Category: News and politics

A story of travels to Kabul and a suitcase

Starting in January 2002 my flights into and out of Kabul where on the United Nations Humanitarian Air Service (UNHAS) charter planes between Dubai or Islamabad and Kabul. I would land in Dubai or Islamabad on a commercial flight, pick up my bag and check into a hotel with my other IMF colleagues for the UNHAS flight the next day. In Islamabad we stayed in the Marriott (since blown up by terrorists) and in Dubai we stayed in any number of first class hotels.

Departure the next day was from a remote part of the airport in Dubai or Islamabad to a remote part of the airport in Kabul. The idea of checking my bag through to Kabul for the convenience of not having to go through immigration to pick it up and recheck it (I was almost always in a rush to get there with no time to stop over anywhere) was a number of years off.

With the advent of commercial flights into Kabul and the ending of the UNHAS flights three or so years ago, our Dubai departures (we had given up on Islamabad after the bombing of the Marriott) moved from the small old Terminal 2 to the big modern Terminal 1 (I always found this numbering confusing). However, it was still not possible to check our bags through to Kabul. We had to wait in the immigration line, then wait while the generally unsmiling Arab immigration officer examined, then stamped, our passports, go pick up our bags, and re check them with Safi Airways, re-emigrate and fly on. The immigration officers, by the way, where just about the only Arabs I encountered in the UAE in a working capacity. Cab drivers, porters, hotel clerks, restaurant waiters and virtually everyone else who serviced us in any way were Filipinos, Indians, Pakistanis and sometimes Bangladeshis.

More recently, agreements were struck with United, BA and other airlines and Safi Airways that make it possible to check our bags through from Washington to Kabul. Thus in Dubai I could go directly from my arriving flight to the departure lounge of Safi without immigrating (i.e. transit). Shoppers will enjoy the massive collection of shops and goods in Dubai’s mammoth airport, but I am not one of them. Most of our IMF team choose to hang out in the airport for the 4 or 5 hours between flights rather than enjoy the sterile splendor of modern Dubai. Some of my colleagues worried about the risk of losing their bags if they checked them all the way through, but I preferred to take the risk in exchange for the convenience and never had a problem until the day before yesterday.

For some reason that I do not understand the check through arrangement does not seem to work in reverse. It is not yet possible to check my bag from Kabul to D.C., though there is some confusion about this. My return home from Kabul yesterday illustrates this point.

After a year of difficult and inconclusive negotiations with the authorities, our IMF team finally agreed with the authorities on a program that we thought our Executive Board could support. The measures that had been taken and were agreed to be taken to resolve the failure of Kabul Bank (potentially the largest bank fraud per capital in history) had been the main stumbling block. The amazing and shocking history of Kabul Bank is set out in detail in: http://www.uspolicyinabigworld.com/2011/09/21/the-kabul-bank-scandal-and-the-crisis-that-followed/.

As the prospect of an agreement became clear, our short five-day visit to Kabul was coming to a close, so we delayed our early Thursday morning departure until Thursday evening. To add an extra hour and a half to the time available to us (my colleagues had gone with only a few hours sleep for the last three days as it was), the Finance Minister (our negotiating counterpart) arranged for our boarding cards to be issued and bags to be checked in the VIP lounge before we left for the airport. One of his aids collected our passports and bags and my hopeful instruction to check my bag through to Washington. When he returned to the IMF guesthouse with our boarding cards and baggage claims, he also had a bill for me for $85 for the check through arrangement. It was worth it to me not to have to recheck my bag in Dubai.

We successfully concluded the negotiations, held a donor briefing (World Bank, USAID, DFID, ADB, ISAF, UN, and others), issued a press release from Washington, http://www.imf.org/external/np/sec/pr/2011/pr11358.htm, and headed for the airport. I must say that it almost made flying enjoyable again to be driven through security up to the VIP lounge (rather than having to drag our bags from a remote parking lot), skipping all the security, emigration, and check-in lines. We boarded soon there after and three hours later deplaned in Dubai.

As we entered the terminal, I was expecting to immigrate and head to the local Hilton for a good night’s sleep. But just inside the door stood someone holding up the unexpected and unwanted sign: “Coats, Jr. Warren L.  Why was I being stopped, I asked? “Follow me please.” To make a confusing story short, a reception service had been engaged to take me passed the long immigration lines to the baggage carousel and arrange for my transportation to the Hilton. As this was not what I had paid for nor wanted (though skipping long immigration lines is always appreciated), and the young lady escorting me around had her own instructions, considerable confusion ensued as we walked from one place to another until it became VERY clear that I would not be able to recheck and leave my bag there until I returned in the morning. So be it. I had a good sleep at the Hilton with my bag at my side and lugged it back to the airport in the morning and was soon on my way to London and home.

I use to hate going through London’s Heathrow airport, but with the addition of BA’s Terminal 5, I rather like it. So my three and a half hour lay over in Terminal 5 passed pleasantly (the BA wi-fi pass word for the day was “Singapore”). On the nine-hour flight from London to DC, I watched one movie, and slept the rest of the way, skipping dinner.

My suitcase drama had one more chapter. When I arrived in DC, it didn’t.  In addition, the BA office at Dulles was closed (typical British service) and its mix of automated and live human telephone service was unpleasant. Nonetheless, my bag was delivered to my door one day later (last night), in time for a quick repack and departure for Grand Cayman this morning for this quarter’s meeting of the Cayman Financial Review’s Editorial Board meeting.

