* Exchange Rate. Exchange Rate. A lower currency makes exports cheaper and imports more expensive, so shifts in the exchange rate have a big impact on trade deficits and surpluses. But the impact is fleeting if the lower currency sets off an inflationary spiral and exporters jack up prices, wiping out any compet.i.tive advantage. A lower currency makes exports cheaper and imports more expensive, so shifts in the exchange rate have a big impact on trade deficits and surpluses. But the impact is fleeting if the lower currency sets off an inflationary spiral and exporters jack up prices, wiping out any compet.i.tive advantage. Conversely, a stronger currency doesn't spell the end of exports: companies can adjust by cutting their own costs or accepting thinner profit margins. Conversely, a stronger currency doesn't spell the end of exports: companies can adjust by cutting their own costs or accepting thinner profit margins.

These factors can push exports and imports up or down in the short run yet some countries run deficits year after year while others run surpluses. Such persistent gaps reflect underlying differences in spending and saving. The United States persistently consumes and invests more than it produces because it has a shortage of saving. That extra consumption thus sucks in imports, leading to a trade deficit. Conversely, a country that always consumes less than it produces will have a trade surplus. Germany has chronically weak consumer spending, a reflection of its aging populations and a national obsession with saving. German stores don't open on Sunday unless they're in railway or gas stations and can only have sales on certain days of the year.

Meet Mr. Smoot and Mr. Hawley Global trade is one of the great economic success stories. One study by Scott Bradford, Paul Grieco, and Gary Hufbauer estimates the average American household is some $10,000 per year richer thanks to the post-war expansion of trade.4 Given that, you'd think tearing down tariffs, quotas, and other barriers to trade would be wildly popular. In fact, the public and politicians generally prefer protectionism-that is, the sheltering of domestic industries from foreign compet.i.tion-to free trade.

Free trade is a tough sell because its benefits are less obvious than its costs. Imports make the majority of consumers better off, but they seldom know or care, whereas companies and workers that lose their livelihoods to imports are quick to let their representatives in Congress know. That's why free trade politically is usually a loser. When John Edwards ran for president in 2004, he would rue the loss of textile factory jobs in North Carolina and lament that some families couldn't afford winter coats for their children. Yet the imports that cost those textile workers their jobs are an important reason why children's clothing cost almost 60 percent less in real terms than in 1980.

Given this political hostility, it's remarkable that free trade has made so much progress. Before World War II, protectionism was the stated preference of Republican presidents, which is why Herbert Hoover signed into law the Smoot-Hawley Tariff Act in 1930. It raised tariffs on thousands of products and triggered outrage and, in some cases, retaliation from other countries. Global trade was already collapsing, but Smoot-Hawley accelerated the process.

Fear of a repeat has since helped free trade put down roots in the halls of power around the world. In 1934, Congress pa.s.sed the Reciprocal Trade Agreements Act. It shifted responsibility for trade policy to the president who is less susceptible to narrow, protectionist interests and more likely to see trade agreements as a foreign policy bargaining chip. In 1947, the world signed onto global rules under the General Agreement on Tariffs and Trade (GATT). In 1995, GATT changed its name to the World Trade Organization (WTO). Visitors often ask the WTO's chief, Pascal Lamy, if the two men whose pictures hang in his office are his relatives. He says they are Senator Reed Smoot and Representative Willis Hawley, the "true founders" of the WTO.

The GATT and WTO have been joined by proliferating bilateral and regional trade groups, like the European Union and the North American Free Trade Agreement. Still, like a virus, protectionism is always mutating, from the tariffs, quotas, and subsidies of old to preferential government procurement ("Buy American" or "Buy Chinese"), restrictive licensing requirements, local monopolies, and trumped-up health, safety, and environmental standards. For instance, for 90 years, Australia kept out New Zealand's apples supposedly for sanitary reasons. Similarly, the United States has kept Mexican truckers off its roads claiming Mexican drivers are not safe, when in reality U.S. truckers just don't want the compet.i.tion. The next big wave of protectionism could be green, as countries whose companies buy permits to belch carbon slap tariffs on countries that don't.

Into the Weeds The benefits of trade are a matter of high-minded economics, but trade relations is a bare knuckle business. The president conducts trade policy through the U.S. trade representative. The trade representative is not there to debate the nuances of economic theory but to cajole and threaten other countries. The House of Representatives' Committee on Ways and Means and the Senate Finance Committee oversee trade policy. The Senate must ratify treaties. Other countries are reluctant to sign a treaty that the Congress may amend before ratifying. To smooth the way, Congress sometimes give the president trade promotion authority, trade promotion authority, sometimes called Fast Track, which permits him to negotiate treaties that Congress can approve or reject, but not amend. sometimes called Fast Track, which permits him to negotiate treaties that Congress can approve or reject, but not amend.

Individual legislators regularly take trade into their own hands, introducing bills that would punish other countries for protectionist behavior. The president usually stops them, but then uses them as leverage to extract concessions from the offending country. Dozens of bills, for example, in recent years aimed to hit China for keeping its currency artificially low. None have become law, but both George W. Bush and Barack Obama have used them as leverage to get China to let its currency rise.

