Numbers newly reported from the IMF’s COFER data base show that in the most recent quarter, the spring of 2009, the share of central banks’ foreign exchange reserve holdings that they allocate to dollars resumed its downward trend. The dollar share has been gradually sliding since the beginning of the decade — perhaps because of the birth of a possible rival, the euro, in 1999, or perhaps because of the long-term path of tremendous fiscal and monetary expansion on which the United States embarked in 2001.

During the four quarters preceding the most recent one, the share of the aggregate portfolio that the world’s central banks allocated to dollars had temporarily reversed direction. Arithmetically, the main source of this increase in the dollar’s share was its appreciation against other currencies. But another source was the action of central banks in industrialized countries, acquiring dollars more rapidly than other currencies. The movement of the raw quantity shares can be seen in the first graph below, and the movement in the shares properly valued at current exchange rates in the second graph. (I am grateful to Ted Truman and Dan Xie, both of the Petersen Institute for International Economics, for these graphs.)

Whether the temporary reversal from Q2 of 2007 to Q1 of 2008 is measured in quantity terms or in valuation terms, the phenomenon was presumably a (surprisingly strong) safe-haven reaction to the global financial crisis. Apparently the recent easing of risk and liquidity concerns has mitigated the flight into dollars. The central banks that had shifted into dollars have now begun to shift back a bit, into euros in particular.

The gradual downward trend of the dollar’s share during the past decade is a continuation of the trend that began the end of the Bretton Woods system: from the late 1970s until 1991. The dollar’s share rose from 1992 to 2000, perhaps because of the deficit reduction path that began with George H.W. Bush’s unpopular fiscal reversal and continued throughout Bill Clinton’s presidency, until George W. Bush took office and reinstated the chronic deficit.

The usual response to worries that US macroeconomic profligacy will eventually end the dollar’s privileged position as lead international currency has always been that no asset constitutes a credible alternative for central banks to hold in their portfolios. I have argued that, since 1999, the euro has constituted a credible alternative. Based on econometric estimates of the determinants of central banks’ reserve holdings in research with Menzie Chinn, we have even gone so far as to report simulations that show the euro overtaking the dollar by 2022. Many, like Ted Truman, consider such speculation exaggerated. They may be right.

But the euro is not the only alternative to the dollar. The yen, pound and Swiss franc remain viable alternatives for national authorities to put some of their reserves. Furthermore, 2009 has seen the resurrection of two international reserve assets that had previously been written off as dead: the SDR and gold. My forecast is that we are gradually moving from the dollar standard to a global monetary system that features multiple reserve assets.

Share of central banks foreign exchange reserves allocated to dollars, 1999 QI — 2009 QII
(among industrial countries, among developing countries, and overall)

National leaders are meeting at the United Nations in New York today, to discuss the climate change negotiations. Talks will continue at the G-20 meeting in Pittsburgh later in the week. But hopes look very bleak for progress sufficient to produce at Copenhagen in December a successor treaty to the Kyoto Protocol. The biggest roadblock is the familiar game of “After you, Alphonse.” The United States will not accept quantitative emission targets unless China, India and other developing countries do the same, at the same time. But the developing countries will not cut their emissions below the Business as Usual path (BAU) unless the rich countries go first.

In the past I have developed my own proposal for how to break the deadlock, a politically realistic plan to assign emission targets in ways that leaves no country feeling it is being asked to incur an economic cost that is unfair or too large. The targets are derived from a family of formulas The specific detailed example of the plan that I have given in the past attained an environmental target by the year 2100 of CO2 concentrations equal to 500 ppm. It did so without violating the political constraints, which included that no country is asked to accept an ex ante target that costs it more than 1% of income in present value, or more than 5% of income in any single budget period.

The G-7 leaders, meeting in Italy in June 2009, set a more aggressive collective goal, corresponding approximately to concentrations of 380 PPM. I have been trying to hit that goal, working with Valentina Bosetti, within the same political constraints and framework of formulas. To achieve the more aggressive environmental goal, we advance the dates at which some countries are asked to begin cutting below BAU. We also tinker with the values for the parameters in the formulas (parameters that govern the extent of progressivity and equity, and the speed with which latecomers must eventually catch up). The resulting target paths for emissions are run through the WITCH model to find their economic and environmental effects. We found that it is not possible to attain the 380 ppm goal, subject strictly to our political constraints. We were however, able to attain a concentration goal of 460 ppm with somewhat looser political constraints than 500.

