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LAST week, I had an extended Twitter debate, which is not easy to do, with environmental writer David Roberts of the green site Grist (full disclosure: I have contributed to Grist in the past). The trigger for the debate was this piece, by Richard Schmalensee and Robert Stavins, on the relative merits of a cap-and-trade policy versus a renewable energy standard (RES). With the former, a cap is set on carbon emissions, the right to emit a certain amount of carbon under the cap is auctioned off or otherwise allocated, and those rights can then be traded on the open market. With the latter, power companies are simply required to generate a certain percentage of their energy output from renewable sources. There may also be a market component to the RES policy; firms can trade green energy credits, much as they'd trade carbon credits under a cap-and-trade plan.

The systems may sound similar, but as Mssrs Schmalensee and Stavins point out they have different impacts:

[R]enewable or clean electricity standards are a very expensive way to reduce carbon dioxide (CO2) emissions -- much more expensive than cap-and-trade. These standards would only affect electricity, thereby omitting about 60 percent of U.S. CO2 emissions. And even then, the standards would provide limited incentives to substitute away from coal, the most carbon-intensive way to generate electricity. Even more problematic, renewable/clean electricity standards would provide absolutely no incentives to reduce CO2 emissions from heating buildings, running industrial processes, or transporting people and goods. And unlike cap-and-trade, which would also affect oil consumption, the electricity standards would make no contribution to energy security. Only a very tiny fraction of U.S. oil consumption is used to generate electricity.

RES is, in their words, "less effective, more costly, but politically preferred" to cap-and-trade. Mr Roberts made clear that he did not agree with the framing of the piece. In his view, cap-and-trade and RES aren't substitutes; they're complements. This didn't make much sense to me, so I asked him to elaborate. Over the course of multiple tweets, Mr Roberts suggested that the two policies support different but related goals. Cap-and-trade is there to reduce emissions, while RES is there to "encourage industries [important] to [the] 21st century", to help generate "a robust set of clean energy industries".

This, as Mr Roberts freely admits, it straightforward industrial policy—choosing an industry to favour and adopting policies to favour it. I think this is a terrible idea on its own merits, carbon impacts aside. Ed Glaeser helps explain why, citing the example of a Massachusetts solar cell manufacturer that recently closed up shop to move to China, where the government incentives were sweeter:

Evergreen Solar’s move to China was supported by a $33 million loan from the Chinese government, and it has suggested that the Chinese production was cheaper because “solar manufacturers in China have received considerable government and financial support.”

But surely China’s skilled, low-wage labor force is a far more important source of its low costs. Japan’s success in the 1980s was also attributed to its activist industrial policy, but subsequent research found that government subsidies backed losers more often than winners.

Joshua Lerner’s superb book “Boulevard of Broken Dreams” (Princeton University Press, 2009) reviews public efforts to support start-ups and entrepreneurship worldwide and reminds us that “for each effective government intervention, there have been dozens, even hundreds, of failures, where public expenditures bore no fruit.”

Labour-intensive industries will always be at a disadvantage in America relative to China, because American labour is expensive. America tends to excel in physical and human capital-intensive kinds of production. Critics of this view might respond that those aspects of production are characterised by clustering. There are increasing returns to scale, and if Chinese efforts to attract production facilities pay off then R&D clusters may follow, leaving Americans with no good jobs at all.

Continue reading "Give me green, and jobs, but not green jobs" >>

TODAY'S recommended economics writing:

• Oil shocks and economic recessions (Econbrowser)

• Spike in global food prices contributes to Tunisian violence (Political economy)

• Fed laugh track (Real Time Economics)

• Full disclosure in economics (Triple Crisis)

• Rebalancing the US-China relationship (Brookings)

IT WAS about one year ago that yields on the debt of a few struggling European economies, Greece chief among them, began drifting steadily upward. Since that time, the loss of market confidence has generated a series of yield spikes, each of which has been associated with a brief period of crisis and a flurry of policy bandages sufficient to stave off an immediate meltdown. But through it all, yields have continued their long march upward. Nothing European leaders have done—not crash austerity plans, not ECB bond purchases, and not emergency bail-out funds—has convinced markets that the situation is under control. And the longer this dynamic persists, the less likely it is to be controllable.

