Could an Obscure Loophole Send the Euro the Way of the Ruble?

Could an obscure loophole known as emergency liquidity assistance (ELA) lead to the collapse of the euro area, much as the post-Soviet ruble area collapsed in 1991-1993? Some people seem to think so. The Irish Independent says that use of ELA by the Irish central bank amounts to "printing its own money." Tracy Alloway, writing on ft.com/alphaville, emphasizes the secret, hush-hush nature of ELA operations. One blogger goes so far as to speak of hyperinflation. Is there really something fishy going on? And what does ELA have to do with the ruble?


Last summer I wrote a post about the breakup of the short-lived ruble area that existed among the 15 successor states of the Soviet Union from 1991 to 1993. The ruble area had several flaws that made its demise inevitable. One of them was the fact that the Central Bank of Russia, as the lead institution within the currency area, retained less than full control over monetary policy. Although it had a monopoly on the issue of paper currency, it allowed national central banks almost unlimited latitude to create bank credit. The national central banks could use bank credit to finance their own government deficits and make loans to state-owned industries. The inflationary consequences of doing so were spread among all 15 ruble area members, creating a serious free-rider problem.

In the earlier post, I saw fiscal policy free riders as a real threat to the euro, as they had been to the ruble, but at the time, I did not see the possibility of a spillover into monetary policy. Now it appears that things are not quite so simple, as a post on Open Europe Blog first called to my attention.

Tracking down the story down led to a research note by Willem Buiter that gives a detailed explanation of emergency liquidity assistance  in the euro area. To make a long story short, it turns out the the national central banks (NCBs) of euro-area members retain lender-of-last-resort powers in at least partial independence from the European Central Bank (ECB). For example, the Irish central bank can loan liquid reserves to Anglo Irish Bank, taking securities as collateral. That causes total reserves of the euro-area banking system increase. If those reserves are used as a basis for further loans, the euro money stock increases. Under the right conditions, the increase in the money stock could cause inflation throughout the euro area. Add in the fact that ELAs are, as a matter of policy, conducted behind a veil of secrecy and it becomes tempting to make a leap to a parallel with the ruble.

But hold on a minute. The whole story is overblown. What is going on with euro ELAs is far different from what brought down the ruble area--so far, at least.

The first big difference is that the ECB has the tools it needs to override any monetary impact of ELAs by national central banks. For one thing, the ECB can use any of its usual policy instruments to withdraw an equivalent quantity of reserves from the euro banking system, thereby sterilizing the effect of ELAs. In addition, although NCBs do not have to report ELAs to the public, they do have to report them to the ECB, which can veto them by a two-thirds vote of its board. True, as Buiter points out, the ECB may choose not to sterilize or veto the monetary effects of ELAs, but presumably, that would either be because it regards their effects as minimal, or because it considers the resulting monetary expansion to be consistent with euro-wide monetary objectives.

The second difference lies in the motivation for liquidity creation by national central banks. In the case of the euro, ELAs are supposed to be made for lender-of-last-resort purposes. As such, they are subject to rules first outlined by Walter Bagehot a century and a half ago. Such loans must be made only to institutions that are illiquid but not insolvent, they must be made on good collateral, and they must be made at a penalty interest rate. Although ELAs made under these conditions do add reserves to the banking system, their purpose is not to bring about an expansion of the money stock. Instead, it is to prevent an undesired contraction that might occur if a solvent but illiquid bank were forced to close its doors. Far from having inflationary potential, properly executed lender-of-last-resort operations contribute to the goal of price stability.

It is true that central banks are sometimes tempted to fudge on matters like collateral and solvency. Some observers suspect the Irish central bank of doing so in some of its recent ELAs. Still, if a national central bank were to violate the lender-of-last-resort principles too egregiously, ECB rules would allow it to veto the operation

The monetary manipulations of NCBs in the post-Soviet ruble area were very different. The post-Soviet NCBs began life as the republic branches of Gosbank, the central bank of the USSR. Gosbank was a monobank that combined central banking and commercial banking functions. As such, it held retail deposits and made loans both to the government and to state-owned industries. When Gosbank broke up, at least some of the NCBs in the post-Soviet ruble area continued those monobank practices. They extended credits directly to local governments and made generous loans to often-failing state enterprises. Those operations were inherently inflationary. When local enterprises used the funds borrowed from their local NCBs to make purchases from firms in other former Soviet republics, and those payments were cleared through the banking system, the inflationary pressures spread throughout the ruble area. The ability to finance national government and state enterprise operations in this way created a free-rider problem on an altogether different scale than anything associated with ELAs in the euro area.

