The 2010 Elections: What Went Wrong?

Nov 2, 2010Daniel Berger

elephant-and-donkey-150Republican ideology and policies created this mess. So how did Democrats squander the opportunity? In the first post of a two-part series, Daniel Berger explains how we got where we are.

elephant-and-donkey-150Republican ideology and policies created this mess. So how did Democrats squander the opportunity? In the first post of a two-part series, Daniel Berger explains how we got where we are.

Regardless of the outcome of the 2010 elections, the Democratic Party urgently needs a fundamental re-evaluation of its political strategy. The 2008 election of Barack Obama could have been a watershed event in U.S. politics -- not unlike Reagan's election in 1980, which initiated the 30-year political dominance of the Republican Party. It still could be.

Obama won a substantial majority based on a strong showing among young people, minorities, and other voter groups far outside the Republican political base and ambit of influence. Together with a narrow plurality among independents, Obama's vote -- if replicated in future elections -- could represent a durable, long-term majority. Moreover, as a result of Obama's election, the Republican Party has splintered into two factions: an extreme mainstream and the ultra-extremist Tea Party. This opens up the possibility of a complete marginalization of the Republican Party to permanent minority status if the Democrats can co-opt its moderate element and demonize its extremes.

But Democrats have had difficulty capitalizing on an apparent fundamental shift in the political landscape. They are actually struggling to maintain political control, even though the major problems facing the nation are directly attributable to 30 years of Republican neglect and misrule. Despite legitimate efforts by the Administration to begin to address these problems, Obama and his allies on Capitol Hill are being blamed for them.

Notwithstanding the role of the Republican Party and its destructive policies, which are directly responsible for current conditions, any rebuke which the Democrats receive in the elections would also be a direct product of the Party's own ineffective political strategy and that of the entire progressive political movement.

It is almost inconceivable that, during the worst economic conditions in 80 years, a conservative populism has arisen which, among other things, calls for the abolition of the national government. This comes after a recent collapse of private sector economic activity that caused mass unemployment. It required the national government to be the spender of last resort to stave off an economic catastrophe and support a slowly recovering economy. Eighty years ago, parallel conditions (which, left unchecked by the national government, spiraled out of control into the Great Depression) ushered in a progressive political movement responsible for the greatest era of political, social and economic reform in the history of the country. The 20th Century became the American Century and the U.S. was admired, even revered in the world.

Yet where is progressive populism now? Why haven't masses of workers; members of the middle class who are unemployed, underemployed and underpaid; and their allies staged mass rallies to protest the behavior of Wall Street? Where are protests against the business sector for overdoing layoffs, or at least against the Tea Party, the intellectual and political successors of the Ku Klux Klan?

At the very moment of recent political triumph for the Democratic Party and its progressive allies, at a moment in which the nation, for the first time in 30 years, has begun to take action to address its fundamental problems, all progress could be quickly lost in the 2010 elections.

The nature and intensity of the opposition make clear that differences between the two parties now do not reflect competing visions of the future, but rather represent the future versus the past and reasonable change versus the entrenched, and often corrupt, status quo. Normally -- particularly in a moment of crisis -- the political argument in any rational political system would be resolved (as it was here during the Depression years) in favor of the future. So why are we now deeply worried that the argument will be resolved in favor of the past?

The Limits of Current Strategies of Democrats/Progressives

The Democrats seem currently to be following these discrete -- sometimes overlapping -- political strategies. First, apparently both the White House  and the Democratic Congress believe that decades of ideological warfare between liberalism and conservatism has sickened the voting public to this type of conflict and has opened the door to a non-ideological political appeal. Such an appeal could presumably identify a set of problems requiring the collective attention of the country and develop a corresponding set of policy solutions based on the best available information and ideas, whatever their ideological origin. This could be called "policy approach" to politics.

While a policy approach is a good approach to governance, its effectiveness as a political strategy is questionable. The problems facing the country are complex. Unfortunately, issues that are poorly understood -- or even inaccessible to the public -- are easy targets of demagoguery and outright falsification (as the recent "debate" over health care showed).

This is particularly true in the current 24/7 media environment, where any proposed idea is intensively scrutinized -- and inevitably distorted -- by the media. As a result, public support for any policy proposal must be established at the very outset of its consideration and at every step along the way. But this is impossible in the current environment, where the Republican Party isn't committed to a good faith discussion and resolution of differences. Thus, any policy proposal can be effectively derailed (or even demonized) if it is not shielded by an aggressive countervailing public relations campaign.

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A second strategy which the Democrats seemed to have adopted has been referred to as "centrist." Until recently, conventional wisdom has held that any political party must move to the center to establish and maintain political support. The Democratic Party represents 25-40% of the electorate. The liberal base is even smaller. So the leadership reasons that it must appeal to moderates and independents to win elections. While liberals, moderates, and independents largely agree on social issues, they disagree -- sometimes sharply -- on many other issues. As a result, Democrats have to straddle the fence between these factions. On policy issues they have had to settle for the most modest form out of fear of losing support among "moderates." They can never address the fundamental causes of a problem without worrying about alienating a group, nor can they articulate a general guiding principle. Thus, Democrats can never adequately explain the true nature of a problem and why action is necessary, so they seem to act out of political opportunism rather than principle.

All this creates profound unease with the largest faction of the Democratic Party, the liberal base. For these reasons, Democrats wind up rarely appealing to them and almost appear to be running away from them.

The President has a related, but discrete, problem. He was elected in large part by young people and minorities, who not only provided votes but also idealism, energy, and grassroots organization. Obama has seemingly deserted this base by not focusing, at least rhetorically, on issues that are important to it. The best example is immigration. The Republican Party's political agitation served up the issue on a silver platter to the Democrats. Their inability to capitalize on it among Latinos and other minority groups is truly mystifying.

The Republicans, on the other hand, never pursue a "centrist" political strategy and always follow a "base" strategy. This causes the Republican Party to adopt extreme rhetoric and policy positions while allowing it to maintain a degree of coherence in its positions, as it is constantly pointing out that it acts "out of principle."

Although Republicans do not try to expand their base by compromising their "core" beliefs, they have tried to move the political center to the right. The conservative movement has constructed an effective network of think tanks, front groups, and media assets that have virtually unlimited resources. This "Right-Wing Message Machine" has been winning the war of ideas, despite the progression of political and social ideas over the last 100 years and social scientific evidence, all of which overwhelmingly favor progressive policies.

One example of the success of the conservative movement in moving the conventional wisdom to the right should suffice: public spending to stabilize the economy. Richard Nixon famously asserted early in his first term, "We are all Keynesians now." This statement reflected not only his Administration's embrace of Keynesian policy, but a consensus in both parties over modern macroeconomic theory. Nonetheless, 40 years later, conventional wisdom explicitly rejects the role of fiscal policy and, in particular, temporary government spending to make up for a collapse of private sector demand. This can only reflect the triumph of right wing ideology over all experience and reason.

In a third strategy, it is also possible that Democrats are specifically appealing not so much to the general public, but to the business and professional elites in this country. These elites have a remarkable degree of influence at all levels of American society -- not only by influencing political decision makers, but by acting as decision makers themselves. Our government, particularly at the national level, consists of a revolving door between the business and public sectors. In effect, they form a class of permanent technocrats and are as close as it gets to a ruling class in the U.S. For this reason, to get anything done politically in the U.S. it is necessary to have their support.

This latter point represents a double-edged sword for the Democratic Party. On the one hand, these elites follow a simplified form of the policy approach seemingly favored by the Democratic Party. Moreover, they are fairly well informed about the context in which policy decision-making takes place. So, unlike the public, it would be possible to make a serious appeal on policy grounds to the elites. Also, to their credit, they are almost all liberal on social issues.

However, at this particular moment, an all-out appeal by the Democratic Party to the elites is treacherous both policy-wise and politically. They tend to be reasonably well informed about business, their professions, and the state of the country, but they are not particularly knowledgeable about specific policy issues. They can be easily misled about -- or willingly distort -- policy issues, particularly on subjects that are counter-intuitive.

