Monthly Archives: December 2007

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Is there a valid case for special treatment for poor countries (developing nations and some emerging markets) in global efforts to combat global warming?

Mr Munir Akram, spokesman for the 130-strong G77 group of developing nations believes he has fought the good fight in Bali, by resisting pressures on developing countries to accept obligations to make absolute cuts in their greenhouse gas emissions, under the successor to the Kyoto Agreement that is now supposed to be negotiated in the coming two years. In the Financial Times of Saturday December 15, he is reported as saying that the developing nations had come under pressure to agree to “commitments and obligations on mitigation which in their dimension we feel are unfair and unjust”.

There are three arguments Mr. Akram and other spokespersons for the developing world make to support their claim for special treatment for developing countries and emerging markets. Two are partisan, confused and invalid, and should be rejected.  The third is valid and can and should be accommodated.   

Alan Greenspan is right (for once). He recently made the obvious but important and oft-conveniently-forgotten point, that the least harmful way of intervening to help US homeowners saddled with mortgages they cannot afford when the early teaser rates on their mortgages re-set to much higher levels, is to give them direct financial aid. This is the opposite of what Treasury Secretary Hank Paulson is peddling.  Paulson proposes an interest rate freeze on some subprime loans, preventing the teaser rate resets for five years. Greenspan’s statement was very much to the point: "It’s far less damaging to the economy to create a short-term fiscal problem, which we would, than to try to fix the prices of homes or interest rates".

Paulson dismissed Greenspan’s argument that it would be better to provide cash aid to homeowners than freeze rates on subprime loans. “I don’t think what we need is a big government bail-out”. The Greenspan – Paulson argument pits the economics of Ann Raynd and Milton Friedman against those of Jozef Stalin and Hugo Chavez.  Raynd & Friedman win.

I argued in an earlier contribution on the US Treasury proposal for a quasi-fiscal bail-out of some of the US subprime mortgage borrowers, that there were two things wrong with Paulson’s proposal.

First, there is no valid argument based on poverty relief or on fairness/distributive justice, for bailing out subprime mortgage borrowers.  They borrowed imprudently and took on home loans larger than they could afford. They should live with the consequences.  There are many Americans who are poorer than these financially challenged subprime borrowers, but who won’t get a dime of financial relief in their Christmas stockings from uncle Sam. This includes the countless homeless in the US – those who have no roof over their head of any kind, owner-occupied or rented. If the government wishes to help the poor, it ought to do so on budget. Even if some of those who imprudently took on subprime loans are now threatened with the loss of their homes, or even with poverty, this is no reason for rewarding and subsidising this particular form of imprudence.  There should be proper assistance and relief for all the poor, but no special aid ‘pots’ for those who are threatened with poverty because of their own greed and ignorance. That would be both unfair and incentive-corrupting.

If there was mis-selling of subprime mortgages to unsophisticated borrowers and if this amounted either to negligence by the originators or to deception or fraud, the civil or criminal courts are the places to deal with these matters.

The same no bail-out argument applies to institutional borrowers like banks and other financial institutions also, and not only in the US.  Keeping Northern Rock and its shareholders afloat at taxpayers’ expense/risk is an inexcusable misuse of UK public funds to avoid political embarrassment.

Second, if despite the previous argument you are going to engage in a government bail-out, do it openly, transparently and on-budget, through explicit cash payments to designated beneficiaries.  Without the truth, there can be no accountability.  Don’t hide the fiscal reality of a tax on the subprime mortgage lender and a cash payment to the subprime mortgage borrower, behind a government intervention in the price mechanism – a prohibition of re-sets of teaser rates to the new scheduled higher levels.

The US Treasury proposal combines the transparency-enhancing miracle of off-budget and off-balance-sheet financing with the incentive-improving subtleties of Soviet central planning.  It deserves a  swift, disrespectful burial.

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I would like to use this blog to post a rather lengthy reply to comments of  Mr. Krzysztof Rybinski on an earlier post of mine to the Financial Times’ Economists’ Forum, on the 12 December announcement of non-coordinated liquidity management policy changes by the Fed, the ECB, the Bank of England, the Bank of Canada and the Swiss National Bank.

I agree with Mr. Rybinski, that the very fact that the five central bank governors who made their simultaneous announcements on Wednesday December 12th did try to make this look like a substantive coordinated action, shows how worried these central bankers are about financial stability and the risk of regional and global recession in 2008 and beyond. The point of my blog was that because the substance of what was announced was a list of five disjoint liquidity interventions, in the Euro zone, the USA, the UK, Canada and Switzerland, it was both strange and rather worrying that the central bank five governors tried to make their simultaneously announced individual actions look like more than they were. This was a set of actions where the whole was no more than the sum of the parts.  To try to make it look like more than it was in unwise. When those in charge of price stability and market liquidity in much of the industrialised world engage in ‘spin’ of this kind, I get concerned.

A swap between the Fed and the ECB of X US dollars for Y euros  for 1 year, say,  is equivalent to  the ECB borrowing X US  dollars for 1 year and the Fed borrowing Y euros for 1 year, provided

                                                           X = eY(1+i)/(f(1+i*)) 

where e is the spot euro-US dollar exchange rate (number of US dollars per euro), f is the one-year forward exchange rate, i is the one-year dollar interest rate and i* is the one-year euro interest rate. The authorities chose to present their reciprocal borrowing of each other’s currency as a swap rather than as two loans. The private sector likes to do this because swaps are off-balance sheet transactions, unlike loans. Surely the desire to keep their mutual support (and mutual exposure) off-balance sheet cannot have been a factor in the three central banks’ decision to proceed through swaps rather than through explicit borrowing of foreign exchange?

More importantly, there was no need for either official swaps or official borrowing to alleviate the liquidity crunch.  All that was required was for the ECB to make euro liquidity available in the Euro zone (through OMOs in euros) and for the Fed to make US dollar liquidity available in the US (through OMOs in US dollars.  Because the foreign exchange market for the euro and US dollar has remained spectacularly liquidity throughout this crisis, Euro-zone banks who had obtained euro liquidity from the ECB could have bought or borrowed US dollar liquidity through the foreign exchange markets without any problems. The could (indeed probably would)  have used swaps to  obtain the necessary US dollars, if they believed the need for dollars in the Eurozone was likely to be short-lived.  So the Fed and the ECB  did not materially improve the terms and other conditions of access to US dollar liquidity for Euro-zone banks through this swap.  This was financial window-dressing.  Why?  Spin always ends up cutting the mouth that spewed it.

