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Monetary policy, fear of commitment and the power of infinity

This is a fascinating time to be thinking about monetary policy…

Like everybody else, central banks can do two things:  they can talk, or they can act.

Some people say that talk is cheap and, in any event, discretion implies bias.

Other people point out that things like central bankers’ concern for their reputation mean that it’s perfectly possible to promise today to implement history-dependent policy tomorrow. Some cheeky people like to point out that this amounts to saying that, when in a slump, a central bank should “credibly commit to being irresponsible” in the future.

In fact, some people argue (pdf) that, in my words, “all monetary policy is, fundamentally, about expectations of the future.”  But if that’s the case, why act at all? Why not just talk and stay away from being a distorting influence in the markets?

There are two reasons: First, since since talk is cheap, credibility requires that people know that you can and, if necessary, will act to back it up (talk softly and carry a big stick). Second, because if you can convince people with actions today, you don’t need to explicitly tell them what your policy rule will be tomorrow and central bankers love discretion because no rule can ever capture what to do in every situation and well, hey … a sense of mystery is sexy.

OMO stands for “Open Market Operation”. It’s how a central bank acts.  Some scallywags like to say that when a central bank talks, it’s an “Open Mouth Operation.” Where it gets fun (i.e. complicated) is that often a central bank’s action can be just a statement if the stick they’re carrying to back it up is big enough.

In regular times, a typical central bank action will be to announce an interest rate and a narrow band on either side of it. In theory, it could be any interest rate at all, but in practice they choose the interest rate for overnight loans between banks. They then commit to accepting in or lending out infinite amounts of money if the interest rate leaves that narrow band. Infinity is a very big stick indeed, so people go along with them.

So what should a central bank do when overnight interest rates are at (or close to) zero and the central bank doesn’t want to take them lower, but more stimulus is needed?

Woodford-ites say that you’ve got to commit, baby. Drop down to one knee, look up into the economy’s eye and give the speech of your life. Tell ’em what you promise to do tomorrow. Tell ’em that you’ll never cheat.  Pinky-swear it … and pray that they believe you.

Monetarists, on the other hand, cough politely and point out that the interest rate on overnight inter-bank loans is just a price and there are plenty of other prices out there. The choice of the overnight rate was an arbitrary one to start with, so arbitrarily pick another one!

Of course, the overnight rate wasn’t chosen arbitrarily. It was chosen because it’s the price that is the furthest away from the real economy and, generally speaking, central bankers hate the idea of being involved in the real economy almost as much as they love discretion. They watch it, of course. They’re obsessed by it. They’re guided by it and, by definition, they’re trying to influence it, but they don’t want to be directly involved. A cynic might say that they just don’t want to get their hands dirty, but a realist would point out that no matter the pain and joy involved in individual decisions in the economy, a cool head and an air of abstraction are needed for policy work and, in any event, a central banker is hardly an industrialist and is therefore entirely unqualified to make decisions at the coalface.

But as every single person knows, commitment is scary, even when you want it, so the whole monetarist thing is tempting. Quantitative Easing (QE) is a step along that monetarist approach, but the way it’s been done is different to the way that OMOs usually work. There has been no target price announced and while the quantities involved have been big (even huge), they have most definitely been finite. The result? Well, it’s impossible to really tell because we don’t know how bad things would have been without the QE. But it certainly doesn’t feel like a recovery.

Some transmission-mechanism plumbers think that the pipes are clogged (see also me).

Woodford-ites say that it’s because there’s no love, baby. Where’s the commitment?

Monetarists say that infinity is fundamentally different to just a really big number.

Market monetarists, on the other hand (yes, I’m sure you were wondering when I’d get to them), like to argue that the truth lies in between those last two. They say that it’s all about commitment (and without commitment it’s all worthless), but sometimes you need an infinitely big stick to convince people. They generally don’t get worked up about how close the central bank’s actions are to the real economy and they’re not particularly bothered with concrete steps.

So now we’ve got some really interesting stuff going on:

The Swiss National Bank (a year ago) announced a price and is continuing to deploy the power of infinity.

