Obama’s Gift to GOP Is Challenge to Supply Siders: Amity Shlaes
Commentary by Amity Shlaes
Feb. 6 (Bloomberg) -- Cut the tax rate on capital gains to 5 percent. Halve the corporate tax rate. Fund a new, super-strong Securities and Exchange Commission to monitor anything that’s traded, including the haziest derivative.
Buy homeowners out of mortgages they can’t afford, and protect the rights of lenders. Make Social Security solvent by curtailing the annual growth in benefits. Forget one “S” word, stimulus, and learn to use two “R” words -- rent and recession.
Too costly, you might say, or too extreme. But the ideas above are neither costlier nor more extreme than the almost- trillion-dollar stimulus package moving through Congress. And they are more likely to bring long-term growth than the legislation advanced by President Barack Obama. Republicans know it, which is why they voted against the administration plan.
Still, there’s no great GOP hero yet making the case for putting growth first. Not even the modern-day supply siders, who so long served the Republicans by stressing the importance of low marginal tax rates for producers in setting the pace of economic growth.
Consider the recent appearance of the lion of the supply siders, Larry Lindsey, on “The Daily Show With Jon Stewart.” Lindsey -- author of a landmark study that showed the 1980s Reagan tax-rate cuts brought in more revenue than predicted -- made his case for a payroll-tax cut as stimulus.
Lindsey would halve the payroll tax, to give $1,500 to the average worker making $50,000. Buried in the plan is a genuine supply-side component: Higher earners would benefit from paying less in Social Security taxes, and the payroll tax cut would also reduce the cost of employment at a time when companies are deciding if and when to hire.
Obama Lite
Two problems. First, the supply-side aspect truly is buried. To the average TV viewer, a payroll-tax holiday is hard to distinguish from Obama’s proposed worker-tax rebate and so comes off as Obama Lite. It’s all about the worker -- in other words, a demand-side reform.
Second, a payroll-tax cut sends the message that suspending Social Security payments is acceptable at a time when the Social Security program itself is moving into deficit. Lindsey proposes a carbon tax as an offset. But the gist of his proposal is that entitlement shortfalls matter less than the current crisis. The opposite is true.
It’s clear why Lindsey offered his plan: it is doable. Still, maybe Republicans should be thinking, not doing, at this point.
There’s evidence they are doing some thinking, especially when it comes to two philosophies, one newer and one that updates supply-side theory by going back to its roots.
Public Choice
The first, known as public choice theory, holds that stimulus packages pretend to be about growth but, in reality, simply feed the government monster. Public choicers, many of whom come out of Virginia’s George Mason University, deem the phrase “reform government” an oxymoron. To them, government isn’t better than the private sector. Public and private are opponents in a perpetual power struggle, like two kindergartners battling it out on a mat.
Public choicers warn that politicians will always exploit an emergency to further unrelated goals. Rahm Emanuel’s statement of last fall -- that “you never want a serious crisis to go to waste” -- validated their nightmares. In their view, sometimes even a nasty but stable institution -- such as a super SEC -- is preferable to a protean one, such as the Troubled Asset Relief Program.
No Fantasy
Public choicers seek certainty from government, not constant fiddling. “Economists often fantasize that if only politicians would put us in charge of the economy, we could fix it. But the economy is too complex,” says Russ Roberts, a professor at George Mason. The hero of the public choicers is Roberts’ colleague, James Buchanan, who won the Nobel Prize in 1986.
The second philosophy can loosely be called classical economics. It is there the concept of supply side -- as opposed to demand side -- originates.
Classical economics says producers matter as much as consumers, sometimes more. It says government medicine is sometimes worse than any economic ill. It says setting prices -- even low ones for struggling securities -- can do more to bring recovery than any number of deals brokered by the Treasury, Federal Reserve or Federal Deposit Insurance Corp.
To the classical folks, entitlement reform matters because it will make the U.S. more competitive internationally. They acknowledge that outgrowing today’s deficits will be harder than outgrowing deficits was in the Gipper’s day.
‘Creative Destruction’
Appalled classical thinkers, led by John Cochrane of the University of Chicago Graduate School of Business, generated an anti-TARP petition last fall. Some of these scholars are “Austrians,” or followers of Joseph Schumpeter, who viewed recession as necessary “creative destruction.” Others prophesy that the trend of forgiving borrowers will cut the supply of mortgages later.
Right now, the public choicers, with their emphasis on the abuse of crises by politicians, seem more timely. They note that the Democrats will have a hard time reconciling a promise to put a leash on K Street with a stimulus package that feeds lobbyists as none before.
The consolation in being out of power is that you have time to try out improbable ideas, or refurbish old ones. Such time is the gift that President Obama has given Republicans, and they may well thank him for it.
CAYMAN FINANCIAL REVIEW
First Quarter 2009
Should you worry about holding the Cayman dollar? The short answer is no, and the following will explain why. The Cayman dollar has been “fixed” to the U.S. dollar since 1972, at a rate of $1.2
The Cayman Island Monetary Authority (CIMA) operates a “currency board” to ensure adequate backing for the
In 1971, the political leaders in Cayman and the
CIMA operates a currency board and not a traditional central bank like the U.S. Federal Reserve Bank or the Bank of England. Most central banks are wholly owned by the government and operate separately from the finance ministry. They have a monopoly on issuing legal tender (notes and coins). Legal tender is the term for the money in which government pays its bills and receives its taxes, and in which private parties must pay their debts (unless they have made other private arrangements to pay it in a foreign currency, gold, etc.).
Central banks operate what is known as “monetary policy” in which they decide how much money to create through the banking system. Monetary policy can have multiple targets, such as price stability and full employment (which is what the U.S. Fed is charged with), or the single target of price stability, which is the primary goal of the European Central Bank. Central banks did not become widespread until the 20th century and became very common after most countries abandoned the gold standard.
Modern day currency boards trace much of their heritage to currency boards established by the British in a number of their colonies. The local government officials could create a currency, usually with the symbols of the colony on the bank notes and coins, which was fixed to the pound sterling. That is, the local currency could be exchanged for the pound, and vice versa, at an agreed upon price. The currency board was normally required to hold 100 percent reserves in approved
Cayman has a classic currency board. Its “anchor” currency is the U.S. dollar. The Cayman currency board keeps more than 100 percent reserves in
The paper currency that Cayman uses is printed by the British bank note firm De La Rue. The basic ingredient in the paper note is not wood pulp, but cotton. Banknotes are a rather complex product in that they have to be made to be both flexible and stiff, and be sufficiently durable to handle abuse and hostile environments (e.g. damp and dirty clothing). They contain many anti-counterfeit measures, such as water marks, complex design, metallic threads that contain information, and some with even holograms. The higher the value of the banknote, the more costly anti-counterfeit measures are included in it. A $100 note will be made more counterfeit proof than a one dollar note. When deciding how many anti-counterfeit devices to put into a banknote, the Monetary Authority does a cost benefit analysis, given that the cost of a banknote can vary considerably depending upon what features it contains. Paper currency does wear out and CIMA regularly replaces dirty, torn, or worn bills.
