Topic: Finance, Banking & Monetary Policy

We Need Real Change at the G8 Meeting

The G8 is meeting in Northern Ireland’s Belfast. The group of important industrial states is chaired this year by British Prime Minister David Cameron.  London’s three top objectives are trade, taxation, and transparency. 

No doubt, there will be a flurry of ponderous public statements and breathless press analyses. But as I argue on National Interest online, the meeting likely will be a waste. 

Trade liberalization is a worthy goal, but the U.S. and European commitment to agricultural subsidies has essentially killed the Doha round under the World Trade Organization. America wants to negotiate the Trans-Pacific Partnership, but including Japan, which wants to protect its farmers, while excluding China, which is the largest economy in Asia, makes the process more than a little complicated. As for a U.S.-European Union agreement, France is standing in the way and other member states are likely to resist liberalization in one area or another.

Only on taxes is more progress likely—unfortunately. As Dan Mitchell long has pointed out, attacks on “tax havens” and such are primarily attempts to mulct more money out of the productive to subsidize the influential. (Influential and greedy. Indeed, higher taxes are used to satisfy perhaps the basest of human emotions, envy.)

Transparency is a better objective, but the greatest offenders are non-G8 members, especially in the Third World. As I point out:

The most important single step in this direction the G8 could take would be to discourage rather than encourage government-to-government transfers, or misnamed “foreign aid.” (G8 gatherings usually include boilerplate promises to up official development assistance.) The wealthy nations should cut the financial windpipe of the most corrupt and wasteful regimes.  Private humanitarian and development assistance from NGOs to private people, and private investment and trade to private companies, are far more likely to deliver positive economic and social results with more limited opportunities for graft and abuse.

Finally, the G8 involves a curious anomaly for the U.S. While Washington pursues greater economic integration in the name of encouraging prosperity and growth, the U.S. could achieve the same result by reducing subsidies to the same countries. The Cold War has been over for 24 years. World War II ended 68 years ago. It really is time for Washington to stop defending Europe and Japan, as well as a number of other, non-G8 defense dependents, such as South Korea.

The Obama administration could make this G8 meeting more useful than normal by adding real substance to the agenda.

The Old Infrastructure Excuse for Bigger Deficits

Washington Post columnist/blogger Ezra Klein recently echoed the latest White House rationale for additional “stimulus” spending for 2013-15 and postponing spending restraint (including sequestration) until after the 2014 elections. Klein argues for “a 10- or 12-year deficit reduction plan that includes a substantial infrastructure investment in the next two or three years.” In other words, a “deficit-reduction plan” that increases deficits until the next presidential election year.

Citing Larry Summers (who similarly promoted Obama’s 2009 stimulus plan while head of the National Economic Council) Klein says, “There’s a far better case right now for being an infrastructure hawk than a deficit hawk.”

“Deficit hawks tend to [worry that] … too much government borrowing can, in a healthy economy, begin to “crowd out” private borrowing. That means interest rates rise and the economy slows… That’s not happening right now. In real terms — which means after accounting for inflation — the U.S. government can borrow for five, seven or 10 years at less than nothing… . That’s extraordinary. It means markets are so nervous that they will literally pay us to keep their money safe for them.”

If low yields on Treasury and agency bonds simply reflected investor anxiety (unlike stock prices),  rather than quantitative easing, then why has the Federal Reserve been spending $85 billion a month buying Treasury and agency bonds? Despite those Fed efforts, Treasury bond yields have lately been moving up rather smartly – even on TIPS (inflation-protected securities). The yield on 10-year bonds rose by a half percentage point since early May. It is not credible to assume, as Summers does in a paper with Brad DeLong, that today’s yields would remain as low as they have been even in the face of substantially more federal borrowing for infrastructure. Even the Fed’s appetite for Treasury IOUs has limits. 

A second worry of deficit hawks, according to Klein and Summers, “is a moral concern about forcing our children to pay the bill for the things we bought… .These are real, worthwhile concerns. But in this economy, both make a stronger case for investing in infrastructure than paying down debt.”  Paying down debt?!  Nobody is talking about paying debt. That would require a budget surplus.  The debate is only about borrowing slightly less (sequestration) or substantially more (Obama).

