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There are probably very few activities which are shared by both schoolchildren and our fiscal & monetary policymakers, but blowing bubbles is one of them. The difference being that the kids' bubbles usually consist of soap, are far more entertaining, and cannot cause ruin to entire economies when they pop. But it's the metaphorical asset bubbles that I am more interested in.

Metaphorical bubbles and their non-metaphorical problems
Which brings us to the lead story in last week's The Economist. The editorial worries that the loose monetary policies adopted by major economies (printing money; very low interest rates) has created an environment vulnerable to further asset bubbles. In the short term, the side-effect of cheap money on asset prices is being welcomed by many: the profits are helping the market rebound from its earlier downward spiral and firms' balance sheets are being strengthened as a result.

But there are longer-run issues to be concerned about. As the articles explains, "The problem for [investors] is not just that valuations look high by historic standards. It is also that the current combination of high asset prices, low interest rates and massive fiscal deficits is unsustainable." Eventually the cheap money is going to run out when governments scale back their extraordinary measures - this is not a secret. What is not known, however, is whether the process of scaling back is going to be smooth or volatile. History suggests that we cannot assume a smooth transition.

Carry Trade 2009-?
Not all the evidence points to asset bubbles - see The Economist's other article - at least not for the wealthiest economies. Emerging markets, however, are the destination of a lot of this cheap money, which creates its own challenges. To understand why this is so, let's look back to Nouriel Roubini's November editorial about the Mother of All Carry Trades that began in 2009. The "carry trade" is the practice of borrowing in a cheap currency (the USD, with a near-zero - and sometimes negative - interest rate) and investing in risky assets with higher return. Here's Roubini:

"Let's sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March [2009]....
Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight... By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets.

Does that bolded sentence sound familiar? It should if you've been following the financial crisis at all. The perception of decreasing risk due to lower volatility can be misleading.

Bear in mind that this carry trade is contingent on cheap borrowing. When (not if) borrowing in USD becomes more expensive, this effect will have to reverse itself or shift to a new currency, like the Yen. If this happens suddenly, Roubini believes there will be a stampede "as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments."

So maybe this bubble will pop, as Roubini argues it will. Maybe it will simply deflate. The fact is that nobody can say for certain - but the risk is there. Remember the story of Icelandic people blowing up their Land Rovers to avoid paying them off after the krona tanked? That's a dramatic but useful illustration of what happens when the carry trade reverses itself rapidly.

In the meantime, as I alluded to above, the consequences of cheap money flowing to emerging markets are being felt in a number of areas. I'll look at some of the implications in the next installment.

In what amounts to a healthy rejoinder to my post from Sunday, Yves Smith challenges the notion that a con job is enough to stimulate economic recovery:

The one bit of policy, if you care to call it that, that has worked well is the Administration’s concerted campaign to talk up the stock market. Its success in using the bogus stress tests to goose bank stocks was remarkably effective, particularly since anyone who knew anything about banking and was not in on the con was highly critical of the tests. But the media played them to the max... And the Administration kept pointing to the improved tone of the markets as proof that the economy was on the mend. And some readers have noticed a cheerleading stance in news outlets that were once more evenhanded, particularly Bloomberg.

Can a con job lead to recovery? The continuing lousy news on the employment front suggests not, but as long as the stock market remains relatively buoyant, few want to challenge this thesis. I had drinks with a hedge fund manager who was recently pilloried at a buy side/sell side get together when he dared suggest that the fourth quarter might not look as robust as everyone assumed. He said the argument against him boiled down to, “We are all feeling better and spending more, so everyone else surely is too.” The fact that they are all in the top 1% of the population and beneficiaries of TARP and other government bennies means it is a huge leap to generalize from them to the other 99%, but they didn’t see it that way.

Over at The Economist, Buttonwood has an excellent piece on how we think about, and often are confused about, wealth. In particular, the article points to the dangers of confusing financial assets with real ones:

[F]inancial assets are not “wealth” but a claim on real wealth. If those claims multiply or rise in price, that does not mean aggregate wealth has increased. If a pizza is cut into eight instead of four slices, there is no more food to eat. If everyone sitting at the table is given shares in the pizza and the share price rises from $1 to $2, the meal will still be no bigger.