Some may conclude from these results that the more aggressive environmental goals are not attainable in practice, and that our earlier proposal for how to attain 500ppm is the better plan. We take no position on which environmental goal is best overall. Rather, we submit that, whatever the goal, our approach will give targets that are more practical economically and politically than approaches that have been proposed by others.

[Readers wishing to post comments are referred to the SeekingAlpha version.]

The field of International Monetary Economics is not without its own cycles and fads.

In a speech at the European Central Bank over the summer, “On Global Currencies,” I identified eight concepts that I saw as having recently “peaked” and eight more that I saw as newly rising in relevance. Those that I viewed as losing traction were: the G-7, global savings glut, corners hypothesis, proliferating currency unions, inflation targeting (narrowly defined), exorbitant privilege, Bretton Woods II, and currency manipulation. Those that I saw as receiving increased emphasis now and in the future were: the G-20, the IMF, SDR, credit cycle, reserves, intermediate exchange rate regimes, commodity currencies, and multiple international currency system.

A condensed version appears this month in Finance and Development, from the IMF, titled “What’s ‘In’ and What’s ‘Out’ in Global Money.” I boil the list down to five concepts that I pronounce “on the way out” and five more that I see as replacing them:

• The G-7 has been rendered largely obsolete by its lack of representation of developing countries, and thus in the course of 2009 has been overtaken by the G-20.
• The corners hypothesis had become conventional wisdom by the end of the 1990s. This was the idea that all countries were or should be abandoning intermediate exchange rate regimes (bands, baskets, crawling pegs, adjustable pegs, and heavily managed floats) in favor of either the floating corner or the institutionally fixed corner (currency boards, dollarization, or monetary union). Since 2001 the tide has turned against the corners hypothesis, and far fewer economists would now assert it as a sweeping generalization. Certainly a huge fraction of the members of the IMF continue to follow intermediate regimes.
• The language of “unfair currency manipulation,” has been in US law since 1988 and the IMF Articles of Agreement for longer. China during the years 2004-2008 was pretty much the first large country to face charges of unfairly manipulating its currency to keep it undervalued. But US Congressmen who have for years urged China to abandon its link to the dollar could well live to regret it, if they were to get their way and the People’s Bank of China did in fact stop buying US treasury bills. It is finally beginning to sink in among Americans that having China as its largest creditor carries with it some new constraints. What concept is “on its way in,” to replace the idea that intervening to prevent one’s currency from appreciating is anathema? Reserves. Two short years ago, Western economists were lecturing surplus countries that they were acquiring too many reserves. Today we see that the developing countries that have weathered the 2007-09 crisis the best are countries that had previously piled up the most reserves, other things equal.
• Most controversially, I assert that Inflation Targeting — narrowly defined, I hasten to add — has seen its best days. The definition of IT I have in mind is the proposition that the monetary authorities should set a target range for the increase in the CPI each year, and then should focus all their efforts on hitting it. This orthodoxy says that the central bankers should pay no attention to asset prices, the exchange rate, or commodity prices, except to the extent that they carry implications for the CPI. For large rich countries, it has become clear since 2007 that Alan Greenspan was wrong when he (plausibly) abjured all attempts to identify or discourage bubbles in real estate and stock markets. As a result, the credit cycle view of monetary policy has been resurrected , after a long period when only inflation was thought to matter. For smaller and developing countries, I would also argue that volatility in commodity prices has made it clear that monetary policy should let currencies depreciate, at least somewhat, when the terms of trade worsen, rather than the opposite as is implied by a strict interpretation of CPI targeting. For them, I would propose replacing the CPI target with a more production-oriented price index, such as a target for the PPI or even an export price index.
• The United States has benefited throughout the post-war period by an unlimited ability to borrow in dollars. A popular view two years ago, supported by some of the best scholars, was that the US had earned the dollar privilege by establishing a unique comparative advantage in supplying a saving-glut world with high-quality assets. Then the sub-prime mortgage crisis in 2007 revealed that US assets were not so high-quality after all. The dollar did retain the benefit of being the safe haven currency in 2008, as an exorbitant privilege — contrary to the predictions of those of us who had predicted that the unsustainable current account deficit would lead to a large depreciation. Nevertheless, some developments in the course of 2009 have suggested a global movement away from the unipolar dollar standard, and toward a new multiple international reserve system. These events include the gradual rise of the euro as an international currency to rival the dollar, the sudden and unexpected resurrection of the SDR from near-death, new interest in the yen and gold as safe haven assets (including among central banks), and the very first glimmerings of an international role for the RMB.

