The Becker-Posner Blog

China Bashing Once Again-Becker

During his confirmation hearing before the United States Senate toward the end of January, Secretary of the Treasury Timothy Geithner accused China of "manipulating" its currency. This is not a statement that helps to further China-US cooperation on trying to stimulate the depressed world economy and on other issues- Secretary of State Hillary Clinton is now in China trying to mend some fences. Yet Geithner's statement is a correct evaluation of the Chinese policy of keeping the value of its currency, the yuan, low relative to the dollar and other currencies. It is far less clear, however, whether this and related Chinese policies harm the US and other countries. By keeping its currency cheap, China encourages greater exports since that policy makes Chinese goods cheaper on world markets. This policy also discourages imports by Chinese consumers and producers since it raises the cost of foreign goods in terms of the yuan. Partly due to its manipulation of the value of the yuan, China has run large surpluses on its current account in recent years because the value of its exports has been significantly above the value of its imports. China has accumulated over $2 trillion of reserves. The world recession has sharply reduced China's exports, but surprisingly the recession has reduced China's imports by much more, so that its foreign trade surpluses have grown greatly during recent months. Some American producers have had trouble competing with cheap Chinese imports, and have either gone out of business, or shifted production overseas, mainly to China itself. Since China mainly exports goods produced with low priced labor that is not available in richer countries, their exports have not had a major impact on production in the richer countries. Far more significant to developed countries are the reductions in the cost of imported clothing and many other goods from China. Consumers, especially low income consumers, now take for granted their ability to buy cheaply many everyday goods that would cost perhaps five times as much were they made in the US, Western Europe, or Japan. The Chinese government holds most of its more than $2 trillion in official reserves in US Treasury securities. China gets a bad deal from selling goods made by Chinese labor and capital in exchange for large amount of paper assets that yield low returns. China has accumulated far more reserves in the form of these assets than can be justified as a buffer against fluctuations in its imports and exports, or than is wise given its low standard of living. The US seems to have made the better bargain by exchanging low interest paper assets for a rich variety of consumer and producer goods. Does China's ownership of large quantities of US government bonds give China the opportunity to "blackmail" the United States into more favorable policies toward China through threats to flood the international capital market with these assets? China has not made such threats, perhaps mainly because they would not be credible. Since China owns only a rather small fraction of US Treasury obligations, and an even smaller fraction of total liquid assets traded on world capital markets, a threat to sell their US governments would give China only a little leverage on world interest rates, including those paid by the United States government. Moreover, China, along with other governments, holds US Treasury assets because they are considered among the safest of all assets, especially during these turbulent times. By selling their US Treasury bonds, China would have to take on riskier assets at a time when China is trying to cut its exposure to risk. To be sure, the high savings rates of China and other Asian countries during the past decade are partly responsible for the low world interest rates that contributed to the housing bubbles in the United States and other countries. To that degree, China bears some indirect responsibility for the financial crisis that is afflicting much of the world. However, China too is being badly hurt by the world recession. Moreover, excessive bank lending and borrowing, and government encouragement of sub prime loans, were much more important culprits in generating excesses in the housing market. The extensive protectionist policies practiced by the Chinese government do hurt the United States and other countries, including China itself. Chinese protectionism is especially common in the financial sector; while foreign banks are being allowed greater access to China markets, they are still subject to considerable discrimination. The general trend in China (and other nations) toward less protectionism has been set back by the global recession, as China has recently introduced various "buy China" programs in its steel and other industries. China bashing during past decade is reminiscent of the Japan bashing that occurred during the 1980s. It turned out that Japan's substantial export surplus with the US, its extensive accumulation of US Treasury bonds, and its purchases of assets in teh US did not hurt the United States, but were for the most part foolish actions on the part of the Japanese government and businesses. I believe that similar conclusions will be reached about the parallel Chinese practices.

