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Alphabet: Less Than Meets the Eye

Tue, 08/11/2015 - 08:27

By James Kwak

The reorganization of Google into Alphabet means … well, not very much, at least for now. Instead of everything being inside one big corporation called Google, now there will be a bunch of corporations (one of them called Google) all owned by a holding company called Alphabet. “Holding company,” in this case, means that Alphabet will have no operations of its own: it will be a corporation that simply owns all the other corporations.

This is supposed to have something to do with making the company “cleaner and more accountable,” “empowering great entrepreneurs and companies,” “improving transparency and oversight,” blah blah blah. In itself, however, it does none of this.

There is no substantive difference between a corporation with a bunch of divisions and a corporation fully owning a bunch of other corporations. In both cases, the CEO at the top of the pyramid has complete control over everything that happens within the entire structure, and is accountable to no one except the board and shareholders of the top-level corporation. As for transparency, there’s no rule saying that any corporation has to release audited financials, or have audited financials in the first place, or publish any financials at all (except for tax filings, which are not public). The rules requiring disclosures only apply to publicly traded corporations, and in the new structure, there is still exactly one of these: Alphabet, which still owns everything.

The new Alphabet is planning to release financial information for its new Google subsidiary, but that’s purely voluntary — and it’s something they could have done already. Any corporation always has the option of disclosing more information than it is legally required to, and most public corporations take this opportunity to release information that they think will help them with their investors (if only because many investors are unwilling to buy stock in companies that don’t say anything about how their numbers break out across product lines or regions).

Alphabet’s subsidiaries will each have a CEO and, presumably, a board of directors. This could be good, it could be bad, but most likely it won’t make a difference. There’s no reason you couldn’t call the head of an operating division its “CEO” instead of “president” or “general manager” as is the case today. Nominally a corporation has to have a board of directors, but in the case of an Alphabet subsidiary all of its members will be named by Alphabet. So to the extent that the board does anything, it will be less efficient than the current situation, in which Larry Page can simply call the head of, say, Nest, and tell him what to do. And to the extent that a subsidiary corporation duplicates any of the infrastructure that is currently handled at the top, Google level (finance, HR, IT, etc.), that’s simply a waste. However, the most probable outcome is that Alphabet will continue doing what Google is doing today: the various subsidiaries will be semi-autonomous, doing some things independently and drawing on shared resources for others.

While we’re at it, let’s clear away the too easily bandied about comparisons to Berkshire Hathaway. Berkshire is a corporation that owns other corporations. But that’s because Berkshire is Warren Buffett’s investment vehicle: he uses it to buy companies that he thinks are undervalued, like most recently Precision Castparts. The companies that Berkshire buys have nothing to do with each other, or with Berkshire’s historical insurance business, so of course Buffett leaves them intact. That also makes sense because he may want to sell them someday, or at least preserve that option. Google, by contrast, has never bought a company solely as an investment play. It has always done so because of supposed synergies between the acquisition and Google’s other businesses. When Alphabet starts buying companies that have nothing to do with its existing companies, then you can start comparing it to Berkshire.

In short, the reorganization of Google into Alphabet doesn’t change anything about how the company has to behave, so any actual changes are things that could have been done without the reorganization. The corporate structure will only really matter if investors can own stock directly in the subsidiaries, so a subsidiary could have a different shareholder mix from Alphabet. Then a host of new rules could apply, including required financial disclosures on the subsidiary level and restrictions on transactions between the subsidiary, Alphabet, and the other affiliates in the group. Then the subsidiary would have to be run independently for the benefit of its shareholders — which is good from its shareholders’ perspective, but bad from the perspective of the conglomerate as a whole, because it limits flexibility.

This week’s reorganization could be a preparatory step in that direction — but, then again, it might not. It’s not clear if Larry Page and Sergey Brin have a master plan. And, if they have a master plan, there’s no particular reason to think it’s a good one. Page and Brin are obviously the technology world’s version of geniuses, having invented the original Google search algorithm and turned it into the world’s dominant search and online advertising business. But there’s no reason to think they have any particular insight into questions of corporate organization. For decades (if not centuries), everyone has known that there’s a basic trade-off between consolidation and autonomy, and that as you get bigger and bigger it gets harder to run everything on a fully consolidated basis.

These days institutional investors tend to distrust companies that combine too many businesses under a single corporate umbrella, so as time passes the pressure on Alphabet to break itself up for real will only grow. In the meantime, the new structure is not a best of both worlds, because there is no best of both worlds: you can’t have a corporate structure that provides maximum autonomy and transparency on the subsidiary level and also permits maximum coordination across the entire group. Not even if you are a Silicon Valley billionaire.

[Also posted at Medium.]

So Tom Hayes Is Guilty. Who Else Is?