Complaints about imports usually fall into one of three categories: subsidies, dumping, or surges. A subsidy subsidy is a government grant or some other favorable treatment that lowers the cost of the import. is a government grant or some other favorable treatment that lowers the cost of the import. Dumping Dumping occurs when a foreign company sells its products abroad for less than it costs to make them, or for less than it charges at home. A occurs when a foreign company sells its products abroad for less than it costs to make them, or for less than it charges at home. A surge surge is a sudden increase in imports. is a sudden increase in imports.

Subsidy and dumping complaints are heard by the Import Administration, part of the Commerce Department. If the Import Administration agrees subsidies or dumping have occurred, as it does 95 percent of the time, it sends the complaint to the federal International Trade Commission (ITC), an independent, bipartisan panel, to determine if the subsidy or dumping actually hurt anyone in the United States. About 60 percent of the time it concludes that it did. In the case of subsidy it recommends a countervailing duty. In the case of dumping it recommends an antidumping duty. The president has little discretion here: if the ITC says injury has occurred, the Commerce Department generally has to impose the duty.

Like a hockey referee, the WTO gives countries an impartial venue to settle their trade disputes rather than mixing it up in the parking lot.

.A company accused of causing a surge of imports hasn't actually done anything wrong: it's just making it hard for local compet.i.tors to survive. U.S. companies or unions can ask for a safeguard against the surge under one of two laws: Section 201, which applies to any country, or Section 421, which only applies to China. Safeguard cases are decided by the ITC. If it concludes that a safeguard is warranted, the president has the discretion to say no.

World trade is like hockey: fights are inevitable, but they're more dangerous when the players leave the rink and settle matters in the parking lot. Like the referee who hands out the penalties and lets the game continue, the WTO gives countries an impartial venue to settle their trade disputes rather than mixing it up in the parking lot. In 2002, George W. Bush slapped tariffs on steel from numerous countries. Rather than strike back, the European Union complained to the WTO. The WTO ruled the tariffs illegal and gave the EU permission to retaliate. As the EU drew up a list of retaliatory moves, Bush backed down, and withdrew the tariffs. The EU declared victory and sheathed its sword.

Still, free trade is a tough sell at the best times, and won't make much progress in coming years, if any. Prolonged high unemployment only makes people and their leaders more suspicious of compet.i.tion. The global balance of power is also changing. For decades the United States let China and other poor countries get away with protectionism in the interests of letting them catch up. China is still poor but Americans now see it as a full-fledged economic and political rival and expect it to play by rich-country rules.

The Bottom Line * Falling trade barriers, rising affluence, and the plunging cost of selling things across borders have fueled globalization. Able to buy from and sell to the entire world, even small countries can achieve exceptional levels of wealth.* Trade makes the United States a whole richer. But the benefits are not shared equally. Especially as services trade grows, the biggest gainers will be the highest skilled workers while those with the least skills will see their wages eroded.* Free trade is not politically popular and every country routinely indulges its protectionist impulses. Yet free trade survives because countries have also agreed to subject their actions to the rules of the World Trade Organization which keeps trade spats from becoming trade wars.

Chapter Seven.

All the World' s an ATM Knitting Global Markets Together THE MESS CREATED by subprime mortgages issued to people of doubtful credit should have been the United States' private headache. After all, the loans were dreamed up to satisfy the American obsession with home ownership. Yet, to leverage themselves to the hilt, Americans had to borrow. If they could only borrow from other Americans, the compet.i.tion for money would have driven up U.S. interest rates and snuffed out the frenzy.

But, as we learned in the previous chapter, economic borders are melting, in particular for borrowers. Factory workers in Shanghai, mutual fund investors in the United States, sovereign wealth funds in the Persian Gulf, and banks in Dusseldorf are all connected to a global ATM that continuously channels money from savers in one part of the world to borrowers in another. Thus, when U.S. homeowners and the U.S. Treasury needed money, the global ATM matched them to Germans, Chinese, and Saudis who needed a place to invest their savings.

When home prices turned down, the pain was felt not just in the U.S. financial system but by the banks and investors of every country that helped finance the housing boom. IKB, a once sleepy German bank that ran out of opportunities to lend to local businesses, loaded up on subprime mortgage-backed securities. In 2007, it had to be bailed out by the German government. It was joined in the injured ward by French, Swiss, and British banks, Australian hedge funds, and Norwegian munic.i.p.alities.

The subprime mortgage crisis eloquently demonstrates how the global markets for a.s.sets, debts, and currencies have knit the world together. It provides many benefits, such as helping countries finance investment when they don't have enough saving and enabling investors and borrowers alike to spread their risks around. But just as modern jet travel allows viruses to cross oceans, modern capital markets rapidly transmits one country's problems to others. And unlike with exports and imports, the currency and capital markets aren't governed by a shared rules of the road. They're a free-for-all p.r.o.ne to crisis.

Financing Deficits and More If you spend more than you earn, you cover the difference by running up your credit card, running down your savings, or cashing in some investments. For a country, the equivalent is running a current account deficit current account deficit-paying foreigners more for imports, interest, and dividends than it receives from them. To finance such a deficit, a country has to either borrow or sell some a.s.sets, such as stocks, bonds, Rockefeller Center, or a beer company to foreigners, with the result that the country's foreign debt mounts.