Cayman has a unique advantage in that many tourists like to keep some of the Cayman currency as souvenirs, particularly the one dollar bills. When they do this, they are in effect giving Cayman a perpetual interest free loan. Thus it is important for Cayman to produce an interesting looking currency that people will want just because of its appearance. CIMA, unlike the money issuing authorities in some countries, maintains a “clean bill” standard, which gives a better image, and also makes it more desirable for people to want to hold the physical currency. However, the liability for non-redeemed banknotes is still kept on the books of the Cayman Monetary Authority.
The Cayman Monetary Authority also supplies coins in denominations of less than one dollar, plus occasional high value commemorative coins. Coins are expensive to produce but have the advantage of durability. As a result of inflation in the U.S. dollar and most other currencies, some low-value coins like the penny cost more to produce than they are worth. This problem has caused some countries to stop producing pennies and other low-value coins. The increasing movement to electronic forms of payment – credit, debit, and smart cards, etc. does serve to reduce the problem of the cost of coinage (and banknotes).
Currency boards need an anchor currency and/or gold or some other commodity. The choice of the anchor currency depends upon predominate economic relationships, expected stability, and international acceptability. The eastern European countries which have set up currency boards have now all opted for the euro as their anchor, even though many of them originally choose the D-mark.
Cayman quite appropriately selected the U.S. dollar as its anchor. The reason is obvious; most Cayman business is done in U.S. dollars, most of its imports come from the
Cayman, by using the dollar anchor, is held hostage to
Cayman could set up a classic central bank and try to run its own monetary policy. Virtually no small country has been successful at this over the long run, except for
In theory, Cayman could go on gold or some other commodity standard, but trying to do so alone, and given the country’s small size, it is not practically feasible. One only needs to look at the swings in world gold prices over the last several years to imagine the kinds of problems Cayman would subject itself to if it adopted such a standard.
Cayman could also drop its own currency and “dollarize” its economy, the way some other countries have done (such as
The tourist industry may be enjoying some additional benefit by Cayman having its own currency, because it makes the islands seem more “foreign” and exotic.
No-thought regulation
No-thought regulation
Richard W. Rahn
If you knew - "a few weeks ago, the federal government had to commit several hundred billion dollars for a guarantee of Citicorp's assets, though examiners from the Office of the Comptroller of the Currency (OCC) have been inside the bank full-time for years, supervising the operations of this giant institution, under the broad powers granted by the Federal Deposit Insurance Corporation Improvement Act of 1991 to bank supervisors" - what would you think about the effectiveness of U.S. bank regulation?
The above quote comes from a thoughtful and important new paper, "Regulation without Reason," by Peter J. Wallison, former general counsel of the U.S. Treasury and now a fellow at the American Enterprise Institute. Mr. Wallison warned for years - in books and articles - that Fannie Mae and Freddie Mac were headed for disaster, and now he is taking on the ill-thought out proposals to increase regulation of the financial industry, both by politicians and people who should know better.
The frightening thing is that many of the same intellectually and (alleged) financially corrupt politicians - e.g. Rep. Barney Frank and Sen. Chris Dodd - whose actions directly helped bring on the present crisis, have now been put in charge of the hen house and are tasked with "making reforms." Rather than acknowledge that their earlier poorly thought out "reforms" caused many of the current problems, they and the so-called "Group of 30" financial experts advocate expanding destructive bank regulation to healthy parts of the financial industry.
Those who are incapable of thinking through the consequences of their actions (like drunken teenagers with car keys) are likely to make matters worse rather than better, which characterizes all too many of the Washington elite - at the Fed, the Treasury, the Securities and Exchange Commission and particularly the Congress. It was they who created and then failed to supervise and provide adequate capital requirements for Freddie Mac and Fannie Mae. It was the members of Congress who, by not thinking through the consequences of their Community Reinvestment Act, forced banks to make loans to unqualified buyers. It was they who created the notorious Sarbanes-Oxley Act, a poorly thought out response to the Enron scandal. This act has driven accounting costs for businesses through the roof, destroying many hundreds of thousands of jobs in the process, forced companies to go private and driven the important initial public offering (IPO) market to London.
Last week the House of Representatives passed a "stimulus" bill that in actuality will slow the recovery and restoration of jobs. There is a "buy America" protectionist provision in the bill, which thoughtful and knowledgeable people understand will raise costs and destroy more jobs than it will create and invite destructive retaliation from foreign competitors. In their thoughtless vote for this bill, the vast majority of the Democrats in Congress ignored the lessons of the Great Depression with the disastrous Smoot-Hawley tariff, hundreds of years of economic history, and good economic theory.
Certain members of Congress have attacked foreign jurisdictions that have lower tax rates, and have proposed to penalize U.S. companies that use such jurisdictions in order to remain internationally competitive.
These members of Congress have shown themselves incapable of thinking through the ultimate consequences of their proposals, which include: making U.S. business less able to compete with foreign competitors that have lower tax burdens, reducing employment growth both in the United States and worldwide by increasing the cost of capital and its proper allocation, and undermining relations with many peaceful countries - which have a sovereign right to have any tax system and rates they so choose - and violating U.S. obligations under the World Trade Organization.
U.S. officials are trying to require foreign entities that bring badly needed foreign investment into the United States (through "QI procedures") to use only U.S. auditors. This is not only offensive to foreign friends but violates their own laws in many cases. How would the United States react to a requirement that companies operating in this country but sending passive foreign investment abroad be forced to use only foreign auditors? These thoughtless and destructive proposals will only damage international relations, which President Obama said he wants to improve, and to reduce investment in the U.S., which in turn will reduce both productivity growth and job creation.
Having previously spent several years as a financial regulator myself, I am keenly aware that regulation can be more destructive than beneficial. Regulation adds to systemic risk in that it reduces market discipline when people think the government is "protecting" them. Regulation favors large over small firms because the costs are more easily borne by large entities, and this in turn causes more industry concentration than is desirable (resulting in the "too big to fail" syndrome).
Regulation often impairs innovation by driving up costs and often adds costs not justified by the benefits, and all these additional costs are ultimately borne by consumers in higher prices, which mean a lower standard of living.
The current rush to regulate, without calmly and adequately thinking through the full ramifications and likely costs associated with each new regulatory proposal, is likely to end in another round of financial disasters.
Richard W. Rahn is a senior fellow at the Cato Institute and chairman of the Institute for Global Economic Growth.
Keynes can't help us now
Keynes can't help us now
It began as a subprime surprise, became a credit crunch and then a global financial crisis. At last week's World Economic Forum in Davos, Switzerland, Russia and China blamed America, everyone blamed the bankers, and the bankers blamed you and me. From where I sat, the majority of the attendees were stuck in the Great Repression: deeply anxious but fundamentally in denial about the nature and magnitude of the problem.
