The Romer Aftermath

The recent departure of Christina Romer signals a troubling future for the Obama Administration's economic policy team -- and does not bode well for the president's party before the crucial midterm elections this November as the American public grows weary with the nation's slow economic recovery.

After his election, the president was criticized for his selection of Washington has-been and politically connected Larry Summers and New York Fed boss Tim Geithner as his main economic policy henchmen. But he balanced these appointments with solid choices in Peter Orszag, former head of the non-partisan Congressional Budget Office, to head up the president's budget office (OMB), and Romer, an academic economist respected for her expertise on recessions, to run the Council of Economic Advisers (CEA). Obama also tapped former Federal Reserve Chairman Paul Volcker as an adviser, though Volcker's role in economic decision-making is not quite as clear or concrete. Orszag and Romer are now gone, both for different reasons.

Though Romer has denied it, it appears the CEA's role in economic policy advising was largely minimized with the presence of Summers, whose position , created ad hoc, seems to conflict the responsibilities of other officials such as Romer, whose role as chief economic adviser to the president was clearly defined.

Despite his many policy successes, President Obama has still yet to send clear signals to the markets as to what his economic policies mean for the American economy, as well as who is informing his policy-making. With Romer's departure, it has become more clear that certain heavyweights such as Summers are pulling more strings, while other advisers may be cut out of the process.

Taxes and Spending: A Moral Gulf

As a die-hard supporter of the Pittsburgh Penguins professional ice hockey team, I was, like every other supporter, ecstatic when it became official that city, county and state authorities approved a massive bond issuance to finance a new arena for the team a few years ago. The deal prevented the team's threatened move to Kansas City, a city with hardly any hockey culture. It came as no surprise, of course, because these days professional sports franchise owners easily have their way with local governments when demanding new facilities.

More importantly, though, part of the arena's financing would come from newly legalized slot machine casinos that the Commonwealth of Pennsylvania legalized to generate new revenues in a cash-strapped economy. On one shore of Pittsburgh's three rivers, just a stone's throw away from a world-class science museum popular among children, local residents could feed their gambling addictions in a new magnet for crime - and thereby help pay for the new arena. As a fan, I was happy to know my team would stay put - and win a championship one year later - but I also felt dirty knowing the means to that end.

The arena illustrated the paradox of the Reagan-era conservatism that has persisted in today's political culture: with a refusal to raise taxes as a means to finance growing government outlays including large public facilities like arenas and stadiums, you put pressures on governments to find revenue in other, less savory places. Conservatism as a means of preventing "big government" only forces governments to look elsewhere for the funds needed to pay for programs: so-called immoral activities, corporations, and in recent years, other countries with whom the United States shares few common interests.

Take, for example, an idea being pushed, ironically, by Democrats in Congress to legalize Internet gambling as a way of raising just $42 billion over 10 years. Such a sum is minuscule to the size of the federal budget deficit. But the new willingness of Congress to legalize Internet gambling - the addiction for which is probably more difficult to prevent because of the Internet's dispersion and anonymity - shows Congress has reached its last resort in an election year and has run out of ideas to combat real waste in government spending.

The Dangers of Austerity

If the recent Group of 20 summit is any indication, a reprise of the mistake of the 1930's may soon be on the horizon.

An interesting article in The New York Times details how governments worldwide are under pressure to begin scaling back their stimulus measures implemented in late 2008/early 2009 as a response to the global financial crisis. A rhetoric of austerity is the new modus operandi among governments who increasingly feel the political pinch from large budget deficits. The major economies in the 1920's and 1930's also attempted the same thing, thinking such a strategy of austerity would remove the ills of an overheating, inflation-bound economy, but with disastrous results.

