Canada's Place in the Global Economy

[Edward Campbell]

I'm not sure where it may lead, but Norway and Switzerland are also outside the EU and, with Iceland and Liechtenstein, for the EFTA.

 

[Edward Campbell]

Double post, sorry.

 

[GAP]

Does this mean we will have to pay them equalization payments too? 

 

[a_majoor]

While this development is funny and somewhat surprising, we can deal with this in several ways.

There is nothing to actually stop the Icelandic parliament from adopting the Loonie as their national currency regardless of what we do; several small nations use the USD as their currency without any authorization from the Treasury or the State Department. The downside for Iceland is they have no say in our fiscal or monetary policy, so in the event that Ontario defaults or an NDP government is formed, Iceland is s****d.

Iceland can also ask to become associated with Canada in some way, ranging from a Co Dominium to a protectorate. A status like the US Commonwealth of Purto Rico or a Province is probably closer to what they would like, but any Canadian government will need to examine the issue very closely, including joining conditions and exit strategies. Domestic politics will also play a heavy role; is Iceland going to end up a marginalized "province", and all the political parties will have to calculate "can we wi a majority without Iceland?". Of course, how will Icelandic domestic considerations affact Canada, our policies and our political discussion?

Given the vast differences in history, culture, economies and everything else I'd say Iceland and Canada could not do a "merger" as a province or anything else without severe strain and dislocation to both parties. OTOH, there is nothing wrong with forming a "North Atlantic Free Trade Agreement" with Iceland as the first partner, and giving them (and us) new market outlets for our respective economies. If they adopt the Loonie at the same time, trade integration becomes much easier.

 

[Edward Campbell]

While this development is funny and somewhat surprising, we can deal with this in several ways.

There is nothing to actually stop the Icelandic parliament from adopting the Loonie as their national currency regardless of what we do; several small nations use the USD as their currency without any authorization from the Treasury or the State Department. The downside for Iceland is they have no say in our fiscal or monetary policy, so in the event that Ontario defaults or an NDP government is formed, Iceland is s****d.

Iceland can also ask to become associated with Canada in some way, ranging from a Co Dominium to a protectorate. A status like the US Commonwealth of Purto Rico or a Province is probably closer to what they would like, but any Canadian government will need to examine the issue very closely, including joining conditions and exit strategies. Domestic politics will also play a heavy role; is Iceland going to end up a marginalized "province", and all the political parties will have to calculate "can we wi a majority without Iceland?". Of course, how will Icelandic domestic considerations affact Canada, our policies and our political discussion?

Given the vast differences in history, culture, economies and everything else I'd say Iceland and Canada could not do a "merger" as a province or anything else without severe strain and dislocation to both parties. OTOH, there is nothing wrong with forming a "North Atlantic Free Trade Agreement" with Iceland as the first partner, and giving them (and us) new market outlets for our respective economies. If they adopt the Loonie at the same time, trade integration becomes much easier.

This is what I think is the next, logical step: Iceland joins NAFTA(II) and, as I have advocated elsewhere on Army.ca, we erase the border by massively harmonizing standards.

 

[Edward Campbell]

And more, reproduced under the Fair Dealing provisions of the Copyright Act from the Globe and Mail:

http://www.theglobeandmail.com/report-on-business/top-business-stories/five-reasons-why-iceland-should-adopt-the-canadian-dollar/article2357815/

Five reasons why Iceland should adopt the Canadian dollar

MICHAEL BABAD

Globe and Mail Update
Published Monday, Mar. 05, 2012

The true north strong (at least one of us) and free

The idea of Iceland adopting the Canadian dollar isn’t as nutsy as it might seem to some.

Indeed, says Justin Wolfers, a prominent U.S. economist, if Iceland really wants to do it, Canada should go for it. And if we don’t, maybe the Aussies will.

It also appears there’s nothing to stop the Icelanders from doing it on their own, by the way.

The suggestion, which has been tossed around in some quarters in Iceland over the past several months, picked up steam late last week when Canada’s ambassador to the tiny nation, Alan Bones, said Ottawa is open to talking about it if Iceland makes the request.

“What we know the nature of the final agreement is will depend very much on the expectations of both countries,” Mr. Bones told a broadcast interviewer in Iceland. “But in a straightforward unilateral adoption of the Canadian dollar by Iceland, where it is clear that there’s no input into monetary policy, then we’d be certainly open to discussing the issue.”

Mr. Bones had actually prepared to take it further, and was planning to deliver a similar message Saturday to a conference on Iceland’s currency, the krona.

But, as The Globe and Mail’s Barrie McKenna reported, Canada’s Foreign Affairs and International Trade Department pulled the plug at the last minute. Coincidentally, that happened just a few hours after my colleague’s story was published online, picked up by other media and flashed around the world via Twitter.

Canadian officials said Ottawa won’t talk about the currencies of other countries (though that didn’t seem to be an issue when the G7 intervened to stem a surge in the yen a year ago) and that it wouldn’t have been right to make such comments at a political event, in this case one held by Iceland’s opposition Progressive Party.

I agree it wasn’t the venue for it, particularly given that Iceland’s government is officially preparing to join the 17-member euro zone, but it does seem clear that someone somewhere has been talking about this. It’s highly unlikely that Mr. Bones went rogue.

Iceland, of course, was the original poster child of the meltdown, suffering a banking collapse, an economic mess and capital controls.

“An independent currency for a country with the population of the size of a decently sized Canadian city was always going to be a problem,” said Sebastien Galy, senior currency strategist at Société Générale.

“Having that country run a financial bubble while offering very high yield was a recipe for a very rapid rise of a financial empire followed by a catastrophic collapse, with the currency ceasing to have a market at one point. The past few years have been of picking up the broken pieces, and a move to a new currency would help to bring credibility while forcing adjustments in internal prices.”

Should that new currency be the loonie, as it’s known in Canada, which is actually a coin rather than a bill?

“While both currencies share some commonality with their exposures to energy and commodities, it is a reaction to the government negotiating and preparing for the eventual introduction of the [euro],” Mr. Galy said of the weekend discussion in the opposition camp.

“Neither currency is optimal for this country and it is a tug of war between Iceland’s European and more independent Nordic roots.”

Mr. Wolfers thinks the Australian dollar would be a better fit for Iceland. But from Canada’s perspective, it would be a “no-brainer,” the associate professor of business and public policy at the Wharton School of the University of Pennsylvania told me.

“Honestly, other countries should compete with Canada for Iceland’s business,” said Mr. Wolfers, also a visiting fellow at Princeton, citing Australia in particular.

This followed his comments Friday on Twitter, to which Australian MP Andrew Leigh, a former economics professor, responded that, indeed, Iceland would be better off adopting the Aussie dollar. So maybe we can get a competition going.

Mr. Wolfers was referring to what is known as seigniorage, which is how Canada could benefit should Iceland actually ever ditch the krona for the loonie.

I’m not talking about a currency union here, just Iceland using the loonie. Here are five things to consider:

1. Seigniorage

This is the biggie, if a bit complex.

Seigniorage is the difference between the cost of printing a currency and its value. As the Bank of Canada explains it, it’s the difference between the interest the central bank reaps on a portfolio of government securities, in turn basically the same amount as the value of outstanding bank notes, and what it costs to issue, distribute and replace the bills.

On its website, the central bank uses the example of a $20 bill, which has an average lifespan of three years and is the most commonly used. If it invests the proceeds of issuing that note in a government security that yields interest of 5 per cent, the bill yields $1 a year. Producing that bill costs 9 cents. Given the three-year lifespan, it costs an average of 3 cents a year to produce the note. Add 2 cents a year to distribute it, and the annual cost is 5 cents, which means revenue for the central bank of about 95 cents a year for each $20 bill that’s out there.

More than $50-billion has been circulating at any given time, though that can and does change. Generally, the central bank says, it reaps about $2-billion a year. Some is used for general expenses - $366-million in 2009 – and the rest goes to government coffers.

Given Iceland’s small size – its population is just 320,000 – and the fact that its people have embraced electronic banking, we’re not talking about a seigniorage windfall here. But Canada’s Finance Minister Jim Flaherty is looking to get his hands on whatever he can.

“Printing money is a good thing for Canada,” Mr. Wolfers said. “Every dollar in circulation is on the debit side of the central bank’s balance sheet, and they’re effectively borrowing from the Icelanders at a zero-per-cent interest rate.”

So if there are no strings attached, why not? Or, as Mr. Wolfers put it, referring to Iceland, “as long as you’re a bastard, it’s all profit”

2. A stable currency

Iceland could of course benefit from a devalued currency. Instead it would get a strong, stable currency that has been something of a haven during this post-crisis period of uncertainty. While strong, exporters at least know what to expect.

Consider, too, that the Canadian dollar is liquid. The krona was "blasted through smithereens and very few banks can trade [it] in anything else than very small amounts," Mr. Galy noted.

The dollar (CAD/USD-I1.00-0.006-0.59%)has been hovering around par with its U.S. counterpart and is expected to remain there, at least through the end of this year.

I’m not sure Ontario Premier Dalton McGuinty would agree, but Mr. Galy believes that the Bank of Canada has held interest rates below where they should be to hold the loonie down and give exporters more time to adjust to the currency’s strength. So that’s at least something for Iceland if you take that view.

“This soft approach means that capital may be increasingly misallocated at too low a rate (e.g. potentially housing),” he said.

