Doha Seems Dead: What Next for the WTO?

The Doha round of trade talks kicked off in 2001. They now include 153 countries trying to reach agreement across nine areas at a time when the high-income countries are suffering the aftermath of a deep recession and watching a shift in global economic power toward emerging markets. After eleven years of negotiation, maybe it's time for the World Trade Organization to focus on something else.

Sure, there's a solid case to be made for the merits of the Doha trade round. Will Martin and Aaditya Mattoo edited a Vox e-book published last November called Unfinished Business: The WTO's Doha Agenda. In a column describing the main findings of the book, they point out: "The tariff cuts on the table compare favourably with those achieved in earlier rounds of multilateral negotiations. Even after allowing for flexibilities such as for sensitive and special products, Doha would cut the applied tariffs faced by exporters of agricultural and non-agricultural goods by around 20% ... The global real income gains from this market opening alone are conservatively estimated at around $160 billion per year. The agricultural proposals also include the abolition of export subsidies, and sharp reductions in maximum levels of domestic agricultural support in the EU and the US. ... A hard-to-quantify but nevertheless significant gain from the negotiations would be greater security of market access."

The main action in international trade talks in recent years has been through "preferential trade agreements" negotiated between two or more countries. The U.S. currently has such agreements with  17 countries.  Worldwide, the WTO now has a list of 512 regional trade agreements.

Regional agreements can lead to reduced trade barriers within the group of participating countries, but greater trade barriers between that group and the rest of the world. Thus, their net effect on free trade is not clear. Caroline Evans of the San Francisco Fed points out in a recent newsletter that preferential/regional trade agreements often lead to complex "rules of origin" about what share of value-added was made in which country, and also to different tariff rates across countries. She gives an example of U.S. trousers imports: 

"Rules of origin are put in place to eliminate cheating, whereby one country imports a product from a non-partner country and then re-exports it to the free-trade partner. Satisfying rules-of-origin requirements has become increasingly complex, since production processes now stretch across multiple countries. When an assembling country sources inputs from a number of other countries and then exports the finished product to another final market, it becomes difficult to determine exactly where the product originates. Since each PTA has its own rules of origin for particular parties to the agreement, meeting those requirements may become quite complicated."

"Different trade agreements also lead to separate tariff rates on imports from different countries. For example, U.S. imports of a certain kind of men’s trousers from most countries face a duty of $0.61 per kilogram plus 15.8% of the product’s value. However, if the trousers are imported from Bahrain, Canada, Chile, Israel, Jordan, Mexico, Peru, or Singapore, no duty is imposed. Trousers from Australia incur an 8% tariff; from Morocco $0.62 per kilogram plus 1.6%; and from Oman $0.488 per kilogram plus 12.6%. For non-WTO member countries, a $0.772 per kilogram plus 54.5% tariff is imposed.  ...  Rules of origin and the profusion of tariff rates increase the costs of trade, both for businesses involved in cross-border commerce and governments enforcing trade rules. Furthermore, they may distort production decisions as businesses navigate the web of rules and rates to minimize transaction costs."

So if the Doha round is becalmed and the alternative of regional trade agreements is imperfect at best, what should the WTO and other friends of free trade be focusing on these days? Last November, the Strategy, Policy and Review Department of the IMF put out a paper called "The WTO Doha Trade Round--Unlocking the Negotiations and Beyond" with some suggestions for multilateral steps that could perhaps be debated and even implemented through the WTO mechanism.

Some of the ideas seem potentially useful to me. For example, greater monitoring of protectionist measures, including nontariff barriers and rules that require governments to buy domestically produced goods and services, seems like a step in the right direction. There are concerns that some countries restrict food exports at certain times, which makes other countries unwilling to rely on food imports, and thus leads them to subsidize their own domestic food production. Perhaps this set of issues could be isolated and discussed. And perhaps it might be possible for WTO to negotiate a set of guidelines for the proliferating preferential trade agreements, so that they are more likely to reduce overall trade barriers for the world economy, rather than reducing trade barriers for participants but raising them for everyone else.

On the other side, some of the IMF suggestions seem implausible to me. For example, one suggestion is that WTO should get into climate change issues, which would mean trying to jump-start one set of dead-in-the-water negotiations by getting involved in another set of dead-in-the-water negotiations. Another suggestion is that the WTO might develop an international antitrust policy. I'm not feeling it.