Which leads to further questions:

Not long ago the BBC transmitted a programme about credit-card use. One man said he felt “wealthier” because he was given a credit-card limit of £5,000 ($8,000). Of course, once he used the card he was poorer. Not only did he have to repay the £5,000, but he had to service a double-digit interest rate as well. Similarly those who buy an overvalued asset with borrowed money have not made themselves richer but poorer.

Thinking about wealth in this way is also useful when assessing rescue packages for the economy. Will these policies boost the amount of goods and services the economy produces in the long run, or will they have consequences that actually restrict economic activity? Does quantitative easing really boost wealth or simply create more claims on the same underlying pool of assets?

These are good points: there's the risk that the stimulus packages have artificially boosted the indicators of economic performance. In other words, we're being deceived into thinking the economy is recovering when in fact the resulting national debt and inflation is making us poorer in the long run. This is certainly the case at the micro level, where - as with the British man referenced above - the use of debt to fund purchases can be net negative.

But at the macro level the distinction between artificial and real wealth is not always so clear. One of the key arguments in favour of the stimulus packages was that they would foster market confidence. When market participants are more confident, they are more willing to spend - the more they spend, the more firms are willing to invest in products/services on which money can be spent. Through playing the confidence game, government spending can use the artificial sense of wealth to stimulate the production of goods and services, or "real wealth." More pizzas, if you will.

This is the theoretical argument, in any case. And it only works in the short-run, since sustained high levels of spending will not have the same impact on market confidence, and may actually reverse it. But whether this artificial-to-real wealth effect balances out the long run costs of higher debt & inflation is something which remains to be seen.

The IMF meetings in Istanbul are something of a victory lap following what many consider a banner year for the Fund. Faced with questions of relevancy just two years ago, the Fund is now globally lauded for its role in fighting fires from Pakistan to Ukraine. While critical questions remain over funding and governance, the IMF looks certain to assume a central role in the post-crisis global financial regulatory regime.

"More than a decade after the Asian Economic Crisis brought world attention to major IMF policy mistakes, the IMF is still making similar mistakes in many countries," CEPR Co-Director and lead author of the paper, economist Mark Weisbrot said. "The IMF supports fiscal stimulus and expansionary policies in the rich countries, but has a much different attitude toward low-and-middle income countries."

The Institute of Supply Management's August survey rose from 48.9 to 52.9, passing the 50.0 threshold signalling an expansion of activity for the first time in 19 months.

Elsewhere, China kept on the gas as manufacturing activity rose for the sixth straight month in August.

Is the big stimulus pay-off starting to take shape?

Millions of protesters took to the streets across France yesterday to protest what is loosely being described as the "economic policies" of French president Nicolas Sarkozy. I know, saying the French are taking to the streets is like saying the sun always rises. Obvious.

However, the protests are but the most immediate example of widespread and growing popular discontent with the financial crisis and the response of governments. Governments in Iceland, Belgium and Latvia have already fallen, and political instability is rising across Eastern Europe, Africa and Asia in response to food shortages, budget cuts and rising unemployment. Even in Russia, the United Russia party lost two local mayoral elections in restive eastern provinces, leading President Medvedev to introduce legislation that would allow provincial governors (appointed by the Kremlin) to replace democratically-elected officials at the local level. This follows brutal crackdowns on protestors; Moscow has become so sensitive to the risk of popular unrest that it recently flew special forces thousands of miles to snuff out local protests against rising tarriffs.

These examples seem to foreshadow a global summer of discontent as unemployment rises and government budgets come under greater pressure. This poses obvious risks to political stability and commerce. It also constrains the options available to policymakers, making beggar-thy-neighbor actions such as the imposition of trade barriers, subsidization or nationalization of industries and currency devaluation more likely. History tells us that these domestic political considerations, particularly in the developing world, risk reinforcing the downward economic spiral, as policymakers appease factions and fail to reach coordinated regional/global programs. They also risk, particularly in the case of currency devaluations, setting off a change reaction of competitive responses that, in the absence of regional cooperation, ultimately destabilizes the system as a whole.