China and the U.S. Depression--Posner

I agree with Becker that China is not responsible for our current depression. It is true that China's trade imbalance with the United States--it exports much more to us than we to them, and so has built up huge dollar balances that it has invested in the United States, mainly as Becker points out in the form of purchasing federal government bonds--was a factor in keeping interest rates low in the 2000-2005 period. And it is true that those low interest rates are a major culprit in the housing bubble and the ensuing financial collapse. The usual effect of an increase in the supply of money is to lower interest rates, because interest is the price of money. But low interest rates were a policy of our Federal Reserve under the chairmanship of Alan Greenspan, who remained chairman until the end of the 2000-2005 period; the Federal Reserve can create all the money it wants; and so even if there had been no Chinese investment in the United States, interest rates would probably have remained low. I say "probably" rather than "certainly" because the cheap Chinese exports to the United States were one of the factors that enabled the Federal Reserve's policy of low interest rates to avoid creating serious inflation. Had there been inflation, the Fed would have raised interest rates, killing the housing bubble before it became serious. Because houses are bought mainly with debt, cheap credit encourages home buying; and since the stock of housing expands only slowly, an increase in the demand for homes can and did result in a steep increase in home prices, which turned into a speculative bubble. Furthermore, China is of course not the only country with a positive trade balance with the United States. I do think that China's trade policy was bad for the United States. I do not think that it is healthy for the United States to run huge budget deficits, whether they are financed by China or by anyone else. One reason that we are in a depression and not merely the "severe recession" that is the preferred euphemism is that, because of those deficits, we cannot spend our way out of the depression without increasing the national debt to a point at which either horrendous inflation or huge tax increases will be required to pay it down. But I would not "blame" China for giving us what we very much wanted, which was cheap goods and the financing of our debt. Nor do I think that China's trade policy is foolish from China's standpoint. In a fascinating chapter of The General Theory of Employment, Interest and Money, Keynes offered the following qualified defense of mercantilism (the policy of accumulating foreign exchange by running a persistent export surplus). Suppose a country has weak domestic demand for goods and services, perhaps because its people are poor or they lack confidence in their economic prospects and therefore hoard money rather than spending it. Because of this weak demand, labor and other productive resources will tend to be underemployed--unless producers have foreign markets. By stimulating exports, the nation can increase the utilization of its productive resources, which by reducing unemployment can increase consumer confidence and thus increase spending and in turn investment. Average incomes in China are very low, domestic demand therefore weak relative to potential output, and so it may make sense for China to encourage production for export, especially if it has a comparative advantage in producing goods that foreign countries such as the United States demand. Moreover, because average incomes in China are so low, there may not be much demand for the types of product that the United States produces, and this would be an independent reason for our trade imbalance with China. But it would not explain China's large dollar balances, unless no other country produces the types of product that Chinese consumers could afford to buy.

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We will not be blogging this week.

