Macro and Markets

My colleagues Daniel Ahn and Michael Levi are out today with a new look at the case for an oil tax.  While an oil tax has little traction on the Hill, many economists favor it.  Arguments for the tax usually include its efficiency (demand is relatively insensitive to price in the near term and it can be broadly applied) and its ability to account for environmental externalities. Levi and Ahn take the analysis further in two ways.  First, they consider the effects of the tax as part of a comprehensive deficit reduction package.  Second, they focus on how the results might change when the economy is starting from a weak position, with significant economic slack. Their model provides support for the notion that an oil tax can be an effective part of grand bargain, by preventing even deeper and more painful cuts to spending and other tax hikes. They show that, in an environment of weak demand, an oil tax that softens the cuts to government spending can be particularly effective.  As CBO’s new outlook (out yesterday) reminds us, recent deficit reduction measures have done little to address our longer-term fiscal challenges.  Ultimately, very tough choices are needed.  Having an oil tax as part of the long-term package may beat the alternatives.

If you are interested in the frontier thinking of European debt restructuring, you need to read the latest from Buchheit, Gulati, and Tirado.  In it, they propose an amendment to the European Stability Mechanism (ESM) that would make future European restructurings easier by strictly limiting the rights of holdout creditors.  It’s designed with an eye to the smaller countries of Europe, which have significant debt issued under foreign law.  With the prospect of a restructuring in Cyprus on the horizon, and concerns about debt sustainability across the periphery, it’s a timely proposal.  While a treaty change seems far fetched, some European policymakers will find it appealing.  That doesn’t mean it’s good policy. I have earlier written on the revival of support for a Sovereign Debt Restructuring Mechanism (SDRM) and this proposal would create a SDRM-like mechanism, within Europe, for European sovereign debtors.  In the Buchheit et.al. plan, if a country was adhering to an ESM-supported program,  their assets would not be subject to attachment in the ESM-member country. Thus it creates a safe harbor in Europe from holdout creditors seeking to enforce judgments obtained abroad.  The idea is modeled after the 2003 restructuring of Iraq’s debt, where a UN resolution protected Iraq’s oil assets against attachment in UN-member states. The appeal from a policy perspective is obvious:  it ensures that when a country is receiving extraordinary support from its European partners and restructures its debt,  that money isn’t going to holdouts.  By making restructurings easier, it gives policymakers confidence that the necessary financial objectives set out by the Troika (the International Monetary Fund, European Central Bank and European Commission) will be achieved.  And while the official European position is that the Greece restructuring was a unique event, debt is unsustainable across the periphery and a full bailout by the core looks neither economically nor politically feasible.  Restructurings will be needed. A few cautions to keep in mind, though: The protections only exist while the country owes the ESM money.  In that sense, it’s a rule to protect creditor countries rather than the debtor.  Further, the protective shield created here covers transactions only within the euro area.  For a European bank with operations in New York, for example, it is unclear how their assets and operations would be protected from U.S. court judgments.  The upcoming U.S. Appeals Court ruling on claims against Argentina will go some way to answering that question. Part of the appeal of this plan comes from the ongoing mess in Argentina.  The analogy for Argentina, had the SDRM been created, would have been protection from creditor judgment as long as it owed money to the IMF.  Sadly for this analogy, Argentina repaid the IMF long ago, so they wouldn’t have been covered.  The broader question, though, is whether a country that abandons its adjustment effort and aggressively refuses to negotiate with its creditors should continue to receive protection. Creditors will understand the intent of the law–to make restructurings easier and more successful.  Further, as Greece showed, its tempting to squeeze private creditors for that last euro of financing when official creditors are deadlocked.  So the innovation will make debt more expensive, much as an emerging market country pays a premium to issue locally (the problem of “original sin”).  The cost much of the time will not be great–certainly we see that during periods of easy credit availability, domestic versus foreign-law spreads can be quite narrow–but will be high during periods of stress, when market access is most valuable. More generally, most of the major debtors of Europe have majority local-law debt, where such a rule is not needed to reschedule.  Where foreign-law debt is significant, market-based exchanges backed by moral suasion from governments should be able to limit holdouts.  In this sense, the problem for Europe is the unwillingness to approach debt sustainability in a comprehensive fashion, rather than threats from holdouts.

The Committee for a Responsible Federal Budget valiantly continues to make the case for “going big” in the fiscal negotiations. I fear their argument is falling on deaf ears:  the window for a fiscal bargain–grand, bland or otherwise–that deals with our long-term fiscal challenge is closing.  The upcoming sequester battle provides one last opportunity to make such a deal.  Yet both Republicans and Democrats say that they are prepared to allow the sequester to take effect on March 1, at least for a while, and they seem to mean it.  A deal that addresses longer term debt sustainability and at least partly restores the sequester cuts remains possible, though unlikely, as part of the continuing resolution (CR) to fund the government from March 28.  That’s the real deadline. Why is the window closing? A diminished sense of urgency.  Budget deals since the fall of 2010 have reduced the deficit by $2.35 billion, and by various estimates another $1.25 to $1.5 billion stabilizes the debt at around 80 percent of GDP through the middle of the decade.  Allowing the sequester to go into effect gets you most of the way there. Fundamental differences.  The January 1 fiscal cliff package widened the divide between the sides on what they want from the upcoming negotiations in terms of revenues and entitlement cuts.  Earlier failed efforts to reach a grand bargain also have left scar tissue of bad feelings and distrust that may make a deal harder to achieve. The low hanging fruit is gone.  Now the cuts on the table–e.g. Medicare–and proposals for new revenue face much more entrenched opposition.  For many, the sequester is the less painful option. Market discipline isn’t working.  Both in the summer of 2011 and again last fall, fears of a market meltdown were not realized.  While I’d argue that there were meaningful costs to these episodes in terms of confidence, spending and investment, fear of the market response looks unlikely to play an important role in the upcoming cliff debates. The Sequester In this context, it’s hard to see agreement prior to March 1 on any package of alternative measures that would turn off the sequester for this year.  The sequester that resulted from the failure of the “supercommittee” cuts budget authority by $85 billion in fiscal year 2013, constituting half of a percentage point of GDP.  In addition, a “mini-sequester” of around $7 billion resulting from spending above limits set in August 2011 also will take effect on March 27.  However, on a cash basis, the effect on government spending will be felt only slowly.  One reason is that a significant portion of spending–and in particular military spending–pays out over several years after budget authority is received.  Notice periods for furloughs of government employees, and uncertainty about the magnitude of the cuts needed, also mean that the direct reduction in government spending will be small in March before beginning to ramp up. With logic that only makes sense in DC, it may be easier to reverse the $85 billion in cuts for fiscal year 2013 (and replace them with other measures) after March 1, in the context of the CR that will fund the government from March 27.  This is a hard deadline, as failure to achieve a deal results in a government shutdown that is unlikely to be politically sustainble for more than a few days.  Restoring the cuts through raising the caps in the CR would seem a hard sell to House Republicans, unless replaced by credible cuts elsewhere.  If entitlements and revenue are off the table, it’s difficult to see where cuts to offset the sequester would come from.  Alternatively, replacing at least a portion of the sequester cuts with savings in the out years through revenue and entitlement reforms not only addresses our longer-term challenge, it would defuse the subsequent debt limit and fiscal year 2014 budget cliffs.  Seems worth a try.