[Any readers wishing to post comments are referred to the Seeking Alpha version.]

The Queen of England during the summer asked economists why no one had predicted the credit crunch and recession. Paul Krugman points out that, inasmuch as economists can almost never predict the timing of recessions (and don’t claim to be able to), the real questions are worse. The real questions are, rather how macroeconomists (most of us) could have gotten it so wrong as to believe that:

1. a severe recession like this was not even looming ahead as a danger, and
2. a breakdown of many of the world’s most liquid financial markets, in New York and London, was not possible.

To anyone wondering about these questions, I recommend Krugman’s essay in the New York Times Sunday magazine, September 6: “How Did Economists Get it So Wrong?”.

I would only add that he is modest in skipping over one point: during Japan’s lost decade of growth in the 1990s Paul forcefully drew from the Japanese experience the implication that a severe economic breakdown was, after all, possible in a modern industrialized economy — a breakdown that both was reminiscent of the Great Depression and was outside the ken of modern macroeconomic theory. But macroeconomics went on as before. (Likewise with the stock market correction of 1987, the LTCM crisis of 1998, and the dotcom bust of 2000-01. I do think, however, that our field did a better job with the emerging market crises of 1994-2001, in part because it was considered permissible to argue that financial markets in this case were highly imperfect.)

Even the cartoons in the NYT article are good… except that I have never seen Olivier Blanchard in a double-breasted suit. But Robert Lucas definitely merits a place there: when given one page to defend orthodox economists regarding the crisis in a recent Economist essay, he actually thought it was a useful rebuttal to point out that critics are repeating arguments they have made before. And he also thought it was useful to explain: “The term ‘efficient’ as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.” — as if it is not the latter question that the public is wondering about.

(For other economists’ reactions to the Krugman piece, see the National Journal site.)

The rate of decline in employment moderated substantially in May, according to the BLS figures released June 5, to about half the monthly rate of job loss recorded over the preceding six months (345,000 vs. 642,000). The news was received in a variety of ways.

First, the cynics. They tend to wax sarcastic at the idea of “things are not getting worse quite as fast as they were” as a good-news proposition. But a wide variety of recent data indicate that the economy is no longer in the state of free-fall that it entered last September, and this is indeed good news. To begin to level off is the first step toward the start of the recovery.

Second, the academics note (correctly) that there is little information in each individual monthly statistical fluctuation that is measured, because the data are inevitably noisy. Still, the public wants to know, in real time, what is the best we can glean from the information we have.

Third, the financial press, in particular, had been asking whether this quarter could turn out to be the bottom of the recession. The May employment report encouraged speculation that the answer was “yes.” The stock market reacted positively.

The members of the NBER Business Cycle Dating Committee (of which I am one) will be responsible for calling the trough when the time is right. We have a range of views regarding the proper place of employment numbers in such deliberations. But one can say, on the one hand, that a decline in economic activity is a decline in economic activity, and therefore still a state of recession, even if the rate of decline has moderated a lot. One can also say, on the other hand, that employment is usually a lagging indicator of economic activity. (For example, the economy continued to lose jobs long after the ends of the 1991 and 2001 recessions. Hence the “jobless recoveries.”)

