Category: News and politics

Republicans and the Fiscal Cliff: What are they thinking?

Our government, whether headed by a Republican or a Democrat, governs for all of us. The Republicans lost this time around, though they still control the House of Representatives. They are in the minority. The Democrats, who control the Senate and the Executive branch, rightly expect to introduce and oversee policies that are more aligned with their view of what is best for the country than the views of the party that lost. But if they are wise and have the best interests of the country at heart they will take into account the views of the rest of the country as well. Compromise is part of the art of governing a diverse people successfully. Limiting the scope of government is another. See my comments on this theme over four years ago: “The Death of the Right?”

Many Republicans, however, are behaving as if they think they should force their views on the majority.  Not only is this unwillingness to compromise unacceptable in our democracy, it is producing worse outcomes for those of us who would like to keep government smaller. These republicans rejected a deal last year tentatively agreed between House Speaker John A. Boehner (R-Ohio) and President Obama that would have increased tax revenue by $800 billion over the next ten years in exchange for spending cuts three times that.  Without some sort of agreement by the end of this week, falling over the “fiscal cliff” will increase tax revenue by around $5,000 billion over the same period. That won’t happen, of course, as both parties want to restore the existing income tax rates for all but the wealthy. The Democrat controlled Senate has already passed such a bill, which would increase tax revenue by $700 billion over the next ten years. That would become the base line from which Obama would bargain for more tax revenue in exchange for budget cuts.

I assume that some minimalist agreement will be reached in the next week that will eliminate the worst tax effects from going over the cliff, but that will only perpetuate and prolong uncertainty over how our currently unsustainable future spending commitments will be rained in and/or financed. This uncertainty is a major factor contributing to the slow recovery of investment and the economy in general. The current impasse will continue to do great damage to the county.

According to Ezra Klein: “If Boehner had taken the White House’s deal in 2011, he could’ve stopped the tax increase at $800 billion. If he took their most recent deal, he could stop it at $1.2 trillion. But if he insists on adding another round to the negotiations — one that will likely come after the White House pockets $700 billion in tax increases — then any deal in which he gets the entitlement cuts he wants is going to mean a deal in which he accepts even more tax increases than the White House is currently demanding.

“Today, Boehner wishes he’d taken the deal the president offered him in 2011. A year from now, he might wish he’d taken the deal the president offered him in 2012.”[1] See also: “The GOPs worst cliff myth”[2]

For the sake of the country and for the sake of the principles in which many Republicans believe, they must recover (with the cooperation of Democrats) the art of governing.

[1] Ezra Klein, “Obamas small deal could lead to bigger tax increases” The Washington Post, Dec 22, 2012

[2] Ezra Klein, The Washington Post, Dec 24, 2012.

The Newtown, Connecticut Tragedy

Most public disputes involve issues for which there is no obvious solution. If there were, it would have been taken already. Even our fractious politicians have been able to pluck the low hanging fruit. To reduce the number of innocent people slain by crazy gunmen (they have all been men/boys) should we tighten gun controls, liberalize institutionalization of the (probably) insane, or restrict violent games and movies or all or none of these. Any of these measures involve tradeoffs between safety and freedom. The preferred boundary shifts from time to time in the face of events and public sentiment. The following two articles are particularly insightful on this topic.

Charles Krauthammer:  “The roots of mass murder”   http://www.washingtonpost.com/opinions/charles-krauthammer-the-roots-of-mass-murder/2012/12/20/e4d99594-4ae3-11e2-b709-667035ff9029_story.html

Senator Jon Manchin:  “Obama and the NRA both fall short”  http://www.washingtonpost.com/opinions/sen-joe-manchin-between-obama-and-the-nra-another-path-to-stopping-mass-violence/2012/12/21/181d4e94-4adc-11e2-9a42-d1ce6d0ed278_story.html

Our Unsupportable Empire

Most of you are grudgingly aware that the U.S. government has promised us more than we want to or can easily pay for.  China is no longer willing to fill the gap knowing that we will not be capable of repaying it.  This is on top of the existing national debt from past borrowing to cover the government’s current and past spending in excess of its revenue of $16 trillion, about the same as the United States’ total annual output.  These numbers pale in comparison with the government’s unfunded commitments (those not covered by the revenue expected from existing tax laws and user charges) to future retirees and recipients of medical care (social security, medicare and Medicaid). The present value of the revenue short fall to pay for these future commitments (the government’s unfunded liabilities) is currently around $50 trillion for an astonishing total debt of around $66 trillion, which is larger than the total annual output of the world per year.

Naturally, these promises must be pared back because they can’t be paid for. To some extent a healthy, growing economy will also increase our capacity (lighten the burden) to pay for them but by itself growth will not be enough. This is one, but only one, of the reasons that we also need to reconsider our military promises around the world, while reducing and reorienting our military budget and modestly increasing our diplomatic (State Department) expenditures.

Our promise to provide security to most of the world suffers from the same moral hazard as does an overly generous welfare state.  Incentives matter. When access to welfare is easy and the level of support is generous, more people will choose it over taking a job that doesn’t interest them much.  When President Bill Clinton signed “The Personal Responsibility and Work Opportunity Reconciliation Act of 1996” (PRWORA) on August 22, 1996 (with strong Republican support), he fulfilled his campaign pledge to “end welfare as we have come to know it.” The law ended welfare as an entitlement by introducing tighter conditions for receiving it. Welfare costs dropped following adoption of the law. “A broad consensus now holds that welfare reform was certainly not a disaster–and that it may, in fact, have worked much as its designers had hoped.”[1] While some people remain skeptical, Sweden’s welfare reforms of the last two decades have demonstrated very similar results.[2]

The United States spends more on its military than the next 14 largest military spenders combined (China, Russia, UK, France, Japan, Saudi Arabia, India, Germany, Brazil, Italy, South Korea, Australia, Canada, and Turkey). We are policing/protecting most of the world. This has two negative effects. The first, similar to chronic welfare recipients, is that other nations spend less on their own defense, taking a free ride on the United States’ ability to keep the world safe for everyone else. The second is that by diverting so much of our productive resources into the military, we reduce the resources available for developing and strengthening our economy. It is our powerful economy that underlies our influence in the world as much, if not more, than our military power. Moreover, our military might is made possible by our economic power. So we need to get the balance right. I urge you to read David Ignatius’ recent discussion of this issue in The Washington Post, (“The foreign policy debate we should be having”, Oct 21, 2012, page A15)

But there are more reasons that our military adventurism and spending should be reduced and more resources given to diplomacy. Our national security and the freedoms America was founded to establish and protect will be strengthened as a result.

