The war in Libya has been, as wars go, a great success. A horrendous dictator has been overthrown by his own people, with a bit of help from an international coalition that, for once, has gotten together to do the right thing (though perhaps not entirely for the right reasons, see my earlier post on this). The big question on many people's minds now is: will democracy emerge, or will Islamists take over and refuse to allow any further elections? This may be an oversimplification of the fears, but it's not a gross one, nor is it entirely unjustified. Still, the Islamists are not the greatest threat to Libya's fledgling democracy.
The number one threat is oil. Oil and other natural resources are always a threat to unstable democracies. The reason is that they can generate loads of cash and push up the value of the currency, killing other exports and making the economy lopsided towards oil. This concentrated source of cash means that politicians control (often by government ownership of the oil company, but not necessarily) much of the money the entire country relies on. Even more importantly, it is a source of cash completely "divorced" from the people the government is meant to serve, to borrow a term from Jason Pack and Shashank Joshi's recent article in The World Today. We might all complain about taxes, but at least they create a link between taxpayers and politicians. With natural resources as the main money spinner, citizens become the recipients of whatever politicians in their infinite wisdom decide to give them. This is a recipe for complacency, dependence, and corruption on the highest level. Politicians should be dependent on voters, not the other way around.
Look around the world at any place that has discovered natural resources (especially oil) first before developing a stable, democratic government. See any democracies? I don't. Discovering such resources can be a boon to a country like Norway or Australia, whose state institutions were already solidly in place upon discovery. They are a disaster for places like Nigeria or, I fear, emerging Libya.
There is a second danger as well that functions along similar lines: foreign assistance. As Libyans try to build institutions for the first time (Gaddafi intentionally built none so that no one could compete with his final say in things), international assistance will be a necessity. It's also very dangerous for the same reason that oil is dangerous: it supplies the rulers of a country with a cash supply independent of the country's citizenry (again, I must credit Jason Pack and Shashank Joshi for bringing this so acutely into focus).
It is important to note the other implications of this, too. The citizens of a country generate tax revenue by working in the economy. It's therefore essential to have a working and growing economy to fuel tax revenues. If a government does not require taxes to have cash flow, it has no incentive to power the economy. In addition, if citizens get handouts they have little incentive to push the economy onwards, either. Not only will the political elites be independent of citizens/voters, those voters won't have much in the way of economic clout anyway, unless they become part of the machine themselves. The result is economic stagnation and rampant corruption.
This problem is incredibly hard to solve. In fact, it is hard to see when it has been overcome. Even when outside aid focuses on assisting a local government and tries hard not to be patronizing and not to take the reigns itself, its very presence can push a country away from the very democracy it is trying to promote. Looking at the Balkans, though, we can conclude that this can still be overcome slowly, with vigilance and patience. The "resource curse," as it is known, is harder to surmount.
So what is the solution? If I knew that, I'd be pretty stellar. What I can say is that it is better to tax oil companies than for a government to own them outright. Believe it or not, having foreign-owned oil companies would be a blessing in disguise (still, they can be expropriated at any time -- just look at Venezuela for a recent example).
In the end, the only thing that can protect Libyans from the resource curse is the Libyans themselves. They must be sure that there are laws and institutions in place that can stop elites from enriching themselves with oil money. No easy task. How do you ensure that the courts and institutions that are supposed to make sure everything is done by the book aren't bribed by loads of oil money? One way is to see that they are well paid. Another is to have a free and competitive press to keep the bright light of the public eye shining on shady dealings. The final thing, of course, is that the Libyan people themselves remain vigilant against this threat. They have shown what can happen if they stand up together. They must make sure future governments never think for a second that they are "divorced" from the Libyan people in any way.
Saturday, October 29, 2011
Sunday, October 9, 2011
Privilege or Curse?
The dollar is still the world's most accepted currency, meaning low interest rates and a high dollar price even with a large trade deficit. But is this good or bad for America?
In the 1960s, the French Finance Minister Valéry Giscard d'Estaing coined the term "exorbitant privilege" to describe the US dollar's position as the world's reserve currency. A reserve currency is one that central banks like to keep in their vaults in case of crises because it may be more widely accepted than the currency they print themselves. I'll first go over how the "exorbitant privilege" works for the US and then discuss whether it really is a privilege -- or whether the costs of this position make up for, or even outweigh, its benefits.