Speaking entirely for myself, I like to look at the rate of change of total hours worked in the economy. Total hours worked is equal to the total number of workers employed multiplied by the average length of the workweek for the average worker. The length of the workweek tends to respond at turning points faster than does the number of jobs. When demand is slowing, firms tend to cut back on overtime, and then switch to part-time workers or in some cases cut workers back to partial workweeks, before they lay them off. Conversely, when demand is rising, firms tend to end furloughs, and if necessary ask workers to work overtime, before they hire new workers. (The hours worked measure improved in April 1991 and November 2001 which on other grounds were eventually declared to mark the ends of their respective recessions.) The phenomenon is called “labor hoarding” and it is attributable to the costs of finding, hiring and training new workers and the costs in terms of severance pay and morale when firing workers.

Unfortunately, as reported by Forbes, pursuing this logic leads to second thoughts about whether the most recent BLS announcement was really good news after all. The length of the average work week fell to its lowest since 1964 ! The graph below shows that, not only did total hours worked decline in May, but the rate of decline (0.7%) was very much in line with the rate of contraction that workers have experienced since September. Hours worked suggests that the hope-inspiring May moderation in the job loss series may have been a monthly aberration. If firms were really gearing up to start hiring workers once again, why would they now be cutting back as strongly as ever on the hours that they ask their existing employees to work? If one factors in falling wages, to compute total weekly earnings, the picture looks still worse. My bottom line: the labor market does not quite yet suggest that the economy has hit bottom.

[Any readers wishing to post comments are referred to the versions on RGE Monitor or Seeking Alpha .]

The current visit of Secretary Tim Geithner to Beijing once again shines the spotlight on the Renminbi (RMB) and on demands by US politicians that the People’s Bank of China (the country’s central bank) abandon the peg to the dollar.

Throughout the period 2003-2008, I, as some others, have thought that demands from American politicians of both parties that China loosen the dollar link have been misguided in a number of particulars. They were misguided in thinking that an appreciation of the RMB would, alone, do much to boost US output or employment. The demands were especially misguided in putting such high priority on the entire exchange rate issue, given that we need China’s help on more important things, such as preventing a nuclear-armed North Korea. But my arguments during this period might reasonably have been viewed by non-wonks as quibbles. After all, I did agree, along with a majority of other economists, that an increase in the flexibility of China’s exchange rate would be a good thing.

Now, in 2009, the situation has changed in some important ways. Continued demands from American congressmen that China should stop intervening in foreign exchange market to keep the RMB fixed against the dollar have become especially foolish. This is because of two developments over the last year.

The first development: in mid-2008, the top leaders in China decided to abandon the policy they had followed in 2007 — which had consisted of the long-desired abandonment of the dollar peg and the placing of a substantial weight on the euro. They changed horses in mid-stream: After mid-2008 they returned to their old policy (e.g., 2005-06) of a fairly close peg to the dollar. Evidently the motivation for the return to the dollar was complaints from Chinese exporters who had lost competitiveness in 2007 as the euro and therefore the new basket appreciated against the dollar. (Barry Naughton, 2008, gives a glimpse inside politburo politics.)

Why, then, are American congressmen wrong to complain that the return of the dollar link has given American firms an additional price disadvantage in world markets? The first reason on the list is that over the last year, the euro (surprisingly) depreciated against the dollar. In other words, at precisely the moment when the RMB jumped back on the dollar horse, the dollar horse and the euro horse changed directions vis-á-vis each other. If the Chinese authorities had kept the (loose) basket policy of 2007 instead of switching back to the dollar peg in 2008, the value of the RMB would be lower today, not higher, and dollar-based producers would be at a greater competitive disadvantage, not lower.

The second development is that, in 2009, the stratospheric rate of rise of China’s foreign exchange reserves has fallen abruptly. In some months earlier this year, the PBoC actually lost reserves. This means that an increase in exchange rate flexibility — in the extreme case, a move to floating — under current conditions might not result in an appreciation of the RMB, and might even result in a depreciation. Again, that does not correspond to what the congressmen actually want, nor to the public opinion that they represent.