Against the Pay Caps--Posner

The government has decided to impose a $500,000 ceiling on the senior executives of banks and other financial institutions that accept bailout money. This is a bad idea, though politically inevitable because of public indignation at financiers, thus illustrating a point I make in my forthcoming book about the depression--for I insist that it is a depression, and not a mere recession, that the country is in--that a depression is a political rather than just an economic event. (The book is entitled A Failure of Capitalism: The Crisis of '08 and the Descent into Depression, and will be published early in April by the Harvard University Press.) It is a bad idea for three reasons. First, it directs attention away from the really culpable parties in the depression, who are not the financiers. They were engaged in risky lending, that is true; but the fact that a risk materializes does not prove that it was imprudent. A small risk of bankruptcy--a risk that almost every business firm assumes--can be, when it is a risk faced by most firms in an industry and the industry is financial intermediation, catastrophic. But the responsibility for preventing catastrophic risks to the economy caused by a collapse of the banking industry lies with the Federal Reserve, other regulatory bodies, and the Treasury Department. A banker is not going to forgo a risk that should it materialize would wreck the economy, because his forbearance would have no consequence, as long as his competitors continued running the risk; it is a classic case of external costs, requiring government intervention. Because the Federal Reserve under Alan Greenspan pushed interest rates too low and kept them low for too long, and because regulation of financial intermediaries had over the years dwindled and became especially lax during the Bush Administration, the bankers were allowed, and competition forced them, to take risks that could have and have had disastrous results. If the government thinks that shaming the bankers and capping their pay will prevent future banking disasters, it will be distracted from making the regulatory changes that are necessary to restore effective public supervision of a vital industry. Second, the pay cap contributes nothing to getting us out of the depression. That can be done only by an active monetary policy, by recapitalizing the banking industry, and by a stimulus program (because the first two policies are not working well)--that is, by trying to stimulate demand for goods and services by putting unemployed or underemployed labor and other resources to work, as by a public-works program, the idea being that if private demand falls below supply, the equilibrium can be restored by substituting public demand for the missing private demand. The pay ceiling does nothing along any of these lines. One reason it does not is that the problem of overcompensation in the banking industry is more serious at the trading level than at the senior management level, since it's the traders who make the transactions. I give an example in my book of how it can pay a trader to make an extremely risky trade. The pay cap doesn't reach down that far in the corporate hierarchy. Third, and worst, the pay ceiling will retard the recovery of the banking industry. Not, I think, because it will drive the ablest executives into other fields; for the demand for their services in other fields is apt to be weak, though some may retire early rather than work for what they are apt to regard as a derisory salary. But some will be hired by banking firms to which the pay cap does not apply because they do not want bailouts. And those who remain in their present jobs and are subject to the cap will be distracted from their work. They will have to make changes in their personal finances to adjust to their lower salary, and, human nature being what it is, they will spend time seeking ways to evade the ceiling--efforts that no doubt will be met by bureaucratic regulations designed to foil them. Their time and attention will be deflected from the challenges facing their companies. The pay ceiling will be more than a personal distraction, however. It may cause senior management at some banks to refuse a bailout, to the detriment of recovery from the depression. Worse, it will increase the volatility of the political and regulatory environment of the banking industry (a term I use broadly to include financial intermediaries in general, since the traditional barriers between banks and other such intermediaries have largely been taken down). Critics of the bailouts complain that banks aren't lending the money that the government has given them, but instead are putting it in the pockets of their executives, in the form of high salaries, bonuses and perks. All that money that is going to the executives, however, is just a drop in the bucket. The banks are not lending the capital the government has given them not because they've squandered it on their executives but because the demand for loans is weak in a depression, because loans in a depression are at a high risk of default, and because the banks are still undercapitalized. Having railed against the banks for taking too many risks, the government now wants them to take more risks! A compelling criticism of the bailout programs is that their erratic administration has left the banking industry uncertain as to what is coming next. Are the banks going to be taken over by the government? Or subjected to new forms of regulation? What strings will be attached if they need additional capital? Will they be forced to lend money even though they are undercapitalized? If so, and they get into trouble, will the government bail them out again? Will they be made scapegoats for lax regulation? All else aside, a firm operating in so uncertain an environment is apt to hunker down and hoard its cash, for it must be prepared for anything. The pay ceiling adds to the uncertainty of their environment by suggesting that they are to be subjected to populist regulation as well as to regulation singlemindedly concerned with getting us out of the depression as quickly as possible. All this said, I don't deny that there is such a thing as executive overcompensation, owing to the weak incentives of boards of directors to police compensation. But that's a long-term problem, rather than anything to do with fighting a depression.