What privileges does the US have in the global economy? To understand this, let's look at what life is like for a smaller, poorer country whose currency is not bought, held, and traded by people around the world. Let's say our country is called Zinj. It's a small country so its economy doesn't carry much weight. It's currency, the zinjoleon, is pretty much only accepted within Zinj itself (this is the way things are for most currencies, really).
If Zinj wants to trade with the rest of the world, or invest outside Zinj, it must convert its currency to another one, very often the dollar. If you run an export business, you will need to exchange currency a lot. Luckily your local banks, as well as the central bank, hold a good deal of foreign currency to facilitate exchanges. Because the dollar is the "gold standard" so to speak, banks have bought US treasury bonds and will have cash on reserve at America's Federal Reserve.
This all works very well, really. You list your goods in dollars so that customers around the world know what they cost (they probably have no idea what a zinjoleon is worth and where to buy one). You ship your goods, receive payment in dollars, and then convert most of them into zinjoleons in order to pay your workers, rent, utilities, etc. You might keep some dollars to buy imports with.
The problem comes when there's a crisis. Maybe when the world economy was doing well, and your economy was too, cash flowed into your country. Zinj citizens and businesses had access to cheap capital from abroad. Then the crisis hit.
Regardless of how things are going in Zinj (maybe Zinj has nothing to do with the crisis), investors panic and pull their cash out of the country, converting zinjoleons to dollars en masse to do so (they do this in part because the dollar is accepted everywhere and is therefore less risky). The price of a zinjeon, euro, dollar, or any other currency is based on supply and demand, just as it is for any other good or service. So what happens when loads of people sell zinjoleons (that few people want to buy) to buy dollars? You probably guessed it: the price of a zinjoleon falls.
Suddenly, 1 zinjoleon no longer buys you $1 worth of goods. Maybe it only buys you $0.80 worth now. That means prices for imported goods (listed in dollars) and goods that rely on imports rise sharply (in zinjoleon terms, the currency that people in Zinj actually earn). At the same time, foreign investment has disappeared, cutting funding for projects. Banks have fewer depositors and creditors, meaning they have to raise interest rates. In addition, the central bank may raise interest rates to stamp out inflation and try to stop the currency's fall. All this means that the economy will most likely stumble, perhaps slipping into a severe recession -- even though there was nothing wrong within Zinj itself! Seem totally unfair?
Would something like that happen in America? If the crisis happens outside of America and the dollar is still the reserve currency, no. In fact, even in 2008, when the crisis WAS in America, this didn't happen. Flip the above scenario on its head: folks are buying dollars all over the place and investing their money in the world's largest, most liquid economy and bond market: America. So what happens? Money flows into the US and the dollar rises in value. These combine to make goods cheaper and lower interest rates, pushing the US economy forward! Does that sound like an exorbitant privilege? Yeah, it kinda does!
But wait, the story doesn't end here. I left out the flip side of both stories. Let's revisit Zinj.
A crisis will generally mean recession -- less investment, less consumption, less money being spread around. If that's happening in the countries you trade with, your exports will fall. Luckily for Zinj, though, its currency has also fallen by 20%, meaning its exports are also up to 20% cheaper. This will make Zinj more competitive in world markets during the crisis, boosting its exports even as world consumption slows. Exports bring money into the economy. They may very well bring in enough to make up for the investment cash flowing out, too. After the initial panic and devaluation, therefore, Zinj's economy may start growing quite quickly again, led by exports, as well as domestic businesses competing more easily with imports that are now more expensive.
Flip that around in America. The cash flowing into the country has made the dollar more expensive. That means America's exports have gotten pricier even as the world economy slows and people are buying less. That really kills American exports. At the same time, imports have gotten cheaper, which turns up the heat on American companies that compete against imported goods to sell to American consumers. So we have cheap credit (loans and whatnot), higher investments in stocks and higher prices for companies (meaning they can buy and pay more even if they aren't necessarily doing better), and investments flowing into all kinds of other things, like housing. At the same time, American exporters are having a heck of a time trying to sell their goods and services abroad and other American companies are having a hard time competing against cheap imports from places like Zinj. Sound familiar?