“The more German approach, familiar to many German communities in Canada, is to get down and fix the productivity issue, irrespective of any short-term pain. There is a fine balance between the easy and hard way, we must all tackle whether in Iceland, Europe or Canada.”

3. Respected central bank

Iceland would of course have no say in monetary policy, but it would have a currency overseen by a very strong central bank and governor, who led Canada out of the recession admirably.

Mark Carney is also respected on the global stage, having recently been named to head up the Financial Stability Board.

"Dear Canada: If Iceland wants you rather than their own inept central bank to earn their seigniorage, accept the deal," Mr. Wolfers said on Twitter.

4. Fiscal, economic stability

Iceland has no reputation in the wake of its banking collapse.

Who would you prefer at that point, a euro zone crippled by recession and a two-year-old debt crisis, or Canada?

With Canada, you get a stable, if lukewarm, economic outlook, a government that’s still rated triple-A, and a fiscal standing to die for (if you’re Greece or Portugal).

And, we can count.

5. Our glowing hearts

For Iceland, do not underestimate friendship in this post-crisis era of currency manipulation and mounting trade tensions.

We’re a wonderful people, they’re a wonderful people. We’ve got a beautiful country, they’ve got a beautiful country. True, it gets cold in Canada in the winter, but remember we’re talking about Iceland.

And surely we can forgive them for Björk.

Iceland is somewhat larger and more productive than PEI and Björk isn't that bad ...

... in fact, think of Celine Dion and, suddenly, Björk looks (and sounds) better and better.

 

[a_majoor]

Iceland is somewhat larger and more productive than PEI and Björk isn't that bad ...

... in fact, think of Celine Dion and, suddenly, Björk looks (and sounds) better and better.

And for that alone I nominate ERC for "Post of the Year"  ;D ;D ;D

 

[Fishbone Jones]

While this development is funny and somewhat surprising, we can deal with this in several ways.

There is nothing to actually stop the Icelandic parliament from adopting the Loonie as their national currency regardless of what we do; several small nations use the USD as their currency without any authorization from the Treasury or the State Department. The downside for Iceland is they have no say in our fiscal or monetary policy, so in the event that Ontario defaults or an NDP government is formed, Iceland is s****d.

Iceland can also ask to become associated with Canada in some way, ranging from a Co Dominium to a protectorate. A status like the US Commonwealth of Purto Rico or a Province is probably closer to what they would like, but any Canadian government will need to examine the issue very closely, including joining conditions and exit strategies. Domestic politics will also play a heavy role; is Iceland going to end up a marginalized "province", and all the political parties will have to calculate "can we wi a majority without Iceland?". Of course, how will Icelandic domestic considerations affact Canada, our policies and our political discussion?

Given the vast differences in history, culture, economies and everything else I'd say Iceland and Canada could not do a "merger" as a province or anything else without severe strain and dislocation to both parties. OTOH, there is nothing wrong with forming a "North Atlantic Free Trade Agreement" with Iceland as the first partner, and giving them (and us) new market outlets for our respective economies. If they adopt the Loonie at the same time, trade integration becomes much easier.

A la the Duchy of Grand Fenwick?
(The Mouse that Roared - http://en.wikipedia.org/wiki/The_Mouse_That_Roared)

 

[a_majoor]

Of course, US unemployment data is fictional now, but the convergence of events in Europe and China should be making people quite nervous over here as well (especially American politicians who are hoping for good news, and Canadians who are riding in too small an economy to stay fully afloat in turbulent economic waters):

http://www.reuters.com/article/2012/03/22/us-global-economy-idUSBRE82L0KL20120322

China factories falter, euro zone business wilts

By Andy Bruce and Nick Edwards

LONDON/BEIJING | Thu Mar 22, 2012 1:26pm EDT

LONDON/BEIJING (Reuters) - Chinese manufacturing activity shrank for a fifth straight month in March and the euro zone economy is showing new signs of wilting, according to surveys on Thursday that pointed to weakening global demand.

Only the United States is showing signs of vigor among the world's top economies, underlined by data showing jobless claims last week fell to a fresh four-year low.

That was reinforced earlier on Thursday by a report from the New York-based Conference Board showing its leading economic index climbed 0.7 percent during February. It was a fifth consecutive monthly rise, the best string of gains since the U.S. economy rebounded out of recession in 2009.

But analysts warned that U.S. momentum is at risk if the global economy keeps sliding.

"With much of Europe already slipping into recession, the U.S. economy will be pushing against significant external headwinds to accelerate in the quarters ahead," said Jim Baird, Chief Investment Strategist at Plante Moran Financial Advisors in Kalamazoo, Michigan.

Investors were unnerved by the reports from Asia and Europe, selling riskier assets such as stocks.

Thursday's batch of purchasing managers indexes suggested China and Europe will not contribute to a global upturn anytime soon.

Factory activity in China contracted for a fifth straight month in March, hit by declining order books, disappointing exports and new hiring hitting a two-year low.

By contrast, Thursday brought more evidence the U.S. jobs market is improving, with initial jobless claims falling by 5,000 to 348,000 last week - the smallest number since February 2008 - and topping expectations for a rise.

"The PMIs give a warning that even if the U.S. economy seems to be doing quite well, that doesn't necessarily translate to solid growth in every other part of the world," said Jonathan Loynes, an economist at Capital Economics in London.

China's slowdown partly reflects the weakness of economies in Europe, its single biggest export partner. The PMIs suggested a euro zone recession is now unavoidable.

Memphis, Tennessee-based FedEx Corp (FDX.N), whose delivery service spans the globe, included a warning with its earnings report issued on Thursday that tepid economic growth was causing it to scale back its outlook for the rest of this year.

"What we're seeing at the moment ... is we just don't have as strong an economy as we would have hoped it would be a year ago," Chief Financial Officer Alan Graf told analysts on a conference call.

In Europe, German and French manufacturing, which at this time last year spearheaded the euro zone's recovery, suffered a sharp decline in March that even the most pessimistic economists failed to predict.

Investors immediately hedged exposure to trades betting on a rebound in global growth. Brent crude oil pared losses to 0.3 percent after the U.S. jobs data before falling again, last trading down 1.4 percent to $122.45 a barrel.

The HSBC flash purchasing managers index, the earliest indicator of China's industrial activity, fell to 48.1 from February's four-month high of 49.6, and firmly below 50, the threshold that divides contraction and growth.

The survey added weight to a string of downbeat anecdotes from major corporations on the world's No. 2 economy. BHP Billiton (BHP.AX), the world's biggest miner, said on Tuesday it was seeing signs of "flattening" iron ore demand from China.

Broad-based weakness in the five key components that generate the Chinese PMI index surprised analysts, particularly those who had anticipated a clear-cut rebound in factory activity in March after the Lunar New Year holiday disrupted output in the first two months of 2012 and distorted the data.

"This data suggests there's something more profound at work, that it's not just a Lunar New Year problem and that it's not just affecting exports, but domestic demand," said Tim Condon, chief economist and head of Asian research at ING in Singapore.

EUROPE FLAGS AGAIN

Markit's Eurozone Composite PMI declined unexpectedly to 48.7 in March from 49.3 in February, a full point below economists' consensus forecast of a 49.7 reading, capping the first quarter of the year in disappointing style.

Most worryingly, the surveys suggested business activity in economic heavyweights France and Germany is starting to flag, with job losses mounting across the euro bloc at the fastest pace since March 2010.

"We're more pessimistic than the consensus on the euro zone over the next year or two, both in terms of the outlook for the economy and also the currency union itself. So in that sense, these numbers give some support to that view," said Capital Economics' Loynes.

The European Central Bank has pumped more than 1 trillion euros ($1.32 trillion)of cheap three-year loans into the banking system over the last four months, lowering bond yields in the process. But the PMIs showed the impact of this has yet to be felt in the wider economy.

"While we still see a good chance of the recession in the euro zone coming to an end in spring, it seems unreasonable to expect more than an anemic upward movement in the further course of this year," Christoph Weil, economist at Commerzbank in Frankfurt, said in a research note.

PMI compiler Markit said the surveys were consistent with a decline of 0.1 percent in euro zone gross domestic product during the first quarter, following the 0.3 percent decline seen in the last three months of 2011.

With France and Germany now struggling, Markit said it was hard to see what could drive the currency union forward in the months ahead, especially since many of its smaller countries are already mired in recession.

"The austerity measures implemented there are going to keep some major economies such as Italy and Spain in recession, which is going to damage the region as a whole," said Chris Williamson, chief economist at Markit.

By contrast, Britain should at least avoid a recession, but hopes that the UK economy will pick up momentum were dealt a blow on Thursday with news that retail sales in February suffered their biggest monthly fall in nine months.

 

[a_majoor]

And a longer term view. Some good news in the long run (but Lord Keynes also said "In the long run we are all dead"):

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2012/03/19/weeks-when-decades-happen.aspx

Weeks When Decades Happen

By Louis Gave
March 14, 2012

Talking about the Russian Revolution, Lenin once said that “there are decades when nothing happens and there are weeks when decades happen.” The last quarter of 2001 looks in retrospect like one of those exciting periods: three events occurred which set in motion the main economic trends of the ensuing decade. Successful investors latched on to at least one of these trends. The problem is, all three trends are now over. The investment strategies that worked over the past decade will not continue to work in the next. What comes next?

The three big events of 2001 were:

• The terrorist attacks of 9/11. This unleashed a decade of bi-partisan “guns and butter”policies in the US and produced a structurally weaker dollar.