Comments on my 9/11 post

Thanks, Warren,

We were then in Bratislava… I was the first to speak after Michael and the Muslim speaker (forgot the name)…  I also remember that we cut the coffee break to listen to Becker’s and Horowitz’ assessments of the impacts — months later it turned out their on-the-back-of-an-envelope calculations were very precise.

Regards.

Krassen [Stanchev]

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Warren

Your “Remembering 9/11..” is eloquent and incisive. Would that we can turn back the unleashed Leviathan; and, with amends, again become a beacon on a hill.

John [Sainsbury

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Dear Warren,

Excellent commentary on 9/11, and the insane government wars in the Middle East……

I was in NY that fateful day, having arrived a week earlier to take over as prez of FEE.  For the next week the phones went dead, nobody called, and we had my first big FEE dinner scheduled in a month at the Harvard Club with Paul Gigot as the speaker.  My first decision was whether to cancel or not.  I decided that if necessary we would hold our first FEE dinner around the dinner table…..Fortunately, the phones came alive and we had over 200 attend.

Did you see that Pres Obama read Psalm 46 yesterday at 911 ceremony?  It’s called Shakespeare’s psalm.  If you look at the 46th word in Psalm 46 and combine it with the 46th word counting backwards from the end of the psalm, you’ll see why……

All the best, AEIOU,

Mark

Mark Skousen

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Dear Warren

Thank you for sending this e-mail…I really liked your article, thought-provoking and balanced. I spent most of the summer in Princeton doing research and missed not getting together with you for lunch during the summer. During one of my visits this fall, let’s try to meet for lunch.

My best.

Iqbal [Zaidi]

Remembering 9/11– Bratislava, Slovakia

As my generation did for many years following the assassination of JFK, we today remember where we were and what we were doing on the day ten years ago that 19 Middle Eastern terrorists hijacked and crashed four American passenger planes into the twin towers of the World Trade Center, the Pentagon, and a field in rural Pennsylvania.

On September 11, 2001 I was in Bratislava, Slovakia (the former Czechoslovakia’s eastern half). I had combined an IMF technical assistance visit to Slovakia’s central bank with a meeting of the Mont Pelerin Society, the free market group established over 50 years earlier by Friedrich Hayek and Milton Friedman. I returned to my hotel room around 3:00 pm (9:00 am in New York and Washington, DC) to an email from IMF security announcing that a plane had crashed into one of the World Trade Center towers. I turned on the television and watched in shock and disbelief as a second plane crashed into the other tower. Then a third plane crashed into the Pentagon, and I wondered if this was the beginning or the end of the attacks.

I called my Icelandic friend Hannes Gissurarson, a member of the board of Iceland’s central bank, who was also attending the MPS meetings. “Hannes, you will not believe what has happened. I don’t want to watch this alone. Please come.”  For the next few hours we sat in front of the television emptying the liquor from my refrigerator and then his. We watched in real-time as the two towers collapsed. I remember thinking that they fell so perfectly straight down that it looked like a Hollywood stunt. I was hoping disparately that it was. We did not see any of the people who jumped or fell to their deaths from the towers, which were not visible or shown at that time (thank God).

Michael Novak, a fellow MPS member, called a meeting to meditate together on these events. Michael has a comforting way of talking about difficult things and the gathering was helpful. Many other friends were there, including Richard Rahn and Marian Tupy.

Later in the evening Hannes and I decided to take a walk. As we walked through the lobby of our hotel, the hotel clerks expressed their heart-felt sympathy. We walked the seven or eight blocks to the American Embassy where we saw people placing flowers and small American flags outside of the Embassy. I was very touched by these displays of sympathy and friendship but felt dazed.

Three days later I was finally able to get a flight home, which was a few blocks from the Pentagon. The hole in western side of the five sided building made by American Airlines flight 77 seemed small considering that it had been made by a very large Boeing 757. It  dramatized just how huge the Pentagon is. Barbara Olson, the wife of the United States Solicitor General at the time (and currently a defender of Marriage Equality in the California appeal of Proposition 8), was one of the 64 people on that plane who died when it crashed into the Pentagon killing an additional 125 people in the building.

The positive side of this tragedy was the outpouring of sympathy and support around the word and the strengthened unity among all Americans. As Ronald Reagan had put it: America is a beacon on a hill. We have created a government that is meant to service us, not the other way around. We have established a society in which very diverse people with very diverse personal beliefs and ambitions live peacefully together (most of the time) because our constitution and our beliefs provide considerable space for such diversity. We require that others respect our property and our space in turn for which we respect theirs. To a large extent we can prosper on the basis of our efforts and the extent to which they satisfy the needs and wants of others in the market place.

The world respected and envied American society. The idea, circulated by a few Neanderthals, that Al Qaeda attacked us because they resented our freedoms, was a silly lie. They resented our troops on their soil (Saudi Arabia) and our intrusions into their countries and affairs. If our leaders had understood that correctly, and fashioned policies accordingly, perhaps we would have retained the respect of the rest of the world over the next ten years after 9/11.

Instead, we have lost thousands of American lives and Afghanistan and Iraq have lost  multiples of that. We have weakened our economic strength and thus our military strength by squandering several trillion dollars in Afghanistan, Iraq and elsewhere. We have traded off more of our liberties and way of life in the name of security (the infamous “War on Terror”) than we should have. We have lost the respect and support of much of the world.