The potential impact of growing popular unrest cannot be overstated. While violent inter-state conflict seems only likely over energy resources, the damage from economic warfare is still profound. Intelligence services have come to recognize this threat. In testimony before the US Congress, Director of National Intelligence Dennis Blair identified the financial crisis as the single greatest national security threat to the United States, before Al-Qaeda or nuclear proliferation. President Obama now receives a daily economic intelligence briefing from the CIA in addition to his traditional daily intelligence briefing. Economic and national security considerations have converged in the eyes of intelligence analysts and policymakers. One has to wonder whether this will lead to more mercantilist policy agendas as liberal economics loses credibility, multilateral cooperation stalls and popular discontent grows.

As we try to come to terms with the crisis and its implications, IPE, as an academic discipline, is well-positioned to explain and guide us through this complex global environment. The discipline arguably isolated itself for many decades as it sought to distinguish its theories from the traditional IR, realist paradigm that dominated both academic and official thinking during the 20th century. It discounted security considerations too much, pushing an almost Marxist-like bottom-line: the economic drives the political. But since the end of the Cold War the discipline has developed a greater appreciation for the security implications, and influences, within the global political economy. Freed from its self-imposed intellectual box, IPE now offers the most multidimensional, comprehensive analytical framework for conceptualizing and forecasting the economic and political consequences of the current crisis. I would guess that more than a few IPE grads will be drafted into their respective national intelligence services in the coming years.

It has become cliche to say we are witnessing a global paradigm shift. But as the crisis plays out over the coming months, and political instability spreads, it will become ever more apparent that one cannot divorce economic conditions from national security. The risk is that this realization leads policymakers to adopt mercantilist policies and abandon multilateral cooperation. Amidst growing protests, the difficulty policymakers face in fashioning a global consensus on regulatory reform and economic stimulus only hardens. Upon this backdrop, the G20 meeting in London develops an even greater sense of urgency. Our leaders must sieze the moment. Their window may be closing.

To cap off a week of quick hits and witty anecdotes, Chinese premier Wen Jiabao, via the NYT:

“President Obama and his new government have adopted a series of measures to deal with the financial crisis. We have expectations as to the effects of these measures,” Mr. Wen said. “We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.”

He called on the United States to “maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

Uh-oh.

According to sources in the room, US Treasury Secretary Timothy Geithner said the following to a meeting of House Democrats last night:

"We're doing in weeks what countries did in years...It will take some time. It will take some patience. But it will work."

Geithner has come under enormous pressure from investors, commentators, bloggers and just about every other person under the sun not named Barack Obama since taking over at Treasury. The biggest criticism has been his apparent "dithering" and inability to formulate or articulate a clear response to the banking crisis. In the current environment, no one has the luxury of time, and doing too little (fiscal stimulus including) runs the very real risk of plunging a deep recession into a depression.

But, doesn't he have a point?

Politique
-Divisions emerge within Europe over EU rescue packages.

-The Sri Lankan cricket team came under attack in Pakistan, with six police officers killed.

-The ICC issued an arrest warrant for Sudan's president Omar al-Bashir for crimes against humanity in Darfur.

-UK Prime Minister Gordon Brown visited the White House and addressed a joint session of the US Congress. Then a bit of a row broke out (ok, within the British press) over the Obama's not-so-thoughtful gifts to the Browns.

Economia
-The Bank of England slashed rates to 0.5%, and embarked upon "quantitative easing."

-The US government pumped an additional $30bn into AIG.

-China's anticipated additional stimulus announcement came, and went, with no stimulus.

The Rest
-Arsenal, ManU and Chelsea go through in the FA Cup. Becks, Milan and LA Galaxy reach tentative deal to keep the England international at the San Siro until the end of the season, and possibly beyond. Becks reportedly put up his own cash to ensure his stay in Milan.