All those cheap loans, high company valuations, and a higher dollar value mean that American consumers, companies, and its government have tended to spend and borrow more than they should have. It also means that outside of finance, in the world of actually selling goods and services, America has had a hard time -- in no small part due to the "exorbitant privilege" provided by the reserve currency that it controls and prints.
Clearly, this is a knife that cuts both ways. Sure, America may have more time than other countries to sort out its budget issues because investors tend not to lose faith (America's debt was downgraded and investors responded -- by buying even more of it). At the same time, there is constant pressure to borrow more and it is ever harder to sell anything. A country like Zinj may feel itself a victim to the winds of the global economy, unable to influence the global currency or exchange rates in any way. True, and America can do a lot to influence the global currency and its value compared with others. But this privilege is also a curse, as I think I have shown. (And I haven't even mentioned the costs of printing the money and the interest payments the Federal Reserve has to make on all the money foreigners have deposited with it.)
Given this double-edged sword, Americans need not fear the dollar's eventual loss of reserve currency status. It will bring a loss of power and prestige, but it may also lighten America's shoulders a bit.
In the 1960s, the French Finance Minister Valéry Giscard d'Estaing coined the term "exorbitant privilege" to describe the US dollar's position as the world's reserve currency. A reserve currency is one that central banks like to keep in their vaults in case of crises because it may be more widely accepted than the currency they print themselves. I'll first go over how the "exorbitant privilege" works for the US and then discuss whether it really is a privilege -- or whether the costs of this position make up for, or even outweigh, its benefits.
What privileges does the US have in the global economy? To understand this, let's look at what life is like for a smaller, poorer country whose currency is not bought, held, and traded by people around the world. Let's say our country is called Zinj. It's a small country so its economy doesn't carry much weight. It's currency, the zinjoleon, is pretty much only accepted within Zinj itself (this is the way things are for most currencies, really).
If Zinj wants to trade with the rest of the world, or invest outside Zinj, it must convert its currency to another one, very often the dollar. If you run an export business, you will need to exchange currency a lot. Luckily your local banks, as well as the central bank, hold a good deal of foreign currency to facilitate exchanges. Because the dollar is the "gold standard" so to speak, banks have bought US treasury bonds and will have cash on reserve at America's Federal Reserve.
This all works very well, really. You list your goods in dollars so that customers around the world know what they cost (they probably have no idea what a zinjoleon is worth and where to buy one). You ship your goods, receive payment in dollars, and then convert most of them into zinjoleons in order to pay your workers, rent, utilities, etc. You might keep some dollars to buy imports with.
The problem comes when there's a crisis. Maybe when the world economy was doing well, and your economy was too, cash flowed into your country. Zinj citizens and businesses had access to cheap capital from abroad. Then the crisis hit.
Regardless of how things are going in Zinj (maybe Zinj has nothing to do with the crisis), investors panic and pull their cash out of the country, converting zinjoleons to dollars en masse to do so (they do this in part because the dollar is accepted everywhere and is therefore less risky). The price of a zinjeon, euro, dollar, or any other currency is based on supply and demand, just as it is for any other good or service. So what happens when loads of people sell zinjoleons (that few people want to buy) to buy dollars? You probably guessed it: the price of a zinjoleon falls.
Suddenly, 1 zinjoleon no longer buys you $1 worth of goods. Maybe it only buys you $0.80 worth now. That means prices for imported goods (listed in dollars) and goods that rely on imports rise sharply (in zinjoleon terms, the currency that people in Zinj actually earn). At the same time, foreign investment has disappeared, cutting funding for projects. Banks have fewer depositors and creditors, meaning they have to raise interest rates. In addition, the central bank may raise interest rates to stamp out inflation and try to stop the currency's fall. All this means that the economy will most likely stumble, perhaps slipping into a severe recession -- even though there was nothing wrong within Zinj itself! Seem totally unfair?