I agree also agree with Mr. Rybinski that the monetary, regulatory and fiscal authorities have to do more in the future to prevent the recurrence of speculative excesses than they have in the past, including the most recent credit orgy – that of 2003-2006.  I believe, however, that the preventative measures that are required will have to be designed and implemented mainly by the regulators /supervisors of financial markets and institutions and by the Treasuries/ministries of finance. Central banks will not play a major part, unless they happen to also be regulators/supervisors for the banking system and/or other financial institutions or markets.

In a world with unrestricted international financial capital mobility, central banks have only one instrument with which to pursue their primary objective, price stability.  That instrument is either the short risk-free nominal interest rate or the nominal spot exchange rate. Central banks have additional instruments for influencing liquidity at various horizons, ranging from overnight to one or at most two years.  There liquidity-oriented instruments include open market operations (collaterlised and non-collateralised or outright) at a range of maturities, reserve requirements and discount window operations.  Both OMOs and discount window operations are multi-dimensional.  The central bank defines the set of eligible collateral, eligible counterparties and the term of the loans. Foreign exchange market intervention is a special case of (outright) open market operations and included in it.

If monetary policy, defined as the pursuit of price stability in the medium term, is entrusted constitutionally and institutionally to an operationally independent central bank, it makes sense to dedicate the short risk-free nominal interest rate (say the target for the overnight interbank rate) entirely to monetary policy.  This is not because the short-run risk-free nominal interest rate (the official policy rate) does not have any effect on liquidity.  Nor is it because the other instruments of the central bank (OMOs, discount window operations and reserve requirements) don’t have an effect on price stability in the medium term.  The reason is a practical political one, grounded in the need for institutional accountability, and reinforced by an appeal to Mundell’s ‘Principle of Effective Market Classification’, which prescribes a division of labour between policy instruments, or an assignment of responsibility for policy objectives to instruments, based on a law of comparative advantage.

Clearly, the policies announced by the five central banks last Wednesday will lower the spreads between the official policy rate and Libor at the maturities for which interventions were announced (mainly one- month and three months), relative to the levels they would have achieved without the announcement.  Since many loans to households and non-financial firms are priced off 3-month Libor, this means that monetary conditions will be less restrictive than they would have been without the announcement.  The central bank will have to allow for this in their setting of the official policy rates, which as a result will be higher in the future than they would have been without the announcement.  They may, of course, still be lower in the future than they are today.  The effect of current liquidity policies on the level of the path of official policy rates most likely to achieve price stability in the medium term is likely to be small, because the price level effect of interest rate changes is subject to long, variable and uncertain lags and of uncertain magnitude. 

Likewise, although cuts in the official policy rate are an inefficient way to boost liquidity under disorderly market conditions, it will have some positive effect on liquidity.  The five central banks, in their open market operations, discount window policies and reserve requirements will have to allow for the fact that the liquidity crunch will be eased a little by cuts in the official policy rates. 

But the regulators and the fiscal authorities will have to do most of the job of (1) making a recurrence of destructive credit cycles less likely, and of (2) minimising the damage to the real economy caused by such episodes of financial manic-depressive illness as are likely to occur despite the best efforts of the authorities.  Without more effective international cooperation and coordination of regulatory standards and of the fiscal treatment of international mobile financial institutions, instruments and their owners, the risk of future credit booms and busts will increase.  Creating a single financial regulator for all of the EU (not just for the Euro zone) would be a valuable contribution from the Eastern rim of the North Atlantic zone of financial instability that has emerged this s century.  This nefarious contribution of the world’s most developed national and regional financial sectors – Wall Street, the City of London, Zurich and Frankfurt – to global financial and macroeconomic instability is in part due to the race to the bottom of regulatory and supervisory standards driven by regulatory and tax arbitrage. The sooner this trend is halted and reversed, the better.

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I have written quite extensively, starting in August 2007, with much of it appearing in this blog, about how the central bank can make a market in illiquid securities for which there is no market price or any other verifiable benchmark available, without providing a subsidy to the private sellers of these securities.  It’s not hard, and does not require the central bank to know anything more than anyone else about the fair value of the security. Indeed, it does not require the central bank to know anything at all – which is probably just as well.

In response to  comments from Martin Wolf on an earlier blog of mine I will here just give a brief summary of these earlier scribblings on how central banks can organise auctions for loans against against illiquid collateral for which there isn’t a market price, without rewarding reckless lending and borrowing and thus encouraging a repeat of past excesses in the provision of credit.

Well-designed auctions will act as reservation price-revealing mechanisms for the central bank. The simplest auction is a reverse Dutch auction with the central bank as the only buyer. The central bank has to have a list of securities eligible for access to the auction. I would recommend the central bank only include simple structured investment products on the list, to provide incentives for private financial innovators to keep their wilder horses under control. It could also restrict access to the auction to sellers that are subject to a regulatory regime approved by the central bank. Unregulated financial institutions would have to try their luck with those regulated institutions that were successful obtaining liquidity from the auctions.

The central bank would have to decide for each auction an upper bound on the amount it is willing to purchase at the auction.  It could do so by setting an upper bound either on the market value or on the notional or face value of the securities it is willing to purchases.  Assume for the sake of argument it sets an upper limit of £10bn for the face value of the securities it is willing to buy.  The central bank starts by offering to buy any amount up to £10bn at the lowest possible price, say, 1 penny for each pound sterling of face value. Assume £2bn worth of face value is sold at 1 penny.  Next it offers to pay 2 pennies for each pound sterling worth of face value for up to £8bn worth of securities.  If the cumulative sales at 1 penny and 2 pennies don’t add of to £10bn, there will at least be a third round, say, at three pennies for each pound sterling of face value.  The auction continues until the pre-set upper limit, £10bn is reached, or until the price reaches 1 pound sterling for 1 pound sterling worth of face value.

In such a reverse Dutch auction, those desperately short of liquidity will offer to sell first, at very low prices.  The less panicked would-be sellers hold out for higher prices, but risk missing out altogether.

The central bank would take the securities it had bought at the auction onto its balance sheet.  If the markets for the securities bought at the auction by the central bank were to normalise later, the central bank could opt to sell the securities at that time.  There is, however, no need to do so.  The central bank can simply hold all the securities it buys at the auction until maturity.  That way it never has to form a view on what they really are worth.  There are advantages to never being liquidity constrained – the happy condition of the central bank.

The central bank would, of course, take credit risk onto its balance sheet if it buys private securities at the auction.  The reverse Dutch auction with a monopolistic buyer is, however, so hard on the sellers, that the central bank could expect to make a profit out of the activity. Should it be hit by an unexpected wave of defaults on these securities, it would have to be recapitalised (bailed out) by the Treasury.  This, of course, is also the situation the Bank of England faces today with its exposure to Northern Rock through the Liquidity Support Facility.