• China joined the WTO in December 2001. China’s full entry into the global trading system signaled a re-organization of global production lines and China’s emergence as a major exporter. Export earnings were recycled into the mother of all investment booms, which drove a surge in commodity demand and a wider boom in emerging markets.

• The introduction of euro banknotes. The introduction of the common currency unleashed a decade of excess consumption in southern Europe, financed unwittingly by northern Europe through large bank and insurance purchases of government debt.

But today, all three trends have stalled—and this perhaps accounts for the discomfort and uncertainty we find in most meetings with clients. Indeed:

• US guns and butter spending is over. For the first time since 1970, real growth in US government spending is in negative territory:

• Chinese capital spending is slowing. China still needs to invest a lot more, but future growth rates will be in the single digits.

• Excess consumption in southern Europe is done. Money is clearly flowing out to seek refuge in northern Europe.

Thus, like British guns in Singapore, investors whose portfolios still reflect the above three trends are facing the wrong way. Instead of lamenting over the past, investors should be coming to grips with the trends of the future: the internationalization of the RMB, the rise of cheaper and more flexible automation, and dramatically cheaper energy in the US.

1- The internationalization of the RMB

China is now the centre of a growing percentage of both Asian, and emerging market trade (a decade ago China accounted for 2% of Brazil’s exports; today it is 18% and rising). As a result, China is increasingly asking its EM trade partners why their mutual trade should be settled in US dollars? After all, by trading in dollars, China and its EM trade partners are making themselves dependent on the willingness/ability of Western banks to finance their trade. And the realization has set in that this menage à trois does not make much sense. Indeed, for China, the fact that Western banks are not reliable partners was the major lesson of 2008 and again of 2011.

As a result, China is now turning to countries like Korea, Brazil, South Africa and others and saying: “Let’s move more of our trade into RMB from dollars” to which the typical answer is increasingly “Why not? This would diversify my earnings and make our business less reliant on Western banks. But if we are going to trade in RMB, we will need to keep some of our reserves in RMB. And for that to happen, you need to give us RMB assets that we can buy”. Hence the creation of the offshore RMB bond market in Hong Kong, a development which may go down as the most important financial event of 2011.

Of course, for China to even marginally dent the dollar’s predominance as a trading currency, the RMB will have to be seen as a credible currency—or at least as more credible than the alternatives. And here, the timing may be opportune for, today, outshining the euro, dollar, pound or even yen is increasingly a matter of being the tallest dwarf.

Still, China’s attempt to internationalize the RMB also means that Beijing cannot embark on fiscal and monetary stimulus at the first sign of a slowdown in the Chinese economy. Instead, the PBoC and Politburo have to be seen as keeping their nerve in the face of slowing Chinese growth. In short, for the RMB to internationalize successfully, the PBoC has to be seen as being more like the Bundesbank than like the Fed.

Following this Buba comparison, China has a genuine opportunity to establish the RMB as the dominant trade currency for its region, just as the deutsche mark did in the 1970s and 1980s. But interestingly, China seems to consider that its “region” is not just limited to Asia (where China now accounts for most of the marginal increase in growth—see chart) but encompasses the wider emerging markets. How else can we explain China’s new enthusiasm in granting PBoC swap lines to the likes of the Brazilian, Argentine, Turkish and Belorussian central banks?

China’s attempt to move more of its trade into RMB is interesting given the current shifts in China’s trade. Indeed, although the US and Europe are still China’s largest single trade partners, most of the growth in trade in recent years has occurred with emerging markets. And China’s trade with emerging markets is increasingly not in cheap consumer goods (toys, underwear, socks or shoes) but rather in capital goods (earth- moving equipment, telecom switches, road construction services, etc; see China Bulldozes a New Export Market). In short, yesterday China’s trade mostly took place with developed markets, was comprised of low-valued-added goods, and was priced in dollars. Tomorrow, China’s trade will be oriented towards emerging markets, focused on higher value-added goods, and priced in RMB.

This would mark a profound change from China’s old development model: keeping its currency undervalued, inviting foreign factories to relocate to the mainland, transforming 10-20mn farmers into factory workers each year, and triggering massive labor productivity gains—gains which the government captures through financial repression and redeploys into large-scale infrastructure projects. But China’s change in development model may be less a matter of choice than of necessity.

2– Virtue from necessity: the rise of robotics

The first harsh reality confronting China is that the country is now the world’s single largest exporter. Combine that impressive status with the reality that the world is unlikely to grow at much more than 3% to 4% over the coming years and it becomes obvious that the past two decades’ 30% average annual growth in exports just cannot be repeated.

Beyond the limits to export growth, the other challenge to China’s business model is the second step, namely the transforming of farmers into factory workers. Not that China is set to run out of farmers (see The Countdown for China’s Farmers). But the coming years may prove more challenging for unskilled workers as robotics and automation continue to gather pace. Over the coming decade, cheap labor may not be the comparative advantage it was in the previous decade, simply because the cost of automation is now falling fast (see The Robots Are Coming).

Of course, factory and process automation is hardly a new concept. What is new is the dramatic recent shift from fixed automation to flexible automation.For decades we have had machines that could perform simple repetitive tasks; now we have machines that can be reprogrammed easily to perform a wide range of more complicated functions. With improved software and hardware, robots can do more, in more industries; and the purpose of automation has shifted from improving crude productivity (making more of the same things at lower cost) to more sophisticated targets like adaptability across product cycles, and improved quality and consistency.

One consequence of cheaper and more flexible automation is that some manufacturing that fled the developed world for cheap-labor destinations like China may return to the US, Japan and Europe, as firms decide that the benefits of low-cost labor no longer outweigh the advantage of better logistics and proximity to customers. Even if this does not occur, factories in places like China may become ever more automated (e.g.: electronics assembler Foxconn, Apple’s main supplier and one of the world’s biggest employers with some 1mn workers, has started to talk about building factories manned with robots). This then raises the question of what China’s hordes of manufacturing workers will do should Chinese factories automate and/or re-localize to the developed world. One obvious conclusion is that China’s leaders will thus have to deal with slowing growth through further deregulation, rather than stimulus and currency manipulation. The remedies of 2008 (large fiscal and monetary stimulus) will not work again.

This dilemma implies that the robotics trend dovetails with the RMB internationalization trend. To understand just why, it is important to recognize one aspect of policymaking which makes China unique: the country’s leaders wake up every morning pondering how to return China to being the world’s number one economy and a geopolitical superpower in its own right (few other world leaders harbor such thoughts). And ever since Deng Xiaoping, the answer to that question has typically been to sacrifice some element of control over the economy in exchange for faster growth.

Today, China faces the imperative of making just such a trade-off between control and growth: the old model of cheap labor and vast capital spending is near exhaustion, so the only way to sustain growth is to go for more efficiency, especially through financial sector reform. For China’s leaders, reform will be painful but the cost of missing out on the global power that comes with further growth would be even more painful. Hence we are convinced Beijing will eventually bite the financial reform bullet, and RMB internationalization is the leading edge of that reform. In that light, the creation of the RMB offshore bond market is an event of much greater significance than is currently acknowledged by the general consensus.
3– Cheap US energy

Along with the possibility of manufacturing returning to the developed world from China and other low labor-cost countries, another key trend of the coming decade should be the gradual achievement of energy independence by the US. Given the discoveries of the past few years in the exploitation of shale gas and oil, and assuming the existence of political will to invest in reshaping US energy infrastructure, such a development is now within reach.

These large natural gas discoveries have two potential global impacts. First, the combination of low-cost automation and low-cost energy could encourage manufacturers to locate their plants not in countries with the lowest labor cost, but in those with the lowest energy cost. For example, on a recent visit to Germany we kept hearing how chemical plants would have a tough time competing with American plants if the price of US natural gas stayed below US$2.50. In fact, with Germany having decided to pull away from nuclear and bet its future on high-cost wind power, energy- intensive industries in the country could be in for a challenging decade.

Second, the return to manufacturing and energy independence should lead to sustained improvement in the US trade deficit. Energy imports account for around half of the US trade deficit (while the other half is broadly manufactured goods from China). Today the US, through its trade deficit, sends roughly US$500bn worth of cash to the rest of the world every year. This money helps grease the wheels of global trade since more than two-thirds of global trade is still denominated in dollars. But what will happen if, in the next ten years, the US stops exporting dollars, thanks to its new strengths in manufacturing and cheap energy? In such a scenario, the dollars would run scarce.

In fact, this may already be happening. This would explain why the growth of central bank reserves held at the Fed for foreign central banks has been in negative territory for the past year—and why, over the past two quarters, the Fed has been exceptionally generous in granting swap lines to foreign central banks (notably the ECB).

This does not make for a stable situation. And given that the RMB is unlikely to replace the dollar as the principal global trading currency for many years to come (see History Lessons and the Offshore RMB), the likely combination of expanding global trade and a shrinking US trade deficit should mean that either the dollar will have to rise, or US assets will outperform non-US assets to the point where valuation differnces make it attractive for US investors to deploy dollars abroad (since US consumers won’t).

4– Conclusion

Obviously, we do not claim to have identified all the big trends of the coming decade. The next several years will doubtless deliver many more important changes and investment opportunities (monetization of Japan’s debt and a collapse in the yen? Demographic challenges in numerous countries? Reform and modernization in the Islamic world? Political upheaval and regime change in Iran? Water shortages in China, India and other Asian countries? Possible energy independence for India through thorium-based nuclear energy plants?). But we are nonetheless confident on these main points:

• The three key macro trends of the past decade have come to a screeching halt. This explains why financial markets seem to lack conviction and direction.