Tue, 08/04/2015 - 15:30

By James Kwak

Tom Hayes was a trader at UBS and Citigroup who was very, very good … at rigging LIBOR. This week, he was convicted in the United Kingdom of conspiring to manipulate the benchmark interest rate and sentenced to fourteen years in prison.

There’s little doubt that Hayes was guilty as charged. In his defense, he argued that he had no idea what he was doing was wrong. But contrary to what some armchair attorneys think, that doesn’t matter. In general, the famous mens rea (guilty mind) requirement isn’t that you know you are breaking the law at the time; it suffices if (a) you know you are doing a thing and (b) that thing is against the law. There’s no question that Hayes knew he was conspiring to rig LIBOR, and that’s enough for the prosecution.

And on one level, it’s good that he was convicted and got a stiff sentence. That prospect should help deter criminal activity of all kinds by bankers and traders who have historically been shielded by prosecutors’ unwillingness to go after individual defendants (except in insider trading cases).

But … Tom Hayes as the evil architect of the LIBOR-fixing scheme? Not so much.

As in so many cases, there are only two logical possibilities. Either Tom Hayes’s bosses at UBS and Citi knew what he was doing, in which case they are guilty as well. Or they didn’t know about a widespread conspiracy being conducted across the electronic communications systems of some of the most technologically sophisticated companies in the world, in which case they are recklessly incompetent.

When it comes to Tom Hayes, there is a lot of evidence for the former. Apparently, when he was being recruited from UBS in 2010, he boasted to a Citi executive about how he rigged LIBOR. Back in 2007, that same executive had said in an internal email, “We will continue to pressure the brokers to talk [LIBOR] down and generally press lower” — when asked by a colleague to help lower Citi’s own LIBOR submissions. When Citi attempted to hire Hayes, his boss at UBS tried to arrange a large bonus for him to stay, citing his “strong connections with Libor setters in London.”

It’s hard to believe that senior executives at UBS and Citi didn’t know that LIBOR was being fixed. If they weren’t in on it directly, it’s likely that they turned a blind eye — precisely because they knew that it was good for the bottom line. Hayes himself generated $260 million in profits for UBS in just three years.

When people make that kind of money for the bank — in markets that are supposed to be highly competitive — executives don’t want to know too much about what they’re doing.

As time goes by, it gets harder and harder to figure out how much of the largest banks’ profits is due to their legitimate operations and how much is due to their tolerance of illegal activity (money laundering, rate fixing, bribery, etc.). Maybe bank executives are so inept when it comes to internal wrongdoing because they like things that way. They want their employees pushing the limits of the law to maximize profits. (“If you ain’t cheating, you ain’t trying.”) And when people like Tom Hayes get caught, the bank itself gets away with a slap on the wrist because it’s too big to jail — and the CEO gets away by claiming ignorance. It’s a win-win strategy.

[Also posted on Medium.]

More Misinformation about Banking Regulation

Tue, 07/21/2015 - 15:22

By James Kwak

“Fed Tells Big Banks to Shrink or Else,” the Wall Street Journal proclaimed in the headline of its lead story today.* If only.

What the Federal Reserve actually did is impose new, additional capital requirements for the largest banks. JPMorgan Chase, for example, will have to hold 4.5 percentage points more capital than it would have had to otherwise. This is clearly a good thing, since it means that the banks that could do the most damage to the financial system will be a little bit safer. But it is neither a complete solution, nor is it the draconian constraint that the banks and the Journal make it out to be.

For starters, the rule will have no effect on seven of the eight banks in question (JPMorgan is the exception), since they already have enough capital to meet the new requirements. That alone should let you know how significant a rule this is.

Even so, the Journal says that banks will have to decide “whether to pay the cost of new regulation, which will fall to the bottom line, or change their business models.” This is not true.

Say some bank has $100 in assets and $95 in liabilities, so it has $5 in capital. Its “bottom line” profits are basically the interest it earns on the assets minus the interest it pays on the liabilities. Then say Janet Yellen comes along and tells the bank that it has to have $10 in capital for every $100 in assets. So the bank sells new shares to the public for $5 and uses the $5 in cash to pay off $5 of its liabilities. Now it has $100 in assets and $90 in liabilities, so its profits actually go up (since it has less debt to pay interest on, and it pays a lower interest rate because its debt is less risky).

The banks’ complaint is not about the “bottom line,” but about something else: return on equity. Even though profits go up, they are now spread across twice as much capital. If you think of capital as the money invested by shareholders, then the shareholders are getting a lower return than they were previously. But this ignores the fact that stock in the bank is also less risky than it was before, so shareholders don’t demand as high a return on their money. Under a few basic assumptions, the return on equity is exactly what it needs to be to meet shareholders’ expectations.