American hegemony rests largely on our economic and military power, but also on widespread respect for the American way of life (our respect for human freedom and dignity and our prosperity). Our efforts to promote democracy via military interventions have generally not gone well.  The talents and spirit of enterprise that have served us so well at home have not generally contributed to success in building new democratic nations where we have militarily intervened. Books like Joseph Heller’s, Catch 22 (about WWII) and movies like Robert Altman’s Mash (about Viet Nam) entertainingly introduced us to the bureaucratic problems of fighting and/or governing in foreign lands. We have the best trained and most well equipped military history has ever known, but it has failed for the last ten years to win in Afghanistan, which is now the longest war in American history. Our powerful military is not good at nation building, nor should we expect it to be. The military is not the right tool for promoting the values we believe in around the world. That is a job for diplomacy (with our powerful military well in the background).

We have been more successful at promoting our values and our economic interests through our promotion of and participation in international organizations like the International Monetary Fund, the World Bank, and the World Trade Organization and a wide range of international agreements and cooperation that facilitate free trade, and capital movements, and that extend the protection of property and human rights internationally. These organizations and agreements have developed the international legal frameworks for telecommunications, patents, financial and product standards, etc. that underlie the explosion of globalization that has dramatically raised the standard of living for much of the world’s population.

Rajiv Chandrasekaran, has written an excellent exposition of our military efforts in Afghanistan, which I urge you to read “Afghan security forces rapid expansion comes at a cost as readiness lags” (The Washington Post, Oct 21, 2012, page 1). Every few years America’s military strategy has changed: from counter terrorism, to counter insurgency, to building and training (and equipping) an Afghan National Army and Afghan National Police. As each approach fails, the Joint Chief’s extract the lessons learned and try a new one until it fails. In recent years, our military commanders have correctly emphasized the fact that “success” cannot be achieved by the military alone (it amazes me that anyone could have thought so – no wonder they are so eager to start wars).

But those are far from the only reasons for reducing our military footprint and budget. I believe in keeping government relatively small and encumbered with the organizational and political checks and balances meant to replace the role of competition in the private sector in bending self-interest to the public good. People are influenced by their self-interest whether they are in government or the private sector. However, in the private sector success comes from serving the needs of others in the market. This exerts a strong incentive on individual behavior. (Dishonesty can exist in either sector and can only be addressed by embracing appropriate moral standards and consistent punishment of breaches of those standards) In place of market discipline (acceptance or rejection), government must rely more on checks and balances to ensure that government officials behave as intended and they can only go so far to keep government honest and impartial in serving the public. The power of the government to coerce, and the expenditure of large sums of money by the government create enormous temptations for personal gain by those in positions of power in the government. The bigger government gets the more difficult it is to prevent some in government from yielding to the temptations to direct its power and money to their own good rather than the general good.

The firms in our large and important military support industry (Lockheed Martin, Boeing, Northrup Grumman, General Dynamics, Raytheon, Halliburton, United Technologies, Computer Sciences, BAE Systems, General Electric, Bechtel, and Honeywell International, to name a few), do not have a disinterested view about the most appropriate and cost-effective military technology the defense budget should provide for. The millions of dollars they spend attempting to influence the choices of the services and congress are, in a sense, “honest” efforts to promote their self-interested view of what best serves our national security. The growing behemoth of the industrial military complex of which Eisenhower warned us over fifty years ago now both defends and threatens our liberties. See my earlier comments on Ike’s famous farewell address: http://dailycaller.com/2011/01/17/ikes-farewell-address-fifty-years-on/

The risks of the misallocation of our resources and waste are directly related to the size of our military (and government more generally). The boundary between honest differences of opinion over the best military equipment and systems and simple cronyism is fuzzy.  Consider, for example, the recent award of a large contract to build 100,000 homes in war-torn Iraq to HillStone International, a newcomer in the business of home building. When its president David Richter was asked how the newcomer swung such a big deal, he replied that it really helps to have “the brother of the vice president as a partner” (James Biden).[3] It would not be fair to disqualify bidders because they are friends or relatives of high government officials (As Afghan President Karzai’s brother Mahmoud said to us with regard to the shares of Kabul Bank given to him by its founders. The Bank is now in receivership as the result of the bank lending 95% of its deposits to its shareholders), but how can you tell what is merit and what is cronyism?

My point is that the defense budget needs to be on the table when our elected officials finally confront the cuts that must be made to the government’s expenditures to save the country. Defense spending needs to be cut not just because we can’t afford it, but also because our oversized military is weakening our economic base on which both our military and our political power in the world rest. And perhaps most important of all, over reliance on military power to the exclusion of diplomacy has actually weakened our security and standing in the world.

[1] The New Republic, editorial September 4, 2006, page 7.

[2] The Economist, “Sweden: The New Model” October 13, 2012.

