How Chinese Inflation Policy Will Shape the Yuan-Dollar Exchange Rate

By freezing its exchange rate and pulling out all the stops on fiscal and monetary stimulus, China got through the global recession with only a mild slowdown in GDP growth. Now it is facing the inflationary consequences. Consumer price inflation, after rising steadily all year, hit a 4.4% annual rate in October, approaching the government's red line. How will China choose to deal with the inflation threat? The answer is important both for China and its trading partners, because anti-inflation policy will determine what happens to the exchange rate of the yuan over the coming months.

Inflation is a key factor in exchange rate developments because the balance of trade depends on the real, not just the nominal, exchange rate--a fact that is not always clearly understood. Everyone knows that we need to adjust nominal wages for inflation to reveal trends in real wages, and adjust nominal interest rates for inflation to find real interest rates. For the same reason, we need to adjust nominal exchange rates for inflation to see what is really happening to the competitive balance between any two countries. In the case of the yuan vs the dollar, the simplest way to make the adjustment is to add the difference between the Chinese and U.S. inflation rates to the rate of nominal appreciation of the yuan. Because inflation in recent months has been faster in China than in the United States, the rate of real appreciation of the yuan has been faster than the nominal rate. The following chart breaks the monthly rate of real appreciation into its components, nominal appreciation and the inflation differential.

 
Some people find it counterintuitive that Chinese inflation causes the yuan to appreciate in real terms. The the confusion arises from a failure to distinguish between two different cases. In the first case, inflation in a country with a floating exchange rate causes its currency to depreciate in nominal terms, leaving leaving the real exchange rate unchanged. (Think of hyperinflation in Zimbabwe a few years back, which was accompanied by an equally rapid nominal depreciation of the Zimbabwe dollar.) In the second case, inflation in a country with a fixed nominal exchange rate causes its real exchange rate to appreciate. The real appreciation reflects the loss of competitiveness of the country's exports on world markets and the greater attractiveness of imports compared to increasingly expensive domestic products. The idea that inflation in a floating-rate country causes nominal depreciation in no way contradicts the idea that inflation in a fixed-rate country causes real appreciation. The two ideas simply reflect different outcomes produced by the same  market forces under different policy regimes.

In the above chart, real exchange rates are calculated using monthly changes in the consumer price index for both countries. Over the most recently reported two months, the CPI-adjusted real exchange rate of the yuan has been appreciating relative to the dollar at about a 13 percent annual rate. That would be enough to eliminate the estimated 20 to 40 percent undervaluation of the yuan in less than three.

Using consumer prices to calculate real exchange rates has the advantage that the monthly CPI for both countries is available with a very short lag. However, many observers think that real exchange rates based on  unit labor costs in manufacturing give a more accurate picture of competitiveness in international trade. Unit labor costs take into account both changes in nominal wage rates and changes in labor productivity, and a focus on manufacturing excludes price and wage changes that affect only non-traded services. Unit labor cost data is not available as rapidly or in as much detail as consumer prices, but estimates from the World Bank suggest that Chinese unit labor costs rose at an annual rate of about 4 percent in the first three quarters of this year. Over the same period, they decreased at an annual rate of about 5 percent in United States, giving a 9 percent differential. Since the June thaw in Chinese exchange rate policy, the yuan has been appreciating at a nominal annual rate of about 6 percent. Adding nine to six suggests that the ULC-adjusted real exchange rate of the yuan has been appreciating at a 15 percent annual rate, even more rapidly than the CPI-adjusted rate.

We can see, then, that rising inflation makes it harder than ever for  Chinese policy makers to restrain the ongoing real appreciation of the yuan. If inflation continues, the real exchange rate would continue to rise even if the nominal exchange rate were frozen once again. But a renewed freeze, or even a slowdown, is unlikely. On the contrary, nominal appreciation of the yuan is the most effective anit-inflation tool available to the People's Bank of China (PBoC). Nominal appreciation has a powerful double effect on inflation. First, a stronger yuan makes imported goods cheaper for Chinese consumers, bringing direct relief to the price level. Second, the more rapidly the PBoC allows the yuan to appreciate in nominal terms, the fewer dollars it has to buy for its already huge foreign exchange reserves. Since the yuan used to purchase dollars flow into the Chinese banking system, allowing more rapid nominal appreciation makes it possible to slow money growth.

Are there any tools available to the Chinese government that would allow it to have its cake and eat it too? To stop inflation while at the same time preventing unwanted real appreciation of the yuan? There may be, but each of them has disadvantages.

One anti-inflation tool used regularly by the PBoC is to "sterilize" its foreign exchange operations by selling PBoC bills, which are IOU's issued by the central bank. Sale of bills soaks up the yuan created when the PBoC intervenes in foreign exchange markets by buying dollars. However, there are limits to how many PBoC bills China's financial markets can absorb. Already interest rates on the bills are rising. This tool alone cannot solve the problem.

The PBoC can instead raise interest rates within the banking system, a tool used to fight inflation by central banks around the world. In some ways, the PBoC has greater powers than the Fed in this regard, since it has administrative control over bank deposit rates as well as the rate at which banks borrow reserves. However, Chinese financial markets are not as interest-sensitive as those in free-market economies. Interest rates have already been increased this year, and more increases are on the way, but this tool, too, is not by itself enough to stop inflation.

Much the same can be said for another anti-inflation tool, increases in the reserves that Chinese banks are required to hold. Reserve requirements have already been increased. Now, at 18.5%, they are far above the similar requirements in the banking systems of developed countries. The downside of high reserve requirements is that they reduce the efficiency of the banking system. That is the reason why central banks in the UK, Canada, and some other countries have stopped regulating required reserves altogether, and why the Fed keeps reserve requirements at much lower levels now than in the past. The Chinese banking system is already not very efficient in channeling saving to its best uses, and raising reserve requirements only makes the situation worse.

Finally, there has been talk of trying to contain inflation by direct price controls on food and perhaps other rapidly-rising components of consumer prices. Although price controls could have an immediate impact on the headline CPI, they would represent a step backward from China's evolution toward a market economy. If kept in place for long, price controls would risk shortages, which in turn would create a need for rationing. And, if price controls were not backed by overall monetary restraint, they could exacerbate the risk of a speculative bubbles in real estate and other asset markets.

Taking all of these considerations into account, the most likely outcome for China over the coming months is the use of all available policies in combination. Expect continued increases in interest rates and reserve requirements. Targeted, temporary price controls are also a possibility. Continued nominal appreciation of the yuan is a virtual certainty. There appear to be factions within the Chinese policy establishment that would even like a slightly faster pace of nominal appreciation. Used together, these tools may succeed in breaking the upward trend of Chinese inflation, but they are unlikely to fully erase the inflation differential with the United States.

As long Chinese inflation remains above the U.S. rate, the real exchange of the yuan will continue its steady appreciation relative to the dollar. Contrary to the political bluster heard from some quarters, appreciation of the yuan will not solve all the world's problems. Over time, however, we can expect it to make a helpful contribution to easing some of the most acute global imbalances.

