Tuesday, February 19, 2008

China Currency Catch-22

U.S. economic policy toward China has concentrated on getting China to revalue its currency, the yuan, with the objective of reducing its large current account surplus with the United States. The underlying theory is that a stronger yuan will raise China’s export prices, thereby reducing U.S. demand, and the weaker dollar against the yuan will increase China’s demand for U.S. products.

China began to loosen the fixed exchange rate between the yuan and dollar in July 2005. Since then, the yuan has risen 13.5% against the dollar, from $1=CNY8.28 to $1=CNY7.16. The higher prices of Chinese imports have begun to stoke inflationary fears in the U.S.

To cope with the U.S. economic slowdown and the prospect of recession stemming from the subprime mortgage crisis, the Federal Reserve Board has sharply lowered the fed funds rate from 5.25% in August 2007 to 3.00% on January 30, 2008. Financial markets expect another half-percentage point decline in the next month or two. The most important constraint that limits the fed’s ability to lower rates, and perhaps compel it to raise rates, is inflation.

Despite the steady revaluation of the yuan, the U.S. current account deficit with China increased in January 2008. As the yuan continues to appreciate against the dollar, projected at 7-10% in 2008, higher Chinese export prices will generate more inflationary pressure in the U.S.

The policies of lowering interest rates to prevent a recession or major economic slowdown coupled with a stronger yuan to reduce the trade gap, but which results in imported inflation, are incompatible. In this catch-22 scenario, what’s a poor secretary of the treasury and chairman of the fed to do?

Monday, February 11, 2008

Whither the Republican Party?

John McCain’s imminent annunciation as the Republican Party’s presidential candidate has set off a vigorous debate within the party. His primary and caucus victories are attributed to support from independent voters, crossover Democrats, and moderate Republicans. A McCain victory in November that rests on these voters means, in the view of some outspoken conservatives, a return to dominance of the old-line, establishment, moderate, Rockefeller wing of the party. To conservatives, McCain is the third stage in the undoing of Ronald Reagan’s legacy. The first was George H. W. Bush’s "kinder, gentler America" and the second was George W. Bush’s "compassionate conservatism."

Some prominent conservatives have stated their preference for a McCain defeat in November, which would enable them to try to rebuild the party on its conservative foundations.

In this regard, Canadian history may be instructive. The Progressive Conservative Party of Canada (PCP) was a party with a center-right stance on economic issues and a centrist stance on social issues. In modern times, the PCP formed the government from 1957 to 1963, from 1979 to 1980, and from 1984 to 1993. In the twelve elections for the House of Commons held between 1957 and 1988, the PCP never won fewer than 72 seats and on two occasions won more than 200 (308 members serve in the Commons).

Following the 1993 election, the PCP went into a decade-long decline and was formally dissolved on December 7, 2003, when it merged with the Canadian Alliance to form the new Conservative Party. The PCP had won a mere 2 seats in 1993, down from 169 in 1988, and a not much more respectable 20 and 12 respectively in 1997 and 2000. The explanations for the PCP’s collapse in 1993 and its decade-long exile in the political wilderness are attributable to its emphasis on socially progressive policies, large persistent government deficits, the introduction of a value added tax, the loss of support in Quebec, and the departure of conservative supporters in the four Western provinces of British Columbia, Alberta, Saskatchewan, and Manitoba to form a new party, the Canadian Alliance, which reflected the older conservative roots of the PCP.

In the 2006 Canada federal election, the new Conservative Party won a plurality of seats, 40.3%. It formed a minority government led by Prime Minister Stephen Harper, cofounder of the new party. In accord with its philosophy, the Conservative Party government cut the rate of value added tax.

The almost complete obliteration of the PCP in 1993 until its merger with the Canadian Alliance in 2003 and return to power in 2006, suggests that the Republican Party perhaps needs to undergo a similar defeat under its progressive wing for the party to reestablish its conservative roots.

Wednesday, February 6, 2008

Stimulate the Economy or Close the Tax Gap?

The president and Congress are on the verge of enacting a "stimulus package" in the neighborhood of $150 billion. It includes sending checks to taxpayers who earned less than $175,000 last year, possibly to Social Security recipients and veterans, accelerated depreciation for small business, and other benefits. The underlying belief is that putting money in the hands of people who are likely to spend it will increase demand, stimulate production, and create jobs.

Meanwhile, the White House and Congress appear likely to agree on a 4.3 percent increase in the budget of the Internal Revenue Service in order to close the "tax gap." The tax gap, the difference between what taxpayers owe the federal government in taxes and what the federal government collects, is estimated at $290 billion. A new measure includes stricter requirements for brokerage houses and other financial institutions to report what investors pay for stocks and other securities to the IRS, stricter enforcement of existing laws, increased audits, and increased penalties on those who willfully fail to file tax returns.

It took three years, from 2004 through 2006, to collect an extra $10 billion through stricter enforcement. A further $10 billion was raised in 2007, bringing the four-year increase to $20 billion. Closing the tax gap has been a priority of Congress and the IRS for many years. If the IRS makes significant progress in narrowing the tax gap, every additional dollar collected in taxes offsets, one-for-one, every dollar sent to taxpayers to stimulate the economy. Wouldn’t it be truly ironic if the IRS succeeded in cutting the tax gap in half during the next fiscal year!