In short, there is no real parallel between emergency liquidity operations as currently conducted by NCBs in the euro area and the inflationary machinations of NCBs in the ruble area. One has to stretch the imagination to see how ELAs could  pose an inflationary threat to the euro. Something like one or all of the following would have to happen:

• The NCBs of the euro's biggest members would have to get involved. Buiter estimates that Ireland's central bank has extended ELA credits equal to 31 percent of the country's GDP, but Ireland is a small country. If Germany were to act on the same scale, then ELAs might start to matter.
• ELAs would have to break through the limits set for lender-of-last resort functions in a big way. Ireland may have put a toe over the line in treating banks like Anglo-American as solvent or by accepting less than gilt-edged collateral, but something more than that would be needed. We might start to be worried, for example, if NCBs were to make loans to banks in the guise of liquidity assistance, and then require the banks to use the proceeds to purchase local sovereign bonds on terms better than those offered by the open market.
• If several NCBs combined to form a blocking coalition of one third plus one on the ECB board to prevent veto of excessive ELA activity, then monetary expansion inconsistent with ECB policy objectives would become possible.

At present, there is no sign that any item on the above list is happening or about to happen. The euro does have its problems, but emergency liquidity assistance operations do not yet add greatly to them.

Follow this link to view or download an updated slideshow on the breakup of the ruble area with comparisons to the present condition of the euro.

Demographics and Politics as Much as Floods and Security Undermine Pakistan's Economy

In a recent White House meeting with President Asif Ali Zadari of Pakistan, US President Barack Obama underscored the importance of the US-Pakistani relationship and emphasized continued US support for the country. Unfortunately, the prospects for a payoff to US strategic commitments in Pakistan remain clouded by deep economic weaknesses that have their origins as much in demographics and political factors as in the more widely publicized natural disasters and security issues.

Just a few years ago, Pakistan's future looked brighter. Its economy seemed to be taking off after years of stagnation. The World Bank was applauding wide-ranging economic reforms. As the chart shows, in the mid-2000s it looked as if Pakistan might be capable of playing in the same league as neighboring India and China. Since then, however, things have fallen apart. The global economic crisis is only partly to blame. More fundamental problems are preventing the kind of recovery that other emerging markets are experiencing.

Demographic factors play a big role in Pakistan's problems. According to UN data, the country has a population growth rate of 2.13 percent, compared to 1.27 percent in India and .61 percent in China. True, as the late Julian Simon was fond of pointing out, people are a country's most important resource. A large or growing population by itself does not necessarily mean a weak economy. But more people are a source of prosperity only to the extent that they are engaged in productive activity. Pakistan scores poorly in that regard.

One key demographic indicator is the dependency ratio, that is, the number of children and retirees per 100 people of working age. Pakistan's dependency ratio, as of 2010, was 69, compared to 56 for India and just 39 for China. China's dependency ratio will rise somewhat in coming decades as its population ages, but India's will decrease as its falling total fertility rate reduces the number of children. Meanwhile, Pakistan's total fertility rate remains high, and as long as it does so, its dependency ratio will remain high as well.

The labor force participation rate of women is another important factor in the effectiveness of human resource use. In Pakistan, just 22 percent of working-age women are in the labor force, putting it in the lowest decile among countries of the world, even lower than India's 36 percent. By comparison, 76 percent of Chinese women of working age are in the labor force.

Education matters, as well. Pakistan's secondary-school enrollment rate is just 33 percent, compared with 57 percent for India and 74 percent for China. Only half as many of Pakistan's women as men have a secondary-school education.

These demographic factors reinforce one another to create a vicious cycle. A high fertility rate keeps women out of the labor force. If women are not expected to enter the labor force, there is less incentive for families to send them to school. And women with less education tend to have more children.

In principle, well conceived pro-growth policies could go a long way toward offsetting all of these handicaps. However, implementing such policies would require a government capable of rising above short-term electoral politics and taking hard decisions with longer-term payoffs. Unfortunately, Pakistan does not have such a government.

The events of early 2011 are a case in point. Under international prodding,  the government advanced a promising set of reforms. Key measures were a restructuring of the country's weak tax system and big cuts in energy subsidies, which together would have reduced a huge budget deficit (now over 5 percent of GDP) and helped to bring inflation (now at 15 percent) under control. Unfortunately, Pakistan's fragile governing coalition chose just that moment to collapse. Although the planned economic reforms were not the only cause, it proved necessary to abandon them in order to restore a workable parliamentary majority.

For the time being, it seems that non-economic issues like the country's draconian blasphemy laws are sucking away all of the political oxygen, to the frustration of the many capable technocrats in the government. Molly Kinder of the Center for Global Development puts it this way: "Time and again, the documents cite the same problems, the donors recommend the same solutions, the government of Pakistan promises to implement the same reform, the government breaks (and donors lament) the same promises.  And the cycle repeats."

None of this is meant to belittle the effects of last year's devastating floods or Pakistan's appalling security situation. Those are real problems. The point made here is that Pakistan would be in bad shape even without them. Real GDP is barely keeping up with population growth, and in some years not even that. Meanwhile, what should be done about the $10 billion or so of US and IMF aid that is in the pipeline? Do US taxpayers and other donors really just want to watch it trickle away into the sand, with little prospect of payoff either for the people of Pakistan itself or for those who like to view it strategic ally?