There's nothing wrong with a current account deficit. Just as a start-up company needs outside investors to develop its technology, a country often lacks the savings to exploit its bountiful investment opportunities. Foreigners lend it the money or purchase shares in its companies so that they can build railroads, dig mines, or erect factories. The investments make the country wealthier, generating wages and profits it can use to repay the foreign investor.

Nowadays, though, far more capital crosses borders than what's needed simply to finance deficits. In 2009, for example, foreigners bought and sold about $40 trillion worth of U.S. stocks and bonds, more than 10 times the total trade that year. According to the Bank for International Settlements, foreign exchange trading now averages more than $3 trillion per day. per day. These flows do more than transfer money from a saver in one country to a borrower in another; they make it possible for both investors and borrowers to diversify. U.S. investors, for instance, can diversify their portfolios by owning mature, stable U.S. companies and riskier but faster growing companies from Brazil and China, while U.S. companies can finance their expansion by raising money from Brazilian hedge funds and Chinese banks. These flows do more than transfer money from a saver in one country to a borrower in another; they make it possible for both investors and borrowers to diversify. U.S. investors, for instance, can diversify their portfolios by owning mature, stable U.S. companies and riskier but faster growing companies from Brazil and China, while U.S. companies can finance their expansion by raising money from Brazilian hedge funds and Chinese banks.

Still, the stunning scale of capital movements poses huge risks. Imagine carrying a cookie sheet filled with water across the kitchen floor. Just the slightest trip and water sloshes over the sides. The global capital market is like that cookie sheet. Enormous amounts of money flow effortlessly across borders around the clock but even a minor disturbance can divert huge sums from one market to another, sending stocks, interest rates, and currencies sharply up or down.

Foreign borrowing binges almost always end badly, as it did for the United States. It could have been worse.

.The easy availability of global capital means a country can finance bigger deficits for longer than when capital was less mobile and harder to get. Most of the time that's good, but sometimes it lets a country dig itself deeper into debt. In the late 1990s, the United States ran current account deficits reflecting its companies' hunger for capital to invest in new technology. In the 2000s, it kept on running current account deficits, but this time to finance our lifestyles, such as suburban McMansions with granite-topped kitchen counters. They did nothing to enhance future growth.

Foreign borrowing binges almost always end badly, as the United States' did. It could have been worse. In small countries, foreign investors suddenly flee a country, sending its interest rates up sharply and its economy into recession; it happened to Mexico in 1994 and throughout east Asia in 1997. Large countries like the United States are spared that trauma but the result is still miserable.

The Currency Market Of all the thousands of prices in a modern economy, the most important may be the price of its currency. It's a real-time vote of confidence in a country's economic health and a transmission channel for prices, investment, and production.

Currencies move about as predictably as a toddler in a toy store, as investors at home and abroad shift their money based on the latest bit of data or on a whim. Yet there is method to their madness. The currency of a country that persistently runs higher inflation than its trading partners will fall. In the 1970s and 1980s Britain's inflation was persistently higher than Germany's, and so the pound declined against Germany's deutsche mark, the currency it used until 2002 when it adopted the euro.

Why? Suppose a Briton wants to buy a Volkswagen. If higher inflation raises its price at home, she'd exchange her pounds for deutsche-marks and buy it in Germany. Eventually, that selling will drive the pound down and the deutsche-mark up-until the Volkswagen was just as expensive in Germany. Over time, then, currencies move toward their purchasing power parity, purchasing power parity, which is the theoretical value of a currency that would make a basket of goods cost the same in two countries. which is the theoretical value of a currency that would make a basket of goods cost the same in two countries.

The Economist Economist magazine's Big Mac index is a quick-and-dirty measure of currency's purchasing power parity. The magazine tracks the cost of a Big Mac in over 20 countries. In July 2009, a Big Mac cost 33 pesos in Mexico, and $3.57 in the United States. To equalize those prices, the dollar would have to trade for 9.24 pesos. In fact, it traded for 13.6 pesos, implying the peso was about 33 percent undervalued against the dollar. magazine's Big Mac index is a quick-and-dirty measure of currency's purchasing power parity. The magazine tracks the cost of a Big Mac in over 20 countries. In July 2009, a Big Mac cost 33 pesos in Mexico, and $3.57 in the United States. To equalize those prices, the dollar would have to trade for 9.24 pesos. In fact, it traded for 13.6 pesos, implying the peso was about 33 percent undervalued against the dollar.

Purchasing power parity is a lousy guide to a currency's movements in the next few years. In the short term, the outlook for economic growth, inflation, and interest rates is more important. If Sweden is entering recession, its central bank will probably cut interest rates. That makes Swedish krona bonds less attractive. Another factor is a country's terms of trade: If oil prices soar, that raises the value of Canadian exports and sucks capital into its oil industry, feeding demand for Canadian dollars. is a lousy guide to a currency's movements in the next few years. In the short term, the outlook for economic growth, inflation, and interest rates is more important. If Sweden is entering recession, its central bank will probably cut interest rates. That makes Swedish krona bonds less attractive. Another factor is a country's terms of trade: If oil prices soar, that raises the value of Canadian exports and sucks capital into its oil industry, feeding demand for Canadian dollars.

In Search of Stability Erratic exchange rates can be a pain, as you know if you've ever had to decide whether to buy euros when you book your French vacation or wait until you travel. For a business trying to decide where to open its next branch the uncertainty is even more debilitating. And a country is always tempted to drive down its currency to boost its exports at the expense of its trading partners.