Worse, they also exhibit serious policy biases -- acting to protect their industries, professions, and permanent employers, and exhibiting biases reflecting the tension between private sector and collective action. The elites are devotees of the market and neo-liberalism. As a result, the elites have a general bias against government intervention in the market and policies designed to level the playing field or re-distribute wealth.

A good example of elite bias is their tendency to support "Free Trade." Arguments in favor of free trade never take into account labor protections such as prohibitions against child labor; wage and hour standards; occupational safety and health protections; the right to organize; or prohibitions against work place discrimination. Nevertheless, free trade is an article of faith among the business and professional elites in the U.S. It is also an open secret that the private sector -- in particular, the large multinational corporations headquartered or operating in the U.S. -- has openly advocated free trade as a way to end-run government work place regulations, lower their labor costs, and increase their profitability.

Thomas Frank makes an important point in "What's the Matter with Kansas." In his book, Frank addresses the following seeming paradox: Why would average working people in Kansas  -- home of staunch early 20th century progressive political populism -- vote against their economic interests and overwhelmingly support the Republican Party, the acknowledged party of Big Business that has systematically dismantled manufacturing and blue collar work in Kansas? Frank, a sociologist, found that on the key issue of jobs and overseas outsourcing, the Democrats were no better than the Republicans. Since there was no alternative on this issue, people in Kansas went with the Republicans, who they favored on some social issues. Frank's conclusion -- and his book -- are a devastating indictment of the Democratic Party on this critical issue.

The irony is also too palpable not to note. Historically, the Democratic Party has been the party of labor and the working class and the Republican Party of business and the elites. But, as we have just seen, the Democratic Party now has tilted strongly toward the business and professional elites on a key issue of outsourcing (and many other issues) as its progressive populism has been hollowed out with the passage of time. Meanwhile, the emergence of conservative populism has been bought and paid for by Big Business to pave the way for the Republican Party to regain power, so as to avoid regulations favored by the Democrats and abhorred by the Republicans. The degree of political bad faith is astonishing. You just have to love politics in this country.

Daniel Berger is an attorney in the field of complex litigation, including securities and anti-trust litigation, and has a broad-based knowledge concerning the structure and functioning of the US economy and US financial markets. He practices in Philadelphia.

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Love in the Time of the Haitian Cholera

Nov 2, 2010Rev. Marcia Dyson

haiti_map-150The Haitian people's will to survive, and thrive, is mighty. But they also need our assistance in battling crisis upon crisis.

haiti_map-150The Haitian people's will to survive, and thrive, is mighty. But they also need our assistance in battling crisis upon crisis.

I've always admired the haunting beauty and sad grace of Gabriel García Márquez's novel "Love in the Time of Cholera". But I never imagined that his title would conjure the force we'll need to fight Haiti's freshest suffering: an outbreak of cholera that threatens the loss of thousands of lives.

It's fitting that the novel in which Márquez temporarily loosens the hold of magical realism is the one that symbolizes Haiti's plight today. There's little state magic to speak of, and the economic realities that this country faces are tragic and legion. But my God, the will and spirit of the people remains indescribably, well, magical, to say the least. I've gotten to know Haiti and its people a lot better over the last two years as I've served and traveled throughout the complicated outlines of this besieged geography.

Haiti's present troubles may yet prove faithful to a script that seems passed down from on high: A small but mighty colony of oppressed black subjects will resist and rise just when nobody gives them a chance in hell to survive. That was certainly true of Haiti at its birth.

In 1804, the nation roared into existence after a decade-long slave revolt fomented by Toussaint Louverture, which ultimately resulted in Napoleon getting beaten at his own game -- and the world's first republic winning independence from France.

Haiti's will to rise was certainly challenged during U.S. military occupation of the country from 1915 to 1934, and its national urge to strength was surely suppressed as the U.S. exerted direct or indirect control of the Haitian economy from 1905 to 1947.

And through a string of tyrants, incompetents and soiled idealists at the helm of the nation (some with American support, or at least with our willingness to look the other way while the country was lost and looted), Haiti's people have managed to keep faith, even though that faith has been unjustly savaged and satirized as "Voodoo" -- with the scare quotes in tow -- little more than a hodgepodge of hocus pocus and superstition.

But that's the retail version of Vodou, pushed in the marketplace of ignorance and bigotry. In Haitian Vodou, practiced widely by much of the population, the spirits of the departed -- sa nou pa we yo, those we don't see -- don't fly away, but remain near to those left behind, permitting the suffering living the triumphant advantage of laughing in the face of death.

That's not a fatalistic position, but a supremely hopeful one. After all, the living have had so much death to defy. Is Vodou any more unrealistic a remedy than, say, colonial exploitation and schemes of duplicitous rationality deployed by would-be saviors in military or ministerial garb?

This doesn't mean that it's a pie-in-the-sky piety that isn't vexed by the mortal wounds of poverty and catastrophe. On the contrary: It's a source of spiritual resilience in the face of tragedy. The bipolar opposition between science and soul doesn't exist in Haiti, at least not in any reasonably concrete fashion. (For that matter, there isn't even a neat division between, say, Catholicism and the catechism of indigenous spirituality that flows effortlessly through the syncretic religious experience that is a noted strength of the African Diaspora.)

Even as we respect the homegrown spirituality of Haitian residents, we've got to ramp up the material resources they so desperately need. After the January earthquake left the nation in shambles and rubble, and 300,000 souls lingering near the living, you'd think God, or at least nature, might leave the Haitian folk alone long enough to recover. Until that theological dispute can be resolved, the political and ecological elements, as well as the moral ones, must be engaged.

We need to send more medical personnel and supplies to tamp down a fever of cholera that has pandemic written all over it. That's for sure. And we certainly need to send more money to responsible agencies to relieve the suffering. No argument here.

But we also need to ask some tough questions. Beyond the cholera crisis, is there a crisis in political legitimacy in Haiti and the United States, where real fault may be found in the use, or misuse, of international aid money? Regardless of the source of the outbreak, it's likely that most Haitians see it as a plague of nature. But what role does man play in this tragedy, especially through shortsighted priorities that diverted needed attention away from structural responses to Haiti's suffering? For every bottle of water sent, an inch of water pipe could have been built. For every tent erected, a transitional house could have been constructed. Simple, yes, but sound, too.

As U.S. taxpayers, are we aware of where this country's $1.15 billion pledge to Haiti is going? Do we know what sustainable deliverables are being guaranteed by contractors and suppliers? Finally, what of the African Diaspora's response to Haiti, especially from her benighted kin in America?

Sure, we brag about Louverture; we even sing the praises of the TransAfrica Forum and other groups that champion Haitian self-determination and effective governance. But in truth, we leave the economic and moral heavy lifting to white celebs like Sean Penn, Mia Farrow and George Clooney. Where are our black celebs -- besides Wyclef Jean -- in the fight for Haiti? What about the rest of us? Where do the sun-kissed children of the black experience stand in times of greatest crisis for our people in Haiti?

We need black love in the time of Haiti's cholera. We need the spirits of the departed ancestors to rally the will of the people to survive. We need the revolutionary spirit of Louverture and other slaves to course through our veins. And we need the sacrificial energy of black American brothers and sisters to circulate all the way to Haiti. Otherwise, we are in peril of losing our souls and condemning our brothers and sisters to even more rubble and disease.

Marcia L. Dyson works with the Fondation Lucienne Deschamps in Port-au-Prince, which is dedicated to education and the training of teachers.

A version of this post originally appeared on The Root.

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G20 Currency Accord Collapses Under the Weight of its Own Contradictions

Oct 25, 2010Marshall Auerback

marshall-auerback-100Our leaders are making decisions based on flawed premises -- but what we really need is jobs, jobs and more jobs.

marshall-auerback-100Our leaders are making decisions based on flawed premises -- but what we really need is jobs, jobs and more jobs.