Some foretold the bottom of the recession by the middle of this year. Others claimed that India and China would be the engines of recovery. But mostly the wise and powerful had decided to trust that John Maynard Keynes would save us all.
I heard almost no criticism of the $819-billion stimulus package making its way through Congress. The general assumption seemed to be that practically any kind of government expenditure would be beneficial -- and the bigger the resulting deficit the better.
There is something desperate about the way economists are clinging to their dogeared copies of Keynes' "General Theory." Uneasily aware that their discipline almost entirely failed to anticipate the current crisis, they seem to be regressing to macroeconomic childhood, clutching the Keynesian "multiplier effect" -- which holds that a dollar spent by the government begets more than a dollar's worth of additional economic output -- like an old teddy bear.
They need to grow up and face the harsh reality: The Western world is suffering a crisis of excessive indebtedness. Governments, corporations and households are groaning under unprecedented debt burdens. Average household debt has reached 141% of disposable income in the United States and 177% in Britain. Worst of all are the banks. Some of the best-known names in American and European finance have liabilities 40, 60 or even 100 times the amount of their capital.
The delusion that a crisis of excess debt can be solved by creating more debt is at the heart of the Great Repression. Yet that is precisely what most governments propose to do.
The United States could end up running a deficit of more than 10% of GDP this year (adding the cost of the stimulus package to the Congressional Budget Office's optimistic 8.3% forecast). Nor is that all. Last year, the Bush administration committed $7.8 trillion to bailout schemes, in the form of loans, investments and guarantees.
Now the talk is of a new "bad bank" to buy the toxic assets that the Troubled Asset Relief Program couldn't cure. No one seems to have noticed that there already is a "bad bank." It is called the Federal Reserve System, and its balance sheet has grown from just over $900 billion to more than $2 trillion since this crisis began, partly as a result of purchases of undisclosed assets from banks.
Just how much more toxic waste is out there? New York University economistNouriel Roubini puts U.S. banks' projected losses from bad loans and securities at $1.8 trillion. Even if that estimate is 40% too high, the banks' capital will still be wiped out. And all this is before any account is taken of the unfunded liabilities of the Medicare and Social Security systems. With the economy contracting at a fast clip, we are on the eve of a public-debt explosion. And similar measures are being taken around the world.
The born-again Keynesians seem to have forgotten that their prescription stood the best chance of working in a more or less closed economy. But this is a globalized world, where uncoordinated profligacy by national governments is more likely to generate bond-market and currency-market volatility than a return to growth.
There is a better way to go: in the opposite direction. The aim must be not to increase debt but to reduce it.
This used to happen in one of two ways. If, say, Argentina had an excessively large domestic debt, denominated in Argentine currency, it could be inflated away -- Argentina just printed more money. If it were an external debt, the government defaulted and forced the creditors to accept less.
Today, America is Argentina. Europe is Argentina. Former investment banks and ordinary households are Argentina. But it will not be so easy for us to inflate away our debts. The deflationary pressures unleashed by the financial crisis are too strong -- consumer prices in the U.S. have been falling for three consecutive months. Nor is default quite the same for banks and households as it is for governments. Understandably, monetary authorities are anxious to avoid mass bankruptcies of banks and households, not least because of the downward spiral caused by distress sales.
So what can we do? First, banks that are de facto insolvent need to be restructured, not nationalized.(The last thing the U.S. needs is to have all of its banks run like Amtrak or, worse, the IRS.) Bank shareholders will have to face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalization, but only after losses have been meaningfully written down. Those who hold the banks' debt, the bondholders, may have to accept a debt-for-equity swap or a 20% "haircut" -- a disappointment, but nothing compared with the losses suffered when Lehman Bros. went under.
State life-support for dinosaur banks should not and must not impede the formation of new banks by the private sector. It is vital that state control does not give the old, moribund banks an unfair advantage. So recapitalization must be a once-only event, with no enduring government guarantees or subsidies. And there should be a clear timetable for "re-privatization" -- within, say, 10 years.
The second step we must take is a generalized conversion of American mortgages to lower interest rates and longer maturities. About 2.3 million U.S. households face foreclosure. That number is certain to rise as more adjustable-rate mortgages reset, driving perhaps 8 million more households into foreclosure and causing home prices to drop further. Few of those affected have any realistic prospect of refinancing at more affordable rates. So, once again, what is needed is state intervention.
Purists say this would violate the sanctity of the contract. But there are times when the public interest requires us to honor the rule of law in the breach. Repeatedly in the course of the 19th century, governments changed the terms of bonds that they issued through a process known as "conversion." A bond with a 5% return was simply exchanged for one with a 3% return, to take account of falling market rates and prices. Such procedures were seldom stigmatized as default.
Another objection to such a procedure is that it would reward the imprudent. But moral hazard only really matters if bad behavior is likely to be repeated, and risky adjustable-rate mortgages aren't coming back soon.
The issue, then, becomes one of fairness: Why help the imprudent when the prudent are struggling too?
One solution would be for the government-controlled mortgage lenders and guarantors, Fannie Mae and Freddie Mac, to offer all borrowers -- including those with fixed rates -- the same deal. Permanently lower monthly payments for a majority of U.S. households almost certainly would do more to stimulate consumer confidence than all the provisions of the stimulus package, including tax cuts.
No doubt those who lost by such measures would not suffer in silence. But the benefits would surely outweigh the costs to bank shareholders, bank bondholders and the owners of mortgage-backed securities.
Americans, Winston Churchill once remarked, will always do the right thing -- after they have exhausted all other alternatives. If we are still waiting for Keynes to save us when Davos comes around next year, it may well be too late. Only a Great Restructuring can end the Great Repression. It needs to happen soon.
Niall Ferguson is a professor at Harvard University and Harvard Business School, a Fellow of Jesus College, Oxford, and a senior fellow of the Hoover Institution. His latest book is "The Ascent of Money: A Financial History of the World."
Economics focus
Burger-thy-neighbour policies
Attacks on China’s cheap currency are overdone
CHINA has been accused of “manipulating” its currency by Tim Geithner, America’s new treasury secretary, and this week Dominique Strauss-Kahn, the managing director of the IMF, said that it was “common knowledge” that the yuan was undervalued. You would assume that such strong claims were backed by solid proof, but the evidence is, in fact, mixed.
Of course China manipulates its exchange rate—in the sense that the level of the yuan is not set by the market, but influenced by foreign-exchange intervention. The real issue is whether Beijing is deliberately keeping the yuan cheap to give exporters an unfair advantage. From July 2005, when it abandoned its fixed peg to the dollar, Beijing allowed the yuan to rise steadily, but since last July it has again been virtually pegged to the greenback. And there are concerns that China may allow the yuan to depreciate to help its exporters—with worrying echoes of the beggar-thy-neighbour policies that exacerbated the Depression. But American politicians are wrong to focus only on the yuan’s dollar exchange rate. Since July the yuan has gained 10% in trade-weighted terms. It is up 23% against the euro, and 30% or more against the currencies of many other emerging economies.