The power of the World Trade Organization is often highly overstated in public discussions. It's not a colossus imposing its own vision of a new world economic order. It's an organization with a staff of about 600 people, where decisions are made by consensus of the 153 member nations. But it is useful to have a world meeting-place for hashing out international trade issues, and there's a lot of knowledge and experience and skill wrapped up in the WTO apparatus. But if the future of the WTO is wrapped up in the endlessly stalled Doha negotiations, the organization seems likely to marginalize itself into irrelevancy.

McKinsey on Reducing Debt and the Pathway to Economic Health

 The McKinsey Global Institute has just published "Debt and deleveraging: Uneven progress on the
path to growth." The report uses the cases of Sweden and Finland in the 1990s as a map for how recovery from too much debt, asset bubbles, and financial crisis might proceed.  MGI writes:
 
"The examples of deleveraging in Sweden and Finland during the 1990s have particular relevance today. Both nations experienced credit bubbles that led to asset bubbles and, ultimately, financial crises. But both also moved decisively to bolster their banking systems and deal with debt overhang. And—after painful recessions—both nations went on to enjoy more than a decade of strong GDP
growth.  The experiences of the two Nordic economies illustrate that deleveraging often proceeds in two stages. In the first, households, the financial sector, and nonfinancial corporations reduce debt, while economic growth remains very weak or negative. During this time, government debt typically rises as a result of higher social costs and depressed tax receipts. In the second phase, economic growth rebounds and then the longer process of gradually reducing government debt begins."





With this pathway to eventual recovery in mind, MGI makes an argument that the U.S. economy is actually further down the road to recovery than most other high-income countries:

"Since the end of 2008, all categories of US private-sector debt have fallen relative to GDP. Financial-sector debt has declined from $8 trillion to $6.1 trillion and stands at 40 percent of GDP, the same as in 2000. Nonfinancial corporations have also reduced their debt relative to GDP, and US household debt has fallen by $584 billion, or a 15 percentage-point reduction relative to disposable income. Two-thirds of household debt reduction is due to defaults on home loans and consumer debt. With $254 billion of mortgages still in the foreclosure pipeline, the United States could see several more percentage points of household deleveraging in the months and years ahead as the foreclosure process
continues.

Historical precedent suggests that US households could be as much as halfway through the deleveraging process. If we define household deleveraging to sustainable levels as a return to the pre-bubble trend for the ratio of household debt to disposable income, then at the current pace of debt reduction, US households would complete their deleveraging by mid-2013. ..."


Here's a figure showing the rapid increase in U.S debt by sector, and the recent change. In contrast to this U.S. pattern, MGI notes that in Japan private-sector debt levels didn't start falling until eight years after the bursting of the bubble.



 What steps should we be seeing along the way in the next year or two that would reassure us that the U.S. economy is returning to health? The MGI report offers six "markers." Here, I'll focus on how the U.S. economy measures up on these markers, although the report offers many intriguing comparisons to other countries, especially the United Kingdom and Spain.

"Marker 1. Is the banking system stable?"
The U.S. economy does seem to have stabilized the banking system (at some cost!). "Net new mortgage lending only recently turned positive in the United States."


"Marker 2. Is there a credible plan for long-term fiscal sustainability?"
In terms of what Congress has enacted and President Obama has signed into law, the answer is clearly "no."

"Marker 3. Are structural reforms in place to unleash private-sector growth?"
"The United States should encourage business expansion by speeding up regulatory approvals for business investment, particularly by foreign companies, and by simplifying the corporate tax code and lowering marginal tax rates in a revenue-neutral way. Business leaders also say that the United States can improve infrastructure and the skills of its workforce and do more to encourage innovation."

"Marker 4. Are the conditions set for strong export growth?"
This step was especially important for Sweden and Finland, as small open economies. It's less crucial for the U.S., with its huge internal market and, by world standards, relatively low trade-to-GDP ratio. Still, the U.S. economy should be recognizing that the most rapid growth in the world economy in the next few decades is going to be happening outside our borders, and we need to be thinking about how we can tap into this growth, with everything from building connections for exporters to encouraging tourism.