In the near future, we could see a return of substantial surpluses on China’s overall balance of payments and a return of the 38-year trend dollar depreciation. In that case, non-intervention would once again imply RMB appreciation against the dollar. But that leads us to the third point.

The third development, this spring, is the appearance in the dollar’s garden of the first “red shoots.” Red as in deficits and red as in China. For decades, the United States has been able to count on foreigner investors, and in a pinch foreign central banks more specifically, to buy dollars to finance US current account deficits. In recent years, the PBoC has been the lead facilitator, piling up $2 trillion in reserves, most of it in dollars. Many argued that this “exorbitant privilege” could continue indefinitely. But during the past two months we have seen the first signals that this might not continue forever. The possibility that rating agencies might eventually downgrade US debt is in the air, and US longer-term interest rates have finally begun to rise over the last month.

The most telling warning shots have come from Chinese officials. Premier Wen in April expressed worry that US Treasury securities would lose value in the future; that required an unprecedented public assurance from President Obama. Then PBoC Governor Zhou in May proposed replacing the dollar as an international currency, with the SDR. Another official told Americans that his countrymen “hate” having to hold a currency that they believe will lose value in the future as it has in the past. Interpreted separately and literally, each of these statements raises interesting economic questions worthy of extended discussion. Taken together, they constitute a simple wake-up call for oblivious Americans. The message is that at a time when big budget deficits lie deep in America’s past (the big debt that Obama inherited from George W. Bush), America’s present (the record budget deficits caused by the current recession), and America’s future (rising medical costs and the retirement of the baby boomers), we are heavily and increasingly dependent on China to buy our treasury securities. If they and other Asian and commodity-exporting countries stop buying our treasuries, the result would almost certainly be a hard landing for the dollar. I define a dollar hard landing as the combination of a big fall in its value together with a big increase in US interest rates. The outcome might be stagflation.

As a general proposition, it is somewhat obtuse to make strident demands on one’s biggest creditor without taking any consideration of the change in the power relationship that debtor status entails. It is astoundingly obtuse to make the demand that the Chinese stop buying dollars, at the same time as we depend on them continuing to buy dollars to finance our deficits. But demanding that they stop buying dollars is precisely what we have been doing for six years, every time we respond to trade concerns by demanding that they stop intervening to prevent the RMB from rising.

Fortunately, Secretary Geithner’s April decision not to declare China guilty of unfair currency manipulation, in Treasury’s semi-annual report, suggests that he understands the subtleties of the situation. Now if those congressmen would just learn some economics…

[Any readers wishing to post comments are referred to the RGE Monitor version or Seeking Alpha version of this post.]

The Commerce Department this morning announced its advance estimate of last quarter’s real GDP. As expected, the estimate shows that GDP fell in the first quarter of 2009 — by a hefty 6.1 per cent at an annual rate. An implication is that the recession has just tied the post-war record for longevity.

The previous record-holders were the recessions of 1973-75 and 1981-82, each of them four quarters in length according to the official NBER chronology. In the current downturn, the NBER’s Business Cycle Data Committee determined that the economy peaked in the 4th quarter of 2007. Although the Committee won’t declare the trough of the recession until well after the fact, and the trough could well be a ways off, a negative 1st quarter of 2009 almost certainly means that the four-quarter benchmark has now been attained. (The Commerce Department often revises its GDP figures substantially between the advance estimate and the final number, and we are due for major backward-looking revisions in July. Indeed that is one reason why the NBER always waits so long to issue its findings. In the past, the size of the average revision has been just over 1 percentage point, whether up or down. It is highly unlikely that future revisions will change this morning’s negative number into a positive one.)

The NBER also keeps a more precise monthly chronology. The postwar record is 16 months, again shared by the 1973-75 and 1981-82 recessions. To match this monthly benchmark, the current downturn would have to have continued into April. Our best single indicator as to whether it did so will be the employment number to be released by the Bureau of Labor Statistics next Friday, May 8. It almost certainly will show that there were further job losses in April. If so, it will further confirm the dismal conclusion: one would have to go back 80 years, to the disaster of 1929-1933, to find a longer recession.