Follow this link to view or download a short slideshow with additional details on Pakistan's economy.

The Impossible Trinity, or, Why Latin America Hates QE2

Latin America is up in arms over QE2. Brazil's finance minister, Guido Mantega, sees the Fed's program of quantitative easing as a form of currency manipulation on a par with China's efforts to maintain an undervalued yuan. We hear dark talk of currency wars and threats to raise the issue with the G20, the WTO, and anyone else who will listen. Why all the anger directed against what most people in the United States view as a purely domestic policy that hopes to reboot a sluggish recovery? Why wouldn't that be welcomed by US trading partners in Latin America and everywhere?

Part of the answer is that in today's world, there is no such thing as purely domestic monetary policy. Actions of the central banks even of small countries send out little ripples through the global financial system. Those of major central banks can send out big waves.


QE2 is a case in point. Under that program, the Fed plans buy some $600 billion worth of longer-term Treasury securities by the middle of this year. Operationally, the policy is purely domestic; both the assets and liabilities it adds to the Fed's balance sheet are denominated in dollars. In that sense, QE2 is quite different from what the Chinese central bank does when it buys dollars in exchange for yuan. Nonetheless, the Fed's actions do affect the world economy.

One reason is that when the Fed buys Treasuries, it reduces the stock of those securities in the hands of the public. Other things equal, that tends to raise their prices and reduce their yields. In practice, the effects have been a little messier. Treasury yields fell when the idea of QE2 was first floated in August, but since the purchases actually began, they have risen again. In a recent speech, Fed Vice-Chair Janet Yellen argues that yields, although higher than they were, are lower than they would have been without QE2. Some people believe the models on which that conclusion is based, and some are skeptical. Latin American finance ministers seem to be among the believers.

Beyond that, when the Fed pays for the Treasuries it acquires, its liabilities, in the form of bank reserve deposits, increase by the same amount. To the extent that banks want to put the new reserves to work by lending them out or investing them, there is additional downward pressure on interest rates. True, because banks are not currently putting all their reserves to work, this effect is weaker, but it is still there. At the very least, the growing mass of excess reserves overhanging financial markets affects expectations.

That would be the end of the story if the United States were a closed economy, but it is not. With QE2 putting downward pressure on interest rates across a broad front, some investors who currently hold dollars are going to start looking for better yields abroad. At that point, the ripples from QE2 begin to affect Brazil, Chile, and other economies that offer attractive investment opportunities. The exact form taken by the external effects of QE2 will differ according to the policies each country pursues regarding exchange rates and international capital flows. We need to consider three possibilities.

First, suppose a country has a freely floating exchange rate and open capital markets. If so, increased financial inflows will put upward pressure on the exchange rate. Exchange rate appreciation is beneficial to importers and consumers of imported goods, but harmful to exporters and to local manufacturers that compete with imports. If exporters and import-competing manufacturers are disproportionately influential in government, as is often the case, the political reaction to currency appreciation will be more negative than positive.

Suppose, instead, that a country has opted for a fixed exchange rate but still maintains an open capital account. In order to  hold the exchange rate steady, the central bank will have to counteract increased financial inflows by purchasing foreign currency and adding it to its international reserves. Each dollar added to reserves must be paid for with newly issued domestic currency, pumping new liquidity into the domestic banking system. The resulting increase in lending and spending create inflationary pressure. As long as the nominal exchange rate is held constant, inflation undermines the country's competitiveness, or, to put it another way, causes its currency to appreciate in real terms. Exporters and import-competing manufacturers are harmed by real appreciation that takes the form of a stable nominal exchange rate plus inflation just as much as they are harmed by nominal appreciation without inflation.

There is one other possibility: A country can fight both nominal currency appreciation and inflationary increases in the domestic money supply by closing its capital account to unwanted financial inflows. However, that option, too, has its drawbacks. Closing a country's capital account to financial inflows can cut off much needed sources of credit to domestic consumers and industry, thereby slowing the economic growth. Stability is then gained only at the cost of isolation and stagnation. On the whole, orthodox economics has frowned at restrictions on international financial flows.

Economists use the term impossible trinity in discussing these alternative policy regimes. It is impossible for a country to choose more than two items from the following menu of three: An independent monetary policy, a fixed exchange rate, and an open capital account. Countries that want to maintain an open capital account and freely use monetary policy to control inflation must let their currencies float; those that want a fixed exchange rate and an open capital account must give up an independent monetary policy and accept the inflationary and deflationary shocks produced by international financial flows; those that want both a fixed exchange rate and an independent monetary policy must introduce capital controls. None of these combinations is painless for a country faced with unwelcome developments in global financial markets.

Of course, just saying something is impossible does not mean no one will try to find a way around it. Brazil, Chile, and some similarly affected countries elsewhere are pursuing blended policies that strike compromises among the three elements of the impossible trinity.