Treasury Secretary Tim Geithner appeared fixated on US trade at last weekend's G20 Summit in South Korea. While it is misguided to focus solely on current account imbalances, there is a certain kind of perverse logic behind his thinking. Given that the US government is likely to cut back on spending in the near future, which won't do anything good for our consumption here at home, one can understand the Treasury Secretary's preoccupation with trade imbalances. In an economy that is far below full employment, higher exports could generate sufficient demand so that, as much as you might be exporting an increasing amount of your domestic output to increase the per capita consumption of foreigners, there is also an accompanying increase in US consumption because of the multiplier effects of more employment. Remember that per capita outputs, and per capita consumption, do not only rise because of imports, but also because we have more people employed. After all, while the Chinese are exporting ever more, they are also slowly increasing their own per capita consumption, especially as more and more of the disguised unemployed in the Chinese countryside become employed in the export sector.

But is the optimal policy truly to target current account imbalances? No. The right policy response is to work toward a full employment policy by vastly expanding fiscal policy. The US government is fully capable of doing this on its own without any global cooperation.

It is true that many of us have been saying for years that exports are a cost and imports a benefit, so therefore the US should maximize net imports. We have got absolutely no traction with this argument because it is a contingent statement, true only at full employment. So while we have suggested fiscal policies designed to get us to full employment, until the rate of unemployment is reduced substantially it is much harder to make the case that maximizing net imports is a good strategy in an economy that is far below its production possibility curve (i.e., far below full employment).

A sensibly constructed fiscal policy that incorporates a Job Guarantee program would be a great start. But let's be honest: It ain't gonna happen anytime soon, especially given the likely configuration of the future Congress after the midterm elections.

Failing a big fiscal response, then, there clearly is a big problem ahead for the US. The latest data from the US western ports indicate that the American economy has gone from a very rapid pace of expansion in exports on a sequential and year on year basis to small declines in exports on a year on year basis and more severe declines on a sequential basis. And a veritable tsunami of Chinese imports is now hitting our shores, the product of China's own substantial build-up of its export capacity last year (which is where their government deployed the majority of its fiscal resources).

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Why is US trade deteriorating? In part because the rest of the global economy might be slowing. But the more significant cause is China's over-investment in industrial tradables and the consequent pressures for greater Chinese exports and a greater degree of Chinese import substitution. More restrictive fiscal policy, added to deteriorating trade accounts, likely equals higher unemployment. It seems almost inevitable that this will engender more than mere threats from the American government next year. Tariff increases appear to be in the cards.

The upshot is that Beijing is going to be hit with the collateral damage via a trade war. Their economy's dependence on export growth  represents a clear and present danger. So the Chinese are doing themselves no favors by maintaining the pegged rate regime, which they should abandon as soon as possible -- largely for their sakes, not ours. Consider the following: According to the Hurun report on China's wealthiest individuals, 95% of those on the rich list earned their money by focusing on domestic consumption; just 5% are export moguls. Clearly this domestic consumption sector wants to grow from the bottom up, but Chinese government policy currently prevents it from doing so.

That said, you can see why Beijing doesn't take kindly to the "helpful suggestions" from the US, which are riddled with contradictions. On the one hand, Congress and the Treasury are accusing China of currency manipulation designed to increase its net exports. Meanwhile, the Federal Reserve, via "QE2", is trying to force a run out of the dollar to appreciate the currencies of our trading partners so that the US can export its way out of its Great Recession.

Similarly, Beijing has been raising its rates on concerns that the Chinese economy is overheating. But our Treasury Secretary is urging them to increase their already booming domestic demand so that they can buy more US output. At the same time, Geithner wants countries with trade deficits like the US to boost saving and cut spending. Fine, except that it seems odd to add to an already booming economy in China while the US is slumping and Geithner talks about the desirability for us to rein in long term deficits and therefore reduce demand.

At a basic level, the incoherence in the American proposals is symptomatic of a broader policy making problem when one operates from a flawed paradigm. Policy makers like Tim Geithner have long been clueless on domestic federal budgets. This time around, however, his focus on current account imbalances might be logical, but only as the stupid outgrowth of a misguided understanding of public reserve accounting. In many respects it is nothing but a sideshow, one which conceals the fact that most of the policies of the Obama Administration are only making matters worse (such as turning a blind eye to fraud as part of financial "reform").

The irony, of course, is that when China does begin to enact policies that allow its population to fully consume the fruits of its own economic output, then we'll be paying a lot more for basic stuff. Remember how great it felt to be paying $5.00 per gallon for gas during the oil price spike in the summer of 2008? That's going to be child's play compared to what's ahead. But we aren't taking advantage of the gift that China is giving us. And things will only get worse, because we remain prisoners of a 19th century gold standard mentality.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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Joseph Stiglitz: The New World Economy

Oct 25, 2010Lynn Parramore

joseph_stiglitz-150This is the sixth and final installment of  "The Influencers,” a six-part interview series that Lynn Parramore conducted in partnership with Salon.

joseph_stiglitz-150This is the sixth and final installment of  "The Influencers,” a six-part interview series that Lynn Parramore conducted in partnership with Salon. She caught up with Joseph Stiglitz, Nobel laureate and the Roosevelt Institute's Chief Economist, to talk about the changing global economy. Stiglitz explains that while the US has traditionally been an economic superpower, it may have to forfeit that role.

Lynn Parramore: People have said that before the crash, the U.S. provided the world's consumer of last resort. How much has the world changed in that respect?

Joseph Stiglitz: Well, before the crisis, the United States was living beyond its means, and much of what it was spending beyond its means was consumption. It is still the case that the United States is living beyond its means, but the good news is that the households are now beginning to save. But on the other hand, the government deficits have actually increased. So the fact is, the U.S. is continuing to spend beyond its means. Now in the long run, this can't continue, and that is what is sometimes referred to as the problem of global imbalances. It changed a little bit since the crisis, but the fundamental problems that have given rise to it have not been corrected.

China is running a massive export surplus, and this is beginning to emerge as a political issue. What's your take on this?

Well, China's problems are distinctive, and in some ways just the opposite of ours. They have a savings rate of 50 percent. China's not the only country that's running large surpluses; Germany's running surpluses that are largely comparable as a percentage of GDP, and Saudi Arabia has surpluses that are also large. The focal point of the debate in the United States has been exchange rates -- concern that the exchange rate between the U.S. dollar and Chinese currency is distorted by government intervention on their part. Adjustments of exchange rate are not likely to fully resolve the problem of global imbalances. In fact, from 2005 to 2008, the time when the crisis occurred, China had basically increased the value of its currency by 20 percent, which is about two-thirds of what most people had thought was the exchange rate adjustment that was needed.

Even if China continues to allow its exchange rate to appreciate, it is not going to solve the U.S. problems. The U.S. will be buying apparel and textiles from Sri Lanka, Bangladesh. It's not likely to start making them itself. And so it is a shifting of blame to say that is the U.S. problem. The problems in the U.S., I think, are more fundamental. It does hurt Sri Lanka and Bangladesh to have an exchange rate that might be distorted in that way, but it won't resolve the more fundamental problems of America's trade deficits.

Policy-makers often talk about the U.S. as the world's indispensable nation. Is that consistent with how you view America's place in a post-crash world economy?

Well, America is still the largest economy in the world, and in that sense it is going to continue to be a central player. Even the most optimistic forecast for China's growth suggests that it will be a quarter century before China is comparable in size, and even then, China's per capita income will be markedly lower than it is in the United States. And I think the United States is likely to continue to be the source of innovation, the source of higher education. So, the role of the U.S. is going to continue to be very, very strong. But there was a short period between the end of the Cold War and the crash of Lehman Brothers where the U.S. was the superpower not only militarily, but economically. It had a very strong role in dictating the terms of international agreements. That position is not likely to be restored.

Let's talk about the U.S. stance toward the crisis in the European Union. The rescue is being done as a joint project between the European Union and the IMF. What's your take on the role of the IMF in a new world economy? There have been some proposals, for example, to restructure the IMF. What do you think about that?