Most international summit meetings are long on photo-opportunities and short on substance.   There was a great danger that last Thursday’s G-20 meeting in London would be merit comparison to the failed World Economic Conference of 1933, which was also held in London.   This one, however, did have genuine substance.   

Nobody reads the communiques, or listens to the press conferences of leaders or finance ministers. But here is the substance:

Top of the list of accomplishments was expansion of IMF resources. The new SDR allocation was perhaps the most noteworthy and unexpected decision: those observers who have proposed such a step in the current international crisis, or in past international crises, have usually been dismissed as pipe-dreamers (John Williamson, Dani Rodrik, George Soros, Joe Stiglitz…). In addition, there seems to have been some forward movement on international regulation of the financial sector, as the Europeans wanted. Although President Obama acquitted himself well overall, the failure to achieve agreement for coordinated additional fiscal stimulus, as the Americans wanted, was probably the greatest shortcoming of the meeting.

I believe the G-20 meeting will be remembered historically, but not primarily for the above reasons. It will be remembered as the occasion on which primary emphasis shifted from the G-7, the global steering group that until now has had a monopoly on real economic decision-making power, to the G-20. Of the various substantive ways in which developing countries could and should have been given more representation in recent years, the shift to the G-20 is the first one to have actually taken place.

It is ironic that the dollar has strengthened rather than weakened over the last year.

• The sub-prime mortgage crisis originated in the United States;
• The crisis has severely undermined the credibility of American financial institutions -- both in the narrower sense that leading investment banks have now disappeared and in the broader sense that American modes of corporate governance have lost value as role models (rating agencies, accounting systems, executive compensation, and so on)
• The response in Washington has included further acceleration in the already-rising national debt plus an expansion of the US money supply and reduction in policy interest rates that, though appropriate, are unprecedented.

Under normal conditions, any country on the receiving end of three such bullet-points would see its currency go down in flames. Yet the dollar has appreciated.

The explanation is not a mystery. The world’s investors have in two years gone from inordinately low perceptions of (and aversion to) risk and illiquidity, to inordinately higher perceptions of (and aversion to) risk and illiquidity. Virtually all assets other than US Treasury bills look risky and illiquid. That there has been a flight to quality is not surprising. What is perhaps surprising is that US Treasury bills continue to be perceived as the safest of safe havens and the US dollar continues to be the preferred international currency. The flight to the dollar shows up in both the strength of the dollar and the low level of US interest rates. For those of us who warned that the unsustainable current account deficit could eventually lead to a decline in the international role of the dollar at the hands of the euro... that day is not today.

The most noteworthy flows into the dollar and into US treasury securities come in the form of purchases by foreign central banks. The People’s Bank of China recently reached $ 2 trillion in international reserves, which it continues to hold predominantly in dollars. Other central banks among Asian exporters of manufactures and Gulf exporters of oil have been behaving similarly. Even the American public is increasingly being made aware that the United States has grown dependent on the Chinese authorities for its funding.

(The accompanying cartoon says it all… except that China’s reserves have increased by half again since then, and that, as Shang-Jin Wei points out, the sign should really say “Float the Yuan” instead of “Fix the Yuan.”)

[Source: KAL's cartoon From The Economist print edition - Aug 9th 2007 - Illustration by Kevin Kallaugher: http://media.economist.com/images/20070811/D3207WW0.jpg]

There is another irony, however. Even while the US has grown increasingly dependent on purchases of dollars by the People’s Bank of China, US politicians maintain their demands that the People’s Bank of China abandon its purchases of dollars. They don’t usually phrase it this way, because the logical contradiction would be too glaring. Instead the US policy has been, and apparently still is, that China should allow its currency to appreciate. But it is elementary economics that PBoC purchases of dollars over the last six years are the force that has prevented the Renminbi from appreciating. The American insistence that the RMB appreciate is an insistence that the PBoC should stop buying dollars.

The authorities in Beijing have in various ways taken some steps in the direction that Americans have demanded. I have written in the past on the details of what exchange rate policy the Chinese have actually followed over the last four years, and I plan to update that analysis in a successor post tomorrow.