"Marker 5. Is private investment rising?"
"Today, annual private investment in the United States and the United Kingdom is equal to roughly 12 percent of GDP, approximately 5 percentage points below pre-crisis peaks. Both business investment and residential real estate investment declined sharply during the credit crisis and the ensuing recession. While private business investment has been rising in recent quarters, total investment remains low because of slow housing starts." My own expectation is that real estate investment isn't going to be driving the U.S. economy forward in the next few years--at best, we can hope that it won't be a drag. So the key to U.S. investment is business investment levels.

"Marker 6. Has the housing market stabilized?"
"Both Macroeconomic Advisers and the National Association of Home Builders predict that new housing starts will not approach pre-crisis levels until at least 2013—coincidentally the year in which we estimate that US households may be finished deleveraging."


In my own view, the most important policy steps that flow from this analysis are the importance of building to an agreement on a credible middle-term plan for holding down the ongoing rise in U.S. government debt levels, and finding ways to encourage business investment.

U.S. Science Needs to Look Beyond Our Borders

The U.S. has traditionally been the dominant world presence in science, although it of course needed to pay some attention to scientific efforts in western Europe, Japan and Canada as well. America is used to scientists and business people from other countries coming here to learn the latest breakthroughs. But the U.S. scientific edge is diminishing. As Caroline S. Wagner writes in "The Shifting Landscape of Science",

in the Fall 2011 issue of Issues in Science and Technology: "The days of overwhelming U.S. science dominance are over, but the country can actually benefit by learning to tap and build on the expanding wellspring of knowledge being generated in many countries." Here are some excerpts:

Here's Wagner with an overview of the past and what's coming: "Since the middle of the 20th century, the United States has led the world rankings in scientific research in terms of quantity and quality. U.S. output accounted for more than 20% of the world’s papers in 2009. U.S. research institutions have topped most lists of quality research institutions since 1950. The United States vastly outproduces most other countries or regions in patents filed. ... In 1990, six countries were responsible for 90% of R&D spending; by 2008, this number has grown to include 13 countries. According to the United Nations Educational, Scientific, and Cultural Organization (UNESCO), since the beginning of the 21st century, global spending on R&D has nearly doubled to almost a trillion dollars, accounting for 2% of the global domestic product. Developing countries have more than doubled their R&D spending during the same period. ...The UNESCO report documents that the global population of researchers has increased from 5.7 million in 2002 to 7.1 million in 2007. The distribution of talent is spread more widely, and the quality of contributions from new entrants has increased."

One common (if imperfect) measure of scientific output is the number of scientific papers published. By this metric, the European Union has taken the lead from the United States, and countries like China and Korea are rising rapidly.

Wagner's overall message is that in a world economy where science and technology are of increasing importance, and a world where a greater share of that research is happening elsewhere, and where pressures on government budgets mean that U.S. spending on R&D isn't likely to rise in a sustained and dramatic way--in that world, the U.S. scientific establishment needs to focus more on identifying excellent research happening around the world and in in keeping tabs on that research and finding ways to participate in it. Here's Wagner:

"Although the U.S. research system remains the world’s largest and among the best, it is clear that a new era is rapidly emerging. With preparation and strategic policymaking, the United States can use these changes to its advantage. Because the U.S. research output is among the least internationalized in the world, it has enormous potential to expand its effectiveness and productivity through cooperation with scientists in other countries.

"Only about 6% of U.S. federal R&D spending goes to international collaboration. This could be increased by pursuing a number of opportunities: from large planned and targeted research projects to small investigator-initiated efforts and from work in centralized locations such as the Large Hadron Collider in Geneva to virtual collaborations organized through the Internet. Most federal research support is aimed at work done by U.S. scientists at U.S. facilities under the assumption that this is the best way to ensure that the benefits of the research are reaped at home. But expanded participation in international efforts could make it possible for the United States to benefit from research funded and performed elsewhere.

"U.S. policy currently lacks a strategy for encouraging and using global knowledge sourcing. Up until now, the size of the U.S. system has enabled it to thrive in relative isolation. Meanwhile, smaller scientifically advanced nations such as the Netherlands, Denmark, and Switzerland have been forced by budgetary realities to seek collaborative opportunities and to update policies. ... An explicit U.S. strategy of global knowledge sourcing and collaboration would require restructuring of S&T policy to identify those areas where linking globally makes the most sense. The initial steps in that direction would include creating a government program to identify and track centers of research excellence around the globe, paying attention to science funding priorities in other countries so that U.S. spending avoids duplication and takes advantage of synergies, and supporting more research in which U.S. scientists work in collaboration with researchers in other countries."