The European Central Bank has switched to infinity, but is not giving a price and is not giving any forward guidance.

The Federal Reserve has switched to infinity and is giving some forward guidance on their policy decision rule.

The Bank of England is trying to fix the plumbing.

It really is a fascinating time to be thinking about this stuff.

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Terrible news from Apple (AAPL)

Apple just reported their profits for 2011Q4.  It turns out that they made rather a lot of money.  So much, in fact, that they blew past/crushed/smashed expectations as their profit more than doubled on the back of tremendous growth in sales of iPhones and iPads.  [snark] I’ll bet nobody’s talking about Tim Cook being gay now. [/snark]

It’s an incredible result; stunning, really. I just wish it didn’t make me so depressed.

I salute the innovation and cheer on the profits. That is capitalism at its finest and we need more of it.

It’s that f***king mountain of cash (now up to $100 billion) that concerns me, because it’s symptomatic of what is holding America (and Britain) in the economic doldrums.

The return Apple will be getting on that cash will be miniscule, if it’s positive at all, and conceivably negative.  Standing next to that, their return on assets excluding cash is phenomenal.

Why aren’t they doing something with the cash? Are they not able to expand profits still further by expanding quantities sold, even in new markets? Are there no new internal projects to fund? No competitors to buy out? Why not return it to shareholders via dividends or share buybacks?

Logically, a company holds cash for some combination of three reasons: (a) they use it to manage cash flow; (b) they can imagine buying an outside asset (a competitor or some other company that might complement them) in the near future and they want to be able to move quickly (and there’s no M&A deal that’s agreed upon faster than an all cash deal); or (c) they want to demonstrate a degree of security to offset any market perceived risk with their debt.

Apple long ago surpassed all of these benefits.  The net marginal value of Apple holding an extra dollar of cash is negative because it returns nothing and incurs a lost opportunity cost.  So why aren’t their shareholders screaming at them for wasting the opportunity?

The answer, so far as I can see, is because a significant majority of AAPL’s shareholders are idiots with a short-term focus. They have no goddamn clue where else the money should be and they’re just happy to see such a bright spot in their portfolio.  Alternatively, maybe the shareholders aren’t complete idiots — Apple’s P/E ratio has been falling for a while now — but the fundamental point is that they have a mountain of cash that they’re not using.

In 2005 that wouldn’t have been as much of a problem because the shadow banking system was in full swing, doing the risk/liquidity/maturity transformation thing that the financial industry is meant to do and so getting that money out to the rest of the economy.[*] Now, the transformation channel is broken, or at least greatly impaired, and so nobody makes any use of Apple’s billions. They just sit there, useless as f***, while profitable SMEs can’t raise funds to expand and 15% of all Americans are on food stamps.

Don’t believe me?  Here’s a graph from the Bank of England showing year-over-year changes in lending to small- and medium-sized enterprises in the UK.  I can’t be bothered looking for the equivalent data for the USA, but you can rest assured it looks similar.  The report it’s from can be found here (it was published only a few days ago).  The Economist’s Free Exchange has some commentary on it here (summary:  we’re still in trouble).

So what is happening to all that money?  Well, Apple can’t exactly stick it in a bank account, so they repo it, which is a fancy way of saying that they lend it to a bank (or somebody else in the financial industry) and temporarily take some high quality asset like a US government bond to hold as collateral.  They repo it because that’s all they can do now — there are no AAA-rated, actually safe, CDO tranches being created by the shadow banking system any more, they’re too big to make use the FDIC’s guarantee (that’s an excellent paper, btw … highly recommended) and so repo is all they have left.

But the financial industry is stuck in a disgusting mess like some kid’s hair with chewing gum rubbed through it. They’re all just as scared as the next guy (especially of the Euro problems) and so they’re parking it in their own accounts at the Fed and the BoE.  As a result, “excess” reserves remain at astronomical levels and the real economy makes no use of Apple’s billions.

That’s a tragedy.