Follow this link to view or download a short slide show with additional details regarding the relationship between Chinese inflation and the yuan-dollar exchange rate

How Chinese Inflation Policy Will Shape the Yuan-Dollar Exchange Rate

By freezing its exchange rate and pulling out all the stops on fiscal and monetary stimulus, China got through the global recession with only a mild slowdown in GDP growth. Now it is facing the inflationary consequences. Consumer price inflation, after rising steadily all year, hit a 4.4% annual rate in October, approaching the government's red line. How will China choose to deal with the inflation threat? The answer is important both for China and its trading partners, because anti-inflation policy will determine what happens to the exchange rate of the yuan over the coming months.

Inflation is a key factor in exchange rate developments because the balance of trade depends on the real, not just the nominal, exchange rate--a fact that is not always clearly understood. Everyone knows that we need to adjust nominal wages for inflation to reveal trends in real wages, and adjust nominal interest rates for inflation to find real interest rates. For the same reason, we need to adjust nominal exchange rates for inflation to see what is really happening to the competitive balance between any two countries. In the case of the yuan vs the dollar, the simplest way to make the adjustment is to add the difference between the Chinese and U.S. inflation rates to the rate of nominal appreciation of the yuan. Because inflation in recent months has been faster in China than in the United States, the rate of real appreciation of the yuan has been faster than the nominal rate. The following chart breaks the monthly rate of real appreciation into its components, nominal appreciation and the inflation differential.

 
Some people find it counterintuitive that Chinese inflation causes the yuan to appreciate in real terms. The the confusion arises from a failure to distinguish between two different cases. In the first case, inflation in a country with a floating exchange rate causes its currency to depreciate in nominal terms, leaving leaving the real exchange rate unchanged. (Think of hyperinflation in Zimbabwe a few years back, which was accompanied by an equally rapid nominal depreciation of the Zimbabwe dollar.) In the second case, inflation in a country with a fixed nominal exchange rate causes its real exchange rate to appreciate. The real appreciation reflects the loss of competitiveness of the country's exports on world markets and the greater attractiveness of imports compared to increasingly expensive domestic products. The idea that inflation in a floating-rate country causes nominal depreciation in no way contradicts the idea that inflation in a fixed-rate country causes real appreciation. The two ideas simply reflect different outcomes produced by the same  market forces under different policy regimes.

In the above chart, real exchange rates are calculated using monthly changes in the consumer price index for both countries. Over the most recently reported two months, the CPI-adjusted real exchange rate of the yuan has been appreciating relative to the dollar at about a 13 percent annual rate. That would be enough to eliminate the estimated 20 to 40 percent undervaluation of the yuan in less than three.

Using consumer prices to calculate real exchange rates has the advantage that the monthly CPI for both countries is available with a very short lag. However, many observers think that real exchange rates based on  unit labor costs in manufacturing give a more accurate picture of competitiveness in international trade. Unit labor costs take into account both changes in nominal wage rates and changes in labor productivity, and a focus on manufacturing excludes price and wage changes that affect only non-traded services. Unit labor cost data is not available as rapidly or in as much detail as consumer prices, but estimates from the World Bank suggest that Chinese unit labor costs rose at an annual rate of about 4 percent in the first three quarters of this year. Over the same period, they decreased at an annual rate of about 5 percent in United States, giving a 9 percent differential. Since the June thaw in Chinese exchange rate policy, the yuan has been appreciating at a nominal annual rate of about 6 percent. Adding nine to six suggests that the ULC-adjusted real exchange rate of the yuan has been appreciating at a 15 percent annual rate, even more rapidly than the CPI-adjusted rate.

We can see, then, that rising inflation makes it harder than ever for  Chinese policy makers to restrain the ongoing real appreciation of the yuan. If inflation continues, the real exchange rate would continue to rise even if the nominal exchange rate were frozen once again. But a renewed freeze, or even a slowdown, is unlikely. On the contrary, nominal appreciation of the yuan is the most effective anit-inflation tool available to the People's Bank of China (PBoC). Nominal appreciation has a powerful double effect on inflation. First, a stronger yuan makes imported goods cheaper for Chinese consumers, bringing direct relief to the price level. Second, the more rapidly the PBoC allows the yuan to appreciate in nominal terms, the fewer dollars it has to buy for its already huge foreign exchange reserves. Since the yuan used to purchase dollars flow into the Chinese banking system, allowing more rapid nominal appreciation makes it possible to slow money growth.

Are there any tools available to the Chinese government that would allow it to have its cake and eat it too? To stop inflation while at the same time preventing unwanted real appreciation of the yuan? There may be, but each of them has disadvantages.

One anti-inflation tool used regularly by the PBoC is to "sterilize" its foreign exchange operations by selling PBoC bills, which are IOU's issued by the central bank. Sale of bills soaks up the yuan created when the PBoC intervenes in foreign exchange markets by buying dollars. However, there are limits to how many PBoC bills China's financial markets can absorb. Already interest rates on the bills are rising. This tool alone cannot solve the problem.

The PBoC can instead raise interest rates within the banking system, a tool used to fight inflation by central banks around the world. In some ways, the PBoC has greater powers than the Fed in this regard, since it has administrative control over bank deposit rates as well as the rate at which banks borrow reserves. However, Chinese financial markets are not as interest-sensitive as those in free-market economies. Interest rates have already been increased this year, and more increases are on the way, but this tool, too, is not by itself enough to stop inflation.

Much the same can be said for another anti-inflation tool, increases in the reserves that Chinese banks are required to hold. Reserve requirements have already been increased. Now, at 18.5%, they are far above the similar requirements in the banking systems of developed countries. The downside of high reserve requirements is that they reduce the efficiency of the banking system. That is the reason why central banks in the UK, Canada, and some other countries have stopped regulating required reserves altogether, and why the Fed keeps reserve requirements at much lower levels now than in the past. The Chinese banking system is already not very efficient in channeling saving to its best uses, and raising reserve requirements only makes the situation worse.

Finally, there has been talk of trying to contain inflation by direct price controls on food and perhaps other rapidly-rising components of consumer prices. Although price controls could have an immediate impact on the headline CPI, they would represent a step backward from China's evolution toward a market economy. If kept in place for long, price controls would risk shortages, which in turn would create a need for rationing. And, if price controls were not backed by overall monetary restraint, they could exacerbate the risk of a speculative bubbles in real estate and other asset markets.

Taking all of these considerations into account, the most likely outcome for China over the coming months is the use of all available policies in combination. Expect continued increases in interest rates and reserve requirements. Targeted, temporary price controls are also a possibility. Continued nominal appreciation of the yuan is a virtual certainty. There appear to be factions within the Chinese policy establishment that would even like a slightly faster pace of nominal appreciation. Used together, these tools may succeed in breaking the upward trend of Chinese inflation, but they are unlikely to fully erase the inflation differential with the United States.

