Quick hits and pink picks: the future of the global economy

The G20 summit in Pittsburgh produced a consensus that, while complacency is dangerous and risks remain, the worst of the financial crisis/global recession has passed us by. So, what's next?

-World Bank President Robert Zoellick on life after the storm.

-Marko Dimitrijevic argues that the term 'emerging markets' is obsolete; the rising giants have arrived.

-Quickly shift your gaze from Germany to Ireland, where a hugely important re-do will affect Europe for decades to come.

-A sterling slide is good for Britain.

-Is China the developed world's new engine of growth?

The Shrinking Giant Re-appears

Last week Rory asked as to the whereabouts of Paul Volcker - the elder economic statesman who has been flying unusually below the radar. Well, Volcker has re-appeared in the headlines to deliver a two-part message:

First, he has doubts about the White House's plan for fixing the financial system and is arguing that, while mostly positive, the plan risks making the moral hazard problem worse for large, interconnected institutions. This sort of contrarianism supports Rory's suspicions that Volcker has been less visible because he is not politically convenient. Nevertheless, his value-added to the Obama administration is to be a strong, independent and experienced voice. So if he is raising doubts about the plan publicly, the doubts should be addressed head-on, no?

Second, he seems to be inclined towards some sort of tax on transactions between financial institutions. I have already explained why I thought a Tobin Tax was a bad idea, but I now suspect that Volcker is referring to something different. Nevertheless, if his biggest concern is moral hazard then a transaction tax will not even begin to address the problem, no matter how effective it might be at achieving other objectives.

In other words: I'm confused.

Links

One link, actually. To an article which, after a lovely introduction, provides the 12 lessons for becoming "a super serious chin stroking elder statesman foreign policy elite [in America]."

Without further delay, lesson #1:

"Being “strong” on a given foreign policy subject is directly proportional to your willingness to blow people/things up, with as little hesitation as possible. Considering any other option betrays your weakness, indecision and inner Frenchman. Further, refusing to bomb a given country is always the equivalent of Chamberlain appeasing Hitler and such reticence will have similar results. Always."

And so it continues. Happy reading.

Why the US Dollar Will Weaken

Predicting the future value of currencies is a tricky business.

For instance, about one year ago, as the US economy started heading down the toilet and investors of all stripes began to panic, one would have thought that the impending collapse of the US economy would be bad for the dollar. But not so. In fact it was the opposite: as the crisis spread, US dollar assets became a safe haven from all the other collapsing world economies. Why? Because the US economy is still the biggest, most open, and most liquid in the world.

Nevertheless, without being too specific, I would argue that we are likely to see a long-run weakening of the US dollar. Here are at least two big reasons why:


Changes in the US Economy
It took having to be beaten over the head with a rather large recessionary stick, but US policy makers have realized that the economic conditions that prevailed in the last decade or so should not be repeated going forward. I'm talking in particular about 1) low domestic US savings, and 2) the US's reliance on everyone else to make stuff, sell that stuff to America on the cheap, and invest the money earned from selling that stuff in US assets with a low rate of return. American financial institutions would then take that money and invest it in riskier assets, earning greater return, and making everyone rich.

That's an oversimplification, but you get the idea. Recognizing that there's a big downside to this state of affairs, Obama's top policy advisors have been advocating a shift in the US economic strategy. Larry Summers has been the most explicit, according to two authors from the Peterson Institute:

"The US, [Summers] said, must become an export-oriented rather than a consumption-based economy and must rely on real engineering rather than financial wizardry. Tim Geithner, the US Treasury secretary, and other top officials have spoken similarly of rebalancing US growth.... Redirecting resources away from finance and consumption towards exports and investment will require relative price shifts, for which the dollar has to move down."

Now, you could argue that the extent to which Summers & friends will be able to achieve this goal is limited. The US competitive advantage is, after all, in financial wizardry and not exports. Nevertheless, that this is the long-run goal of Obama's policymakers is a statement of intent that deserves to be taken seriously. And I think that it is being taken seriously by a country whose policies will likely have an even greater impact on the future of the dollar: China.