This is the Modigliani-Miller Theorem, which has been around for more than half a century and is taught in every finance class. It says that a firm’s capital structure — the amount of equity it has relative to debt — doesn’t matter: in the case of the hypothetical bank, if you increase equity and reduce debt, after the reduced debt payments, there is just enough cash left over to compensate the larger number of shareholders at the lower rate that they are now willing to accept.

Now, the assumptions of Modigliani-Miller don’t hold in the real world, but the main reason they don’t hold is the tax subsidy for debt: companies can deduct interest payments on debt from their taxable income, but they can’t deduct dividends paid to shareholders. Even so, that’s not terribly hard to get around. A company can reinvest its profits in its business; as long as it finds something useful to spend the money on during the same year that it earns the profits, it won’t have to pay tax on them (because they won’t be profits — they’ll be either operating expenses or depreciation of capital investments).

Tim Pawlenty, the latest flack for the largest banks, complains that higher capital requirements will “keep billions of dollars out of the economy.” Again, this is simply not true. The amount of bank lending is dependent on the volume of lending opportunities available to banks with a risk-adjusted interest rate that exceeds their cost of capital. Since the cost of capital doesn’t change with capital requirements (except, again, because of the tax subsidy for debt), the amount of bank lending doesn’t change either.

Anat Admati and Martin Hellwig have been making these points for years now. Unfortunately, the banks, their lobby, and their water-carriers in the media persist in spreading misinformation about capital and banking regulation.

* That’s the headline in the print edition, not online.

[Also posted at Medium.]

Friedrich Hayek Supported a Guaranteed Minimum Income

Mon, 07/20/2015 - 14:21

By James Kwak

“We shall again take for granted the availability of a system of public relief which provides a uniform minimum for all instances of proved need, so that no member of the community need be in want of food or shelter.”

That’s from The Constitution of Liberty, “definitive edition,” p. 424. Yes, it comes as part of Hayek’s argument against mandatory state unemployment insurance. But it reflects a fundamental understanding that no one should go without food or shelter, and that it is the duty of the government to ensure this minimum level of existence. “The necessity of some such arrangement in an industrial society is unquestioned,” he wrote (p. 405).

The standard that Hayek simply assumed would exist goes beyond merely keeping poor people alive. In a wealthy society, he thought it inevitable that it would become “the recognized duty of the public to provide for the extreme needs of old age, unemployment, sickness, etc.” (p. 406). On this basis, he even endorsed the idea of compulsory insurance, such as the individual mandate of the Affordable Care Act.

I’m not claiming that Hayek would have supported Obamacare — he almost certainly would have favored less government involvement than the system of state-level exchanges. But on the questions of welfare and government intervention in insurance markets, he was to the left of the entire Republican Party today.

[Also posted on Medium.]

I Agree with Milton Friedman!

Mon, 06/15/2015 - 13:02

By James Kwak

In Capitalism and Freedom, Milton Friedman asks what types of inequality are ethically justifiable. In particular (pp. 164–66):

“Inequality resulting from differences in personal capacities, or from differences in wealth accumulated by the individual in question, are considered appropriate, or at least not so clearly inappropriate as differences resulting from inherited wealth.

“This distinction is untenable. Is there any greater ethical justification for the high returns to the individual who inherits from his parents a peculiar voice for which there is a great demand than for the high returns to the individual who inherits property? …

“Most differences of status or position or wealth can be regarded as the product of chance at a far enough remove. The man who is hard working and thrifty is to be regarded as ‘deserving’; yet these qualities owe much to the genes he was fortunate (or fortunate?) enough to inherit.”

I think Friedman is correct here. This is basically the same point that I made in my earlier post: the money that you make because you are smart and hard working is the product of good fortune just as much as the money that you inherit directly from your parents.

Read more at Medium.

What Is the Trans-Pacific Partnership (TPP) Really All About?

Thu, 06/04/2015 - 10:54

By Simon Johnson

The Trans-Pacific Partnership (TPP) is a proposed free trade agreement (FTA) between the United States and 11 other countries.  It is comprised of two main parts: reductions in tariffs (and related non-tariff barriers), of the kind typically seen in trade agreements; and new rules for foreign direct investment and intellectual property rights, which have not previously been prominent in FTAs.

The new rules part has become controversial.  The case for introducing an investor-state dispute settlement seems less than compelling – this would favor foreign investors over domestic investors, not an idea that sits well with the standard idea of equality before the law (going back at least 800 years) and a direct contradiction to the usual principles of FTAs (emphasizing non-discrimination across types of investors).  As currently formulated, it would also be open to considerable abuse.  And the precise rules under consideration for patent protection appear likely to reduce access to affordable medicines in both our trading partners and potentially also in the United States.