To encourage those private financial institutions that do not wish to mark to market their illiquid assets to participate in the auction, it could be made a legal or regulatory requirement that all securities for which auctions are organised, even those not offered for sale, be marked-to-market at the prices established in these auctions (in the case of the reverse Dutch auction, you could use the average price, say, for this).

The Fed, in its Term Auction Facility, could extend the range of eligible collateral further.  There is no reason why illiquid junk could not be auctioned and bought by the Fed using the mechanism outlined here.  There are many other kinds of auctions with desirable properties, that don’t require the auctioneer (or the monopolistic buyer), to know much if anything about the fundamental value of the securities that are being auctioned.  Economists like Paul Milgrom in the US, or Paul Klemperer and  Ken Binmore in the UK, should be able to get a suitable set of auctions up and running in no time.

So, no, the central bank does not have to establish what a competitive market price would be.  It does not have to buy at a price above ‘the market price’.  My reverse Dutch auction will generically not have a single market price.  Securities will be bought at different prices, starting at the lowest.  In its purest form, this would be a perfect price discrimination mechanism that creams off all the surplus over the seller’s reservation price for the monopolistic buyer.  It would be tough on the sellers, but it would be efficient. There would not be even the faintest whiff of moral hazard in the air.

What it takes to make these auctions successful is not a central bank that knows more than the private sector about the fundamental value of the securities that are being auctioned.  There need never to have been a market for the security in question – they could be (standardized) OTC instruments. The central bank could be a bear of very little brain. All it needs is deep pockets and the ability and willingness to take the long view.  Those do not seem of to be unreasonable demands to place on the central bank.

On Wednesday, 12th December 2007, five central banks, the Fed, the ECB, the Bank of England, the Bank of Canada and the Swiss National Bank (SNB) were reported to have launched a coordinated attack on the North Atlantic liquidity crisis that has been with us since August 2007. In a contribution to the Financial Times’ Economists’ Forum, I have argued that in fact there was no announcement of any policy action that required substantive policy coordination. Instead we had the simultaneous and joint announcement of a set of five disjoint policy packages, one for each of the central banks severally, none requiring the coordination of the actions of more than one central bank.

What did the individual central banks announce?

Ignoring the coordination spin the Famous Five tried to put on their disparate and substantially independent policy actions, what can one say of the substantive measures taken by the three largest of the five individual central banks involved in the joint announcement?

The Bank of England
To the Bank of England’s credit, it was not part of the attempt to present the shadow-boxing currency swap-cum-US dollar repo package as the real Merriweather-Hatton thing.  Indeed, the most important change in liquidity policy and the largest intervention (in relation to the size of the underlying economy) was announced by the Bank of England. It increased the scale of two already announced long-term open market operations (OMOs) through repos on 18 December and 15 January by £8.5 bn to £11.35bn. Of this, £10bn would be at the 3-month maturity where most of the pain has been, and which is important as a key benchmark for the pricing of bank credit to household and non-financial corporations.

More importantly, the repos at the 3-month maturity will have a much wider range of acceptable collateral, and they will not be subject to a penalty rate or a penalty floor to the rate. This is in contrast to when the Bank of England on September 19 announced four term auctions for which the minimum bid rate was 100 basis points above Bank Rate. Because of this, and possibly also because of stigma attached to participation in these special term repos, there were no takers for the Bank’s offerings. More US dollar-denominated securities will be accepted as collateral in the December and January auctions, including debt issued by the US Government Sponsored Entities (GSEs), Fannie Mae and Freddie Mac. The most important addition to the list of eligible collateral, however, are AAA-rated tranches of UK, US and EEA asset-backed securities (ABS) backed by credit cards; and AAA-rated tranches of UK and EEA prime residential mortgage-backed securities (RMBS) and covered bonds rated AAA.

This modification in its collateral procedures brings to Bank of England much closer to fulfilling the role of market maker of last resort (MMLR) advocated by Anne Sibert and myself. It did not increase the range of eligible counterparties in the repos, so one has to hope that the additional liquidity will make its way through the OMO-eligible counterparties to financial institutions that need it but are not on the OMO-eligible list.

Even with this relaxation of its collateral requirements for 3-month repos, the Bank of England has a more restricted list of eligible collateral than the ECB, which accepts similar classes of assets but only requires an A rating. The Bank has not relaxed its collateral eligibility requirements for repos at maturities other than three months or at its discount window (the standing (collateralised) lending facility, which makes overnight loans at a rate 100bps above Bank Rate). The Bank is learning, but slowly….

The Fed
The next most important announcement came from the Fed. It established a temporary Term Auction Facility (TAF), to auction loans to the counterparties and against the collateral normally acceptable at its primary discount window. Both the list of eligible counterparties and the set of eligible collateral at the primary discount window are wider than for conventional repos through OMOs. Two auctions have been scheduled thus far, for December 17 and December 20, for USD20bn each. 

While eligible collateral and eligible counterparties are the same for the TAF as for the primary discount window, there are important differences. First, the primary discount window is at a penalty rate of 50 basis points over the Federal Funds target rate for overnight loans. The TAF rates will be determined through the auction, subject to a floor set by the OIS rate (the overnight indexed swap rate), which measures the market’s expectation of the compounded overnight Federal Funds rate over the term of the loan.

Second, the standard term of the primary discount window is overnight. This was, in August, extended to loans with up to a one-month duration. The proposed auctions are for 27 days and 35 days respectively.  Rather surprisingly, the Fed appears to be focusing more on possible year-end kerfuffles, which I consider to be of the millennium bug variety, i.e. not systemically important, than on the 3month Libor spread anomaly, which will be with us long after the bridge to the new year has been crossed safely.

Third, access to the primary discount window is demand-determined (subject to the would-be borrower having the right collateral), while with the TAF, the Fed comes to the would-be borrowers. With many borrowers in the TAF auctions, the stigma attached to borrowing at the primary discount window should be avoided.

Fourth, borrowing at the primary discount window has typically been in small amounts. The two auctions scheduled thus far are also for small amounts (up to USD20bn each, with a limit of 10 percent of the auction for any one borrower), but these numbers could be raised even for the December 27 auction, and certainly for any future auctions that may be scheduled if the temporary TAF were to become a permanent feature of the Fed’s liquidity management toolkit.

The only substantive new measures announced by the ECB were two more term repo operations against its usual collateral, on the same dates at the Fed repos (December 20 and 27) and for the same small amounts (USD20bn on each of the two dates). For an organization that has pumped as much as €100bn into the markets in a single auction, this is small potatoes. There was no relaxation of its collateral requirements, nor any increase in the list of eligible counterparties. As argued earlier, the fact that the ECB (and the SNB) will do repos in US dollars rather than in euros is worth a yawn at best. It looks like the substitution of motion for action.