"One recent example of movement in the direction of global knowledge sourcing is the U.S. government participation with other governments in the Interdisciplinary Program on Application Software toward Exascale Computing for Global Scale Issues. After the 2008 Group of 8 meeting of research directors in Kyoto, an agreement was reached to initiate a pilot collaboration in multilateral research. The participating agencies are the U.S. National Science Foundation, the Canadian National Sciences and Engineering Research Council, the French Agence Nationale de la Recherche, the German Deutsche Forschungsgemeinschaft, the Japan Society for the Promotion of Science, the Russian Foundation for Basic Research, and the United Kingdom Research Councils. These agencies will support competitive grants for collaborative research projects that are composed of researchers from at least three of the partner countries, a model similar to the one used by the European Commission. ..."

"Looking for the opportunity to collaborate with the best place in any field is prudent, since the expansion of research capacity around the globe seems likely to continue and it is extremely unlikely that the United States will dramatically increase its research funding and regain its dominance. Moreover, it may be that the marginal benefit of additional domestic research spending is not as great as the potential of tapping talent around the world. Thus, seeking and integrating knowledge from elsewhere is a very rational and efficient strategy, requiring global engagement and an accompanying shift in culture."

Thoughts on Ultra-Low Interest Rates

Philip Turner asks "Is the long-term interest rate a policy victim, a policy variable or a policy lodestar? in a December 2011 working paper for the Bank of International Settlements.

Not all long ago, a number of papers tried to estimate the "normal" long-term real interest rate on safe assets. Estimates were typically in the range of 2-3%, which is a substantially higher than the barely-above zero percent rates of interest on safe borrowing, like 10-year U.S. bonds that pay an interest rate above the rate of  inflation.  Here's Turner: "There has been much debate among economists about the “normal” long-term interest rate. Hicks (1958) found that the yield on consols over 200 years had, in normal peacetime, been in the 3 to 3½% range. After examining the yield on consols from 1750 to 2006, Mills and Wood (2009) noted the remarkable stability of the real long-term interest rate in the UK – at about 2.9%. (The only exception was between 1915 and 1964, when it was about one percent lower). Amato’s (2005) estimate was that the long-run natural interest rate in the US was around 3% over the period 1965 to 2001 and that it varied between about 2½% and 3½%." [For the record, a "consol" is a kind of perpetual bond issued by the British government: that is, it paid interest but had no date of maturity.]

Here's a figure showing the U.S. federal funds rate, as well as yields on 10-year inflation-linked Treasuries in the U.S. and the UK:

Turner sorts through the possibilities: Are these ultra-low interest rates a result of U.S. monetary policy? Are they a result of a "savings glut"--historically high rates of saving in the global economy, driven primary by the growing and high-saving economies of Asia, which drives down interest rate? Or are they the result of the ability of private financial markets to produce a huge supply of "safe" financial assets--although many of those assets then turned out not to be so safe.

My own sense is that although other explanations may have been more relevant a few years ago, longer-term interest rates now are low largely as a result of policy decisions, and that the "quantitative easing" policies in which central banks buy and hold government debt are a sign that such debt would not be sold at the same low interest rate without a policy intervention. However, as Turner rightly points out after a discussion of the relevant theory:  "This paper argues great caution is needed in drawing policy implications based on the real long-term interest rate currently prevailing in markets. This interest rate has moved in a wide range over the past 20 years. At present, it is clearly well below longstanding historical norms. Several explanations come to mind. But not enough is known about how far the long-term rate has been contaminated by government and other policies. Nor is the persistence of such effects clear. And the various policies will have impacted different parts of the yield curve in ways that are hard to quantify."