Would something like that happen in America? If the crisis happens outside of America and the dollar is still the reserve currency, no. In fact, even in 2008, when the crisis WAS in America, this didn't happen. Flip the above scenario on its head: folks are buying dollars all over the place and investing their money in the world's largest, most liquid economy and bond market: America. So what happens? Money flows into the US and the dollar rises in value. These combine to make goods cheaper and lower interest rates, pushing the US economy forward! Does that sound like an exorbitant privilege? Yeah, it kinda does!
But wait, the story doesn't end here. I left out the flip side of both stories. Let's revisit Zinj.
A crisis will generally mean recession -- less investment, less consumption, less money being spread around. If that's happening in the countries you trade with, your exports will fall. Luckily for Zinj, though, its currency has also fallen by 20%, meaning its exports are also up to 20% cheaper. This will make Zinj more competitive in world markets during the crisis, boosting its exports even as world consumption slows. Exports bring money into the economy. They may very well bring in enough to make up for the investment cash flowing out, too. After the initial panic and devaluation, therefore, Zinj's economy may start growing quite quickly again, led by exports, as well as domestic businesses competing more easily with imports that are now more expensive.
Flip that around in America. The cash flowing into the country has made the dollar more expensive. That means America's exports have gotten pricier even as the world economy slows and people are buying less. That really kills American exports. At the same time, imports have gotten cheaper, which turns up the heat on American companies that compete against imported goods to sell to American consumers. So we have cheap credit (loans and whatnot), higher investments in stocks and higher prices for companies (meaning they can buy and pay more even if they aren't necessarily doing better), and investments flowing into all kinds of other things, like housing. At the same time, American exporters are having a heck of a time trying to sell their goods and services abroad and other American companies are having a hard time competing against cheap imports from places like Zinj. Sound familiar?
All those cheap loans, high company valuations, and a higher dollar value mean that American consumers, companies, and its government have tended to spend and borrow more than they should have. It also means that outside of finance, in the world of actually selling goods and services, America has had a hard time -- in no small part due to the "exorbitant privilege" provided by the reserve currency that it controls and prints.
Clearly, this is a knife that cuts both ways. Sure, America may have more time than other countries to sort out its budget issues because investors tend not to lose faith (America's debt was downgraded and investors responded -- by buying even more of it). At the same time, there is constant pressure to borrow more and it is ever harder to sell anything. A country like Zinj may feel itself a victim to the winds of the global economy, unable to influence the global currency or exchange rates in any way. True, and America can do a lot to influence the global currency and its value compared with others. But this privilege is also a curse, as I think I have shown. (And I haven't even mentioned the costs of printing the money and the interest payments the Federal Reserve has to make on all the money foreigners have deposited with it.)
Given this double-edged sword, Americans need not fear the dollar's eventual loss of reserve currency status. It will bring a loss of power and prestige, but it may also lighten America's shoulders a bit.
Friday, October 7, 2011
The Second Great Depression Delayed?
For all the bad economic news out there in the US and Europe (I'll call them, admittedly imprecisely, "the West" or "western countries") these days, most people are at least still relieved that unemployment in most western countries has not reached the levels it reached in the Great Depression and that things are far less dire than they were back then. But are we really out of the woods?
What saved us from Great Depression II was a huge bout of monetary and fiscal stimulus. When the Crash of 1929 happened, people feared that central banks would abandon their commitments to convert paper money to gold at the promised rate. This caused a rush into gold. To attract people away from gold, and to assure them that the dollar, for example, was "as good as gold," the Federal Reserve and other central banks ratcheted up interest rates, offering to pay a lot of interest on paper money -- but obviously not on gold. In order to do this, they also had to demand a lot of interest on loans (the difference between the money a bank receives from loan interest and the interest rate it pays to depositors is how a bank makes money, so it can't raise deposit rates much without raising loan rates).
This meant borrowing money became almost completely unaffordable -- no new business ventures then. It also meant that spending money became less enticing, since you could make money by squirreling it away. This meant money flowed into gold, perhaps other commodities, and various forms of saving. It flowed out of buying stuff and investing in future business. Business that relied on the latter two (that's most business) therefore collapsed. This brought down any other businesses with it.
This "monetary tightening" as it's called was accompanied by fiscal tightening. Governments received less in taxes because people were getting poorer -- so they raised taxes and cut spending, hitting people even harder in their wallets and depressing growth further.