The markets, for once, saw immediately who had made a substantive policy move and who had not. Following the joint announcement, 3-month sterling Libor dropped by 10 basis points; 3-month USD Libor by 6 basis points and 3-month Euribor by nothing. That’s about right.

The response of the interbank spreads and rate levels to the policy announcement makes clear the magnitude of the task remaining, because the 3-month interbank spreads over the OIS rate remain around 100 basis points. The monetary authorities of the five countries involved in the announcement will have to do more, both as regards the scale of the repos and, in the case of the UK at least, as regards the collateral that will be accepted. There is no risk of contributing to moral hazard, that is, rewarding past reckless lending or borrowing behaviour by banks and other financial intermediaries, as long as the collateral offered in the repos is valued properly and subject to appropriate haircuts. 

But the central banks cannot do it alone. Today’s Financial Ttimes reports that the Eurozone’s 21 largest banks hold €244bn in off-balance sheet assets that may have to be brought back on their balance sheets. This could trigger a credit squeeze in the wider economy, as these banks hoard liquidity in preparation for the ‘Great Balance Sheet Take-In’. Clearly, the central banks can and should provide the additional liquidity (properly collateralized and priced) needed to facilitate this re-intermediation of prior off-balance sheet exposure.

However, the demand for liquidity is not just driven by the need to take a given known value of off-balance sheet assets onto the banks’ balance sheets. It is also driven by pervasive uncertainty about who owns what and who owes what and to whom. Massive losses have been incurred on a wide range of asset-backed securities (not only subprime mortgage-backed (RMBS)) that have not yet been recognised by the owners of these assets, revealed and reflected in balance sheets and profit and loss accounts. Hundreds of billions of US dollars worth of capital losses are still ‘missing in action’.

With the mood of the markets having turned from euphoria to depression, subjective perceptions of pervasive counterparty risk are paralyzing lending. A solvent and liquid potential lender will not lend at 3-month maturity to a counterparty if there is material uncertainty in his mind about the solvency of the counterparty or if the potential lender fears that both he and the counterparty may be illiquid three months from now. The failure of too many banks to come clean about their losses is acting like a prohibitive tax on new lending.

When banks recognise and reveal their losses, the first cause of unwillingness to lend (high subjective perceptions of default risk by the would-be borrower) would disappear. But the second cause of illiquidity today (fear of lender and borrower illiquidity 3 months from now) remains and can only be efficiently tackled by the central banks. It is not enough for central banks to insist that three months from now they will stand ready to inject overnight liquidity. Seeing is believing. Term liquidity today beats overnight liquidity tomorrow.

Liquidity is a public good. It can be managed privately (by hoarding inherently liquid assets), but it would be socially inefficient for private banks and other financial institutions to hold liquid assets on their balance sheets in amounts sufficient to tide them over when markets become disorderly. They are meant to intermediate short maturity liabilities into long maturity assets and (normally) liquid liabilities into illiquid assets. Since central banks can create unquestioned liquidity at the drop of a hat, in any amount and at zero cost, they should be the liquidity providers of last resort, both as lender of last resort and as market maker of last resort. There is no moral hazards as long as central banks provide the liquidity against properly priced collateral, which is in addition subject to the usual ‘liquidity haircuts’ on this fair valuation. The private provision of the public good of emergency liquidity is wasteful. It’s as simple as that.

Let’s agree that global warming is happening: the earth’s atmosphere and oceans have been warming up since the beginning of the last century and continue to do so.  Let’s also agree that human activity, especially the emission of greenhouse gases, makes a significant contribution to this process of global warming.  On the basis of my admittedly amateurish reading of some of the relevant literature, including the Stern Report, I conclude that while there may be some local benefits from global warming, the overall global impact is negative.  That still leaves unanswered the following question: what is the optimal global temperature (or perhaps: is there an optimal global temperature)?  For the moment, define optimal as optimal for humanity.

The answer to this question matters, because with the many proposals and plans for mitigation and adaptation we are approaching a situation where the first stage of ‘terraforming’, the collective management and regulation of the average temperature of the globe, could become an option.  Strangely enough, none of the literature I have seen addresses this question.  Indeed most of the literature either assumes or attempts to demonstrate that any and all change in average level of the global temperature is bad.  What the current level is does not seem to matter much, it’s the change that is costly.

Up to point, a rule for guiding global temperature policy that can be summarised as "whatever the current temperature is, don’t plan or expect it to change", (or, more pedantically, the optimum average temperature follows a Martingale) makes sense.  With the speed of adaptation of biological species other than humans  to climate change measured, if not quite in aeons, then certainly not in years either, but rather in centuries, millennia or even longer time-spans, more rapid climate change is likely to be more costly than less rapid climate change.  But would it really be best simply to stabilise the average global temperature at its current level?  Is it obvious we should not instead let is rise a few degrees, say 5 or 10, over some period of time, and then stabilise it at this higher level?  Or should we aim to lower it a few degrees, again, say 5 or 10 degrees over a period of years, decades or centuries, and then stabilise it?

The historical record either shows that the present is unusually warm (if you have limited recall) or that it is unusually cold (if you take the long view).

Wikipedia (yes, I know) informs me that "The last 3 million years have been characterised by cycles of glacials and interglacials within a gradually deepening ice age".  Instrumental measurement-based records only exist for the last 150 years or so, and show the now well-documented increase in temperature since about 1910, shown in Chart 1, taken from Wikipedia, below:

Chart 1


This picture of recent global warming to unprecedented levels is broadly confirmed if we take the 1000-year view of Chart 2, below (also from Wikipedia).



Chart 2


However, taking the longer view, as is done in Charts 3, 4 and 5 (all from Wikipedia) for ever-lengthening horizons, it is clear that we are in a spectacularly cold period from a long-run perspective.




Chart 3





               Chart 4







Chart 5


When you consider the near-infinite variety of species that must have been wiped out the onset of our current cold spell (nothing like it has been seen for 450 million years), it may seem only fair that temperatures appear to be rising from what is obviously a very low level.  Perhaps we should give evolution a chance to come up with life forms that are better suited to a warmer climate.  A longer perspective like the one in Chart 5 can make one question the human-centric approach to climate change that virtually everyone in the climate change debate seems to adopt.  At most a concern is expressed for a few ‘higher’ life forms, or for ‘biodiversity’ as a resource that may be useful for longer-term human survival and well-being.  Let’s hear it for the cockroach instead, and for the one-celled organisms that can survive extreme temperatures!  Or even, let’s hear it for the inorganic forms of creation, for whom all manifestations of life must be essentially parasitic.