-Really, Medvedev? Really?

-Paris Fashion Week.

I discuss the devaluation of the rouble and Russia's deteriorating economy at zzzeitgeist. Check it out!

Politique
-US Vice President Joe Biden outlined the foreign policy vision of the young Obama administration in a speech at Munich. He called for a "reset" of US-Russian relations, offered Iran "meaningful incentives" to abandon its nuclear program, and called on America's allies (i.e. Europe/NATO) to shoulder a greater burden in security (Afghanistan, Guantanamo detainees). The speech comes days after Kyrgyzstan, under Kremlin pressure, announced it would close an American military base of great strategic importance. Russia embraced the "reset" concept.

-The US Senate reached a tentative deal on a $827 trillion stimulus package. After fierce political debate that all but shattered Obama's "post-partisan age", the Democrats appear to have picked off three Republican votes by cutting direct aid to states and localities and increasing the percentage of tax incentives in the bill (the bill cuts the size of the so-called 'middle-class tax cut' while increasing incentives to purchase homes and cars). Congress must now reconcile the House and Senate bills before a final package can be sent to Obama's desk.

-Morgan Tsvangirai returned to Zimbabwe to form a coalition government with Robert Mugabe. The president will sign a constitutional amendment allowing Tsvangirai to become prime minister, while a judge threw out treason charges against an important MDC figure.

-Abdul Qadeer Kahn, father of Pakistan's nuclear bomb and prolific nuclear proliferator, was freed from house arrest after 5 years. France and the US immediately criticized the move.

Economia
-The US unemployment rate hit 7.6% and GDP plummeted 3.6% in Q4 2008. According to The Economist, the fall would have been over 5% if not for a sharp rise in inventories. Elsewhere, German industrial output fell by a record 4.6% in December.

-The BoE cut rates to 1%, while the ECB held steady once again.

-Obama imposed a cap on executive compensation at companies receiving "exceptional assistance" from the US government. Politics 101: if you want to appeal to public anger, but have little intention of widely enforcing a rule, insert a vague definition like "exceptional assistance."

-The rouble floor announced by the Russian central bank was tested this week; traders are betting the floor was set too high; oil price and capital flows volatility will continue to weigh on the currency.

The Rest
-In the Prem, Torres fires Liverpool top of the table (for now), Chelsea are in free fall (bye bye Big Phil?), and Arsenal just suck. In Italy, Milan's initial formal offer for Becks was rejected outright by LA Galaxy.

-French street artist JR brought his "28 millimetres: Women" project to Kibera, Kenya. The artist imposes facial images on homes and buildings, providing an identity and voice to the women of one of Africa's largest slums.

-Over 84 people have been killed in Australia's deadliest fire disaster. The state of Victoria has been ravaged by the bushfires, fueled by a prolonged drought and soaring temperatures.

-Scientists have identified a key protein in the process by which the H5N1 virus replicates itself. It is hoped that the discovery will lead to more effective drugs to combat the virus. Egypt confirmed its second human case this year, while both Hong Kong and Vietnam announced new cases in birds.

...on protectionism. First off we have the indefatiguable free-trade defender Jagdish Bhagwati who is, well, defending free trade. Even if the US enacted measures that were WTO-consistent, Bhagwati points out that other countries could do the same:

Nothing would prevent India and China from choosing to raise tariffs thus on items of export interest to the US. Besides, they could shift their own purchases of aircraft away from Boeing to Airbus, and of nuclear reactors from American to French companies. The response would, of course, be for the enraged US congressmen to start enacting their own retaliation. The game would become lively.

In the interest of balance, I point you to a column by Oxfam's Duncan Green that argues that protectionism is not all bad, particularly for developing countries. I had the pleasure of having Duncan give a guest lecture in one of my graduate school classes - he offered a refreshingly blunt assessment of what it was like to work for an NGO, both good and bad.