Freedom of Speech – Final Thoughts (for a while at least)

Our right of free speech is not a partisan issue in America. Democrats and Republicans, both President Obama and Presidential aspirant Romney, vigorously support its value and its constitutional guarantee. The extent of that right, which is not without limits, is greater in the U.S. than in any other country. The right to speak in some countries is simply at the whim of the existing government. The residents in some counties, such as Egypt, have more limited but legally defined (in principle at least) rights. Even the UK limits its press more than it is in the U.S. (think of the invasion of the privacy of the Queen and her family, though British standards are evolving too).

On this as with so many other issues, the world would benefit from a civil but vigorous discussion of the value of free speech to a healthy society and as a check on the powers of government and of where it is most appropriate to define its boundaries with the right to privacy and other values. We also need to understand and respect (but not necessarily agree with) the boundaries established by other countries and cultures.

President Obama reflected the American view well in his UN speech September 25.

“As president of our country, and commander in chief of our military, I accept that people are going to call me awful things every day. And I will defend their right to do so…. We do so because in a diverse society, efforts to restrict speech can become a tool to silence critics, or oppress minorities. We do so because given the power of faith in our lives, and the passion that religious differences can inflame, the strongest weapon against hateful speech is not repression, it is more speech — the voices of tolerance that rally against bigotry and blasphemy, and lift up the values of understanding and mutual respect…. There are no words that excuse the killing of innocents. There is no video that justifies an attack on an embassy. There is no slander that provides an excuse for people to burn a restaurant in Lebanon, or destroy a school in Tunis, or cause death and destruction in Pakistan.”

The next day, to the same UN audience, Egyptian President Mohamed Morsi defined a different position: “The obscenities that I have referred to that were recently released as part of an organized campaign against Islamic sanctities are unacceptable. We reject this. We cannot accept it. We will not allow anyone to do this by word or deed…. Egypt respects freedom of expression, [but] not a freedom of expression that targets a specific religion or a specific culture.”[1]

Any real dialog over this issue requires a deeper understanding of just President Morsi means when he says “we will not allow anyone to do this.” He clarified this in the same speech: “Egypt respects freedom of expression,… [but] not a freedom of expression that targets a specific religion or a specific culture.”[2]

The arrest in Cairo of Alber Saber, a 27-year-old Coptic Christian Egyptian illustrates an application of what President Morsi means. Saber was accused of providing a link on his Facebook page to the inflammatory video “Innocence of Muslims”, which he denies.  He “was arrested two weeks ago on charges of disdaining religion and ridiculing religious beliefs and rituals….  Showing contempt toward what Egyptian statutes call the “heavenly” religions — Christianity, Islam and Judaism — is punishable by up to five years in prison.

“The same day, [as Obama’s UN address] Egyptian authorities announced that charges would be filed against a prominent Islamist activist and TV personality, Ahmed Mohammed Abdullah, who tore up a copy of the Bible during a demonstration outside the U.S. Embassy in Cairo…. But liberal activists here say the blasphemy laws are so vague, and applied almost exclusively when people allegedly defame Islam, that they are nothing more than a political tool.”[3]

Clearly Egypt has a very different standard of free of speech than we do. We have very good reasons for believing that our more liberal standards are better and we should defend that view. But obviously views differ and those differences must be respected.

The freedom of speech is not absolute anywhere. All Americans know that we are not free to shout fire in a theater unless we think there is one. We are not allowed to deliberately tell lies about others in public. But that already puts us in some difficult waters, as the distinction between deliberate and unknowing lies is not easy to establish. In seeking the best balance between free speech and the right to privacy, American libel laws have set different standards for public (politicians, movie stars, etc.) and private individuals on the grounds that by choosing to become “public” officials or celebrities, such people have chosen to forgo some of their privacy.

For most of our country’s existence, free speech was thought to apply primarily to political speech and religious expression. America’s legal system evolved from English Common Law, which set a rather low standard for the prosecution of publishers of libelous material, who could be jailed for material that damaged the reputation of a member of the community. In 1734 New York publisher John Peter Zenger was imprisoned for printing political attacks against the colonial governor of New York.  However, his lawyer established a new legal precedent by arguing successfully that truth was a proper defense in libel cases. Prior to that, truth of allegedly libelous statements was not relevant to whether libel had been committed. Since the Zenger case, however, someone can sue successfully for libel only if the defamatory information is proven to be false.

Since the 1964 Supreme Court ruling in the case of New York Times Co. v. Sullivan, “public officials no longer could sue successfully for libel unless reporters or editors were guilty of ‘actual malice’ when publishing false statements about them…. Retired Justice William J. Brennan, Jr., who wrote the Sullivan decision, defined it as ‘knowledge that the [published information] was false’ or that it was published ‘with reckless disregard of whether it was false or not.’ In other words, public officials no longer could sue for libel simply by proving that something that had been broadcast or printed about them was false. Now they would have to prove that a journalist had knowingly printed false information while making little, if any, attempt to distinguish truth from lies.”[4] Egypt obviously has a different balance between conflicting rights in mind.

Even in the United States, freedom of speech is under constant attack from within. Columnist George Will, with his usual flare for sarcasm reports on bone chilling attempts by North Carolina’s Board of Dietetics/Nutrition to stop Steve Cooksey from offering nutritional advice on his internet blog based on his personal experience with losing 75 pounds. They argue that he does not have a license to offer such advice (hopefully the self interested protection of the right of only their members to offer such advice doesn’t need to be explained).[5]

Finding the best balance between free and acceptable speech is an ongoing quest and different societies, even the same society at different points in its history, define it differently. I, like most of my countrymen and our constitution, believe that we have very good and compelling reasons to tightly limit exceptions to and limits on free speech to the minimum. In defending this view to others, we must respect that they may prefer a different balance, while at the same time explaining the reasons for our view.

That said, the quality of any society also depends on what actually gets said. A society in which most residents adhere to the values of mutual respect and make public pronouncements that are thoughtful and well meaning is clearly a more desirable one that where many are rude and thoughtless and speak hatefully. But the freedom of all members of society to speak freely is, in my view, is the best way to develop a thoughtful and civil society.