As a result, advocates of TPP are now emphasizing the benefits of tariff reductions in terms of boosting US exports.  But the administration’s claims in this regard are greatly exaggerated and the United States Trade Representative (USTR) is unfortunately refusing to fully discuss the broader trade impact, including the precise impact of higher imports into the United States.

In an interview with Politico this week, Ambassador Michael Froman, listed some examples of high tariffs on American goods in other countries – and emphasized that these might come down as part of TPP.

There are two main problems with Mr. Froman’s list.  First, he naturally picked the relatively few goods that have such tariffs.  We have free trade agreements already with many of the countries in TPP (details here), so most tariffs are already quite low.

There are some high tariffs on some US agricultural goods, including going into Japan.  But when the US Department of Agriculture looked at the entire trade impact (i.e., exports from and imports into the U.S.) – with a focus on food and related commodities – they found a total likely effect on US GDP of precisely zero.

The USDA is presumably expert on the agricultural side of trade and their measures of tariffs match up in detail with what Mr. Froman talks about.  Mr. Froman and his colleagues should explain exactly why specialists within the Obama administration do not agree with the USTR assessment of the likely TPP impact.

We should, of course, also look at all other dimensions of trade – including manufacturing and services.  Here also Mr. Froman makes some claims about the great benefits of reducing tariffs and non-tariff barriers.

The best independent research on this topic is by Peter A. Petri, Michael G. Plummer, and Fan Zhai, and – as a model of transparency – the details of their relevant work are available on-line.

Included in these very helpful materials is a page with the details of their results specifically on trade.  (Some of this work is available through the Peterson Institute for International Economics, where I am a senior fellow; I’ve not been involved in this project in any way.)

To understand the precise size and nature of potential GDP gains from TPP in this framework, you should look at the Excel spreadsheet posted under “Adding Japan and Korea to the TPP” (the fourth set of links).  The spreadsheet name is “Macro-TPP-7-Mar-13”.

There are two scenarios worth considering – what the authors call TPP11 (which is the TPP without Japan) and TPP12 (including Japan).  Some version of TPP12 is now likely, although we don’t know the full extent of trade liberalization in any country that will be in the final agreement, and well informed observers express skepticism about the extent to which Japan will really open to US agriculture or to autos and auto parts (where we have long-standing difficulties selling in Japan due to profound non-tariff barriers).

In 2025, according to this model, the baseline Gross Domestic Product for the US is $20,273bn.  Under TPP11, this falls (very slightly) to $20,268.0bn.  Perhaps this is a rounding error, but the fact that the increase in trade could lower US GDP should give us pause.  (The authors themselves prefer to emphasize “income gains” in the spreadsheet, which attempt to adjust for changing relative prices between 2007 and 2025 – a sensible but difficult exercise.  The income gains measured this way are $23 billion under TPP11, a tiny increase precisely because we have extensive FTAs with these countries already.)

All the GDP gains to the US from TPP (via trade) come from adding Japan to the agreement, to get TPP12 GDP of $20,312.9 billion in 2025.  (Looking at “income gains”, 69 percent of the headline improvement of $76.6 billion for the US is due to Japan.  Most of this is not due to trade but actually due to increased US foreign direct investment in Japan, including in the service sector.)

No matter how you look at it, the positive impact on GDP (measured at 2007 relative prices) is miniscule: roughly $40 billion in a total economy of $20 trillion, i.e., 0.2 percent.  And all of this positive impact comes from the details of what Japan allows in (and what we give in return, including with tariff reductions on light trucks/sports utility vehicles.)  The devil really is in these details, as Representative Sander Levin (D., MI) has emphasized.

In addition, it is entirely possible that any such increase in GDP or income may be associated with widening inequality or a fall in median wages – we know that the distributional impact of such trade agreements is typically much larger than the total GDP effect.  We really need to see what is in TPP in order to assess this dimension of the impact, but the relevant details are a closely held state secret.  Labor standards are a particular worry here, particularly with respect to Mexico.  Will there be sufficient prior actions, before TPP goes into effect?  Relying on vague promises of enforceable labor standards simply will not work.

Mr. Froman’s rhetoric implies effects that are far beyond what is in the numbers.  In terms of any claims about a net positive impact on US GDP, TPP is mostly a free trade agreement with Japan, and it is much more about potentially liberalizing FDI into Japan than it is about increasing trade.

Seen in this context, it is ironic – and disturbing – that Mr. Froman refuses to include language in TPP that would discourage currency manipulation , i.e., central bank intervention in the foreign exchange markets that causes a country’s currency to depreciate, boosting exports and reducing imports.  The Petri, Plummer, Fan work assumes no manipulation of this kind takes place.  But if Japan were to manipulate its currency in the future as it has in the past, this would more than wipe out any US gains from TPP.