In early 2005 two American senators brought a bill to Congress that threatened a tariff of 27.5% on all Chinese imports unless the yuan was revalued by that amount. This curiously precise figure was the midpoint of a range of estimates (15-40%) of the yuan’s undervaluation. The bill was dropped, but the yuan has since risen by that magic amount in real trade-weighted terms (see left-hand chart, below). So how much further should it rise?
Those who argue that the yuan is still too cheap point to three factors: China’s foreign-exchange reserves have surged; it has a huge current-account surplus; and prices are much cheaper in China than in America. Start with official reserves. If China had not bought lots of dollars over the past few years, the yuan’s exchange rate would have risen by more. So does the yuan’s fixed level against the dollar in recent months mean that intervention has risen? On the contrary, in the fourth quarter of 2008, China’s reserves barely rose, despite a record current-account surplus. This suggests that private capital is now flowing out of China.
Charles Dumas, an economist at Lombard Street Research, argues that outflows of hot money could become a flood if China did not have capital controls. Currency “manipulation” amounts to more than foreign-exchange intervention; China also has strict capital controls which, although leaky, keep private savings at home. If Beijing scrapped those controls, firms and households would want to invest abroad to diversify their assets. In other words, if the value of the yuan was not “manipulated” and instead was set entirely by the free market, it might fall, not rise.
Some argue that China’s large current-account surplus is incontrovertible proof that the yuan is too cheap. Morris Goldstein and Nicholas Lardy, at the Peterson Institute for International Economics in Washington, DC, estimate that the yuan’s real trade-weighted value needs to rise by another 10-20% to eliminate the surplus. But other economists say it is wrong to define the yuan’s fair value by the revaluation required to eliminate the current-account surplus. Trade does not have to be perfectly balanced to be fair. And China’s surplus partly reflects its high saving rate. A stronger yuan will help to shift growth away from exports towards domestic consumption, but is unlikely to do so on its own. In 2005 Messrs Goldstein and Lardy reckoned that the yuan was 20-25% undervalued; it has since risen by that, yet the surplus has doubled. To reduce China’s external gap, policies to boost domestic spending will be more important than its exchange rate.
Beefing up the argument
An alternative way of defining the “fair” value of a currency is purchasing-power parity (PPP): the idea that, in the long run, exchange rates should equalise prices across countries. The Economist’s Big Mac index offers a crude estimate of how far exchange rates are from PPP. Our January update found that a Big Mac cost 48% less in China than in America, which might suggest that the yuan is 48% undervalued against the dollar. But by this gauge, the currencies of virtually all low-income countries are undervalued, since prices are generally lower in these countries than in rich ones (see right-hand chart, above). This is the basis of the Balassa-Samuelson theory which holds that average prices will be higher in countries with higher productivity (ie, high GDP per head), because higher wages will push up prices in labour-intensive goods and services. This implies that it is natural for China’s exchange rate to be below its PPP, but as it gets richer and productivity rises, its real exchange rate should rise.
PPP is a long-term concept. However, the relationship between prices and GDP per head can be used to estimate the short-term fair value of a currency relative to others. Using a simple model, which adjusts the Big Mac index for differences in countries’ GDP per head and relative labour costs, gives the result that the yuan is now less than 5% undervalued.
A new study* by Yin-Wong Cheung, Menzie Chinn and Eiji Fujii arrives at a similar result using World Bank price data across the whole economy. Previous assessments of such data had found that the yuan was around 40% undervalued. But the latest price surveys have raised the estimated price level in China (and so reduced GDP per head measured at PPP). The authors conclude that the yuan was 10% undervalued against the dollar in 2006, which means that it might now be close to parity.
The evidence that the yuan is significantly undervalued is hardly rock-solid. It probably is still a bit too cheap, and it would certainly be a mistake for Beijing to allow it to fall, not least because this would risk a protectionist backlash from abroad. In the longer term, the yuan needs to keep rising against a basket of currencies. But for now, some of the accusations being thrown at China are wide of the mark.
Children of the revolution
Young Iranians
Children of the revolution
Iran’s young people have mixed feelings about the country’s 30-year-old revolution
THE old American embassy in Tehran is known as the “nest of spies”. On its walls are lurid murals depicting the Statue of Liberty with a ghastly skull for a face and guns decorated with the stars and stripes. It was here that a group of students held 52 American diplomats hostage for 444 days from November 1979. The remaking of Iran was in its early months, following the overthrow of Shah Mohammad Reza Pahlavi and the establishment of the Islamic Republic in February that year. The hostage crisis helped to seal the world’s view of post-revolution Iran as a country of religious fundamentalists.
Iran’s relations with America and the rest of the outside world have improved a little since then but any hopes of a greater thaw under America’s new president, Barack Obama, received an early hit. An American women’s badminton team were denied visas to visit Iran for a tournament starting on Friday February 6th timed to celebrate the revolution. And on the same day the offices of the British Council, a cultural organisation that seeks to build links, particularly between young people from both countries, was forced to close by the Iranian authorities after months of intimidation and harassment.
Iran’s curtailment of outside influences on its numerous students and young people belies their important role in the downfall of the shah 30 years ago. The hostage–taking showed just how far Iranian youth was prepared to go in support of change in the country. But three decades on, the children of the revolution feel differently about the upheaval in Iran.
Iran has a overwhelmingly youthful population. Some 60% of its 70m citizens are now under 30. This group did not experience the revolution directly. Nor did they suffer under the Shah’s rule that preceded it. They did not fight in Iran’s brutal and lengthy war with Iraq. They have grown up exclusively under Iran’s strange blend of theocracy and democracy and they are far from happy with it.
Since 1979 governments have varied in how much they have sought to control the lives of ordinary Iranians. Under the reformist rule of Muhammad Khatami, president between 1997 and 2005, young Iranians experienced the “Tehran spring”, a period of cautious political liberalisation that was accompanied by a slight relaxation of the strict rules governing behaviour. With the election of Mahmoud Ahmadinejad as president in 2005, that largely came to an end.
Young people have suffered disproportionately from their government’s economic failures. Iranians are generally extremely well-educated with high literacy rates and a soaring number of students. But once finished with university, many graduates struggle to find a job. With inflation running at around 25% and an estimated 3m unemployed, it is the young who are most affected. The rapid growth in population after the revolution was accompanied by rapid urbanisation: seven in ten Iranians now live in towns and cities. This has made it even harder for young people to find work.
With young people representing such a huge constituency, politicians are naturally anxious to win their support, particularly as presidential elections are due in June. Mr Ahmadinejad has established a $1.3 billion “love fund”, to subsidise marriage for poor Iranians. Without jobs or incomes, it is nigh on impossible to wed. Populist initiatives like this go down well but ultimately do little to address young Iranians’ more pressing concerns.