Since the collapse of the Bretton Woods system in 1971, the global monetary system has been a free-for-all.

.Fixed exchange rates eliminate both uncertainty and the temptation of compet.i.tive devaluation. When countries all fixed their currencies to gold, they in effect fixed them to each other, as well. The gold standard collapsed in the 1930s but world leaders resurrected it in modified form under the Bretton Woods agreement, named for the New Hampshire resort where they met in 1944. Partic.i.p.ating countries fixed their currencies to the dollar and the United States fixed its dollar to gold; it would convert another country's dollars to gold at $35 per ounce. The International Monetary Fund would police the system, lending money to a country that struggled to finance a current account deficit, and permitting it to devalue if necessary to eliminate the deficit altogether. rates eliminate both uncertainty and the temptation of compet.i.tive devaluation. When countries all fixed their currencies to gold, they in effect fixed them to each other, as well. The gold standard collapsed in the 1930s but world leaders resurrected it in modified form under the Bretton Woods agreement, named for the New Hampshire resort where they met in 1944. Partic.i.p.ating countries fixed their currencies to the dollar and the United States fixed its dollar to gold; it would convert another country's dollars to gold at $35 per ounce. The International Monetary Fund would police the system, lending money to a country that struggled to finance a current account deficit, and permitting it to devalue if necessary to eliminate the deficit altogether.

The system fell apart when the United States began to run current account deficits in the 1960s, which left foreigners holding a lot of dollars. Eventually, it dawned on everyone that the United States didn't have enough gold to redeem all those dollars. In 1971, Richard Nixon shut the gold window: the United States would no longer exchange its gold for dollars. The world entered a period of generally floating exchange rates. floating exchange rates.

Since then, the global monetary system has been a free-for-all. Several times a year, the heads of state, central bank governors and finance ministers of the biggest economies-the G7, and, increasingly, the G20-meet to discuss the global economy. Afterward they issue long, anodyne statements promising cooperation and a resolute attack on their various economic flaws. Occasionally this makes a difference. In 1985, what was then the G5 kicked off a big decline in the dollar, and in 1987, the G7 brought that decline to a halt. In 2008, their pledge not to let any more big banks fail helped end the panic that began with the collapse of Lehman Brothers. Usually, though, it doesn't matter. There's no one to enforce the commitments. The IMF has no leverage over countries that are themselves lenders, like China, or even over borrowers that visit the global ATM instead. Unlike the IMF, the ATM doesn't attach conditions to its money such as freer markets or smaller budget deficits.

Fixed exchange rates didn't die with Bretton Woods. They are now regularly adopted by individual countries, usually without the consent of the country they peg to. This gives their businesses a predictable investment environment and, by eliminating devaluation as the solution to rising costs, controls inflation. Over 60 countries, from China to Belize, peg to the dollar in some way.

As with any form of price-fixing, a fixed exchange rate won't last if the fundamentals are all wrong, such as excessive inflation or persistent current account deficits. The central bank supports its currency by purchasing it in the open market in exchange for foreign currencies in its reserves. If reserves run low, it has to raise interest rates to draw investors back in. But it may not have the fort.i.tude to keep rates high if recession threatens. As a last resort, a country can impose capital controls, in effect threatening to jail anyone who trades the currency outside its official value.

Hong Kong has successfully pegged its currency to the U.S. dollar since 1983 thanks to a gigantic h.o.a.rd of foreign exchange reserves and a willingness to endure a deep recession to keep it there. Yet the only sure way for a country to lock in an exchange rate is to surrender its monetary pa.s.sport and adopt another country's currency altogether. Ecuador, Panama, and El Salvador use the dollar, while 16 European countries exchanged their currencies for the euro. But, this adoption process comes at a price-when you give up your monetary citizenship you live by the interest rates of the economy you adopted. You can no longer cushion your economy from domestic misfortune by using a weaker exchange rate to boost exports. You may conclude you can't live with these fetters and switch back to your old currency. Indeed, the euro's future is clouded by the possibility that some countries may renounce its use.

The Case of China's Yuan Since 1997, China has kept its currency, the yuan, also called the renminbi, either steady or changing only gradually against the dollar. It succeeds for several reasons.

First, it has capital controls, which means you need the government's permission to buy and sell the yuan. Currency dealers who trade in the black market to avoid those controls have been busted on television. Second, it keeps the currency artificially low, not artificially high. To force the currency higher, speculators would have to buy up a lot of it. Yet the central bank can simply print as much as it wants to meet their demand, accepting in return their U.S. dollars, euros, or other currencies. Although this practice would normally lead to inflation, China has avoided that in part because productivity has kept pace with its rapidly rising wages. Third, and most important, Chinese households and companies save a lot. They plow those savings into foreign a.s.sets like Treasury bonds, which props the dollar up against the yuan.

China's exchange rate policy has been a huge boon to its development. It has fueled exports, enabling it to move millions of workers from subsistence farming to better paying, more productive factory work. But it also contributed to the crisis. China needed to put its excess savings somewhere, and the United States needed the money. So China put a huge chunk of its money into Treasurys, keeping the United States' long-term interest rates artificially low, fueling the housing bubble.