It's very clear that the IMF has taken a much more constructive role in this crisis than in earlier crises. Dominique Strauss-Kahn as the leader has really changed many of the policies and orientations, talked about the importance of unemployment, the necessity to have counter-cyclical fiscal policies, so in that way there has been a very big change in the role of the IMF. On the other hand, there is concern that if the IMF could change so quickly in one direction, it could change just as quickly back to where it was, and that raises very fundamental issues about governance, the need for changes in governance to make sure they are reflective not only of the advanced industrial countries and not only of the financial sectors in the advanced industrial countries, but of a broader representation of views.

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Japanophobia: Economic Myths in the American Media

Oct 20, 2010Lynn Parramore

lynn-parramore-web-headshot-1If fiscal hawks have their way, we'll learn the wrong lessons from an ailing Godzilla.

lynn-parramore-web-headshot-1If fiscal hawks have their way, we'll learn the wrong lessons from an ailing Godzilla.

I'm turning Japanese
I think I'm turning Japanese
I really think so
~~The Vapors

The American obsession with the Japanese is nothing new. We marvel at their meteoric trains and mouth-watering cuisine. We once spoke of their economic prowess in hushed awe. But reading the New York Times last Sunday, I realized that our fixation was taking a new, dangerous turn. Japanophilia is morphing into Japanophobia --  a fear that the U.S. economic outlook will somehow mimic the Land of the Rising Sun if we don't heed the fiscal hawks. In truth, we are in danger of learning all the wrong lessons from the Japanese. A shame, because they have much of value to teach us.

Martin Fackler's "Japan Goes From Dynamic to Disheartened" presented a fear-inspiring narrative that does little more than perpetuate myths that benefit the rich. His story: the Japanese economy is in the shitter because of too much "wasteful spending" by the government. Fackler breezily suggests a consensus on this point among economists:

"Japanese leaders at first denied the severity of their nation's problems and then spent heavily on job-creating public works projects that only postponed painful but necessary structural changes, economists say."

Oh, really? Creating jobs that put people back to work is about denial? Funny, but I know some economists who say otherwise. My Roosevelt Institute colleague Thomas Ferguson dismisses the false choice implied by the author. "You don't have to choose between working to keep full employment and making structural changes," Ferguson wrote to me in an email. "The issue is whether you just let unemployment go up, which drives people to desperation and widens the gulf between the rich and the rest of us, or whether you keep people employed while you make the structural changes you think are needed. The latter way is much easier to do and far more productive for society."

Fackler draws his analogy between the U.S. and Japan beginning with the Japanese bubbles that burst in the 80s and 90s. According to him, the country "fell into a slow but relentless decline" that could not be reversed, alas, even by "enormous budget deficits" or "a flood of easy money". Then comes the ominous warning:

"Now as the United States and other Western nations struggle to recover from a debt and property bubble of their own, a growing number of economists are pointing to Japan as a dark vision of the future."

Memo to Fackler: If you look closely at the history of the Japanese economy, it provides precisely the opposite illustration. Government spending didn't cause the Japanese economy to stagnate. It was the fitful confusion of stop-start fiscal spending that seesawed the economy between hopeful improvement on the one hand, and wrenching cut-backs and consumption taxes urged by austerity-preaching deficit hawks on the other. Bipolar fiscal policy during a time when the private sector is trying to pay down debts and repair balance sheets is a recipe for disaster. The "flood of easy money" Fackler references, also known by the wonky term "quantitative easing", was the wrong approach by the Japanese government, which should have maintained the focus on jump-starting a weak economy by putting people back to work. That's the smart, productive way to get things moving. Unfortunately, a failure of nerve and political will crippled Godzilla. And the dismal vision Fackler outlines will emerge in the U.S. if we buy into his false narrative. Ironically, reports like Fackler's are creating the very reality they purport to warn against.

My colleague Marshall Auerback provides some facts that Fackler-the-Feckless would do well to master. In a mini-history of the Japanese response to economic crisis, he observes:

"In 1997, just as Japan was beginning to emerge from recession, the government introduced a 40% increase in the consumption tax, which promptly threw the country back into the throes of recession. Then you had the Asian financial crisis, which obliterated the export sector. Then you had the Koizumi Administration attempting "fiscal consolidation" throughout the early 2000s, which actually caused economic growth to slow and the budget deficit to rise. This, despite the fact that the Bank of Japan started to do "quantitative easing" in March 2001. It wasn't until September 2003, when the Koizumi government finally stopped the crazy fiscal austerity fetishism, when, lo and behold, the economy began to grow steadily again and the budget deficits began to go down. That's what was happening until the financial crisis of 2008."(Also see Auerback's "What Ever Happened to Japan?").

Contrary to Fackler's story, Japan's deficits show the dangers of what happens when you stop spending proactively and productively during a crisis: you get larger deficits as automatic stabilizers kick in and tax revenues decline. To avoid this fate, we have to deploy our fiscal resources to generate greater economic activity. Put plainly, we need to create jobs. It would be great if the private sector were creating all the jobs we need. But it isn't. And that's where government can step in.

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But meanwhile, we have to combat the Facklers who whip up Japanophobia and freeze our political will. As Rebecca Wilder points out at the News N Economics blog, cherry picking anecdotes about down-and-out Japanese people crushed by deflation as Fackler does is not a substitute for responsible analysis. Contrary to what he implies, the Japanese standard of living has actually grown over the last two decades. And as for the country's unemployment numbers, they ought to make Americans blush: They're around 5%. The Japanese may be wary of the future after the bubble-fueled economic euphoria of past decades. But most of them have jobs. And as to what they enjoy in the public sphere, well, let's just say that if you take a train out of Tokyo and compare that to a train ride from New York City, you will quickly discover just how well our fiscal austerity is working for us. Go ahead. Use the toilet if you dare.

But the big question is this: Why does America continue to put up with high unemployment when we can directly create jobs, just as FDR did through the Works Progress Administration? Is it because big corporate interests want to keep wages down by keeping large numbers of Americans out of work? Is it because the rich become more powerful when ordinary people have less? These are the dark visions we should be worried about. History shows that when times are tough, the government can create jobs and find plenty of useful things for laid-off folks to do. Like repairing roads and rebuilding decrepit schools. Where there's a will, there's a way. Political will is what stands between millions Americans and a more prosperous future. That, and reporters who don't do their homework.

Lynn Parramore is the editor of New Deal 2.0, Media Fellow at the Roosevelt Institute fellow, Co-founder of Recessionwire and the author of Reading the Sphinx.

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The Foreign Exchange Mystery

Oct 13, 2010Wallace Turbeville

money-question-150Why would such a large swaps market be a possible exemption from FinReg?

money-question-150Why would such a large swaps market be a possible exemption from FinReg?

The traded foreign exchange market is the big enchilada. It is the largest financial market in the world. The Bank for International Settlements estimates that the daily turnover in this market, including swaps, futures and spot purchases, is $4 trillion as of April 2010. This turnover increased more than 20% in the last 3 years. Trading is concentrated in London, accounting for 36.7%, while the New York share of the market is around 18%.

Since FX swaps and forwards are based on currency values, it is very easy to embed other financial transactions in a dealtransaction that involves exchange rates on its face. For instance, a loan can be the primary purpose for a swap of currency values. The danger in such obfuscation is illustrated by the foreign exchange transactions between the Greek government and Goldman Sachs, which disguised the debt burden of Greece and triggered a crisis.

In the Dodd-Frank Act, clearing (if available) is mandated for most derivatives, with "end user" hedging transactions carved out. But a second carve out, for FX swaps and forwards, is permitted if the Treasury orders it. There is significant concern among progressives monitoring the implementation of Dodd-Frank that the Secretary will soon exempt FX instruments from the clearing mandate. (See Mary Bottari, "Is Geithner Planning a Stealth Attack on the Wall Street Reform Bill" and David Wigan, "Traders Angered by Swaps Legislation.") Why did the Act envision this enormous exception? Why would Treasury implement the exemption? Why would it act now? These and other questions are shrouded in mystery, and that fact alone is of great concern.