[1]Anne Gearan, “Egypt’s president Morsi tells UN insults to Muhammad unacceptable” The Washington Post, September 27 Page A2.

[2] Ibid

[3] William Booth, “Egyptian blogger Alber Saber’s arrest shows differences over freedom of speech” The Washington Post, September 27, 2012, page A9

[5] George Will, “Bureaucrats declare war on free advice”, The Washington Post, September 27, 2012.

Further thoughts on Free Speech

Why are Americans (in particular) so attached to free speech, even repugnant free speech? Why is the first item in our Bill of Rights (i.e. the First Amendment to our Constitution) devoted to its protection? Our strong defense of free speech rests largely, in my view, on three beliefs held by most Americans.

The first is that it is our right and our responsibility to decide for ourselves what to read, view or listen to. We turn to ourselves and our families first and to our communities and our government second and third for most things. No one is absolutely self-reliant (even Robinson Crusoe had his man Friday), but Americans have historically been more self-reliant than most any other people. We trust our own judgment more than that of a public morality police. Though we often turn to trusted advisors in our churches or communities for guidance, we choose whose guidance we respect. No one has a stronger interest in our getting it right than we do ourselves. I don’t buy the paternalistic argument of some “do gooders” that the poor or uneducated just don’t care.

The second belief, born of centuries of experience and accumulated evidence, is that government power is always in danger of being corrupted to the service of those in power if not carefully checked and balanced. If government had the power to control what we heard, it would, sooner or later, be abused. If government is able to filter what we see and hear, it will not be able to resist filtering out information inconvenient to or critical of itself.

The third belief is that competition in ideas and information as well as in the provision of goods and services will reward the truth and drive out falsehood. This issue of discovering the truth is complicated. These days anyone can say anything and post it on the Internet. However, it doesn’t generally take long for the truth to crowed out lies (the claims that Ambassador Stevens body had been sodomized or that American Embassy Marine guards did not have live ammunition come to mind). To the extent that we trust the statements of our government it is only because we know that we (and the press) are free to contradict it if we have contrary evidence.

Our strong defense of free speech does not obligate us to defend the content of that speech. The Turkish Prime Minister Recep Tayyip Erdogan said that “’both the mentality and the organization behind this movie and those perpetrating terrorist actions exploiting Islamic symbols and discourse’ were equally to be condemned.” (The Washington Post “Anti US fury widens in Muslim world” 15/9/2012). Secretary of State Hillary Clinton called the offending video “disgusting and reprehensible.” She was right to say so, though I found the film merely pathetic.  We defend the right of the cretins who made this film to make it and to show it where ever they can convince some company or person to do so while also defending our right to denounce it.

This brings us to the “Muslim” reaction to the film. Many Muslims around the world have complained loudly about pictures or films that denigrate Mohammed, as do many Christians when pictures or films denigrate Jesus. That is simply an exercise of free speech. But what about demonstrations at American Embassies? “The right of the people peaceably to assemble,” is merely one of the means of exercising free speech and is also protected by the First Amendment to our Constitution.

Attacking our Embassies and their officials and employees is quite another matter. Muslims are wrong to do this and their governments should not allow it. I hope that you stumbled at my broad brushed attribution of this violence to “Muslims”.  If you didn’t you should have. Muslims did not kill four Americans in Benghazi or set various American properties on fire in several countries. “It is no more accurate to condemn the Muslim world for the atrocities of a relative few than it is to indict America because one lowbrow decides to upload a lousy flick that nobody otherwise would watch or even know about.” (Kathleen Parker, “In Libya and America-imbeciles affecting foreign policy” 14/9/2012.) Individuals did these things, each with their own motives. What drew people to these demonstrations? Who are they and what are their goals? In Benghazi, the murderers may have been al-Qaeda linked. The attacks in Egypt were primarily lead by hard line Islamists groups against the somewhat more tolerant and moderate new government of the Muslim Brotherhood. (David Ignatius, “Cairo and Libya attacks point to radicals jockeying for power” The Washington Post 12/9/2012)

Not everyone in the world understands or accepts our strong commitment to free speech. Our self-interest calls for us to carefully explain to the rest of the world its value and importance for the kind of societies that respect individuals that we want to live in.

American Values and Foreign Policy

One of America’s values and traditions is standing together in the face of foreign attack or challenge. Presidential candidate Mitt Romney has violated that tradition by attacking the statements of the American Embassy in Egypt’s condemnation of an anti-Muslim film made in California: “The Embassy of the United States in Cairo condemns the continuing efforts by misguided individuals to hurt the religious feelings of Muslims — as we condemn efforts to offend believers of all religions.”

Following news on September 11 of American casualties at an American consulate in Libya, Romney’s foreign policy advisers recommended that he speak out against the government’s apologies. He issued the following statement:

“I’m outraged by the attacks on American diplomatic missions in Libya and Egypt and by the death of an American consulate worker in Benghazi. It’s disgraceful that the Obama Administration’s first response was not to condemn attacks on our diplomatic missions, but to sympathize with those who waged the attacks.”

The next day Romney pressed his attack further, saying that, “I think it’s a terrible course for America to stand in apology for our values, that instead when our grounds are being attacked and being breached, that the first response of the United States must be outrage at the breach of the sovereignty of our nation. An apology for America’s values is never the right course.”

Romney was apparently not aware that the American Embassy’s statement on September 11 had been issued before the tragic death of Ambassador Stevens and three other Americans in Libya. Christopher Stevens was a fraternity brother of mine from the ATO house in Berkeley, though we were not there at the same time and I have never met him. President Obama in fact condemned the killings and according to the Washington Post: “unnamed White House officials told news outlets later Tuesday night that the [Egyptian] embassy statement did not reflect U.S. government views.” That is a pity because it does reflect American values and should reflect U.S. government policy.

