Peterson Institute for International Economics Update Newsletter
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PIIE Update Newsletter
May 24, 2012

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  Congressional Testimony
Assessing the Strategic and Economic Dialogue

C. Fred Bergsten
  C. Fred Bergsten The Strategic and Economic Dialogue (S&ED) between the United States and China is the most extensive institutionalization of the informal G-2 that Bergsten has proposed since 2004. He congratulates the US administration for the serious attention and priority it has attached to the Dialogue and emphasizes that the S&ED is a crucial component of US (foreign and national security as well as economic) policy and must be continued and indeed strengthened.

The currency issue has been the dominant concern of the S&ED over its four-year history, and the exercise has played a very useful role, and added an important pressure point, in persuading the Chinese authorities to gradually reduce their beggar-thy-neighbor policy. China of course had to come to believe that such a change was in its national interest but the S&ED, and related US-China discussions, have been extremely important in at least two respects: convincing the Chinese of the (very powerful) case that a stronger exchange rate was in their own economic interest and emphasizing constantly that China's (exceedingly important) relationship with the United States would be significantly affected by their behavior on this issue. Largely as a result, the Chinese exchange rate has strengthened substantially, and their current account surplus has dropped from the record high of 10 percent of their GDP in 2007 to less than 3 percent today. The S&ED has thus helped achieve major progress on a central goal of the exercise.

The S&ED can also be immensely useful in addressing the euro crisis and, specifically, the creation of additional lending capacity at the International Monetary Fund (IMF) to help affected countries. China, as the world's largest holder of foreign exchange reserves and a major surplus country, should be a large (probably the largest) contributor to such enhanced lending capability at the IMF. The S&ED has covered an impressive array of bilateral, including trade, issues, notably export finance, on which China has agreed to negotiate new international rules by 2014. But as the US-China economic relationship deepens, the list of bilateral economic problems continues to grow. To successfully resolve these issues, which are currently addressed in an ad hoc manner, Bergsten proposes that the two countries consider launching negotiations for a bilateral trade agreement. Another alternative would be to look for an early occasion to bring China into the Trans-Pacific Partnership. The S&ED can productively begin these conversations. Building on its considerable progress to date, the S&ED has a rich potential agenda for the years ahead.

>> Read full testimony [pdf]

  Policy Brief 12-14
Estimates of Fundamental Equilibrium Exchange Rates, May 2012

William R. Cline and John Williamson
  Cline and Williamson calculate a new set of fundamental equilibrium exchange rates (FEERs) based on the new round of International Monetary Fund (IMF) projections in the spring 2012 World Economic Outlook. These show that on a trade-weighted basis the US dollar is now overvalued by 3-4 percent, while the Chinese renminbi is undervalued 3-4 percent. Both misalignments are much lower than in previous years (6 percent overvaluation and 16 percent undervaluation respectively a year ago). Because of the large roles of China and the United States in global imbalances, the GDP-weighted absolute value of divergence from FEERs has fallen from 8.4 percent in 2009 to 2.6 percentage points in April 2012. In contrast, large imbalances and misalignments have persisted in a number of smaller economies, including Australia, New Zealand, South Africa, and Turkey on the deficit side and Hong Kong, Malaysia, Singapore, Sweden, Switzerland, and Taiwan on the surplus side.

While the world has probably made genuine progress in groping its way to more realistic exchange rate relationships, in particular through the 30 percent odd real revaluation of the renminbi since 2005 (40 percent real bilaterally against the dollar), the measurement of this progress is also influenced by the fact that in 2012 the IMF has revised downward its estimate of the size of the Chinese surplus in the out-years. But China remains a country with fast productivity growth in its tradable-goods sector, and accordingly there will be a continuing need for China to maintain appreciation in the future. Moreover, it is conceivable that the IMF has overadjusted for its past overestimates of China's prospective surpluses and that the needed exchange rate changes are in fact larger than the current Cline-Williamson estimates. Apart from the imbalance centered on the United States and China, there is a second major problem with real exchange rates today: the overvaluation of the European periphery in terms of German costs. Despite the unavailability of depreciation as a corrective mechanism within the single currency, substantial reductions in current account deficits have been achieved since 2010 in Italy, Spain, and especially Portugal, but in Greece the deficit remains large.