But whatever the reason behind the ultra-low long-term interest rates, what possible risks do they raise? The obvious possibility is that low interest rates encourage borrowing and discourage saving. At present, the ultra-low interest rates are keeping debt payments low, despite the historically high underlying levels of debt. Turner touches on this point in several places:

"From the mid-1950s to the early 1980s, this aggregate [debt of domestic US non-financial borrowers – governments, corporations and households] was remarkably stable – at about 130% of GDP. It was even described as the great constant of the US financial system. The subcomponents moved about quite a bit – for instance, with lower public sector debt being compensated by higher private debt. But the aggregate itself seemed very stable. During the 1980s, however, this stability ended. Aggregate debt rose to a new plateau of about 180% of GDP in the United States. At the time, this led to some consternation in policy circles about the burden of too much debt. It is now about 240% of GDP. Leverage thus measured – that is, as a ratio of debt to income – has increased. Very many observers worry about this. Whatever the worries, lower rates do make leveraged positions easier to finance. Once account has been taken of lower real interest rates, debt servicing costs currently are actually rather modest: Graph 3 illustrates this point."

Graph 3 shows nonfinancial debt in the U.S. economy as a share of GDP with the solid line, rising to aboug 240% of GDP as measured on the right-hand axis. It shows the falling real long-term Treasury yields as a measure of interest rates on the left-hand scale, with the thin dashed line. And it shows interest expenses as a share of GDP with the thick dashed line, measured on the left-hand axis. Notice that even thought debt is historically very high, interest payments are historically low."

In this setting, an ever-larger share of private assets are locked into very low real returns. Institutions that have liabilities far into the future, like insurance companies and pension funds, suffer greatly when interest rates are so low. It becomes much easier for the federal government to finance its huge budget deficits with such low interest rates. The pressure on households and firms to reduce their borrowing and to save more is greatly reduced, too.

This combination of high debt and low interest rates creates a potentially unstable situation. If or when interest rates rise again, the oversized debt burdens will be tougher to finance. All of those who are locked into long-term low interest rates--including large financial institutions and the Federal Reserve--would see the value of those investments fall if higher interest rates become available. Turner concludes:

"The concluding note of caution is this: beware of the consequences of sudden movements in yields when long-term rates are very low. Accounting and regulatory changes may have made bond markets more cyclical. There is no evidence that bond yields have become less volatile in recent years. Indeed, data over the last decade or so mirror Mark Watson’s well-known finding that the variability of the long-term rate in the 1990s was actually greater than it had been in the 1965–78 period. A change of 48 basis points in one month ...  would have a larger impact when yields are 2% than when they are 6%. With government debt/GDP ratios set to be very high for years, there is a significant risk of instability in bond markets. Greater volatility in long-term rates may create awkward dilemmas in the setting of short-term rates and decisions on central bank holdings of government bonds. Because interest rate positions of financial firms are leveraged, sharp movements could also threaten financial stability."

One sometimes hears the argument that as long as inflation isn't noticeably rearing its head, ultra-low interest rates should continue onward, for years if necessary. I quite agree that inflation isn't a threat just now, or in the near future. But historically ultra-low interest rates raise other dangers, too.

Lessons for Europe's Debt Crisis from Early U.S. History

For much of the last decade, all European governments that borrowed using the euro were viewed as equal credit risks: that is, they paid essentially the same interest rate when borrowing. For an American, the obvious parallel involves borrowing by state and local governments, who all borrow in the same currency of U.S. dollars but have different credit ratings and borrow at different interest rates. Not coincidentally, the U.S. federal government has a long tradition of not bailing out state or local governments in financial trouble, while there is clearly a widespread expectation that the European Union will somehow act to bail out Greece and others.


At a first glance, pointing out that the U.S. federal government doesn't bail out the state or local governments might seems to make the case that Europe should also avoid such bailouts.  But C. Randall Henning and Martin Kessler point out that the historical patterns and potential lessons are more nuanced in "Fiscal Federalism: US History for Architects of Europe's Fiscal Union." It's available here as Working Paper 12-1 from the Peterson Institute for International Economics and also here as part of the Bruegel Essay and Lecture Series. They point out that in some ways, the centrality of the federal level of the U.S. system was created by assuming the debts of the states after the Revolutionary War. But around 1840, the federal government then ended this practice. Here is Henning and Kessler (footnotes and citations omitted):

"The first secretary of the Treasury, Alexander Hamilton, is by all accounts credited with creating a “modern” financial system for the new United States. The magnitude of his achievements emerges from considering the prior condition of the US economy. Before 1790, the United States was effectively bankrupt, in default on most of its debt incurred during the Revolutionary War, and had no banking system, regularly functioning securities markets, or national currency. Reliant on the 13 states to collect and share tax revenue, the federal government was unable to pay war veterans or service, let alone redeem, debts. Under the Articles of Confederation, the federal government had no executive branch, judicial branch, or tax authority...."