Several knowledgeable individuals who were involved in the discussions of this provision during the drafting of Dodd-Frank report that Treasury never articulated a coherent rationale. It was clear that the New York Federal Reserve sought the exemption, but their motive was obscure. There was no structural impediment to mandating the clearing FX instruments: the Chicago Mercantile Exchange has a thriving FX futures business. It follows that Congress did not have the information to assess the proposed exemption, and the decision was delayed and delegated to Treasury.

According to Dodd-Frank, the Treasury Secretary must consider the following in deciding whether to grant the exemption:

1) "whether the required trading and clearing of foreign exchange swaps and foreign exchange forwards would create systemic risk, lower transparency, or threaten the financial stability of the United States;

2) whether foreign exchange swaps and foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by this Act for other classes of swaps;

3) the extent to which bank regulators of participants in the foreign exchange market provide adequate supervision, including capital and margin requirements;

4) the extent of adequate payment and settlement systems; and

5) the use of a potential exemption of foreign exchange swaps and foreign exchange forwards to evade otherwise applicable regulatory requirements."

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If the Secretary decides to grant the exemption, he is required to submit specific information to the relevant congressional committees, including:

1) "an explanation regarding why foreign exchange swaps and foreign exchange forwards are qualitatively different from other classes of swaps in a way that would make the foreign exchange swaps and foreign exchange forwards ill-suited for regulation as swaps; and

2) an identification of the objective differences of foreign exchange swaps and foreign exchange forwards with respect to standard swaps that warrant an exempted status."

It is hard to imagine that, in the months of discussion that preceded the enactment of Dodd-Frank, these issues were not thoroughly analyzed by the Treasury and the Fed. Certainly there is nothing that has emerged since enactment that is relevant to these issues. Granting the exemption now doesn't make sense with the flow of events. Congress could have been presented with all relevant facts and arguments so it could have decided instead of delegating the decision to Treasury.

The process suggests that this delay and the procedure were designed to appease opponents to the exemption and those who were concerned that the rationale was insufficiently presented. If this is true, the result is probably inevitable, at least in the minds of those in charge of the Treasury and the Fed. It is really maddening that the administration and the Fed were unwilling or unable to lay out the necessary factors to allow Congress to decide on such an important segment of the market.

We are left to guess at the reasons the FX market is to be treated so differently from other derivatives markets. There are several distinctions:

• As stated above, it is large. Worldwide, it is the largest of the financial markets.

• There is no meaningful distinction between a forward purchase and sale and a swap. Buying euros for future delivery at a fixed dollar price is not materially different from a euro/US dollar swap. In contrast, if someone sells a bushel of corn, he or she must deliver it.

• There has been much debate about the proportion of hedging and speculation in the FX market. However, it is clear that, compared with other markets, the amount of speculation is quite large.

• Relative currency values are directly related to central bank activities.

• The London market, being twice the size of the US market, plays a central role.

• The market presence of US financial institutions is significant, but the larger participants are European banks.

None of these distinctions compels a decision to exclude FX transactions from mandatory clearing, a process in which trade data is reported and a standard system for margining is imposed. Until the Treasury and Fed fill the public in on their thinking, it is pointless to speculate (unless you are a bank speculating on foreign exchange rates). It is ironic that, in implementing legislation designed to bring transparency to the financial markets, the Treasury and the Fed are so unconcerned about their own lack of transparency.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co. He is Visiting Scholar at the Roosevelt Institute.

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How War Debts, High Tariffs, and Competitive Devaluation Led to War

Oct 8, 2010David B. Woolner

Roosevelt historian David Woolner shines a light on today’s issues with lessons from the past.

Roosevelt historian David Woolner shines a light on today’s issues with lessons from the past.

Last week, in a little-noticed story, the German government announced that on October 3 -- the twentieth anniversary of German Unification -- Germany would make the final payment on the debts it acquired through the allied demand for reparations in the aftermath of World War I. The timing of this development is interesting. It brings to mind one more example of the misguided economic policies that came in the wake of the First World War, which contributed to the financial collapse that brought about the Great Depression. We now know that these polices -- which included the passage of the Hawley-Smoot Tariff that raised import duties to their highest level in American history, competitive devaluation of currencies among the leading industrialized nations, and other protectionist measures such as exchange controls -- were contributing factors to the onset and severity of the Depression. They also helped propel Adolf Hitler into power in Germany and hence had horrific consequences far beyond mere economics. How did the world get into this mess? And are we in danger of repeating some of the same mistakes today?

In the wake of the carnage wrought by the world's first truly "total war" -- the British alone lost over nineteen thousand men on the first day of the Battle of the Somme -- the desire for revenge against Germany was very strong, especially in France and Belgium, where large areas were devastated by the conflict. This sentiment, coupled with the fairly widespread belief among the allied powers that Germany was responsible for starting the war (Germany certainly bore a large share of the responsibility, but there were other forces at work as well), led to ever-increasing calls for Germany to pay for it. The allies had also taken on huge debts during the conflict, mostly owed to the United States, which emerged from the war as the world's leading creditor nation. Based on these determinations, the allies included the so-called "war guilt clause" in the Treaty of Versailles, which stated that Germany must accept responsibility for "causing all the loss and damage to which the Allied and Associated Governments and their nationals have been subjected as a consequence of the war..."

Having concluded that Germany was liable for the cost of the war, the allies imposed a reparations regime upon Germany that called for a payment of 269 billion gold marks. The treaty also stripped Germany of her overseas colonies and investments, drastically reduced the size of her military, eliminated her merchant marine, and split the country in two so as to provide a corridor to the sea for the newly reconstituted country of Poland.

Needless to say, these measures placed a significant economic (not to mention psychological) burden on the inchoate Weimar Republic. This was especially true with respect to the reparations, for as John Maynard Keynes observed in his landmark work The Economic Consequences of the Peace, the reparations not only involved payments of gold and/or foreign currency, they also transferred important coal, iron and steel properties from Germany to France and prohibited their utilization by German industry. The treaty as such struck at the very heart of the German economy and made it much more difficult for Germany -- even then the most important economic unit in Europe -- to fully recover from the war.

It was only a matter of time before the German government defaulted on its reparations payments. When it did so in 1922, the French responded by invading Germany's industrial heartland, the Ruhr. This in turn led to a campaign of passive resistance among German workers and the decision by the German government to continue to pay them, leading to hyper-inflation and the collapse of the German economy.

Even though the United States had rejected both reparations and the Treaty of Versailles, it was the US that ultimately came to Germany's and Europe's rescue in response to the 1923 "Ruhr crisis." Under the terms of the Dawes (1924) and later Young (1929) plans, the total reparations due was reduced to 112 billion gold marks, and millions of private American dollars were pumped into the German economy to stabilize its currency and make it possible for Germany to pay her reparations. This in turn made it possible for the British and the French to make their war debt payments to the United States.

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This inherently unstable system worked fine so long as American investors were willing to keep the flow of dollars moving into Germany. But when the bottom fell out of the US stock market in 1929 the flow stopped, the German economy once again collapse,; and with unemployment soaring, the popularity of the Nazi Party rose dramatically. In 1928, for example, the Nazis held only 12 seats in the Reichstag, but in 1930 they polled 107 seats and in 1932 they took 230, making Hitler's party the largest in the German Parliament. Within a matter of months, Hitler was appointed Chancellor of Germany and the fate of the world would never be the same.

None of this happened overnight. It took some time for these events to unfold, which is why in hindsight the actions of the governments involved look so disturbing. With Germany experiencing a rapid economic decline after the 1929 crash, for example, the allies offered to reduce the reparations demands, but only if the United States would be willing to do the same with respect to the war debts. The Hoover Administration, however, refused to do so, even going so far as to insist repeatedly that there was no link between the two issues. Hoover did offer -- and instigate -- a one year moratorium on all inter-governmental debt in 1931, but this was too little too late. Moreover, to make matters worse, the US by this point had instigated the Hawley-Smoot Tariff, making it even harder for the European nations to earn the dollars they needed to pay off their American debts. By 1931, the situation had reached crisis proportions, and in response the British and many other smaller nations abandoned the gold standard and depreciated their currencies in an attempt to promote their exports and revive their domestic economies. This in turn hurt American exports and placed further downward pressure on domestic American prices, deepening an already bleak economic picture.