>> Read full policy brief [pdf]

  Policy Brief 12-13
Right Idea, Wrong Direction: Obama's Corporate Tax Reform Proposals

Gary Clyde Hufbauer and Martin Vieiro
  The need for US corporate tax reform is blindingly obvious. Conservatives contend that the top corporate tax rate—whether measured in statutory or effective terms—is the second highest in the Organization for Economic Cooperation and Development (OECD). Liberals argue that the US corporate tax system is riddled with complex "loopholes," enabling many firms—whether or not incorporated—to pay less than their fair share.

Responding to these criticisms, Obama's White House and Treasury Department released a joint report entitled "The President's Framework for Business Tax Reform." Unfortunately, the report omits the detail needed to fully assess its proposals. But if the devil ever lives in the details, it is in the details of the tax code. Instead of details, the Framework report focuses on five elements of reform: the nominal and effective corporate tax rate, incentives for domestic manufacturing, taxation of international income, the tax code for small business, and the fiscal impact of proposed reforms. The report greatly exaggerates the revenue loss entailed by cutting the statutory corporate tax rate, and it proposes damaging new taxes on international business that would undermine US exports. Overall, the report unduly concentrates on manufacturing activity, while neglecting America's strength in services, the most prominent future driver of jobs, investment, and growth. Projected revenue gains are not large enough to help curb the rising debt-to-GDP ratio, but the report ducks any discussion of a national consumption tax.

>> Read full policy brief [pdf]

  Congressional Testimony
Increasing Market Access for US Financial Firms in China

Nicholas R. Lardy
  Nicholas R. Lardy The US-China Strategic and Economic Dialogue (S&ED) and its predecessor, the US-China Strategic Economic Dialogue, have made some progress in addressing economic issues in the bilateral relationship. China has partially liberalized foreign access to its domestic financial services industry, including banking, insurance, securities, and asset management, since its accession to the World Trade Organization (WTO) in 2001. In assessing the pace of this progress it is important to recognize limits that constrain the ability of negotiators from both the United States and China to make reciprocal concessions. Critics of the dialogue, who argue that it has failed to sufficiently open China's market in financial services for example, fail to take into account three important factors. First, there are severe limits on the ability of negotiators on both sides to make reciprocal concessions. In the United States these stem importantly from US law; in China they arise because of domestic politics. Second, a principal reason that China's financial market is not more open is that the US Department of the Treasury did not push for more opening in the 1990s. China by and large has complied with the limited opening that was agreed in that negotiation. Third, the frequently voiced argument of US officials, that further financial sector opening in China would improve the allocation of capital and help sustain long-term economic growth, is far less compelling today than it was prior to the onset of the global financial crisis.

>> Read full testimony [pdf]

  Congressional Testimony
How the Taxation of Labor and Transfer Payments Affect Growth and Employment

Simon Johnson
  Simon Johnson The United States faces a serious medium-term budget deficit problem—realistic forecasts show a rising trajectory for US government debt over the next two decades. The primary drivers of the large increase in public debt over the past decade were the George W. Bush–era tax cuts, wars in Iraq and Afghanistan, Medicare Part D, and the financial crisis that began in the fall of 2008. This is the sixth surge in national debt in US history; the previous five surges were all caused by war. The current nature of the US financial sector generates system risk that has negative macroeconomic implications in the United States, including for its public finances. Looking forward, as society ages the United States faces increasing pressures on social security, Medicare, and other forms of basic social insurance. Healthcare spending—not just the government paid part of health care—needs to be brought under control. In this context and over the coming decades, the United States needs to make a longer-term fiscal adjustment. Part of that should include additional tax revenues, phased in over the next two decades. Raising taxes is never easy or pleasant, but not extending the Bush-era tax cuts is the best way to strengthen revenue and sustainably fund the federal government.