"The debt assumption plan involved the transfer of state debt to the federal government in the amount of $25 million. Added to existing federal debt incurred to foreign governments (France) and domestic investors in the amount of $11.7 million and $42.1 million, respectively, federal debt would then amount to $79.1 million —a very large sum compared with nominal GDP in 1790 estimated at $187 million."

Hamilton's plan was controversial at the time--so controversial that by around 1790, was a real chance that the new country might break up. Was the plan constitutional? How to deal with the fact that some states had borrowed far more than others, but after the federal government assumed the debt, all states would now need to repay it? Hamilton was also restructuring the debt at about the same time. However, as Hamilton and others perceived, making the federal government central in this way could help bind the states together into a union.  In the end, the federal government did assume the debts of the states, did restructure them, and did pay them off. But would this pattern continue?  Henning and Kessler: 

"[T]he debt assumption of 1790 set a precedent that endured for several decades. The federal government assumed the debt of states again after the War of 1812 and then for the District of Columbia in 1836. During this period, the possibility of a federal bailout of states was a reasonable expectation; moral hazard was substantially present. This pattern was broken in the 1840s, when eight states plus Florida, then a territory, defaulted.  ... The indebted states petitioned Congress to assume their debts, citing the multiple precedents. British and Dutch creditors, who held 70 percent of the debt on which states later defaulted, pressed the federal government to cover the obligations of the states. They argued that the federal government’s guarantee, while not explicit, had been implied. Prices of the bonds of even financially sound states fell and the federal government was cut off from European financiers in 1842. ...John Quincy Adams evidently believed that another war with Britain was likely if state debts were not assumed by the federal government."

What were the underlying reasons that caused the U.S. Congress to break the assumption that it would take over the debts of the states as needed?

"However, on this occasion Congress rejected the assumption petition and was able to do so for several reasons. First, debt had been issued primarily to finance locally beneficial projects, rather than national public goods. Second, domestically held bonds were not a large part of the US banking portfolio, and default had limited contagion effects at least through this particular channel. Third, the financially sound states were more numerous than the deeply indebted ones. And, finally, the US economy had matured to the point where it was less dependent on foreign capital. Foreign loans were critical to Hamilton’s plan in 1790, but they were a minority contribution when investments eventually resumed in the 1850s."

"Eventually, most states repaid all or most of their debt as a condition for returning to the markets. ...The rejection of debt assumption established a “no bailout” norm on the part of the federal government. The norm is neither a “clause” in the US Constitution nor a provision of federal law. Nevertheless, whereas no bailout request had been denied by the federal government prior to 1840 , no such request has been granted since, with one special exception discussed below [the District of Columbia in the 1970s].

"The fiscal sovereignty of states, the other side of the no-bailout coin, was thereby established. During the 1840s and 1850s, states adopted balanced budget amendments to their constitutions or other provisions in state law requiring balanced budgets. This was true even of financially sound states that had not defaulted and their adoption continued over the course of subsequent decades, so that eventually three-fourths of the states had adopted such restrictions."

Henning and Kessler suggest three lessons from U.S. history that Europeans should consider as they look at whether or how to assume some of the debts of countries like Greece.


"First, debt brakes are likely to be more durable and effective when “owned” locally rather than mandated centrally."

The U.S. states didn't have a no-deficits rule imposed on them. They volunteered for such rules as part of wanting to borrow for infrastructure projects. U.S. states could drop their no-deficits rules at any time if they wanted. This is fundamentally a different situation than having the European Union or the European Central Bank try to imposed debt limits on recalcitrant countries.

"'Second, maintaining a capacity for countercyclical macroeconomic stabilization is essential. Balanced budget rules have been viable in the US states because the federal government has a broad set of fiscal powers, including countercyclical fiscal action.

When a recession  hits, U.S. states and their citizens often get some help from the federal government. With a common central bank and a common currency, many countries in the EU have already given up the paper to react to a recession within their borders by cutting interest rates or by depreciating their currency. If they also have debt limits imposed on them, they may be unable to react to a recession with fiscal policy, either. In the modern economy, arrangements that have the effect of preventing governments from reacting at all when their countries are in a recession are not likely to work well.