From the usual crass anthropocentric perspective, it is obvious that, if we value the continued existence of humanity at all, a climate policy summarised as  "never mind what level average global temperature is at, just keep it at its current level" cannot make sense for all temperature levels.  At an average global temperature of  100 degrees Celsius many currently existing life forms, including humanity, would perish, and the same would hold for a sufficiently low average temperature.

Perhaps things are so dire for humanity, that the question as to what the optimum average global temperature is, need not be asked for the next 200 years.  Perhaps the current rate of increase in the average global temperature threatens to outstrip our ability to adapt and cope by such a wide margin, that the need to slow down this rate of increase, and preferably to halt the increase in temperature altogether, should be our dominant or even our only concern.  Still, I would like to know an answer to that question.  Until I get a better sense of the long-run desired level of the average global temperature, I will not be fully convinced  convinced that the argument for stopping it from rising further is well thought out.

Paulson’s subprime mortgage borrower bail out
The Bush administration appears to have converged on a plan to help financially challenged subprime mortgage borrowers sucked into their state of indebtedness through adjustable rate mortgages with very low, up-front borrowing rates, so – called teaser rates – which re-set after two or three years to a much higher level – up to three percent or more above the introductory teaser rates. Many of these subprime mortgage borrowers would no longer be able to afford their monthly mortgage payments following the interest rate resets, and would stand to lose their homes as a result.

The Bush administration proposal, put together in negotiations of Treasury Secretary Henry Paulson with the mortgage industry, freezes the introductory teaser rates for subprime borrowers that are still just about afloat (roughly current on their mortgages, i.e. at most a little bit pregnant), but have credit scores below 660. The proposal prevents the low introductory teaser rates for these subprime borrowers from resetting to higher rates for five years.. Subprime borrowers with a credit score of 660 or higher, who are more likely to be refinanceable with new loans on commercial terms, will be fast-tracked. Josh Rosner, a consultant at Gram Fisher was quoted in the Financial Times of 7 December as saying: “This modification of existing contracts without the full and willing agreement of all parties to those contracts, risks significant erosion to 200 years of contract law”. He is right. By offering a higher ex-post subsidy for those with a lower credit score, it also piles moral hazard on top of moral hazard.

This proposal is a classic example of a politically attractive, economically ugly quasi-fiscal window dressing exercise.

Quasi-fiscal policy measures
Quasi-fiscal measures are government actions that are economically equivalent to taxes or subsidies but are not formally classified as such. They are off-budget taxes and subsidies, often administered by entities other than the general government. I would include in the quasi-fiscal category also all forms of off-budget and off-balance sheet financing by the government, that is, all financial arrangements that increase the net indebtedness of the government but do not, for technical reasons, show up (at least not in the short run) in the conventional government financial accounts. 

Examples of quasi-fiscal measures are non-remunerated reserve requirements imposed by central banks. To the extent that minimal reserve requirements exceed the quantity of reserves that would have been held voluntarily in their absence, they represent a tax, equal in magnitude to the quantity of reserves held involuntarily multiplied by the financial opportunity cost of holding these involuntary reserves. Other examples include price controls on food, which amount to a subsidy on food, requirements to surrender foreign exchange earned from exporting to the central bank at an unfavourable exchange rate, which amounts to a tax on exports or export quotas which depress the domestic price of the exportable good below the world price, which amounts to a tax on the producer and a subsidy to the consumer. Government guarantees provided at less than their opportunity cost are another popular quasi-fiscal instrument.

In the US, quasi-fiscal measures have long distorted the housing market and the market for housing finance. The deductibility of mortgage interest from the Federal income tax is a quasi-fiscal subsidy. With inflation positive and likely to remain so, a further distortion is introduced by the fact that it is the nominal interest cost that is deductible.

Freddie Mac and Fannie Mae, the two Government Sponsored Entities – notionally private listed companies but de-facto Federally guaranteed, engage in securitisation of eligible mortgages and insuring mortgages. Their combined balance sheets at the end of 2006 was about $1.65 trillion, $843bn for Fannie Mae and $813bn for Freddie Mac. The total mortgage credit book of these companies is, however, much larger than their balance sheets. In the case of Fannie Mae, in addition to a mortgage portfolio of $729bn (the unpaid principal balance of mortgage loans and mortgage-related securities held in its portfolio) there also were Fannie Mae Mortgage-Backed Securities held by third parties worth $1,777bn and $20bn worth of other guarantees. The corresponding numbers for Freddie Mac were $704bn for its mortgage portfolio and $1,477bn for its Mortgage-Backed Securities outstanding. The total amount of mortgages and mortgage-backed securities outstanding of the two GSEs is therefore around $4.5 trillion. 

On December 7, 2007, the 10-year US Treasury yield was 4.01 percent and 10-year Freddie Mac and Fannie Mae bonds yielded 4.64 percent. A-rated corporate bonds yielded 5.83 percent and high-yield or junk yielded anything over 7.5 percent. Recently, City Group borrowed $7.5bn from the Abu Dhabi Investment Authority at 11 percent. Let’s be generous and assume that, without the de facto guarantee of the Federal government, the two GSEs would have to borrow from the markets at terms slightly better than Citigroup, say, 10 percent. The annual subsidy provided by the tax payer to the GSEs, and through them to American mortgage borrowers is therefore 5.36 percent of $4.5 trillion or $241 bn. Even if you halve that, it’s still a nice figure. 

To this massive subsidy benefiting households borrowing against eligible residential property, the Treasury now proposes to add a further subsidy, whose amount is as yet unknown, but which will be small compared to the massive subsidy provided through the two GSEs. For those fortunates whose teaser rate get extended for five years, the subsidy is the difference between the level that would have been effective following the reset and the teaser rate. There is a corresponding tax on the lending institution or on the current owners of securities backed by the mortgages whose rates have been frozen. The subsidy on borrowers whose refinancing will be fast-tracked (and the corresponding tax on the lender or the investor in mortgage-backed securities) cannot be determined until we know the actual terms of the fast-tracked re-mortgaging and find a way of computing the counterfactual mortgage cost without the government-imposed fast-tracking. 

I can see little justification for these interventions in housing finance. There may be positive externalities associated with home ownership and with owner-occupation of residential dwellings. That would provide an argument for subsidizing home ownership or owner-occupancy. It would not provide an argument for subsidizing borrowing secured against residential homes. 