The Economist has approached the question of debt restructuring cautiously. Default wouldn't be simple, or pretty, or a cure-all. But at this point restructuring looks like the best hope for a clean resolution of the crisis:

Europe’s bail-out strategy, designed to calm financial markets and place a firewall between the euro zone’s periphery and its centre, is failing. Investors are becoming more, not less, nervous, and the crisis is spreading. Plan A, based on postponing the restructuring of Europe’s struggling countries, was worth trying: it has bought some time. But it is no longer working. Restructuring now is more clearly affordable than it was last year. It is also surely cheaper for everybody than it will be in a few years’ time. Hence the need for Plan B.

The initial response, forged in the rescue of Greece in May 2010, has been undone by its own contradiction. Europe’s politicians have created a system for making loans to prevent illiquid governments from defaulting in the short term, while simultaneously making clear (at Germany’s insistence) that in the medium term insolvent countries should have their debts restructured. Unsure about who will eventually be deemed insolvent, investors are nervous—and costs have risen.

The least-bad way to deal with this contradiction is to restructure the debt of plainly insolvent countries now.

Who is insolvent? In a three-part Briefing, The Economist runs the numbers.

Greece is clearly insolvent, and Spain is almost certainly not. Ireland and Portugal are less clear-cut, but they are probably closer to Greece than Spain.

Continue reading "Time for default" >>

ALMOST everyone takes it for granted that a failure to raise the debt ceiling will eventually force the United States to default on its Treasury debt. This notion is superficially puzzling. The question is addressed in this week’s issue of The Economist. I’ll dig into it a bit more here.

A default would result from failure to pay principal or interest. The debt ceiling doesn’t bar either. Treasury can roll over maturing issues so long as the overall stock of outstanding debt doesn’t rise. (A caveat: Treasury must invest surplus Social Security and Medicare taxes by issuing non-marketable debt to the plans’ trust funds, which erodes the remaining capacity for marketable debt.) As for interest, even in today’s straightened circumstances, revenue is more than enough to cover interest charges. The helpful table below from Lou Crandall of Wrightson ICAP shows that in every month this year, projected cash receipts comfortably exceed interest payments; the narrowest margin comes in November, when receipts exceed interest by $131 billion.

What this clearly means is that Treasury can easily remain current on existing debt, provided it is willing to suspend some non-interest outlays. Does it have the authority to do so? What is the relative seniority of creditors of the United States government? States often specify the relative seniority of their bondholders either in their constitution or statute; in California, for example, bond holders stand ahead of all creditors except schools. Illinois has remained current on its bond debt while racking up some $6 billion in unpaid bills to other creditors.

I have yet to find a similar ranking for the federal government. This should not be surprising; the United States has never defaulted. There is the fourteenth amendment to the constitution which says: “The validity of the public debt of the United States… shall not be questioned.” The purpose of this section was to forbid the United States from honouring Confederate debts. The Supreme Court has apparently ruled that it also bars Congress from voiding a government bond, although not from abrogating the gold clause as it did in 1934.

I’ve poked around on this, and it seems to be a legal black hole. A bond is in essence a contract; does a contractual obligation rank ahead or behind a statutory obligation such as Social Security cheques? This is a matter of interpretation that, I am told, is largely up to the federal government itself. Without explicit guidance otherwise, Treasury would pay obligations in the order that they come due, which could clearly mean missing an interest payment.

However, some statutes, and the actions of the Clinton Administration in 1995-96, suggest that non-interest obligations are not sacrosanct. Several laws explicitly consider the possibility of late payment; the Prompt Payment Act dictates the interest penalties the federal government must pay for late payment to commercial vendors while the Internal Revenue Code does the same for late tax refunds. During the government shutdown of 1995-1996 (which was triggered not by the debt ceiling but by failure to enact appropriations), the Office of Management and Budget apparently did establish priority among various outlay categories. However, that would not have addressed bond interest which is subject to a permanent appropriation.