The decision in the 1930's to deflate was borne out of a stubborn bias among the world's major central banks of the time - those of the United States, England, Germany and France - toward the international gold standard, which required countries during economic downturns with high inflation prospects to reduce aggregate demand, and therefore prices (wages) and stabilize trade flows, thereby stimulating gold inflows and bringing trade flows back into balance. It is widely believed by scholars, including current Federal Reserve Chairman Ben Bernanke, that this bias by central bankers toward the gold standard during the economic crash in the 1920's and 1930's inadvertently accelerated the descent into Depression because unemployment exploded and the banking system of the time could not handle the stresses of such economic uncertainty.

A major reason why central bankers held such a view was the relative political strength of Wall Street and other financial political-economic machines at the time. The 1920's spelled the official rise of New York as an international financial center, and helped catalyze a shift of political weight from Washington and the farmers to New York. This growing class of financial elite demanded government economic policies that were staunch against inflation, because deflation favors people with assets (bankers and other elite) and disfavors those with liabilities (everyone else).

Today, however, it is unclear whether the financial elite hold as much relative political power. It is therefore doubtful that governments, at least the U.S. government at that, will actually follow through on promises to impose austerity measures. Only in those countries where the financial or industrial sectors hold greater political power (the United Kingdom, for example), will governments actually implement real austerity measures - or at least create the political illusion of it. Indeed, the UK's coalition government proposed an austerity budget that could create drastic cuts in government ministries. Though each country has its own reasons for and against imposing austerity measures, such measures at a time of continuing economic weakness around the world could be disastrous and undo any of the progress made in the last year.

The Peg is Dead

China's controversial currency policy may finally be headed to the gallows, but what remains unclear is how this will affect and prompt movement on numerous politically sensitive issues in the United States, namely its large twin deficits, the current account and government primary deficit.

Make no mistake: China's move is largely motivated by domestic factors - the need to allow inflation to finally creep into its possibly overheating economy and re-balancing its export-based economy with a decidedly smaller dependence on other economies - but, certainly, it was also under pressure to allow the yuan to appreciate by external players.

But for this move to re-balance global economic flows, the United States will have to do its part in the medium to long term. That is, to reduce its deficits and minimize its dependence on foreign creditors to finance those deficits by cutting spending and boosting national saving. Some of this could be accomplished by the hoped-for re-balancing in the current account. But currency values alone do not dictate trade, and therefore current account, balances. The United States needs to go back to being a center of innovation in manufacturing for a real re-balancing to be meaningful. And, with the current crisis in the eurozone, there is even one view that the revaluation could actually backfire.

The Obama Administration and his Treasury have achieved a victory long-sought by the president's predecessor. But now that China has been tamed on the currency issue, the ball is in the American court to do what is necessary to allow the full economic results of a yuan appreciation to benefit those constituencies who yearned for it.

More on the ECB...

More soul-searching at the ECB...

http://www.nytimes.com/2010/05/31/business/global/31deflation.html

Banking on Europe - the ECB's Uncharted Waters

Just in time for the 50th post of this less-than-illustrious blog, the Greek debt crisis reaches a fever pitch and her European neighbors step in to save the day.

Late Sunday various leaders and finance ministers in the European Union and Eurozone as well as the International Monetary Fund announced the creation of an almost $1 billion fund to aid indebted countries in Europe, calming markets and soothing nervous politicians - especially German Chancellor Angela Merkel, whose delicate tightrope walk in leading Europe through troubled economic times has already cost her party in the polls in a recent regional election.

In the elastic thinker's view, while this move was a necessity in the short run to sustain the euro currency zone and calm market fears, it undermined a major institutional strength of the European Union: its autonomy on matters of regional economic policy.

The European Central Bank is widely praised as one of the world's most independent central banks, conducting monetary policy strictly on a singular objective of keeping inflation close to a target range and harmonizing economic growth throughout the currency zone with zero regard for political pressures in individual countries to keep interest rates high or low or to finance government debt. As a result of its independence, it cannot serve as a lender of last resort to Eurozone members like Greece that forgo their responsibilities to keep public spending and debt, and ultimately inflation, under certain levels to prevent a misalignment in the exchange rate parities that keep the European Exchange Rate Mechanism functional.