If the information provided to the financially distressed subprime borrowers was incomplete, misleading or outright dishonest, there should be recourse to the criminal justice system. For those subprime borrowers who bet on being bailed out by ever-rising house prices, the adagium: “you break it, you own it” applies. They gambled and they lost. There is no argument based on fairness or efficiency for allowing them to stay in homes they cannot afford without a subsidy. Foreclosure and repossession were designed for just such occasions. The fact that we are approaching an election year should have no bearing on this. Unfortunately it does. This bailout of the imprudent and the short-sighted is unfair to the prudent and far-sighted. It also creates terrible incentives for future overborrowing. 

The bailout proposed for the subprime market is wrong for two reasons. First, because it is a bailout. Second, because it is a bailout implemented with quasi-fiscal instruments rather than with explicit fiscal instruments: a tax on investors in subprime mortgages (or securities backed by them) and a subsidy to subprime mortgage borrowers. Quasi-fiscal instruments are opaque and non-transparent. They serve and are intended to hide the true nature and the real cost of what the government is up to. They kill accountability for the use of public resources. It redistributes not through explicit taxes and transfers but by interfering with the price mechanism. That is why it is so popular with opportunistic politicians everywhere. 

Every politician wants to finance his or her pet projects and hobby horses in an off-budget and off-balance-sheet manner. The public sector knew and applied most of the tricks performed by corrupt and criminal private sector outfits like Enron long before Enron became a household word. Take, for instance, Gordon Brown’s International Finance Facility. This is an off-budget and off-balance sheet arrangement or special purpose vehicle (SPV) that securitises future development aid commitments of the UK government.

The off-balance-sheet vehicle borrows against these future aid commitments to finance development today. Whether it is a good idea to rob future poor Peter to pay today’s poor Paul is an important issue, but not the one I wish to focus on here. What the SPV permits the government to do, is to borrow today without having it show up as borrowing in the government’s financial accounts. The earmarking of future aid commitments will, of course, constrain future government budgetary elbow room, but for myopic and opportunistic politicians, there is no difference between 10 years from now and the next millennium.

The quasi-fiscal measures proposed for the subprime borrowers and lenders have the advantage of never showing up in the government budget. The implicit Federal government guarantees for the debt of Fannie Mae and Freddie Mac are a contingent liability. Even if they are not priced and accounted for in today’s government balance sheet, they could pop up in tomorrow’s Federal Budget and balance sheet should default threaten the GSEs. Of all the governments I know, only New Zealand attempts a comprehensive accounting for contingent assets and liabilities. That remarkable country indeed provides most of the information required for a construction of a comprehensive government intertemporal budget constraint.  Many of the financial shenanigans of governments would become much harder to perpetrate if they were forced to take the long view in the presentation of their accounts. Unfortunately, the kind of quasi-fiscal raid proposed by Mr Paulson for the US subprime market would not be captured even by a New Zealand-style comprehensive balance sheet of the government. Through direct government interference in price setting and through the government-imposed rewriting of long-term contracts, fiscal policy is conducted without leaving a trace in the government’s budget, today or tomorrow.

Argentina and other emerging markets dominated by populist governments are frequent users of government-created price distortions in the pursuit of electoral and other political advantage. In Argentina, the authorities rolled back and capped utility prices. In the US, the authorities prevent interest rate resets in the subprime mortgage markets. Is Argentina the new economic model for the Bush administration?

The Bank of England cut its official policy rate (Bank Rate) by 25 basis points to 5.50 percent today (December 6, 2007). A month ago, on November 7, the Bank released an inflation forecast conditioned on market expectations of future interest rates. At the time at least 50 basis points of cuts were incorporated in market expectations. Despite the incorporation of 50 basis points worth of Bank Rate cuts in the forecast, the most likely outcome for inflation at the two-year horizon was below two percent – the official target. At the MPC meeting of November 8, Bank Rate was kept constant. 

To my way of thinking, it makes no sense to produce a forecast that (1) is supposed to reflect the views of the MPC, (2) incorporates an assumption of at least 50 basis points worth of rate cuts, (3) undershoots the inflation target at the horizon when the impact of current interest rate decisions is strongest, and then not to cut rates at the earliest opportunity, that is, on November 7. Based on the (admittedly incomplete) information available to me, if I had signed up to the forecast of November 7, I would have voted for a 50 basis points rate cut on November 8. Instead we got nothing on November 8 and a 25 basis points cut on December 6. Small mercies…. 

What accounts for this apparent addiction to gradualism (or reactive rather than pre-emptive) decision making by the MPC? 

The science (or lack of it) of uncertainty, gradualism, prudence and caution
Much of macroeconomic thinking still proceeds as if the economy would be represented by a system of linear equations with known coefficients. The only uncertainty allowed for is ‘additive noise’ – random disturbances that don’t affect the transmission mechanism from monetary and fiscal policy instruments or from exogenous shocks and developments to variables of interest, such as output, inflation, employment or asset prices. Instead they just change the realisations of these variables of interest by some random amount that is independent of the rest of the transmission mechanism. If in addition the objectives of the policy maker can be represented by a quadratic function (e.g. a weighted average of the squared deviation of inflation from target and of the output gap), then optimal policy satisfies the ‘principle of certainty equivalence’ (PCE).

According to PCE, policy under uncertainty should be formulated as follows: first, all random variables are set equal to their expected values; second, proceed to optimise the resulting non-stochastic or deterministic system. To put it crudely: according to the PCE, the way to handle uncertainty is to replace uncertain, random variables by their expected values and then to ignore the uncertainty. Under the conditions stated above, such a policy is actually optimal. 

Back to the real world. Any useful ‘model’ of the macro economy will be both non-linear and stochastic. Uncertainty will not just enter in the form of additive disturbances. Ignorance and uncertainty will affect all the key components of the transmission mechanism. If this is what the ‘real world’ (or our best empirical approximation to it) looks like, what will optimal policy look like? The honest answer is: we don’t have a clue. 

There is a massive and once again rapidly growing literature on optimal or robust policy design when there is ‘model uncertainty’ – pervasive uncertainty about the nature of the relationships between key variables; uncertainty about which variables should be included and excluded; ‘parameter uncertainty’ and even our trusty friend additive uncertainty. Except for a few hilariously simplistic examples that can be solved on the back of a rather large envelope, however, there are no general results, no robust policy-relevant conclusions. 

When there is pervasive model uncertainty, but the economy is known to be a non-linear stochastic system, policy makers have to specify and estimate a model, use it to make predictions of the future and to derive optimal policy. In general, specification, estimation, prediction and optimisation should not be done separately or sequentially. In practice, that is exactly what is done, because the right approach is not implementable. Old warhorses are re-activated, such as the use of maximin or minimax strategies (policy rules that minimize the likelihood of the worst possible outcome).