As far as his argument goes, I think he's in good intellectual company when he points out that the poorest developing countries may need trade barriers to help them escape from a poverty trap. I think the well-respected development economist Paul Collier argues as much in The Bottom Billion. To be fair, however, we've been focusing our criticism on the Buy America, Buy China and Buy India type policies enacted by members of the G20. For these countries, at least, Duncan thinks protectionism is a rotten idea.

...and on fiscal stimulus. There's no end to the material provided by all sides of this lively discussion, but I particularly enjoyed this sarcastic op-ed by Benn Steil:

Citing Keynes gives us special licence to talk economics without using any. To paraphrase the lawyers’ dictum, when the facts are on our side, we pound the facts; when theory is on our side, we pound theory; and when neither the facts nor theory are on our side, we pound Keynes – and to great effect.

I think that Keynes is right when it comes to the need compensate for market downturns through active policy measures, rather than simply waiting things out, and Stein takes Keynes' quote about how "in the long run we are dead" out of context. But his target is not so much some long-dead economist but rather the people who are inclined to use the name of some long-dead economist as justification for spending our money. Just because there is a clear need to "do something" significant doesn't mean our legislators should be given a free reign. With huge stimulus packages being proposed by almost every major Western government, it has become more important than ever to ensure that the money is A) being spent on what's being promised, B) having the effect that's promised, and C) not mortgaging our financial future in the process.

Easier said than done.

Update: Brad DeLong retorts to the Steil piece.

Politique
-As the financial crisis rolls on, the next phase of government (re)action is developing: US House approves an $819bn stimulus package (with a certain provision we don't like very much) and the FT reports that Obama will unveil a "Big Bang" package of banking/financial/housing reforms this week (now next), Harper's minority government unveils a federal budget that includes the country's first fiscal deficit in over a decade, Merkel has reportedly settled on a plan to create government-backed "bad bank" vehicles to clean up balance sheets, and Aso unveiled his own stimulus package under considerable opposition (he also pledged $17bn in aid to other Asian nations).

-62% of Bolivian voters approved a new constitution in last Sunday's referendum. The new constitution increases the government's control over strategic industries (including natural resources), strengthens indigenous rights, and furthers land reform. Despite the popular majority, 4 of the country's 9 provinces voted against the changes.

-North Korea voided all political and military agreements with the South this week, as mounting tensions on the Korean peninsula threaten all out military conflict. While Kim's motivation is unclear, a few theories seem plausible: 1) he is pushing his way onto Obama's agenda, 2) he is provoking an international crisis to stem any internal revolt amid his ailing health, 3) he has lost control and hardliners are their authority over foreign policy.

-Social and political instability is spreading across Europe: Iceland's government fell, massive strikes paralyzed France, and British workers walked off the job to protest the use of foreign workers amid rising British unemployment. Nationalism, protectionism, and industrial action are all on the rise.

-Iraqis voted in provincial elections. Despite a lower than hoped turnout, the elections were peaceful.

Economia
-The IMF reduced its global GDP forecast for 2009 to 0.5%, and the global economy shed over 70,000 jobs in one day.

-Sterling had a small recovery this week on a slight confidence jump in UK banks, the Euro slipped amid eurozone economic weakness and lack of faith in the ECB, and the USD and Yen both endured "rollercoaster" weeks.

-Exxon Mobile reported record earnings for the 4th quarter. The Lex column in the FT praised the company for "generating free cash flows as others invested" during the good times, positioning itself to pick off rivals and acquire assets in the bad. This conservatism has acted as a hedge against the rapid fall in prices.

The Rest
-In the Prem, ManU go 2 clear with 1 in hand, Liverpool score 2 late to take all 3 from a 10-man Chelsea, and Arsenal throw up a big 0 at home against West Ham. Elsewhere, Becks scores his second for Milan as speculation mounts over his return to LA.

-In tennis, Nadal beat Federer in 5 for the Australian Open title. Rafa's performance was simply incredible, coming less than 48 hours after his Australian open record 5 hour, 14 minute semifinal match against fellow Spaniard Fernando Verdasco. Many took Federer's uncontrollable tears in the post-match ceremony as a sign that even the Swiss great doubted his ability to ever beat Nadal again in a major final and catch Sampras' record 14 major titles.

