The Baseline Scenario

At his confirmation hearing in January, Tim Geithner nailed the China Question.  China prevents its exchange rate from appreciating through intervention (buying foreign currency), and this allows it to sustain a large current account surplus.  Geithner said, as plainly as you can expect from a senior official: this is not in accordance with international rules and should stop.

Not only is this sensible economics and correct on the rules, it is also good politics.  If you want to head off the considerable inclination towards protectionism in Congress, it would help greatly for the Chinese renminbi to rise in value (e.g., review the discussion at this House hearing).

But almost as soon as Geithner spoke on this issue, there was slippage.  By late February, Hillary Clinton was asking the Chinese nicely to continue holding US Treasury securities and, it now seems, punting the exchange rate issue.  Above all else, China wants to be left alone on the renminbi – variously arguing that any appreciation would jeopardize jobs, derail growth, and plunge the country into chaos.

So what should we expect from Geithner’s upcoming China trip? Read the rest of this entry »

Gordon Brown, the British Prime Minister, is in big trouble.  It turns out that a medium-sized industrialized democracy like the UK can be run in pretty much the same way as a traditional emerging market – fiscal irresponsibility (cyclically-adjusted general government deficit now forecast at 12.2 percent of GDP for 2010) gives you a boom for a while, but the eventual day of reckoning is economically painful and politically disastrous.  If you also need to deal with an oversized bubble finance sector, that makes the adjustment even more painful.

It is of course sensible to use fiscal stimulus to offset a fall in private demand, and to some extent this can be effective – with a lag.  But if you lose control over public spending and borrow too heavily (helped by the fact people like to hold your currency), it ends badly.

From the beginning, we’ve expressed concern here that the entire Summers Plan was overweight fiscal, i.e., not enough resources for recapitalizing banks and addressing housing directly (for the context of this assessment, see our full baseline view).  Back in December/January, this was a strategic choice worth arguing about; now it’s a done deal and following the (very) limited recapitalization outcome of the bank stress tests, it seems likely that household and firm spending will remain sluggish.  If that is the case, the Administration’s logic implies throwing another big fiscal stimulus into the mix – and the Summers’ team is already preparing the groundwork.

The IMF is now warning against the risks of this approach, albeit using carefully worded language. Read the rest of this entry »

The NYT is ran an online discussion of the new Geithner Plan yesterday.  The worry I expressed there is whether the Plan is scalable – i.e., it could work at a modest level, but to really have impact it needs to be huge.  And, as it gets larger, I think we’ll see a political backlash.

Looking back over the comments of the day, my position put me closer to Paul Krugman but not too far also from Mark Thoma (look at his response to me, further down the discussion).  Brad DeLong came across as the most positive, but even he is doubtful that the planned purchases are large enough – he makes the point that the Administration couldn’t get Congress to agree on any additional money for this purpose, but this puzzles me. 

The Administration (1) has not really made this case on Capitol Hill (my contacts there tell me), (2) is asking for lots of money to do other things (their strategy was overweight fiscal from the start), (3) hasn’t communicated well a more general sense of priority or urgency - if we don’t fix our banking system how many other good things are possible over the next decade? 

By Simon Johnson

There is an old saying among experienced economic policymakers, “in a major crisis, do not err on the side of being insufficiently bold.”  And we know that President Obama’s economic team are avowed proponents of this approach.

The housing plan unveiled yesterday is impressively comprehensive – I go through some of the details in a post this morning on The New Republic’s Site.  But is it bold enough?  Read the rest of this entry »

Larry Summers made a convincing case yesterday that Congress should release the remaining $350bn of the TARP.  It’s good to see the Obama team emphasizing themes beyond the fiscal stimulus, including banks and housing.  Stronger governance and greater transparency are timely commitments for this program, and who can object to limits on executive compensation in today’s environment?  Some Congressional debate makes sense and could be productive, but it’s hard to see this request being turned down.

Still, what exactly should the money be spent on?  I’m tempted to say: housing, because this continues to be a major unresolved problem that looms over both consumers and their balance sheets.  Unfortunately, however, the banks remain a greater priority.  The latest developments for both Citigroup and Bank of America suggest the banking situation is (again) seen by insiders as more desperate than we outsiders wished to believe.

The next round of bank recapitalization (again) needs to be big and bold, for example along the lines we have been suggesting for some time (but I’ll take another comprehensive plan, if you have one, with strong expected taxpayer value).  The problem today is that we just don’t know if any major bank is well capitalized; there are too many black boxes that may contain toxic assets.  At best, this is a brake on the positive effects that should come from the fiscal stimulus.  At worst, we still have a major system issue on our hands.

And there is no reason to think that $350bn is enough to handle this problem.  The original $700bn was obviously an arbitrarily chosen number, and the money has been spent so far in a rather unplanned manner.  What we do next should not be constrained by the fact that there is a check for $350bn waiting to be picked up.  We should design a systematic recapitalization program, figure out what it will cost, and get on with it.  My working assumption, based on the published analysis of the IMF regarding losses relative to private capital raising, is that $1trn – properly deployed – should do the trick. 

Then we should get to work on housing (yes, this needs more money).

Update: Ben Bernanke seems to be thinking aloud along similar lines.

Most of the current discussion regarding the Obama Economic Plan focuses on whether the fiscal stimulus should be somewhat larger or smaller ($650-800bn seems the current range) and the composition between spending and tax cuts.  President Obama stressed on Tuesday that trillion dollar deficits are here to stay for several years, and it looks like part of the arguing in the Senate will be about whether this is a good idea.

There is at least one key question currently missing from this debate.  Is this Plan too much about a fiscal stimulus and too little about the other pieces that would help – and might even be essential – for a sustained recovery?  The fiscal stimulus may be roughly the right size (and $100bn more or less is unlikely to make a critical difference), but perhaps we should also be looking for more detail on the following:

1. Recapitalizing banks.  Their losses to date have not been replaced by new capital and it is currently not possible to issue new equity in the private markets.  If you think we can get back to growth without fixing banks, check Japan’s record in the 1990s.

2. Directly addressing housing problems, including moving to limit foreclosures and reduce the forced sales that follow foreclosures.  There is apparently some form of the Hubbard-Mayer proposal waiting in the wings, but we don’t know exactly what – and this matters, among other things, for thinking about the debt sustainability implications of the overall Plan.

3.  Finding ways to push up inflation, presumably by being more aggressive with monetary policy.  Deflation is looming – according to the financial markets, despite all of the Fed’s moves and recent statements, prices will fall or be flat over the next 3 to 5 years.  This fall in inflation, from its previous expected level around 2 percent per year, constitutes a big transfer from borrowers/spenders to net lenders/savers.  The contractionary effect is likely to outweigh any fiscal stimulus that is politically feasible or economically sound.  (We have more detail on this point on WSJ.com today, linked here.)

So perhaps the issue is not the absolute size or composition of the fiscal stimulus, but rather the role of the fiscal stimulus relative to other parts of the Plan.  Hopefully, it’s a more evenly weighted package, and just we haven’t yet seen the details.  Still, it’s odd that the presence and general contours of these other important elements have not yet been clearly flagged.