Martin Feldstein, in his Jackson Hole Conference Speech of August 2007, called for ‘risk-based decision theory’ to be applied to the fall-out from the housing market collapse and sub-prime crisis. That is unhelpful advice, however, unless you specify the objective function of the policy makers a little more precisely than Martin Feldstein did, and unless the transmission mechanism was specified more clearly.  Clearly, Feldstein’s call for a 100 basis points cut in the Federal Funds target rate must put rather more weight on the real economy than on inflation, and must attribute a quick and powerful impact of rate cuts on the real economy – a debatable assumption.  With different assumptions, I could have risk-based decision theory calling for a 50 basis points increase in the Federal Funds target rate. It won’t be long before we will see the ‘precautionary principle’ transplanted from the eco-sciences and eco-ethics into optimal macro policy design  (the precautionary principle is a ethical principle according to which which action should be taken to prevent serious or irreversible harm to public health or the environment, despite lack of definitive scientific certainty as to the likelihood, magnitude, or causation of that harm; what it means in practice will of course depend on whether it is short-run output and employment or inflation that is valued most, and on the likelihood of ‘irreversible’ harm being done to either).

The economic models that are useful for policy analysis are all shot through with private sector expectations of future asset prices, rates of return, income streams and future policy behaviour. For a while, the massive problem of modelling private expectations was finessed through the use of the assumption of rational or model-consistent expectations: private sector expectations were assumed to correspond to the optimal forecasts that would be made by using the (correct) model that these private expectations are a building block of. Except in classrooms, rational expectations no longer play a meaningful role. In its place has come an undisciplined explosion of ad-hoc learning models. They range from under-educated price and wage setters using ordinary least squares estimation methods, to post-graduate price and wage setters using some version of the Kalman filter (a recursive estimation method), to Nobel-calibre price and wage setters using optimal Bayesian estimation and prediction methods. But in any realistic setting, the exercise becomes utterly ad-hoc and seat-of-the-pants. There is no theory of ‘learning’ that has been shown to be useful to estimation, prediction and optimisation in non-linear stochastic macro models. Those who are groping around for a theory of rational learning don’t realise that they blind men looking in a pitch-dark room for a black cat named Oxymoron which isn’t there in the first place.

Central bank gradualism as a manifestation of timidity and indecision
So, since we know nothing, why the common central bank presumption in favour of gradualism – what is often called caution or prudence?

The only explanation I can think of is that this presumption reflects a massive misunderstanding of the implications of one among the very few analytically tractable papers on decision making under uncertainty. The paper is by my former teacher and colleague, William C. Brainard – the fastest mind in the west. He looks at a world in which a single instrument (the interest rate, say) affects a single target (inflation, say). The effect is linear, but in addition to additive uncertainty, the policy impact (the effect of the interest rate on inflation) is itself random. This case of instrument uncertainty implies that, if you care, say, about the expected squared deviation of inflation from its target level, you will end up acting cautiously compared to someone who follows a certainty-equivalent strategy. You will do less. 

And off they go. Model uncertainty, which includes instrument uncertainty, is a feature of the real world. In Brainard’s model of instrument uncertainty, instrument uncertainty motivates cautious behaviour. Cautious behaviour means doing less. In a monetary policy setting doing less means, obviously, achieving a given required change in interest rates in a number of little steps rather than in one big step. Not! 

Consider the following policy making under uncertainty exercise. I stand before a 5 feet wide and 500 feet deep precipice. It is broad daylight. I want to get to the other side. I can target my leaps accurately, but jumping farther is more costly to me. I will make a jump somewhere over 5 feet long. Now it is pitch dark. I know where the near edge of the precipice is, but not where the far edge is. I know the precipice is either 4 feet wide or 6 feet wide (and still 500 feet deep). I will indeed be cautious, even prudent. But cautious here means that I will take a bigger leap that when there is no uncertainty. Under most plausible specifications of the cost of jumping and my valuation of life, I will jump at least 6 feet under uncertainty. Caution means doing more. 

I don’t know whether the British economy, and specifically the transmission mechanism from Bank Rate to the inflation target and to the real economy is more like the Brainard example or my leap over the precipice example. I don’t think the MPC know either. The choice between gradualism and ‘cold turkey’/big bang/whole hoggism/ may therefore well be more a matter of temperament and instinct than of science. 

Against that, most central bankers are born procrastinators. They have an almost pathological ‘fear of reversals’: raising rates one month and having to reverse this increase at the next meeting or soon after. That fear of reversals is completely irrational. If you are anywhere near the optimum, there is always a good chance of a rate change in either direction at the next meeting, regardless of what the direction of your last move was. Anyone asking me why I favour a cut this month when I favoured an increase last month will get the answer: “that was then, this is now”, or “when the facts change, I change my mind - what do you do, sir?". Fear of reversals is likely to lead to central banks being systematically “behind the curve”, always looking for that elusive additional bit of information and higher degree of certainty that is bound to be just around the corner – if we but wait.  The ECB is a prime example of a central bank that it always running to catch up with the facts. The Bank of England was the central bank least subject to this procrastination bias in its first decade, but it appears to be slipping into the same quagmire so many other central banks have as their preferred habitat. 

There are few central bankers who, when faced with the need for a significant increase or cut in interest rates don’t prefer to do it in six steps of 25 basis points each rather than in one 150 basis points steps. The most extreme example of such a policy was the Fed’s 17 successive 25 basis points increases from June 2004 until June 2006.  If ever there was an example of rampant, out-of-control gradualism, this is it.  It meant that rates were far too low for far too long and that an inordinate amount of unnecessary liquidity was injected into the US financial markets and, through the exchange rate pegs of Bretton Woods II, also into much of the rest of the world. 

Things could have been worse today. The Bank of England could have kept rates unchanged.  The language of the statement suggests deep disagreement among the members.  It is quite possible that the Governor opposed today’s rate cut and was in the minority.  I believe that the real economy in the UK is likely to turn down more sharply than in the MPC’s central forecast, and that, over the horizon that the MPC can influence inflation, the inflation rate is more likely to undershoot the target than to overshoot it. The financial turmoil that erupted on August 9 is one of the drivers of this slowdown, but by no means the only one.  Further cuts are likely to be required to meet the inflation target, so why not have them now?

When then Secretary of State Colin Powell told the UN that Saddam Hussain had chemical and biological weapons of mass destruction, I believed him.  When he said that US and UK intelligence had incontrovertible evidence that Saddam Hussain had an active programme to create nuclear weapons and the means to deliver them to targets I cared about, I believed him.  When then Prime Minister Tony Blair went beyond even what Powell had asserted and told us that Saddam’s chemical weapons could be activated within 45 minutes, I believed him also.

We now know that none of this was true.  What is unclear is whether Powell and Blair were lying or relying on bad intelligence – or both. 