Eventually, China will want to abandon this system. By roping its currency to the dollar it has outsourced much of its monetary policy to the United States. China's economy may need higher interest rates than America's but raising interest rates may suck in speculative capital, blowing up property prices and threatening financial instability, inflation, or both.

The American Dollar: The World's Problem One of the rewards for the United States for emerging as the economic superpower after the Second World War was its dollar became the place where global central banks liked to park their spare cash. At the end of 2009, the world's central banks held $8 trillion in reserves between them and 60 percent were in dollars, insofar as could be determined.

The U.S. Treasury bond market is to the world what money market mutual funds are to ordinary investors: a safe, dull place to store cash you need in a hurry.

.The dollar owes its reserve-currency status first to the United States' leading share of the global economy. Most countries in the world do business with the United States. International trade is routinely priced in dollars even when an American isn't in on the transaction. The United States' legal and political stability means anyone with dollars is pretty sure the country that printed them will still exist when the time comes to spend them.

The dollar will lose this status one day as the United States' share of global GDP shrinks. But for now there are no realistic rivals. Because of China's capital controls, the yuan is mostly useful for buying stuff from China. For a central bank to keep its reserves in yuan would be like you keeping your savings in frequent flyer miles. As for the euro, are you sure that if you own a 10-year Greek euro bond, Greece won't have abandoned the euro 10 years from now-and repay you in drachmas?

Thus, the U.S. Treasury bond market is to the world what money market mutual funds are to ordinary investors: a safe, dull place to store cash you need in a hurry. This gives the United States what Valery Giscard d'Estaing, then the French finance minister, in 1965 called the exorbitant privilege exorbitant privilege of borrowing astronomical sums in its own currency. If the dollar depreciates, the lender has a problem, not the United States, a point Nixon's Treasury Secretary made in 1971 to the great irritation of the Europeans. of borrowing astronomical sums in its own currency. If the dollar depreciates, the lender has a problem, not the United States, a point Nixon's Treasury Secretary made in 1971 to the great irritation of the Europeans.

Of course, being inundated with preapproved credit cards also seems like an exorbitant privilege until the credit card bill arrives. At some point, the United States may wish the world hadn't let it borrow quite so easily. All that foreign debt has costs, and not just the interest bill that foreigners send us every year. There are political implications, as well.

After Britain and France seized the Suez Ca.n.a.l in 1956, the United States threatened to dump Britain's bonds, driving down the pound, if its forces didn't withdraw. Britain complied. Who knows? Maybe China will do to the United States what the United States did to Britain. In other words, if one day China takes a dislike to American foreign policy it may threaten to dump Treasurys, which would perhaps drive up American interest rates. Skeptics note that by hurting its biggest customer this would also hurt China. But then countries routinely put national security ahead of economic expedience: it's why the United States embargoes Cuba. This "balance of financial terror," as Larry Summers called it in a speech in 2004, should keep someone at the Pentagon awake at night.5 Into the Weeds We measure a country's dealings with the rest of the world with the balance of payments, balance of payments, which has two sides: the which has two sides: the current account current account and the and the capital account. capital account. The The current account current account includes money we send to foreigners for services rendered: imports and exports of goods like oil and cars and services like tourism, investment income such as interest on bonds and profits that corporate subsidiaries send back to the head office, and transfers, such as money immigrants send home. includes money we send to foreigners for services rendered: imports and exports of goods like oil and cars and services like tourism, investment income such as interest on bonds and profits that corporate subsidiaries send back to the head office, and transfers, such as money immigrants send home.

Betting on currencies is best left for those with more money than pride.

.A country that runs a $10 current account deficit must finance it by attracting a net $10 worth of capital, that is, it must run a capital account capital account surplus of exactly the same size. Conversely, a country with a current account surplus has to lend to another country or buy its a.s.sets. surplus of exactly the same size. Conversely, a country with a current account surplus has to lend to another country or buy its a.s.sets.

Each quarter, the Bureau of Economic a.n.a.lysis releases the balance of payments that provides a snapshot of global capital movements. (See Table 7.1 Table 7.1.) It includes the current account and its components, and the capital account: how much flowed into and out of the country in the form of stocks, bonds, direct investment, and so on. The two are supposed to equal, but seldom do. ( Just to confuse you further, these official government statistics refer to the capital account as the financial account. financial account.) Table 7.1 The International Ledger: The Balance of Payments, 2009 The International Ledger: The Balance of Payments, 2009 Source: U.S. Bureau of Economic a.n.a.lysis U.S. Bureau of Economic a.n.a.lysis

The Bottom Line * Global capital markets let investors diversify their portfolios and borrowers choose from different sources of capital. There's a downside, though: Investors' savings may be battered by events in far off countries, while companies and countries can abruptly have their access to capital cut off.* Currencies over time reflect their purchasing power and thus countries' inflation. But in the short run, economic growth, interest rates, and current and capital account balances drive currencies, sometimes violently.* The United States borrows cheaply abroad in great part because foreign central banks like to hold dollars: they're safe, easy to convert to other currencies, and backed by a strong, stable country.

Chapter Eight.