One approach is to impose partial capital account restrictions designed to filter out destabilizing, short-term "hot money" while allowing growth-enhancing, long-term direct foreign investment. Examples are Chile's requirement that investors make interest-free deposits at the central bank and Brazil's measures to curb short-selling of the dollar. Such limited controls are gradually gaining acceptance even by institutions like the IMF, which has discouraged them in the past. However, doubts persist on their effectiveness in the long run, and international treaties are thought to pose barriers to more comprehensive capital controls.

Sterilized foreign exchange intervention is another compromise approach. A central bank is said to sterilize when it buys foreign currency to slow nominal appreciation, but neutralizes the inflationary monetary effects by financing the forex purchases with sales of long-term bonds or other non-monetary financial instruments. However, sterilization also has its drawbacks. For one thing, it can be expensive, since interest rates on instruments issued by emerging-market central banks are likely to be higher than those earned on foreign exchange reserves. Also, if investors think a central bank will not be able to continue to sterilize indefinitely, expectations of future appreciation could increase hot-money inflows and make the situation worse.

In short, it is easy to see why Latin America hates QE2. Small wonder that finance ministers and central bankers throughout the region, faced with an unappetizing menu of policy options, wish QE2 would just go away.

Still, the "currency wars" rhetoric deployed against QE2 seems overblown. The following chart, which gives real effective exchange rates for Brazil and Chile, two of the most affected countries, shows that the trend toward real appreciation was underway well before QE2 was launched, and indeed, even before its keel was laid. One factor behind the appreciation is simply that these are well-managed and dynamic economies that offer many attractive investment opportunities, quite apart from short-term speculation. Another factor is a sharp run-up in the prices of regional commodity exports since the depths of the global crisis. These underlying pressures would not disappear even if the Fed were to cancel QE2 tomorrow. Finally, there is often-repeated fact that if QE2 does succeed in getting the US economy back on track, Brazil, Chile, and all our trading partners will benefit from increased demand for their exports.

The bottom line: Yes, QE2 is making waves in international financial markets, although hardly a tsunami, as some have called it. Yes, it does make the life of Latin American finance ministers and central bankers just a bit harder. But their lives would be hard anyway, so perhaps they should at least be grateful for a convenient scapegoat.

Follow this link to view or download a short slideshow discussing QE2, its effects on Latin America, and the impossible trinity.

Could Federal Spending be Capped at 20 Percent of GDP? Should it Be?

As the budget debate heats up, we will hear much about capping U.S. federal government spending at 20 percent of GDP, roughly its level for several decades leading up to the global financial crisis. Likely presidential candidate Rep. Mike Pence (R-Ind.) has been among the most vocal backers of this idea. Together with colleagues, he has packaged it in the form of a proposed Spending Limit Amendment. Would it really be possible to impose such a spending limit? Yes. Would we like the results if we tried it? Not all of us would. Here is why.

Part of its attraction is that the 20 percent solution appears to require no real sacrifice. If we were content with the level of government services enjoyed in past, pre-crisis decades, why would there be any hardship in holding to that level in the future? Unfortunately, the pretense that it would be possible to maintain the same level of real government services as in the past without future increases in spending is an illusion. The reality is that holding government spending to past levels would require a significant reduction in real public services. To see why, we need to look in more detail at what has happened to individual components of government spending over past decades. The following chart gives the basic data.

First, the chart shows that the discretionary component of federal spending was not constant over the decades leading up to the crisis. Instead, discretionary spending, which includes defense, law enforcement, education, highways, and all the daily business of government, followed a long downward trend, from more than 12 percent of GDP in the 1970s to less than 8 percent in the mid-2000s. A 20 percent cap on total federal outlays would lock in not current levels of discretionary spending, but the downward trend.

Second, we notice that there was a moderate recovery in discretionary spending in the mid-2000s. The recovery was facilitated by a decrease in net interest payments on the federal debt, which fell from their usual level of around 3 percent of GDP to about half that. The decline occurred partly because of unusually low interest rates and partly because of a decrease in total debt due to the the budget surpluses that appeared at the end of the Clinton administration. Unfortunately, federal interest expense is now on its way back up, with a vengeance. By the end of this decade, it will be well above its historical average. If total spending is capped at 20 percent of GDP, interest payments will soon be adding to the squeeze on discretionary programs, rather than relieving it, as in the mid-2000s.

A third budget trend evident from the chart is the growth of entitlement spending, from 6 percent of GDP in 1970 to over 10 percent by the mid-2000s. Perhaps something could be done here. If the growth in the share of entitlement spending could at least be stopped, even if not reversed, that might preserve at least an austere sliver of funding for defense, schools, and highways.

Unfortunately, the idea of freezing the growth of entitlement spending runs up against some hard demographic realities. The growth of entitlements, mostly in the form of social security and Medicare, does not primarily reflect increasing generosity of these programs. True, in some respects benefits have grown, for example, through the addition of drug benefits to Medicare and overly generous inflation adjustment of  social security benefits. However, future growth in entitlements will be driven less by growth in benefits per recipient than by demographics, especially a dramatic increase in the country's elderly population, as shown in this chart:

The implication of these demographic trends is that capping total entitlement spending as a share of GDP would do more than simply deny benefit increases to future generations of retirees. Instead, it would mean sharply cutting both social security and medicare benefits per recipient. Real cuts would be needed even if stringent cost-cutting measures held medical inflation to the rate of increase of average consumer prices.