 

 

 

[*] Yes, the shadow banking industry screwed up. They got caught up in real estate fever and sent (relatively) too much money towards property and too little towards more sustainable investments. They structured things in too opaque a manner, failed to have public price discovery and operated under distorted incentives. But they operated. Otherwise useless cash was transformed into real investment and real jobs. Unless that comes back, America and the UK will stay in their slow, painful household deleveraging cycle for another frickin’ decade.

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It’s not a fiscal union and Cameron didn’t veto it

A fiscal union would have transfers from various parts of the union to various other parts over the business cycle.  A guarantee to stand behind somebody’s debt while simultaneously insisting that you’ll never actually need to cough up a cent because you’ve made them pinky swear is not a fiscal union.

A veto stops a thing from happening (think of the UN Security Council).  The fiscal compact is going to go ahead, just without Britain.  Therefore, Britain did not veto it; they declined to take part.

That is all.

Update:

Okay, that isn’t quite all.  Just to be clear, I think that Cameron did the wrong thing.  I believe that, at a minimum, he should have committed to bringing the proposal to the UK parliament.  It may well have been voted down at that point, but nevertheless it should have happened.  Parliament is sovereign in the UK.  This was a serious proposal with potentially significant consequences from either agreeing to it or walking away from it; the people of Britain deserved to have their elected representatives decide.

I am undecided on whether signing up to the pact would be in the best interests of the UK.

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Policy options for the Euro area [Updated]

I here list a few policy options for the Euro area that I support, broadly in descending order of my perception of their importance.  Everything here is predicated on an assumption that the Euro itself is to survive and that no member nation of the Euro area is to exit the union.  I don’t claim that this would solve the crisis — who would make such a claim? — but they would all be positive steps that increase the probability of an ultimate solution being found.

  • Immediately establish a single, Euro area-wide bank deposit guarantee scheme.  A single currency must absolutely ensure that a Euro held as money in Greece be the same as a Euro held as money in Germany.  That means that retail and commercial deposits in each should be backed by the same guarantee.  I have no firm opinion on how it should be funded.  The classic manner is through a fee on banks proportional to their deposits, but if Euro area countries ultimately prefer to use a Tobin-style tax on transactions, that’s up to them.  Just get the thing up and running.  Of course, a unified deposit guarantee also requires a unified resolution authority in the event of an insolvent bank collapsing.  There are many and varied forms that fiscal union can take; this is the most urgent of them all.  I am shocked that this does not already exist.
  • The ECB should switch from targetting current inflation to expected future inflation.  The Bank of England already does this.  Accepting that any effect of monetary policy on inflation will come through with a lag (or at least acknowledging that current inflation is backward looking), they “look through” current inflation to what they expect it to be over the coming few years.  This is important.  Current inflation in the Euro area — i.e. the rate of change over the last 12 months — is at 3%.  On the face of it, that might make an ECB policymaker nervous, but looking ahead, market forecasts for average inflation over the coming five years are as low as 0.85% per year in Germany.  They will be much lower for the rest of the Euro area.  Monetary policy in the Euro area is much, much too tight at the moment.  At the very least, (a) interest rates should be lowered; and (b) the ECB should announce their shift in focus toward forward inflation.
  • The ECB should start to speak more, publicly, about forms of current inflation that most affect future inflation.  This follows on from my previous point, but is still logically distinct.  The Fed likes to focus on “core” inflation, stripped of items with particularly volatile price movements.  I don’t much care whether it is non-volatile prices or nominal wages, or even nominal GDP.  I just want the ECB to be speaking more about something other than headline CPI, because it is those other things that feed into future headlines.
  • The ECB’s provision of liquidity to the banking system, while currently large, is not nearly large enough.  The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this.  I currently have no opinion on whether this ought to be in the form of increasing the duration of loans to Euro area banks, relaxing the collateral requirements for loans or working with member countries’ treasuries to increase the provision of collateral.  I certainly believe (see my second point above) that interest rates should be lowered.  The point, as far as is possible, is to make replacing lost market funding with ECB funding more attractive to banks than deleveraging.
  • A great deal of Euro area sovereign debt is unsustainable; hair-cuts are inevitable and they should be imposed as soon as possible (but, really, this requires that a unified bank resolution authority be established first).  The argument for delaying relies on banks’ ability to first build up a cushion of capital through ongoing profitability.  When banks are instead deleveraging, the problem is made worse by waiting.
  • Credit Default Swaps must be permitted to trigger.  The crisis may have its origins in the the profligacy of wayward sovereigns (frankly, I think the origins lie in the Euro framers not appreciating the power of incentives), but the fundamental aspect of the crisis itself is that various financial assets, previously regarded as safe, are coming to be thought of as risky.  By denying market participants the opportunity to obtain insurance, Euro area policymakers are making the problem worse, not better.  Market willingness to lend to Greece in 2025 will in no way depend on how we label the decisions made in 2011 and 2012.
  • Every member of the Euro periphery should be in an IMF programme.  Yes, I’m looking at you, Italy.  If the IMF does not have sufficient funds to work with, the ECB should lend to it.  All politicians in Euro periphery countries should be speaking to their electorates about multi-decade efforts to improve productivity.  These things cannot be fixed in two or three years.  They can, at best, be put on the right path.
  • For every country in an IMF programme, all sovereign debt held by the ECB should be written down to the price at which they purchase it.   If the ECB buys a Greek government bond at, say, a 20% discount to face value, then that bond should be written down by 20%.  The ECB should not be in a position to make a profit from their trading if Europe finds its way through the overall crisis.  Similarly, the ECB should not be in a position to take a loss, either — they should not be required to take a hair-cut below the price they pay for Euro area sovereign debt.