Since neither Romney nor Obama seem to understand what American values are in this context, I am volunteering a refresher course.

We believe passionately in free speech and tolerance of the views of others. This is far from accepting anything someone might say. It is hardly the same thing as condoning insulting or ignorant things people sometimes say. Sam Bacile’s “The Muhammad Movie” is crude and disgusting. It deserves to be condemned and the Egyptian Embassy was quite right to apologize for it. Terry Jones, the hate mongering, Koran burning, so-called Christian minister in rural Florida has been promoting the film. Real Christians should condemn him, while at the same time acknowledge his right to state his twisted views.

Our values were reflected, for example, when many Christians complained that Andres Serrano had received $15,000 from the National Endowment for the Arts (a government agency) for his photograph of a crucifix submerged in a glass of urine without questioning the artists right (at his own expense) to do such things. Although the artwork was condemned by many as an affront to Christians, mobs did not storm the gallery that planned to show it nor the NEA. Secretary of State Hillary Clinton is one of the few to get the balance about right: http://www.washingtonpost.com/blogs/she-the-people/post/hillary-clinton-speaks-out-for-the-same-american-values-upheld-in-retracted-embassy-statement/2012/09/13/ccbf05f2-fdd6-11e1-b153-218509a954e1_blog.html

Standing together in the face of foreign attacks does not mean that we cannot or should not criticize foreign policies that we think do not service the best interests of our country.  But wise and thoughtful people know when the timing is right for such serious discussion. The present moment of grieving for our lost brothers and sisters is not a time for divisive political maneuvering. Romney’s foreign policy advisers have given him bad advise before (think Israel/Palestine. See my earlier blog: https://wcoats.wordpress.com/2012/08/05/romney-on-culture/). Romney should fire them.

Has the ECB provided the missing piece to resolve the EU debt crisis?

On September 6, Mario Draghi, president of the European Central Bank (ECB), announced that the ECB would engage in unlimited secondary market purchases of government bonds of member countries adhering to the policy conditions agreed to with the IMF and EU (and thus qualified to borrow from the European Financial Stabilization Fund – EFSF – or the European Stabilization Mechanism – ESM) to the extent needed to promote the efficient transmission of monetary policy throughout the Euro area. The over all liquidity impact of such purchases will be sterilized (offset by the sale of some other ECB assets), as needed, in order to preserve the ECB’s inflation objective of an inflation rate below but near 2% over the next two years. What does this add to the existing European tool kit and is it enough to resolve the EU debt crisis?

All responsible government officials recognize and accept that in the long run nations, like individuals, must live within their means (pay fully for what they consume). Their standard of living will depend on what they are able to produce (productivity).  Eliminating government deficits requires reducing government spending and/or increasing its tax revenue. Increasing the sustainable standard of living of its people (the level of consumption they can fully pay for with what they produce) requires liberalizing restrictions on labor and product markets and investment that will increase the productivity and thus output of workers and businesses. The debate is primarily over the optimal pace of introducing the measures needed to balance budgets and increase productivity and competitiveness.  This matters in that it takes time for the economy to adjust to reforms before it enjoys the benefits of more rapid growth. In the interim continuing but declining deficits must be financed either in the market (if market lenders have confidence in the effectiveness of the measures being taken), or by the IMF/EU/ECB until market confidence can be established.

I have elaborated these points in earlier blogs: “European debt crisis: causes and cures”; “Saving Italy and the euro”;   “Buying time for Italy”; and “Saving Greece-Austerity and/or Growth”.

Throughout the crisis Germany has demanded that Greece and other over indebted and uncompetitive countries undertake the needed corrective measures before being granted the financing needed for the transition back to normal market borrowing.  Events have proven Germany to be right as earlier “bailout” commitments have led to a suspension or slow down in policy reforms thus prolonging recovery.  For the same reason Germany has vigorously opposed (correctly in my view) the adoption of Eurobonds, which would allow Greece and others to borrow at the same interest rate as Germany and all other EU members. The moral hazard of bad fiscal behavior when market discipline of over borrowing is removed is a real and serious issue.

On the other hand, Germany is also pushing for Fiscal Union in order to gain better EU wide control over excessive national deficits. This may or may not be a good idea for Europe (I have my doubts) but it is certainly not, contrary to much opinion, essential for the viability of the Euro. The idea behind the German push for Fiscal Union stems from the markets’ failure to properly price the risk of lending to Greece, Portugal and some other overly indebted countries and Germany’s belief that the only way it can protect its tax payers from supporting inflated living standards to the South is by gaining control over their governments’ expenditures. Until the last few years, the governments of Greece and Portugal could borrow in the market at interest rates very close to the rates paid by the German government, which by the way has borrowed quite a lot itself (the ratio of German government debt to its GDP is currently above 81%). These governments spent and over promised future benefits recklessly on the (temporary) basis of relatively cheap debt financing in the market.

It is certainly a fair question to ask why the market failed in this regard and over lent to a number of governments that now have difficulty repaying. The expectation that Germany and other Northern EU countries would not allow the profligate southern ones to default made such lending seem risk free and the market priced it accordingly.  Fiscal Union and/or EU-wide fiscal rules are one way to limit such excessive borrowing and unfunded future promises. Improved market discipline of borrowing via more accurate risk premiums on market lending is another, and in my opinion, superior approach. Greece’s orderly default (75% haircut) on its publicly held debt and the current crisis have restored a large measure of market discipline to sovereign borrowing. Greece and Portugal do not need to borrow from the market for several more years as long as they implement and adhere to the reforms demanded by the IMF/EU/ECB. However, Spain and Italy closely watch the now far more sensitive interest rates demanded by the market when lending to them. Given the substantial outstanding debt of these countries, those interest rates can make the difference between the success or failure of reform efforts. Ireland, which has successfully, though painfully, implemented all of the conditions of the IMF et al “bailout,” is well on the way to full recovery and is now able to borrow again in the market at reasonable interest rates.