The Summers-Klein argument for larger deficits is that interest rates are very low, so why not borrow billions more for a “substantial investment” in highways, bridges and airports?  Summers says, “just as you burden future generations when you accumulate debt, you also burden future generations when you defer maintenance.”  This might make sense if there was any link between government tangible assets and federal liabilities.  In reality, though, this smells like a red herring. Politicians always say they want to borrow more to build or rebuild highways and bridges.  But this is not how borrowed money is spent, particularly when it’s federal borrowing.

Accumulation of federal debt since 2008 − including the 2009 stimulus plan − had virtually nothing to do with investment. Nearly 90 percent of the  2009 “stimulus” was devoted to consumption – $430.7 billion in transfer payments to individuals, more than $300 billion in refundable tax credits, $18.4 billion in subsidies (e.g., solar and electric car lobbies), more pay and perks for government workers, etc. Stanford’s John Taylor shows that even the capital grants to states − ostensibly intended for infrastructure projects − were used to reduce state borrowing and increase transfer payments such as Medicaid.

In the National Income and Product Accounts (NIPA), the closest thing we have to a measure of “infrastructure” is government investment in structures.  Federal borrowing in the NIPA accounts rose from $493.5 billion in 2008 to $1,177.8  in 2010, yet total federal, state and local investment in structures was unchanged − $310.1 billion in 2008 and $309.3 billion in 2010. Such investment was lower by 2012, but not because federal borrowing was “only” $932.8 billion that year.  

NIPA accounts show only a $12.9 billion federal investment in nondefense structures in 2012 and $8.5 billion for defense structures. By contrast, transfer payments accounted for 61.7 percent of federal spending in 2012, consumption for 28.2 percent, interest 8.5 percent and subsidies 1.6 percent.   Consumption is mostly salaries and benefits. Transfer payments did include more than $607 billion in grants to states and localities in 2011, according to a new CBO study, but 81.7 percent of such grants were for health, income security and education, leaving only 10 percent for transportation. Transportation accounted only 3.2 percent of total federal spending in 2012 and nine percent of “discretionary” spending.

In short, direct federal infrastructure investment plus grants to states add up to only a little over $80 billion out of a budget that exceeds $3.5 trillion. If federal borrowing had anything to do with $80 billion a year in federal infrastructure spending, then we wouldn’t have been borrowing about a trillion a year for the past four years. 

Klein’s rephrasing of Summers’ rerun of the 2009 “infrastructure” excuse is not a plausible argument for increased federal debt. It is, at best, an argument for ending the chronic misuse of borrowed money to pay for transfer payments and government consumption so that we could prudently reallocate a greater share to transportation infrastructure.  

 

On Iran’s Inflation Bogey

With Friday’s Iranian Presidential election fast approaching, there has been a cascade of reportage in the popular press about that opaque country. When it comes to economic data, Iran has resorted to lying, spinning and concealment – in part, because of its mores and history, and more recently, the ever-tightening international sanctions regime. In short, deception has been the order of the day.

The most egregious example of this deception concerns one of Iran’s most pressing economic problems – rampant inflation. Indeed, while the rest of the world watched Iran’s economy briefly slip into hyperinflation in October of 2012, the Statistical Centre of Iran and Iran’s central bank both defiantly reported only mild upticks in inflation.  

It is, therefore, rather surprising that the major international news outlets have continued to report the official inflation data without so much as questioning their accuracy. Even today, with official data putting Iran’s annual inflation rate at a mere 31 percent, respectable news sources faithfully report these bogus data as fact.

As I have documented, regimes in countries undergoing severe inflation have a long history of hiding the true extent of their inflationary woes. In many cases, such as the recent hyperinflation episodes in Zimbabwe and North Korea, the regimes resort to underreporting or simply fabricating statistics to hide their economic problems. Often, they stop reporting economic data all together; or, when they do report economic statistics, they do so with such a lag that the reported data are of limited use by the time they see the light of day.

Iran has followed this course – failing to report important economic data in a timely and replicable manner. Those data that are reported by tend to possess what I’ve described as an “Alice in Wonderland” quality. In light of this, it is fair to suggest that any official data on Iran’s inflation be taken with a grain of salt.