-In Olympic swimming, Oops!

-While much of the fashion world has been tailoring collections to reflect our dark economic times, these designers look to color.

-Move over Highlander, meet Turritopsis nutricula: immortal jellyfish.

On Wednesday I poked fun at the hypocrisy of Vladimir Putin's Davos speech. Despite this, his warning on the dangers of protectionism should be heeded by policymakers, particularly in the US, especially now.

The US House yesterday passed the $819 billion stimulus package, known as the American Recovery and Reinvestment Plan (I love the use of the word "reinvestment", you just know it focus-grouped so much better than "exploding deficit"). The vote was along party lines; not a single Republican voted for the package. The debate over the contents and balance of spending/tax cuts is endless, and I won't wade into those waters here. But I am very troubled by one aspect of the bill: the now notorious "Buy America" clause (which, I must boast, I was all over from the beginning). What at first looked like a shameful attempt at backdoor protectionism, is now officially on the table. It passed.

We know that the House version of the bill is different from the one the President will ultimately sign. It is likely that many of the "pork-lite" programs will be shed to deflect widespread criticism over their relevance to the immediate economic crisis. But in all the partisan back and forth, I have yet to hear a passionate criticism of the "Buy America" clause. The Republicans are more outraged by $335m in funding for sexual health education and prevention programs. The silence on "Buy America" is dangerous and increases the likelihood that the clause remains in the final version. It also provides a fundamental test of Obama's trade policy, whatever that might be. Megan McArdle and Dani Rodrik agree.

Luckily, the European Commission has a bit of a problem with "Buy America" (Canada too). Peter Powers, Commission spokesman, warned, "If a bill is passed which prohibits the sale or purchase of European goods on American territory, that is not something we will stand idly by and ignore." Furthermore, the European Confederation of Iron and Steel Industries (Eurofer), a powerful lobby representing over 370,000 EU workers, has called on the EU to bring it to the WTO, saying, "Our view is that if passed this would be a clear violation of their WTO commitments on government procurement rules", and, "It is a protectionist measure which goes against the commitment made to the G-20 to keep markets open."

Dave was spot on when he said of this rising protectionism, "the real danger is that tariffs/bans on stuffed kittens and fancy cheese are the first snowballs that kick off an avalanche of protectionism that smothers trade and damages geopolitical relations." But what if that avalanche is exactly what we need? Could "Buy America", cheese duties, and stuffed kitten tariffs be the sparks that finally break the DDA deadlock? A rapid deterioration in the trading system could compel leaders to look past the modalities and embrace the central role of trade in saving the global economy.

Maybe. We've learned that a crisis is often necessary to force policymakers out of their comfort zones and stand up to powerful interests. At the very least, a little pressure from the across the Atlantic might bring US policymakers to their senses.

UPDATE: The FT reports that the "Buy America" clause is not present in the current Senate bill, but Senators like Sherrod Brown of Ohio are pushing for its inclusion. I mistakenly assumed it was.

(Photo: funkandjazz)

Politique
-On Tuesday, Barack Obama became the 44th President of the United States. Or was it Wednesday? He swiftly moved to roll back the Bush years through executive orders on Guantanamo, interrogation, and foreign assistance. The President also named two high profile envoys to the middle east and south Asia, a signal that the State Department and America's "soft power" will lead US foreign policy.

-Israel completed its withdrawal from Gaza, days after both Israel and Hamas declared "unilateral" ceasefires. The death toll from the conflict is estimated at 1,300 Palestinians and 13 Israelis. In related news, the BBC came under intense pressure following its refusal to broadcast a Gaza aid appeal by the Disasters & Emergency Committee.

-The Prime Minister of Iceland, Geir Haarde, called a March general election and will not seek reelection. The Daily Mail (and many others) incorrectly labeled Haarde's government the "first in the world to be effectively brought down by the credit crunch." As Dave noted in December, Belgium's government was the first to fall under pressure directly stemming from the financial crisis.