So, could federal spending be capped at 20 percent of GDP? Yes, it could. Some set of measures like this would do the job:

• Cram discretionary spending down to its pre-9/11 level of 6.3 percent of GDP, compared with 8 percent in the last year of the George W. Bush administration. That would make room in the budget for a doubling of net interest payments, which, given the size to which the total debt has already grown, will inevitably be necessary when interest rates recover to normal.
• Within the discretionary spending category, make a choice between drastic cuts to defense spending, including withdrawal of troops from foreign deployments, or cuts deep into the muscle, not just the fat, of every domestic discretionary program, including law enforcement, education, infrastructure and all the rest.
• Cap entitlements at their current level of GDP. Convert social security from a pension program for all into a means-tested safety net for the neediest. Implement cost-cutting measures for Medicare that have been rejected in the past, such as malpractice reform, elimination of tax preferences for employer-provided plans, a phase-out of fee-for-service medicine, and increased co-pays for all but the lowest-income elderly.

Should it be done? That depends on what kind of government you want. If you want approximately the real level of government services per capita as in the past, and the same level of real social security and medical benefits per retiree, then forget about the 20 percent solution. On the other hand, if you are content with a pared down government that provides a pre-1930s social safety net along with third-world levels of defense, education and infrastructure spending, then by all means, slap on the cap. But please, don't pretend you can have it both ways.

Follow this link to view or download a brief slideshow containing additional data related to the federal budget and the 20 percent solution.

Hidden Pitfalls of Increasing U.S. Dependence on Canadian Oil Sands

Canada is the biggest supplier of oil imports to the United States. Increasingly, those imports come from its vast reserves of oil sands. Is the growing U.S. dependence on Canadian oil sands a win-win deal for both countries, crucial for U.S. energy security, and a source of jobs and economic growth, as American Petroleum Institute President Jack Gerard claims? Is the development of Canadian oil sands "the most destructive project on earth", as a Canadian environmental report calls it? What pitfalls for policy makers and investors lie hidden in the heated rhetoric coming from both sides in the oil sands debate?


The debate places much emphasis on how just dirty or clean oil from the Canadian sands is compared with the alternatives. Detractors prefer to call them "tar sands" to project an image that is as dirty as possible. (Both "oil sands" and "tar sands" are popular terms; purists prefer "bituminous sands.") They cite data showing that greenhouse gas (GHG) emissions for a barrel of oil from Canadian sands run from three to as much as seven times as high as from a barrel of conventional Texas crude. Oil sand supporters cite different numbers that indicate only 5 to 15 percent more GHG emissions from the sands than from conventional oil.

Surprisingly, the widely differing numbers do not come from competing scientific teams. Instead, both sides draw on the same studies, like this one from the National Energy Technology Laboratory of the U.S. Department of Energy. A closer look at the underlying data shows that two factors account for the gap between the "clean" and "dirty" numbers for oil sands.

One is whether GHG emissions are measured on a "well-to-tank" basis or a "well-to-wheels" basis. Most of the extra GHG emissions for oil sands come from the energy-intensive process of getting the gunky bitumen out of the ground, upgrading it to refinery quality, and then refining it. That is the well-to-tank part. Subsequent highway use of the fuel, regardless of its source, produces the bulk of GHG emissions for the whole well-to-wheels fuel cycle. As a matter of simple arithmetic, then, moving from a well-to-tank measure to a well-to-wheels measure makes oil sands look relatively less dirty.

The second source of the gap between the clean and dirty numbers lies in what oil sands are compared to. Oil sands detractors like to use U.S. domestic crude as the basis for comparison. On a well-to-tank basis, DOE data show that production of diesel fuel from Canadian sands emits two and a half times more GHG than the average for diesel from domestic crude. But domestic crude is a poor basis for comparison. We use all our domestic crude first; after that, we have to go out and import the rest. The decision to use more or less oil from Canadian sands means importing correspondingly less or more from other sources. It turns out that almost all U.S. oil imports are low quality, heavy, or high in sulfur, meaning more emissions from extraction and refining. Long-distance transportation adds more emissions. All things considered, then, it appears that oil from Canadian sands is about 10 percent dirtier than crude from Nigeria (8 percent of imports) and 42 percent dirtier than oil from Mexico (12 percent of imports) on a well-to-tank basis. The gap is even less on a well-to-wheels basis.

So what do we really learn from parsing the DOE emissions data? We learn that although oil from Canadian sands is dirtier than average, no oil is really clean. As far as GHG emissions are concerned, what really matters is the total quantity of oil that is used. Where it comes from makes some difference, but a fairly small one.