All the President' s Men They Don't Control the Economy But They Sure Do Try PRESIDENTS LIVE or die by the economy. If you tracked public disapproval of the president against the unemployment rate, you'd see they move closely together. Unfortunately, being held responsible for the economy isn't the same as being able to do something about it. Economic growth is the product of countless unorchestrated actions by business, consumers, innovators, investors, and government at home and abroad. A president may get a change in taxes or spending through Congress, but the effect on growth is often fleeting and hard to detect. The government agency with the most immediate, tangible influence on the economy, the Federal Reserve, is also the one the president is least able to push around.

Republicans and Democrats argue incessantly about who's better for economic growth, with Republicans preaching the mantra of small government and low taxes and Democrats the elixir of enlightened management of the economy. Who's right? According to a 2006 study by Elliot Parker at the University of Nevada, Reno, the economy has grown faster under Democratic than under Republican presidents since 1929. It's hard to say why, though, because a president's policies may not show results for years, and then, not the intended ones.

For instance, the inflation that Gerald Ford and Jimmy Carter struggled with began with mistakes by their predecessors, Lyndon Johnson and Richard Nixon. The deregulation often attributed to Ronald Reagan actually began under Carter. The Internet revolution that buoyed the economy in Clinton's last years in office could be traced to the Defense Department's development of a communications network in the 1960s that could survive a nuclear attack. And who's to blame for the financial crisis that made the last years of George W. Bush's presidency and the first of Barack Obama's so miserable? You'd have to finger a litany of disconnected regulatory and political decisions stretching back two and a half decades.

Still, presidential decisions do matter for individuals, companies, and industries, and if done right, they can help the economy grow faster and spread the fruits of that growth to more people.

Presidents populate their administrations with economic experts whose influence depends on their personal rapport with the president and the president's willingness to listen.

The Company Presidents Keep The president implements economic policy both through his own decisions, aided by a network of advisors and government departments, and through the people he appoints to run regulatory agencies.

Presidents populate their administrations with economic experts whose influence depends on their personal rapport with the president and the president's willingness to listen. Inevitably, the economic advisors compete to be heard with political advisors, Congress and the president's own predispositions, and they often don't win. The economic experts themselves may disagree. When the little-known economist, George Warren, persuaded Franklin D. Roosevelt to take the United States off the gold standard, another adviser called it "the end of western civilization." History, however, shows that Warren was right.

With a staff of 25, the National Economic Council is one of Washington's smallest economic agencies yet potentially its most powerful.

.Of the numerous agencies that give the president economic advice, four are key.1. National Economic Council (NEC). National Economic Council (NEC). With a staff of 25, the National Economic Council is one of Washington's smallest, yet most powerful economic agencies. Bill Clinton created the NEC in 1993 and named Robert Rubin as its first director. From a warren of offices in the West Wing of the White House, the NEC filters the economic advice that pours in from the rest of the administration and presents its findings and recommendations to the president. Yet, other advisers still have channels to the president. The NEC is supposed to be an impartial broker between Treasury, the Office of Management and Budget (OMB) and other economic agencies. In practice, though, the NEC director often has strong views of his own and may be at odds with other agencies, as Larry Lindsey was as George W. Bush's NEC director and Larry Summers occasionally is as Obama's. With a staff of 25, the National Economic Council is one of Washington's smallest, yet most powerful economic agencies. Bill Clinton created the NEC in 1993 and named Robert Rubin as its first director. From a warren of offices in the West Wing of the White House, the NEC filters the economic advice that pours in from the rest of the administration and presents its findings and recommendations to the president. Yet, other advisers still have channels to the president. The NEC is supposed to be an impartial broker between Treasury, the Office of Management and Budget (OMB) and other economic agencies. In practice, though, the NEC director often has strong views of his own and may be at odds with other agencies, as Larry Lindsey was as George W. Bush's NEC director and Larry Summers occasionally is as Obama's.2. The Office of Management and Budget (OMB). The Office of Management and Budget (OMB). The Office of Management and Budget develops the president's fiscal and budget policy. The OMB director's job boils down to finding a way to fit a gigantic expanse of budget requests into the straitjacket of projected tax revenue. This means both weighing in on high profile initiatives and screening government agencies' many mundane budget requests. The Office of Management and Budget develops the president's fiscal and budget policy. The OMB director's job boils down to finding a way to fit a gigantic expanse of budget requests into the straitjacket of projected tax revenue. This means both weighing in on high profile initiatives and screening government agencies' many mundane budget requests.One of the OMB director's main jobs is to say no to the constant demands for more spending or lower taxes from Congress and other agencies. The Wall Street Journal Wall Street Journal once reported that to warn off supplicants, Mitch Daniels, George W. Bush's first budget director, tried unsuccessfully to have his telephone's hold music changed to play the Rolling Stones' "You can't always get what you want." But, the fact remains: Budget directors are routinely overruled by political priorities. During Bush's first six years, including Daniels' tenure, spending galloped ahead without so much as a veto. Peter Orszag, Obama's first budget director, kept Obama's health reform from adding to projected deficits but made little progress halting the upward spiral of health costs. once reported that to warn off supplicants, Mitch Daniels, George W. Bush's first budget director, tried unsuccessfully to have his telephone's hold music changed to play the Rolling Stones' "You can't always get what you want." But, the fact remains: Budget directors are routinely overruled by political priorities. During Bush's first six years, including Daniels' tenure, spending galloped ahead without so much as a veto. Peter Orszag, Obama's first budget director, kept Obama's health reform from adding to projected deficits but made little progress halting the upward spiral of health costs.