When you strip out the distractions, TPP comes down to essentially three things:

  • A free trade agreement with Japan. We need to see the details of that, including the FDI dimension, to understand if there will be GDP gains for the US or not.  The impact on US inequality and median wages also remains at best unclear.
  • Investor State Dispute Settlement. This is of very dubious value to residents of the United States, at least unless the administration agrees to introduce greater safeguards against abuse.
  • Greater protection for pharmaceutical patents. This will almost certainly reduce access to affordable medicines, both in the US and in our trading partners.

There are also vague claims about improving labor and environmental standards.  But, as far as outsiders can discern, any agreement along these dimensions will not require actions before TPP goes into effect.  Enforceability of such clauses after the fact is typically weak or nonexistent.

TPP is a very important potential trade agreement, primarily because it will establish the rules that can be included in this kind of deal going forward, including with other countries such as China.  But in this kind of arrangement, it is essential to examine and understand the details in order to comprehend the full nature of the commitments (as well as the gains or losses).

Just saying “tariffs will fall greatly, so exports will increase” – and implying big gains from this for the US economy – is not convincing and not even remotely accurate.

Instead of thinking hard about these details, Congress is poised to pass the Trade Promotion Authority – with the goal of making it easier to pass TPP irrespective of the crucial details.  This is not likely to lead to a good set of rules in TPP.

Over at Medium: Geo-Engineering Doesn’t Reduce Long-Term Risk

Mon, 06/01/2015 - 15:42

By James Kwak

Mark Buchanan — who is actually a physicist, after all — makes a compelling argument against relying on geo-engineering to deal with our climate change problem. For one thing, some of the proposed technologies simply won’t work, because they do nothing about the fact that the poles are warming faster than the rest of the planet. For another, the geo-engineering fairy is being used to lobby against other approaches — conservation and renewable energy sources — that would deal with climate change at its source.

Another reason to be skeptical of geo-engineering is the effect it has on the risk profile of humanity’s future. Technology has produced some amazing things in the past century. But, with zero exceptions that I can think of, they weren’t things that our species needed to survive, or to prevent widespread natural and societal devastation. If we’re talking about technologies that can make our lives better in all sorts of ways, like the Internet or DNA sequencing or quantum computing, then risk is good: we want to place lots of bets that have a high chance of failure but high potential returns.

Read more at Medium.

Over at Medium: Organized Crime on Wall Street

Fri, 05/22/2015 - 10:23

By James Kwak

One of the central dramas of the early seasons of The Wire is the cat-and-mouse game between Avon Barksdale’s drug operation and the detectives of the Major Crimes Unit. The drug dealers started off using pagers and pay phones. When the police tapped the pagers and the phones, Barksdale’s people switched to “burner” cell phones that they threw away before the police could tap them. By Season 4, Proposition Joe advised Marlo Stanfield not to use phones at all.

Well, apparently, Wall Street currency traders don’t watch The Wire. I don’t think anyone was surprised to learn that major banks including JPMorgan, Citigroup, Barclays, RBS, and UBS conspired to manipulate currency prices — something that regulators have been investigating for over a year and a half. One common strategy was cooperating to time large transactions in order to manipulate daily benchmark rates at which other client transactions are executed.

Read more at Medium.

Why Is The White House Threatening To Veto An Imaginary Trade Promotion Authority (TPA)?

Thu, 05/21/2015 - 17:33

By Simon Johnson

At today’s daily briefing, White House spokesman Josh Earnest communicated the president’s threat to veto any trade promotion authority (TPA) that “could undermine the independence or ability of the Federal Reserve to make monetary policy decisions”.  (The question was posed at minute 42:50, Mr. Earnest’s answer starts at 43:31, and the lead up to this quote starts around 45:20.)

Mr. Earnest’s statement seems clear enough, but what potential TPA is he talking about?  Either the White House is confused or some other communications strategy is at work here.  Either way, Mr. Earnest is describing some imaginary version of TPA that is simply not on the congressional table.

He most certainly cannot be accurately describing the bipartisan Portman-Stabenow amendment, currently before the Senate.  This amendment specifically goes out of its way to state that it would not “restrict the exercise of domestic monetary policy.”

Here is the full text:

 “In section 102(b), strike paragraph (11) and insert the following:

“(11) Currency manipulation.–The principal negotiating objective of the United States with respect to unfair currency exchange practices is to target protracted large-scale intervention in one direction in the exchange markets by a party to a trade agreement to gain an unfair competitive advantage in trade over other parties to the agreement, by establishing strong and enforceable rules against exchange rate manipulation that are subject to the same dispute settlement procedures and remedies as other enforceable obligations under the agreement and are consistent with existing principles and agreements of the International Monetary Fund and the World Trade Organization. Nothing in the previous sentence shall be construed to restrict the exercise of domestic monetary policy.”

