“The Dodd bill on financial regulatory reform embraces a supposed solution to the ‘Too Big To Fail’ conundrum: Contingent Convertible Bonds, or CoCos, which turn into equity once a bank’s capital falls below a certain level.”

My response:

I do think that measures such as the Contingent Convertible Bonds would be a useful step. Some argue that it would be hard to know when to invoke the contingency clause. It strikes me that this argument largely vanishes when one realizes that the clause would of necessity be invoked by the time we got to the stage of a Bear Stearns or Lehman Brothers bankruptcy.

CoCos would not go very far in themselves toward comprehensive reform of the financial system, if that is the goal. But then no single policy measure would do that. I agree with Gillian Tett: “In theory, I think that CoCos certainly could be a useful additional to banks’ tool kits. However, in practice, the contagion risk suggests it would be dangerous to rely too heavily on an exclusive diet of CoCos for any policy ‘fix’.” (in the Financial Times, Nov. 12).

Two related issues are of much bigger import. First, is it a feasible goal to eliminate, credibly, the problem “too big to fail” or “too interconnected to fail,” ,thereby eliminating the critical moral hazard problem? My suspicion is that this is not an achievable goal, when push comes to shove, ex post, in a crisis; and if I am right, then it is very important that we don’t return to the rhetoric of claiming “no bank is automatically too big to fail” and so fail to regulate and collect insurance from the banks ex ante. This would just exacerbate the moral hazard problem. Commercial banks are like river banks in this respect.

Second, would the legislation that is offered by Senator Chris Dodd be a better approach to financial reform than alternative proposals, or even than the status quo? While the 1,000+ page Dodd bill undoubtedly has some good things in it (the CoCos and the principle of a Consumer Protection Agency in lending are probably at the top of the list), I believe it would be very damaging overall. The major reason is that it would seriously undermine the power of the Fed to set fully-informed monetary policy in normal times and to respond effectively in times of crisis. It seems that Barney Frank understands these things much better.

My response:

I am astounded by claims that fiscal stimulus under recession circumstances doesn’t create jobs. Or at least I am astounded when such claims come from reputable economists. Do they think that a construction job on a road-building project doesn’t count as a real job if the funding comes from the government? Or do they think that the increase in demand doesn’t raise output in the aggregate, because the federal debt crowds out private production and so someone else somewhere loses his or her job? That would be hard to believe, at a time when the Fed is keeping interest rates at zero, long-term interest rates are also quite low, and capacity is lying idle. Moreover, Republican lectures to Democrats about the evils of the national debt take real chutzpah, after Presidents Reagan, Bush I and Bush II increased the debt ten-fold during periods when no national emergency required it.

Yes, the effort to identify specific jobs saved is more a political exercise than an economic exercise; the true number of jobs saved, relative to what would otherwise have happened is greater than the 650,000 number. It is legitimate as a communications strategy for the White House to make the benefits concrete by pointing to the many teachers who would have been laid off by fiscally devastated state and local governments in the absence of federal government money. But one problem is that the exercise doesn’t count the indirect effects of most of the spending and tax cuts, where it is hopeless to try to pinpoint whose job was saved.

The biggest problem, of course, is that one cannot estimate accurately, let alone prove, what would have happened in the absence of the stimulus package. Claims by Republican congressmen that one should judge Obamanomics by looking at whether employment is greater now than before February are nonsense. If there hadn’t been a severe recession underway (starting on the predecessor’s watch, if you want to get political about it), there would have been no need for the stimulus. None of us claims that fiscal stimulus creates a lot of jobs on net when the economy is already expanding strongly. The increased government spending that occurred during the terms of Presidents Reagan and Bush after the recessions of their respective first terms had already ended, for example, did not create a lot of jobs. But without the recent stimulus, the recession would have been worse.

The appropriate way to estimate the stimulus impacts is by means of a standard macroeconomic model with fiscal multipliers in it. But if you believe philosophically that fiscal multipliers are zero, even in a severe recession, then neither a standard macroeconomic model nor anything else will convince you.

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)

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.]

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.]

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.)

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 .]

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 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.

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.