A poll taken in the U.S. near the end of August found that: “Six in ten Americans believe that the U.S. weakened its economy by overspending in its responses to the 9/11 attacks. In particular, respondents felt this was especially true of the U.S. mission in Iraq. Two out of three Americans perceive that over the decade since 9/11, U.S. power and influence in the world has declined. This view is highly correlated with the belief that the U.S. overspent in its post-9/11 response efforts — the wars in Iraq and Afghanistan.”

The “Patriot Act” and the “Department of Homeland Security” are names that could have been proposed by “Big Brother” in Orwell’s 1984. How could our government have chosen such names and more importantly how could we have let it. The constant announcements at airports to be on the alert—the flashing signs along the main streets of Washington, DC to report any suspicious activities to XXXXX, are right out of 1984 and Huxley’s Brave New World. Former Vice President Cheney writes without embarrassment that we were right to torture terrorists. I get extremely uncomfortable sitting in the same room with Paul Wolfowitz at AEI. Hopefully I would get up and leave if John Bolton walked in. What has happened to us?

Big Brother/Big Government, however well-meaning, are dangerous to what made us great. They create self-interests that work night and day to direct government spending and policies to their benefit rather than to the nations benefit. That is just how governments work and why our founding fathers were so concerned to limit its scope as much as possible. Governments work best to serve the broad social (national) interest when they provide impartial enforcement of private agreements (courts) and property rights (police and army) and the basic infrastructure of commerce (roads, water, sewage disposal).

Though with every nibble and further intrusion into what was once the private sector Leviathan grows stronger and more dangerous, we don’t have to lose the principles that made us great and made us the envy of the world. We can again be the beacon on the hill that cares about each and every person and thus mankind and sets an example of respect for our fellow-man that others will want to emulate.

But we cannot each have everything in the social sphere exactly the way we each want it. We must live together in cooperation in the pubic sphere. This requires compromises whenever the government is involved (there are not enough desert islands for each of us to each have everything our own way). Thus the broadly accepted need to eliminate our government’s deficit in the future and bring its cumulative debt down to lower levels relative to our economic output over the coming decade or two can only be achieved if each side compromises a few things in order to reach a common agreement on how to do it (what to cut and what taxes to adjust). The President’s largely ignored Debt Commission set out a good basis for such compromises last year. I hope that we can come together again to find an agreement and again become a nation we can be proud of and that is again respected by our neighbors around the world.

European debt crisis: Causes and Cures

Greece’s debt problems are the fault of its use of the Euro

[Comments from friends have led me to strengthen my arguments in the following slightly revised version of this post.]

Public misunderstandings of economic issues do not go away easily. Recently, I began an e-mail exchange with four Chinese students. Perhaps it is forgivable for them being in one of China’s remote provinces to say with regard to the Greek and Portuguese debt problems: “The root cause is that different developing countries use the same currency, [which] is not appropriate.”[1] While this may sound plausible, some of their other beliefs were totally  bizarre. However, it is not forgivable for the German chancellor, Angela Merkel, to say: “We can’t have a common currency where some get lots of holiday time and others very little.” This is not only ridiculous because Germans have longer vacations than the Greeks (I am speaking only of official time off, not German versus Greek work habits), which they do. It is ridiculous and wrong because it implies that it is not viable for rich people to live in the same country with poor people.

The use of a common currency, the Euro, IS NOT the root cause of Europe’s debt problems. As this does not seem to be obvious to some intelligent people who should know better, let me spell it out in very simple, elementary terms.

A person or family in the United States (or any other country) that spends more than her income for long periods has a potential problem and that problem has nothing to do with the fact that she is using the same currency as everyone else in the country. She may rationally borrow for short periods to cover temporary interruptions in her income or finance large purchases that she has the income to repay over time, but if she continually borrows amounts that she cannot reasonably expect to be able to repay, she and her foolish creditors have a problem. More often (hopefully), debt defaults result from unexpected changes in fortune. All countries have legal procedures (bankruptcy) for dealing with such defaults that avoid sending the defaulter to debtors’ prison. But as long as each person or family lives within its means, there is no reason on earth why their means can’t vary enormously without undermining the harmony of their coexistence. If this is so within countries, it is even more so between them (security concerns aside).

The probability of lending money to someone who cannot repay is directly related to the incentives faced by borrowers and lenders. A debtors’ prison was about as strong an incentive you could have against careless borrowing though they varied a great deal from one country to another. Most took the form of workhouses. In England, a debtor (and often his family) remained in confinement until his debt was repaid. In most European countries he stayed for a maximum of one year. However, from the establishment of the United States, Americans decided that people should be given second chances and abolished debtors’ prisons. In England, the Bankruptcy Act of 1869 abolished debtors’ prisons. We now take second chances for granted. But this does increase the risk that some people will borrow too much.

Who gets credit is almost totally regulated by the requirements of lenders to have confidence that borrowers can and will repay them. No one is forced to lend. Lenders require information from borrowers on their past and expected income and on their track records of repaying earlier loans. They may require collateral to “secure” the loan. Borrowers themselves are deterred from borrowing what they cannot be paid by the penalties imposed by bankruptcy laws should they default even if they aren’t sent to prison. This very fact increases the confidence of lenders to lend in the first place. If the penalties are too severe and/or collateral and other security too costly, less will be lent. A delicate balance is needed to optimize the reallocation of savings to investors (or consumers).