Economia
-Negotiations over the US stimulus package intensified as Obama met with leaders from both parties to shape a consensus. The stimulus package will undoubtedly pass, but what will it look like: will it hit $1 trillion (many economists believe it must to be effective)? how large are the tax cuts (will Obama bend to his own party by limiting this political manoeuvre)? how many Republicans will ultimately be on board?

-Spain and Portugal were hit with downgrades this week, and the eurozone looks to be on the verge of a serious crisis of confidence. Following its second bail out of the banking sector and the Pound's sharp decline, is the UK in the firing line? Does Britain=Iceland?

-In a written statement to the Senate Finance Committee, US Treasury Secretary designate Timothy Geithner accused China of "manipulating" the renminbi. In a measured response, the Chinese government said Geithner's comments were "out of keeping with the facts", would undermine the global effort to combat the financial crisis, and could fuel protectionism. In other China news, year-on-year GDP growth slowed to 6.8% in the 4th quarter, the slowest pace in 7 years.

The Rest
-Holders Pompey crash out of the FA Cup, Arsenal are held at last year's finalists Cardiff City, and the Merseyside derby ends in a draw, setting up a 4th round replay. In other Prem news, Kaka's megadeal to Man City fell through and a Kuwaiti consortium's proposed takeover of Liverpool has reportedly collapsed.

-In other sporting news, the disturbing balkanization of grand slam tennis.

-Affirming Dave's "political economy theory of fashion", Milan fashion week reflected the economic downturn, with the suit notably absent from many collections.

-The 81st Academy Awards nominations were announced in Los Angeles. The Curious Case of Benjamin Button lead the pack with 13 nominations, followed by Slumdog Millionaire with 10.

-Blackberry addicts the world over are scrambling to get their hands on the "Barackberry", after the US President finally wins his battle to stay connected in the White House. The NSA-enhanced device will have two "modes": one for personal contact with a tiny group of family and friends, another for official communications with a small circle of advisors and officials.

On the topic of Obama and the market, it seems one company is already feeling the impact of an Obama stimulus.

Shares of J Crew Group Inc. ended the day up more than 10% on the news that J Crew was the prefered inauguration outfitter of the Obamas. The Prez: white satin bow-tie. First Lady: gloves, sweater, skirt. Girls: coats, dresses, accessories. Not since Camelot has a First Family made such an impact on the fashion world.

I think Obama's stimulus strategy is clear. Expect to see him driving a different GM vehicle each day, ditching Air Force One for US commercial airlines, opening brokerage accounts at Citi and BofA, and buying up beach houses across the country.

Too lazy to string together a coherent argument, I instead provide links for your reading pleasure.

I'm making a concerted effort to read both interventionist and classical liberal types when it comes to economics with the hopes of cutting down on bias. As a Canadian, it's much easier to come across strong leftish sentiments, but it's reassuring to see that both sides get equally worked up. Check out the comments on Alex Tabarrok's summary of Obama's speech at GMU. I, for one, am hoping Alex is right.

Canada has no coherent government. "Essentially we are arguing that Canada has become a more genteel Somalia." Spicy!

The November stats are in. Consumer spending in America was way down, but volume of consumption was up. Wait, what?

A new blog over at Science has been launched with Darwin's Origin of Species as inspiration. On a related note, Dr. Boli has made a scientific discovery.

(I'm nitpicking here, but hopefully the content of Origins will be better than its grammar. The serial comma is running rampant in the welcome:

As part of its celebration of these two anniversaries, Science will be blogging, with Darwin as our inspiration. On this site, our writers and editors, as well as guest researchers and blog readers, will share their thoughts, not just about the origin of species but also about key nodes throughout the evolution of life, just as Darwin did.

I enjoy a comma as much as the next guy, but that's painful.)