In early 1996, Bill Clinton warned that because the debt ceiling had not been raised, Social Security cheques might be late. This scared Congress into passing a small increase in the debt ceiling solely to meet Social Security payments. Treasury could acquire considerable additional borrowing room by not issuing non-marketable debt to the Social Security and Medicare Trust funds and by failing to rollover existing issues as they come due, and issuing IOUs in their place, as it does with the civil-service pension funds. While it seems to have rejected that option in the past, I’m not sure it is legally off limits. (Though this simply means replacing one IOU with another, it would be politically explosive; the public thinks of the trust funds as inviolable lock boxes, not accounting entries.)

Thus, it seems to me that if Tim Geithner has to make a choice, he can, and should, prioritise bond interest. To be sure, failure to pay Social Security cheques or any other payment on time would cause hardship for recipients, provoke a public backlash against the administration, Congress or both, and embarrassment for the United States; after all, how can the world’s most powerful economy not pay its bills on time? But even a brief default on Treasury debt would be unprecedented, with widespread systemic ramifications. Would banks around the world have to classify Treasury holdings as non-performing? Would money-market mutual funds break the buck? Would all federal entities lose their AAA-credit rating? Would the Federal Deposit Insurance Corporation’s ability to backstop the nation’s banks come into question? Would foreign central banks start to shift out of dollars? Since no one doubts the ability of Treasury to pay once the debt ceiling is lifted, it’s conceivable the damage would be containable; but why take the risk?

The consequences of defaulting on other obligations should not be minimised, either. The federal government now has to borrow about 40 cents of every dollar it spends. A prolonged inability to meet 40% of its obligations would sow economic disarray, trigger litigation, and eventually raise doubts about its ability to meet any obligations. Illinois’s gaping credit-default-swap spreads suggest its inability to pay non-interest bills factors into the market’s assessment of its ability to service bond debt. Failure to raise the debt ceiling need not entail default; but it would still ding Uncle Sam’s credit rating.

EARLIER this week we learned that China's trade surplus fell sharply in November, to just $13.1 billion. A look at the latest American data would indicate that trade between the two big economies didn't have that much to do with the tumbling Chinese surplus. America's trade deficit fell just a tiny bit in the month of November, from $38.4 billion to $38.3 billion. Both exports and imports rose a bit, but exports rose more, and a slight increase in America's goods deficit was offset by a bigger rise in the services surplus.

That goods deficit now stands at $51 billion, and it overwhelmingly represents two factors. The first is trade with China. America's deficit in goods trade with China rose slightly in November, as growth in imports from China barely outpaced growth in exports to China (which hit another all-time high). Of the $51 billion monthly deficit, about $26 billion of that is attributable to China. Another big chunk, about $20 billion, represents America's petroleum deficit.

Economists had expected the deficit to increase in November, and the surprising decline in the trade gap will likely lead to further upward revisions to growth in the fourth quarter of 2010. But a big question looms: will improvements in the trade deficit continue? It seems likely that the China portion of the deficit will fall in the months ahead. China remains under pressure to let the yuan appreciate, and Chinese inflation continues to outstrip that in America (November core producer prices rose just 0.2% in November, and 1.4% over the year prior). These development should slowly erode the Chinese surplus.

But what about oil? America remains heavily dependent on the stuff, and with global recovery comes rising prices, which feed through to rising imports. Buttonwood muses today:

This combination of still-subdued activity and high raw material prices illustrates a wider truth; that America is no longer the price-setter for these products. Now it is Asia. One of the side-benefits of past US slowdowns was that commodity prices would fall, acting as a tax cut for consumers. But now consumer budgets are being squeezed at a time when unemployment is still high and wage rises are hard to come by. At least the US still produces commodities; Europe is in an even worse position, as this week's column will argue.

Anyway it is one more thing for westerners to get used to as power shifts to the developing world. One can have boomtime prices without boomtime conditions.

America's economy limped forward in 2010, but global growth last year was above the average for the previous decade. And that helped sustain a steady rise in commodity prices. As American recovery continues, that will only add further stress to supplies. One of the main variables shaping American economic performance this year will be the interaction between the economy and rising oil prices.