Pay Controls Do Not Work at Any Level-Becker

Several big banks and other companies have badly fumbled their public relations during these difficult times, such as the big three auto makers who took their private jets to Washington to beg Congress for a bailout, or the board and CEO of Merrill Lynch that granted generous bonuses to their executives just as the company was avoiding bankruptcy through being taken over by Bank of America. However, anger, even when justified, is not a good reason for ceilings on the pay of top executives at companies receiving assistance from the federal government. The main problem with wage (and price) controls is that they never work, although governments have imposed them throughout history. They will not work in this case either, where the plan includes a salary cap of $500,000 for top executives at companies taking "extraordinary assistance" from the federal government, restrictions on when these executives can cash in the stock they will receive, limits to their severance pay, and monitoring of fringe benefits, like company jets. There are no good guides to a priori setting of either the form or the level of compensation to employees in any occupation, including top executives. Competition, with all its defects (which I discuss later), is still the best mechanism available for setting salaries and other prices. Pay caps will encourage companies that take government aid to hire high priced lawyers and accountants to devote their expensive time trying to find loopholes in these caps. Loopholes include reclassifying some employees to positions below top executives so that their pay would not be subject to any government pay caps. Most loopholes center on various forms of deferred payments and non-monetary benefits. For example, companies started to provide free medical coverage to its employees during World War II as a way to circumvent controls over wages. This fringe benefit has persisted as a tax advantage that is usually not available to workers who pay for their own medical insurance. The plan for executive pay caps already includes restrictions on several fringes, including the ownership of corporate jets by companies taking government assistance, even though company jets are often valuable savers of the expensive time of executives who do a lot of traveling. Able lawyers and accountants will discover many other fringe benefits that can help circumvent the pay caps. Companies that take government assistance do so because they fear going bankrupt. Sometimes that is because they were badly managed by the CEOs and other executives in charge. What many of these companies need are new executives who can take a fresh look at their problems. Unfortunately, pay caps that leave total pay considerably below what able executives receive in other companies make it more difficult to attract these executives to companies in distress because they can earn more, and work with considerably less government interference, in companies that do not take or need aid. Moreover, severe limits on severance pay help to lock in incompetent executives who then might refuse to leave voluntarily because they would not receive any significant financial incentives to leave. Apropos of turnover of top executives, I believe many company boards, and also boards of universities and other non-profit institutions, fail in their most important responsibility: to determine when top management should be replaced. This is partly because many board members spend very little time on board activities, and also because many members are friendly, or at least sympathetic, to the top executives. As a result, they are either too ignorant of how the companies they oversee are really doing to overrule top management, or they are too close to management to make the hard decision to fire them when they perform badly. Of course, one reason caps on the pay of bank top executives are popular is because of the general perception that boards of directors also overpaid these executives, and thereby failed in this duty to protect stockholders. Perhaps they did, but even if the pay of top executives at many banks and funds were well above what they would receive in a well functioning competitive market for executives, that could not explain the devastating hit taken by stockholders of these companies during this crisis. For example, even a 100% overpayment to bank executives would usually have only a small direct effect on bank profits since their pay, however large in an absolute sense, was rather small compared to the normal profits of these companies. Another criticism of the compensation of the top executives of banks and other financial institutions is that it encouraged excessive risk-taking because their pay was excessively loaded toward stocks and bonuses. In retrospect, obviously, top executives of many financial companies took risks that turned out to be catastrophic for stockholders and employees. Yet, since the value of the stocks owned by these top executives also dropped sharply, and since their bonuses have been sharply reduced or eliminated, most top executives did suffer greatly along with stockholders when their risky decisions failed. So any distortion in the pay structure toward risk taking was surely limited.