Our discussion of the environmental impact of Canadian oil sand development would be incomplete if it stopped with the GHG issue. There are also major adverse effects on the local environment. One big issue is land reclamation. Much of the bitumen is recovered by surface mining, which leaves a moonlike landscape in place of the original boreal forests and wetlands. Water is another issue. Both surface and subsurface extraction of bitumen use vast quantities of fresh water and leave behind huge storage ponds full of toxic tailings. Candice Beaumont, an industry supporter who thinks oil sands may help delay "peak oil," describes the situation this way: "If a bird flies over a river near the oil sands, the bird dies just from flying over the river. It's that toxic. They are just dumping all the waste into the waterways. If you did that in the U.S. you would be in jail." (She discounts environmental impacts on the grounds that few people live in the main mining areas.)

Canadian authorities, to their credit, require that producers restore the land and water, and deposit funds in escrow to ensure that they do so. However, critics question the adequacy of the regulations. They point out that restoration technology is poorly demonstrated--very little land and none of the most toxic tailing ponds have actually been restored as yet. Furthermore, they argue that the required escrow deposits are not adequate to protect against potential disasters like a major wastewater spill.

Because environmental concerns cannot be entirely dismissed, oil sands supporters play the national security card. As the American Petroleum Institute's Jane Van Ryan puts it, "Every barrel imported from Canada could replace one from a less secure source, adding to our energy security and benefiting our economy." To evaluate the energy security argument, we have to think both about the nature of the oil security threat and that of the global oil market.

One aspect of the security threat is logistical. If, say, a civil war cut off supplies from Nigeria, the United States would have to scramble to find alternative sources. Contracts would have to be renegotiated. Tankers would have to be rerouted. Refineries would have to be reconfigured to handle a different type of crude. Even if those adjustments were eased by releasing oil from the strategic petroleum reserve, there would be short-term costs.

A second aspect of the security threat comes from oil price volatility. Oil is an import into virtually everything produced in the economy, and a major component of the cost of living. Sharp spikes in oil prices caused by war, politics, natural disasters, or industrial accidents send shockwaves through the whole economy.

A third security concern is who ends up pocketing the vast revenues generated by high oil prices. It has become a cliche to point out that not all oil producers are among America's closest friends. At worst, oil money funds authoritarian governments, the weapons programs of hostile states, and terrorism.

What could be better, then, than to replace oil from unstable countries like Nigeria with oil from friendly, democratic, and near-by Canada? It sounds good, but when you think about it, the security benefits are less than they seem. Again, consider a hypothetical Nigerian civil war. How much would it matter if, before the war started, Canadian output had expanded by enough that the United States was no longer an importer of Nigerian crude? It would not matter very much,  because the global oil market operates as a single pool. Oil prices everywhere would spike as other countries scrambled to replace Nigerian oil. The dictators, hostile arms programs, and terrorist training centers we worry about would still get their inflow of new money. The U.S. economy would still be set back by higher import costs, unless, perhaps, our friendly neighbors to the north generously agreed to keep selling us oil at the low, pre-crisis price. True, there would still be logistical benefits to a short pipeline link with a stable Canada compared with a long sea route to a volatile Nigeria, but those would be of a second order of magnitude. For national security, as for the environment, the biggest part of the threat lies in excessive total consumption of oil, not in the specific sources from which that oil comes.

The preceding discussion of environmental and security issues reveals the hidden pitfalls of growing U.S. dependence on Canadian oil sands.

The pitfall for U.S. policy makers is that stable and abundant Canadian supplies will serve as an excuse to avoid the hard work of implementing a rational energy policy. Such a policy would be one that accounted for the full cost of every unit of energy from every source, new and old, and imposed those costs on the end user through higher prices. Meanwhile, Canadian policy makers would hopefully make sure that producers were pricing in the full costs of contingent liabilities from land reclamation and wastewater spills. A well-coordinated set of policies would place appropriate charges against all forms of energy, but oil from Canadian sands would take one of the biggest hits. Yes, such a policy would substantially increase end-user energy prices in the United States, but once the transition was complete, the economy would be strengthened, not weakened. As I have argued elsewhere, the one thing the country definitely cannot afford is "affordable energy."

The pitfall for investors is that putting money into the development of Canadian oil sands amounts to a bet that both the United States and Canada will, for the foreseeable future, remain committed to pro-producer policies that are non-rational from the point of view of broader national interests. True, that is not  a completely stupid bet. Oil has a strong lobby on both sides of the border, and both governments are currently committed to further oil-sand development. But that might change.

It would be a mistake for investors to fool themselves with the arguments their own lobbyists are using to underplay the environmental impact of oil-sand development and overplay its national security benefits. Experience shows that a crisis can quickly shift public sentiment, and when that happens, politicians tend to run for cover. A generation ago, Chernobyl and Three Mile Island shifted sentiment against nuclear power. Last summer, BP's blowout in the Gulf of Mexico did the same for offshore drilling. A dramatic climate event like an ice-free summer on the Arctic Ocean or a burst dam on a big Alberta tailings pond could do the same for Canadian oil sands. At such moments policy can shift quickly from irrationally permissive to irrationally restrictive. Investors beware.