Instead, with the creation of this fund, albeit necessary, Europe has decided to make the ECB more of an activist monetary authority without explicitly calling it that. By creating a separate "fund," there will be an appearance that a separate body, not the ECB, will be stepping in and rewarding bad behavior by bailing out profligate spenders in the eurozone - when in fact the ECB has already started purchasing bonds to inject money into the banking system. It may continue to be statutorily independent, however it will undoubtedly have no choice but to support any move to bail out countries because such bailouts will ultimately have monetary implications that will influence future interest-rate policy.

By sacrificing the ECB's independence in the short run, the European authorities have mortgaged away the biggest strength of its currency. This will hurt the value of the euro in the long run and undermine the currency's prospect of rivaling the U.S. dollar as the world's reserve currency.

It will be interesting to see how these uncharted waters for the ECB and other EU economic policy-making bodies will evolve during this key test of Europe's institutional unity.

Financial System Reform in the U.S.: What Happens Next

Columbia University's Committee on Global Thought yesterday hosted a lecture with two movers-and-shakers, past and present, in the world of financial regulation in the United States: former Securities and Exchange Commission Chairman Arthur Levitt, and current Commodity Futures Trading Commission chief Gary Gensler. The topic: how to reform a regulatory system that fell asleep at the wheel and failed to detect a crisis.

The panel discussion - chaired by Nobel laureate Joseph Stiglitz - came to two key conclusions: financial markets need more transparency, and the United States needs to take the lead in developing smart regulations if the rest of the world is to sign on.

Gensler's proposal is to bring more futures/derivatives trading into a central clearinghouse, allowing regulators to more easily monitor and assess risk in a market that is fragmented. Centralizing derivatives transactions into a more open, central clearinghouse will cut into the premiums earned by derivatives dealers but will also make the market less risky and more transparent, he contends.

Levitt, a veteran of the Clinton Administration, was decidedly pessimistic on the financial reforms proposed both in the U.S. House and Senate, saying they would do little to prevent moral hazard and a "too big to fail" mentality among major financial institutions. He also said Europe, the United Kingdom and other major financial centers will fail to tighten their regulations until the United States takes the lead. Gensler agreed, but admitted that after 18 years on Wall Street, he knows bankers will, in such a case, take advantage of the inevitable opportunity for regulatory arbitrage - that is, investors will put their money in jurisdictions where capital is less tightly regulated at the expense of American financial markets. These points illustrate that any kind of real policy coordination between the United States and the European Economic Community is an idealistic, rather than realistic, endeavor in such tight political and economic conditions.

What the panel failed to accomplish was finding a way to navigate through the alphabet soup of agencies that are already charged with regulating various segments of the American financial system. Very little was said about the Federal Reserve System, which despite being charged with regulating the banking system from a macroeconomic view, is widely criticized for failing to regulate and for creating the conditions that enabled the crisis through its loose monetary policy. And yet, the Fed remains a key player in any regulatory structure going forward and needs to be a keystone of any reform.

In the end, the discussion itself and the very presence of two speakers representing regulators that, in the grand scheme, have a small purview over the American financial system, revealed how broad a reform is needed. As such, is any discussion that contains only the SEC and CFTC even relevant?

The SEC, staffed with just 3,700 regulators, for example, has very little authority over financial instruments that fall outside the more traditional definition. And, how does an agency such as the SEC both target run-of-the-mill insider trading and securities fraud while also tracking systemic risk in a complex financial system? The failure to bring down Bernard Madoff before it was too late shows how overextended the agency already is.

In the meantime, as Gensler aptly pointed out, the CFTC only regulates futures markets, missing the important and growing piece that is over-the-counter derivatives, among which are the many mortgage-backed securities that were at the heart of the sub-prime crisis. The two in combination have little effect on monitoring a financial system that is increasingly global and increasingly spread over a variety of financial instruments.