Thursday, October 28, 2010

Tax Reform as a Path to Growth-Friendly Fiscal Consolidation



















Sunday, October 24, 2010

China's Fragile Rare Earth Monopoly

On September 7, a Chinese fishing boat collided with a Japanese Coast Guard vessel near a group of disputed islands in the East China Sea. The collision sparked a chain of events that led to an apparent cutoff of China's shipments to Japan of rare earth elements (REEs), vital ingredients in many high-tech products. Suddenly the world became aware that China, home to some 95% of global REE production, held an alarming strategic monopoly.

The episode raises several economic questions. What factors allowed China to become the world's leading producer of REEs? Does China's current 95% market share represent a true natural monopoly? What factors could undermine China's current REE dominance? Application of a few basic economic concepts can go a long way toward providing answers.

We can begin by revealing what everyone already seems to know: Rare earths are not really rare. All 17 rare earth elements are more abundant in the earth's crust than gold, and some of them are as abundant as lead. The thing that makes them hard to mine is the fact that they are not found in highly concentrated deposits like gold and lead are. Even the best REE ores have very low concentrations. On the other hand, such ores are found widely throughout the world. Until the 1960s, India, Brazil, and South Africa were the leading producers. From the 1960s to the 1990s, the Mountain Pass Mine in California was the biggest source. China's dominance of REE production dates only from the late 1990s.

So, what explains China's big market share? Good ore deposits, but not uniquely good, are one factor. Second, low labor costs help China's REE mines just as they help its toy factories. A third consideration may have been most important of all. Mining of REEs can produce very nasty waste products. Up until recently, Chinese authorities were willing to turn a blind eye to environmental devastation caused by primitive, often illegal, but low-cost small-scale mines. Meanwhile, environmental problems were a major factor leading to the shutdown of the Mountain Pass Mine. Following a big spill of radioactive waste, US authorities demanded new environmental safeguards. Already facing low-cost Chinese competition, the mine closed rather than undertake the needed investments.

The abundance of REE ores suggests that China's 95% market share does not represent a true natural monopoly, that is, one based on ownership of unique resources. However, that does not mean it lacks short-run monopoly power. In the short run, supply of REEs is much less elastic than in the long run. Any short run increase in supply can only come from mines that are already open or, to a very limited extent, from "urban mining"--recycling of REEs from scrapped computers and the like.

Short-run demand is also inelastic. High-tech production lines are set up to produce hybrid cars and computer hard drives using well-tested but REE-dependent technologies. You can't just substitute nickel for the neodymium in a magnet and expect the product still to do its job.

Given highly inelastic short-term supply and demand, it is not surprising that China's cutback in supplies this year sent market prices soaring. Bloomberg reports that prices of Neodymium jumped from $41 per kilogram in April to $92 in October, and Cerium oxide from $4.70 to $36 per kilo over the same period.

In the long run, all evidence points to much greater elasticity of both supply and demand. The press is full of news about old mines reopening or new ones under development. California's Mountain Pass Mine is expected to come back on line in 2011. Canadian companies are moving rapidly forward with projects in Wyoming and Tanzania, among other places. Australia, a supplier of nearly every other mineral, may also become a player.

On the demand side, it is not quite true to say that REEs are irreplaceable ingredients of today's high-tech products. At least in many cases, current REE-dependent technologies were chosen not because they are the only way to do something, but because they are a good way to do it given reasonable prices and reliable availability of the raw materials. Finding alternative technologies can take time, but the clock is now ticking. Japanese researchers are reporting success with REE-free technologies for electric car motors. Several new technologies are competing to replace conventional hard drives for computers, until now another big REE user. The Korean government is encouraging research into REE substitutes, as well.

The bottom line: China has a big market share, but no natural monopoly. Any efforts it makes to exploit its advantage based on low short-run elasticities only accelerates the development of alternative sources and new technologies.