Follow this link to view or download a short slideshow on Canadian oil sands. The slideshow includes graphic material too extensive to include in this blog post.

If a Stronger Yuan is Good, Can A Weaker Dollar be Bad?

One of the top themes for 2010 in economics, politics, and diplomacy was the damage being done to the U.S. economy by an undervalued Chinese yuan. As the yuan began to appreciate in the second half of the year, slowly in nominal terms but more rapidly in real terms, everyone cheered. At the same time the yuan appreciated, the dollar depreciated, not just relative to the yuan, but to all foreign currencies on average. The broad weakness of the dollar was welcomed much less enthusiastically. Words like "unpleasant" and "grim" tended to be used instead.

So what gives? If a stronger yuan is good, can a weaker dollar really be bad?

It is easy to understand why appreciation of the yuan has been so widely sought and so well received. A weak yuan makes it hard for U.S. manufacturers of toys, shoes, and solar panels to compete with imports from China, and for U.S. exports of goods and services to penetrate Chinese markets. That, in turn, puts downward pressure on U.S. wages as employers struggle to cut costs and stay in business. Yuan appreciation takes some of the pressure off. It is even more welcome at a time when there is already so much slack in the U.S. economy.

Of course, the yuan is not the only currency out there. If it appreciated while other exchange rates stood still, not many of those toy and T-shirt jobs would come home. Importers would just find new sources in Bangladesh, or Vietnam. Trade deficits and political tensions would increase with those countries and there would be calls for them, too, to realign their currencies.

Fortunately for those who look after the interests of U.S. exporters and import-competitors, the yuan-dollar relationship has not moved in isolation. Instead, the dollar has depreciated across a wide front. The broadest measure of the trend is the real effective exchange rate (REER), which is a weighted average of a country's exchange rate relative to the currencies of all its trading partners, adjusted for differences in national rates of inflation. As the following chart shows, by the end of 2010 the dollar's REER reached a low point for the decade. The weak dollar contributed to a healthy 14 percent growth in U.S. exports (based on data through October). Interestingly, that 14 percent is right on track with the president's National Export Initiative, which aims to double exports over five years.

Of course, there are downsides to the dollar's weakness. The chief one is an increase in the cost of imports. In part, that means toys and T-shirts cost more at Wal-Mart. At the same time, it means the dollar costs of imported raw materials, from oil to neodymium, also rise. As high import costs pass through wholesale and retail markets, dollar depreciation puts upward pressure on the rate of inflation.

But even the inflationary impact of the weak dollar is not entirely unwelcome at present. U.S. inflation, whether you measure it by the consumer price index, the personal consumption expenditure core deflator, or whatever, is well below the 2 percent or so that is widely thought to be consistent with a healthy economy. In a heroic attempt to get the inflation rate back up to target, the Fed has undertaken a program of quantitative easing in the form of massive purchases of Treasury securities. Although for diplomatic reasons the Fed is reluctant to say so, dollar depreciation is one of the channels through which quantitative easing is supposed to work. For that reason, a bit of depreciation-induced inflation is actually welcome at the moment.

It would be nice to end this post with a confident prediction about the dollar's exchange rate in the coming year, but I cannot. There are too many uncertainties, the future direction of U.S. fiscal and monetary policies being among the greatest. Instead, I will end with a more modest reminder: Exchange rate changes always produce both winners and losers, but the balance between the gains and the losses can vary according to circumstances. At the moment, and with the proviso that last year's gradual adjustments do not turn into a rout, both a stronger yuan and a weaker dollar are more to be welcomed than lamented.

Follow this link to view or download a brief slideshow discussing appreciation of the yuan and depreciation of the dollar during 2010.

What is Price-Level Targeting? Has Its Time Come?

As we enter 2011, we are hearing more about something called price-level targeting. It clearly has something to do with monetary policy, but what does the term really mean, and why is it coming up for discussion right now? Is it a policy the Fed is likely to adopt, or is perhaps already using?

Price-level targeting is not a new idea. It was used by the Swedish central bank as long ago as the 1930s. It has been widely discussed in the academic literature. It is most easily explained by comparing it with inflation targeting, its more widely used policy alternative. An inflation-targeting central bank tries to hold the price level on or close to a path that increases at a steady rate over time, say 2 percent per year. When everything is functioning smoothly, a price-level targeting central bank would aim for exactly the same path. The difference between the two policies comes when the inflation target is missed.

Suppose, as is the case in the United States now, inflation drops below its target rate for an extended period, as at point A in the chart below. (The vertical scale of the chart is exaggerated for clarity, but it is roughly based on actual U.S. data and Fed forecasts.) Having arrived at point A, the question is what kind of corrective action to take. The inflation targeter would take whatever actions are necessary to get the rate of inflation back to 2 percent. If successful, those actions would put the price level on a new path parallel to, but permanently below, the original one. The price-level targeter would instead undertake policies to return the price level to the original path, even though doing so would require the rate of inflation temporarily to exceed 2 percent, along the segment A to B, until the price level had made up for its earlier shortfall.