So, how can this problem be overcome? At the heart of the solution is the exchange rate. If free-market data (usually black-market data) are available, the inflation rate can be estimated. The principle of purchasing power parity (PPP), which links changes in exchange rates and changes in prices, allows for a reliable estimate. Indeed, PPP simply states that the exchange rate between two countries is equal to the rates of their relative price levels. Accordingly, if we can obtain data on free-market exchange rates, we can make a reliable estimate of the inflation rate.

In short, changes in the exchange rate will yield a reliable implied inflation rate, particularly in cases of extreme inflation. So, to calculate the inflation rate in Iran, a rather straightforward application of standard, time-tested economic theory is all that is required.

Using this methodology, it is possible to estimate a reliable figure for Iran’s annual inflation rate. At present the black-market IRR/USD exchange rate sits at 36,450. Using this figure, and a time series of black-market exchange rate data that I have collected over the past year from currency traders in the bazaars of Tehran, I estimate that Iran’s current annual inflation rate is 105.8 percent – a rate almost three and a half times the official annual inflation figure (see the accompanying chart). 

Moral of the Story: Tax Havens Are Okay if You’re a Politically Connnected Statist

Earlier this year, I had some fun when it was revealed that the president’s new Treasury Secretary had a lot of money in the Cayman Islands.

After all, leftists want us to believe tax havens are rogue regimes that should be eliminated. Some of them even want military intervention against these low-tax jurisdictions!

Much to my amusement, Mr. Lew even pretended he was financially illiterate to justify making sensible decisions to invest via the Cayman Islands.

And unlike the president’s first Treasury Secretary, Mr. Lew didn’t break the law and cheat on his tax return.

You probably won’t be surprised to learn that Secretary Lew wasn’t the first Democrat to utilize tax havens. Lawmakers such as John Kerry, Bill Clinton, John Edwards, and others on the left also have utilized tax havens to boost their own personal finances.

And it appears that Mr. Lew won’t be the last Democrat to be caught with his hands in the cookie jar.

Here’s some of what’s being reported by the New York Times in regard to the president’s nominee to be U.S. Trade Representative:

Michael Froman, a longtime White House economic aide nominated to be President Obama’s trade representative, has nearly half a million dollars in a fund based in the Cayman Islands, according to financial documents provided to the Senate Finance Committee. …White House officials said Mr. Froman played no role in creating, managing or operating the investment funds and had done nothing wrong. “Mike Froman has paid every penny of his taxes and reported all of the income, gains and losses from the investment on his tax returns,” Mr. Whithorne said.

I don’t remember that compliance with the tax law mattered when Obama and the media were going after Romney in 2012 for legally investing in the Cayman Islands.

Could it be that tax havens are okay, but only if you support big government?

The Federal Reserve vs. Small Business

Given all the attention that the Federal Reserve has garnered for its monetary “stimulus” programs, it’s perplexing to many that the U.S. has been mired in a credit crunch. After all, conventional wisdom tells us that the Fed’s policies, which have lowered interest rates to almost zero, should have stimulated the creation of credit. This has not been the case, and I’m not surprised.

As it turns out, the Fed’s “stimulus” policies are actually exacerbating the credit crunch. Since credit is a source of working capital for businesses, a credit crunch acts like a supply constraint on the economy. This has been the case particularly for smaller firms in the U.S. economy, known as small and medium enterprises (“SMEs”).

To understand the problem, we must delve into the plumbing of the financial system, specifically the loan markets. Retail bank lending involves making risky forward commitments, such as extending a line of credit to a corporate client, for example. The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market – a market operating with positive interest rates and without counterparty risks.

With the availability of such a market, banks can lend to their clients with confidence because they can cover their commitments by bidding for funds in the wholesale interbank market.

At present, however, the interbank lending market is not functioning as it should. Indeed, one of the major problems facing the interbank market is the so-called zero-interest-rate trap. In a world in which the risk-free Fed funds rate is close to zero, there is virtually no yield be found on the interbank market.

In consequence, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market. As a result, thanks to the Fed’s zero-interest-rate policies, the interbank market has dried up (see the accompanying chart).

 

Without the security provided by a reliable interbank lending market, banks have been unwilling to scale up or even retain their forward loan commitments. This was verified in a recent article in Central Banking Journal by Stanford Economist Prof. Ronald McKinnon – appropriately titled “Fed ‘stimulus’ chokes indirect finance to SMEs.” The result, as Prof. McKinnon puts it, has been “constipation in domestic financial intermediation” – in other words, a credit crunch.