China's Investment Strategy

"You should be screaming if your life savings are in dollars."
That's the assessment from FT Alphaville after further evidence that China is trying to quietly tip-toe away from the US dollar - something that is hard to do when you own about 1.5 trillion (!) of them. Nevertheless, China is attempting to escape its "dollar trap" by directing state-owned firms to start investing in dollar-alternatives like commodities and commodity-related companies. As China starts selling US dollar assets there will be more US dollars in the market, the value of any given dollar will go down and the currency will depreciate.

The long-term objective of this strategy is to eventually bring about the full convertibility of China's currency, the remnibi, and have it compete with (or replace) the US dollar as the world's reserve currency of choice. I say "long-term" because Beijing will need a long time to diversify away from the US dollar. But nevertheless, when you own 1,500 billion of another country's assets, your strategic decisions are going to be of some consequence.

Now, as I stated in the opening, currency predictions are fickle things. One could easily imagine a scenario where China's economy has an unexpected downturn and the safety of US assets will once again be appealing. Economic analysts are prone to overstating the long-run significance of current events. But caveats aside, the macro-level economic strategies of the two largest economies in the world suggest that the US dollar is going to weaken. Big time.

US Scraps Missile-Defense Plans in Europe

The US has reportedly decided to scrap its controversial missile-defense plans in Europe. This is a really big deal.

Despite the incredibly unfortunate timing of making the announcement on the 70th anniversary of the Soviet invasion of Poland (you always wonder why officials don't know these things, and cant wait ONE EXTRA DAY to make such a sensitive announcement; after all, isnt this what public relations/communications officials are paid to do, know these kind of things?).

Anyway, the implications of this decision are immense, positive and negative, but I for one applaud the US president. This is a really bold move that hits the 'reset' button with full force. But, more urgently, it is all about Iran, and I cannot imagine this decision was reached without some concrete assurances from Moscow that they will squeeze Iran in return.

These are the kind of major shifts in foreign policy we have been waiting for from the Obama administration. The ball is now is Moscow's court, and the Obama administration may come to find that the destiny of its foreign policy is now controlled less by itself, and more by the Kremlin.

The Incredible Shrinking Giant

Jut a quick thought I have been tossing around in my head for the past few minutes...where the heck is Paul Volcker?

A giant of policy making, Volcker was brought into the Obama administration in an advisory role, but one that was thought to be an integral part of the US president's financial and economic policy formulation.

Almost ten months later, and he is seemingly MIA, minus the occasional statements that lead you to believe he thinks his boss is doing far too little in addressing the financial system's problems.

Which might just be the explanation for his absence.

Thinking About Compensation

In the run-up to the G20 in Pittsburgh next week, the issue of compensation for top executives is becoming a hot-button issue. As financial indicators are improving (or becoming less worse), some banks' incentives schemes are returning to their old ways. Goldman Sachs, for instance, sparked a furor when they announced that they were on track for record bonuses earlier in the summer. Goldman's CEO has since wisely attempted to attack the practice of handing out massive bonuses, but the figurative pitch forks have been hoisted and the torches lit.

To properly argue that caps on executive pay would be good policy, I think that you would need to two things. First, some sort of philosophical argument which presents capping executive pay as a "public good" because of their special position in our economy. Given that the same argument was used, in reverse, to justify bailing out financial institutions, there's plenty of material to work with. Secondly, however, you would need to show that any such caps would be practical to implement and actually effective at curbing executive pay. Those kinds of arguments are a lot harder to find

But none of this matters because, politically, this issue is a real winner. As Rory pointed out in the links below, France's Sarkozy is leading the charge, with the governments of Germany and many other countries behind him. The UK authorities are split on the issue, but Gordon Brown, ever in election-campaign mode, seems keen to appeal to popular sentiment. Moreover, as Michael Skapinker argues today, for the first time in a long while the gulf between Europe and America on bonuses has shrunk - the Obama administration is a lot more open to this idea than has traditionally been the case. This issue may very well be watered down at the G20 drafting table, but it's steaming in with a lot of momentum.