Let me make one additional point. The president's deficit commission recommended that Congress act to raise America's petrol tax, which is among the rich world's lowest and hasn't been increased since 1993. One drawback to doing so would be the negative impact on already weak growth. But of course, rising petroleum prices will have a similarly negative impact. The difference in the impact of the two is that an increased petrol tax will help close America's fiscal deficit and will place downward pressure on the total value of American petroleum imports, both of which will move America's economy toward a better balance of trade with the rest of the world. It may be time for America's government to acknowledge that rising energy prices will inevitably put a constraint on America's recovery, and that that constraint can either be harnessed in the service of broader economic adjustments or allowed to worsen the economy's imbalances.

PAUL KRUGMAN isn't really wrong here:

I’m with Calculated Risk here: it says something about the sheer desperation of the European situation that Portugal’s ability to sell 10-year bonds at an interest rate of “only” 6.7 percent is considered a success. If you think about the debt dynamics here — the burden of growing interest payments on an economy that is likely to face years of grinding debt deflation — an interest rate that high is little short of ruinous. But it is, indeed, not as bad as people were expecting last week; hence, success.

A few more successes and the European periphery will be destroyed.

Countries on the European periphery will be facing bond markets a number of times in coming days, and so there was a real concern that a terrible performance here by Portugal would mean a big jump in spreads and the need for another big intervention. Potentially, it could have forced Europe to make a lot of momentous decisions at once and amid a crisis atmosphere.

Instead, the auction yielded a slight improvement in Portuguese yields. That means that Europe's leaders don't find themselves facing a seriously abbreviated timetable, but neither have they been let off the hook by bond markets. It's almost impossible to see a route to solvency via 6.7% interest rate on debt while the Portuguese economy shrinks (as the EIU forecasts it will in 2011). In that situation, interest payments rise as a share of GDP, forcing ever more savage cuts to budgets—until eventually the economy is in a shambles while there's nothing left to cut.

Indeed, the high yield markets are demanding of Portugal likely indicates some market expectation of eventual debt restructuring. The question is whether European leaders are prepared to accept this possibility and are ready to take steps to make sure it occurs in non-catastrophic fashion.

AHEAD of a looming Sino-American summit, it's once again time for newspapers to allocate ink to coverage of the spat over the value of China's currency. Happily, we seem to be seeing an improved understanding that movement in the nominal dollar-yuan exchange rate is not the most important factor shaping imbalances. Tim Geithner (who, bless him, once got in trouble for saying that the dollar needed to decline) declared today that the yuan is "substantially undervalued" and needs to strengthen. But he later elaborated:

“This is a pace of about 6 percent a year in nominal terms, but significantly faster in real terms because inflation in China is much higher than in the United States,” Geithner said. Taking inflation into account, the yuan is rising at a rate of about 10 percent a year, “so if that appreciation was sustained over time, it would make a very substantial difference,” he said in response to a question after the speech.

Yes, China continues to manipulate its currency. This much is clear from the latest data on Chinese reserve accumulation. Here's the Washington Post:

At issue is the imbalance in their financial relationship. China's central bank said Tuesday that Beijing's holdings of foreign cash and securities amount to $2.85 trillion - a jump of 20 percent over the year before - despite Chinese promises to try to balance its trade and investment relations with the United States and other countries.

China added $200 billion to that stockpile in the last three months of the year alone, as the country socked away capital from the rest of the world at a torrid pace.

That reserve accumulation is directly connected to China's interventions in currency markets to keep the yuan cheap against the dollar. But the Post makes a mistake in saying that:

The reserves are so large and the recent run-up so rapid that it's casting new doubts over whether Beijing is reforming the handling of its currency and curbing its heavy reliance on exports as a source of jobs and growth.

And the reason has everything to do with China's limited ability to control its real exchange rate. A cheap yuan makes for dear Chinese imports and excess demand for Chinese goods, leading to rising Chinese inflation. That's makes Chinese goods more expensive to foreign buyers—just what a nominal appreciation would accomplish. To wit:

When garment buyers from New York show up next month at China’s annual trade shows to bargain over next autumn’s fashions, many will face sticker shock.

“They’re going to go home with 35 percent less product than for the same dollars as last year,” particularly for fur coats and cotton sportswear, said Bennett Model, chief executive of Cassin, a Manhattan-based line of designer clothing. “The consumer will definitely see the price rise.”