When Franklin Roosevelt took office in 1933, there were great hopes in London and Paris that he would be much more sympathetic to the British and French desire to reduce or even eliminate the war debts. This may have been the case privately, but the US Congress was in no mood to compromise. So the matter was left unresolved, and as the Depression continued, eventually the payments ceased.

As for the German reparations payments, they were suspended in 1931 and were not recognized as legitimate under the Nazis. But in 1953, the West German government agreed at a conference in London to resume paying its foreign bond obligations from the inter-war years. By the early 1980s, the entire principal on these bonds had been repaid. Also included in the London agreement was an understanding that Germany would not have to pay the interest on this foreign debt until it had achieved unification. With this accomplished in 1990, Germany began paying off the interest in annual installments, making the final payment of 70 million Euros last Sunday.

The experience of the inter-war years -- including the determination that World War II was caused largely by economic forces -- helped inspire the creation of the American-led postwar multilateral economic system based on freer trade and the free movement of capital that for the most part served the world well. But the nationalistic "beggar-thy-neighbor" impulses of the interwar years have not disappeared and are clearly on the rise. Witness, for example, the tensions between China and the US over China's refusal to raise the value of its currency (what Treasury Secretary Geithner calls "competitive non-appreciation"); the response of the US House of Representatives, which just passed a bill targeting Chinese imports; the widespread speculation that these tensions and others among the world's emerging economies will lead to an all-out currency war; and the emerging anti-free trade stance among members the extreme right-wing of the Republican Party (61% of Tea Party members say they are opposed to free trade).

The experience of the 1920s and 30s taught our parents' generation that economic nationalism is a double-edged sword. Recent events seem to indicate this is one lesson this generation has either forgotten or is prepared to reject, with unknown consequences for the future.

David Woolner is a Senior Fellow and Hyde Park Resident Historian for the Roosevelt Institute.

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Is Japan Rolling into Recession? A Look at the Impact of China's Policies

Oct 7, 2010Marshall Auerback

How have China's policies affected Japan, and what to they mean for the U.S.?

The recently-released Tankan survey is consistent with the negative trends in Japan noted in yesterday's post.


How have China's policies affected Japan, and what to they mean for the U.S.?

The recently-released Tankan survey is consistent with the negative trends in Japan noted in yesterday's post.


Though the manufacturing sector index rose from +1 to +8, the forward looking measures deteriorated. Capital spending intentions of large corporations were +2.4%, down from +4.4% in the prior quarterly Tankan. The message is somewhat more negative because the September survey tends to seasonally show slightly higher capital spending intentions versus the June survey. More importantly, manufacturing optimism went from +3 in the June survey to -1 in the September survey.

The odds are that Japan may already be rolling into recession. Consumption has been buoyed by spending incentives; they expire this month. The Kan government is preparing a new round of such incentives, but the experience of other economies shows that a second round of such incentives has much less impact.

Most ominous is the trend in exports. Exports have led the Japanese economy over the last decade or so. It was almost a 50% decline in exports that took Japanese GDP down by a huge 8.9% from peak to trough in this latest recession. The rise in exports has accounted for 80% of the recovery since that trough which still has GDP 4.2% below the prior cyclical peak. The export data now shows a possibly significant outright downturn in exports already. This is striking because the world economy had still been recovering fairly strongly and Asia, led by 10% economic growth in China was still growing robustly.

Worse yet, the deterioration we are now seeing in Japanese exports do not reflect the strength in the yen this year. THE LAGS IN TRADE ARE LONG. The threat to Japan from the rising yen is that Japanese corporations are forced by the strong yen to move their production platforms to lower cost economies and thereby hollow out Japan. It takes a long time to make these business investment decisions and act on them. To the extent that "hollowing out" is now hurting Japanese exports, it reflects 95 to 100 yen to the dollar and not 83 yen to the dollar. A further adverse impact on Japanese exports and industrial production from recent yen strength could be huge. Already exports are weak and industrial production is rolling over even though Japanese firms report they can live with 95 yen to the dollar. The majority of Japanese industrial firms say they cannot live with 85 yen to the dollar. The deterioration in Japanese exports and industrial production we are seeing now could be much worse, all other things being equal, if the yen stays above 85 to the dollar.

Worse yet, the new China mega-investment boom is ongoing. Only the shortest lead time projects are in production, which are now competing with Japan. But, there is a huge surge in new Chinese production ahead which will compete with and substitute for Japanese exports. Exchange rate considerations aside, the secular trend whereby emerging Asia and especially China are competitively advancing on Japan will undermine Japan's exports and industrial production in the near to intermediate future.

This deterioration is all happening in an overall still-strong global economy. What will happen to Japan if there is considerable global weakness ahead and the yen remains strong? The odds are that Japan will have another severe recession.

Japan truly appears to be the canary in the coal mine in regard to China's overinvestment which, coupled with yen strength, is hollowing out the former. We now have the spectacle of half of all Japanese industrial corporations saying they will have to move their production platforms out of Japan to low cost economies at 85 yen, and yet we see commentaries from Bloomberg's William Pesek "How I Learned to Stop Worrying and Love the Yen", suggesting that an even stronger yen "can be a magnet for the foreign investment that tends to avoid Japan."

It was recently reported that the Band of Japan bought 2.12 trillion yen between August 28 and September 28. Apparently the BOJ continues to drag its feet. We have a market place that expects Helicopter Ben to engage in mega QE and believes a stubborn BOJ will resist intervening in the yen no matter how weak the Japanese economy has been and may be. This brilliant "expectations management" on the part of the BOJ now risks sending Japan into yet another recession while the rest of the world's economy is still growing. And China's ongoing purchases of yen bonds is both irresponsible and exacerbating this trend. This is the type of provocative behavior that could lead to real wars, let alone trade wars.

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The market with the biggest underexposure with the most bearish sentiment attached to it is the Japanese equity market. Eight months ago short the yen was the favorite macro trade of UBS and Goldman which means that all the macro funds were in that trade. Today, there is no bandwagon of yen bulls. So what explains yen strength? There is no manifestation of buying of yen in the balance of payments. Instead you see capital outflows. So who is taking the other side in the short term capital flow account? Have the "quant traders" taken over the market to such an extent that there is some obvious correlation their computers have all picked up and that is the nature of the buying? Or is there something of a more historical nature now enveloping this market?

Consider the recent fishing dispute between Japan and China: it is part of a longstanding rivalry between the two countries, predicated on a century of ill will. Perhaps the Chinese are buying far more yen than they have shown in their accounts. They only show the cash positions, not the forward positions. Could it be that they are buying huge quantities of yen in the forward market, which are then arbed to the short term capital account? The motive here would not just be to price a competitor out of the market, but to settle grievances from the Second World War, such as the Rape of Nanking. Most countries tend to bury these longstanding historical grievances in their diplomacy, but this fishing boat incident and Beijing's handling of it has to at least leave one with the impression that this newly emergent economy, now ranked number 2 in the world, is in a position to get revenge for the past. The best means of avenging the nation for historical slights and grievance, and making oneself the dominant power in Asia (whilst mitigating the influence of the US through its levers on Japan) is very simple: just buy yen and force the Japanese corporations to hollow out Japan.

Could this be the source of the mysterious strength of the yen? If so, then we have the makings of a real renegade nation on our hands. It is apparent that the post-bubble trauma in Japan has become so great that the body politic in Japan is near a breaking point. It appears to be only a matter of time before the Kan government, forced by the political tides, will simply steamroll the Bank of Japan and try to match the QE zeal of Helicopter Ben. However, if it does not act soon on a scale advocated by Ben Bernanke, Japan may already enter recession before the global economy approaches a double dip, and it may wind up with an economic and fiscal deficit and fiscal debt disaster if one or more major economies like the U.S. or Europe go into a double dip, even if it is a mild one.