When banks put the brakes on lending, it is small and medium enterprises that are the hardest hit. Whereas large corporate firms can raise funds directly from the market, SMEs are often primarily reliant on bank lending for working capital. The current drought in the interbank market, and associated credit crunch, has thus left many SMEs without a consistent source of funding.

As it turns out, these “small” businesses make up a big chunk of the U.S. economy – 49.2% of private sector employment and 46% of private-sector GDP. Indeed, the untold story is that the zero-interest-rate trap has left SMEs in a financial straightjacket.

In short, the Fed’s zero interest-rate policy has exacerbated a credit crunch that has been holding back the economy. The only way out of this trap is for the Fed to abandon the conventional wisdom that zero-interest-rates stimulate the creation of credit. Suppose the Fed were to raise the Fed funds rate to, say, two percent. This would loosen the screws on interbank lending, and credit would begin to flow more readily to small and medium enterprises.

How about ‘Don’t Give Them Loans at All’?

The big catch phrase for those fighting to keep subsidized student loan interest rates at 3.4 percent is “don’t double my rate.” That’s because the rate is set to increase from 3.4 percent to 6.8 percent on July 1. But if President Obama’s Rose Garden pep rally today is any indication, the phrase should be more like “don’t raise my rate at all.”

The POTUS attacked recently passed legislation in the House–which tracks pretty closely with his own proposal–because, he said, it doesn’t do enough to keep loan rates low. Really? The Smarter Solution for Students Act–which, by the way, is hardly all that smart–would set interest rates for subsidized loans at the 10-year Treasury note plus 2.5 percent. Today, that rate is 2.3 percent. Adding 2.5 to it is 4.8 percent, absolutely not a doubling of 3.4.

Of course, T-bill rates could, and likely will, rise, but the main point is supposed to be to make student loan rates track with normal interest rates rather than have politicians set them arbitrarily. That was certainly the case over the last few years, when student loan rates didn’t plummet along with overall rates. But it seems a tracked rate isn’t really what students and colleges want: they want super-cheap–preferably free–loans, which makes sense (for them). Like normal people, they want money at as little cost to themselves as possible. Unfortunately, but not surprisingly, that is what many vote-seeking politicians want to give them, despite the powerful evidence that aid mainly lets colleges raise their prices at breakneck speeds, fuels demand for frills, and abets serious noncompletion. In other words, it likely does more harm than good.

All of this is why Washington should get out of student aid entirely. But for that to happen, regular people will have to make their catch-phrase, “Don’t give them loans at all.”

It’s Obvious Student Aid Is Driven by Politics. But Not This Obvious

Federal aid for college students, it’s really no secret, is driven by what works politically, not what’s best for students. While logic and evidence strongly suggest that aid mainly enables colleges to raise their prices at breakneck speeds, politicians talk nonstop about aid making college “affordable.” Financial reality simply does not trump appearing to “care.” But on Friday, the Obama administration appears poised to take aid exploitation to a new level.

Tomorrow, the President will host what sounds like will be a textbook, campaign-style event featuring lots of no doubt somber – but oh-so-grateful-to-the-President – looking college students. With the photo-op thus set up, Mr. Obama will demand that Congress do something to stop the impending doubling of interest rates on subsidized federal loans from 3.4 percent to 6.8 percent.

But the GOP-led House has done something, and it is largely along the lines of what the President has called for. Last week, the House passed legislation that would peg student loan interest rates to 10-year Treasury bills, and would even cap rates at 8.5 percent or 10.5 percent, depending on the type of loan. It’s not exactly what the President wants – rates will vary over the life of the loan rather than being set at the origination rate, and the add-on to T-bill rates is higher – but the plans are still pretty close.

At this point, you’d think the President would be negotiating, not grandstanding. But then you wouldn’t understand federal student aid (or, really, almost anything government does). It is first and foremost about politicians – who are normal, self-interested people – getting what they need: political support, not sane college prices. And you get a lot of that support by appearing to want to “help people” more than the other guys.

If ever there will be a blatant, inescapable demonstration of what really drives federal aid policy, it will be the event we are likely to witness tomorrow. Let’s hope the public will get the right message: Politicians aren’t primarily driven by a desire to make college affordable. They’re driven by a desire for political gain. And that’s why we need them to get out of the student aid business.