Note that I have not yet used the phrase “Euro bond” anywhere.  Note, too, that a central bank is only meant to be a lender of last resort to banks.  The lender of last resort to governments is the IMF.

If Euro area policymakers really want to engage in a fiscal union (a.k.a. transfers) beyond the absolutely essential creation of a unified bank deposit guarantee scheme, it is perfectly possible to do so in a minimal fashion that does not lessen the sovereignty of any member nation:  Have a newly created European Fiscal Authority (with voluntary membership) provide the minimum universally agreed-on level of unemployment benefits across the entire area, funded with a flat VAT.  Any member country would retain the ability to provide benefits above and beyond the minimum.  This will have several benefits:

  • Since its membership would be voluntary and it would provide only the minimum universally agreed level, it cannot, by definition, constitute a practical infraction on sovereignty;
  • It will help provide pan-European automatic stabilisers in fiscal policy;
  • It will provide crucial intra-European stabilisation;
  • It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high; and
  • It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

———————-

Update 30 Nov 2011, 13:05 (25 minutes after first publishing the post):

It would appear that the world’s major central banks have announced a coordinated improvement in the provision of liquidity to banks.  This is a good thing. Press releases:

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Basel III will help fix the Euro

The Basel III compromise is out.  Via Free Exchange, you can read the text here.  Or you can just look at the BIS’s handy-dandy little chart:

Let me quote Ryan at Free Exchange:

The minimum common equity requirement has been increased from 2% to 4.5%. Common equilty is what is called “core” Tier 1 capital. Regulators have agreed on an additional 2.5% “conservation buffer”. Most large banks will likely maintain such a buffer, as falling below it will lead to additional regulatory scrutiny. The likely impact, then, is a pretty substantial increase in the common equity reserves banks need to hold.

What he said. Anyway …

The asterisk on the countercyclical buffer has this note against it: “Common equity or other fully loss absorbing capital”.  Here’s some more detail, from the press release itself:

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

In other words, the countercyclical buffer is expressly designed to allow for different rates of credit expansion across different countries.  This is excellent news for the Euro area, because (as I mentioned previously) it explicitly allows — heck, even encourages! — individual member countries to re-assert some control over monetary policy.  Remember that the level of credit in an economy is not just affected by demand for the stuff (which is itself influenced largely through interest rates), but also through the supply of the stuff, which falls under the umbrella of macro-prudential regulation (since, it is assumed, banks will generally supply all the credit they can subject to the restrictions of capital adequacy regulations).  The former may remain the remit of the ECB, but the latter can be economy-specific.