• The internationalization of the RMB and the birth of the RMB bond market is likely to be one of the most important developments of the decade. The closest analogy is the creation of the junk bond market by Michael Milken in the 1980s. Interestingly, just as in the early 1980s, few people are taking the time to work through the ramifications of this momentous event. Understanding this new market will prove essential to understanding the world of tomorrow.

• The likely evolution of the US from record high twin deficits to much smaller budget and trade deficits should help push the dollar higher over the coming years. And this in turn will have broad ramifications for a number of asset prices.

 

[a_majoor]

Well if Germany will no longer accept this sovereign debt as collateral, why would anyone else? Expect to see interest rates rise as bond markets start demanding higher risk premiums for bonds from at risk polities. Bonds issues by "Blue" American states in financial difficulty (like New York and California) as well as Ontario and Quebec can also be put under pressure from investors seeking higher risk premiums as well. The follow on effect on national economies will also be devastating. Canada alone pays over $30 billion/year in interest on the national debt in this very low interest rate environment. What will hapen to programs, finances etc. if the interest costs double or triple?

In a macro sense, this is very bad for all of us, particularly anyone with outstanding debts. Pay down what you can while you can still take advantage of low interest rates, and lock in anything that you won't be able to pay off quickly.

http://www.nationalreview.com/corner/294928/ever-closer-union-andrew-stuttaford

Ever Closer Union
By Andrew Stuttaford
March 30, 2012 3:03 P.M. Comments0

On the day that the Eurozone’s leadership announces that it has blended its old bailout fund (the European Financial Stability Facility) with what was originally intended to be its replacement (the European Stability Mechanism) to build a bigger, better emergency stash amounting to¸ well, it’s not so easy to say (check out Open Europe’s calculations here), Germany’s central bank,  the Bundesbank, does this (via the Wall Street Journal):

FRANKFURT—The central bank of Germany will no longer accept bank bonds backed by Ireland, Greece and Portugal as collateral, becoming the first euro-zone central bank to exercise a new privilege to protect its balance sheet from the region’s debt crisis. The decision signals the determination of the Deutsche Bundesbank to limit risks from the nonstandard measures the European Central Bank has taken to combat market stress during the crisis.

More broadly, it reflects concerns that the ECB’s crisis-fighting measures may be encouraging banks to shift debt of dubious value to central-bank balance sheets, ultimately exposing taxpayers to what may wind up being toxic assets.

Last week, the ECB gave the 17 national central banks in the Eurosystem permission to reject collateral bonds backed by governments that have received a bailout from the European Union and International Monetary Fund or whose credit rating falls below ECB standards.

Taking advantage of that freedom, the Deutsche Bundesbank has decided to no longer accept bonds guaranteed by Ireland, Greece and Portugal, starting with €500 million ($665.1 million) already on its balance sheet, a spokeswoman said on Friday. All three countries are receiving loans from the EU and the IMF to keep their governments afloat.
“Our credit assessment of these government-guaranteed bank bonds does not meet the minimum requirements for collateral,” the Bundesbank spokeswoman said. She added that to her knowledge the Bundesbank is the first euro-zone national bank to reject such bonds.

At the end of February, German-based banks had a total of €47.50 billion in borrowings from the ECB, using the Bundesbank as their counterpart. The €500 million it holds in collateral therefore only affects 1% of German banks’ borrowings.

But it’s the thought that counts.

 

[a_majoor]

Spain may yet pull down the EU project, since its economy is so much larger than the other PIIG nations. I must point out Ontario's own NDP is also advocating tax hikes to deal with our stalling economy, so econo0mic illiteracy is common on both sides of the Atlantic and apparently all ends of the political spectrum.

A Spanish default will put global financial markets in chaos, and the most probable outcome will be rapidly rising interest rates as people start demanding a much higher risk premium on sovereign debt, particularly jurisdictions with high levels of debt. Even sub national entities with high levels of exposure will be targeted; Ontario, the US "Blue" states and highly exposed municipalities will all feel the heat:

http://www.forbes.com/sites/louiswoodhill/2012/04/11/spain-is-headed-for-a-major-economic-crash/

Spain Is Headed For a Major Economic Crash
By Louis Woodhill

On June 1, 2009, Air France flight 447 crashed into the Atlantic Ocean, killing all 228 people aboard. The disaster was caused by human error. With the plane already in a stall, the pilots pointed the nose upward, which was the exact opposite of what the situation required. When recovered, the cockpit voice recorder revealed that, before they hit the water, the pilots knew that they were going to crash.

With Spain’s economy already in a stall, the conservative government that was elected on November 30, 2011 first raised the top personal income tax rate from 45% to 52%. Then, on March 30, 2012 it announced corporate tax increases. In other words, Spain pointed their tax rates up in a situation where they should have pointed them down. Thus far, the response from the financial markets amounts to, “She’s going in!”

The ability of the Spanish government to service its debt is a function of the present value of Spain’s future GDP. Since the corporate tax increases were announced, the market interest rate on Spain’s 10-year bonds has risen to 5.98% from 5.35%. While this may not seem like much, this 63-basis-point move (assuming inflation at 2%) has the effect of reducing the present value of Spain’s future real GDP by 32%.

The interest rates on Spanish bonds went up because the markets perceived a higher probability of default. The only thing that could have caused this is a reduction in the expected long-term real growth rate of Spain’s economy.

A two-percentage-point reduction in future GDP growth (from 2% down to zero) would, by itself, cut the present value of future Spanish GDP by 60%. If you add the effects of lower expected economic growth and higher interest rates together, you get a two-thirds reduction in the expected present value of Spain’s future GDP.

With government debt expected to hit 80% of GDP by the end of 2012, Spain has become like a family with a big mortgage where the primary breadwinner has lost his job. Unless they find a way to increase their income, they are going to go bankrupt. It is only a matter of time.

If people want to know what life looks like in the “Prohibitive Range” of the Laffer Curve, all they have to do is to visit Athens. Greece is literally falling apart. Unfortunately, by raising taxes, Spain is making exactly the same mistake that the Greeks made.

The impact upon a modern economy of excessive tax rates is even worse than the Laffer Curve (which is an oversimplification) suggests. Not only do people choose to work less, but also capital begins to flee. The economy goes into a death spiral. GDP falls and unemployment rises, resulting in lower tax receipts and increased social welfare spending. This causes deficits to explode, which causes interest rates to rise, which in turn causes even higher deficits.

Unfortunately, thus far, one response of many European governments to falling revenues has been to increase tax rates. At least in Greece, the tax hikes were imposed by a socialist government. The tragedy of Spain (and, to a lesser extent, England and France), is that the voters elected so-called “conservatives”, only to see them raise taxes and accelerate their country’s economic death spiral. Where can the people turn, when both sides of the political aisle are peddling the same economic poison?

Just as the pilots of Air France 447 needed to reverse their “plane attitude policy” to avoid disaster, the Spanish government needs to reverse its tax policy to avoid an economic calamity. There is still time, but they can’t afford to wait much longer. Unemployment in Spain has already reached 23.9%, with the rate for people 25 and under at more than 50%. And, Spain is so large that it would not be possible for anyone to bail it out while its GDP is contracting at 2.0 – 3.0% per year (except perhaps the ECB, and then, only temporarily).

Large cuts in top personal and corporate tax rates would pull Spain out of its fiscal dive almost instantly. This is because the financial markets run on present value calculations. The markets would respond to higher expected Spanish GDP growth with lower interest rates and a renewed willingness to lend.
What is true for Greece, Portugal, Spain, Italy, France, etc, is also true for the U.S. The only way out of our deficit and debt problems is to cut tax rates and thereby increase GDP growth. Hopefully, in November, we will have the opportunity to elect a new president who understands this.

 

[a_majoor]

Spain is demoted to BBB+. The rating agencies and Bond Hawks are also looking at Italy and the other PIIGS cannot be far behind. There is also an object lesson for Ontario, which is on a downgrade watch. A spike in Canadian interest rates due to an Ontario downgrade cannot have any positive effects for us either (and a chain reaction of debt downgrade or interest rate spikes in Europe will not be contained in Europe either). Since governments are not acting swiftly enough, we must get our personal houses in order, and be prepared for a rough economic ride ahead.

http://www.reuters.com/article/2012/04/27/us-spain-economy-idUSBRE83Q0BQ20120427

Spanish economy in "huge crisis" after credit downgrade

By Nigel Davies
MADRID | Fri Apr 27, 2012 12:49pm EDT

(Reuters) - Spain's sickly economy faces a "crisis of huge proportions", a minister said on Friday, as unemployment hit its highest level in almost two decades and Standard and Poor's downgraded the government's debt by two notches.

Unemployment shot up to 24 percent in the first quarter, one of the worst jobless figures in the developed world. Retail sales slumped for the twenty-first consecutive month as a recession cuts into consumer spending.

"The figures are terrible for everyone and terrible for the government ... Spain is in a crisis of huge proportions," Foreign Minister Jose Manuel Garcia-Margallo said in a radio interview.

Standard and Poor's cited risks of an increase in bad loans at Spanish banks and called on Europe to take action to encourage growth.