Instead of trying to keep prices at the current high levels, once the ripples from the fishing-boat episode die down, China is likely to practice "limit pricing." Limit pricing is a classic monopoly tactic that involves holding prices high enough to give moderate but steady profits, while still low enough to discourage the growth of competition. At the same time, expect China's own rapidly expanding high-tech industries to absorb more of its REE output. In fact, encouraging them to do so seems to be an element of Chinese policy. Preferential access to low-cost REE supplies could give those industries a competitive advantage on world markets over a longer time horizon than that over which China could hope to maintain its near monopoly as a supplier of raw REEs.

Meanwhile, China's competitors in Asia, North America, and Europe should get serious with incentives to develop alternative sources and REE-free technologies. Targeting research funds would be helpful. Military research dollars should be included, since REEs have key applications in helicopter blades, laser gun sites, radars, and other military hardware.

The issue of environmental harm from REE mining also needs to be addressed. Relaxing environmental regulations in the United States and other new source countries is not the way to go. We do not want the Mountain Pass Mine to go back to spilling radioactive waste water in the California desert. China is showing signs of cleaning up its own worst REE polluters, and if it follows through, this may become a non-issue. If it does not, one option for consideration would be countervailing environmental tariffs, to the extent these are allowed by WTO rules.

With or without major government action, however, market forces appear unfavorable to China's continued dominance of REE production. After the East China Sea incident, concerns over reliability of supply, as much as concerns over price, are triggering research and investment to an extent that suggests that the long run--as in "long-run elasticity"--is fast approaching.

Follow this link to download a slide show with charts and additional analysis related to China's fragile rare earth monopoly.

Friday, October 22, 2010

What Is QE2 Trying to Do? Is the Fed Rebasing its Inflation Target or Not?

What exactly is the Fed trying to do with QE2? Assuming that our central bankers don't surprise everyone and forgo quantitative easing after all, they seem to be following some kind of inflation targeting strategy, but what kind?

The cautious variant of inflation targeting would be one of "rebasing." In the figure below (not drawn to scale) the Fed has been trying to keep the price level close to the inflation path marked 2%, but has slipped below it to nearly flat inflation, leaving us at point A. From there, the cautious variant of inflation targeting would be to rebase by setting a new target path with the same 2% slope, but lying entirely below the previous one. To implement this variant, the Fed would calibrate QE2 to try to bring the price level up to, but not above, the new path leading toward point B. If market participants believe the Fed will try this, and will succeed, they will set their inflation expectations at about 2% going forward.

The more aggressive strategy would be not to rebase. Instead, QE2 would aim to bring inflation up to the original 2% target path, which would mean following the arrow toward Point C. Doing so would provide a much stronger stimulus, and would, ideally, lead to faster recovery of the economy while still being consistent with the Fed's mandate.

There is a lot to be said for the more aggressive strategy, the one without rebasing. However, it would be tricky to pull off. One obvious issue is whether there is really a reliable transmission mechanism running from an increase in the monetary base via massive bond purchases to an increase in aggregate demand. I have rarely seen a more divided economics profession than we have regarding this question. The only honest answer is that we won't know if the transmission mechanism will work until QE is actually tried.

Assuming the transmission mechanism does work, the second issue will be managing inflation expectations. The path back to point C, without rebasing, implies an interim period during which the rate of inflation is purposely allowed to exceed the long-term 2% target. Without that, the economy can't get back on its former target path. But if market participants do not have confidence, even a short period of higher inflation could quickly spread fear that the Fed has lost control of the price level altogether. There are a lot of people out there who look at today's bloated monetary base and get very nervous about an inflation breakout. With all that dry tinder lying around in the form of excess reserves in the banking system, such a scenario is far from impossible.

The Fed's delicate task, then, has to be to steer inflation expectations within a narrow corridor. To push the floor of the inflation expectations corridor up to the 2% mark, it has to carry out a convincingly aggressive program of bond purchases. At the same time, in order to put a ceiling on the corridor, it has to convince everyone that it has a workable exit strategy in case things start to get out of hand. The recent trial run of the reverse repo tactic for withdrawing reserves from the banking system should be read in this context. 