The missing piece in the EU/ECB tool kit to manage the ongoing debt crisis is the availability of sufficient temporary adjustment financing for larger countries such as Spain and Italy should markets loss confidence in one or both of them before their reforms have had time to bear fruit. The resources of the EFSF/ESM, still waiting for the German constitutional court’s approval, are not sufficient to finance stabilization programs with both countries. This leaves markets uneasy and volatile.  Market interest rates on ten-year Spanish government bonds have varied this year between under 5% to 7.6%. German government bond rates have varied between 1.24% and 1.85%.  Mario Draghi’s commitment of ECB funds to buy short-term sovereign debt (with maturities of up to three years) in secondary markets does not augment the resources available to the EFSF/ESM to finance adjustment programs with the IMF, but by buying such bonds in the secondary market should liquidity in a program country dry up, the ECB should be able to significantly reduce the prospects of what it considers unrealistically high risk premiums for such bonds. The ECB would only buy bonds of countries meeting the conditionality of an IMF supported adjustment program. Outright secondary market purchases are a standard and traditional liquidity management tool for central banks. What is unique in the European context is that open market purchases must be for the bonds of individual countries and the choice of countries matters. It is for others to determine whether, as Mr. Draghi claims, the new initiative is consistent with the ECB’s mandate.

This past week I attended a meeting of the Mont Pelerin Society in Prague. Friedrich Hayek, Milton Friedman and a few other free market champions founded the MPS in 1946. Czech President Vaclav Klaus, also an MSP member, hosted this year’s meeting. President Klaus has opposed the Czech Republic’s adoption of the Euro. It has kept its own currency, which the Czech National Bank has managed very well under an “inflation targeting” policy regime. However, Spanish economist Jesus Huerta de Soto spoke at the meeting in defense of the single currency. He favors a return to the gold standard but convincingly argued that the monetary discipline on Spain provided by giving up its own currency to the Euro was a good second best.  The key to success or failure of the Euro for the overly indebted countries that use it is whether they reform deeply enough to live within their own means within a few years and to sufficiently improve their competitiveness with the rest of Europe and the rest of the world. Failure to do so will harm the defaulting country far more than it will harm the Euro.  I wish them well.

Romney on Culture

Mitt Romney is clearly an intelligent guy with an impressive business track record. This makes it all the more disturbing that while visiting Israel Romney felt called upon to blame the difference in living standards between Israel and the occupied West Bank and Gaza (WBG) on cultural differences. I will unpack the ignorance of this claim further on, but first, why did he do it?

We know that Romney is weak on foreign policy issues and regrettably influenced in this area by neocon advisors who tend to favor the one Israeli state solution to the Israeli/Palestinian problem favored by the Israeli right wing over American interests and policies. Since George W Bush American policy has explicitly supported a two state solution. Those unfamiliar with the history of these issues are urged to read my earlier blogs on the topic: “The View from the West Bank – a history of the conflict”, “Jerusalem in august 2006″, “Leaving Israel August 11 2006″. “The Invented Palestinians”.

The United States has a strong commitment to the military defense of Israel and it was appropriate for Romney to restate that commitment while visiting Israel. But it is neither in our national interest nor Israel’s to support or endorse every measure the current Israeli government might think up or take in relation to its neighbors. Israel’s well being depends on making a just peace with its neighbors and returning the West Bank and Gaza to the Palestinians that live there. This is well known and accepted by most Israeli’s but not, apparently, by Romney’s neocon advisors. Given Romney’s lack of understanding in these issue, wisdom would have called for him to remain silent on the issue. So why did he say it, then deny it and than say it again?

First, what did he actually say? According to the Associated Press (“Romney outrages Palestinians by saying Jewish culture helps make Israel more successful”) on July 30 Romney told a breakfast meeting with wealthy donors at the King David Hotel in Jerusalem:  “As you come here and you see the GDP per capita, for instance, in Israel which is about $21,000 dollars, and compare that with the GDP per capita just across the areas managed by the Palestinian Authority, which is more like $10,000 per capita, you notice such a dramatically stark difference in economic vitality…. And as I come here and I look out over this city and consider the accomplishments of the people of this nation, I recognize the power of at least culture and a few other things.”

Saeb Erekat, a top Palestinian official told the AP: “What is this man doing here? Yesterday, he destroyed negotiations by saying Jerusalem is the capital of Israel, and today he is saying Israeli culture is more advanced than Palestinian culture. Isn’t this racism?”

The next day in an interview with Fox News’ Carl Cameran in Poland, Romney denied that he has spoken of the role of culture in the differences in income between Israel and Palestine. (Cameron interview of Romney) It did not take long for Romney to correct this misstatement in a National Review article under his name, “Culture does matter-Mitt Romney”: “During my recent trip to Israel, I had suggested that the choices a society makes about its culture play a role in creating prosperity, and that the significant disparity between Israeli and Palestinian living standards was powerfully influenced by it. In some quarters, that comment became the subject of controversy.”

So why did he say it?  Sadly Tom Friedman probably has it right in his July 31 column in the New York Times: “Why not in Vegas”  “Since the whole trip was not about learning anything but about how to satisfy the political whims of the right-wing, super pro-Bibi Netanyahu, American Jewish casino magnate Sheldon Adelson, why didn’t they just do the whole thing in Las Vegas? I mean, it was all about money anyway — how much Romney would abase himself by saying whatever the Israeli right wanted to hear and how big a jackpot of donations Adelson would shower on the Romney campaign in return.”

So statesmanship, diplomacy, American national interest had nothing to do with it. So maybe Romney actually understood how stupid his comments were. But let me walk us through the facts.