Buy American Once Again-Becker

Every recession, including those milder than the current recession, leads to pressure to reduce spending on foreign goods by raising tariffs and other import restrictions. The avowed goal is to help domestic workers and businesses that are going through difficult times. Hostility to imports when unemployment is high and rising is surely understandable. Nevertheless, it is unwise to engage in seriously restrictive international trade policies even during a serious recession. Unfortunately, in the recent stimulus bill passed by the Democratic members of the House of Representatives, the recession is used as an excuse to promote "buy American" policies. The bill would, among other similar restrictions, ban the use of non-American steel in the many construction projects that are part of the stimulus package. This provision was included even though it appears to violate US obligations under the rules of the World Trade Organization, and under the Nafta agreement with Canada and Mexico. This buy American provision in the stimulus bill has already led to retaliatory threats by several European and Asian countries since many other countries are also eager to place greater restrictions on imports. The economic case for higher tariffs and other trade restrictions during serious recessions is that the economic system does not function well during depressed times. This malfunctioning of the economy creates higher unemployment of both labor and capital. The protectionist argument is that under such abnormal conditions, various means of putting these resources to work, such as tariffs and buy American laws, may be desirable, even though during normal times these would clearly be inefficient and hurt consumers and the economy. The merit in this argument is overwhelmed by several more powerful arguments against increased trade restrictions, even during serious recessions and depressions. One obvious argument is that retaliation against American exports would surely follow if buy American restrictions remain in the version of the stimulus bill that will become law. The most famous example of such a tariff war occurred during the Great Depression. In 1930, during the early stages of that depression, Congress passed the Smoot-Hawley Tariff Act- named after the two Republican congressmen who promoted the bill. It raised the US tariff on over 20,000 imported goods to unusually high levels. Over 1000 economists of different political views signed a petition that urged President Herbert Hoover to veto the bill. He did not, even though he had favored lower rather than higher tariff rates. In addition to Smoot-Hawley, Congress and President Roosevelt in 1933 passed the first buy American law that required the federal government to prefer US products in its purchases. After Smoot-Hawley passed, many countries retaliated with increased tariffs on American goods. American-European trade crashed rather soon after these tariff increases, although the growing world depression may have been more important in this crash than the higher tariffs. The Smoot-Hawley tariff played an uncertain role in worsening the world-wide depression of the 1930s, but it surely does not appear to have helped the US moderate the depression that began a year earlier in 1929. By 1933, unemployment had climbed to 25% from only about 3% in 1929, and output had fallen by over 30%. Retaliation from other countries is not the only negative effect of raising trade restrictions during a recession. The primary determinant of which trade restrictions get imposed on foreign imports, such as the buy American steel clause of the House stimulus bill, is the level of political power different industries have in Congress. The dominance of politics over economic benefits is a general weakness of so-called stimulus packages. The House stimulus bill not only restricts imports of foreign steel, but its spending programs are only distantly related to any positive effects on unemployment. For example, broadband access and alternative sources of energy, such as windmills and solar panels, are both generously subsidized by the House bill. Spending on these and the many other programs in the bill may (or may not) be worthwhile, but such spending will have little effect on unemployment because it will mainly utilize high skilled workers and capital that would otherwise be employed at other activities. Recessions generally concentrate unemployment among lower skilled workers, along with workers in industries that are particularly hard hit, such as residential housing and banking in this recession. Trade restrictions can do only modest amounts to help either low skilled unemployed workers, or the unemployed in industries like banking and residential construction. However, the retaliation from other countries induced by more restrictive policies would reduce the demand for exports of American goods, such as products of the high-tech industry and agricultural goods, and reduce profits and employment in these sectors. One major reason why trade restrictions and other government "stimulus" programs may be politically attractive during a recession is that identifiable groups benefit, such as the steel industry, or the recipients of the government stimulus spending. By contrast, the harm to workers in export industries who suffer because of the indirect effects of trade restrictions on exports, or the harm to workers in industries that are crowded out by government spending, is remote and not so apparent.

Protectionism in a Depression--Posner

I have little to add to Becker's post, with which I agree. One does understand the support in Congress for adding "Buy American" provisions to the stimulus package now moving through Congress (the "American Recovery and Reinvestment Act of 2009," as it is called). Apart from the usual interest-group pressures, the goal of the Act, or at least the stated goal (for besides the goal of stimulating the economy, there is the goal of advancing President Obama's long-term policy agenda at an opportune time, by grafting the agenda onto the stimulus), is to increase employment, and that means employment in the United States, obviously. If suppliers say of broadband equipment receive a government order and satisfy it by buying the equipment abroad, the increase in employment (if any) will take place in the country in which the equipment is bought. An appropriate solution to this dilemma is to focus the stimulus package on goods and services that are made in the United States. That is one more reason why, as some Republican senators are now urging, more of the stimulus money should go to construction, whether of roads or bridges or schools. True, some inputs into these products, such as steel for bridges, may come from abroad, but most are local, in particular of course labor--and there is a lot of unemployment in the construction industry. Indeed, government-financed construction, especially of transportation facilities, strikes me as the optimal Keynesian anti-depression program: the inputs are local, unemployment in the industry is great, our transportation infrastructure needs investment, improving it will confer external benefits (such as faster commuting and less wear and tear on vehicles), the costs can be eventually recovered, after the depression ends, in tolls and other user fees, and construction projects (especially repairs) can be commenced pretty quickly, especially if emphasis placed on funding state and local road and other infrastruture projects that have been interrupted or deferred by the states' depression-caused revenue shortfalls. On the topic of sending stimulus money abroad, I think the big foundations, such as the Gates foundation (the biggest), should be strongly urged to redirect their extensive foreign charity to the United States at this time of depression. I am not suggesting that his projects should "Buy American," in the sense of buying U.S. products to give to foreign recipients of his charities. The point is rather that charity should begin at home when home is suffering. The bailouts and stimulus and other expenditures, over and above our already huge budget deficits, aimed at getting us out of our economic doldrums as fast as possible, are going to increase the national debt significantly and by doing so impose heavy costs for years to come. The foundations in the aggregate spend many billions of dollars a year, and the substantial portion that goes to fight malaria in the Third World or promote agriculture or family planning there could be redirected--not all of course and not all at once, because the programs induce reliance on the part of the recipients--to the United States to help get us out of our economic predicament without assuming a staggering further burden of debt. I grant that poor countries may be harder hit by what is a global depression than the United States, but I consider Americans' obligations to be primarily to Americans rather than to the inhabitants, however worthy, of foreign countries. I am also inclined to think that charitable giving abroad is so closely entwined with the nation's foreign policy objectives that it should be regulated by the State Department rather than left entirely to private choice.