The downgrade spooked financial markets, raising the interest rate fellow euro zone struggler Italy was forced to pay to sell 10-year bonds at auction. The yield was its highest since January as investors worried about the economic outlook in the bloc's indebted states.

Analysts said the 5.95 billion euro Italian auction went well under the circumstances, but Rabobank strategist Richard McGuire said the 5.84 percent 10-year yield "leaves a question mark over how long Italy will be able to finance itself at levels that can be deemed sustainable".

Italy's main banking association said the economy may contract by 1.4 percent this year, more than the government's 1.2 percent forecast.

Spain's country risk, as measured by the spread on yields between Spanish and German benchmark government bonds, spiked before leveling off to around 420 basis points.

Spain has slipped into its second recession in three years and fears that it cannot hit harsh deficit cutting targets this year have put it back in the centre of the debt crisis storm, pushing up its borrowing costs.

Recovery and job creation are still two years off, Economy Minister Luis de Guindos said on Friday in a news conference where he forecast 0.2 percent growth in the gross domestic product next year and 1.4 percent growth in 2014.

De Guindos also said Spain would increase the value-added tax and other indirect taxes next year, but would seek to reduce payroll taxes. Spain has a low VAT compared with other European countries even after raising it in 2010.

The government has already rescued a number of banks that were too exposed to a decade-long construction boom that crashed in 2008, and investors fear vulnerable lenders will be hit by another wave of loan defaults due to the slowing economy.

"It's a very challenging situation. I don't think that the banks are cornered yet, but the government must come out soon to say how they will address them," said Gilles Moec, an economist with Deutsche Bank.

DEFICIT TARGETS DOOMED

S&P's head of European ratings, Moritz Kraemer, told Reuters Insider television that Spanish banks could need state aid and the country faced further downgrades if its debt troubles continue to escalate.

"It is not going to be an easy job for most Spanish banks to find funding in the market. So the state may be called for at some point. But that, for now at least, is something the Spanish government seems to be unwilling to contemplate," he said.

Spain has ruled out any use of European funds to recapitalize its banks, weighed down by bad property loans. Economy Secretary Fernando Jimenez Latorre said Spain had sufficient financial capacity to handle a rescue itself in case of need.

The government is considering whether to create a holding company for the banks' toxic real estate assets after three rounds of forced clean-ups and consolidations in the financial sector have failed to draw a line under the problem.

Conservative Prime Minister Mariano Rajoy, in office since December, has passed an austerity budget and introduced new laws to try to make the economy more competitive, such as by reducing costs for companies to lay off workers. He has also agreed with Brussels a higher deficit target for this year.

But he has not convinced investors, and Spain's borrowing costs have shot up recently as the effect of a flow of cheap loans from the European Central Bank has worn off.

On Thursday Rajoy said he was determined to stick to austerity measures even though they are aggravating the economic slump and calls for growth measures are mounting around Europe.

The treasury ministry estimated the increase of 365,900 jobless people in the first quarter meant a loss of 953 million euros in tax income, making deficit cutting even harder.

The unemployment rate was up from 22.9 percent in the last quarter of 2011 and was worse than economists had forecast. Half of Spain's youth are out of work, and figures are unlikely to improve for some time as the government slashes spending by 42 billion euros this year, some 4 percent of economic output.

EUROPEAN ACTION NEEDED

S&P now has Spain on a BBB+ rating, which means "adequate payment capacity" and is only a few notches above a junk rating. Fitch and Moody's still rate Spain's sovereign with a "strong payment capacity".

The ratings agency called on euro zone countries to better manage the sovereign debt crisis.

Standard & Poor's said the euro zone should implement growth-promoting structural measures, feeding into the mounting debate in Europe about the self-defeating nature of austerity-only or austerity-first measures.

S&P said steps to restore financial confidence should "include a greater pooling of fiscal resources and obligations, possibly direct bank support mechanisms to weaken the sovereign-bank links, and a consolidation of banking supervision or a greater harmonization of labor and wage policies."

The call for a Europe-wide system to resolve and underpin banks echoed similar comments from the ECB's Executive Board members Joerg Asmussen and Benoit Coeure.

(Additional reporting by Sonya Dowsett, Inmaculada Sanz, Julien Toyer and Andres Gonzalez; Writing by Fiona Ortiz; Editing by Peter Graff)

 

[a_majoor]

BZ for our government for finally saying no to the nonsensical bailing out of debt ridden EU states. The debtor nations solemnly swear to fix the problems, but either take half measures or put off solutions (has Greece or any of the other PIIGS actually reduced their debts and deficits by a significant amount?) Asking our taxpayers to fork over for the irresponsible actions of others should never be an option:

http://www.torontosun.com/2012/04/28/canada-rightly-said-no-to-the-imf-kent

Canada right to deny IMF: Kent

Jim Flaherty saved Canadian taxpayers from funding failed Eurozone economies with fiscal settings stuck on stupid

Simon Kent
By Simon Kent ,Toronto Sun

First posted: Saturday, April 28, 2012 10:43 AM EDT | Updated: Saturday, April 28, 2012 07:21 PM EDT
finance The IMF’s Christine Lagarde’s effort to raise more than $400-billion (U.S.) to build a financial buffer against the threat posed by the seemingly endless Eurozone debt crisis was politely declined by Federal Finance Minister Jim Flaherty. He decided to save Canadian taxpayers from footing part of the bill.
 
Federal Finance Minister Jim Flaherty dropped the n-word last week and taxpayers across Canada should be glad he did.

The forum was an International Monetary Fund (IMF) meeting in New York. Its members had just tried, for the second time in eight weeks, to hit up Canada for a loan of, well, let’s just say it was something in the order of a lazy $7 billion or so.

True to his conservative financial instincts, Flaherty wasn’t having any of it. So he leaned forward and uttered a word now so rarely heard in global financial circles that many wondered if they’d heard him correctly the first time.

They had. He just said `no.’

In doing so he put Canada at odds with almost the entire membership of the G20. All members (bar the US) backed the IMF’s Christine Lagarde’s effort to raise more than $400-billion (U.S.) to build a financial buffer against the threat posed by the seemingly endless Eurozone debt crisis.

Flaherty’s reason for denying the IMF’s plea for funds is simple.

Until nations like Portugal, Ireland, Greece and Spain – to name just a few – take their fiscal settings off stupid and cease spending like drunken matelots, reduce their borrowings, trim inflated civil services and generally behave like grown-ups instead of spoilt children, Canada will deny the bailout funds everyone knows will just go into more profligate spending.

“They need to step up to the plate and overwhelm this issue with their own resources,” Flaherty said with considered understatement. “There are adequate resources in Europe to address these issues and they ought to be employed.”

Put simply, more debt does not solve a debt problem. Anyone in small business knows that.

If you walked into your local bank here in Canada as the head of a failing business and said you wanted to borrow more money to get out of debt you’d be laughed out of the building.

Flaherty would also probably concede in private that it’s pretty rich for the world’s wealthiest trading bloc to be asking Canadian taxpayers for a handout when the IMF was specifically established in 1945 to help developing countries.

That’s why it’s called the International Monetary Fund. Not the European Monetary Fund or the Save Failed Socialist Eurozone States From Themselves Fund.

Despite Canada joining the US in not giving in to the IMF’s entreaties, things don’t look like they’ll be getting any better any time soon. Just look at the early runoffs for the French presidency.

President Sarkozy, a staunch ally of German Chancellor Angela Merkel and her tough fiscal prescriptions for the eurozone, lost the first round of voting in his re-election bid.

Polls now show him losing the runoff next month to Socialist rival François Hollande, whose dewy-eyed rallying cry is an “end of imposing austerity everywhere, austerity that brought desperation to people throughout Europe.”

That’s right. Hollande wants to start spending again. To do that, no doubt he’ll be asking the IMF for money so he can hire more teachers, increase the size of the civil service and go on funding some of Europe’s more generous retirement schemes that for most government employees start at the grand old age of 53.

Here in Canada access to retirement benefits will soon officially start at the age of 67.

The French are not alone in wanting to borrow against the future of their children.

At the same time voters were exercising their fervent desire to reach for somebody else’s wallet, Irish voters announced they’d had it with the whole austerity caper as well. They want out and they want out now.

Marchers in Galway, Carlow, Wickford and Dublin gathered Sunday to voice their opposition to stringent fiscal cutbacks. Their government has been working to claw back spending but now voters and public sector unions have together decided they’ve had enough.

Other politicians in Europe are also taking heat from an electorate addicted to living off the largesse of free spending administrations.

Netherlands Prime Minister Mark Rutte resigned Monday after European Union demands for budget cuts to bring Holland into line with euro spending rules caused the collapse of his coalition government.

So the world is being held to ransom by eurozone countries that can’t borrow and spend quickly enough and treat the IMF as their national credit card provider.

Canada has successfully resisted two calls from the IMF for more money. There is another full meeting of the fund due later this year.

Canadians can only hope Jim Flaherty looks in the mirror every morning as he shaves and keeps practicing saying that n-word.

CANADA AND THE IMF

The International Monetary fund is one of the major institutions that grew out of the ashes of the Second War II.

Its aim remains to develop an effective monetary system in order to avoid a repetition of such economic crises as the Great Depression of the 1930s, which ruined millions of people around the world.

Canada was one of the first nations to join and was present at the first meeting in December, 1945. Today it is the eighth-biggest contributor to the IMF, after the six other G-7 countries and Saudi Arabia.

The IMF’s role is to oversees the economic policies of member states, provides economic and financial advice, and gives short- and medium-term financial assistance to countries facing balance of payments problems and other difficulties.