We could have greater confidence in the Fed's exit toolkit if it had the power to sell its own central bank bills, like the People's Bank of China does. Congress is not about to grant that power, but in theory, the Treasury and the Fed working together could do the same thing. The tactic would be for the Treasury to sell newly issued bonds or bills, soaking up excess reserves of the banking system, and then sequester the funds in deposits at the Fed, with the promise that these would be left untouched until the operation had its desired effect.

Get ready to watch exactly how the Fed frames its expected QE2 gambit, both in its official statements and in speeches of board members. Will it cautiously try to rebase its inflation target, or will it act more boldly? We should find out fairly soon.

For a more detailed discussion of the mechanics of quantitative easing, see this earlier post and its accompanying slide show.

Monday, October 18, 2010

Tutorial on Central Bank Operations with Answers to FAQs About Monetary Policy and Exchange Rates

I have been doing some blogging lately on the topics of quantitative easing and exchange rate manipulation. Looking around, especially at comments,  I can see that many bloggers, myself included, are wrongly assuming that their readers understand the basic mechanics of central bank operations. In the hope of making a small contribution to economic literacy, I have prepared a short tutorial explaining what happens when the Fed, the People's Bank of China,  or any other central bank carries out certain monetary policy operations:
  • Purchases and sales of securities, including the large-scale programs called quantitative easing
  • Intervention in foreign exchange markets
  • Sterilization of exchange rate intervention
In addition to explaining basic terms and concepts, the tutorial attempts to answer certain frequently asked questions. Here are four of those questions with answers in brief. These are real questions taken from recent comments on several blogs, edited only to combine a greater number of original questions into these four generic FAQs. The full tutorial slide show gives more complete answers, illustrated with balance sheets and T-accounts.

FAQ No. 1: What is "quantitative easing" (QE) and how does it affect the money supply?

Answer: "Quantitative easing" means large-scale purchases of securities, incuding long-term securities, by a central bank. QE is an extension of the normal day-to-day buying and selling of short-term securities, which are called open market operations.

When the Fed or another central bank buys Treasury securities, whether as part of a program of QE or otherwise, it does not buy them directly from the Treasury, but rather, from some dealer or other party in the private sector. It pays the seller by means of a bank transfer. The result of the transfer is to increase not only the seller's bank deposit, but also the reserves of the banks where the sellers hold their accounts. Those bank reserves count as part of the economy's "monetary base," which can be thought of as the raw material from which money is created.

When banks later use this raw material (their new reserves) as a basis for making new loans, total bank deposits held by the public expand further. Looking at the procedure from start to finish, then, any purchases of securities by the Fed tends to expand the money supply.

Notice the words "tends to expand." Sometimes market conditions are such that banks are reluctant to make loans. Then the new reserves that the Fed injects into the banking system just pile up on banks' balance sheets, and the effect on the money supply is much weaker. That is what seems to have been happening since the start of the financial crisis. For that reason, among others, some people doubt that QE is a very effective way of stimulating the economy.

FAQ No 2: When the Fed buys Treasury bonds, does it lift the burden of interest costs from the shoulders of taxpayers? Does that mean there is, after all, such a thing as a free lunch?

When the Fed buys Treasury securities, the Treasury keeps right on making interest payments. The interest now becomes a source of income for the Fed. In contrast to an ordinary commercial bank, however, the Fed is not allowed to make a profit when its interest income goes up. Instead, after deducting its operating costs, it turns any surplus back to the Treasury. In that sense it is true that there is no interest burden on the taxpayer, and the government is getting a sort of free lunch, at least in the short term.  However, there are two important qualifications to the free lunch concept.

First, since October 2008, the Fed has had the power to pay interest on bank reserves, and does so. Because purchases of Treasury securities add to bank reserves, they also add to the Fed's interest costs. As a result, part of the interest that the Treasury pays to the Fed leaks out into the banking system before it gets recycled back to the Treasury. True, the interest rate the Fed pays on bank reserves is less than the rate on long-term Treasury bonds, so there is still a net saving to taxpayers. In this sense, we might say that taxpayers are getting their lunch at a discount, even if it is not free.