At the end of the day, life is uncertain. Not everything can be foreseen. Some chances are reasonable, however, and worth taking. Some lenders are willing to take larger risks if compensated by higher interest rates on such loans. Thus markets tend to demand higher interest rates (relative to those on safe loans) for riskier loans. Lenders still expect to make a reasonable return on their loans on average with the “risk premium” received from those who repay covering the limited losses on the few who don’t.

Sovereign borrowers, like Greece, are generally considered low risk because they can tax their citizens to repay borrowed money. But as Argentina and Russia have shown there are limits to taxation. Unless lenders (buyers of sovereign debt) think that sovereign borrowers will be bailed out by the IMF or others under all circumstances, they will demand an interest rate that reflects their assessment of the risk that the borrower might default. A higher interest rate for riskier borrowers is a good thing as it provides a financial incentive for the borrower to slow down.

Greece’s adoption of the Euro contributed to its current debt problem only in that it removed one of the risks of lending to Greece—the risk that Greece would devalue its currency and thus reduce the foreign currency value of what it owes (if lenders had denominated their loans in the Greek currency). Greece no longer has its own currency and thus lenders no longer face so-called “exchange rate risk.”

Until recently lenders did not add a risk premium to loans to Greece or Portugal. They charged these borrowers almost the same as they charged the German government. Thus there was little financial incentive from this source for Greece to limit its borrowing. But like any borrower, whether an individual, a company, or a country, the game lasts only as long as lenders believe they will be repaid and borrowers are foolish to borrow what they cannot productively use and repay. That Greece has been foolish is perhaps one of the nicer ways of putting its behavior. Now, finally lenders have become more discriminating and have begun to add large risk premiums to any new loans to Greece and other riskier borrowers. This came late but is welcome.

The above discussion provides background to my views on the proposal now being made by many in Europe to finance national government borrowing with Eurobonds. Rather than individual countries issuing sovereign debt and paying the risk premium the market demands for their particular situation, they would borrow through an EU wide institution, such as the European Financial Stabilization Fund (EFSF). Greece would sell its bonds to the EFSF, which would pay for them with funds raised by issuing its own Euro denominated bonds. EFSF bonds would be backed by the financial resources of the EU (all European member countries collectively) and would thus enjoy the credit rating of the EU rather than of Greece.

Eurobonds (not to be confused with the US dollar denominated bonds of the same name with which many European and other governments and companies have borrowed for half a century) would reduce the cost to Greece of borrowing and would provide a better asset in which central banks and multilateral companies could hold Euro reserves. The latter would facilitate the use of the Euro as an international reserve currency.

The cost of Greek debt service would drop immediately, but without other steps by the Greek government to reduce its bloated budget and to free up the competitive capacity of its economy more debt would be accumulated until it again reached the limits of its ability to service its debts. I outlined the issues and options for Greece in more detail over a year ago (May 2010) at https://wcoats.wordpress.com/2010/05/30/greeces-debt-crisis-simplified/.

The ability of Greece to borrow unlimited amounts via the EFSF at safe Eurobond interest rates would remove an important incentive for Greece to adjust and live within its means. Thus the Eurobond idea in this form is a bad idea and Germany is right to oppose it. The financial assistance now being given by the EU and the IMF carries conditions that Greece address the underlying and real causes of its debt problem (excessive government spending and an uncompetitive economy) and it has been making considerable progress toward satisfying those conditions. Such loans (also at low risk free rates) provide an alternative way of imposing incentives for better behavior by Greece to that of high risk premiums for market borrowing.

Because of this perverse incentive effect of opening Eurobond financing to Greece and other EU members with excessive debt, its proponents speak of the need to combine it with stronger EU control over national fiscal policies. It is not clear what form such tighter control might take and it is frankly difficult for me to imagine France or Italy, for example, allowing EU bureaucrats in Brussels to dictate limits on their national expenditures.

“Eurobonds ‘mean telling the people, the citizenry, that you are ready to share risks,’ [Amadeu Altafaj] Tardio [a spokesman for the European Commission’s economic and monetary affairs committee] said. ‘That would be the strongest support for the euro area. It makes sense in the context of a monetary union. . . . Politically it does not seem feasible.’”[2]

It is instructive to contrast the EU situation with that of the United States. The federal government of the U.S. issues debt securities in its name and with its (now slightly down graded) own credit rating (AA+). The stock of its debt outstanding is approaching $15 trillion dollars, almost half of which is owned (lent from) abroad. Each of the 50 states in the United States also borrow by issuing debt securities in their own names and each receives its own credit rating and pays interest accordingly. The money raised by the federal government is to supplement its tax revenue to finance its own expenditures (though the federal government does grant some revenue to the states from its budget). Thus it has full control (I am ignoring the political dysfunction of our current Congress) over its own expenditures and borrowing needs. States have full control over their own budgets and financing.

The situation in Europe is quite different. The Eurobond proposal is not for the financing of the EU budget (comparable to the federal budget in the U.S.), but for the financing of individual country budgets (comparable to states in the U.S.). This is why advocates of Eurobonds couple their proposal with the need to increase EU control over member countries’ budgets. Such control would be comparable to federal government control over state budgets in the U.S. This seems both politically very unlikely in Europe and, in my opinion, undesirable.