This is arguably desirable because, since the Euro-area economies are not perfectly synchronised, we have for many years seen monetary policy be overly tight for low-inflation countries like Germany and overly lax for high-inflation countries like Spain.

To some extent, one might view Germany’s reluctance to accept tighter capital requirements as evidence that they have been tacitly using this logic all along:  that is, they were already compensating for the (to them) overly-high interest rate with relatively lenient policies on the supply side.  To a German’s mind, it may therefore appear that with these higher minimum ratios, a neutral position for the German economy will require lower interest rates on average than previously prevailed.

The risk, from the Germans’ point of view, is that in a Eurozone world with higher capital ratios but lower interest rates, countries like Spain may be tempted to avoid making use of the countercyclical buffer and so may still end up with faster-than-ideal credit expansion.  How to convince the central banks and/or regulatory authorities in Mediterranean countries to be financially conservative, even when their governments aren’t, is clearly the next challenge.

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Improving the Euro

On BBC Radio 4, Jonathan Charles — the BBC’s European correspondent in the 1990s — has done a special on the Euro and the trouble it’s experiencing.  It’s well worth a listen if you have 40 minutes to spare.

It reminded me that I’d meant to write a post on two things I think ought to be done in improving the long-term outlook for the single currency.  None of this is particularly innovative, but I needed to put it down somewhere, so here it is.

First, a European Fiscal Institution (EFI)

At the start of February, when Greece and her public debt was dominating the news, I wrote:

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment. Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment. The latter is difficult in Europe with it’s multitude of languages, but not impossible.

Let me hang some meat on those not-even-bones.  I like the idea of a partially shared, European Fiscal Institution (EFI) that can conduct counter-cyclical spending, subject to strict limits on its mandate.  I am deliberately avoiding calling it an “authority” because that implies a certain freedom of action, which I oppose.  Instead, I think that an EFI should:

  • be limited to implementing commonly-agreed automatic stabilisers (in particular, a universally-agreed-upon minimum level of unemployment benefits);
  • be able to issue its own “Euro bonds”;
  • have a mandate to retain the very highest regard for the safety of its borrowing; and
  • be funded (and its bonds be guaranteed) by member countries in a manner part way between proportionate to population and proportionate to GDP.

I do not think that membership of such an institution should be required of any European country.  If a non-Euro country wants to be in it, fine.  If a Euro country wants to not be in it, fine.

The unemployment benefits provided would be the absolute minimum that everyone could agree on.  I want to emphasise that this should be extremely conservative.  If it ends up being just €100/week for the first month of unemployment, so be it; so long as it is something.  Member countries would provide additional support above the minimum as they see fit.

This will have several benefits:

  • It will help provide pan-European automatic stabilisation in fiscal policy.
  • It will provide crucial intra-European stabilisation.
  • It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high.
  • It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

Second, country-specific lending standards

A crucial problem with a single currency is that it imposes a one-size-fits-all monetary policy on all member states, even when those states’ economies are not perfectly synchronised.  Synchronisation was, and is, one of the requirements for accession to the Euro, but perfect synchronisation is impossible.  In particular, inflation rates have varied significantly across the Euro-area, meaning that the common-to-all interest rates set by the ECB have been, by necessity, too low for those economies with the highest rates of inflation (e.g. Spain) and too high for those with the lowest rates of inflation (e.g. Germany).

But the (causal) link from interest rates to inflation travels via the extension of credit to the private sector, and the level of credit is determined not just from the demand side (with agents responding to changes in interest rates), but also from the supply side (with banks deciding to whom and under what conditions they will grant credit).  Monetary authorities in individual member countries therefore retain the ability to influence the level of credit through regulatory influence on the supply of the same.

Altering reserve requirements for banks operating in one’s country would be the crudest version of this mechanism. A more modern equivalent would be changes to the minimum level for banks’ capital adequacy ratios.  Imagine if the Spanish banking regulators had imposed a requirement of 10% deposits on all mortgages from 2005.