Many of Iran's youth are disenchanted with the revolution. The “Islamic democracy” offered by Mr Khatami failed to address their desire for a freer society. Mr Ahmadinejad’s conservatism has added to their woes. Young Iranians find a multiplicity of ways to rebel against the regime’s control: with alcohol fuelled parties, painted nails or flirtatious behaviour on the street.
Many outsiders, who dislike the regime and wish to see it fall, hope that Iran’s disaffected youth could bring about its demise. But the anger that many young people share at the failures of their government is unlikely to topple it. Though they may chafe at its restraints, religion remains important to many young Iranians. By and large, they do not wish to see Iran become a secular country and few would describe themselves as atheists. But they would rather see Islam confined to their private lives and eliminated from the public sphere.
More importantly, young Iranians have a strong sense of national pride. They may grumble about the strictures of the Islamic Republic and the failings of Mr Ahmadinejad but there is little sign that they want to dispense with the revolution just yet. Like the founding fathers of the revolution, they resent fiercely any hint of Western meddling in Iranian affairs. They may be unhappy with their leaders and resent their rule, but they will rally round them in the face of outside attack.
Afghanistan Will Be a Quagmire for al Qaeda
Afghanistan Will Be a Quagmire for al Qaeda
The war on terror will end once we've empowered the Muslim majority to stand up against extremists.
JOSEPH LIEBERMAN
Although President Barack Obama and all of us in Congress are understandably focused on the economic crisis, we also face multiple crises in the rest of the world -- beginning with the war in Afghanistan. Security there has been deteriorating as the insurgents have grown in strength, size and sophistication, expanding their influence over an increasing swath of territory.
Reversing the downward spiral will not be easy. But as Gen. David Petraeus once said of another war, "Hard is not hopeless." And we possess considerable strengths in this fight.
The biggest strength is the American military, which through the crucible of Iraq has transformed itself into the most effective counterinsurgency force in history. Although Iraq and Afghanistan are very different, many of the guiding principles of counterinsurgency do apply to both theaters -- most importantly, the need to provide security for the population. Moreover, our troops will be redeploying from Iraq to Afghanistan with the momentum, experience and morale that comes with success.
We also have an ally in the Afghan people -- a proud people with a proud history. Although their frustration with our coalition is growing, Afghans are not eager to return to the tyranny and poverty of the Taliban. That is why the insurgents have not won their support and must resort to self-defeating tactics of cruelty and coercion.
The other critical strength, and reason for hope, is the broad support for success in Afghanistan in the new administration and Congress. Mr. Obama has made clear this is a war he intends to win. He has pledged to deploy more troops and appointed one of our most talented diplomats, Ambassador Richard Holbrooke, as special envoy for Afghanistan and Pakistan. The combination of Mr. Holbrooke and Gen. Petraeus led by Secretary of State Hillary Clinton and Secretary of Defense Robert Gates is not a team to bet against.
That, then, is the good news. The bad news is that, even if we do everything right, conditions are likely to get worse before they get better, and the path ahead will still be long, costly and hard. The president's pledge to send more troops to Afghanistan is absolutely necessary and right -- but turning the tide will take more than additional troops. In fact, we must match the coming surge in troop strength with at least five other "surges" equally important to success.
- First and most importantly, we need a surge in the strategic coherence of the war effort. As we learned in Iraq, success in counterinsurgency requires integrating military and civilian operations into a seamless and unified strategy. In Afghanistan, we do not have in place a nationwide, civil-military campaign plan to defeat the insurgency.
This is an unacceptable failure. It is also the predictable product of a balkanized military command structure, in which different countries are left to pursue different strategies in different places. The international civilian effort in Afghanistan is even more disorganized, as well as unsynchronized with the military.
Unquestionably, it is a good thing so many countries are contributing to the fight in Afghanistan, and we owe a great debt of gratitude to our allies for their sacrifices. But we also owe them success, and that demands an integrated campaign plan and stronger American leadership.
- Second, we need a surge in civilian capacity. The U.S. Embassy in Kabul needs to be transformed and expanded, with the necessary resources and the explicit direction to work side by side with the military at every level. In particular, the civilian presence must be ramped up outside our embassy -- at the provincial, district and village levels, embedding nonmilitary experts with new military units as they move in.
- Third, we need to help surge the Afghan war effort. This means expanding the Afghan army to 200,000 or more, and ensuring they are properly equipped, paid and mentored.
The U.S. needs to take tough action to combat the pervasive corruption that is destroying the Afghan government and fueling the insurgency. This requires a systemic response, not just threatening specific leaders on an ad hoc basis. Specifically, we must invest comprehensively in Afghan institutions, both from top-down and bottom-up.
In doing so, the U.S. should embrace a policy of "more for more" -- specifically, by offering the Afghan government a large-scale, 10-year package of governance and development aid in exchange for specific benchmarks on performance and progress.
- Fourth, we need a surge in our regional strategy. As many have observed, almost all of Afghanistan's neighbors are active in some way inside that country. Some of this activity is positive -- for instance, aid and investment -- but much of it is malign, providing support to insurgent groups. We must help "harden" Afghanistan by strengthening its institutions at both the national and local levels, empowering Afghans to stop their neighbors from using their country as a geopolitical chessboard.
The U.S. can help by beginning to explore the possibility of a bilateral defense pact with Kabul, which would include explicit security guarantees.
Some neighbors are hedging their bets today because they fear what happens "the day after" America grows tired and disengages from the region, as we did once before, after the Soviet withdrawal from Afghanistan. Nothing will discourage this destabilizing behavior better than a long-term American commitment to Afghanistan.
- Fifth, success in Afghanistan requires a sustained surge of American political commitment to the mission. Fortunately, and unlike Iraq, the Afghan war still commands bipartisan support in Congress and among the American people. But as more troops are deployed to Afghanistan and casualties rise, this consensus will be tested.
Indeed, there are already whispers on both the left and the right that Afghanistan is the graveyard of empires, that we should abandon any hope of nation-building there, additional forces sent there will only get bogged down in a quagmire.
Why are these whisperings wrong? Why is this war necessary?
The most direct answer is that Afghanistan is where the attacks of 9/11 were plotted, where al Qaeda made its sanctuary under the Taliban, and where they will do so again if given the chance. We have a vital national interest in preventing that from happening.
It is also important to recognize that, although we face many problems in Afghanistan today, none are because we have made it possible for five million Afghan children -- girls and boys -- to go to school; or because child mortality has dropped 25% since we overthrew the Taliban in 2001; or because Afghan men and women have been able to vote in their first free and fair elections in history.
On the contrary, the reason we have not lost in Afghanistan -- despite our missteps -- is because America still inspires hope of a better life for millions of ordinary Afghans and has worked mightily to deliver it. And the reason we can defeat the extremists is because they do not.