As long Chinese inflation remains above the U.S. rate, the real exchange of the yuan will continue its steady appreciation relative to the dollar. Contrary to the political bluster heard from some quarters, appreciation of the yuan will not solve all the world's problems. Over time, however, we can expect it to make a helpful contribution to easing some of the most acute global imbalances.

Follow this link to view or download a short slide show with additional details regarding the relationship between Chinese inflation and the yuan-dollar exchange rate

No Room for Students at Community Colleges

As unemployed workers seek to retrain at community colleges, state budget cuts are limiting the number of students that can enroll. As the Washington Post article "Workers seek new skills at community colleges, but classes are full" reports even as community college enrollments swelled because of the recession the majority of states cut their higher education budgets last year and most are planning to cut them next year as well. The result is that many individuals who want to learn new skills are prevented from doing so because of a lack of space at community colleges.

The Decline of the Left in Europe

As America has been moving left, Europe is taking the opposite course. Social-Democratic parties have lost some of their dominance.

These two maps plot political power. For countries with coalition governments, the holder of the Prime Minister or being the largest party in the coalition is used.

Purple is where the Prime Minister and President are from different blocks (for countries where the President has some actual power).

I follow European tradition by using the color red to signify leftwing control. In November 2000, the center-right controlled only countries representing 16% of the population in west and central Europe (with divided power in France and Poland).


In November 2010, the right holds power in countries that constitute 83% of the population(!). A different map of Europe, to say the least.


Spain and tiny Iceland are the only country that went from right to left control between these two dates.

Germany, UK, Italy, France, Poland, Czech Republic, Netherlands, Denmark, Finland, and Sweden switched from full or partial left control to complete right control. Even in Switzerland, a decade ago the largest political party was the Social Democrats. As of the last election, the largest party is the ultra-conservative Swiss People’s party.

So why has this been happening?

Part of it is cyclicality and coincidence. Particularly in Central Europe there is still a lot of chaos in terms of who gets to be in power (voters are constantly dissatisfied and vote out most governments). And because of reversion to the mean in competitive political systems, the more countries your side control compared the historical average; the more likely are you to lose some in the following elections.

Still, a large portion of the decline is systematic, with 3 trends that comes to mind:

1. Working class voters have less class consciousness, and don’t vote as a block to the same extent.

2. Voters are punishing the left as a reaction to the failures of mass immigration and multiculturalism.

3. Middle of the road voters as well as the European elites are ideologically abandoning Social Democratic economic policy.

The last tendency crucially depends on the center-right parties accepting the popular parts of the welfare state (a safety net for the poor, publically financed health care and higher education) but opposing the less popular ones (long term welfare dependency, high tax level, deficits).

During the last decade, the expansion of size of the government in Europe stopped, and even slowly started to reverse. The main exception is the U.K, where the welfare state expanded rapidly during Blair/Brown. But if we look at the other traditional western European welfare states (Germany, France, Italy, Spain, Portugal, Greece, The Netherlands, Belgium, Austria, Sweden, Norway, Denmark, Finland and Iceland), the government is in full retreat, decreasing its share of the economy in 10 out of the 14 above mentioned countries.

As a whole, total government expenditure in these countries decreased from 49% of GDP to 47% of GDP during the last decade. In Sweden, total government expenditure declined from 59% of GDP to 52% of GDP.

Needless to say, it is quite ironic for the left in America and in Europe to champion an Europeanization of the American economy during the same period when Europe is abandoning those exact same policies.

The Dollar, Gold and the World

The dollar, gold and the world

**part of the Global Economy 101 series**

by:  Tim Williamson
18 Nov 2010


Until now the dollar has been the gauge against which other currencies and economies are assessed and valued, but that situation is not tenable nor even desirable over the long-term. As other economies grow and mature, the strength and sustainability of other currencies matches, and in some cases exceeds, the metrics that define the overall palatability of the dollar as a hedge of stability, trade and finance for the rest of the world. It is only natural that as other economies mature, they would and should take their place as equal partners in sharing responsibility for protecting, promoting and insuring measured global economic growth and global governance. Either the dollar, and those who manage it, must accept this new multi-currency equality paradigm on the world stage, and the world continue to suffer wildly erratic economic cycles with multiple disjointed currencies, with their own separate fiscal and monetary policies, or we, as in the whole world, must pursue a new way to achieve sustainable, long-term, measured, and thus less volatile, global economic growth as a team through concerted and realistic global governance. Which will it be?

Tying a currency to a commodity is also not wise. All commodities are subject to price manipulation, bubbles, investor fears, supply, demand, institutional and personal avarice, state control of production, and so on, ad infinitum. These influences upon the commodity, no matter which commodity or basket of commodities is being discussed, are not manageable by any reasonable or rational system in the way that a single currency, and the amount of that currency in circulation, would be controllable. Why is control and manageability a requirement? The short answer is that we must manage inflation and deflation, and we must control the rate of growth, locally and globally, so that the economy does not burn up or melt down. Commodities, on the other hand, being subject to the fickle nature of the markets, and to the supply and demand of those commodities, will go up and down, and any currency tied to the commodities would likewise experience the same volatility. Whereas the volume of a single currency can be independently managed to give better and more efficient control of growth for the long-term. A commodity based currency is a proven invitation for chaotic economic volatility.

Gold is a commodity like any other. The only difference is that people unreasonably feel a need to possess gold in tough times. When people experience those tough times for extended periods beyond what they expect, then people rush to buy gold - like their fathers before them. This drives the price up, which in turn feeds more fear and 'onlooker' purchases, driving the price up again and again. This is the definition of a bubble - an unreasonable run-up in price. Gold is in a bubble now. We may not be at the peak yet. But it will fall and destroy lots of investors along the way when it crests the peak. It is a commodity. And thus subject to the whims of the market. By that very definition, gold is not even the best commodity to use to underpin a currency - its volatility is worse than using a less precious commodity. Which again strengthens the claim that commodities should not be used to 'back' a currency. Unless of course the entire world were willing to take that commodity out of all markets, restrict its supply, stop all prospecting, mining, and or production of that commodity, and give it a globally determined value between all states on the earth. Only then would it really work as a basis for defining the value of currency. But wait. If that is the case, then the commodity is not needed is it? Just a managed global currency would do the same without having to restrict a commodity or tie the currency to that commodity.

So the real solution is for the world to skip all the ancillary and intermediary explorations into ways that obviously will not resolve long-term economic issues and then create a strong global central bank and a single global currency for use by all peoples, states, businesses, and institutions worldwide. Some people, locally and globally, will not see long-term sustainable economic growth, nor a restoration of good jobs for themselves or their children, because apparently, by their actions or inaction, states would rather have their people continue to suffer, as they try to unilaterally adjust a complex and antiquated system that is not working, rather than give up a little of their supposed sovereignty on this issue for the sake of themselves and everyone else.

What steps should we pursue to encourage states to think outside their normal myopic self-interests when clearly a new way is demanded? While the real world grows smaller and smaller for all its people, the states and some people seem to be determined to turn inward in the face of facts. We either work together to form a better more unified and successful world or we will become squabbling isolated cavemen existing in insignificant tribes. Which do you prefer?