The IMF is funded by the annual contributions of its members according to their gross domestic product and adjusted every five years. The sums held by the fund - close to US$287 billion - are used to grant loans to members in financial difficulty.

The IMF is permanently based in New York. Its next major meeting is in October.

simon.kent@sunmedia.ca

 

[a_majoor]

While "Its the Spending, Stupid" should be the tagline for today's ongoing economic crisis, this author looks beyond straight austerity and tax increases (programs which have failed in the EU zone), and tries to suggest the proper policy mix:

http://www.hoover.org/publications/defining-ideas/article/116071

Beyond Austerity
by Richard A. Epstein (Peter and Kirsten Bedford Senior Fellow and member of the Property Rights, Freedom, and Prosperity Task Force)
We must liberalize labor markets, not rely on macroeconomic “fixes.”

Grim is the right word to describe the latest economic news from both the European Union and the United States. Throughout the European Union, austerity programs have failed both politically and economically. In Spain, unemployment rates have soared above 24 percent. The Dutch government is on the edge of collapse because of the popular and political unwillingness to accept the austerity program proposed by its conservative government. Romania is not far behind. Greece, Italy, and Portugal remain in perilous condition. France faces a presidential run-off election between President Nicholas Sarkozy, who is moving rightward on immigration issues, and the free-spending socialist candidate Franciose Hollande. On the American front, the decline of GDP growth to 2.2 percent rightly raises fears that our sputtering domestic recovery is just about over.

It is no surprise, therefore, that leading columnists like Paul Krugman have taken this opportunity to announce triumphantly that austerity is a “fairy tale” that shatters the social confidence that it is designed to shore up. It is futile to invoke fiscal austerity, he argues, when economically beleaguered countries really need to be “spending more to offset falling private demand.” The cure is supposed to be increased government spending, but that solution has its own serious problems. Krugman assumes that the declines in private demand and private investment are attributable to mysterious external forces that are beyond the power of government to control.

The rise in public expenditures has to be financed in one of three ways: higher taxes, increased inflation, or more borrowing. The question of which device is used is, in general, a secondary issue. But the primary insight is this: Any increase in public expenditures in either good or bad times will necessarily result in a larger fraction of the economy under government control.

The ostensible short-term benefit of increased spending comes with a high, but hidden, cost of substituting unwise government expenditures for more sensible private ones. The upshot is that these expenditures might give life-support in the short run, but in the long run they will surely delay the increase in private expenditures that make the stimulus gains unnecessary. And sooner or later, the long-term debt will come due, at which point the only alternative to austerity is wholesale default on key social obligations.

Focusing, therefore, solely on monetary and fiscal policy has dire consequences that the macroeconomic establishment wants to ignore. It is right to say that austerity, taken alone, will fail. But it is wrong to think that increased public expenditures are the road to long-term salvation. The slowness of the American recovery offers solid evidence that priming the pump will fail as well. Even if it does not raise debt costs in the short run, it sops up resources better deployed by sustainable private investment.

Throughout the EU, austerity programs have failed both politically and economically.

How then to create desirable conditions for growth? The first key element is to focus on growth by calling off the acerbic attack on the top one percent. The good Keynesian concentrates on the fall in aggregate demand in the private sector, and should therefore not be concerned with whether that demand is flexed by the rich or the poor or any combination thereof.

All too often, macro-types engage in fancy footwork by claiming that skewing the tax breaks to those at the bottom of the income distribution will hasten the recovery because of their greater marginal propensity to consume. But that bet is exceedingly uncertain because people at all income levels may choose to save, rather than consume, their money depending on how they perceive future economic opportunities.

If low-income workers think that the downturn is permanent, then they will increase their savings to offset the anticipated decline in their future income. Or they will use some of their tax savings or public subsidies to pay off overdue debt, or to save for the college education for their children or, like Joe Nocera, to subsidize their own (underfunded) retirement. Trying to organize a revival of the economy by jiggering tax rates is doomed to fail. Individuals will choose to run their own lives as they see fit, and their financial decisions may negate any supposed advantages that the economic elites can impose through fiscal or monetary policy

So what next? The best first step is to free up labor markets world wide. Specifically, we need policies that take aim at the unbearable political forces that seek to tighten the regulatory noose on voluntary labor markets.

Unfortunately, the dominant attitude of macroeconomists is to assume that nothing that takes place within the labor market (of which Krugman never speaks) is large enough to influence the large macro trends to which they attribute today’s high employment rates.

The blunt truth is exactly the opposite. The calcification of labor markets is the primary impediment to economic recovery. The direct effects of government regulation of labor can matter far more than the indirect effects of macroeconomic policy, whether Keynesian or austerity-based. Neither austerity nor lavish public expenditures will improve the overall situation, which is why the massive increase in American public debt has not nudged unemployment rates down. The only workable solution has to stress job creation, not by misdirected subsidies, but by dismantling the government obstacles to market exchange.

The calcification of labor markets is the primary impediment to economic growth.

Start with the basic microeconomic theory of contract relationships. Private parties have objectives they wish to achieve by coordinated behavior. Voluntary agreements remain the only tool that they have to improve their joint position. There is nothing that the law can or should do to identify the gains through cooperation. That is for the parties to do. The simple combination of labor can allow two individuals to do more together than they could do separately. Two people can raise a barn wall at a small fraction of the cost of each person acting alone.

Specialization increases gains from trade. The function of the law is to reduce the transaction costs to permit the mutual gains to flow. Put another way, if the gains (G) exceed the transaction costs (T), then markets can operate. Where the gap narrows, the gains from trade shrink. When G is less than T, the market folds. Obviously, government should not work to shrink G or increase T. Today, however, it does both.

That said, some modest forms of regulation actually increase gains from trade. Think of a requirement that a real estate sales contract be put in writing. Simple formalities at the outset of a transaction can reduce the uncertainty about the deal and its terms. But virtually all government regulations on wages and terms increase that uncertainty. The high transaction costs reduce the possibilities of cooperation, and the explicit limitations on substantive terms kill off gains from trade. The common view that labor law protections are necessary to protect financially weaker workers from exploitation gets things exactly backwards by, again, raising T and lowering G.

Most voluntary employment contracts are entered into on an “at will” basis, which means that employers can fire their workers and employees can quit their jobs for any reason at any time. Parties that want more complicated deals can write them out. Usually they don’t because of the efficiency advantage of an “at will” arrangement.

European law at the EU and national level specializes in a set of “for cause” dismissal rules that make it virtually impossible for any employer to lay off any worker. Those rules cause massive amounts of labor market rigidity, which make it difficult for employers to lay off workers for general incompetence (which can never be proved) or in times of slack demand. The unfortunate consequence of that civil-service rigidity is that it reduces the likelihood that an employer will hire workers in the first place. The same is true of the disability regulations in the United States.

Faced with transactional obstacles, the parties will resort to inefficient substitute short-term contracts, where employers are less willing to invest in training workers for the long haul. The eager regulator can try to block this avenue of escape by imposing special taxes on independent contractors. But the likely response to that is simply to not hire new workers; instead, employers may choose to pay current workers overtime, to increase outsourcing, or to invest in capital equipment that reduces the overall demand for labor. Protection works, for a while, for the few in power, but in the long run, it leads to massive layoffs from struggling firms.

Labor markets operate best when gains from trade exceed transaction costs.

Just that outcome describes the fate of heavily unionized industries in the United States. The deeply protectionist National Labor Relations Act dictates that many employment contracts be governed by collective bargaining agreements, which never incorporate at-will principles. Dismissals are often subject to judicial challenges that leave the courts in the hapless position of having to decide whether the decision to dismiss the employee was for anti-union or legitimate employer motives.

In addition to this short-term difficulty, these agreements can never be economically efficient because no union can just bargain to get a bigger slice of a larger pie. Instead, the unions have to worry about maintaining political support from the rank and file. In response, they opt for inefficient labor contracts—think of the complex set of job rules found in standard union contracts—to achieve their dual objectives. These contracts are not easily amenable to mid-term corrections in response to changes in external conditions, all of which require time-consuming and tense renegotiation with unions.

The situation gets no better with the endless number of employer mandates and taxes that are routinely imposed on firms. A typical statute may say that an employer need not supply any health-care insurance for its employees at all, but if it chooses that route, it must meet the following mandates for health, disability insurance, and a host of other conditions. None of these conditions are bad in and of themselves. But legislators never ask the hard question of whether they are worth what they cost. If they are, such provisions would be included voluntarily in the agreement. If they are not, they should not be imposed at all. The constant uncertainty over the potential reach of the Health Care Act currently acts as a disincentive to hire workers.

Nor are bad output effects offset by favorable distributional consequences. The costs of these devices tend to constitute a larger fraction of total earnings for employees at the bottom end of the income distribution. The panoply of restrictions exerts its greatest pressure at the bottom end of the labor market. The upshot is that we see a rise in chronic unemployment, which has brought forth an endless set of laments—all warranted—by such notables as the New Yorker’s James Surowiecki about the socially corrosive consequences of the economic current policies.

But forget the laments. We need to reverse course now. Think simple: increase G and reduce T and labor markets will start to open up again. Regulatory costs will decline, unemployment costs will decline, and consumption will increase. If we fix what is broken, then the economy will start to recover. But if we fiddle at the macro level, then we will stretch the current malaise out for years and years.