>> Read full testimony [pdf]

Greece's Exit May Become the Euro's Envy

Arvind Subramanian
  Arvind Subramanian Default would be disastrous for Greece and the resulting contagion would be damaging for Europe—so goes the conventional wisdom. The only debate has been about the strength of contagion and the appropriate response of vulnerable countries. Might the debate be misguided because the premise is flawed? Expelled from the euro area, Greece might prove more dangerous to the system than it ever was inside it—by providing a model of successful recovery. There is an overlooked scenario in which default is not a disaster for Greece. If this is the case, the real, more existential threat to the euro area might be a very different one, in which the Greeks have the last laugh. The immediate consequences of Greece leaving or being forced out of the euro area would certainly be devastating. Capital flight would intensify, fuelling depreciation and inflation. All existing contracts would need to be redenominated and renegotiated, creating financial chaos. But this process would also produce a substantially depreciated exchange rate, and that would set in motion a process of adjustment that would soon reorient the economy and put it on a path of sustainable growth. In fact, Greek growth would probably surge, possibly for a prolonged period, if it adopted sensible policies to rapidly restore and sustain macroeconomic stability.

>> Read full op-ed

  Policy Brief 12-12
Japan Post: Anti-Reform Law Clouds Japan's Entry to the Trans-Pacific Partnership

Gary Clyde Hufbauer and Julia Muir
  In 2005, Prime Minister Junichiro Koizumi pushed his landmark bill through the Japanese Diet, aimed at reforming Japan Post, the giant state-owned enterprise that provides postal services and houses two huge financial arms, Japan Post Bank and Japan Post Insurance. The bill envisaged substantial privatization by 2017. Subsequent Japanese governments have toyed with the idea of reversing the Koizumi law, but in January 2012, it still seemed possible that Diet members would preserve essential features of the Koizumi reforms. As it turned out, the opposition Liberal Democratic Party (LDP)—putting current political advantage ahead of its past pro-reform stand—joined anti-reform forces in the ruling Democratic Party of Japan and the New Komeito Party. This alliance submitted the Bill to Partially Revise the Postal Privatization Law through the Diet on March 30, 2012. The anti-reform bill was passed by the Upper House on April 27, 2012, with only one absenting vote from the LDP, and became law. The revised law turns back the clock on the Koizumi reforms and will cloud Japan's potential participation in the Trans-Pacific Partnership (TPP) talks.

>> Read full policy brief [pdf]

  Working Paper 12-8
Networks, Trust, and Trade: The Microeconomics of China–North Korea Integration

Stephan Haggard and Marcus Noland
  A central hope of engagement with North Korea is that increased cross-border exchange will encourage the strengthening of institutions, and eventually, a moderation of the country's foreign policy. An unprecedented survey of Chinese enterprises operating in North Korea reveals that trade is largely dominated by state entities on the North Korean side, although the authors cannot rule out de facto privatization of exchange. Little trust is evident beyond the relationships among Chinese and North Korean state-owned enterprises. Formal networks and dispute settlement mechanisms are weak and do not appear to have consequences for relational contracting. Rather, firms rely on personal ties for identifying counterparties and resolving disputes. The weakness of formal institutions implies that the growth in exchange does not conform with the expectations of the engagement model and may prove self-limiting. The results also cast doubt that integration between China and North Korea, at least as it is currently proceeding, will foster reform and opening.

>> Read full working paper [pdf]

Peterson Perspectives Interviews

audio  Are World Currencies Becoming More Aligned?
John Williamson says the world is groping toward more realistically aligned currency values, but the US-China and Northern vs. Southern Europe current account imbalances remain worrisome.

audio  Stimulus vs. Austerity in Europe
Anders Åslund says it is more important for ailing European countries to cut their budgets, reduce their debts, and win market confidence than to embark on economic stimulus right now.

audio  Russia's New Cabinet Could Bring Economic Reform
Anders Åslund says President Putin will continue a hard line on foreign policy, but his team of technocrats is notable for the absence of KGB operatives and others with a reputation for corruption.

audio  Greece's Dilemma and Europe's Anxiety, Part III
Edwin M. Truman says that for all its hardline talk, Europe will have to renegotiate at least some parts of the austerity package for Greece even if Greek voters decide to stay in the euro area.

audio  Greece's Dilemma and Europe's Anxiety, Part II
Jacob Funk Kirkegaard and Arvind Subramanian debate whether a Greek exit from the euro area will be an incentive for Spain, Portugal, or other countries to stay—or to follow the Greeks.

audio  Greece's Dilemma and Europe's Anxiety, Part I
Jacob Funk Kirkegaard says an exit by Greece from the euro area will be disastrous, but Arvind Subramanian argues that in the medium term Greece will be better off.