I suspect that the new “macro-prudential” role of the Bank of England, in addition to its role of more conventional — and, with Q.E., unconventional — monetary policy will grant them the ability to engage this sort of control.  I think it will become more important over time, too, as the British economy continues its (to my mind inevitable) decline relative to the Euro-area, the UK moves closer to the textbook definition of a “small, open economy” and the BoE thus finds itself more constricted in their choice of interest rates.

Update 13 September 2010:

The new Basel III capital adequacy requirements are out and they appear to enable exactly this second idea.  Good!

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Note to self: holidaying in Greece will soon be cheap

Megan McArdle directs the world to this piece in the FT.  From the FT article:

The European Commission said on Tuesday it would endorse Athens’ plan to bring back under control the public sector deficit, which last year reached almost 13 per cent of gross domestic product.
…
Under a three-year plan, the Greek government seeks to cut the national budget deficit to less than 3 per cent of GDP by the end of 2012.

and:

In response to criticism that earlier plans had not included sufficient spending cuts, Mr Papandreou also announced an across-the-board freeze in public sector wages which, together with cuts in allowances, would reduce the public sector wage bill by 4 per cent. The government has also pledged to raise the retirement age.

If the Greek government can achieve this without massive, nation-wide strikes, I’ll be terrifically impressed.  Megan’s comments:

Everyone is expressing optimism. But while this sort of belt-tightening is necessary for Greece to stay in the EU, it’s going to come at a huge cost. Greece is already in recession–that’s why its budget problems loom so large–and the fiscal contraction will only make them deeper. Meanwhile, the EU will be setting its interest rates to meet the needs of larger, healthier members (and inflation-hawk bondholders). Tight fiscal and monetary policy means a long, painful period ahead for the Greeks.

This is the dilemma that faced Argentina with its monetary peg to the dollar; ultimately, it led to devaluation and default. We will see if Greece can whether [sic] it better.

I don’t think that this sort of belt-tightening is strictly necessary in the near term.  Germany will, again, fund a bail-out if it really comes down to it because, if nothing else, the loss to Germany of a member of the EU dropping the currency is greater than the loss to Germany of paying for Greece’s debt.

It’s clearly necessary in the long term that Greece get it’s fiscal house in order, but since they’re in such a severe recession, this isn’t really the time to do it (financial market pressure aside).  This is, in essence, the same debate that is gripping America, although there the pressure to address the deficit is coming from a successful political strategy of the opposition rather than, much as that same opposition might like, pressure from the markets.

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment.  Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment.  The latter is difficult in Europe with it’s multitude of languages, but not impossible.

In a perfect world where all regions of the EU currency zone were equally developed, this would simply replace the EU development grants.  But this isn’t a perfectly world …

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How much trouble is Europe in?

The 2008:Q4 figures for the EU-countries came out recently.  It’s not pretty.  But a regular recession is nothing compared to what might be coming.

In the understatement of the day, Tyler Cowen writes:

It’s a little scary:

Stephen Jen, currency chief at Morgan Stanley, said Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region’s GDP. Good luck. The credit window has slammed shut….

“This is the largest run on a currency in history,” said Mr Jen.

The naked capitalism entry that Tyler points us to is itself a wrapper for this article in the Telegraph.  It’s a little hyperbolic, but if the facts it’s listing are correct, not overly.  Here are a couple of paragraphs from it:

Whether it takes months, or just weeks, the world is going to discover that Europe’s financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus.

Under a “Taylor Rule” analysis, the European Central Bank already needs to cut rates to zero and then purchase bonds and Pfandbriefe on a huge scale. It is constrained by geopolitics – a German-Dutch veto – and the Maastricht Treaty.

To this mess we can add the case of Ireland.  Simon Johnson, writing at The Baseline Scenario, observes:

Look at the latest Credit Default Swap spreads for European sovereigns (these are the data from yesterday’s close).  As we’ve discussed here before, CDS are not a perfect measure of default probability but they tell you where things are going – and changes within an asset class (like European sovereigns) are often informative.