There is a version of the Eurobond proposal that does make sense to me. Bruegel, a European think tank, has suggested an approach that differentiates between debt financing member country borrowing that is less than 60% of their GDP and borrowing that is more. Eurobonds proper would only finance borrowing up to the 60% level. Any country wishing to borrow more than that would need to issue their own bonds and pay whatever risk premium the market demanded of them individually. Eurobonds would have priority standing in the event of default. This would restore the market discipline of excessive borrowing that the open-ended Eurobond proposal would remove, and would be easy to enforce.

Reducing the borrowing cost on debt equal to 60% of its GDP would help make the existing stock of debt more sustainable. But unless Greece and other EU members addressed their fundamental problems, the flow of new debt would continue. The market’s assessment of the prospects of Greece defaulting on such additional borrowing (over 60% of its GDP) would determine the risk premium Greece would have to pay for such borrowing and would provide better market discipline of its behavior than a pure Eurobond scheme.

Don’t blame the Euro. Blame the misbehavior of individual countries. Both rich countries and poor countries can participate in the global economy whether using the same currency or not if each lives within its means. When looking for solutions, don’t destroy the costs of bad behavior and thus the incentives for good behavior. This includes the incentives faced by market lenders (banks and others), who, thankfully, are finally taking some loss in the restructuring of Greek debt, but perhaps not enough to be more careful next time nor to reduce the exciting stock of Greek debt to make it sustainable. In the final analysis, only Greece, like any household, can make the changes that will restore its credit worthiness and its place in the global economy.

[1] Email correspondence with Chinese students who found my address on the Internet.

[2] Howard Schneider, “Europe debt crisis forces officials to revisit creation of common eurobonds”, The Washington Post, August 26, 2011, Page A11.

Libya: Part II

What will happen next in Libya and what should we do?

As we attempt to save the Republic by trimming government back to size (back to what we can afford and back to what only government can do), surely we can forego a few of wars the neocons would like to plunge us into. Actually my warning cries as we were sliding into another one in Libya had much more to do with the unlearned lessons of the past about how best to influence future event for the better than with the wasting of more precious treasure (lives and other resources). To his rather bumbling credit, President Obama gave in to the pressures of the warmongers reluctantly and only partially in Libya. Our involvement has been largely supportive of more direct, though also limited, NATO support for the rebels.

But here we are at the beginning of Part II of the Libya drama. The rebels seem to have finally toppled the truly crazed Gaddafi. We can all cheer his demise, but what will follow? Who are the rebels and where are they planning? We actually know more about them than when we first chose to support them (a collection of different tribes, political philosophies, and religious views, some good and some bad). Who will emerge on top and what will the struggle for dominance of the new regime be like? Will the average Libyan be better off or worse off? It is impossible to know at this point.

Craig Whitlock reports some interesting reactions to the Libyan civil war from the area in yesterday’s Washington Post, “Libyan rebels renew hopes of Arab Spring”

“If the shooting quickly subsides and the Libyan rebels are able to build a functioning central government, it would give further encouragement to protesters in the streets of Damascus and Sanaa. But if Libya descends into factionalism or tribal warfare — with scenes reminiscent of Iraq after the fall of Saddam Hussein — then ardor for the Arab Spring could cool again.

“‘People are going to be looking at how this plays out very, very closely,’ said Jon B. Alterman, director of the Middle East program at the Center for Strategic and International Studies. ‘It’s easy to agree that the leader must go. It’s much harder to agree on what comes next.’

“Some Palestinian activists said that their aspirations, too, had been buoyed by the success of the Libyan rebels but that NATO’s involvement had taken the sheen off the results.

“‘It is getting a cautious welcome because it was achieved with foreign intervention rather than by the people themselves, as was the case in Egypt,’ said Hani al-Masri, a political analyst in Ramallah, West Bank. ‘Some people are calling it liberation through occupation. The Egyptian experience was inspiring. In Libya, we have to wait and see.’”

My pessimism about our ability to improve the world (and our safety) with armies does not mean that I think we should do nothing in Libya or elsewhere to promote a better world (rule of law, respect for human liberty and rights). We know a lot about the blessings of liberty and the institutions (not necessarily, or even very often, just like our own) that help promote and preserve it. We have an interest, both humanitarian and national self-interest, in doing our best to share our knowledge and to promote sound governance and free markets in Libya and elsewhere. This is often done best by international organizations such as the International Monetary Fund and the World Bank. It cannot be successfully imposed from outside. It must to the form of support and encouragement to the indigenous forces for good (if we think we know who they are).

I commend to you the op-ed piece on this subject in the The Washington Post by Stephen Hadley on August 18th: “Our chance to shape change in North Africa and the Mideast”.

Should Geithner resign?

Calls for U.S. Treasury Secretary Geithner’s resignation following S&P’s modest downgrading of U.S. government securities are strange. Strange and ignorant. The U.S. Treasury Secretary, our Finance Minister, has nothing to do with our deficit or our debt problem (unless you are blaming him for keeping its maturity shorter than he might). His job is to finance as best he can all of the expenditures our Congress pass and our President sign into law. It would make more sense to call for the resignation of the Congress and the President.

Unlike most countries, in the United States the responsibility to propose a budget to the legislature and to finance whatever the legislature approves are spite between the Office of Management and Budget (OMB) and the Treasury. Most other countries combine the two into their Finance Ministry. The practice else where better aligns incentives to the extent that the level of spending proposed is arrived at in full knowledge of the capacity to finance it.

If calls for Geithner’s resignation are related to debt and deficit problems, the callers need a civics lesson.