Second, there are limits to how big a portfolio of Treasury bonds the Fed can accumulate. Right now, because of the financial crisis, the limit is larger than usual, so the Fed can hold a lot of bonds, but that situation cannot be expected to last forever. Sooner or later, the economy will recover and banks will become more aggressive about making loans. At that point the Fed will have to sell off a large part of its holdings of bonds in order to keep the money supply from growing too fast and causing unwanted inflation. When that happens, the free lunch is over and the interest burden shifts back to the taxpayer.

FAQ No 3: Why do the Chinese central bank's efforts to manipulate the value of the yuan cause inflationary pressures in China?

China's huge trade surpluses create a constant flow of dollars into China. The big supply  tends to push down the value of the dollar and, correspondingly, causes yuan to rise in value (appreciate). If the Peoples Bank of China (PBoC) wants to keep that from happening, it jumps into the foreign exchange market itself. To mop up some of the excess supply of dollars, it buys dollars from the various private forex dealers that are acting on behalf of the ultimate suppliers--companies that import Chinese goods to the US.  The dollars the PBoC buys are used to acquire U.S. Treasury securities, adding to China's ever-growing foreign currency reserves.

When the PBoC buys dollars from private dealers, it pays in yuan. Those yuan end up in the bank accounts of the dealers, and eventually in the accounts of Chinese companies that are exporting goods to the US. The end result is an increase in the Chinese money supply. If the PBoC intervenes too often and too aggressively in the foreign exchange market, the Chinese money supply starts to grow faster than the country's expanding economy can safely absorb. Ultimately, the excess supply of yuan pushes up China's rate of inflation.

FAQ No. 4: If currency manipulation by the PBoC causes inflation, why hasn't China's inflation rate been a lot faster?

The PBoC has another policy instrument in its toolkit that we haven't mentioned yet. If its foreign exchange intervention threatens to cause inflation, it can mop up at least some of the excess yuan by selling its own securities, which are called PBoC bills. The PBoC bills, which do not count as part of the monetary base or money supply, replace bank reserves, which do count. This operation--the swap of PBoC bills for yuan-denominated bank reserves--is called "sterilization."

Sterilization looks like a kind of free lunch for the PBoC--it lets it resist unwanted appreciation of the yuan without paying the inflationary price of doing so. But like all apparent free lunches, this one is not quite as good a deal as it looks at first. After a while, the market becomes saturated with PBoC bills. The bank has to offer higher and higher interest rates to sell them. That would not only create a potentially enormous interest expense, it would push up interest rates throughout the Chinese financial system, slowing investment and growth. Because the PBoC exercises great administrative authority over Chinese banks, it can pressure them to absorb a lot of bills at low interest rates, but that tactic has its limits, too. Eventually the unwanted PBoC bills start to clog up the banking system and prevent it from operating efficiently. 

Although no one outside China really understands the internal politics behind the government's exchange rate manipulation, there are hints that the PBoC would just as soon allow a little more appreciation of the yuan in order to ease inflationary pressures. Presumably there are interests on the other side, including China's huge export industry, that use their political influence to resist appreciation. Outsiders can only guess how this will all play out.

Follow this link to download the complete tutorial in the form of a classroom-ready slide show.

Friday, October 15, 2010

How Successful Is China's Currency Manipulation?

The US Treasury has been reluctant to name China as a currency manipulator. It fears that official use of these words would be seen as the start of a trade war. In the plain-English sense, however, China certainly does manipulate its currency, doing so by frequent intervention in foreign exchange markets. Heated rhetoric aside, the real question is, how successful has the manipulation been in maintaining the competitiveness of Chinese exports?

To answer that question, we need to look not just at nominal exchange rates, but at real rates. In nominal terms, the yuan has strengthened about 2.5% since China's June 19 decision to ease its currency policy. That works out to an annualized rate of nominal appreciation of almost 8%. The simplest way to calculate real appreciation is to add on the difference between China's inflation rate (3.5%, according to August data) and US inflation (about 1%, or even less if the dip in the September figures holds up). Doing so gives us an annual rate of real appreciation of more than 10%. Two or three years of that would pretty well eliminate the 20 to 40% undervaluation that critics are talking about. True, three years is longer than the time horizon of your average politician, but it's not exactly a glacial pace of change, either.