This, ultimately, is how the war on terror will end: not when we capture or kill Osama bin Laden or Mullah Omar -- though we must do that too -- but when we have empowered and expanded the mainstream Muslim majority to stand up and defeat the extremist minority.
That is the opportunity we have in Afghanistan today: to make that country into a quagmire, not for America but for al Qaeda, the Taliban and their fellow Islamist extremists, and into a graveyard in which their dreams of an Islamist empire are finally buried.
Mr. Lieberman is an Independent Democratic senator from Connecticut. This op-ed is adapted from a speech he delivered last week at the Brookings Institution.
Bracing Ourselves
Bracing Ourselves
America prepares for the worst, and Republicans suddenly seem serious.
All week the word I kept thinking of was "braced." America is braced, like people who are going fast and see a crash ahead. They know huge and historic challenges are here. They're not confident they can or will be met. Our most productive citizens are our most sophisticated, and our most sophisticated have the least faith in the ability of our institutions to face the future and get us through whole. They have the least faith because they work in them.
Tuesday I talked to people who support a Catholic college. I said a great stress is here and coming, and people are going to be reminded of what's important, and the greatest of these will be our faith, it's what is going to hold us together as a country. As for each of us individually, I think it's like the old story told about Muhammad Ali. It was back in the 1960s and Mr. Ali, who was still Cassius Clay, was a rising star of boxing, on his way to being champ. One day he was on a plane, going to a big bout. He was feeling good, laughing with friends. The stewardess walked by before they took off, looked down and saw that his seatbelt was unfastened. She asked him to fasten it. He ignored her. She asked him again, he paid no attention. Now she leaned in and issued an order: Fasten the seatbelt, now. Mr. Clay turned, looked her up and down, and purred, "Superman don't need no seatbelt."
She said, "Superman don't need no airplane. Buckle up." And he did.
We all think we're supermen, and we're not, and you're lucky to have a faith that both grounds you and catches you.
But during the part in which I spoke in rather stark terms of how I see the future, I think I saw correctly that the physical attitude of some in the audience was alert, leaned forward: braced. Again, like people who know a crash is coming. Afterward I asked an educator in the audience if I was too grim. He looked at me and said simply: No.
A sign of the times: We had a good time at lunch. It is an era marked by deep cognitive dissonance. Your long-term thoughts are pessimistic, and yet you're cheerful in the day to day.
On Wednesday, in an interview with Politico, Dick Cheney warned of the possible deaths of "perhaps hundreds of thousands" of Americans in a terror attack using nuclear or biological weapons. "I think there is a high probability of such an attempt," he said.
When the interview broke and was read on the air, I was in a room off a television studio. For a moment everything went silent, and then a makeup woman said to a guest, "I don't see how anyone can think that's not true."
I told her I'm certain it is true. And it didn't seem to me any of the half dozen others there found the content of Cheney's message surprising. They got a grim or preoccupied look.
The question for the Obama administration: Do they think Mr. Cheney is essentially correct, that bad men are coming with evil and deadly intent, but that America can afford to, must for moral reasons, change its stance regarding interrogation and detention of terrorists? Or, deep down, do the president and those around him think Mr. Cheney is wrong, that people who make such warnings are hyping the threat for political purposes? And, therefore, that interrogation techniques, etc., can of course be relaxed? I don't know the precise answer to this question. Do they know exactly what they think? Or are they reading raw threat files each day trying to figure out what they think?
The bad thing about new political eras is that everyone within them has to learn everything for the first time. Every new president starts out fresh, in part because he doesn't know what he doesn't know. Ignorance keeps you perky.
On the economy, I continue to find no one, Democrat or Republican, who has faith that the stimulus bill passed by the House will solve anything or make anything better, though many argue that doing absolutely nothing will surely make things worse by not promising at least the possibility of improvement through action.
Meanwhile, the inquest on President Obama's great stimulus mistake continues.
His serious and consequential policy mistake is that he put his prestige behind not a new way of breaking through but an old way of staying put. This marked a dreadful misreading of the moment. And now he's digging in. His political mistake, which in retrospect we will see as huge, is that he remoralized the Republicans. He let them back in the game.
Mr. Obama has a talent for reviving his enemies. He did it with Hillary Clinton, who almost beat him after his early wins, and who was given the State Department. He has now done it with Republicans on the Hill. This is very nice of him, but not in his interests. Mr. Obama should have written the stimulus bill side by side with Republicans, picked them off, co-opted their views. Did he not understand their weakness? They had no real position from which to oppose high and wasteful spending, having backed eight years of it with nary a peep. They started the struggle over the stimulus bill at a real disadvantage. Then four things: Nancy Pelosi served up old-style pork, Mr. Obama swallowed it, Republicans shocked themselves by being serious, and then they startled themselves by being unified. But it was their seriousness that was most important: They didn't know they were! They hadn't been in years!
One senses in a new way the disaster that is Nancy Pelosi. She was all right as leader of the opposition in the Bush era, opposition being joyful and she being by nature chipper. She is tough, experienced, and of course only two years ago she was a breakthrough figure, the first female speaker. But her public comments are often quite mad—we're losing 500 million jobs a month; here's some fresh insight on Catholic doctrine—and in a crisis demanding of creativity, depth and the long view, she seems more than ever a mere ward heeler, a hack, a pol. She's not big enough for the age, is she? She's not up to it.
Whatever happens in the Senate, Republicans have to some degree already won. They should not revert to the triumphalism of the Bush era, when they often got giddy and thick-necked and spiked the ball. They should "act like they been there before." They should begin to seize back the talking mantle from the president. And—most important—they must stay serious.
The national conversation on the economy is frozen, and has been for a while. Republicans say tax cuts, tax cuts, tax cuts. Democrats say spend, new programs, more money. You can't spend enough for the Democratic base, or cut taxes enough for the Republican. But in a time when all the grown-ups of America know spending is going to bankrupt us and tax cuts without spending cuts is more of the medicine that's killing us, the same old arguments, which sound less like arguments than compulsive tics, only add to the public sense that no one is in chargeObama's Trade Deflection
Obama's Trade Deflection
Will he stand up to his own party's protectionists?
Amid the bacchanal that is the Beltway stimulus debate, a rare note of sobriety has sounded. President Obama exercised some leadership on trade this week, and the Senate proceeded to water down the "Buy American" provisions in the House version.
It ain't over until Nancy Pelosi sings, but if the Senate prevails in conference a nascent trade war will have been averted, at least for now. The world is warily watching the new Obama Administration for protectionist signals, after his campaign promises to get tough with our trading partners. Mr. Obama let the House run wild with language demanding procurement rules that clearly violate U.S. commitments as part of the World Trade Organization. That drew protests from Canada, Brazil, Australia and Europe, among other friends of the U.S.