Our Faltering Economic Recovery

Historically, all recoveries from recessions precipitated by a financial crisis have been long and slow. Our current recovery from the financial crisis of 2008 is starting to look longer and more uncertain than the historical norm. The main reason is the enormous uncertainty over future taxes, spending priorities, and regulations coming from the government. Our looming debt crisis requires significant adjustments in government policies one way or another (see my earlier note on “Thinking about the public debt”) and private investors and consumers naturally retreat in the face of such uncertainty until the course of government policies is settled.

Our high unemployment rate means that aggregate spending (demand) on U.S. output falls short of full employment output. At the highest level of aggregation, economists divide total aggregate demand into the spending by households on current goods and services (Consumption), spending by businesses on capital and capacity improvement (Investment), spending by foreigner (Exports), and spending by the government at all levels (Government).

The Federal Reserve quickly and correctly injected liquidity into the financial system in 2008 – 9, thus containing the scope of the financial crisis. There is nothing left for it to do other than withdraw the extra liquidity in time to avoid inflation when the right time comes.

The government increased its demand for output through several stimulus programs in an effort to fill the demand void created by the retrenchment of private sector Consumption and Investment. Government stimulus required spending without tax financing because tax increases would have further reduced private Consumption and Investment just as tax reductions were meant to increase them. The resulting deficit is unsustainable and has itself become a source of concern. Moreover, some of the government’s increased spending reflected long-term increases in the size of government rather than temporary countercyclical stimulus adding to long-term debt sustainability concerns as well as concerns about government encroachment into undesirable areas. Government stimulus is now being withdrawn.

Recovery requires an increase in Consumption, Investment, and Exports sufficient to match full employment output without the artificial boost of Government stimulus. So what is holding it back?

Until recently, the recovery, slow as it has been, was being lead by an increase in Exports. Over half of our exports go to Europe and recent debt problems in Europe (Greece, Ireland and Portugal) have slowed Europe’s economic recovery and its demand for American exports.

The main factor holding back the recovery of Investment and Consumption is the large uncertainty over the environment in which firms would invest and households would spend. Businesses invest when they think it will be profitable to do so. Significant changes and prospective changes to business and especially financial regulations will take several years to clarify. Until they do it will not be possible to estimate their cost on businesses (and thus consumers) with any accuracy.

Everyone has now accepted the fact that government spending levels and projected levels combined with existing tax revenue and projected revenues are not sustainable. Significant adjustments are unavoidable. The problem is that there is no consensus about what spending to cut and how much to cut it, and what taxes to change and by how much. This is particularly challenging for the big three categories that make up most of the budget (defense, Medicare/Medicaid, and social security).  Businesses find it particularly difficult to estimate the tax treatment new investments might face and follow the sensible path of just waiting to see.

The impasse between Republicans and Democrats in the Congress over the conditions they each require to raise the debt ceiling is in the news and in our faces daily. Few firms are willing to undertake new investments in such an environment.

It is unthinkable that Congress will not raise the debt ceiling, but that does not mean that the game of chicken might not postpone raising it until considerable additional damage has been done to the economy. The stakes are high and neither side will yield easily. The government would quite properly cut expenditures or default on other obligations before they would default on its debt (the U.S. government securities held by households, banks and other firms, as well as other governments around the world). The unquestioned integrity and safety of U.S. government securities is one the critical backbones of the role of the dollar as an international reserve asset and of the dominance of the United States in world financial markets and commerce. But what would it cut?

The expected revenue shortfall for 2011 is $912 billion.[1]Failure to raise the debt ceiling would mean that planned spending would need to be cut by that amount if it could not be borrowed (or taxes increased—but increased revenue from higher tax rates or new taxes, if they materialized at all, would take some time to collect). If the cuts are made in areas other than interest on the existing debt (which for this year is expected to be $287 billion) they will have to include cuts to entitlements like social security and Medicare or defense because discretionary spending (the total Federal budget less defense, entitlements and interest on existing debt) is only $656 billion it cannot be cut below zero. The cuts would need to be greater than the entire defense Department budget of $727 billion. These would be actual cuts, not reductions from planned increases. It is hard to imagine the government defaulting on it monthly social security payments to pensioners or cutting off payments for covered medical treatments or defaulting on salary payments to government employees. Thus the debt ceiling will have to be raised in order to allow a longer more orderly adjustment to spending priorities and levels, which when agreed should be fully financed by an efficient and equitable tax system (see “US Federal Tax Policy”).

Our faltering economy is the result of the government’s inability to get its act together, agree on the rules and on the tax and regulatory environment in which households and businesses operate, consume and invest. No side can force a decision and have their way. It is not reasonable to expect a major reworking of entitlements or the tax system in the next two months, but it is possible to agree on the aggregate size of the cuts required for Republicans to agree to an increase in the debt ceiling so that entitlements, defense and taxes can be more carefully debated over the next year. House Speaker John Boehner’s offer to support a dollar increase in the debt ceiling for every dollar cut from the budget deserves support. But it will only buy badly needed time to more fundamentally reform entitlements, defense spending, and the tax system.

Until these decisions are made and the business environment clarifies and stabilizes, investment and economic recovery will suffer.

[1] Office of Management and Budget, “Budget of the United States Government”

The impact of language on understanding: two small examples

The morning Post is often the catalyst for my blogs. This morning’s edition provoked the following two comments.

According to the Post, in an article reviewing a speech by the justly highly respected Secretary of Defense, “President Obama has pledged to reduce projected spending on national security by $400 billion over the next 12 years, the ‘preponderance of which would come from the Department of Defense,’ Gates said.