Chinese inflation is running consistently higher than American inflation, which is scarcely above 1%. That translates into rapid real appreciation despite the slow movement in the nominal exchange rate. And that should produce a decline in Sino-American imbalances, which seems to be emerging. In December, China's trade surplus fell sharply from its November level, from $22.9 billion to $13.1 billion.

It appears that markets are pushing the real exchange rate in the appropriate direction, despite Chinese intervention. That will help bring trade between the countries closer to balance. But it's up to the governments in China and America to facilitate this process and reduce its cost to citizens by removing structural obstacles to adjustment.

THE Wall Street Journal's Sudeep Reddy has captured a lot of attention today with an interesting story on falling wages, the impact of a deep labour market slump. He writes:

But the decline in their fortunes points to a signature outcome of the long downturn in the labor market. Even at times of high unemployment in the past, wages have been very slow to fall; economists describe them as "sticky." To an extent rarely seen in recessions since the Great Depression, wages for a swath of the labor force this time have taken a sharp and swift fall.

The only other downturn since the Depression to see similarly large wage cuts was the 1981-82 recession. But the latest downturn is already eclipsing that one. Unemployment has stood above 9% for 20 straight months—longer than the early 1980s stretch—and is likely to remain above that level for most of 2011, putting downward pressure on wages.

Mr Reddy collects an impressive array of anecdotes to support this assertion. He finds an ex-money manager working at Starbucks, a training manager at a manufacturing firm who now works as a janitor, and so on. The stories reflect his thesis, that long spells of joblessness tend to conclude (if it all) with a re-hiring at a much lower wage. And yet Mr Reddy runs into trouble when it comes time to cite data:

Overall, U.S. wages continue to grow, but at a slow pace. Wages and salaries for civilian workers were up 1.5% before adjusting for inflation in the 12 months ended in September, according to the Labor Department's comprehensive Employment Cost Index, which compares wages in the same jobs and doesn't reflect wages of people switching careers. Over the same period, consumer prices rose 1.1%.

Here's a chart of average weekly earnings for all employees since 2007:

We observe wages levelling off and dipping just slightly during the collapse in late 2008, but by the time early 2009 rolls around earnings are rising again. Now, this trend doesn't mean that Mr Reddy is describing a false trend. When we begin pulling apart the weekly earnings data, we see that the biggest contribution to the increase is a rise in hourly earnings (up 1.8% over the past 12 months), followed by a rise in average weekly hours (up 1.5%), while total payrolls are only up 0.9%.

So what we see is a two-track labour market. Workers who never lost their jobs saw, on average, a slight decrease in hours worked and a pause in wage increases, but since that time they've been able to work more and have potentially enjoyed pay increases. But this could coincide with a group of jobless workers who have struggled to find work and who can generally only do so at a significant wage cut relative to their previous pay.

How can we explain this? I mentioned a few explanations ventured by Rob Shimer in a recent post:

One big issue is the problem that nominal wages aren't very flexible in a downward direction. Another issue could be that since existing firms aren't motivated to hire new and cheap workers, new firms are needed to absorb jobless workers, but new firm creation is hampered by tight credit conditions. Mr Shimer also speculated that unemployed workers could somehow be different—uniquely unskilled or improperly skilled—or they could be pinned in place by housing conditions in particularly bad job markets.

Is downward wage rigidity a problem? Mr Reddy's anecdotes indicate that many of those who've been without work for a long time are willing to take new jobs at significant pay cuts, but perhaps others are still holding out for the wages they're used to.

On the other hand, there may not be jobs available for them. Why would that be the case? Why wouldn't firms swap out older, more expensive workers for the cheaper unemployed ones available to them? One possibility is that firms are worried about the disruptive impact of such workforce turnover and have decided that it's better to keep employing existing labour at existing wages. But then we might expect new firms to start up and hire jobless workers; if the unemployed were just as productive as the employed, new businesses could operate at a significant cost advantage over competitors. But Robert Hall argues that credit conditions remain tight for new businesses, who are the big job creators.

Or it could be that jobless workers are simply much less productive than those who continue to work. Ragu Rajan indicates that this kind of structural explanation could be behind most current unemployment, and he therefore emphasises the importance of retraining. But if so many workers are now too unproductive to hire, one has to ask why firms had them on payrolls before the recession. Mr Rajan points to the unusual growth and subsequent collapse in the construction industry, but as Mr Shimer notes unemployment has basically doubled among all subgroups within the labour force. The data seem not to point toward structural factors as the primary driver of unemployment.