Recent Blog Posts

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  North Korea as Ireland

Networks, Trust, and Trade

The Panel of Experts: Final Report?

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PIIE Noted in the News and on the Web

Osborne's Scope to Reshape Bank of England Widens on Posen Exit
"...Posen has done a phenomenal job.... He called the economy right and he stood his ground. You need to have brains and you need to be courageous. He's going to be difficult to replace." —Richard Barwell, economist at the Royal Bank of Scotland Group Plc and former Bank of England official, on Adam Posen's departure August 31, 2012, from the Bank of England.

Financial Times
Posen to Step Down from Bank of England
The Financial Times reports that Sir Mervyn King called Adam S. Posen's contribution to the Bank of England's Monetary Policy "outstanding" following the announcement that Posen will accept his appointment as president of the Peterson Institute for International Economics. The Financial Times calls the Peterson Institute "a leading US think-tank with a rare international perspective."

Wall Street Journal | Real Time Economics Blog
Q&A: Lessons on Central Banking From Bank of England's Posen
Adam S. Posen shares insights gained through his experience as external member of the Bank of England's Monetary Policy Committee with the Wall Street Journal's Sudeep Reddy.

Wall Street Journal | Real Time Economics Blog
Posen: Undercapitalized Banks, Not Greece, Cause of Europe Crisis
"The sources of our current problem in the euro area are the various financial exposures that we all have in the interbank market that have not yet been resolved because...institutions remain insufficiently capitalized and insufficiently disciplined."

PBS NewsHour
How Europe's Turmoil Rattles World Markets
C. Fred Bergsten sits down with the NewsHour's Ray Suarez and former US Ambassador to Greece Nicholas Burns to discuss Greece's political turmoil and how this instability is affecting economies worldwide.

NPR | Morning Edition
US Politicians See Opposite Messages in Euro Crisis
C. Fred Bergsten says that the United States has more time than Greece to figure out its deficit problems because the United States can still finance its budget deficits easily at low interest rates.

Council on Foreign Relations
The G8 and Eurozone Clouds
C. Randall Henning explains to's Christopher Alessi that the G-8 summit is an opportunity for the members to prepare for the upcoming NATO and G-20 meetings, but the euro area crisis is likely to dominate the discussions.

Voice of America
Europe's Economic Woes Shadow G8 Summit
Simon Johnson tells Voice of America's Kent Klein "Hopefully, the Americans and the others will be pressing the Europeans to rethink the structure of the euro zone and to come up with something that is much more sustainable, for example, a more unified fiscal entity."

'Dire Consequences' If Greece Exits Euro
Simon Johnson tells NPR's John Ydstie that the bank run in Greece paired with Greece's inability to form a government could force a disorderly exit from the euro before the next elections in June. Nicolas Véron then explains why he is more optimistic that a Greek exit from the euro area can be prevented.

Bill Moyers
Are JPMorgan's Losses a Canary in a Coal Mine?
Simon Johnson and Bill Moyers discuss Jamie Dimon and how JPMorgan Chase lost $2 billion "all because of the complex, now-you-see-it-now-you-don't trading in exotic financial instruments that he has so ardently lobbied Congress not to regulate."

Wall Street Journal
Beijing's Growth Tools Are Limited
The Wall Street Journal explains that measures utilized by China's leaders in the past to stimulate the economy are no longer as effective as they once were. Nicholas R. Lardy argues that interest rates for depositors should be increased to help encourage domestic consumer spending. As household savings increase over time, consumers will become more willing to spend money.

CNBC Squawk Box
China Can Prevent a Hard Landing
Arvind Subramanian says that there is a low probability of a hard landing in China, and that Beijing has the means to prevent such a scenario. Subramanian is author of Eclipse: Living in the Shadow of China's Economic Dominance.

Preview of Our Next Issue

What Is India's Real Growth Potential?
Arvind Subramanian

In This Issue


Jean-Claude Trichet Lessons from the Crisis: Challenges for the Advanced Economies and for the European Monetary Union

Jean-Claude Trichet delivers the eleventh Stavros Niarchos Foundation Lecture.
Taeho Bark The KORUS FTA, Korea's FTA Policy, and the Dynamics of East Asian Economic Integration

Korean Trade Minister Taeho Bark discusses Korea's free trade agreement policy.

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