First, Palestinians and non Arab Israelis are first cousins racially. So this can’t be what Romney had in mind. Religiously, Judaism, Christianity, and Islam, the three great monotheistic religions, with Islam the most recent in that evolutionary chain, all share cultures of individual responsibility and work ethic. So it is hard to see Romney’s point in this area. My point is not that culture is unimportant, though calling in “everything” is clearly wrong. My point is that anyone who knows anything about Israel and the WBG, knows that it does not apply there. A very informative and well worth reading criticism of Romney’s statement is in Fareed Zakaria’s Aug 2, Washington Post op-ed, “Capitalism not culture drives economies”.

If Romney had driven the short, but time consuming, distance from Jerusalem to the temporary Palestinian capital in Ramallah, he would have seen some of the physical evidence of how Israel is choking the economies of the occupied, land locked West Bank and the blockaded Gaza Strip (high concrete walls cutting through Palestinian farms, check points blocking the movement of people and commerce, illegal Israeli settlement on Palestinian lands, etc.). I would have thought that a man of Romney’s intelligence would chose to remain silent on these deeply explosive issues until he could consult a more balanced group of foreign policy experts. Sadly he seems to have put politics above national interest.

Spain’s Financial Crisis: First Principles

Europe’s debt crisis has many contributing elements: bloated government bureaucracies, unaffordable social welfare programs, and productivity stifling labor and commercial laws.  However, none is as central as the condition and behavior of those European banks that overlent to and undercharged many European governments, and whose potential insolvency should one or more European governments default (as Greece has already to some extent) has dominated the EU’s slow, halting approach to dealing with it. Focusing on the case of Spain, the following note illustrates the importance for the future of Europe’s financial markets of resolving the banking sector’s problems properly.

Overview

In some respects the financial and debt situation of Spain is similar to that of the U.S.[1] Its central government debt is less than the U.S.’ and Germany’s (68%, 103%, and 83% respectively). This year its public sector deficit is expected to be 5.9% (8.5% last year), less than the U.S. at 7.6%, but more than Germany’s at 1.3%. Its total debt (public and private) to foreigners (external debt) is less as well (84%, 103%, and 142% respectively). Spain’s housing bubble and subsequent collapse were average. The decline in Spain’s real housing prices from their peak in 2007 of about 20% was about the same as the UK’s and the Euro zone’s and less than in Ireland and the U.S.

To over simplify, what sets Spain apart is a) its lack of competitiveness (its current account deficit with the rest of the world relative to GDP was 9.6% in 2008 and is currently almost 3% while the Euro area as a whole is balanced – i.e., 0); b) the heavy reliance of its banks on borrowed funds (its loan to deposit ratio is about 150% compared with 80% for U.S. banks; and c) its banks’ large exposure to the real estate and construction sectors (56.5% compared to 30% for U.S. banks). In addition, Spanish and European banks in general operate on much less capital than do American banks. Going into the recent financial crisis—2007—the ratio of total European bank assets to capital—i.e., the leverage ratio—averaged around 30, while for American banks it averaged around 13 (i.e. capital gearing ratios of 3.3% and 7.7% respectively).

Spain was confident that it could make sufficient budgetary and policy adjustments to convince markets that it was still safe to lend to while gradually winding down excess spending and liberalizing rigid labor and product markets (its no bailout strategy). But after four years of inadequate measures Spanish voters ousted the Socialist Party and gave the center right party of Mariano Rajoy a solid majority in Parliament with a mandate to move more aggressively. Prime Minister Rajoy’s reform program has been a mixed bag (see “Spain’s Economic Reforms: A Mixed Bag”). The central government’s spending and deficit are falling rapidly, though excessive regional government spending remains a problem. Labor market reform has been quite quick and strong and is already producing improvements in competitiveness. However, Spain has fallen back into recession and unemployment is the highest in Europe at over 24%.  (see Rajoy government reform program)

Spain’s Banks

Spain’s primary vulnerability comes from its banks. In fact, a central feature of the European debt crisis is the relatively large exposure of European banks, including German banks, to the sovereign debts of Greece, Portugal, Ireland, Italy, Spain, etc. If depositors think that their deposits are at risk, they will move them. If they think all banks in Spain suffer this risk, they will move them out of Spain to other banks that accept Euros. If depositors withdraw their deposits too rapidly (i.e., bank runs) then even solvent, well capitalized banks can have trouble liquidating assets fast enough to fund the withdrawals. The total deposits of Greek banks have fallen from € 245 billion at the end of 2009 to € 175 billion at the end of April 2012. However, Spanish banks’ deposits have not begun to decline until very recently.

Countries limit the risk of deposit runs by explicitly insuring bank deposits up to a limit and/or by standing ready to intervene (bailout) failing banks. In Spain, all deposits are insured up to € 100,000 per depositor. If governments guarantee all deposits as a result of a comment to bail out insolvent banks, deposit insurance is redundant and not needed. Even a full deposit guarantee provides some market discipline of bank behavior if the regulator intervenes promptly when a bank becomes insolvent, because shareholders lose all of their investment in the bank. Market discipline is strengthened further if bank bondholders also incur losses when the assets of an intervened bank are not sufficient to cover their repayment.

The Importance of Bank Capital

Without deposit insurance or government deposit guarantees, their bank’s capital is the primary protection for depositors against the risk of loss.  If depositors think that their bank’s capital is too low to cover potential losses, they will move their deposits to safer banks. Unfortunately, the value of a bank’s capital cannot be known with certainty. Economic capital (net worth) is the difference between the value of assets and the value of liabilities. A large share of banks’ assets is loans. The value of a loan is less than its face (book) value if it is not repaid fully or on time. It is impossible to know for sure which loans are “good” and which are doubtful and how doubtful they might be in the future.