Asked about this on Fox News, Mr. Obama said, "I agree that we can't send a protectionist message." He added that it would be a mistake "at a time when world-wide trade is declining, for us to start sending a message that somehow we're just looking after ourselves and not concerned with world trade."
The Senate followed by amending its earlier draft, which had been even more protectionist than the House. Now the Senate language says "buy American" provisions cannot violate U.S. international agreements.
For a taste of the damage that might have been done, look no further than Brazil. Reacting to the U.S. stimulus proposals, the ministry of development in Brasilia announced that 3,000 new items would be added to the list requiring import licensing. As one source explained to us, this was a "'buy American' provision, Brazilian style."
Brazilian auto makers and the electronics industry resisted the move because they use imported components to maintain their competitiveness. And a brawl broke out inside President Luis Inacío "Lula" da Silva's government. Lula reversed the decision, explaining that he did "not want Brazil being identified with protectionism." That's a sign of Brazil's growing economic and political maturity.
Let's hope the U.S. doesn't go the other way. Even as Mr. Obama was warning against a trade war, Washington state Democrat Brian Baird was lecturing a Brazilian journalist at the annual Davos confab that the world was just "going to have to swallow the [buy-American] clause." This is crude and dangerous politics. Mr. Obama is moving in the right direction on trade, but he's going to have to spend some of his own political capital standing up to the most parochial elements in his own party.
Banks Should Raise Prices in a Recession
Banks Should Raise Prices in a Recession
In working on my forthcoming book dealing with the Great Depression, I noticed something intriguing about the discount rate of the Fed. Oh wait, I should first clarify — I'm talking about the New York Federal Reserve Bank, because the Fed banks had more autonomy in the beginning, and so you couldn't talk of "the Fed's" discount rate.
What I noticed is that from the time it opened its doors in November 1914, all the way through 1931, the New York Fed charged its record-low rates at the very end of this period. The "discount rate" was the interest rate the Fed banks would charge on collateralized loans made to member banks. For the New York Fed, rates had bounced around since its founding, but they were never higher than 7 percent and never lower than 3 percent, going into 1929.
This changed after the stock-market crash. On November 1, just a few days following Black Monday and Black Tuesday — when the market dropped almost 13 percent and then almost 12 percent back to back — the New York Fed began cutting its rate. It had been charging banks 6 percent going into the Crash, and then a few days later it slashed by a full percentage point.
Then, over the next few years, the New York Fed periodically cut rates down to a record low of 1 ½ percent by May 1931. It held the rate there until October 1931, when it began hiking to stem a gold outflow caused by Great Britain's abandonment of the gold standard the month before. (Worldwide investors feared the United States would follow suit, so they started dumping their dollars while the American gold window was still open.)
The Fed Hiked Rates During the Depression of 1920–1921
So far my story doesn't sound unusual. "Everybody knows" that the Fed is supposed to slash rates to ease liquidity crunches during a financial panic. It helps to ease the crisis, and provides a softer landing than if the supply of credit were fixed.
But guess what? Throughout the period we are considering, the highest the New York Fed ever charged banks was 7 percent. And the only time it did that was smack dab in the middle of the 1920–1921 depression.
Although you've probably never heard of it, this earlier depression was quite severe, with unemployment averaging 11.7 percent in 1921. Fortunately, it was over fairly quickly; unemployment was down to 6.7 percent in 1922, and then an incredibly low 2.4 percent by 1923.
After working on these issues for my book, it suddenly became obvious to me: the high rates of the 1920–1921 depression had certainly been painful, but they had cleaned the rot out of the structure of production very thoroughly. The US money supply and prices had roughly doubled during World War I, and the record-high discount rate starting in June 1920 was a pressure washer on the malinvestments that had festered during the war boom.
Going into 1923, the capital structure in the United States was a lean, mean, producing machine. In conjunction with Andrew Mellon's incredible tax cuts, the Roaring Twenties were arguably the most prosperous period in American history. It wasn't merely that the average person got richer. No, his life changed in the 1920s. Many families acquired electricity and cars for the first time during this decade.
Why Central Banks Should Raise Rates in a Panic
In contrast, during the early 1930s, the Fed's rate cuts "for some reason" didn't seem to do the trick. In fact, they sowed the seeds for the worst decade in US economic history.
Now let's be clear, I am not merely arguing from historical correlations. There is a perfectly good theoretical explanation for why the record-high rates in the early 1920s were the right policy, while the record-low rates in the early 1930s were the wrong policy. We quote from Lionel Robbins, who wrote from a 1934 vantage point and applied the Mises-Hayek business-cycle theory to the world collapsing before his eyes:
Now in the pre-war business depression a very clear policy had been developed to deal with this situation. The maxim adopted by central banks for dealing with financial crises was to discount freely on good security, but to keep the rate of discount high. Similarly in dealing with the wider dislocations of commodity prices and production no attempt was made to bring about artificially easy conditions. The results of this were simple. Firms whose position was fundamentally sound obtained what relief was necessary. Having confidence in the future, they were prepared to foot the bill. But the firms whose position was fundamentally unsound realised that the game was up and went into liquidation. After a short period of distress the stage was once more set for business recovery.
It's actually easier to see if you forget about a central bank, and just pretend that we were living in the good old days when banks would compete with each other and there was no cartelizing overseer. Now in this environment, when a panic hits and most people realize that they haven't been saving enough — that they wish they were holding more liquid funds right this moment than their earlier plans had provided them — what should the sellers of liquid funds do?
The answer is obvious: they should raise their prices. The scarcity of liquid funds really has increased after the bubble pops, and its price ought to reflect that new information. People need to know how to change their behavior, after all, and market prices mean something.
But in more modern times, thanks not just to Keynes but, more important, to Milton Friedman, central bankers now think that during the sudden liquidity crunch, they are supposed to shovel their product out the door. But in order to do that, of course, they have to water down its potency. It's as if a wine dealer suddenly has a rush of customers for a rare vintage of which he only has 3 bottles, and his response is to put the vintage on sale but then dilute it with 9 parts water to 1 part wine. That way he can sell to all the eager customers and not pick their pocket at the same time.
Now I know there is a big dispute in the Austrian-libertarian academic world over whether banks in a legitimately free market would have 100% hard-money reserves in the vault, or if banks would be allowed to lend out some of their customers' checking-account deposits to other customers. I'm not taking a stand on that here.
What I am saying, though, is that if we decide banks ought to be able to engage in fractional-reserve lending — so that the total supply of credit can be expanded if the banks want to stretch their reserves thinner — then we still agree that the unit price of that expanded credit issue ought to be higher.
If the owner of a trucking company experiences a huge rush for his services, he might decide to postpone essential maintenance on his fleet, to take advantage of the unprecedented demand. But during this period he will be charging record shipping prices to make it worth his while to deviate from the normal, "safe" way of running his business. He will only be willing to bear the extra risk (either to the safety of his drivers or just the long-term operation of the trucks) if he is being compensated for it.