Perhaps the problem is a shortfall in demand, which is preventing existing firms from expanding. It could be that the real interest rate simply isn't low enough to induce firms to invest in new plants and equipment—investments that would produce corresponding jobs.

These are the factors with which economists are currently wrestling in an attempt to understand unemployment. I do think it's worth pointing out that a little bout of inflation would be helpful in resolving all of the above issues, with the possible exception of structural skills mismatch. So I continue to find criticism of the Fed's decision to resume easing perplexing.

THE blogosphere continues to debate whether or not Texas' economy is special, and today the Bureau of Labour Statistics has provided us with another piece of evidence. New, county-level data on employment and wage conditions through June of 2010 are now out, and there are industry-level numbers for the ten largest counties. Among the ten largest counties are Harris and Dallas counties in Texas, the centres of the Houston and Dallas metropolitan areas, respectively.

In general, these two counties haven't managed spectacular employment growth. Harris County employment fell by 0.3% over the year to June, while Dallas County employment rose 0.2%. The national average was a drop of 0.2%, while the best large county performance came in Manhattan, which saw an employment increase of 0.3%. (New York was also tops in wage growth, by a large margin.)

But what's really interesting are the industry patterns. For the country as a whole, employment rose in four categories: natural resources and mining (1.5%), Professional and business services (2.0%), Education and health services (1.7%), and government (1.1%). Among the large cities, the big gains typically come in the middle two categories—the services—with a few exceptions (New York's gains are powered by big increases in Leisure and hospitality.

Harris and Dallas counties look different, however. The gains from Natural resources and mining,  at 3.1% and 8.3%, respectively, are much bigger than in other large cities and the national averages. And what's really unusual are the anomalous gains in government employment. The two enjoyed increases of 3.8% and 4.4%, respectively, in those categories.

Based on this datapoint, at least, the factors setting Texas cities apart from other large metropolitan areas would seem to be energy and growing government (the latter will soon face reversals). One shouldn't read too much into any one piece of evidence, but this would seem to render the Texas experience less generalisable than its advocates suggest.

TODAY'S recommended economics writing:

• More bank reforms needed, economists say (Wall Street Journal)

• Analysis of health care repeal (CBO)

• The dollar: dominant no more? (Vox)

• Should we subsidize or tax research into time travel (Marginal Revolution)

RECENTLY, the data and graphic wizards here at The Economist put together a tool enabling readers to determine when China will overtake America as the world's largest economy:

Given reasonable assumptions, China will pull ahead within the next ten years. if you play around with the interactive, you'll find that this isn't particularly sensitive to changes in the variables. If you double expected American growth from 2.5% per year to 5% per year, you push the key date back from 2019 to...2022. If you then slow China's growth to 5% annually, you delay il sorpasso to 2028. Absent a total disaster in China, the transition will take place, and that right soon. Why? Well, China remains far behind the developed world in per capita terms, and because there is plenty of catch-up left to accomplish, there's plenty of room for rapid growth. And China's population is enormous. It has over four times as many people as America, and so its output per capita only needs to be about a fourth of America's to match it in total size. At this moment, that would mean a level of per capita wealth roughly equal to that in Turkey, or Brazil, or Panama, which seems entirely achievable. If China can manage Portuguese or Slovakian wealth, it will have an economy twice the size of America's.

So even if China never becomes as productive as western Europe or South Korea, to say nothing of America, it will have the world's largest economy by a healthy margin (until, that is, India catches up). And that means that China will have enormous influence in the world—will be an agenda setter—and will, in some ways, be able to marshal more real resources than America. Within Asia, China's influence will dwarf that of America. Power inevitably follows economic might, and China will soon be the mightiest.

A lot of time is spent hand-wringing over the economic implications of this shift, but I actually think those aren't that important. China can overtake America without any loss in American living standards, and a larger Chinese market should be quite good for developed nation economies. What strikes me as difficult to game out and potentially unpleasant is the handing-over of the mantle of global leadership.

Continue reading "How to gracefully step aside" >>