Minimizing the risk of deposit runs via capital adequacy consists of three elements:

  1. The level of capital banks are required to hold in normal times (dynamic or cyclically adjusted capital requirements deserve more serious attention) must be sufficient to absorb possible losses. Higher capital requirements provide more deposit protection.
  2. The rules for valuing assets and thus capital must reflect their real value as best as possible. Most bank loans have no secondary market from which to measure their value. Thus bank regulators have established rules of thumb for estimating the probable loss in value for loans that are not performing or are at risk of falling into arrears and potentially defaulting. Banks are required to provision (write down capital) to cover such probable losses. This is the equivalent of “marking to market” the probable value of loans that have no market. Loan valuation and loan loss provisions need to realistically reflect and cover the most likely repayment outcomes.
  3. Depositors must have confidence in the adequacy of the first two measures and the faithfulness with which banks apply them. This is the issue of transparency. The recent deployment of stress tests, when properly explained (especially when undertaken by third parties, such as the IMF), is meant to reduce the uncertainty surrounding the adequacy of measured capital.

The risks to Spanish bank depositors come primarily from three sources:

  1. The potential losses from loans to Spain’s now busted housing and construction markets and from holdings of sovereign debt of Greece are uncertain and have almost certainly been underestimated and under provisioned in the past. Significant exposure to Spanish sovereign debt is now becoming an issue as well. Capital injections are needed just to keep actual capital at currently reported levels. Higher levels of capital are needed to compensate depositors for the uncertainty of the actual level of capital.
  2. The ability of Spain to honor its deposit insurance commitments or its implicit commitments to cover deposits in the event of an intervention are increasingly in doubt because the ability of the Spanish government to borrow additional amounts to cover such commitments is in doubt.
  3. The ability of banks to fund their loans from non-deposit sources or to fund deposit withdrawals even if they are well capitalized are in doubt in current market conditions. This is a liquidity problem, not a solvency problem, and should be handled by the provision of central bank liquidity.

Spanish banks fund a large part of their loans with relatively short-term borrowed money rather than deposits. Access to such funds has become difficult and expensive. From the beginning of central banking, a core function of central banks has been to provide banks with the liquidity they need in such circumstances. The long-established principle is that the central bank should provide illiquid but solvent banks with all the liquidity they need (generally by lending to them against good collateral), but should not lend to insolvent banks (banks lacking sufficient good assets to cover their deposit and other liabilities). The ECB’s three-year Long Term Refinancing Operation is addressing banks’ liquidity problem (#3).

But even without deposit runs (or walks), Spanish and other European banks (especially) need to reduce the extent to which they lend long-term on the basis of short-term borrowed funds. They can only do so by reducing lending until their deposits finance a larger share of it and/or by increasing capital. The bank deleveraging now underway around the world is an important source of reduced bank lending and the slow pace of recovery (see Carmen M. Reinhart & Kenneth S. Rogoff, “This Time is Different: Eight Centuries of Financial Folly”).

Spanish banks were better capitalized than most at the onset of the international financial crisis but more recently have been overwhelmed by the magnitude of the collapse of Spain’s housing and construction markets. The government (previous and current) has taken measures to address banking sector weaknesses but always a bit behind the curve.  Seven failing cajas (regional savings banks heavily exposed to real estate) were merged in 2010 to form Bankia making it Spain’s fourth largest bank. In May the bank was largely nationalized (costing the Spanish government around 20 billion Euros to date) and trading of its shares was suspended on May 25, 2012. Deposit insurance was established then raised. Government guarantees of senior bank bond holdings were introduced (October 2008).

As time passed, depositors have only become more concerned about the safety of their deposits. In an effort to finally get ahead of the curve, the authorities have increased the provisions required against weak and doubtful loans and other assets, and initiated third-party stress tests of its banks. The IMF’s recent Financial Sector Stability Assessment found Spain’s large internationally active banks to be well capitalized and able to absorb the new capital strengthening requirements. However, its former savings banks and some of its medium and small private sector banks are more vulnerable and will need capital injections from the government to cover insured or guaranteed deposits. Because of its own financing difficulties, the government of Spain has turned to the EU to backstop its ability to recapitalize (replace capital lost by or potentially lost by defaulting loans) those of its banks with inadequate capital. For this purpose the EU has committed €100 billion.

The Way Forward

Deposit runs on Spanish banks (including the drying up of wholesale funding) can be prevented only by convincing depositors that their money is safe, i.e. that their banks have sufficient capital to cover any losses. This requires honest accounting and full implementation of the indicated provisioning, and adequate capital; or creditable government guarantees.

For the future health of Spanish banks, it is important that Spain’s banking interventions preserve the intended discipline of excessive risk taking that results from imposing losses on shareholders and senior bond holders while honoring its commitments to protect depositors. Thus liquidity support should only be given to solvent banks. Nonperforming loans should be properly provisioned. Banks that are critically undercapitalized and are unable to raise their own capital to required levels within a reasonable period should be intervened. Intervened banks should be resolved according to the least cost principle (least cost to the tax payer). Shareholders and senior bondholders should be wiped out before government money is injected to cover other liabilities. Viable banks should be continued and sold to new owners within a reasonable period of time. Non-viable banks should be wound down (liquidated) paying off all insured or guaranteed depositors with the help of public funds as needed.

In requesting EU financial assistance, Spain is committed to abiding by EU rules on state aid to banks. However, emergency responses to a financial crisis much too often produce the foundation of moral hazard and excessive risk taking that creates the next crises delaying true and long-lasting resolution. More market discipline of risk taking needs to be reintroduced via a sound bank resolution policy. Spain will contribute to the future soundness and vitality of its banking sector and that of all of Europe if it adheres to the above principles as it “cleans up” its financial sector.

[1] The International Monetary Fund’s “Financial Sector Stability Assessment”  provides an excellent summary as of May 2012.