But let's ignore all of this silliness. A good friend of mine has sent me something far more interesting: Dan Pink presenting at TED.

Rather than debate whether financials execs "deserve" millions in bonuses, Dan asks instead whether monetary incentives are an effective tool in the first place. According to considerable research in the social sciences, the conclusion is that people working on complex tasks with monetary incentives perform worse than those without monetary incentives.

Roll that conclusion around in your mouth a little. What does it taste like to you?

Cause to me it tastes like a wholesale rejection of the bonus culture on empirical, rather than emotional, grounds. If this conclusion can be applied generally, then not only can we argue that huge bonuses are potentially bad for the public good, but also for the firms themselves.

Less importantly, why is this conclusion so hard for me to accept?

Quick hits and pink picks: One year on from Lehman

-Stiglitz thinks the banking system is even more broken today than on the day Lehman died.

-A very good measure of business sentiment is how quickly business leaders are dumping their shares...well, they are really dumping. Bad sign??

-Martin Wolf's lessons to be learnt from Lehman's demise and its aftermath.

-A lot of political hot air has been expended over executive pay in the post-Lehman age, because its easier to grandstand over the compensation of a few top executives, than it is to actually reform the perverse incentives and regulatory failures that led taxpayers to commit such capital to the survival of the financial system.

One source of that hot air, Super Sarko, looks ready to sink a summit over a NON-ISSUE!! Reforming compensation practices is important, but please, there are far greater matters to address in Pittsburgh.

Scattered Thoughts on Gold

There has been a lot of noise recently about gold cracking $1,000/oz last Friday and what that means for investments, etc. We will likely have a lot more to say about that in some posts this week, but here are some quick thoughts:

1) I don't know anything about investments.

2) The $1,000/oz benchmark is making a lot of news because human beings like benchmarks and even numbers. The fact that gold moving from $999/oz to $1,000/oz results in headline news, whereas its moving from $983/oz to $984/oz would not, tells you a lot less about gold than it does about the financial press.

3) Today I saw a headline from the Moncton Times & Transcript that read: "Now is the time to invest in gold." Now - bearing in mind point 1)! - I suspect that by the time an article in a small-town syndicated newspaper is telling you to invest in X, it is no longer a good idea to invest in X.

Quote of the Day

Brought to you by none other thannnnn...... Silvio Berlusconi!

"I sincerely believe I am by far the best prime minister Italy has had in its 150 year history (since unification in 1861),"

And it actually gets better. Read the rest here.

Doing Business affirms the brighter side of crises

The World Bank has released its annual Doing Business report, which looks at the ease of doing business around the world.

Doing Business ranks economies based on 10 indicators of business regulation that record the time and cost to meet government requirements in starting and operating a business, trading across borders, paying taxes, and closing a business. The rankings do not reflect such areas as macroeconomic policy, security, labor skills of the population or the strength of the financial system or financial market regulations.

It is a narrow measure of a country's economic prospects, but an important one in a globalized economy, particularly for country's dependent on foreign investment and trade. Amidst the creeping protectionism, rapid decline in international capital flows, and poor credit availability of this crisis, you might expect such indicators to plunge. However, the World Bank found 2008/09 to be a record year of reform. Surprising? Perhaps not:

-Singapore was ranked #1 for ease of doing business for the fourth year in a row. This is no surprise (small, open, and highly integrated economy).

-Two-thirds of the recorded reforms were in low- and lower middle-income countries. This isn't that surprising either, as the threshold for these countries is typically low (any concerted reform agenda will drive these countries high up the ranking), and crises tend to disproportionately affect smaller, less-diversified economies heavily dependent on exports and commodity prices. Amidst these conditions, either external (IMF, WB, etc.) or electoral (regime change) factors tend to provide a strong impetus to reform.