No Fix For US Fiscal Policy without New Rules

A short time ago, I wrote that the EU needs better rules for fiscal policy. So does the United States. A new report from the Peterson-Pew Commission on Budget Reform provides an outline for such a set of rules. It is unfortunate that the Peterson-Pew report has been overshadowed by the almost simultaneous release of the draft co-chairs' report of the president's fiscal reform commission, because they complement one another. The mandate of the president's commission is to figure out a combination of tax reform and spending cuts that will get the deficit down to a sustainable level, whereas the Peterson-Pew report focuses on the rules needed to maintain sustainability over the long term.

The Peterson-Pew Commission  is a joint effort of the Peter G. Peterson Foundation and the Pew Charitable Trust. Its co-chairs are three former Congressmen, Bill Frenzel, Republican, Timothy Penny, Democrat, and Charlie Stenholm, a conservative Democrat and former member of the Blue Dog Coalition. The Commission has issued two reports. Red Ink Rising, December 2009, which documents the nature of the budget problem, and the just-released report, which is titled Getting Back in the Black.

In its new report, the Commission characterizes the problem in these terms (slightly paraphrased): "Budgets are created annually, without any kind of fiscal target guiding the process . . .  Increasingly there is no comprehensive action on the budget at all: rather, a series of short-term continuing resolutions followed by huge omnibus spending bills. . . .  The bulk of spending and revenue occurs on autopilot without annual review or any constraint on growth . . .  Lawmakers routinely continue programs that could not withstand rigorous evaluations of their costs and benefits."

To correct the situation, the Commission proposes a thorough revision of the rules of the game, consisting of two main components.

The first component is to set medium-term and longer-term fiscal policy targets. Working from a baseline scenario that is somewhat more pessimistic than the CBO baseline, the Commission suggests a medium-term debt target of 60 percent of GDP, to be achieved by 2018, with further reductions below that target for the longer term. The report is less explicit about deficit targets, but it is not hard to fill in the blanks. As I have explained elsewhere, achieving sustainability for the debt would require a moderate cyclically adjusted primary surplus, that is, a surplus on the budget when adjusted to take into account both interest expenditures and cyclical changes in tax revenues and expenditures. Keep in mind that as of 2009, the United States had a cyclically adjusted primary deficit of some 7 percent of GDP. That was the highest in the OECD except for Ireland, which is now teetering on the edge of the abyss. It is easy to see, then, that the Peterson-Pew target for the debt is an ambitious one.

The second component of the Commission's plan, and really the most important one, is a set of revisions to the budget process. In part, these aim to lengthen the time horizon of the budget process beyond its current one-year span. Even more important, they include tough automatic mechanisms that would come into play if targets are not being met. Failure to pass a budget consistent with targets would trigger automatic adjustments consisting 50 percent of across-the-board spending cuts and 50 percent of broad-based tax surcharges. The president would also be empowered to impose rescisions of excess spending.

The Commission's call for long-term budget rules and enforcement mechanisms is sound economic policy. The unfortunate thing is that many of these ideas have been tried before, without lasting success. The report details the history of past budget rules, including Gramm-Rudman-Hollings, the Budget Enforcement Act of 1990, PAYGO, the line item veto, and others. Some of these have met with temporary success, contributing to the period of relative fiscal soundness in the 1990s. However, three factors have undermined them all in the long run.

One factor is a U.S. Constitution that gives Congress preeminent authority in budget matters. The Supreme Court has tended to reject budget rules that give the president or others outside Congress the authority to impound, rescind, sequester, or override Congressional spending decisions in pursuit of broader economic policy goals.

A second factor is the inherently political nature of fiscal policy. With monetary policy, it is to some extent possible to spin off macroeconomic aspects to the central bank while leaving microeconomic financial regulation to others. It is much more difficult to do the same with fiscal policy, since every tax and spending decision has very specific microeconomic as well as macroeconomic impacts.

The third problem is the time-inconsistency between fiscal policy decisions geared to a two-year political cycle and the needs of fiscal sustainability averaged over a significantly longer business cycle. Fiscal sustainability becomes a political issue only during recessions, when current deficits are high. That is just the time it is most difficult to carry out the adjustments needed for long-run sustainability. When a period of expansion comes and deficits shrink, pressure for long-run sustainability evaporates, and nothing is done. Eventually the debt grows to a point where the country finds itself in a recession with no "fiscal space" to carry out needed countercyclical policy--exactly the situation we are in now.

In the end, I must say that I found the Peterson-Pew Commission's report to be more depressing than encouraging. The report is right to insist on the need for fiscal policy rules. Although there is room for discussion regarding the technical details of targets and processes, the Commission's ideas are on the whole sound. But how is our politically divided country going to get together on viable set of fiscal policy rules, when it has failed so often in the past? There seems to be no answer, either in this new report or anywhere else.

Follow this link to view or download a brief slide show presenting additional data and details from the Peterson-Pew Commission report.

No Fix For US Fiscal Policy without New Rules

A short time ago, I wrote that the EU needs better rules for fiscal policy. So does the United States. A new report from the Peterson-Pew Commission on Budget Reform provides an outline for such a set of rules. It is unfortunate that the Peterson-Pew report has been overshadowed by the almost simultaneous release of the draft co-chairs' report of the president's fiscal reform commission, because they complement one another. The mandate of the president's commission is to figure out a combination of tax reform and spending cuts that will get the deficit down to a sustainable level, whereas the Peterson-Pew report focuses on the rules needed to maintain sustainability over the long term.

The Peterson-Pew Commission  is a joint effort of the Peter G. Peterson Foundation and the Pew Charitable Trust. Its co-chairs are three former Congressmen, Bill Frenzel, Republican, Timothy Penny, Democrat, and Charlie Stenholm, a conservative Democrat and former member of the Blue Dog Coalition. The Commission has issued two reports. Red Ink Rising, December 2009, which documents the nature of the budget problem, and the just-released report, which is titled Getting Back in the Black.

In its new report, the Commission characterizes the problem in these terms (slightly paraphrased): "Budgets are created annually, without any kind of fiscal target guiding the process . . .  Increasingly there is no comprehensive action on the budget at all: rather, a series of short-term continuing resolutions followed by huge omnibus spending bills. . . .  The bulk of spending and revenue occurs on autopilot without annual review or any constraint on growth . . .  Lawmakers routinely continue programs that could not withstand rigorous evaluations of their costs and benefits."

To correct the situation, the Commission proposes a thorough revision of the rules of the game, consisting of two main components.