More to the point, is Japan the lead indicator as to why could happen to the rest of the world, as a resurgent China continues on its current mercantilist course? The west coast port data for the US on outbound containers (exports) and inbound containers (imports) points to significant ongoing trade deterioration in the US in the months ahead. Because the second quarter reported U.S. trade deterioration was so great, it may have undershot a declining trend, so such trade deterioration may not surface in the next trade report. But it is there. Fiscal support to offset the declines in trade is non-existent (and likely to remain so given the likely future political configuration in Congress). We have gone from a very rapid pace of expansion in exports on a sequential and year on year basis to small declines in exports on a year on year basis and more severe declines on a sequential basis.

Why is U.S. trade deteriorating? In part because the rest of the world might be slowing. However, the more significant cause may well be China's over investment in industrial tradeables and consequent pressures for greater Chinese exports and a greater degree of Chinese import substitution. In that regard, Japan is proving to be the lead indicator.

There is a curiously perverse but symbiotic relationship that exists between China's mercantilists and America's finance capitalism. The whole "Bretton Woods II" process contributes to the financialization of our economy, as it continues to hollow out our manufacturing base. It represents an unholy alliance between Wall Street and China's military, which is driving much of the investment in China because they are reaping so many material benefits. The problem, however, is that at some point Chinese credit expansion has no place to put its money. All of the targets have been saturated, which means that there will be overinvestment in all industries and to an incredible degree. This may well kill industry after industry. It appears to be happening already in Japan.

How can there be an encore? To avoid recession you have to keep the investment ratio up. But capex as a percentage of GDP in China is already off the charts - it is in excess of 50% of GDP. So the Chinese can build an additional round of capacity, which may be equal to ten times annual demand by next year, and fifteen times by the year after, in Of course, this process has its limits. When the ratio is this high it is very hard to keep it this high. There is a tendency for it to fall and it will fall faster if there is a trade war. But if it falls there will be a recession in China, so perhaps China is far more recession prone than anyone thinks. It may ultimately be recreating Japanese-like bubble conditions in its own country.

And what does this mean for Japan, which is the canary in the coal mine? With this kind of investment going on in China, the Japanese firms haven't a chance to compete with the yen prevailing at this level. And China knows this so it continues to buy Japanese yen bonds, which keeps the currency high and basically destroys its main Asian competitor. It represents the ultimate revenge for Manchukuo and the Rape of Nanking. And this is a development that could move very fast because the excesses of investment in China are currently so great.

As Chris Dialynas and I have pointed out before, there is no question that China's mercantilism is a product of our ham-handed approach to Asia during the 1997/98 crisis, Less appreciated, however, is Beijing's role in creating that crisis via its cumulative 60% devaluation against the dollar from 1992-94. Very few people are looking at the direct impact of China's trade policies and how it is beginning to hollow out other countries' manufacturing bases. It's not just the US. The Japanese economy is now at the cutting edge of this threat.

Can the US be far behind?

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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How Much Will Currency Policies Really Affect Our Economy?

Oct 6, 2010J. W. Mason

downarrow-money-150Does the math really add up on these potential solutions to our economic problems?

downarrow-money-150Does the math really add up on these potential solutions to our economic problems?

A number of economists of the liberal Keynesian persuasion have been arguing recently that dollar devaluation is an important step in moving us back toward full employment. In principle, of course, a cheaper dollar should raise US exports and lower US imports. But what's missing from many of these arguments is a concrete, quantitative analysis of how much a lower dollar would raise demand for American goods.

In the interest of starting a discussion, here is a very rough first cut. There are four parameters to worry about, two each for imports and exports: how much a given change in the dollar moves prices in the destination country (the passthrough rate), and how much demand for traded goods responds to a change in price (the price elasticity). We can't observe these relationships directly, of course, so we have to estimate them based on historical data on trade flows and exchange rates. But once we assign values to them, it's straightforward how to calculate the effect of a given exchange rate change. And the values reported in published studies suggest that the level of the dollar is a relatively minor factor in US unemployment.

For passthrough, estimates are quite consistent that dollar changes are passed through more or less one for one to US export prices, but considerably less to US import prices. (In other words, US exporters set prices based solely on domestic costs, but exporters to the US "price to market".) The OECD's global macro model uses a value of 0.33 for import passthrough at a two-year horizon; a simple OLS regression of changes in import prices on the trade-weighted exchange rate yields basically the same value. Estimates of import price elasticity are almost always less than unity. Here are a few: Kwack et al (2007), -0.93; Crane, Crowley and Quayyum (2007), -0.47 to -0.63; Mann and Plück (2005), -0.28; Marquez (1990), -0.63 to -0.92. (Studies that use the real exchange rate rather than import prices generally find import elasticities between -0.1 and -0.25, which is consistent with a passthrough rate of about one-third.) So a reasonable assumption for import price elasticity would be about -0.75; there is no support for a value beyond -1. Estimated export elasticities vary more widely, but most fall between -0.5 and -1.

So let's use values near the midpoint of the published estimates. Let's assume import passthrough of 0.33, import price elasticity of -0.75, export passthrough of 1 and price elasticity of -1. And let's assume initial trade flows at their average levels of the 2000s -- imports of 15 percent of GDP and exports at 10.5 percent of GDP. Given those assumptions, what happens if the dollar falls by 20 percent? The answer is, the US trade deficit shrinks by 1.9 percent of GDP.

That might sound like a lot. But keep in mind, these are long-run elasticities -- in general, it takes as much as two years for price movements to have their full effect on trade. And the fall in the dollar also can't happen overnight, at least not without severe disruptions to financial markets. So we are talking about an annual boost to demand of somewhere between 0.5 and 1.0 percent of GDP for two to three years. And then, of course, the stimulus ends unless the dollar keeps falling. This is less than half the size of the stimulus passed last January. (Although to be fair, increased demand for tradables should have a higher multiplier than the mix of direct spending, transfers and tax cuts that made up the Obama stimulus.) The employment effect would probably be of the same magnitude -- a reduction of the unemployment rate by between 0.5 and 1.0 points.

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So it's not a trivial effect, but it's also not the main thing we should be worried about if we want to get back to broadly-shared prosperity. We should remember, too, that a policy of boosting US demand by increasing net exports has costs that a policy of boosting domestic demand does not.

And what about China? At least as often as we hear calls for a lower dollar, we hear calls for China to allow its currency to rise. How much could that help?

Unfortunately, there aren't as many good recent studies of bilateral trade elasticities between the US and China. And the BEA's published series for Chinese import prices only goes back to 2003, which isn't enough for reliable estimates. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn't affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is an implausibly high 1.5; then a 20 percent appreciation of the Chinese currency only provides a boost to US demand of less than one half of one percent of GDP in total, spread out over several years.

And of course, those are all wildly optimistic assumptions. A recent Deutsche Bank report uses an estimate of -0.6 for the exchange rate elasticity of Chinese exports. They don't give any estimates for US-China flows specifically, but given the well-established empirical fact that US imports are unusually exchange-rate inelastic, we have to assume that the number for Chinese exports to the US is substantially smaller than for Chinese exports overall. Consistent with that, my own simple error-correction model, using 1993-2010 data and the relative CPI-deflated bilateral exchange rate, gives an exchange rate elasticity of US imports from China of -0.17. If the real figure is in that range, then a Chinese appreciation of 20 percent will reduce our imports from China by just 0.03 percent of GDP -- and of course much of even that tiny demand shift will be to goods from other low-wage exporters. This last point makes a focus on the Chinese peg particularly problematic as an explanation of US unemployment. If you are talking about reducing the value of the dollar against our trading partners as a whole, any resulting shift away from imports has to be to domestic goods. But presumably the closest substitutes for Chinese imports are usually other imports, not stuff made in the USA.