-Rwanda was the biggest reformer across almost all indicators, a first for a sub-Saharan African economy, but again, not a surprise. President Kagame has vigorously promoted foreign investment to diversify the economy away from commodity exports (coffee and tea), and with donor funds accounting for almost 50% of the budget, Rwanda has a strong external commitment to reform.

The biggest point, but if you know your history perhaps the least surprising, was the following statement:

'The financial crisis has also prompted governments to act in areas where regulatory reform may be more difficult and require more time.'

I have noted on a number of occasions over the past year that despite the massive destruction caused, global crises also present the biggest opportunities for reform. Often, interests are realigned, reformers and technocrats elected, and economies and foreign investment regimes restructured. The latest Doing Business report reaffirms this trend.

So while there is justifiable pessimism over the protectionist slide of many major economies, we should take comfort in knowing that on at least one measure, globalization pushes on.

Nifty Graphs: Public Debt

The Economist has a nifty graph on the amount of global public debt, projecting into the next couple of years. Check it out.

According to their maths, Iceland will have an average debt-per-person of over $107,000.00 in 2011. From a quick scan, that's almost twice as much per person as any other country (even the Italians!), and it amounts to almost 200% of their projected GDP. Ouch.

The figures for the United States don't actually look too bad for 2009, but it's that little "yearly rate of change" percentage that you want to keep your eye on.

Update: Click on Zimbabwe. Hilarious.

Thanks to Free Exchange for the pointer.

The Tobin Tax, Explained

Last week, as Rory pointed out, the idea of a Tobin tax once again appeared in popular economic discussion. This was prompted in large part because Lord Turner, the head of Britain's Financial Services Authority, re-introduced the idea of the Tobin tax as a possible way to keep the City from growing too big - and yes, 4-5% of GDP is probably too big.

So what is this Tobin tax, and does it have merit? This post will take a stab at answering these questions.

What is it?
As the name might suggest, the idea was introduced by Yale economist and Nobel laureate James Tobin in 1972.The Tobin tax consists of a modest ad valorem tax applied to certain financial transactions; proposals for taxation levels range from 0.5% to 0.01%.

The appeal of the tax is two-fold. Firstly, the flat tax would specifically target short-term capital flows. For example, if the yearly cost of a “round-trip” investment is 0.2% (a 0.1% tax, applied twice), then the monthly rate would be 2.4%; the weekly rate, 10%; and the daily rate, 48%. In other words, in order for a round-trip investment of one day to be worthwhile, the return would need to be nearly half-again as big as the initial investment. Over the span of a year, however, the tax rate is considerably less.

Why target short-term capital flows? Although opinions on this vary, one line of thinking is that the flows of short-term capital (hot money) are less productive than longer-term foreign investment. Investors are prone to herd behaviour and often lack full information. Larry Summers called them "IDIOTS" but the technical term is noise traders. Either way, the ability to move money around quickly and at low cost can produce volatility. Volatility is bad when you're trying to use foreign investments to build an economy. If that money just picks up and leaves, you're in trouble.

Indeed, it was precisely this problem which helped cause the Asian financial crisis in 1997-8: the collapse of Thailand's economy made investors panicky about the whole region and they pulled their short-run investments out en masse. At least, they pulled their money out of countries that didn't have capital controls: China, which had controls, was largely unscathed.

Insert the Tobin tax. By placing a fixed cost on the movement of money across borders, you force investors to think harder about their investments - hopefully making them more productive. The tax also provides stability by acting as a buffer against the herd behaviour of international capital markets. Moreover, the tax acts as a significant source of government revenue (which could be good or bad) and, as explained above, wouldn't scare away longer-term foreign direct investment. Great idea, right?

Will it work?
The answer depends upon what your objective is. The fact is, a flat tax on international capital movements is a pretty blunt instrument indeed. Even a 0.1% tax can be a huge cost, and could result in significant market distortions.