The first component is to set medium-term and longer-term fiscal policy targets. Working from a baseline scenario that is somewhat more pessimistic than the CBO baseline, the Commission suggests a medium-term debt target of 60 percent of GDP, to be achieved by 2018, with further reductions below that target for the longer term. The report is less explicit about deficit targets, but it is not hard to fill in the blanks. As I have explained elsewhere, achieving sustainability for the debt would require a moderate cyclically adjusted primary surplus, that is, a surplus on the budget when adjusted to take into account both interest expenditures and cyclical changes in tax revenues and expenditures. Keep in mind that as of 2009, the United States had a cyclically adjusted primary deficit of some 7 percent of GDP. That was the highest in the OECD except for Ireland, which is now teetering on the edge of the abyss. It is easy to see, then, that the Peterson-Pew target for the debt is an ambitious one.

The second component of the Commission's plan, and really the most important one, is a set of revisions to the budget process. In part, these aim to lengthen the time horizon of the budget process beyond its current one-year span. Even more important, they include tough automatic mechanisms that would come into play if targets are not being met. Failure to pass a budget consistent with targets would trigger automatic adjustments consisting 50 percent of across-the-board spending cuts and 50 percent of broad-based tax surcharges. The president would also be empowered to impose rescisions of excess spending.

The Commission's call for long-term budget rules and enforcement mechanisms is sound economic policy. The unfortunate thing is that many of these ideas have been tried before, without lasting success. The report details the history of past budget rules, including Gramm-Rudman-Hollings, the Budget Enforcement Act of 1990, PAYGO, the line item veto, and others. Some of these have met with temporary success, contributing to the period of relative fiscal soundness in the 1990s. However, three factors have undermined them all in the long run.

One factor is a U.S. Constitution that gives Congress preeminent authority in budget matters. The Supreme Court has tended to reject budget rules that give the president or others outside Congress the authority to impound, rescind, sequester, or override Congressional spending decisions in pursuit of broader economic policy goals.

A second factor is the inherently political nature of fiscal policy. With monetary policy, it is to some extent possible to spin off macroeconomic aspects to the central bank while leaving microeconomic financial regulation to others. It is much more difficult to do the same with fiscal policy, since every tax and spending decision has very specific microeconomic as well as macroeconomic impacts.

The third problem is the time-inconsistency between fiscal policy decisions geared to a two-year political cycle and the needs of fiscal sustainability averaged over a significantly longer business cycle. Fiscal sustainability becomes a political issue only during recessions, when current deficits are high. That is just the time it is most difficult to carry out the adjustments needed for long-run sustainability. When a period of expansion comes and deficits shrink, pressure for long-run sustainability evaporates, and nothing is done. Eventually the debt grows to a point where the country finds itself in a recession with no "fiscal space" to carry out needed countercyclical policy--exactly the situation we are in now.

In the end, I must say that I found the Peterson-Pew Commission's report to be more depressing than encouraging. The report is right to insist on the need for fiscal policy rules. Although there is room for discussion regarding the technical details of targets and processes, the Commission's ideas are on the whole sound. But how is our politically divided country going to get together on viable set of fiscal policy rules, when it has failed so often in the past? There seems to be no answer, either in this new report or anywhere else.

Follow this link to view or download a brief slide show presenting additional data and details from the Peterson-Pew Commission report.

Challenge local - Solution globale

Challenge local - Solution Globalepar: Tim Williamson16 novembre 2010
QE2 est une tentative de court terme myope à résoudre un problème local. QE2 ne résout pas le plus important et beaucoup beaucoup plus importants défis à long terme qui se posent aux États-Unis et le monde - que de traiter équitablement et systématiquement et rapidement avec le fait incontournable que toutes nos économies distinctes sont étroitement liés et interdépendants. Si un État manipule sa monnaie directement, ou d'une autre le fait indirectement, par exemple en QE2, toute l'expérience des conséquences de ces actions à des degrés divers - certains gravement, et certains moins que d'autres.
Étant donné que nous n'allons pas revenir en arrière sur l'influence mondiale de l'Internet et l'informatique, que ce soit sur nos téléphones, ordinateurs de bureau ou ordinateurs portables, et que les entreprises vont se rendre dans les endroits où les coûts sont réduits, alors deux choses se feront sentir à au niveau local.
Tout d'abord, si les ressources humaines et naturelles ne sont pas facilement disponibles à un bon prix au niveau local, puis les entreprises, qui ne manqueront pas de suivre les principes du capitalisme, se déplacera à réduire leurs coûts afin qu'ils puissent vendre leurs marchandises à un prix compétitif localement et globalement, si elles veulent survivre. Dans le cours naturel des événements dans un état donné, une entreprise se déplace d'un endroit à l'autre que lorsque les coûts de production et de transport sont considérablement suffisamment faible pour justifier que déplacer et besoins de ses clients peut encore être atteint. Le monde est à ce point aujourd'hui. Et, ce mouvement ne fera que s'accélérer avec le temps. Il n'ira pas dans le sens inverse.
Un système de communication mondial, de réduire les coûts de transport, réduit les coûts de production dans différentes régions du monde, contribuent à cette évolution naturelle de la migration d'affaires autour de la terre. Nous n'allons pas être en mesure d'arrêter ce mouvement, nous devons donc œuvrer pour rendre les autres paramètres, sur lesquels nous avons certains disent, plus efficace et plus moderne. Cela m'amène à la deuxième.
Puisque nous ne sera pas en mesure d'arrêter le transfert des activités d'ici à là, et retour dans le temps, alors quelle partie du système local et mondial présente les plus grands défis à la stabilisation de l'ensemble de nos économies distinctes, offrant l'opportunité pour le développement durable et significative de l'emploi à long terme, et d'encourager la croissance des entreprises privées et d'entreprises et le développement? Y at-il une telle chose? Avec force, Oui! Mais seulement si nous avons le courage de le faire se rendre compte que d'un avenir stable et sûr pour chacun de nous, individuellement et collectivement est beaucoup plus importante que le maintien des sens de l'isolement et le protectionnisme au sein de deux Etats distincts. La solution réside dans l'amélioration des systèmes mondiaux de la finance, l'économie, la monnaie, les banques, le commerce et la gouvernance. Oui! C'est un défi de taille, mais pas celui qui n'est pas insurmontable.
Qu'est-ce que ça veut dire de chercher à améliorer les systèmes mondiaux? Le système actuel de réglementation massive et complexe entre les Etats est la rupture à cause de sa complexité, et parce qu'elle ne résout pas le problème réel - Une connexion de plus en plus et de dépendance entre les Etats. Les États-Unis face à cette difficulté dans son passé aussi. Le système des États-Unis au début des Etats séparés et souverains avec leurs propres banques centrales et les diverses politiques monétaires et fiscales et de devises à plusieurs reprises connu des turbulences économiques, jusqu'à ce qu'un plan a été élaboré qui a toutes les banques d'État en vertu d'une banque centrale nationale avec une monnaie unique national. Oui! Il a fallu de nombreuses années, mais la nation finalement mis en oeuvre le plan de Hamilton.Son plan a créé une banque centrale forte pour les États-Unis. Il a travaillé.
Nous avons besoin du même système à l'échelle mondiale. Nous avons besoin de créer une banque centrale mondiale forte et une monnaie mondiale unique pour être utilisé par tous les individus, les entreprises et institutions à travers le monde. Et, de façon réaliste, nous avons besoin d'un organe unique de gouvernance, à laquelle tous les Etats sont responsables, et pour lesquels l'organisme est responsable - tout en appliquant et l'application de la Déclaration universelle des droits de l'homme dans le monde. Mais il faut faire davantage pour créer un avenir durable pour tous les niveaux local et mondial.
Sommes-nous vraiment sérieux au sujet de l'amélioration de nos économies locales et de l'état et la situation de tout notre peuple? Vraiment? Dans quelle mesure sommes-nous honnêtement prêts à nous aider et les autres à réussir sur le long terme? Ensuite, il est temps de cesser de jouer avec notre peuple à court terme des solutions d'huile de serpent myope et ensuite poursuivre à long terme des solutions concrètes.En l'absence de vision, le peuple, et les Etats, mourir. Si nous voulons sérieusement prospérer et de croître, alors nous avons besoin d'un vaste projet d'engager les entreprises et les États du monde. Quelque chose vers lequel toute la planète peuvent travailler. Quelque chose qui inspire l'imagination et stimule les entreprises privées à travers le monde. Nous avons besoin d'une projection globale à couper le souffle pluriannuel vers lequel nous pouvons tous travailler. Ensuite, vous verrez non seulement les économies locales à prospérer et de croître, et les personnes et les entreprises à prospérer, mais vous verrez d'énormes progrès dans les sciences, la médecine, l'ingénierie et la technologie disponible pour tous alors que nous poursuivons cette vision. Quel type de vision d'inspirer le monde entier? Toutes les idées?
Tim WilliamsonBrookwood, en Alabama, Etats-Unisglobaleconomy101@gmail.com