"Finally, because debt brakes threaten to collide with bank rescues, the euro area should unify bank regulation and create a common fiscal pool for restructuring the banking system."

 The interaction between bank failures and government debt needs to be addressed. In some cases, like Ireland, bank failures were the main cause of government debt--when government offered guarantees that the banks would not go under. In other cases, like Greece, excessive government debt risks bringing a wave of bank failures, because Greek debt is so widely held by many large European banks. A unified and funded system of bank regulation across Europe would reduce both of these risks.


I don't have a trail map for how Europe should tiptoe through its current debt and financial crises. The middle of an economic crisis can be a poor time to try to implement the long-term arrangements, that if only they had been in place, would have reduced the risk of the crisis in the first place. But the U.S. model of not bailing out states does depend, in part, on the fact that states adopted their no-borrowing rules themselves, on a powerful federal fiscal authority, and on a unified and funded system of banking regulation. Without these conditions in place, Europe may have set itself up for a situation where intermittent bank bailouts and government debt bailouts are better than the even less-palatable alternatives.

Health Care Costs are Eating Your Pay Raise

Rand Research Highlights, based on the work of David I. Auerbach and Arthur L. Kellerman, asks: "How Does Growth in Health Care Costs Affect the American Family?"
"In the ten-year period between 1999 and 2009, U.S. health care spending nearly doubled, climbing from $1.3 trillion to $2.5 trillion. In 2009, while the rest of the U.S. economy plunged into recession and millions lost their jobs, health care costs grew by 4 percent. As a result, the percentage of our nation’s gross domestic product (GDP) devoted to health care reached 17.6 percent, up from 13.8 percent only ten years earlier.
Although these numbers are striking, they do not easily translate into figures that are meaningful to individual Americans.

"To paint an accurate picture of how health care cost growth is affecting the finances of a typical American family, RAND Health researchers combined data from multiple sources to depict the effects of rising health care costs on a median income married couple with two children covered by employer-sponsored insurance. The analysis compared the family’s health care cost burden in 1999 with that incurred in 2009. The take-away message: Although family income grew throughout the decade, the financial benefits that the
family might have realized were largely consumed by health care cost growth, leaving them with only $95 more per month than in 1999. Had health care costs tracked the rise in the Consumer Price Index, rather than outpacing it, an average American family would have had an additional $450 per month—more than $5,000 per year—to spend on other priorities."

Here are the calculations for that median family. The row showing "Taxes devoted to health care" is the cost of Medicare, Medicaid, and other public health programs.

In short, when you see comments about how pay hasn't gone up much in recent years, one big reason is that health care costs are swallowing the gains. Moreover, friends of mine in public policy circles sometimes point out, with a powerless shrug, that if the rate of increase in health care costs doesn't drop substantially, there isn't going to be room for any other government priorities--and that's true whether your priorities are lower taxes or preserving or even increasing spending on other programs.

The Role of Safe Assets in a Financial System

Gary Gorton, Stefan Lewellen, and Andrew Metrick presented "The Safe-Asset Share," one of those rare academic papers with a basic empirical finding that shakes up your mental landscape,  at the annual meetings of the Allied Social Science Associations a couple of weeks ago in Chicago. Here is their opening (citations and footnotes omitted):

"Over the past sixty years, the total amount of assets in the United States economy has exploded, growing from approximately four times GDP in 1952 to more than ten times GDP at the end of 2010. Yet within this rapid increase in total assets lies a remarkable fact: the percentage of all assets that can be considered “safe” has remained very stable over time. Specifically, the percentage of all assets represented by the sum of U.S. government debt and by the safe component of private financial debt, which we call the “safe-asset share”, has remained close to 33 percent in every year since 1952."

The dynamics of the safe-asset share are important for economists, policymakers, and regulators to understand because “safe” debt plays a major role in facilitating trade. ... Most financial-sector debt has the primary feature that it is information-insensitive, that is, it is immune to adverse selection in trading because agents have no desire to acquire private information about the current health of the issuer. Treasuries, Agencies, and other forms of highly-rated government debt also have this feature. To the extent that debt is information-insensitive, it can be used efficiently as collateral in financial transactions, a role in finance that is analogous to the role of money in commerce. Thus, information-insensitive or “safe” debt is socially valuable. Importantly, the stability of the safe asset share implies that the demand for information-insensitive debt has been relatively constant as a fraction of the total assets in the economy. Given the rapid amount of change within the economy over the past sixty years, the relatively constant demand for safe debt suggests an underlying transactions technology that is not well understood."