This morning, I read in the papers that US intelligence has, in the words of the Financial Times, "downgraded its assessment of the risks posed by Iran’s nuclear ambitions with a surprise declaration that the country, led by President Mahmoud Ahmadi-Nejad …, halted its nuclear weapons programme in 2003 and may not have restarted it".

If this is true, I should be relieved.  Ahmedi-Nejad is a religious fanatic with strong Millenarian tendencies, who is waiting for the return of the hidden Imam.  He is confronted by George W. Bush, a religious fanatic with strong Millenarian tendencies, who is waiting for the return of Jesus Christ.  That’s the kind of configuration  likely to expedite the end of the world.  News that Iran has taken its foot off the nuclear accelerator would would be welcome indeed.

But can we believe it?  I have reached the point that, when an official spokesman in the US or the UK makes an assertion about a fact or issue that I cannot verify directly myself, I really only consider two possibilities: (1) (s)he is lying; (2) (s)he doesn’t know what (s)he is talking about.  The possibility that the authorities could be both truthful and competent is barely worth considering.

Truth telling has become a tactical option in political life. You do it when it is convenient – when it serves your purpose, rather than because it is the right and self-evident thing to do.  Competence is no longer expected of our political leaders and hardly hoped for.  The moral, political and economic cost of this erosion of trust and social capital will be with us for a long time, unless of course either the hidden Imam or Jesus Christ make an unexpected (by me) early return.

The Democratic Party has well-established and well-deserved ugly credentials as a hotbed of populist protectionism.  Occasionally, we find a pearl among the Democratic swine.  Bill Clinton, who never wavered in his support for free trade, even when it was electorally costly, is an example.  Unfortunately, this wisdom and courage has not rubbed off on his wife, Senator Hillary Clinton, who is running hard and scared for President of the USA. The other Democratic candidates are, if anything, even more lamentably protectionist than Senator Clinton. The Republicans aren’t much better, but they don’t matter this election, because George W. Bush has made certain that the next president of the USA will be a a Democrat.

When educated persons are deeply ashamed of what they are about to say, they tend to either invoke God or spray the name of a Nobel Laureate around, as a form of mental smokescreen.  Senator Clinton goes the Nobel route.  Quoting:

I agree with Paul Samuelson, the very famous economist, who has recently spoken and written about how comparative advantage, as it is classically understood, may not be descriptive of the 21st century economy in which we find ourselves.”

This statement is complete codswallop.  Granted, Senator Clinton, who doesn’t understand the first thing about economics (as demonstrated by her disastrous attempt at health care reform in the first (Bill) Clinton administration), may not understand precisely why she is talking rubbish.  But the benighted adviser who fed her this bit of misinformation can be presumed to be aware that they are feeding their candidate a bill of goods.

One of the great things about intellectual property rights is that you cannot plagiarise yourself.  I will therefore shamelessly reproduce a chunk of a comment I posted on July 1, 2007, on the FT Economists’ Forum in response to a careless piece of writing by Larry Summers which, come to think of it, ran along the same lines as the quote from Senator Clinton. Here it is:

In support of his claim that "If globalization is taken to mean a combination of more openness and growth of developing countries it is not even altogether clear that it benefits America in aggregate", Larry invokes Paul Samuelson’s elegant paper on the welfare effects on a nation of growth abroad. The appeal to Samuelson’s (correct) analysis should, however, be taken with a pinch of salt.

Samuelson’s paper deals with the effect of growth abroad on home country welfare in a world with two countries (or regions) that have fully integrated (free, competitive) trade in goods and services throughout (both before and after growth abroad takes place). There is no capital mobility or labour mobility. Samuelson’s analysis is intuitive: if growth abroad (whether through total factor productivity growth or the hard way) is concentrated in sectors where the home country used to have a comparative advantage, the terms of trade may turn so badly against the home country that everyone in the home country is worse off. A nation of candle-makers and candle-exporters who don’t have many productive alternative uses for their labour and capital resources may well be worse off when the rest of the world starts producing cheap gas lamps.

However, despite getting clobbered by this technological change abroad, the candle-makers’ nation can do no better for itself than imposing the optimal tariff and trading away. This was true also before the rest of the world invented and produced the gas lamp. Even with the optimal tariff, the candle-makers’ nation can be worse off than before. ‘Shutting off’ globalisation does not mean reducing openness in the sense of reducing trade. The only way to restore the status quo ante is to stop the rest of the world from producing gas lamps.

Back in the real world, the analogue would be to stop India from producing software, operating call centres and providing back office functions to the world at large. It would mean to stop China from acquiring or re-inventing and then using modern technological and managerial know-how to create a mighty manufacturing machine. You would have to stop both technology transfer and internal R&D and other knowledge creation in the Chindias of this world. This, fortunately, is as impossible as it would be immoral. The genie is out of the bottle.

Given that China, India, the other BRICS and ultimately most other emerging markets and developing countries will acquire modern technology, management techniques and governance institutions, the best response of the old industrial countries (the OECD countries, say) is to trade freely, with just the optimal tariff separating them from truly free trade. Even if the old industrial countries were to be worse off as a result of the growth of the emerging markets and developing countries (a theoretical but not a practical possibility for most countries, although individual groups of workers and owners of capital could well be worse off), they would minimize the extent of the welfare loss by optimal tariff-qualified free trade. Going self-sufficient would mean that the candlemakers would have to eat their own candles.

The optimal tariffs are optimal only from the perspective of the countries setting them. Globally they are welfare-reducing. Intelligent bargaining-with-side- payments at the level of the WTO should ensure that the optimal response of the old industrial countries to the rise of the new giants is unqualified free trade.

Whatever happens, the candle-makers can never get their export markets back. Living with it and trading despite it, is the only efficient policy. Using domestic distributional instruments to meet domestic distributional objectives is the other blade of the policy scissors.

So, no Senator Clinton, you are quite wrong about comparative advantage.  Paul Samuelson is, not surprisingly, absolutely right.  Despite outsourcing and off-shoring, despite alleged Chinese currency manipulation and the threat of Sovereign Wealth Funds from the Gulf and the far East owning most of Main Street before long, comparative advantage continues to provide the valid foundations for pursuing free trade, preferably multilaterally, but if necessary unilaterally. The exercise of national market power is the only reason to depart from this, if you are confident that there will be no retaliation.

There is more to international economic policy than trade policy of course, and I encourage Senator Clinton to develop new initiatives in the fields of intellectual property rights, multilateral surveillance by the IMF, migration policy, global regulation of internationally mobile financial institutions and instruments, co-operation in tax policy, including tax administration and a co-ordinated crackdown on tax havens and "regulators of convenience". 


Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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