European CDS have been relatively stable – albeit at dangerously high levels – for the past month or so.  But now Ireland has moved up sharply (the green line in the chart).  We’ve covered Ireland’s problems here before (banking, fiscal and – big time – real estate); type “Ireland” into our Search box for more.

Interesting times …

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Farm subsidies promote terrorism

Well, maybe not directly, but it bears thinking about. It’s not a new idea, either, but I thought I’d put it out there anyway …

US and European farm subsidies artificially suppress world crop prices by causing American and European farmers to produce more than they profitably otherwise could. By the World Bank’s estimates, the prices of course grains, rice and wheat would rise by between 4% and 7% relative to other prices if all subsidies and other impediments to trade were removed (hat tip: Dani Rodrik).

That means that farmers in places like Afghanistan turn to other crops like poppies (for heroin). Since drugs are illegal, the farmers can only sell their crops through black (well, in Afghanistan, grey) markets that are controlled, America tells us, by people who support and funnel profits to the Taliban and al-Qa’ida.

Those Afghani farmers don’t really care what they grow. They just want to make a profit, like anybody else. How do we know this? Because when the price of crops goes up for other reasons, they happily started switching to planting wheat:

In parts of Helmand Afghan farmers are this year sowing wheat instead of poppy – not because they have suddenly been converted to the argument that producing heroin is not in the national interest.

Market forces have been the deciding factor – with wheat prices doubling in the past year, and the street price of heroin falling, it is now more cost effective to grow wheat.

So there you have it. If America was serious about fighting drugs and terrorism, it would cut it’s farm subsidies.

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Carbon tariffs

Well, well.  It would appear that Nicolas Sarkozy is threatening China with “carbon tariffs.”  It comes as no surprise that:

His idea already has supporters in the European Commission, particularly among officials charged with defending the interests of European industry.

In other words, the criticism of China is not really based on a perceived risk to the global environment, but that by acting first and China not following, the EU feels that European industry suffers unfairly.  It’s difficult to see how this would be legal under WTO rules.

The stated justification for the threatened action was:

“We cannot have one response from Europe and one from Asia, one from the north and one from the south,” he said. “China can and must play its full part.”

…

“I will defend the principle of a carbon compensation mechanism at the EU’s borders with regard to countries that don’t put in place rules for reducing greenhouse gas emissions,” Mr Sarkozy said.

This might be morally defensible if (and I really have to stress that ‘if’) the EU were to hand the Chinese government every cent they took in tariffs from Chinese exporters, thus allowing Europe to claim that they really were acting on behalf of the planet and not just their domestic industry.

However, we still have the very large problem of sovereignty.  Why should the EU get to dictate policy to China and to impose it arbitrarily if China doesn’t comply?  Even if China were to agree that (a) climate change is real and (b) humankind can and ought to do something about it, it does not follow that China and the EU would agree on an acceptable cost to impose on polluters, not least because China is still a developing country.

The point is that for every tonne of CO2-equivalent emitted in the EU, Europe gets more goods for consumption, but for every tonne emitted in China, we get more goods for consumption and another couple of people lifted out of poverty.

This message was driven home Tuesday by an article in a Communist party newspaper that said 95 per cent of carbon dioxide emissions from the era of the Industrial Revolution through the 1950s came from today’s developed countries.  Rich nations’ per capita emissions of greenhouse gases are also far above those in the developing world, the overseas edition of the People’s Daily newspaper said.

Now, if the world can agree on some sort of framework for reducing greenhouse gas emissions that also includes some restrictions on China and India, it seems sensible enough to me to allow carbon tariffs as punitive action against non-compliant states, but that’s pretty much the only way I’d support it.

I suppose that you might argue that if one country refused to ratify some treaty and other countries judged that by failing to do so, that country was placing other countries in peril, then taking action against them – in this case, imposing carbon tariffs – might be justified under “self defence.”  It’d be a tough sell, since the danger would not be imminent, but you might try it.  The problem then would be that if the stand-alone country were one of the UN security council’s permanent members, they could veto any attempt at multilateral action.