These are rough calculations and only intended to start a conversation. But it's a conversation we very much need to have. Before we launch a trade war with China for the sake of American workers, we need more concrete answers on the size of the potential gains.

Historically-minded critics of China and other surplus countries often quote Keynes' writings from the 1930s and '40s, with their emphasis on the importance of "creditor adjustment". The implication is that it's China's responsibility to reduce its net exports. But this is a misleading reading of Keynes. In fact, his concern was only ever to ensure that no country was prevented from pursuing full employment by the need to earn foreign exchange. The US, as the supplier of the world reserve currency, cannot face a balance of payments constraint; if we fail to pursue full employment, we have no one to blame but ourselves. If Keynes were alive today, I suspect he would be telling American policymakers to forget about China and focus all their efforts on boosting US demand -- by public investment in infrastructure, by unconventional monetary stimulus, by paying people to dig holes and fill them up again if need be. Because he knew that the only reason to worry about the trade balance was to gain the freedom to pursue "a policy of an autonomous rate of interest, unimpeded by international preoccupations, and of a national investment program directed to the optimum level of domestic employment, which is twice blessed in the sense that it helps ourselves and our neighbors at the same time."

J. W. Mason is a graduate student in economics at the University of Massachusetts, Amherst. A version of this post previously appeared at The Slack Wire.

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Whatever Happened to Japan?

Oct 6, 2010Marshall Auerback

marshall-auerback-100Marshall Auerback explores Japan's poorly-performing economy and what it augurs for the rest of the world.

Something is very wrong with Japan.

marshall-auerback-100Marshall Auerback explores Japan's poorly-performing economy and what it augurs for the rest of the world.

Something is very wrong with Japan.

The Japanese economy has been much weaker than any other major economy for a while now: over the last business expansion, through the Great Recession, and in the recovery since the Great Recession trough. Japan's business cycle has been led by its exports for well over a decade. It has been my guess that overinvestment in industrial tradeables by Japan's Asian mercantilist competitors, especially China, along with yen strength has been seriously undermining the Japanese economy for some time. The recent all-time new highs in Chinese overinvestment and this year's crazy yen strength would only accelerate this process and might well presage what lies ahead for the rest of the world, especially the US.

Throughout the past month, the data coming out of Japan has been uniformly poor. This data -- especially a METI forecast for a coming 3% decline in industrial production in the next two months -- has been of a particularly gloomy and alarmist nature, especially from an organization such as METI, which has tended to be overly optimistic in its forecasts. But the data now says Japan may already be rolling over into a recession despite a growing global economy and a booming neighboring China. The markets right now with their yen "bid" seem as "out to lunch" regarding Japan as they were out to lunch regarding Europe last May/June, when the ECB contained an incipient currency/solvency crisis by backstopping the nations' respective bond markets.

What to do about Japan? Both Federal Reserve Chairman Ben Bernanke and economist Paul Krugman recommended to the Bank of Japan over a decade ago that it adopt a significantly positive inflation target and conduct monetary policy with that objective. Bernanke suggested that the Bank of Japan do this by buying foreign exchange and issuing monetary base until that target was reached. Similarly, in the recent Democratic Party of Japan (DPJ) leadership election campaign, challenger Ichiro Ozawa argued for such an inflation target for the Bank of Japan.

Although Naoto Kan retained his leadership position (and, hence, remains the country's Prime Minister), there are indications that he has begun to embrace much of the Ozawa platform. About a week ago, the Kan government moved to purchase significant quantities of foreign exchange through unsterilized issuance of yen in order to depreciate the yen. But it has not followed through after an initially promising start.

Unless the Bank of Japan follows Ozawa's recommendation and conducts foreign exchange intervention on a scale consistent with ending deflation and reestablishing inflation, it will probably fall short of the policy actions needed to weaken the yen. This cannot be done through quantitative easing per se. I have argued before that QE in terms of targeting reserve balances is ineffective. It is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn't have adequate reserves, then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending. Right?

Wrong. Bank lending is not "reserve constrained". Banks lend to any credit-worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves, then they borrow from each other in the interbank market. Or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank's capacity to lend. Loans create deposits which generate reserves. But whereas a policy to target reserves might be in effective, this does not appear to be the objective right now in terms of what the Federal Reserve is currently doing in the US. In effect, it is trashing bonds as well as cash (getting bond yields lower through the promise of additional, but as yet undisclosed, measures) and inciting investors into risk assets, notably equities, on the premise that this will increase spending. In effect the Fed is targeting equity prices as a means of buttressing consumption.

Will it work? With the private non financial debt to GDP ratio still at 170% and only ten percentage points off its highs it appears that there are very high risks in the Fed's approach. The markets may well call "Helicopter Ben's" bluff and a failure to see some positive economic outcome from the embrace of outright QE could well cause a serious crisis of confidence in the US markets.

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But let us take Japan; clearly, a very different situation pertains. For one thing, Japan can buy foreign exchange and sell yen forever and get the exchange rate down. The BOJ has done so in the past and these interventions have for the most part been successful. The exchange rate matters far more for Japan, whose ratios of exports to GDP and industry to GDP are far higher than in the US. Furthermore, if Japan manages to reverse deflationary expectations, there may be a real financial and real response. Japan has reduced its ratio of private non financial debt to GDP by FIFTY percentage points, not ten. There is more scope for loan demand. More important, in addition to less private debt, the liquid assets held by the private sector in Japan is just huge. The ratio of M3 to GDP has gone from 105% to 164% in twenty years. The public holds huge quantities of government bonds and, if the Japanese public thought they might not earn anymore the real return generated by deflation, the BOJ could well "chase" the public into a different category of risk assets, such as equities.

Japan has been experiencing a post-bubble adjustment for twenty years. The adjustment process in the US, by contrast, has been going on for a mere two years. It makes a difference. An aggressive intervention by way of forex purchases might really work for Japan.

But what is the alternative? We have just experienced a hint of that: the country's largest consumer finance company, Takefuji, has just filed for bankruptcy. Deflationary pressures are intensifying again. There has generally been a high correlation between Japan's ratio of fixed investment to GDP and its ratio of exports to GDP. Both went up in the 2000s into 2008 when the economy began to grow again. However, by 2008 the export growth was slowing. Economist Andrew Smithers blamed it on economic growth in Japan's trading partners, which he argues was slowing.

Perhaps, but a more plausible thesis is that by that time China was starting to seriously compete with Japan's export machine. Consider what happened to the Japanese economy in 2008: exports fell by almost forty percent, and of course fixed investment fell in turn. Even more striking is that Japan's exports have recovered less than any other major economy post the Lehman induced catastrophe -- likewise with its GDP. In spite of 20 years of largely subpar growth (with the notable exception of 2003-2007), the Japanese economy's resilience in the face of ongoing external economic shocks has proven to be quite feeble, particularly in relation to its Asian competitors, especially China. It appears that a combination of Chinese technological advances and overinvestment, along with a super strong yen/dollar exchange rate has created the beginnings of a hollowing-out effect in Japan.

More economic data has come out in the latest Japanese tankan to confirm this abysmal picture. August industrial production fell -.3%. The consensus was looking for a rise of 1.1%. Industrial production is now below the level of January.

Worse yet is the METI forecast for industrial production in September and October. Companies who responded to the Meti survey expect a-0.1% decline in September and a -2.9% decline in October. These METI forecasts are often very wrong. So such a future decline is not set in stone. But my experience is when Japan's industrial production is moving towards weakness these forecasts are too optimistic. Throughout this year, as industrial production has flattened and began to fall, the METI forecasts, which were consistently predicting significant rises in future months, have proven to be too optimistic. Other data appears to confirm the prevailing gloomy picture. Earlier last September, Japan recorded a large monthly fall in export volumes. Over the previous two months of July and August, the average level of exports at 3.8% is below the average of May and June. The Japan manufacturing PMI is also falling and is now below 50.

Tomorrow, I'll examine the specific impact of China's policies: how it has adversely impacted Japan and what it might portend for the US in the future.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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