The OMB also screens the regulations issued by other federal agencies, from the Environmental Protection Agency to the Food and Drug Administration. If it thinks a regulation is poorly formulated or justified, it can send it back. The OMB also oversees the nuts and bolts of how the government and the civil service are run.

3. Council of Economic Advisers (CEA). Council of Economic Advisers (CEA). The Council of Economic Advisers is the president's in-house think tank. It is a creature of the Employment Act of 1946 and that era's utopian belief that good economics can produce better government. The CEA is peopled mostly by itinerant economists plucked from academia or think tanks for two- to four-year stints. The council's three members, one of whom is chairman, have included some of the country's best-known economists, including James Tobin, Burton Malkiel, Alan Greenspan, Joseph Stiglitz, and Ben Bernanke. It is a nonpartisan rite of pa.s.sage for many of the country's most promising economists. Paul Krugman and Larry Summers, though both Democrats, worked for Martin Feldstein, the Republican chairman of Reagan's CEA. The Council of Economic Advisers is the president's in-house think tank. It is a creature of the Employment Act of 1946 and that era's utopian belief that good economics can produce better government. The CEA is peopled mostly by itinerant economists plucked from academia or think tanks for two- to four-year stints. The council's three members, one of whom is chairman, have included some of the country's best-known economists, including James Tobin, Burton Malkiel, Alan Greenspan, Joseph Stiglitz, and Ben Bernanke. It is a nonpartisan rite of pa.s.sage for many of the country's most promising economists. Paul Krugman and Larry Summers, though both Democrats, worked for Martin Feldstein, the Republican chairman of Reagan's CEA.The CEA is supposed to give the president expert economic opinion, no matter how discomforting. When Christina Romer, Obama's first CEA chairman, briefed him on horrible job numbers before either had taken office, Obama replied, "It's not your fault-yet." It's also supposed to stop bad ideas from seeing the light of day. As with all government agencies, though, the CEA's influence primarily depends on how much the president values it. John F. Kennedy put great faith in the opinions of his CEA chairman, Walter h.e.l.ler. On the other hand, Feldstein's harping about the deficit made him so unpopular in the White House that Reagan's Treasury Secretary Donald Regan once recommended that Feldstein's annual economic report be thrown in the garbage.

4. The Treasury. The Treasury. Created in Congress' first session in 1789, the Treasury is the oldest and arguably most prestigious federal department and the only one with its own tunnel to the White House. Secretaries of the Treasury have always been among the most prominent cabinet members, starting with the first, Alexander Hamilton. The Treasury's formal responsibilities are quite prosaic: It collects taxes and manages the national debt. Created in Congress' first session in 1789, the Treasury is the oldest and arguably most prestigious federal department and the only one with its own tunnel to the White House. Secretaries of the Treasury have always been among the most prominent cabinet members, starting with the first, Alexander Hamilton. The Treasury's formal responsibilities are quite prosaic: It collects taxes and manages the national debt.Informally, the Treasury Secretary's main job is chief economic spokesman of the administration and indeed the country. His actual influence varies. He may be a major architect of economic policy or he may mostly recite White House talking points..

Most federal regulators are independent but their actions still reflect the inclinations of the political appointees who run them.

.However, in the compet.i.tion for the president's ear, the Treasury Secretary has formidable advantages: a gigantic staff of experts and desk officers and a rolodex of finance ministers and central bankers from around the world. The world's budget directors have no equivalent to the regular confabs finance ministers hold around the world. The Treasury Secretary is official spokesman on the dollar, and traders cling to his words like burrs to his clothes.

The Long Arms of the Law The president's economic advisors are the public face of his economic policy. Yet many of the most momentous economic decisions emerge from regulatory agencies. There are some 50 such agencies from the National Labor Relations Board to the Office of Pipeline Safety. Most are independent in that they enforce rules defined in law rather than follow the dictates of the president or Congress, but how they interpret the law reflects the inclinations of the people who run the agencies and the politicians who appoint them.

For the economy, the most important regulators are those overseeing the financial system since they can determine how freely and safely credit flows. U.S. bank regulation is ridiculously complicated. Some banks are state chartered and some are federally chartered. Some are, technically, thrifts (or savings-and-loans) inst.i.tutions. Finally, most banks are owned by holding companies that might have lots of other subsidiaries that aren't banks.