Local Challenge - Global Solution

Local Challenge - Global Solution
by:  Tim Williamson
16 Nov 2010

QE2 is a short-term near-sighted attempt to solve a local challenge.  QE2 does not solve the more significant and vastly much more important long-term challenges confronting the US and the world - that of dealing fairly and systemically and quickly  with the inescapable fact that all our separate economies are intertwined and interconnected. If one state manipulates its currency directly, or another does so indirectly, such as by QE2, all experience the consequences of those actions in varying degrees - some severely, and some less so than others.  

Given that we are not going to turn back the clock on the global influence of the internet and computing, whether on our phones, desktops or laptops, and that businesses will move to those locations where costs are reduced, then two things will be felt at the local level.  

First, if the human and natural resources are not readily available at a good price at the local level, then businesses, which will inevitably follow the principles of capitalism, will move to reduce their costs so that they may sell their wares at a competitive price locally and globally if they are to survive. In the natural course of events in a given state, a business will move from one location to another only when production and transportation costs are significantly low enough to justify that move and its customers needs can still be met. The world is at this point today.  And, this movement will only accelerate over time.  It will not go in reverse.  

A global communications system, reduced transportation costs, lowered production costs in differing regions of the world, contribute to this natural shift in business migration around the earth.  We are not going to be able to stop this move, so  we must work to make the other parameters, over which we do have some say, more efficient and modern.  That brings up the second point.

Since we not going to be able to stop the move of businesses from here to there, and back again over time, then what part of the local and global systems presents the biggest challenges to stabilizing all our separate economies, offering the opportunity for sustainable and significant long-term employment, and to encourage private and corporate enterprise growth and development?  Is there such a thing?  Emphatically, Yes!  But only if we have the guts to do it realizing that a stable and secure future for each of us individually and collectively is much more important than maintaining some sense of isolation and protectionism within separate states. The solution lies in improving the global systems of finance, economics, currency, banking, trade, and governance. Yes!  It is a tall order, but not one that is not insurmountable.

What does it mean to seek to improve the global systems?  The present system of massive and intricate regulations between states is breaking down because of its complexity, and because it does not fix the real problem - One of growing connection and dependence between the states. The US faced this difficulty in its past too. The early US system of separate and sovereign states with their own central banks and individual monetary and fiscal policies and currencies repeatedly experienced economic turmoil, until a plan was devised that brought all the state banks under a national central bank with a single national currency.  Yes! It did take many years, but the nation eventually implemented Hamilton's plan.  His plan created a strong central bank for the US.  It worked.

We need the same system on a global scale.  We need to create a strong global central bank and a single global currency to be used by all individuals, businesses and institutions worldwide.  And, realistically, we need a single governing body, to which all the states are responsible, and for which that body is responsible - while applying and enforcing the Universal Declaration of Human Rights globally.  But more is required to  create a sustainable future for all locally and globally.

Are we truly serious about improving our local economies and the condition and situation of all our people?  Really?  To what extent are we honestly willing to help ourselves and others succeed over the long-term?  Then it is time to quit playing games with our people with short-term myopic snake-oil solutions and then pursue long-term real solutions.
With no vision, the people, and states, die.  If we seriously want to prosper and grow, then we need a massive project to engage the businesses and states of the world. Something toward which the entire planet can work.  Something that inspires the imagination and spurs private enterprise throughout the world.   We need a global awe-inspiring multi-year goal toward which we can all work.  Then you will see not just local economies thrive and grow, and people and businesses prosper, but you will see huge improvements in the sciences, medicine, engineering and technology made available for all as we pursue that vision. What kind of vision would inspire the whole world?  Any ideas?

Tim Williamson
Brookwood, Alabama, USA
globaleconomy101@gmail.com

The Iranian Economy

It’s common to read western analysis about Iran's economic situation, especially in the context of foreign policy. While the level of interest is natural, there are many misperceptions about the Iranian economy.

In my opinion, on the whole it is not true that the Iranian economy is getting worse. While the standard of living fell sharply after the turmoil of the 1978-1979 revolution and Saddam Hussein’s subsequent invasion of Iran, it is forgotten the economy eventually recovered. Iran currently enjoys the same or higher standard of living than before the Islamic Revolution.

Here is per capita income as measured by the late Angus Maddison, in purchasing power adjusted numbers.


The economy grew rapidly from 1950-midd 70s, declined until the end of the Iran-Iraq war, but recuperated since. The end of the war coincided with a period of free-market and fiscal reform, lauded for example by the IMF. Obviously the last few years of growth is closely linked to increasing oil prices (although the volume of oil exports has stagnated).

1. If Iran’s economy is growing, why do we constantly hear about the problems in the Iranian economy, but not about the progress?

One reason is mismanagement and squandering of the nation’s wealth. Having zero per capita growth for 30 years is nothing to be proud of, and all around you in Iran you observe signs of misallocation, poor policies, rationing, inflation, asset bubbles and corruption. The cost of family formation is prohibitively high for some young people in larger cities. Iran’s economy is doing relatively well despite, not because of Iranian economic policy.

Another reason may be that the group that was most hard hit economically by the revolution was the educated middle class, who are the people who moved to the west and whose voice is heard loudest. The biggest benefactors were islamists followed by the rural and urban poor. These are not exactly groups well represented in western media.

A third, probably most important reason is the ratio of expectations and outcome. The standard of living in Iran is growing, but nowhere near as rapidly as people want it to.