The Portman-Stabenow amendment is focused entirely on “protracted large-scale intervention in one direction in the exchange markets,” i.e., the situation when a foreign central bank acquires a massive amount of foreign assets (typically dollars) in a successful attempt to keep their currency undervalued – and therefore their exports much cheaper than they would otherwise be.

This is not something that the Federal Reserve does – nor anything that it is likely to do in the foreseeable future.

Reference to the IMF principles and agreements here has a clear meaning for anyone who follows international currency and macroeconomic issues.  The US Treasury was involved in drafting the IMF agreements in the 1940s and has kept a firm hand on the pen at every stage of the way since – including the very latest versions.  There is no way that any serious person could claim – or even imagine – that relying on IMF principles would impede the operation of the Federal Reserve and its monetary policy.

Congressman Sandy Levin, ranking Democrat on the House Ways and Means Committee, made this point forcefully this afternoon in a major floor speech – and put the issue in exactly the right broader context with regard to the Trans-Pacific Partnership as a whole.

“The International Monetary Fund has up-to-date guidelines that define currency manipulation and are intended to prevent it. There is nothing wrong with the spirit or even the letter of those guidelines. Unfortunately, the IMF cannot enforce those guidelines because currency manipulators are able to essentially stall action in that forum.”

“Arguments that prohibiting currency manipulation in TPP is impossible, for political or technical reasons, remind us of previous claims about trade agreements not being able to help defend forests or discourage child labor.”

“For example, some prominent people have asserted that U.S. monetary policy would be put at risk if currency disciplines are included in TPP. I responded to that argument in a highly detailed blog post months ago. I have seen no serious rebuttal of the points I made in that post – or to similar and related points made by Simon Johnson, Fred Bergsten, and many other notable economists, ranging from Art Laffer to Paul Krugman. Nevertheless, those who oppose currency disciplines continue to raise this false argument.”

“TPP should address instances in which countries buy large amounts of foreign assets over long periods of time to prevent an appreciation of their exchange rate despite running a large current account surplus. The Federal Reserve does not engage in such practices. That is why the U.S. already agreed to and even insisted upon what is in the current IMF guidelines.”

“And now there is the claim that including currency disciplines in TPP would be a “poison pill” and that our trading partners would walk away from the table. There is no way to accurately judge this issue until it is properly brought to the negotiating table. To the contrary, the fact that the Administration says this only creates the risk of a self-fulfilling prophecy. It is irresponsible to make this claim. Indeed, our trading partners in TPP would greatly benefit from these disciplines. Many of them are the victims of manipulation every bit as much as we are.”

“A progressive trade agreement for workers and the middle class must address currency manipulation, which has caused millions of job losses and contributed to wage stagnation over the past decade. President Obama is right that we should write the rules and not accept the status quo. But if we fail to address currency manipulation in TPP, we are essentially letting China write the rules and are accepting an unacceptable status quo.”

Over at Medium: “Payout Baby!!!”

Thu, 05/21/2015 - 15:00

By James Kwak

“In my many years of experience working in compliance, do you know how many fixed and variable annuities I’ve seen being invested in IRAs??? Countless.

“Investing a tax deferred investment within a tax deferred account simply does not make sense, except for very very few exceptions. … And when brokers answered me honestly as to why they picked annuities over mutual funds or even plain vanilla stocks??? Payout baby!!!”

That’s a compliance officer at Wells Fargo talking about the kinds of abuses that brokers — who advise clients about where to put their money, even if they aren’t “registered investment advisers” — inflict on their customers. For context: The benefit of an annuity is that taxes on earnings are deferred until withdrawals — but you get that benefit in any IRA, so there’s no point in putting an annuity (which has higher costs than an ordinary mutual fund) in an IRA. Yet in this case the brokers were pushing annuities because of the (legal) kickbacks they were getting from the annuity providers.

Read more at Medium.

The Trans-Pacific Partnership (TPP): This Is Not About Ricardo

Thu, 05/21/2015 - 05:06

By Simon Johnson and Andrei Levchenko

The Obama administration is lobbying hard for Congress to pass a trade promotion authority (TPA) and to quickly approve the Trans-Pacific Partnership (TPP), a free trade agreement that is on the verge of being finalized.

The administration and its supporters on this issue, including leading Republicans, argue that the case for TPP rests on basic economic principles and is only strengthened by the findings of modern research.  On both counts their claims are greatly exaggerated – particularly with regard to the notion that more trade, on these terms, is necessarily better for the United States.