This has resulted in a sprawling collection of regulators, including: * The Federal Reserve. The Federal Reserve. As the big dog of economic regulators, it regulates bank holding companies like Citigroup Inc. and J.P. Morgan Chase & Co. and state-chartered banks that are members of the Federal Reserve System. As the big dog of economic regulators, it regulates bank holding companies like Citigroup Inc. and J.P. Morgan Chase & Co. and state-chartered banks that are members of the Federal Reserve System.* The Office of the Comptroller of the Currency The Office of the Comptroller of the Currency (OCC). (OCC). Regulates nationally chartered banks, which includes most of the biggest banks, like Citibank. Regulates nationally chartered banks, which includes most of the biggest banks, like Citibank.* The Office of Thrift Supervision. The Office of Thrift Supervision. Regulates thrifts (also known as savings-and-loans). Regulates thrifts (also known as savings-and-loans).* The Federal Deposit Insurance Corporation (FDIC). The Federal Deposit Insurance Corporation (FDIC). Regulates state-chartered banks that aren't part of the Federal Reserve system and runs the deposit insurance fund. Regulates state-chartered banks that aren't part of the Federal Reserve system and runs the deposit insurance fund.* State Banking Departments. State Banking Departments. Share the regulation of state-chartered banks with the Fed and the FDIC. Share the regulation of state-chartered banks with the Fed and the FDIC.Alongside these bank regulators, there are separate federal regulators for the markets.* The Securities and Exchange Commission (SEC). The Securities and Exchange Commission (SEC). Regulates securities brokers and dealers, mutual funds, and stock exchanges like the New York Stock Exchange and NASDAQ Stock Market. It also polices investment advisors, credit rating agencies, and any company whose shares trade on a stock market to ensure its financial statements comply with the law. Regulates securities brokers and dealers, mutual funds, and stock exchanges like the New York Stock Exchange and NASDAQ Stock Market. It also polices investment advisors, credit rating agencies, and any company whose shares trade on a stock market to ensure its financial statements comply with the law.* The Commodity Futures Trading Commission (CFTC). The Commodity Futures Trading Commission (CFTC). Regulates derivatives, such as futures contracts on corn, Eurodollars, and oil, and the exchanges on which they trade, like the Chicago Mercantile Exchange and the Intercontinental-Exchange. Regulates derivatives, such as futures contracts on corn, Eurodollars, and oil, and the exchanges on which they trade, like the Chicago Mercantile Exchange and the Intercontinental-Exchange.

To a visitor, this plethora of regulators is perplexing. Since banks all do much the same thing, why are there so many regulators? Why separate agencies for stock futures and stocks? Clearly, the number of regulators is not correlated with their efficacy. Citigroup has over 100 regulators in the United States alone and over 400 around the world. Yet Citi still took on huge amounts of risk it barely understood and received infusions of federal cash to prevent collapse.

The explanation is history and politics. Long ago these firms did distinctly different things. Though the distinctions have long since blurred, many firms prefer the regulator they know to one they don't. Cynics would say they prefer the regulator they can co-opt to the one they can't. Congress plays along. Because they oversee the CFTC, Congress' agricultural committees can hit up big financial companies for donations; if they let it merge with the SEC, all that money would go to the banking committees. Americans also like compet.i.tion among the regulated to extend to regulators on the theory it keeps any from getting too big and oppressive.

In 2010, Congress and Obama pa.s.sed a ma.s.sive financial overhaul. It will close the Office of Thrift Supervision and create the Consumer Financial Protection Bureau to take over bank regulators' jobs of writing and enforcing rules for credit cards, mortgages, and other consumer financial products. The Federal Reserve could regulate any big financial company even if it isn't a bank, if it thinks its failure could wreck the financial system. The FDIC could take over a big failing company even if wasn't a bank, pay off some of its creditors in hopes of preventing panic, and wind it down.

The federal government enforces the rules of the free market at home through compet.i.tion laws. Two agencies lead the effort: the Federal Trade Commission (FTC) and the Department of Justice through its Ant.i.trust Division. They enforce the Sherman Ant.i.trust Act of 1890, which prohibits anticompet.i.tive behavior and monopolies; the Clayton Act of 1914, which prohibits anticompet.i.tive mergers; and the Hart-Scott-Rodino Act of 1976, which requires mergers be scrutinized for compet.i.tive impact. While the two share many duties such as reviewing mergers and investigating anticompet.i.tive conduct, there are some differences. Only the Justice Department can bring criminal charges, and the FTC has broader power to investigate questionable business practices and consumer complaints.

The activity the FTC and the Justice Department investigate is usually confined to a company or market and includes things like cartelization, price-fixing, bid-rigging, and illegal monopoly. In theory, the ant.i.trust laws are nonpartisan but in practice, different administrations pursue these things differently. For example, Democrats are fonder of breaking up corporate monopolies or oligopolies in hopes of bringing down costs and fostering compet.i.tion, while Republicans are more likely to trust market forces to loosen any would-be monopolist's grip. Thus, the Clinton Administration pursued Microsoft for years for its alleged anticompet.i.tive behavior, but the Bush Administration settled the case with just a slap on the wrist.

Even though compet.i.tion policy is usually aimed at individual companies, it can have reverberations for the entire economy. The Department of Justice's long-running ant.i.trust suit against AT&T eventually resulted in the company's breakup into separate long distance and regional operating companies with major implications for the development of technologies and markets.

The globalization of business means ant.i.trust rulings increasingly reach across borders. In the last decade, the European Union's compet.i.tion commissioner has become a force to be reckoned with by U.S. companies; it killed General Electric's merger with Honeywell and kept up its investigation of Microsoft long after the United States dropped its own.

The Bottom Line * Presidents don't control the economy but they sure try. A president's economic agenda is dictated by ideology, but how it is implemented depends on the circle of economic advisers in the National Economic Council, the Treasury Department, the Office of Management and Budget, and the Council of Economic Advisers.* The president also exercises a lot of influence through his appointments to dozens of federal regulatory agencies. The bank regulators, for example, influence who gets credit and under what terms while the Justice Department and the Federal Trade Commission set the ground rules for business conduct and compet.i.tion.