Willem Buiter certainly thinks so. His essay is, as usual, probably too long and dense for casual readers so I'll try to draw out some of the main points here. Before doing that, here is some background:

For quite some time now, the United States economy has been taking in more foreign investment than its citizens are investing abroad. Despite this negative net investment, American investors are earning more from their foreign investments (in aggregate) than the interest being paid on debts owed to foreign investors. This situation is what is being referred to when we talk of "alpha" - being able to secure positive returns despite a situation of negative net investment. This alpha has resulted from two factors: the very low rate of return offered on US assets and the increasingly risky nature of US-owned assets abroad (leading some to describe the United States as the world's largest venture capitalist).

Buiter outlines one possible explanation for the existence of alpha:

"Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run."

The problem is, to the extent that it ever existed, this situation has been undermined:

There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future.

Thems fightin words. In order to generate those primary surpluses, the American economy will need higher taxes and/or less government spending (as well as higher personal savings). Yet the prospective Obama administration's economic stimulus plan contains precisely the opposite: lower taxes and higher government spending.

Buiter doesn't expect to change the outcome of the stimulus package, but his point is this: while the short run effects of a stimulus package may be beneficial, it will destroy the long-run prospects for the entire US economy. In short, the US economy cannot afford a Keynesian stimulus package. He predicts a global dumping of US assets in 2-5 years.

I wouldn't spend too much time worrying about Buiter's specific predictions on asset-dumping. Keynes himself pointed out that our ability to forsee the long-run is so limited as to be practically useless. Moreover, currency predictions are fickle at the best of times because everything is relative. For instance, even with current US economic weakness, we're seeing a flood to the US dollar a safehaven from other crashing currencies. So in two to five years, just about anything could happen. For more counter-arguments, see Free Exchange here and here.

Nevertheless, Buiter's overall concern is a real one and I'm not willing to dismiss it out of hand. But I think the most important questions to policymakers with more short-run horizons still comes down to: what's the alternative? and can America really afford not to have a Keynesian stimulus? A political consensus appears to forming that makes the answer to that last question a resounding "no."

So either Buiter is overstating the extent to which investors will be scared off by higher US debt levels, or there could be some very real long-run consequences that will make Obama's Harlem-Globetrotter-esque economic advisors look like the Washington Generals.

The interwar period is a fascinating "topic" in IPE. Scholarship on the period is vast, offering multiple explanations for the trends, events and ideas that contributed to the Great Depression and WWII. Some of the great thinkers in IPE (such as Kindleberger, Eichengreen and some guy named Bernanke) have contributed to the analysis of the period.

The interwar period is studied so closely because it provides lessons on how NOT to respond to economic contraction and financial crisis. If this history is any indication, protectionism should be avoided like the plague. The Smoot-Hawley tariff set off a change reaction of protectionism from 1930 on that plunged the world much deeper into depression. While a global (meaning British and American) consensus on trade was unattainable immediately following the war (see ITO failure), the GATT succeeded largely due to the Anglo-American recognition that tariffs were dangerous to economic recovery, prosperity and peace itself.

Over the next few weeks, the Obama transition team and US Congress would do well to brush up on their interwar history. The US steel industry, after years of benefiting from illegal subsidies, are reportedly lobbying in favor of a massive public works plan that would have a "buy US" provision inserted into every project. This would conceivably require the recipients of federal funds for public works and infrastructure projects to purchase US steel.

The proposal is troubling on a number of levels. For one, it would prove that the TARP was but the tip of an iceberg of government subsidy. Banks, autos, steel...where does it end? Second, it underlines the risks posed by the DDA's failure. WTO and G20 indecision in the face of rising protectionism risks exactly the domino effect that Smoot-Hawley accelerated nearly 80 years ago. Finally, a "buy US" clause would be a dangerous precedent for the President-elect to set. Many are already skeptical of his commitment to a liberal trading system, and early support for such backdoor protectionism would do little to burnish his trade credentials internationally.

Vice-President elect Biden believes that to be credible and effective, the Economic Recovery Plan must be "pork-free". It is equally important that it avoid the kind of backdoor protectionism the US steel industry is lobbying for.

I have found a solution to the boring old government spending vs. tax cuts stimulus debate: it's QuikCash! Just in time for the holidays.

Part one.