For instance, it's possible that a Tobin tax could punish countries that don't use major world currencies. If you want to convert Chilean pesos into Indian rupees to invest in India, you will most likely have to switch the pesos to dollars, then the dollars to rupees. With a Tobin tax in place, it's possible that this transaction will be taxed twice. Bad news for developing countries.

A similar story unfolds with international trade, where firms often hedge their contracts through spot or swap transactions. If these secondary transactions were taxed, international trade - one of the fundamental benefits of market capitalism - could be less appealing.

We could also spend a great deal of time discussing the practical difficulties of implementing such a tax. International coordination at the G20 level would be a minimum for this to be truly effective at slowing hot money and reducing volatility.

If your main concern is to generate revenue, the Tobin tax might still be a good idea. I've seen proposals for using the tax as a way to generate aid money for developing countries. Lovely notion, but Tobin himself explicitly rejected the idea of using the tax primarily as a revenue-generator because the point was to create financial stability.

But if the point is to create financial stability by limiting the size of the financial sector, as Lord Turner suggests, Willem Buiter argues that the Tobin tax is still a lousy idea. A transaction tax would not even begin address the fundamental problems in our financial markets, especially the problem of moral hazard (read his article for more detail, if you're interested).

The appeal of the Tobin tax is understandable: its beauty lies in its simplicity. But it is too blunt a tool to achieve what is being asked of it, and the G20 is rightly focusing on other issues. Nevertheless, this will not be the last we hear of the Tobin tax.

The Fed: Making the IRS Look Good

Here's a quick follow-up on Rory's assessment of Ben Bernanke's re-appointment as Chairman of the US Federal Reserve: The Economist looks at the challenges facing Bernanke in his second term.

While the technical challenges for the Fed are ongoing, the political aspects of their work are growing in importance. One thing is certain: they face an uphill battle in the public relations department. According to a Gallup poll conducted in July, the Fed's approval rating was about 30% - below the CIA, IRS and Homeland Security. Dan Drezner quips:

When your agency is less popular than the federal institutions responsible for torture..., tax audits, and the requirement that you take your shoes off at the airport, you know you have a public image problem.

The prospects for US financial sector reform: revisited (warning: wonky congressional politics ahead)

A few weeks back I looked at the prospects for meaningful financial sector reform in the US, and ended on a decidedly pessimistic note. To recap, health care and climate change will soak the congressional agenda and shrink Obama's political capital, leaving an overhaul of the nation's financial regulatory structure for a less accommodating political environment in 2010.

The Politico agrees, in a wonky kinda way, with this interesting look at the impact of Ted Kennedy's death on the prospects for financial sector reform. Senator Chris Dodd, current chair of the Senate Banking, Housing and Urban Development Committee (financial sector reform), is next in line for the chair of the Senate Health, Education, Labor and Pensions Committee (health care reform). Following Kennedy's death, and in need of high-profile achievements in the midst of an uphill reelection bid, Dodd might jump ship from financial to health reform.

If Dodd does switch chairs, what would be the implications for the reform effort? Most importantly, the financial services industry would gain a major ally in Senator Tim Johnson, the next Dem in line for the Banking chair. By one account he has been a vigorous opponent of capping credit card fees/rates, proponent of 'voluntary' industry standards, and anti-mortgage renegotiation. The financial industry is also a major financial backer of the Senator.

Dodd has also been a big proponent of the proposed consumer protection agency, something Johnson, as a friend of credit card and mortgage lenders, would likely attempt to kill or diminish beyond recognition.

Dodd is often accused of being too close to the financial services industry, which he undoubtedly is, but to his credit he has been a driving force behind the president's reform proposals and instrumental in reforming the credit card industry. Switching committees would be a blow to the reform agenda.

Stay tuned...

Stats of the day: manufacturing edition

The Institute of Supply Management's August survey rose from 48.9 to 52.9, passing the 50.0 threshold signalling an expansion of activity for the first time in 19 months.

Elsewhere, China kept on the gas as manufacturing activity rose for the sixth straight month in August.

Is the big stimulus pay-off starting to take shape?