The same is true for the banks. Just as every other business during a recession wants to bolster its cash reserves, so too with the business that rents out cash reserves. If there's a hurricane, the stores selling flashlights and generators should raise the prices on those essential items, to make sure they are rationed correctly. The same is true for liquidity — the moment after the community realizes they are in desperate need of it.
Conclusion
It was a good thing for Americans that Herbert Hoover — regardless of his other disastrous policies — did not want the United States to abandon the gold standard. Because its gold reserves were plummeting, the Fed had no choice but to reverse its disastrous course in late 1931. The next two years were awful, but that was because so much capital had been squandered in the boom and then in the easy-money collapse.
FDR was sworn into office in March 1933. Had he followed the same pattern as Warren Harding and Calvin Coolidge — i.e., had he basically kept the federal government out of it — Americans might have looked back at the Great Interruption, referring to the three-year gap between the Roaring Twenties and the Zooming Thirties.
Switching to today, the sad fact is that Ben Bernanke and the other central bankers of the world do not have any feedback on their behavior. There is no dwindling stock of gold reserves to signal to them that they are doing something horribly wrong. Like all central planners, they are groping in the dark, as Mises said.
Although the dollar is no longer tied to gold, that will not stop the dollar price of gold from exploding when more investors realize that no one, not even a sharp guy like Ben Bernanke, ought to hold the fate of the world's economy in his hands.
Thursday, February 5, 2009
Why 'Stimulus' Will Mean Inflation
Why 'Stimulus' Will Mean Inflation
In a global downturn the Fed will have to print money to meet our obligations.
GEORGE MELLOAN
As Congress blithely ushers its trillion dollar "stimulus" package toward law and the U.S. Treasury prepares to begin writing checks on this vast new appropriation, it might be wise to ask a simple question: Who's going to finance it?
![[Commentary]](http://s.wsj.net/public/resources/images/OB-DB924_oj_mel_E_20090205224128.jpg)
Chad CroweThat might seem like a no-brainer, which perhaps explains why no one has bothered to ask. Treasury securities are selling at high prices and finding buyers even though yields are low, hovering below 3% for 10-year notes. Congress is able to assure itself that it will finance the stimulus with cheap credit. But how long will credit be cheap? Will it still be when the Treasury is scrounging around in the international credit markets six months or a year from now? That seems highly unlikely.
Let's have a look at the credit market. Treasurys have been strong because the stock market collapse and the mortgage-backed securities fiasco sent the whole world running for safety. The best looking port in the storm, as usual, was U.S. Treasury paper. That is what gave the dollar and Treasury securities the lift they now enjoy.
But that surge was a one-time event and doesn't necessarily mean that a big new batch of Treasury securities will find an equally strong market. Most likely it won't as the global economy spirals downward.
For one thing, a very important cycle has been interrupted by the crash. For years, the U.S. has run large trade deficits with China and Japan and those two countries have invested their surpluses mostly in U.S. Treasury securities. Their holdings are enormous: As of Nov. 30 last year, China held $682 billion in Treasurys, a sharp rise from $459 billion a year earlier. Japan had reduced its holdings, to $577 billion from $590 billion a year earlier, but remains a huge creditor. The two account for almost 65% of total Treasury securities held by foreign owners, 19% of the total U.S. national debt, and over 30% of Treasurys held by the public.
In the lush years of the U.S. credit boom, it was rationalized that this circular arrangement was good for all concerned. Exports fueled China's rapid economic growth and created jobs for its huge work force, American workers could raise their living standards by buying cheap Chinese goods. China's dollar surplus gave the U.S. Treasury a captive pool of investment to finance congressional deficits. It was argued, persuasively, that China and Japan had no choice but to buy U.S. bonds if they wanted to keep their exports to the U.S. flowing. They also would hurt their own interests if they tried to unload Treasurys because that would send the value of their remaining holdings down.
But what if they stopped buying bonds not out of choice but because they were out of money? The virtuous circle so much praised would be broken. Something like that seems to be happening now. As the recession deepens, U.S. consumers are spending less, even on cheap Chinese goods and certainly on Japanese cars and electronic products. Japan, already a smaller market for U.S. debt last November, is now suffering what some have described as "free fall" in industrial production. Its two champions, Toyota and Sony, are faltering badly. China's growth also is slowing, and it is plagued by rising unemployment.
American officials seem not to have noticed this abrupt and dangerous change in global patterns of trade and finance. The new Treasury secretary, Timothy Geithner, at his Senate confirmation hearing harped on that old Treasury mantra about China "manipulating" its currency to gain trade advantage. Vice President Joe Biden followed up with a further lecture to the Chinese but said the U.S. will not move "unilaterally" to keep out Chinese exports. One would hope not "unilaterally" or any other way if the U.S. hopes to keep flogging its Treasurys to the Chinese.
The Congressional Budget Office is predicting the federal deficit will reach $1.2 trillion this fiscal year. That's more than double the $455 billion deficit posted for fiscal 2008, and some private estimates put the likely outcome even higher. That will drive up interest costs in the federal budget even if Treasury yields stay low. But if a drop in world market demand for Treasurys sends borrowing costs upward, there could be a ballooning of the interest cost line in the budget that will worsen an already frightening outlook. Credit for the rest of the economy will become more dear as well, worsening the recession. Treasury's Wednesday announcement that it will sell a record $67 billion in notes and bonds next week and $493 billion in this quarter weakened Treasury prices, revealing market sensitivity to heavy financing.
So what is the outlook? The stimulus package is rolling through Congress like an express train packed with goodies, so an enormous deficit seems to be a given. Entitlements will go up instead of being brought under better control, auguring big future deficits. Where will the Treasury find all those trillions in a depressed world economy?
There is only one answer. The Obama administration and Congress will call on Ben Bernanke at the Fed to demand that he create more dollars -- lots and lots of them. The Fed already is talking of buying longer-term Treasurys to support the market, so it will be more of the same -- much more.
And what will be the result? Well, the product of this sort of thing is called inflation. The Fed's outpouring of dollar liquidity after the September crash replaced the liquidity lost by the financial sector and has so far caused no significant uptick in consumer prices. But the worry lies in what will happen next.
Even when the economy and the securities markets are sluggish, the Fed's financing of big federal deficits can be inflationary. We learned that in the late 1970s, when the Fed's deficit financing sent the CPI up to an annual rate of almost 15%. That confounded the Keynesian theorists who believed then, as now, that federal spending "stimulus" would restore economic health.
Inflation is the product of the demand for money as well as of the supply. And if the Fed finances federal deficits in a moribund economy, it can create more money than the economy can use. The result is "stagflation," a term coined to describe the 1970s experience. As the global economy slows and Congress relies more on the Fed to finance a huge deficit, there is a very real danger of a return of stagflation. I wonder why no one in Congress or the Obama administration has thought of that as a potential consequence of their stimulus package.
Mr. Melloan is a former deputy editor of the Journal's editorial page.
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