This time around, luckily, the reaction was the opposite. Unhindered by the straitjacket of the gold standard, central banks slashed interest rates to try to make borrowing and spending easier and to discourage saving. That's meant to keep the economy moving. In addition, governments responded to the crisis by spending more and either taxing less or at least just letting tax revenues fall without raising taxes. This is fiscal and monetary stimulus. Disaster averted.
Or at least it was. We're now getting into a sticky situation that is getting governments constrained in ways that have similar effects to those of the 1930s. Governments throughout the "West" are either cutting deficits or talking seriously about it. Fiscal tightening is therefore underway or will begin soon. This is partly because governments can't run deficits forever. At some point, the investors that lend money to governments begin to worry that these governments will not be able to pay them back as agreed. Governments have to offer higher and higher interest rates to make investors willing to take this risk. This makes government spending more expensive and less attractive.
(By the way, "investors" include anyone with a bank account or retirement fund.)
So fiscal stimulus is disappearing, at least we still have the monetary sort, right? Well, this is partly true. The Federal Reserve has said it will keep interest rates at around 0% for as long as is necessary. The Bank of England (the UK's central bank) has just announced another round of what is called "quantitative easing," in which the bank buys government and even corporate bonds to make borrowing and spending cheaper and further discourage saving.
There are some forces working in the opposite direction, too, however. First of all, with inflation lower and therefore less of a worry in the US than in the UK, we might expect the Federal Reserve to follow the Bank of England and embark on a third round of quantitative easing as well. This is unlikely for political reasons: even though core prices in particular have remained stable and are rising only slowly, Republican politicians especially are railing against the Fed for allegedly destroying the dollar. Not only that, international investors in the dollar are also protesting loudly, concerned that a decline in the value of the dollar will destroy their investment. The European Central Bank (ECB) is also constrained from taking more bold measures by similar political pressures, mostly from monetarily conservative Germany.
So central banks are being restrained. At least interest rates are not set to go up, right? The thing is: borrowing is getting more difficult, whether interest rates are rising or not (though often they are). This is because individuals and most corporations cannot deal directly with their central bank. Central banks can print money, other banks can't. This is mostly a problem in Europe. As panic spreads concerning European governments' (in)ability to pay what they owe bond investors (many of whom are banks), investors are also starting to demand higher interest rates from banks, too. The banks, in turn, are scared about what would happen if some European governments (like Greece or Italy) didn't pay them back. Their reaction is to lend less money and to raise rates on loans (remember that a bank must demand higher rates if it also costs it more money to borrow, whether from depositors or investors buying its bonds). This is gumming up the wheels of business in a way not unlike that of the 1930s, though less dramatically.
So lending is partly blocked and governments are cutting spending and raising taxes. Still, lending hasn't stopped, trade barriers haven't gone up (a big 1930s mistake that intensified the Great Depression), and interest rates are very low overall. Plus, much the rest of the world is still growing fast, pushing things forward. All grounds for some guarded optimism. But: things may get worse. If Eurozone countries were to default on (not pay back) their debts or leave the euro (which would result in much the same thing happening), panic could ensue that would be similar to 2008. The difference, though, would be that central banks can't provide much more monetary stimulus (interest rates are already extremely low), and governments are (sometimes severely) constrained in how much additional fiscal stimulus they could provide. Their reaction to round two of "the Great Recession" might be less vigorous than to round one, and this one could end up being worse.
Alarmist? Yes, but this is not ludicrous. It's also far from inevitable, however. If governments in the US and Europe can get ahead of this thing, it can be managed without panic breaking out. Good thing we're all confident in our politicians, right?
What saved us from Great Depression II was a huge bout of monetary and fiscal stimulus. When the Crash of 1929 happened, people feared that central banks would abandon their commitments to convert paper money to gold at the promised rate. This caused a rush into gold. To attract people away from gold, and to assure them that the dollar, for example, was "as good as gold," the Federal Reserve and other central banks ratcheted up interest rates, offering to pay a lot of interest on paper money -- but obviously not on gold. In order to do this, they also had to demand a lot of interest on loans (the difference between the money a bank receives from loan interest and the interest rate it pays to depositors is how a bank makes money, so it can't raise deposit rates much without raising loan rates).