There is a strong theoretical and empirical case – dating back to David Ricardo in 1817 – that freer trade should make countries better off. However, modern-day trade agreements, including those currently being negotiated, are very different from earlier experiences with trade liberalization.

The TPP is not only – perhaps not even mostly – about freer trade, and thus who gains and who loses is very much dependent on what exactly are the details of the agreement. The exact nature of the provisions matters and at this point, because the TPP text is not available to the public, we cannot be sure whom this trade agreement will help or hurt within the United States or elsewhere.

Outside of agriculture, international trade is already substantially liberalized, and thus the gains from further reductions in tariffs are most likely limited by the fact that tariffs are already quite low.

And the scope of modern-day trade agreements has expanded – primarily into areas in which the economic theory case for mutual benefits is far from clear.

Perhaps the most prominent example is intellectual property rights (IPRs), including patents.  Contrary to the mutual benefits of international trade in general, there is no clear-cut theoretical case that stronger enforcement of IPRs will benefit all parties.

In the world in which the developing countries can imitate technologies of developed countries, improving intellectual property rights protection in developing countries is actually likely to make them worse off.  This is intuitive: ignoring the developed countries’ IPRs allows developing countries to adopt better technologies faster, increasing welfare there.  In the case of medicines, for example, forcing lower income countries to fully respect all patents will mean more expensive treatments and less access to life-saving drugs.

What is more, it may even be the case that the developed countries themselves will benefit from weaker IPRs in the poorer countries (though of course this is not a necessary outcome).  This is because poorer countries tend to have lower wages, and as production shifts to the poor countries due to imitation, prices paid by rich countries’ consumers fall.  Helpman (1993) contains the modern classic exposition of these results.  (Precise references to the research cited here are at the end of this article.)

The second example is provisions that require liberalization of inward investment in oligopolistic industries.  For instance, recent US trade agreements with Central America/Dominican Republic, Peru, Panama, and Colombia contain specific clauses liberalizing investment in the financial services industry (as well as government procurement and investment more broadly).  Again, the theoretical case that these provisions will be mutually beneficial is not straightforward.

For instance, if an industry is uncompetitive, countries may gain from retaining the domestic oligopolistic firms.  Entry by foreign firms may not increase competition but instead primarily result in transferring the profits abroad.  Brander and Spencer (1985) develop these ideas for cross-border trade; a recent paper by Fiorini and LeBrand (2015) focuses on inward investment by foreign firms.

The third example is the potential for a negative impact of international trade on the quality of domestic institutions. The standard argument for mutual gains from trade assumes that international exchange of goods does not lead to changes in the institutional environment – including who has secure property rights (as in land), as well as enforceable rights as a worker (including occupational safety standards).

There have been historical episodes in which trade booms led to worse institutional outcomes, such as property expropriation by elites.  Do and Levchenko (2009) develop a theoretical model of one possible mechanism for such an effect.  Historical instances of this include the cotton boom in Central America (Do and Levchenko, 2006), and sugar in the Caribbean (Dippel, Greif, and Trefler, 2015).

To be clear, we are not saying that this is a likely impact of TPP.  But it is a possible impact of any free trade agreement (or other form of trade liberalization).  This only confirms the point that the details matter in terms of determining who does well and who may do very badly.

We remain confident that there is a potential TPP that could be negotiated that would involve gains for all trading partners.  But whether this is the case depends completely on the specific rules that are being written.

Given that these rules are secret (from us), we have no way of judging what is or is not in the TPP.  Congress will vote soon on TPA, to greatly increase the odds of passing TPP, without there being first a proper public discussion of the TPP details.  This is not a triumph of democracy – and it is not likely to lead to better economic policymaking.

Simon Johnson is a professor at MIT Sloan.  Andrei Levchenko is an associate professor at the University of Michigan.


Brander, James A. and Barbara J. Spencer, 1985. “Export subsidies and international market share rivalry,” Journal of International Economics, Elsevier, vol. 18(1-2), pages 83-100, February.

Dippel, Christian, Avner Greif, and Dan Trefler, 2015, “Trade Rents and Coercive Labor Market Institutions,” NBER Working Paper 20958,

Do Quy-Toan and Andrei A. Levchenko, 2006, “Trade, Inequality, and the Political Economy of Institutions,” IMF Working Paper 06/56, February.

Do Quy-Toan and Andrei A. Levchenko, 2009, “Trade, Inequality, and the Political Economy of Institutions,” Journal of Economic Theory, 144:4, 1489-1520, July.

Fiorini, Matteo and Mathilde Lebrand, 2015 “Foreign Lobbying, Barriers to FDI, and Investment Agreements,” mimeo, EUI.

Helpman, Elhanan, 1993. “Innovation, Imitation, and Intellectual Property Rights,” Econometrica, Econometric Society, vol. 61(6), pages 1247-80, November.