That’s on top of $78 billion in long-term spending reductions that the defense secretary announced earlier this year, as well as $100 billion that he said would be cut from wasteful or inefficient programs and reallocated for new weapons and other purposes.”[1]

In the very next sentence the Post says: “All told, the cuts would leave the Pentagon with flat budgets — increasing just below the rate of inflation — until at least 2024.”[2] What does this mean? It means that on the basis of the proposed “cuts” defense spending would increase every year for the next twelve years at a rate slightly below the assumed inflation rate over that period, i.e. real spending would fall slightly. The $478 billion cut in spending over that same period, refers to cuts from currently budgeted or assumed increases over that period. Readers need to pay close attention to understand the meaning of such numbers.

Another article in today’s Post reports on a survey of public attitudes about raising the debt ceiling of the Federal government. The survey finds that more people are concerned about the dangers of raising the debt ceiling than of defaulting on the debt (77% to 73%).[3]  This is strange. The reason they worry about raising the debt ceiling is that it could lead to an even larger federal debt over time. The only reason to worry about that (aside from legitimate concerns about the negative effect on the economy of larger government expenditures, which, of course, could be paid for with tax revenue without an increase the debt) is that if the debt gets too large the government might default. So how is it that people worry more about something that might lead to default than they do about default itself?????

Trying to imagine the consequence of the U.S. government defaulting on its debt is rather like trying to imagine the affect of all out nuclear war. It is unimaginable. A short, temporary default (a failure to pay interest on and repay maturing debt for a few weeks) might not be catastrophic, but it would certainly destroy the high confidence the world now has in owning U.S. debt and would add a significant risk premium to any subsequent U.S. government borrowing. But a longer default would not only lock the U.S. out of domestic and international capital markets (no more borrowing), but would also destroy the dollar’s international reserve currency status (over half of dollar bank notes are held abroad) instantly, and bankrupt thousands of banks and other firms holding U.S. debt. The knock on effects to the world economy (of which we are very much a part) truly are beyond the world’s experience and beyond imagining.

The Rule of Law

The idea that government exists to serve the interests of the people rather than the other way around is modern. It underlies the attitude that Americans and the citizens of other democracies have toward their governments. The essence of this idea and of democracy is not that rulers are chosen by the people; it is that however they are chosen their rule—their powers—are limited by law. The rule of law and the limits it places on the power of the state to interfere with our lives is the essential foundation of our liberties, not voting.

Government involvement in the provision of a service or product is a game changer. There is a centrifugal force that draws private players, “special interests,” into influencing outcomes by influencing politicians and government bureaucrats rather than by competing with better services or products in the market place. This centrifugal force must be continually resisted by limiting what government gets involved in and by insisting on the rule of law. Failure to do so creates a government that looks and behaves more and more like, well, like what we are seeing. America has been exceptional in its success and in its attitudes toward the liberty on which it rests. This exceptionalism is worth fighting (continuously) to preserve.

Richard Lowry & Ramesh Ponnuru explain American exceptionalism as follows:

“It was, to simplify, the most individualistic elements of En­glish society — basically, dissenting low-church Protestants — who came to the eastern seaboard of North America…. America was blessedly unencumbered by an ancien régime. Compared with Europe, it had no church hierarchy, no aristocracy, no entrenched economic interests, no ingrained distaste for commercial activity. It almost entirely lacked the hallmarks of a traditional post-feudal agrarian society. It was as close as you could get to John Locke’s state of nature…. All of this made Amer­ica an outlier compared with England, which was an outlier compared with Europe.

“The late Seymour Martin Lipset defined [the American creed] as liberty, equality (of opportunity and respect), individualism, populism, and laissez-faire economics…. Liberty is the most important element of the creed. To secure it, the Founders set about strictly limiting government within carefully specified bounds.”[1]

War always weakens liberty. When forced, people usually chose security over liberty. A never-ending “War on Terror,” if permitted to continue for too long, threatens to significantly undermine the liberty we are trying to defend. The growing importance of our military might, and the industrial and political interests that feed and support it—the military-industrial complex—will ultimately destroy our exceptionalism. We have been saved so far by our deep tradition of limited use of our military might, our exceptionally capably, honorable, and professional military officers, and the civilian control of their activities. I have written about this theme before: “Eisenhower’s farewell address 50- years later”, “When Values Clash”, “Keep it lean”.

But when our security is threatened we can be tempted to set our principles of respect for human dignity aside. The willingness of some short-sighted individuals to contemplate torture as a tool of warfare in such times illustrates this danger. A number of good articles have been written on this issue. One of the best was by Aryeh Neier: “Enhanced to the point of torture”. Other excellent discussions include: “The Torture Debate”, “Torture is immoral and doesn’t work”, and “Gitmo and us”.

The entertaining Robert Redford movie “The Conspirator,” is a dramatic illustration of the dangers and folly of setting aside the rule of law for what a ruler believes is the interest of the country. The movie depicts (whether historically accurate or not I do not know) the overriding of the important principle of the due process in the “interest” of national healing after the assassination of Abraham Lincoln. I recommend the movie.

Almost everything about government is a slippery slope that can only be prevented by continually challenging the entry and expansion of government into new areas and activities. Some times with proper limits and controls they are justified. More often they are not.

[1] Richard Lowry & Ramesh Ponnuru, “An Exception Debate” National Review Online, May 16, 2010.