Richard A. Epstein, the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, is the Laurence A. Tisch Professor of Law, New York University Law School, and a senior lecturer at the University of Chicago. His areas of expertise include constitutional law, intellectual property, and property rights. His most recent books are Design for Liberty: Private Property, Public Administration, and the Rule of Law (2011), The Case against the Employee Free Choice Act (Hoover Press, 2009) and Supreme Neglect: How to Revive the Constitutional Protection for Private Property (Oxford Press, 2008).

 

[Edward Campbell]

The Financial Times is reporting that Iran is accepting Chinese RMB as payment for oil. This is a major development because the RMB is not, generally, a convertable currency but the Chinese are trying to change that. In fact the Chinese want to make the RMB fully convertable and add it to the World Bank's basket of global reserve currencies.

But there are other implications:

1. US sanctions against Iran are seriously weakened; and

2. Ditto US power to use sanctions to impose its political will.

The Chinese are taking a risk, maybe a small one, in exposing the RMB to the slings and arrows of the free market but they are hoping to reap economic, social and political gains.

My guess:

1. Asia, generally, will get behind China;

2. India, specifically, will feel emboldened to defy the US and buy its much needed oil from Iran; and consequently

3. Euro-American economic sanctions will fail to damage Iran; and, thus

4. US global power will be weakened again.

 

[GAP]

Once the sanction power is diminished enough, then force becomes an option.....

 

[a_majoor]

The changing Global economy will also herald changes to geopolitical alignments, as Walter Russell Mead points out here:

http://blogs.the-american-interest.com/wrm/2012/05/17/the-geopolitics-of-greeces-exit-from-the-euro/

The Geopolitics of Greece’s Exit from the Euro

Geopolitics has so far been absent from the eurozone crisis. But is that about to change? As banks, businesses and Brussels begin accepting the possibility that Greece may indeed exit the euro—until recently an inconceivable proposition—the political ramifications could be just as profound as the economic consequences.

Europe has been so consumed with putting out the fiscal fires that its attention has been diverted from the geopolitical upheaval threatening to engulf the eastern Mediterranean. If Greece falls then Cyprus will crumble as well. As the Financial Times explains:

    The damage to Cyprus’s financial system, heavily exposed to Greek debt, would be devastating. Cyprus last year received a cheap €2.5bn loan from Russia in a gesture that reflected the Kremlin’s interest in protecting wealthy Russian depositors with billions parked in Cypriot banks. It may soon need more aid.

And if Europe cuts Greece loose, Russia may fill the void there as well. There are close cultural ties between these Orthodox countries, and both are like to join in a feeling of bitterness and exclusion vis-à-vis the West.

Americans often don’t “get” the Russia-Greek connection. In Ottoman times, Orthodox Russia was the protector of Orthodox Christians in the great Islamic empire and frequently used its diplomatic clout to defend the rights of its co-religionists. Greece looked to Russia as a reliable ally during much of the troubled period after modern Greece gained independence from the Turks.

The feeling is reciprocal. Russia received the gospel from Greek Christians. The Russian tsars married into the Byzantine royal house; the word tsar (or czar) is the Russian form of Caesar, indicating the strong Russian sense that Orthodox Moscow, after the fall of Constantinople, was the “Third Rome.” Much of modern Russian identity and sense of a unique place in the world is wrapped up in its civilizational connection with Byzantine culture and religion.

Mount Athos, the center of Orthodox monasticism and the spiritual heart of Greece, looms large in Russia. No less a person than President Vladimir Putin has made pilgrimages to this site.

There are other connections as well. Much of the Russian oligarchy’s money has been moved through Greek Cyprus, where the banking system has long been very close to post-Communist Moscow.

Israeli interests are also involved. As Turkish-Israeli relations have cooled, Greco-Israeli ties have warmed. The discovery of vast natural gas deposits in Cypriot and Israeli waters have pushed those countries closer together; indeed, the gas reserves may be large enough to make Cyprus self-sufficient in energy and turn Israel into a major gas exporter for the next several decades. Turkey doesn’t like this.

Meanwhile, the very large wave of immigration from post-Communist Russia to Israel has created new networks of business, investment, and trade between Russian-speaking Israelis and their families and friends in the old country.

The European Union is in retreat in the eastern Mediterranean. Turkey no longer sees its destiny in EU membership; if Greece and Cyprus either jump or are pushed from the euro, they will remain members of the EU, but that membership will mean something much less than it formerly did.

By reaching out to Cyprus and Greece in their hour of need, Russia may build some important new relationships to help compensate for their lost contracts and connections in Iraq, Libya, and perhaps now Syria. If Greece is floundering with a weak drachma and an economic meltdown, a relatively small amount of Russian aid and trade could go a long way.

The creation of the euro was a political as well as an economic event. Its break up will be a political event as well.

How this will affect Canada will be interesting to contemplate; Russia is hardly a friendly power and having it’s influence grow and spread in the Eastern Mediterranean is going to have unpredictable consequences for everyone.

 

[a_majoor]

Sadly, most governments will not be following this advice. This will have disastrous results in the EUzone, and spillover effects throughout the world. Sub polities like Ontario and the Blue US states will be implementing this advice, either in a controlled drawdown or during a financial catastrophe as revenues collapse:

http://online.wsj.com/article/SB10001424052702304707604577423720925560872.html?mod=WSJ_Opinion_LEFTTopBucket

To Get Growth, Shrink the State
The best stimulus is a smaller government.

By TIM KNOX AND RYAN BOURNE

Confusion reigns supreme. The International Monetary Fund told the U.K. this week that it should cut taxes and boost spending while also praising the fiscal consolidation of 2010, which saw a mere 1% cut from public spending. Labour and Conservative politicians argue over the extreme severity of the coalition's spending cuts while ignoring the fact that the national debt is set to increase to a staggering £1.6 trillion by 2015, from £1 trillion in 2010. A false dichotomy—will "austerity" get us out of the economic crisis or will "growth"?—is posed as if the right answer will somehow lead us out of economic despair.

At a time such as this, we need clarity. We need to know where we want to go—and then to boldly implement the policies that will get us there. For all those who wish to see a return to enduring prosperity, new research published today by the Centre for Policy Studies suggests a simple, specific destination. We find that the size of government as a proportion of GDP is a major influence, controlling for other factors, on a country's rate of economic growth. If you want growth, scaling back the state should be an aim whether you have a deficit or not.

We examined the 28 OECD countries defined as "advanced" by the IMF between 1965 and 2010. Using regression analysis to control for the growth rates of the factors of production (physical capital, labor and human capital) and initial GDP, our results suggest that reducing the ratio of taxes or spending to GDP by five percentage points increases the growth rate of GDP per capita by 0.5 to 0.6 percentage points per year.
[knox]

A broader sample of all "advanced" countries (again, as defined by the IMF) over the past 10 years seems to support these findings. Over this period, countries whose governments tax and spend less than 40% of GDP have grown more quickly than the big-government countries.

These differences in growth rates are important. Small differences in percentage growth rates roll up to huge differences in wealth generation over a number of years. If the differential of the last 10 years were to be constant over 25 years, then the economies of those countries with small governments would have more than doubled (an increase of 115%) while big government countries would have only seen growth of 64%.

Is this conclusive proof that cutting the size of government will always increase growth? Of course not. The accumulation and quality of other factors are also important. But this evidence shows that other things equal, countries with small governments and with small tax burdens grow faster.

Everyone—perhaps apart from the ultra-green fringe—accepts that higher growth is a good in itself. But it also has other benefits. Higher growth rates mean more money to spend on public services. As Margaret Thatcher used to say, if you want a bigger slice of cake, bake a bigger cake.

The fact that small-government countries can increase their spending on public services more quickly than big-government countries may explain another fascinating result: that key measures of health and education are similar in both groups of countries—and in many cases are better for the small-government countries. For example, according to the OECD's PISA studies, pupils in small-government countries achieve significantly better results in reading, math and science than those in big-government countries. Life expectancy is also slightly higher in small-government countries (at 81.3 years) than in big-government countries (79.9 years).

Our findings add to the already significant body of economic literature that suggests that small-government countries grow more quickly after accounting for other characteristics. It also shows that there appears to be little correlation between government size as a proportion of GDP and some key outcomes in health and education. The implication is that in the medium term, constraining the size of the state is good for growth, and can also provide social outcomes that are at least as good as those in big-government countries.

Three lessons can be drawn. First, we need financed tax cuts now. Government spending must be quickly reduced, balanced by targeted tax cuts to encourage business growth. This should not be considered as draconian in any way. Spending in the U.K. increased by a huge 53% in real terms in the New Labour years. To cut spending back after such a binge should be merely considered as prudent.

Second, politicians should focus on results, not the amount of money spent, when discussing public services. While New Labour boasted about its "record investment in the NHS" without mentioning the stagnant productivity, today the coalition seems to think that increasing its overseas aid budget is a good thing in itself. This should stop. It makes no sense to judge competency in a policy area by the proportion of GDP spent on it.

Finally, we need an exclusive focus on supply-side reform to promote growth. Luxuries such as family-friendly employment legislation or green initiatives such as the carbon taxes are no longer affordable in the age of austerity.

—Mr. Knox is director, and Mr. Bourne is head of economic research, at the Centre for Policy Studies, which today publishes "Small is Best: Lessons From Advanced Economies."

