Daily Archives: March 1, 2012

With the US presidential race heating up, the candidates are increasingly prone to make sweeping promises. They say they will do this or that in their first day in office – balance the budget, close the prison at Guantánamo, abolish the Federal Reserve, whatever – and their supporters all cheer that one of their cherished goals will be achieved instantly if only their man gets to sit in the Oval Office.

This is, of course, rank nonsense. And it has nothing to do with the relative absurdity of the promises being made. It has to do with the nature of US government, which is something even Americans often forget.

In the US system, the president is far weaker than the chief executive in most other countries. The reason is that it was baked in the cake by the framers of the constitution who were deeply sceptical about monarchism. They wanted a leader who was subservient to the legislature, not its overlord.

Congress was given most of the power in the American system. The executive branch is severely constrained. For example, all senior executives must be confirmed by the Senate, an enormously difficult and time-consuming process. Congress also controls the executive’s purse strings. The president’s budget is merely a proposal that is often “dead on arrival” in Congress.

But the founding fathers didn’t trust Congress either. They divided it into two branches, the House of Representatives and Senate. Each has powers denied to the other. The Senate, in addition to having sole jurisdiction over confirmations, is the only branch necessary to ratify international treaties. All revenue bills must originate in the House.

The founding fathers didn’t give much thought to political parties. It may not have occurred to them that Congress and the presidency could be under different party control or that the House and Senate could be controlled by different parties. Presently, the president is a Democrat and the Senate is controlled by his party, while the House is controlled by the Republican party.

Lastly, the American system bends over backwards to accommodate minority viewpoints in Congress, creating many choke-points in the legislative process where a small group of legislators can block and even defeat legislation that has majority support. In the 100-member Senate, it only takes 40 votes to kill a nomination or piece of legislation.

While it is possible that the next president will bring in with him an overwhelmingly large number of congressmen and senators of his own party, such that he really can implement his promises, no matter how extravagant, this is extremely unlikely. Even if one party gets control of the White House, Senate and House, the other party is almost certain to have at least 40 votes in the Senate, thus ensuring gridlock for any proposal that is remotely controversial.

Thus we can safely ignore sweeping promises from all the presidential candidates if they require the enactment of legislation. This is especially so regarding the federal budget. The vast bulk of spending is effectively on automatic pilot in the US because it involves entitlement programs such as Social Security and Medicare that are exceedingly difficult to change because so many people are affected by them.

Where the American president has a freer hand is in the area of foreign affairs. However, given that Barack Obama’s foreign policy is virtually identical to that of his predecessor’s, Republican George W. Bush, it’s unlikely that any significant changes will occur regardless of who is elected. The rhetoric may change, but the substance will be pretty much the same, I believe.

The American government is like a large ocean-going vessel – it changes direction only very slowly. This is both strength and a weakness. It’s a strength when momentary radical movements gain popularity and discover that they can’t really change anything, as leaders of the so-called Tea Party have discovered, to their dismay. It’s a weakness when some existing program desperately needs reform and a determined minority blocks action, thus perpetuating an undesirable status quo indefinitely.

The writer is a former senior economist at the White House, US Congress and Treasury. He is author of ‘The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take’

With the €530bn lent to banks through its latest three-year longer-term refinancing operation, the size of the European Central Bank’s balance sheet has increased to unprecedented levels, raising three separate concerns. Not all are justified.

The first is that sooner or later the increase in central bank money will lead to inflation. However, there is no empirical evidence – across countries and over time – that the size of the central bank balance sheet in advanced economies is related to inflation. Even though inflation is ultimately a monetary phenomenon – to paraphrase Milton Friedman – the quantity of money circulating in the economy also depends on the motives underlying the demand for money by the private sector, in particular by the banking system. If the increase in central bank money helps commercial banks to finance additional private or public consumption and investment, over and above the economy’s productive potential, it may indeed fuel inflation. If, instead, the demand for central bank money reflects a change in the composition of financial market participants’ portfolios, towards less-risky assets, the increase in central bank money is not inflationary. It contributes instead to preventing deflation.

The data show that market participants’ current demand for central bank money does not reflect an intention to increase their balance sheets but rather their difficulty in accessing financial markets – the result of a generalised increase in risk aversion. Replacing market financing with central bank funding has prevented a sharp contraction in banks’ liabilities, which would have induced a drastic deleveraging and possibly a credit crunch. Money and credit statistics in the euro area confirm that there are no inflationary pressures, while aggregate demand growth is expected to be modest, if not negative; and below potential for some time.

The large amount of liquidity will, of course, have to be mopped up once financial markets have recovered, to avoid fuelling inflationary pressures. The process will be partly endogenous, as commercial banks in the eurozone will request less central bank money as risk aversion subsides, or will reimburse existing loans in advance, as the three-year LTROs allow. The ECB can hasten this process, if needed, by raising the refinancing rate, by increasing the spread between the refinancing and the deposit rate, by adopting variable rather than fixed-rate tenders for its operations, or by issuing term deposits or certificates of deposit.

The second concern relates to the overall risk a large balance sheet may create for the central bank and its shareholders. This concern is mitigated by the fact that the ECB lends against collateral. For a loss to materialise, the counterparty has to be insolvent and the collateral must be sold at a price lower than the central bank’s valuation (market price minus a haircut). These events are unlikely to occur simultaneously. In fact, markets are concerned about the opposite issue – that the ECB has de facto acquired preferred creditor status. The recent Greek bonds swap, which allowed the ECB to avoid loss, has confirmed this status. Under these circumstances, the larger the central bank balance sheet, the larger the risk shifted to the remaining unsecured bondholders, who might be more and more discouraged from lending to banks as they would find it harder to return to market financing.

This raises a third, more serious concern: that cheap three-year funding creates a disincentive for eurozone commercial banks to restructure their balance sheets and strengthen their capital base, as they must to stand on their own feet once the crisis is over. Banks may become addicted to easy central bank financing and delay the adjustment indefinitely. This can be prevented only if supervisors put sufficient pressure on bank managers and shareholders to continue adjustment, and to use central bank funds only as a temporary, exceptional source of financing. However, supervision in the eurozone is implemented at national level, with little incentive to pursue these objectives rigorously and on a level playing field.

With the three-year LTRO, the ECB has helped to reduce systemic risk and avoided a credit crunch. To minimise the inefficiencies and perverse incentives that may result from the increase in its balance sheet, and to reduce counter-party risk, the ECB should be given a greater role in co-ordinating and overseeing supervision of the eurozone banking system. The euro area needs a supervisory and regulatory compact, as much as – if not more than – a fiscal compact.

The writer is a visiting scholar at Harvard’s Weatherhead Center for International Studies and a former member of the ECB’s executive board

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