My position on what policy the Chinese should follow regarding the Renminbi has been roughly in the middle of a contentious range of commentators over the last few years:

On the one hand, I have argued:

1. that it is foolish for American politicians to place so much emphasis on this issue in our bilateral relations
2. that it is dangerous to ignore the flip-side implications for funding of US deficits, and
3. that it is unwise to use language such as "unfair manipulation" or "violation of international rules."

On the other hand, I have argued that an appreciation was both

1. in the interest of China, for a number of reasons, and
2. in the interest of the world, to help address the global imbalances problem.

The balance of arguments has now shifted. Overheating is no longer the problem for the Chinese economy that it was as recently as a year ago, having been pushed aside by an abrupt fall in exports. Global imbalances are no longer the most important problem for the world macroeconomy, having been supplanted by the inadequacy of demand. If American politicians are still inclined to make demands on China, it should be for increased fiscal stimulus. Given that China often reacts adversely to foreign pressure, however, perhaps it is just as well that American politicians have been asking for the wrong thing.

[If you wish to post a comment, please go to the versions at Seeking Alpha or RGE Monitor.]

Now I am a believer.

Few readers of my blog will be surprised to hear that I voted Barack Obama in the election. But I was always skeptical that he would be able to achieve fully his promises to bring candor, responsibility, and bipartisanship to Washington. Experience had convinced me it wasn't practical. OK, I am still dubious whether it is possible to achieve bipartisanship -- even for Obama. The evidence was his failure a week ago to get a single Republican vote for his fiscal stimulus in the House (and only three votes in the Senate) despite his substantial election mandate, 63% approval rating, the severity of the current recession, and the concessions he made to the other side.

When it comes to honesty and responsibility, however, what Obama did at his Fiscal Responsibility Summit today was breathtaking. The President didn't just promise to cut the budget deficit in half over the next four years. Both his predecessors promised to do that. He and OMB Director Orszag provided enough details to make me believe that they actually might be able to do it, despite the remarkably adverse circumstances that he has inherited. (This assumes that recovery begins within a year, as most forecasters assume.)

Before I elaborate on how he apparently plans to bring fiscal sanity back to Washington, let me explain what to us policy wonks is the most amazing thing of all: With a few bold waves of his hand, Obama has brought down all the cobwebs of misleading and dishonest budget math that have hopelessly obscured and encumbered the making of fiscal policy at the White House. This is a risk: it means admitting that the budget situation is far worse than the Republicans have been claiming. They could try to blame the appearance of worse numbers on him. But he is doing the right thing. And this is the right time to do it.

To get more specific, here are three kinds of tricks that his predecessor used in order to pretend to be on a path back to fiscal solvency. They sound childish, but they fooled most of the country. (I am skipping the wilder claims, that didn’t fool as many people.) Obama and his team are voluntarily giving up these tricks, even though he probably won't get much credit for it:

• Trick #1: Omitting from future budget estimates the cost of the wars in Iraq and Afghanistan. Every year, for the past 5 years, the expensive wars have continued; and every year the White House and its allies in Congress pretended that this was a surprise. Obama is putting the estimated future costs of the wars into the forecasts right now.
• Trick #2: Pretending in every succeeding budget forecast that you will allow temporary tax cuts such as the “AMT patch” to expire in a few years, thereby bringing in more tax revenue, even though everyone knows you will renew them when the time comes and this is in fact your declared policy. The White House forecasts will now include honest forecasts of future taxes. Gone also will be the similar trick of pretending in the budget forecasts that the government will in the future cut Medicare payments to doctors even though you have no intention of doing so (because it would result in the doctors dropping out of Medicare).
• Trick #3: Using as the base line for a promise to “cut the budget deficit in half” an artificially high budget deficit that you yourself proposed. This is what Bush did in the fine print of his promise in the 2004 campaign. (Not that he cut the budget deficit at all, in the end. But we will get to actual policies below. Right now we are just talking about ways to fool the press into reporting misleading claims with a straight face.) Obama has explicitly said that he plans to cut the deficit in half relative to the $1.3 trillion deficit he inherited, not relative to the much higher deficit that will occur in the coming fiscal year as a result of the recession….that is, as a result both of inevitably lost tax receipts and of the fiscal stimulus that Obama correctly deemed necessary to moderate the recession's severity. This choice of benchmark was brave. After all, he would have been within his rights to say that because he inherited the recession from his predecessor, the corresponding rise in the deficit in 2010 should not count as his responsibility.