Preventing Currency Manipulation

Tue, 05/19/2015 - 20:31

By Simon Johnson

As Congress debates the trade promotion authority, TPA, the issue of currency manipulation remains firmly on the table.  The administration and Republican leadership insist that language discouraging currency manipulation should not be included in the TPA (and also not in the Trans-Pacific Partnership, TPP, a trade agreement currently under negotiation).  Many Democrats and Republicans continue to argue in favor of prohibiting currency manipulation.

On Tuesday, the Treasury Department and White House claimed that the amendment proposed by Senators Rob Portman (R., Ohio) and Deborah Stabenow (D., Michigan) would actually impede the ability of the Federal Reserve to conduct monetary policy.  This is absurd.  The Portman-Stabenow amendment clearly and precisely addresses protracted one-way intervention in foreign exchange markets, i.e., large-scale purchases of foreign assets by a central bank.  The Federal Reserve does not engage in such activities – nor will it engage in this kind of intervention in the foreseeable future.  US monetary policy involves buying and selling domestic assets.  The Fed does not buy foreign assets on any significant scale.  There is nothing in this amendment that would impede the workings of US monetary policy.  To suggest otherwise is to mischaracterize the nature of this amendment.

There are instead three main issues of substance worth further consideration.

First, can we measure currency manipulation?  The answer here is clear: yes.  It is true that there is often disagreement about the extent to which a particular currency is undervalued or overvalued (a point made by Ian Talley in the Wall Street Journal).  But the most important episodes of prolonged competitive undervaluation are the ones that do the most damage – and in these instances, for example with China in the early 2000s – there is no disagreement.

A country with a massively undervalued exchange rate will accumulate a lot of foreign exchange reserves while running a current account surplus – and its stock of foreign assets will become large relative to its own economy (and relative to the world economy, if the country in question is big).  There was really no ambiguity about what China was doing.  Unfortunately, however, there were political problems that prevented the International Monetary Fund and the US Treasury from being sufficiently clear on the nature and extent of this manipulation.  (I was the chief economist at the IMF from early 2007 through August 2008.)

Second, do countries currently manipulate their exchange rates on a massive scale?  For the most part, the extent of manipulation is at a relative low (as Robert Samuelson argues in the Washington Post).  But this does not mean that we should forget about this issue – the incentive to manipulate (keep an exchange rate undervalued in order to boost a country’s exports) will likely return in the future, for example when a country experiences a slowdown in growth.  In fact, the Treasury Department is raising concerns along these lines with regard to South Korea’s current behavior.

And the fact that manipulation is relatively less important in country strategies at this moment – for example, in China and Japan – means that this is a good moment in which to negotiate the issue.  This is not about confrontation with current policies; it is about preventing future action that can be damaging to the US economy.

When currency manipulation again becomes significant – and when it does great damage to parts of US manufacturing and to our service sector – it will be too late to attempt a negotiated response.  Now is likely the best time to shift official thinking on what can be regarded as reasonable trade practices for the coming decades.

Third, if the US insists on addressing currency manipulation in the TPP, would this derail the agreement?  No, it would not – precisely because the US would be taking up this issue in a constructive negotiated framework.

Look carefully at the countries involved in TPP – Australia, Brunei Darussalam, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, and Vietnam.  All of them have a great deal to fear from other countries manipulating exchange rates so as to gain an unfair competitive advantage.  If we can shift the rules so as to strongly discourage currency manipulation, this will help all our trading partners.

The most effective – and completely fair – way forward is to have countries voluntarily agree not to manipulate their currencies.  Everyone understands that there is some leeway provided by how any such negotiated guidelines would operate (and how currency undervaluation is measured).

The point is to get our major trading partners to agree not to undervalue their currencies on a massive scale.   When it next happens on that scale, there will be no ambiguity.  But it will also be too late to do anything about it in a negotiated framework.

President Obama is right that the TPP is about writing the rules for the next century of international trade.  We should want to get these rules right.

Over at Medium: The Importance of Taxing Capital

Tue, 05/19/2015 - 06:43

By James Kwak

“At present, when zero interest rates make capital costs as low as they have ever been but corporate profits are at record levels, there needs to be much less concern with capital costs and more concern with the distributional aspects of capital taxation.”

That’s Larry Summers — with whom I have often disagreed in the past — at a Brookings event on the tradeoff between equality and efficiency. For most of our lives, government policy in the United States and most of the developed world has been focused (at least in theory) on efficiency: colloquially speaking, making the pie bigger rather than worrying about how the pie is divided up. Rising tide, boats, you know the rest: Laffer Curve, unleashing the job creators, and so on. Inequality is something we profess to regret while doing nothing about it.

Read more at Medium.