 

[a_majoor]

While this example is specifically American (and could go in the US economy thread), the implications are universal and could be imported to the EUzone or Ontario, for that matter. We may all actually live to see this, but not as a policy choice due to controlled drawdowns of spending and winding up of programs, but as a collateral result of the bankruptcy and collapse of the social welfare state model. The problem in that case is the transition period, which will not be pretty:

http://www.hoover.org/publications/defining-ideas/article/120481

A Fiscal History Lesson
by David R. Henderson (Research Fellow)

Following World War II, government spending cuts led to an incredible economic boom.
“The final conclusion to be drawn from our experience at the end of the last war is inescapable—were the war to end suddenly within the next 6 months, were we again planning to wind up our war effort in the greatest haste, to demobilize our armed forces, to liquidate price controls, to shift from astronomical deficits to even the large deficits of the thirties—then there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.”

—Paul Samuelson, 1943

“[A]t the end of 1946, less than a year and a half after V-J day, more than 10 million demobilized veterans and other millions of wartime workers have found employment in the swiftest and most gigantic change-over that any nation has ever made from war to peace.”

—Harry S. Truman, January 1947
 
We often hear that big cuts in government spending over a short period of time are a bad idea. The argument against big cuts, typically made by Keynesian economists, is twofold. First, large cuts in government spending, with no offsetting tax cuts, will lead to a large drop in aggregate demand for goods and services, thus causing a recession or even a depression. Second, with a major shift in demand (fewer government goods and services and more private ones), the economy would experience a wrenching readjustment, during which many people would become unemployed, and the economy would slow down.

But if such claims were true, wouldn’t history confirm them? And wouldn’t the decline in the economy be large when the government cuts spending a lot? That’s certainly what the late Keynesian economist Paul Samuelson thought. Well, Samuelson was wrong, and not just wrong, but spectacularly wrong.

In a 2010 study for the Mercatus Center at George Mason University, I examined the four years from 1944, the peak of World War II spending, to 1948. Over those years, the U.S. government cut spending from a high of 44 percent of gross national product (GNP) in 1944 to only 8.9 percent in 1948, a drop of over 35 percentage points of GNP. The result was an astonishing boom. The unemployment rate, which was artificially low at the end of the war because many millions of workers had been drafted into the U.S. armed services, did increase. But between 1945 and 1948, it reached its peak at only 3.9 percent in 1946. From September 1945 to December 1948, the average unemployment rate was 3.5 percent.

Most of the policies that Samuelson had feared actually happened, and in spades. Price controls were eliminated. Not only was the federal budget deficit decreased, but also, in 1947, the budget surplus was over 5 percent of GNP. Demobilization happened big-time. Between 1945 and 1947, when the postwar transition was complete, the number of people in the armed forces fell by 10.5 million. Civilian employment by the armed forces fell by 1.8 million, and military-related employment in industry fell off the cliff from 11.0 million to 0.8 million. As demobilization proceeded, optimistic employers in the private sector scooped up millions of the soldiers, sailors, and others who had been displaced from the armed forces and from military industries.

What Do You Believe: The Official Data or Your Own Lying Eyes?

According to official government data, in 1946, the U.S. economy suffered the worst one-year recession in its history. The official data show a 12-percent decline in real GNP after the war. That certainly sounds like a depression. So, is the story about a postwar boom pure myth? No. What is mythical are the government’s data. Ask most people who were young adults in those years (a steadily diminishing number of people, so talk to them soon) about economic conditions after the war, and they will talk about “the postwar boom.” Why is there such a disconnect between their perceptions and the data? There are two reasons.

The first is what economists call an “index-number problem.” When price controls were removed after the war, prices shot up. Therefore, the prices used to convert nominal GNP into real GNP made real GNP look lower than it actually was. Milton Friedman and Anna J. Schwartz note in their modern classic, A Monetary History of the United States, 1867– 1960:

The jump in the price index on the elimination of price control in 1946 did not involve any corresponding jump in “prices”; rather, it reflected largely the unveiling of price increases that had occurred earlier.

Consider the following example. Imagine that the free-market price of a pound of filet mignon during the war was $1.40 a pound. But imagine further that the government’s price controllers had set the price at $1.00 a pound. Then, when the price control was removed, the price would have shot up to $1.40 a pound. Inflation statistics would have recorded some amount of inflation due to this large price increase. But those statistics would have overstated the real price increase because getting beef at $1.40 a pound would have been better for many of the people who couldn’t, because of the wartime beef shortage, get it at $1.00 a pound.

The second reason that the government’s data are mythical is that GNP and GDP, which are supposed to measure the value of production, instead measure government spending on goods and services at their costs—that is, at the

prices the government paid for them. But we have no idea what those goods and services bought by the government during the war were actually worth. So we can’t straightforwardly compare GNP during the war with post-war GNP.

If we can’t compare, then why do I say that there was a postwar boom? Because people bought cars, houses, gasoline, tires, sugar, nylons, meat, and other products that they were unable to buy during the war. Also, one important piece of information was not subject to the same measurement problem that the GNP data were: namely, the unemployment rate. As noted, that was under 4 percent.

But why did this postwar boom occur? The answer, in a nutshell, is that the U.S. economy went from being centrally planned, with price controls and government allocation in large sectors of the economy, to being much more free market. During the New Deal, Franklin Roosevelt had many advisors who were hostile to free markets. But during the war, Roosevelt, although he centrally planned the economy for the duration, kicked out most of his anti-market advisors, people like Ben Cohen, William O. Douglas, trust-buster Thurman Arnold, price controller Leon Henderson, and Felix Frankfurter. In 1945 and 1946, Harry Truman got rid of the remaining New Dealers, including two of the most prominent ones: former Vice President Henry Wallace and Harold Ickes.

As a result of these changes, writes economic historian Robert Higgs, “Investors were then much more willing to hazard their private property than they had been before the war, as both survey data and financial market data confirm.”

And invest they did. Gross private domestic investment was $44.4 billion in 1941 (in real 1964 dollars). For all of the war years, it was half or less than that 1941 level. In 1946, it shot up to $51.7 billion, grew slightly to $51.8 billion in 1947, and then grew to $60.6 billion in 1948.

The Keynesian Response

Keynesians and others have their own explanations for why the Keynesian predictions of postwar economic disaster did not come to pass. The three most popular are: Rosie the Riveter left the labor force; the G. I. Bill put many returning soldiers in college rather than into the workforce; and the American people stopped saving and started spending the money they had accumulated during the war. The data, however, do not support these explanations.

Rosie Goes Home

“There was no surge in unemployment,” goes the first explanation, “because women left the defense plants and went back to being housewives and raising families.” This explanation is half true and totally misleading. First, approximately half of the women who entered the labor force in the early 1940s stayed in it after the war. The number of women in the labor force rose from 14.5 million in 1941 to a peak of 19.4 million in 1944, declining to 16.9 million in 1947. In other words, of the 4.9 million women who entered the labor force between 1941 and 1944, 2.4 million stayed in the labor force. Thus, there was still a need for millions of jobs to open up for newly demobilized male soldiers. The fact that the unemployment rate stayed in the low single digits is an outstanding success story.

Second, what defense plants? Almost all of them shut down or were reconverted to peacetime uses after the war. Women who wanted to stay employed had to find other private work. As Higgs points out, “The real miracle was to reallocate a third of the total labor force to serving private consumers and investors in just two years.”

The G. I. Bill

The second explanation goes, “The economy adjusted smoothly because the G. I. Bill put so many of those 10 million demobilized soldiers and sailors into college.” But at its peak, in September 1946, the G. I. Bill put only 800,000 veterans into college. Had all these veterans been officially unemployed instead, which is unlikely, the unemployment rate would have been higher by only 1.4 percentage points.

Pent-Up Demand and the Drawing Down of Savings

Keynesian economists also explained away why their glum postwar predictions hadn’t come true by arguing that people drew down their savings to finance their “pent-up demand” for the various goods they could not have had during the war: cars, tires, refrigerators, stoves, and so on. In 1943, Samuelson argued that pent-up demand for consumer goods would cushion the blow of demobilization. Cited in almost every textbook on U.S. economic history, this explanation has become orthodoxy. There’s a problem with this explanation, though: It doesn’t fit the evidence.

There are two parts to Samuelson’s explanation. The first, which is plausible, is that there was pent-up demand due to the heavy rationing that the government imposed during the war. People were ready to buy cars, for example, after having not been able to do so for over three years. But even Samuelson pointed out that this would be a short-term cushion at best. Of course, one could argue that the two years from 1945 to 1947 were short term. But then, after this pent-up demand was satisfied, there should have been a major drop in economic activity and a major increase in unemployment in the medium term. That didn’t happen. The unemployment rate was 3.8 percent in 1948 and rose to only 5.9 percent in 1949.

The second part of the explanation is that people drew down the savings that they had accumulated during the war. But if people were drawing down their savings after the war, their rate of saving would have been negative. It wasn’t. While the personal saving rate did fall substantially from a wartime peak of 25.5 percent in 1944 to 9.5 percent in 1946 and 4.3 percent in 1947, it remained positive.

The bottom line is that after the biggest percentage government spending cuts in American history—the cuts in government spending after World War II—the economy boomed. There are, of course, policy lessons to be drawn from the post-war experience—lessons that we can apply to today’s fiscal crisis. Since we must cut the federal budget deficit, the best way to do so is with cuts in spending.

David R. Henderson is a research fellow with the Hoover Institution. He is also an associate professor of economics at the Naval Postgraduate School in Monterey, California.