Turning from word to deed, how will Obama move the country back toward fiscal responsibility? It won't be easy, so deep is the current hole we are in. But I perceive four categories of initiatives, each of them encompassing further breaths of fresh air: (1) limiting spending growth, (2) increasing tax revenue, (3) making new initiatives more cost-effective, and (4) long-term entitlements reform.

(1) Limiting spending growth

Three examples of measures that Obama mentioned in his speech today that I particularly like:

• Cut unneeded federal payments to agribusiness. This one is high on the wish list of virtually every economist.
• Eliminate expensive weapons systems that are of no help meeting today's national security challenges and which the Pentagon does not want.
• Withdraw combat troops from Iraq. Enough said.
• Reinstate PAYGO (Pay as You Go). This provision means that if some Congressman proposes a new outlay, they have to show how to pay for it by proposing someplace else to cut. The provision was originally adopted by the first President Bush in 1990 (as part of a courageous budget agreement with congressional Democrats, which probably cost him re-election); it was extended by President Clinton in 1993 (without a single Republican vote); it helped a lot to deliver fiscal surpluses by the latter part of the decade (1998-2000); and it was allowed to expire by the second President Bush in 2001 (with the result that the rate of spending growth tripled thereafter).

(2) Increasing tax revenue

Two examples (among other possibilties):

• Let Bush's tax cuts on income for those earning above $250,000 expire as scheduled after 2010.
• Tax investment income earned by hedge fund partners at the same ordinary income tax rates that the rest of us pay. It's about time.

(3) Seeking cost-effectiveness when addressing priorities that the Democrats consider neglected, such as health care and global climate change.

Two examples:

• Increase the efficiency with which health care is delivered.
• By 2012, require that companies buy permits for Greenhouse Gas Emissions, rather than giving them all the permits for free. Free allocation would be a big windfall to utilities and others because they will in any case pass on much of the increased cost of energy to consumers.

(4) Long-term entitlements reform.

The overwhelming problem in the longer term is the coming deficits of Social Security (big) and Medicare (much bigger). The easy thing for Obama to do would have been to put off any attempt to deal with them until after he had put behind him the financial crisis, recession, and first steps toward budget responsibility. But he has indicated that he wants to put in place during his first year in office the process to deal with the future entitlements problems.

Everybody familiar with the facts has always known how to fix Social Security. The solution is not all that hard, but is politically painful to enact. The answer is some combination of three changes:

(i) progressive indexation of benefits. (Current retirees would not have their benefits cut, not even relative to what they otherwise would have been. Really);

(ii) raising the retirement age. (Just a little. Really. And let’s exempt workers who do heavy manual labor); and

(iii) making upper-income workers pay higher payroll taxes than those earning $107,000.

One could add that in the past it was always considered necessary to add a fourth component in order to bring Republicans on board: privatization of some part of Social Security, which would be invested by workers in the stock market. Predictably, the clamor for this provision died down when the stock market crashed.

I have no inside knowledge if this is what Obama is planning. The game in the past has always been that no politician would propose any combination of the three components, because if he or she did, members of the opposite party would promptly attack him. So the thing to do is to form a study group comprising knowledgeable members of both parties in the Congress, have them meet for one year, and then come out holding hands and simultaneously declaring their support for a precise package of this sort.

This was the strategy Bill Clinton chose to address Social Security, after having successfully delivered on his earlier promises to cut the budget deficit in half in his first term and then to eliminate it entirely. (”Save Social Security First,” State of the Union speech, January 1998.) But before the year was up, the Republicans decided they would rather impeach him than solve the Social Security problem. In this sense Obama is taking up where Clinton left off eight years ago. Too bad the country sank $5 trillion in the hole in the meantime.

[For any readers wishing to post a comment, I suggest you go the version of this post at SeekingAlpha.]