach.
Given the sheer size of the PBoC intervention, the tremendous comcomitant need to sterilize and supress interest rates, and resistance to currency appreciation, its seems the PBoC capital exports is a policy choice. This is policy choice is supported since PBoC and other Asian reserve accumulation exploded after 1997 Asian Financial Crisis.
The U.S. could have resisted the increase in capital account (capital imports) by sharply raising interest rates, which would have reduced investment faster than U.S. savings. The resulting rise in unemployment would have lowered consumption and imports which would have reduced the current account deficit.
The Fed did not do this. The capital surplus rose. Since the current account is investment minus savings, the capital suplus rises either when savings declines, investment rises, or the some combination in that relationship.
Unfortunately for the world and the U.S., private investment doesn't surge enough. The current account deficit means production is moving abroad, partly because of currency intervention and other factors, which makes foreign investment more profitable.
Here, the government could surge investment to offset the increase in capital account. The result may have been increased future profitability, recapturing the advantage in production it has lost. The U.S. would have run a huge trade deficit, but the deficit would result in a surge in investment, not consumption.
Instead, without the surge in investment, the savings rate declined. Here again, capital exports from another country forces down saving, and forces debt up. No moral finger wagging on over consumption. By the same token, if China forces capital exports, its people must save more. They are not suddenly thrifty, household wealth is reduced to reduce consumption.
So here, the simple conclusion to reverse this is by forcing China to stop exporting capital, which would result in a rise of the RMB.
Of course, the cause might not be capital exports, but a result of US policies that forced savings down and consumption up. Or, it might be that Chinese just save a lot, "naturally", which is augmented by the extremely cheap cost of labor relative to the rest of the world.
Given the sheer size of the PBoC intervention, the tremendous comcomitant need to sterilize and supress interest rates, and resistance to currency appreciation, its seems the PBoC capital exports is a policy choice. This is policy choice is supported since PBoC and other Asian reserve accumulation exploded after 1997 Asian Financial Crisis.
The U.S. could have resisted the increase in capital account (capital imports) by sharply raising interest rates, which would have reduced investment faster than U.S. savings. The resulting rise in unemployment would have lowered consumption and imports which would have reduced the current account deficit.
The Fed did not do this. The capital surplus rose. Since the current account is investment minus savings, the capital suplus rises either when savings declines, investment rises, or the some combination in that relationship.
Unfortunately for the world and the U.S., private investment doesn't surge enough. The current account deficit means production is moving abroad, partly because of currency intervention and other factors, which makes foreign investment more profitable.
Here, the government could surge investment to offset the increase in capital account. The result may have been increased future profitability, recapturing the advantage in production it has lost. The U.S. would have run a huge trade deficit, but the deficit would result in a surge in investment, not consumption.
Instead, without the surge in investment, the savings rate declined. Here again, capital exports from another country forces down saving, and forces debt up. No moral finger wagging on over consumption. By the same token, if China forces capital exports, its people must save more. They are not suddenly thrifty, household wealth is reduced to reduce consumption.
So here, the simple conclusion to reverse this is by forcing China to stop exporting capital, which would result in a rise of the RMB.
Of course, the cause might not be capital exports, but a result of US policies that forced savings down and consumption up. Or, it might be that Chinese just save a lot, "naturally", which is augmented by the extremely cheap cost of labor relative to the rest of the world.
Accounting Identities and Trade
This post draws in large part on M. Pettis, P. Krugman, and S. Roach
To think about trade lets start by understanding that China's government engages in massive capital export, accumulating foreign assets funded with domestic liabilities. It does this in part due to restrictions on capital inflows.
Two basic accounting identities:
Capital Account + Current Account = 0
Current Account = Domestic Savings (Prod- Cons) - Domestic Investment
So, China has a capital account deficit, and thus a current account surplus - so we can say it exports its savings to the rest of the world. Thus, the rest of the world must import savings and spend in excess of what it produces. This is an accounting necessity.
Note - we can further break this down into:
Households + Business + Government + Current Account (foreign) = 0.
So if households and businesses decide to run a large surplus, then the governement and foreigners must run a deficit.
The accounting identity for the capital account is therefore : Domestic Investment - domestic savings (prod - cons). In other words, a country borrows the excess of its investment over its domestic saving.
This also means that domestic savings - domestic investment = current account.
Note - this says nothing about causality. If (Krugman) argues that foreign currency intervention forces China to export capital, then other must import it. If Chinese are forced to save, then either domestic or foreign entities are forced to borrow. If American's went on a consumption binge, someone must sell them their goods.
To think about trade lets start by understanding that China's government engages in massive capital export, accumulating foreign assets funded with domestic liabilities. It does this in part due to restrictions on capital inflows.
Two basic accounting identities:
Capital Account + Current Account = 0
Current Account = Domestic Savings (Prod- Cons) - Domestic Investment
So, China has a capital account deficit, and thus a current account surplus - so we can say it exports its savings to the rest of the world. Thus, the rest of the world must import savings and spend in excess of what it produces. This is an accounting necessity.
Note - we can further break this down into:
Households + Business + Government + Current Account (foreign) = 0.
So if households and businesses decide to run a large surplus, then the governement and foreigners must run a deficit.
The accounting identity for the capital account is therefore : Domestic Investment - domestic savings (prod - cons). In other words, a country borrows the excess of its investment over its domestic saving.
This also means that domestic savings - domestic investment = current account.
Note - this says nothing about causality. If (Krugman) argues that foreign currency intervention forces China to export capital, then other must import it. If Chinese are forced to save, then either domestic or foreign entities are forced to borrow. If American's went on a consumption binge, someone must sell them their goods.
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