The Iranian middle class for example has rapidly expanded, as many more people have entered the middle class. With being middle class comes middle class values and middle class expectations.

This growing group and their growing complains have been misinterpreted by westerners as a sign of Iranians being increasingly squeezed.

Lastly there may be an element of wishful thinking behind some of the more negative assessments about Iran’s economy by foreign policy hawks.

2. Oil is very important, but it’s not all about oil. Oil prices started to be high in 1973, yet Iran was growing at a rapid rate throughout the 1950s and 1960s.

One factor that is now virtually completely forgotten is the foreign aid Iran received during this period as an important regional ally against the Soviet Union, mostly from the U.S. If I remember correctly for a long period this aid was as important as oil exports.

Also, Iran is not Saudi Arabia or Kuwait. There are too many people to live completely off oil. On the other hand you have a large labor force that (unlike Gulf Arabs) has no problem doing hard manual labor. Iran is more similar to a slightly less developed version of Mexico or Russia, which is to say an oil economy + a large lower middle income economy.

During the 1960s, when Iran’s growth was second only to Japan, there was a lot of industrial development, and a great deal of non-oil entrepreneurship.

Since than Iran has developed its service economy. If you have lots of oil to export, it is not as crucial to be able to compete in global markets with reasonably high quality manufactured goods (which Iran is still not capable of). You have enough currency to important high tech products, capital goods and whatever else you can’t produce at reasonable prices yourself.

Instead the remaining capacity of the economy is geared towards what Iran can compete in, namely import substitution and local services.

3. Iran has experienced a dramatic expansion of physical and human capital. Most importantly, Iran’s rise as a regional power cannot be understood without taking into the expansion of the educated workforce. This process started before the revolution, but was a priority of the leadership and continued afterwards.

The investment rate recreated during the decade of turmoil following the revolution, but later recovered to very high levels, closer to that of China than to the West.


The gross saving rate has now been around 40% for two decades.


I have further downloaded some statistics on education levels from the World Bank. Public education expenditure is currently 5% of GDP in Iran, above the world average, partially because the population is so young. This figure is in comparison 3% in Turkey, 3.7% in Egypt and 2.8% in Pakistan, other large Middle Eastern countries with many young people.

Part of the explanation for is the strong tradition of learning in Iran relative to other countries in the region, dating to pre-Islamic times.

The illiteracy rate witnessed an astonishing decline from 63% in 1976 to only 18% in 2006.

The share of the working age population with completed territory education quadrupled from about 2% in 1975 to about 10% in 2010 (it's about 20% in the west). Iran now has around 9 million college graduates to replace the two million or so expatriates. Meanwhile the share with at least completed high scool roughly increased from 19% to 64%.


This kind of explosion in human capital would transform any economy. Notice also the type of education. The share of college graduates in Iran who study engineering and manufacturing was 31% is, one of the highest in the world (in comparison the figure is 14% in Turkey and 7% in the U.S).

It is perhaps in part because of all these new technically educated individuals that Iran has been able to regionally challenge the U.S.

4. Social indicators have improved following the revolution.

The absolute poverty rate has declined (click on this link) from about 30% to a little over 10%.

The mortality rate for children under 5 declined at impressive and fairly steady pace before and after the revolution. It went from 0.29 in 1960 to 0.155 in 1975 to 0.032 in 2008.

Life expectancy continued to increase, again it appears with little interruption, after the revolution. Health expenditure as a share of GDP is also fairly high in Iran at 6.4% of GDP. Some of this is private spending and under-the-table payment to doctors, but the poor do have access to health care.


Illiteracy was targeted both before and after the revolution, and is largely gone.


Electricity production was more than ten times higher in 2007 than 1977, in a period when the population doubled. This is interesting for two reasons. First, if you don’t trust GDP estimates in a country such as Iran, electricity production is a reasonably objective measure of economic activity (although keep in mind that energy is heavily subsidized in Iran).

Second, much of rural Iran did not have electricity until about a generation ago. They do now, as the regime made this into a priority. Anecdotally, when my father installed an electric generator for his horse breeding farm just prior to the revolution that was the first time anyone in that Kurdish village had any electricity. Having access to electricity for the first time in your life is a concrete and sizable improvement in the standard of living. One third of Iran’s population is still rural.

5. The Iranian economy is dysfunctional, but has some safety valves. Corruption is a huge problem, but it does grease the wheels on occasion and the high degree of corruption, nepotism and overall inefficiency in the state is ironically one of the reasons that Iran is not a totalitarian country (it is “merely” authoritarian).

Furthermore, Iranians adjust their behavior in response to poor policies. For example, the labor market is heavily regulated, and (like many developing countries) you have a constant problem of underemployment.

However, this major inefficiency is mitigated by the very high rate of self-employment. Iran has a remarkable rate of non-agricultural self-employment of 37% according to the ILO.

If regulations and poor institutions make work in large organizations difficult, people can sell their labor directly through self-employment.

Granted, this motivation for self-employment is not a sign of health for the economy. However it is what economists refer to as a second best solution. Sure, Iran would be richer if the 500 best entrepreneurs and managers in the country got to expand their firms and absorbed much of the remaining mom-and pop operations, small scale family firms and the like (or if large, efficient foreign firms increased their presence in Iran). But having all these tiny firms is clearly superior to the alternative, which is unemployment induced by regulations and poor institutional quality.

Again, for all the talk about there being no jobs, the employment to population ratio in Iran has remained fairly constant during the last 20 years, increasing from 46% in 1991 to 49% in 2008.

Comparatively little is known about the Iranian economy. One obvious reason is the lack of hard data, but another reason is pervasive misinformation. We would learn and understand more about Iran’s economy, future growth perspectives, investments opportunities and similar issues if Irans economy was analyzed more by disinterested parties. Furthermore, it would be preferable if the discussion on Irans economy was decoupled from the sensetive and ideological foreign policy debate.

Update on Fiscal Consolidation: The Draft Report of The President's Debt Commission

My initial reaction to yesterday's draft report of the bipartisan National Commission on Fiscal Responsibility and Reform is very positive. It has already been called "unacceptable" by both the left and the right, which pretty much proves it is on the right track.

The version I downloaded from the New York Times is marked "DO NOT QUOTE CITE OR RELEASE," so I will play be the rules for the moment and forgo line-by-line comments. However, if you read my post on growth-friendly fiscal consolidation a few days ago, you will know that one thing I like about the draft NCFRR report is its focus on tax reform. The draft shows that taking the ax to tax expenditures makes it possible to cut both personal and corporate tax rates and at the same time improve revenue collection. That's a real winner.

I also like its endorsement of an increase in the gasoline tax. The increase in the gas tax will be panned by the "affordable energy" lobby, but, as I have argued before, affordable energy is something we cannot afford. However, I would go beyond draft report in that I would prefer a broader-based energy tax or carbon tax to steer non-transportation sectors, as well as transportation, toward an energy mix more consistent with national security and environmental realities.