Either strategy can be interpreted as broadly consistent with price stability, but price stability is not the only goal of monetary policy. The Fed operates under a dual mandate that requires it both to maintain price stability and to achieve the highest level of employment consistent with doing so. In the case at hand, price-level targeting involves more aggressively expansionary actions that in all likelihood would reduce unemployment more rapidly than simple inflation targeting. At the same time, it would cause no more inflation than there would have been if the price level had never fallen below its its intended path in the first place.

If price-level targeting is consistent with price stability and at the same time is superior to inflation targeting in terms of employment, it seems that it should be the hands-down favorite. Price-level targeting does have some support at the Fed. New York Fed President William C. Dudley, a permanent voting member of the Federal Open Market Committee (FOMC), has written favorably of the policy. Charles Evans, President of the Chicago Fed, has been an even more outspoken proponent. Fed Chairman Ben Bernanke, however, has been lukewarm on price-level targeting. In a 2003 speech, he spoke favorably of it as an option for Japan, which was then in a situation not too different from the U.S. today. However, in an August 2010 paper, he rejected price-level targeting for the United States. On balance, price-level targeting appears to lack majority support on the FOMC at this time.

One source of opposition to price-level targeting is the fear that it could increase uncertainty. It could "befuddle a public long accustomed to thinking in terms of inflation rather than price levels," as The Economist put it in a critical article. Increased uncertainty, in turn, could raise risk premiums and make business planning more difficult.

Another concern is that price-level targeting could undermine the Fed's hard-won credibility. The thinking seems to be that if the Fed openly encouraged a rate of inflation above 2 percent even for a brief period, people might come to doubt its commitment to price stability altogether.

A third objection is that price-level targeting might not be appropriate in all circumstances. In particular, it could cause problems if an external shock, like an increase in global energy prices, temporarily pushed inflation above, rather than below, its target path. In such a case, rigid adherence to a price-level target would require policy measures sufficiently contractionary to achieve absolute declines in prices and nominal wages in non-energy sectors. Rather than subject the economy to such harsh medicine,  it might be better to let bygones be bygones, and put the economy on a new 2 percent inflation path starting from a higher base.

Not everyone finds these objections persuasive. Charles Evans argued in an October 2010 speech that the standard objections could be overcome by using what he calls state-contingent price-level targeting. His version of the policy would work as follows:

First, the Fed need not, and should not, commit to price-level targeting as a policy for all seasons. Instead, it should make it clear that that price-level targeting would be undertaken only when the economy has undershot the rate of inflation that is desirable in the long run. Other states of the economy, including overshooting of the inflation target due to external shocks, would be handled differently.

Second, Evans addresses the problem of expectations. The worry is that inflation expectations could become unanchored as price-level targeting began to move the economy along the high-inflation A-to-B segment in our earlier chart. To prevent that from happening, the Fed should be explicit about its exit conditions. It should make it clear that as soon as the desired long-run price-level path has been reached, monetary stimulus will be ratcheted down by enough slow inflation to the rate thought desirable in the long run.

Third, clear communication would eliminate the risk that price-level targeting would undermine the Fed's credibility. Credibility can come under threat only if the Fed fails to make clear what it is trying to do, or makes a clear statement of its intentions and then does something else instead. State-contingent price-level targeting that is explicit about both entry and exit conditions is arguably more consistent with preservation of credibility than what the Fed is now doing.

Consider, for example the FOMC's most recent policy statement of December 14, 2010. The statement does not really give much guidance about just what the Fed is targeting or what its exit conditions are. We are told that the Fed will try to keep the fed funds rate low for "an extended period." We are told that it will continue its QE2 program of buying long-term Treasury securities. But clarity is significantly undermined by the vagueness of the statement of exit conditions: "The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate." Does that mean that the Fed will ease off as soon as inflation hits 2 percent? Will it instead persist with its current aggressively expansionary policy until employment has recovered, even if doing so temporarily results in a higher rate of inflation? In short, the statement could easily be read as consistent either with pure inflation targeting, or with price level targeting, or with flying by the seat of the FOMC's pants.

The bottom line: We can look forward to a renewed debate on price-level targeting in 2011. Support for the policy will be strengthened a bit by the fact that the Chicago Fed has a voting seat on the FOMC in odd-numbered years. If inflation remains stubbornly low, as it did throughout the fall, perhaps Chairman Bernanke will become less confident that "both inflation expectations and actual inflation remain within a range consistent with price stability," one of the reasons he gave for rejecting price-level targeting in his August speech. It is even possible that the FOMC has already committed to de-facto price level targeting without saying so explicitly. Developments over the coming months should make it clear whether the time for price-level targeting has now come.

Follow this link to view or download a brief slideshow discussing price-level targeting, including the views of supporters and critics of the policy.