Thinking about the Public Debt

The U.S. Federal Government spent $1.7 trillion dollars last year more than its tax revenue. It had to borrow that amount. This increased the outstanding public debt of the Federal government to 14.2 trillion dollars or 96 percent of GDP. This includes that part owned by the Social Security trust fund and the Federal Reserve but does not include the unfunded liabilities of Medicare, Medicaid and Social Security, which will add an additional $46 trillion to the deficit in present value terms over the next 75 years.

This year’s federal deficit is expected to be 1.4 trillion. Interest payments on this debt are forecast to be $287 billion this year (almost 8% of total outlays) and are expected to grow to three or four times that over the next decade as the stock of debt grows and interest rates rise.

This is not sustainable. Without spending cuts and/or tax increases this amount will not only continue growing without end but will increase as a share of GDP until bond holders are no longer willing to trust the government’s ability to pay the interest required. At that point they will dump U.S. Treasuries and the U.S. will be forced to default. Standard & Poors has already downgraded its “credit outlook” for the U.S. to negative.

All of this is by now well-known as is the fact that there is no longer any choice about the need to cut spending and/or raise taxes. But that is just the beginning of the search for responsible and effective governance by our representatives here in Washington. It makes a big difference which expenditures are cut and which taxes are raised. The deficit will fall and our ability to finance it will increase with the growth of our output/income. Specific spending cuts and tax increases effect income growth differently.

The job of our political representatives is to determine what the government should be doing within the set of things it is permitted to do by the Constitution and the resources the public wishes to make available. Their job is to carefully and wisely set priorities on the use of the limited resources available to them.

David Ignatius provides one of many examples that I strongly agree with: “Today, the United States is allocating about $110 billion annually for the Afghan war, about $3.2 billion for military and economic aid to Pakistan, and about $0.15 billion in special assistance to help Egypt’s democratic revolution. In terms of U.S. national interests, those spending levels don’t make sense. The pyramid is upside down.”[1]

The budget for the Defense Department in 2010, including our several wars, was $664 billion while the State Department (including all foreign aid) was $52 billion.  We have the best fighting machine the world has ever seen and rather mediocre diplomatic capabilities. Better and more extensive use of diplomacy and less use of drones and lesser-guided bombs can often produce better results (improved security for the U.S.). Spending more to develop well-trained (history, culture, language) Foreign Service officers and less to manufacture more munitions might be a good idea. It is hard to imagine that spending less on DOD and more on DOS wouldn’t improve our security for less money.

All spending should pass a strict cost benefit analysis but setting a cap on total spending relative to GDP (e.g., 18 or 19 percent) would be a useful disciplining tool for forcing more careful prioritization. So we must cut deeply but not evenly. We can and should spend less and get more benefit by better prioritizing what is really important to our safety and quality of life. This will not be an easy debate.

The same must be said for taxes. Not all taxes have the same effect on the economic growth that lifts our standard of living and makes a given debt easer to service. And not all taxes are equally fair.  So while the revenue generated by taxes should match the level of government spending over the business cycle, how that revenue is raised is as important as how it is spent.

The primary standards for judging tax systems are neutrality and fairness. Neutrality means that the tax does not distort business and spending decisions so that the allocation of investment and economic resources are not distorted. A neutral tax damages economic growth less than, say, a tax that falls largely on investments. A neutral income tax, for example, treats all sources of income the same.

If tax revenue is raised in ways that do not discourage economic growth, income growth itself will increase tax revenue and reduce a given debt as a share of national income (an indicator of the government’s ability to services it). The arguments in favor of the most neutral possible tax structures are well-known and broadly accepted by economists across the political spectrum. The tax base (whether income or consumption) should be comprehensive making the marginal tax rate as low as possible.

Business income taxation double taxes the same income (by the business and again by the shareholders as individuals) and introduces wasteful and risky corporate behavior in their effort to minimize the tax. Everyone agrees that the corporate profits tax in the U.S. should be lowered more in line with the rates in other countries, but in fact the corporate tax should be abolished. It raises only modest revenue and causes great damage. I favor complete reliance on a flat comprehensive consumption tax (VAT) because it does not tax saving and thus encourages more investment and growth, is simpler to collect and is fairer. [2]

There is less agreement about what is fair. Everyone agrees that the rich should pay more taxes than the poor but how much more. Actually, under the existing tax code those with incomes in the top 1 per cent paid 40 per cent of all income tax revenue in 2006 and earned only 22 per cent of all income, the top 10 per cent paid 71 per cent and the bottom 50 per cent less than 3 per cent.

President Obama thinks that this is not progressive enough and wants to tax high income families even more and the Republicans think it is already too progressive both in terms of fairness and in discouraging investment that promotes faster growth.

A “flat” income tax, the same marginal tax rate for everyone with incomes large enough to pay taxes at all, is the most neutral rate structure when applied to a comprehensive income (or consumption) base. But it is also a good benchmark for discussing fairness. A flat rate means basically that someone with twice the income pays twice as much tax. I consider that fair, but of course our existing rate structure increases with income so that tax payments would more than double when income doubles. Increasing marginal rates is a rather open field. Where should you stop? Clearly our tax system needs to be made more neutral and more fair. The debate over how to do that will not be easy either.

[1] “Time to up the ante on Egypt”, The Washington Post, April 20, 2011, A17.

[2] Warren Coats, “U.S. Federal Tax Policy” , Cayman Financial Review, July 7, 2009