This meant borrowing money became almost completely unaffordable -- no new business ventures then. It also meant that spending money became less enticing, since you could make money by squirreling it away. This meant money flowed into gold, perhaps other commodities, and various forms of saving. It flowed out of buying stuff and investing in future business. Business that relied on the latter two (that's most business) therefore collapsed. This brought down any other businesses with it.
This "monetary tightening" as it's called was accompanied by fiscal tightening. Governments received less in taxes because people were getting poorer -- so they raised taxes and cut spending, hitting people even harder in their wallets and depressing growth further.
This time around, luckily, the reaction was the opposite. Unhindered by the straitjacket of the gold standard, central banks slashed interest rates to try to make borrowing and spending easier and to discourage saving. That's meant to keep the economy moving. In addition, governments responded to the crisis by spending more and either taxing less or at least just letting tax revenues fall without raising taxes. This is fiscal and monetary stimulus. Disaster averted.
Or at least it was. We're now getting into a sticky situation that is getting governments constrained in ways that have similar effects to those of the 1930s. Governments throughout the "West" are either cutting deficits or talking seriously about it. Fiscal tightening is therefore underway or will begin soon. This is partly because governments can't run deficits forever. At some point, the investors that lend money to governments begin to worry that these governments will not be able to pay them back as agreed. Governments have to offer higher and higher interest rates to make investors willing to take this risk. This makes government spending more expensive and less attractive.
(By the way, "investors" include anyone with a bank account or retirement fund.)
So fiscal stimulus is disappearing, at least we still have the monetary sort, right? Well, this is partly true. The Federal Reserve has said it will keep interest rates at around 0% for as long as is necessary. The Bank of England (the UK's central bank) has just announced another round of what is called "quantitative easing," in which the bank buys government and even corporate bonds to make borrowing and spending cheaper and further discourage saving.
There are some forces working in the opposite direction, too, however. First of all, with inflation lower and therefore less of a worry in the US than in the UK, we might expect the Federal Reserve to follow the Bank of England and embark on a third round of quantitative easing as well. This is unlikely for political reasons: even though core prices in particular have remained stable and are rising only slowly, Republican politicians especially are railing against the Fed for allegedly destroying the dollar. Not only that, international investors in the dollar are also protesting loudly, concerned that a decline in the value of the dollar will destroy their investment. The European Central Bank (ECB) is also constrained from taking more bold measures by similar political pressures, mostly from monetarily conservative Germany.
So central banks are being restrained. At least interest rates are not set to go up, right? The thing is: borrowing is getting more difficult, whether interest rates are rising or not (though often they are). This is because individuals and most corporations cannot deal directly with their central bank. Central banks can print money, other banks can't. This is mostly a problem in Europe. As panic spreads concerning European governments' (in)ability to pay what they owe bond investors (many of whom are banks), investors are also starting to demand higher interest rates from banks, too. The banks, in turn, are scared about what would happen if some European governments (like Greece or Italy) didn't pay them back. Their reaction is to lend less money and to raise rates on loans (remember that a bank must demand higher rates if it also costs it more money to borrow, whether from depositors or investors buying its bonds). This is gumming up the wheels of business in a way not unlike that of the 1930s, though less dramatically.
So lending is partly blocked and governments are cutting spending and raising taxes. Still, lending hasn't stopped, trade barriers haven't gone up (a big 1930s mistake that intensified the Great Depression), and interest rates are very low overall. Plus, much the rest of the world is still growing fast, pushing things forward. All grounds for some guarded optimism. But: things may get worse. If Eurozone countries were to default on (not pay back) their debts or leave the euro (which would result in much the same thing happening), panic could ensue that would be similar to 2008. The difference, though, would be that central banks can't provide much more monetary stimulus (interest rates are already extremely low), and governments are (sometimes severely) constrained in how much additional fiscal stimulus they could provide. Their reaction to round two of "the Great Recession" might be less vigorous than to round one, and this one could end up being worse.
Alarmist? Yes, but this is not ludicrous. It's also far from inevitable, however. If governments in the US and Europe can get ahead of this thing, it can be managed without panic breaking out. Good thing we're all confident in our politicians, right?
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