Protectionism in a Depression--Posner

I have little to add to Becker's post, with which I agree. One does understand the support in Congress for adding "Buy American" provisions to the stimulus package now moving through Congress (the "American Recovery and Reinvestment Act of 2009," as it is called). Apart from the usual interest-group pressures, the goal of the Act, or at least the stated goal (for besides the goal of stimulating the economy, there is the goal of advancing President Obama's long-term policy agenda at an opportune time, by grafting the agenda onto the stimulus), is to increase employment, and that means employment in the United States, obviously. If suppliers say of broadband equipment receive a government order and satisfy it by buying the equipment abroad, the increase in employment (if any) will take place in the country in which the equipment is bought. An appropriate solution to this dilemma is to focus the stimulus package on goods and services that are made in the United States. That is one more reason why, as some Republican senators are now urging, more of the stimulus money should go to construction, whether of roads or bridges or schools. True, some inputs into these products, such as steel for bridges, may come from abroad, but most are local, in particular of course labor--and there is a lot of unemployment in the construction industry. Indeed, government-financed construction, especially of transportation facilities, strikes me as the optimal Keynesian anti-depression program: the inputs are local, unemployment in the industry is great, our transportation infrastructure needs investment, improving it will confer external benefits (such as faster commuting and less wear and tear on vehicles), the costs can be eventually recovered, after the depression ends, in tolls and other user fees, and construction projects (especially repairs) can be commenced pretty quickly, especially if emphasis placed on funding state and local road and other infrastruture projects that have been interrupted or deferred by the states' depression-caused revenue shortfalls. On the topic of sending stimulus money abroad, I think the big foundations, such as the Gates foundation (the biggest), should be strongly urged to redirect their extensive foreign charity to the United States at this time of depression. I am not suggesting that his projects should "Buy American," in the sense of buying U.S. products to give to foreign recipients of his charities. The point is rather that charity should begin at home when home is suffering. The bailouts and stimulus and other expenditures, over and above our already huge budget deficits, aimed at getting us out of our economic doldrums as fast as possible, are going to increase the national debt significantly and by doing so impose heavy costs for years to come. The foundations in the aggregate spend many billions of dollars a year, and the substantial portion that goes to fight malaria in the Third World or promote agriculture or family planning there could be redirected--not all of course and not all at once, because the programs induce reliance on the part of the recipients--to the United States to help get us out of our economic predicament without assuming a staggering further burden of debt. I grant that poor countries may be harder hit by what is a global depression than the United States, but I consider Americans' obligations to be primarily to Americans rather than to the inhabitants, however worthy, of foreign countries. I am also inclined to think that charitable giving abroad is so closely entwined with the nation's foreign policy objectives that it should be regulated by the State Department rather than left entirely to private choice.