But wait, you might say, we can't be sure that China will continue to allow an 8% rate of nominal appreciation. The latest hints from inside the PBoC suggest that 3% nominal appreciation could well be the maximum. Wouldn't that mean it would take a lot longer to correct the existing undervaluation?

No, not necessarily. In order to slow the rate of nominal appreciation, the PBoC would have to step up its currency intervention. Chinese inflation is already accelerating month after month. Slowing nominal appreciation from its recent 8% pace would increase inflationary pressure even more, both by keeping import prices from falling, and via the newly minted yuan that intervention pumps into China's domestic money supply. With inflation accelerating further, the rate of real appreciation might not slow by much, if at all.

The bottom line: Yes, China is a currency manipulator, but not a completely successful one. Condemning as trivial the 2.5% appreciation of the yuan since June sounds good in the halls of Congress, but that number far understates the rate at which the yuan is really losing its competitive edge against the dollar.

Flash footnote (published on Treasury web site shortly after the above post)

"WASHINGTON – Secretary of the Treasury Timothy Geithner recognized China's actions since early September to accelerate the pace of currency appreciation, while noting it is important to sustain this course.

Since June 19, 2010, when China announced it would renew the reform of its exchange rate and allow the exchange rate to move higher in response to market forces, the Chinese currency has appreciated by roughly 3 percent [sic] against the U.S. dollar. Since September 2, 2010, the pace of appreciation has accelerated to a rate of more than 1 percent per month. If sustained over time, this would help correct what the IMF has concluded is a significantly undervalued currency. "

Follow this link to download a free set of classroom-ready slides discussing China's currency policy and the real exchange rate. An earlier version of this post appeared on

Monday, October 11, 2010

Chocolate Lovers Keep Nervous Watch on Volatile Cocoa Prices








Wednesday, October 6, 2010

The Continuing Resolution: Fiscal Alchemy in Action?

Once again, on October 1, 2010, the federal government's fiscal year started without completion of the budget process. Instead, Congress passed a continuing resolution allowing most branches of government to keep on spending at the same rate as last year until early December. The budget process has been completed on time, without continuing resolutions, only three times in the past 35 years.

Continuing resolutions, with their short time horizons and failure even to attempt optimization of policy, are an example of what Eric Leeper has called "fiscal alchemy." (Monetary Science, Fiscal Alchemy, presented at the Kansas City Fed's 2010 Jackson Hole conference.) "Monetary policy choices," writes Leeper, "tend to be based on systematic analysis of alternative policy choices and their associated macroeconomic impacts: this is science. Fiscal policy choices, in contrast, spring from unsystematic speculation, grounded more in politics than economics: this is alchemy."

Leeper sees another sign of fiscal alchemy in the long-term debt projections issued by the Congressional Budget Office. These project debt within limits marked by a "baseline scenario" that assumes no changes in law, and an "alternative scenario" that shows an exploding debt that cannot possibly be achieved. The gap between these two projections, neither of which can rationally be expected to occur, is not only large--it is growing larger every year. (He would like to see the CBO issue more realistic, model-based projections that would narrow, although not eliminate, the range of uncertainty.)

Although no one claims monetary policy is perfect, there is a great contrast between fiscal policy by continuing resolution, with no attempt at all to provide a stable framework for expectations, and the carefully worded policy statements issued by the Fed, which explicitly recognize the importance of anchoring expectations about the future course of policy.

In a rare comment on fiscal policy, Fed Chairman Ben Bernanke has recently noted that countries that continually spend beyond their means suffer slower growth in living standards. The only real question, Bernanke says, is whether the needed adjustments to fiscal policy will take place through a careful and deliberative process that weighs priorities and gives time to adjust to new policies, or whether it will be the kind of rapid and painful response to crisis that we have recently witnessed in Greece and elsewhere.

Follow this link to download a free set of classroom-ready slides that discuss continuing resolutions and fiscal alchemy.