 Here's figure showing the safe asset share over time: 

However, the composition of these safe assets has shifted dramatically in recent decades. It used to be mainly bank deposits, but it has now become mainly private securities. They write: "The figure shows that bank deposits were near 80 percent of the total through the 1950s and 1960s, and remained as high as 70 percent as late as 1978. This percentage then began a steep 30-year decline, with the rise of money market mutual funds, broker-deal commercial paper, securitized debt from GSEs, and other asset-backed securities. On the eve of the financial crisis, the share of bank deposits had fallen to 27 percent. At the end of 2010, it stood at a little less than 32 percent."

Having documented the pattern, they end their paper with more questions than answer: "[W]e currently know very little about the demand for and supply of “safe” debt. While we hope that our work is a start in the right direction, our paper raises a number of important questions. Why is the safe-asset share constant? Did the demand for safe assets play a role in the rise of the shadow banking system? What is the underlying transactions technology that relates the safe asset share to the rest of the economy? We hope that these and other questions regarding safe debt will be addressed through future research."

However, there is a bit more to say here. Gorton in particular has been thinking through the role of safe assets in an economy and a financial system for some time. For example, the subject came up in an interview he did with the Region magazine, published by the Federal Reserve Bank of Minneapolis in December 2010. Here's Gorton from that interview, on how a "safe asset" can be conceived of as an asset that is insensitive to information, and how when that an asset thought to be safe becomes sensitive to information, a financial crisis can result:

"Global financial crises are about debt. About debt. But, obviously, we need to have a theory of debt to understand why people would use a security, bank debt, and how that could lead to a crisis. ... In my work with Tri Vi Dang and Bengt Holmström, we develop this idea, that you mention, of the optimality of debt arising from its information insensitivity. Roughly speaking, the argument for the optimality of debt is simply that it’s easiest to trade if you’re sure that neither party knows anything about the payoff on the debt. ...


That intuitive logic applies to repo as well. Nobody wants to be given collateral that they have to worry about. And the mechanics of how repo works is exactly consistent with this. Firms that trade repo work in the following way: The repo traders come in in the morning, they have some coffee, they go to their desks, they start making calls, and in a large firm they’ve rolled $40 to $50 billion of repo in an hour and a half. Now, you can only do that if the depositors believe that the collateral has the feature that nobody has any private information about it. We can all just believe that it’s all AAA.

This is a feature of an economy that is fundamental. It is fundamental that you have these kinds of bank-created trading securities. And the fact that it’s fundamental and that you need these is not widely understood in economics.  ...

The way standard models deal with it is, I think, incorrect. A lot of macroeconomists think in terms of an amplification mechanism. So you imagine that a shock hits the economy. The question is: What magnifies that shock and makes it have a bigger effect than it would otherwise have? That way of thinking would suggest that we live in an economy where shocks hit regularly and they’re always amplified, but every once in a while, there’s a big enough shock … So, in this way of thinking, it’s the size of the shock that’s important. A “crisis” is a “big shock.”

I don’t think that’s what we observe in the world. We don’t see lots and lots of shocks being amplified. We see a few really big events in history: the recent crisis, the Great Depression, the panics of the 19th century. Those are more than a shock being amplified. There’s something else going on. I’d say it’s a regime switch—a dramatic change in the way the financial system is operating. This notion of a kind of regime switch, which happens when you go from debt that is information-insensitive to information-sensitive is different conceptually than an amplification mechanism."

 In a post last June 17, I quoted Ricardo Caballero about "Demand for Safe Assets in an Financial Crisis." He argues that the world economy as a whole, with the rise of economies in Asia in particular, is suffering from a shortage of safe assets, that the financial sector tried to manufacture the desired safe assets out of mortgage-backed securities, and that when these assets were clearly seen to be not safe [Gorton would say they switched from being information-insensitive to being information-sensitive], the crisis erupted.

This story of how safe assets relate to the financial system and to the possibility of crisis is still being fleshed out. But to misquote Gertrude Stein, "There is a there there."