I also like the realistic goals set by the draft report. It rejects some of the pie-in-the-sky demands of the Tea Party right, including an annually balanced budget and a near-mythical 20% cap on federal government spending. Given the demographic realities of an aging population, we are not going to get back to 20% no matter how hard we try. Can't be done, won't be done. So stop talking about it. Also, instead of focusing on headline budget balance, the draft report is sophisticated enough to realize that the really important thing for sustainability is a small primary surplus. If that goal is achieved, small annual deficits in the overall budget are consistent not just with long-run fiscal sustainability, but with gradual reduction in the debt as a share of GDP.

There must be something I don't like about the draft, right? OK, here is one. Although the draft endorses substantial cuts in defense spending, its proposals focus mainly on waste in the defense department. They don't touch the hot iron of what we should actually be doing with our armed forces. I think foreign policy and national security strategy have to be dragged into the budget discussion at some point. To put it bluntly: Are our adventures in Iraq and Afghanistan really cost-effective as ways of protecting the homeland? A few courageous voices on the right, notably Rand Paul, are willing to discuss this issue, but I suppose it is too much to hope for the NCFRR to take it on.

Follow these links for related slide shows on tax reform, affordable energy, and the primary deficit.

Update on Fiscal Consolidation: The Draft Report of The President's Debt Commission

My initial reaction to yesterday's draft report of the bipartisan National Commission on Fiscal Responsibility and Reform is very positive. It has already been called "unacceptable" by both the left and the right, which pretty much proves it is on the right track.

The version I downloaded from the New York Times is marked "DO NOT QUOTE CITE OR RELEASE," so I will play be the rules for the moment and forgo line-by-line comments. However, if you read my post on growth-friendly fiscal consolidation a few days ago, you will know that one thing I like about the draft NCFRR report is its focus on tax reform. The draft shows that taking the ax to tax expenditures makes it possible to cut both personal and corporate tax rates and at the same time improve revenue collection. That's a real winner.

I also like its endorsement of an increase in the gasoline tax. The increase in the gas tax will be panned by the "affordable energy" lobby, but, as I have argued before, affordable energy is something we cannot afford. However, I would go beyond draft report in that I would prefer a broader-based energy tax or carbon tax to steer non-transportation sectors, as well as transportation, toward an energy mix more consistent with national security and environmental realities.

I also like the realistic goals set by the draft report. It rejects some of the pie-in-the-sky demands of the Tea Party right, including an annually balanced budget and a near-mythical 20% cap on federal government spending. Given the demographic realities of an aging population, we are not going to get back to 20% no matter how hard we try. Can't be done, won't be done. So stop talking about it. Also, instead of focusing on headline budget balance, the draft report is sophisticated enough to realize that the really important thing for sustainability is a small primary surplus. If that goal is achieved, small annual deficits in the overall budget are consistent not just with long-run fiscal sustainability, but with gradual reduction in the debt as a share of GDP.

There must be something I don't like about the draft, right? OK, here is one. Although the draft endorses substantial cuts in defense spending, its proposals focus mainly on waste in the defense department. They don't touch the hot iron of what we should actually be doing with our armed forces. I think foreign policy and national security strategy have to be dragged into the budget discussion at some point. To put it bluntly: Are our adventures in Iraq and Afghanistan really cost-effective as ways of protecting the homeland? A few courageous voices on the right, notably Rand Paul, are willing to discuss this issue, but I suppose it is too much to hope for the NCFRR to take it on.

Follow these links for related slide shows on tax reform, affordable energy, and the primary deficit.

India's Secret Weapon in its Economic Race with China

The eclipse of the G7 by the G20 puts the spotlight more than ever on India and China as the economic superpowers of the future. So far, China has the lead, but India has a secret weapon that will carry it into first place by the end of the century. What exactly? Widely spoken English? That helps India's service sector, but it is not decisive. Democracy? True, democracies outperform authoritarian regimes on average. It is no coincidence that 17 of the G20 are functioning democracies, but China is hanging in there as an exception to the rule. No, the real secret weapon that will carry India into the lead is demographics.

It is not just that sometime around 2030, India's total population will become larger than China's. Total population is an ambiguous factor in prosperity, as those of us know who were raised on the intellectual sparring of Julian Simon and Paul Ehrlich. On the one hand, people are a country's most valuable resource; on the other hand, badly managed population growth can overtax other resources and leave a country populous but impoverished. Rather than total population, it is the inner dynamics of population growth, in particular, the evolution of the dependency ratio, that will make the difference for India and China.

The total dependency ratio is the ratio of the nonworking population, both children and the elderly, to the working age population. Low-income countries with fast population growth have high dependency ratios because they have lots of children. Rich countries with slow population growth have high dependency ratios because they have many retirees. In between these two states, countries go through a Goldilocks period when the working age population has neither too many children nor too many parents to support. The dependency ratio reaches a minimum, and growth potential reaches a maximum. The following chart shows the dynamics of the dependency ratio for India and China, with the United States included for comparison.

As the chart shows, India is just entering its Goldilocks period while China, like the United States, is already leaving. Furthermore, The dip in the Indian chart is more gradual and longer-lasting than the corresponding dip for China. For the next several decades, China will be tacking into the wind while India still has its spinnaker up. Chinese economic growth will slow, while India's, assuming a supportive policy environment, will edge past it.

What explains the difference in population dynamics? The answer can be found in the evolution of the total fertility rate in the two countries. (Total fertility is a measure of the number of children born to a representative woman over her lifetime.) China's total fertility rate dropped from almost six in 1965-70 to under three just a decade later. The famous one-child policy, introduced in 1978, contributed to the decline, but it was already well underway before that. By 1990-95, China's fertility rate had dropped below the replacement mark of about 2.1. In India, by contrast, the decrease in total fertility from six to three took 30 years to accomplish, and fertility is not expected to drop to the replacement rate until sometime in the coming decade. To switch metaphors, China slammed on the brakes, leaving big skid marks, while India made a more prudent deceleration. Furthermore, as Adam Wolfe, among others, has pointed out, China's official data may understate the true rate of decline in fertility, and therefore understate the future demographic drag on the country's growth.

There is nothing inherently wrong with slow, or even negative, population growth, but the transition to it is not easy to manage. The United States is not doing a particularly good job, as we know from the wrenching debate over the impact of social security and Medicare on the budget deficit. China is not doing well either. It has not yet found a social safety net to replace the long-vanished "iron rice bowl" of the Maoist era, and social insecurity, in turn, contributes to other imbalances in its economy. India, too, is not not exactly a Swedish-style paradise for the young and the old, but at least it has more time to get its act together.

In short, India, by all indications, is likely to be the world's largest economy at the end of the 21st century. It appears that President Obama knew what he was doing when he endorsed India for a permanent seat on the UN security council during his recent South Asia visit. He wasn't just maneuvering to put together a coalition to contain China, as some commentators suggested. Instead, he was backing the probable winner in the global economic race.

Follow this link to view or download a short slide show with additional demographic data for India and China.