Markets Insight

December 19, 2011 11:55 am

The ugly side of ultra-cheap money

By Bill Gross

Gresham’s law needs a corollary. Not only does “bad money drive out good,” but “cheapmoney may as well. Ultra low, zero-bounded central bank policy rates might in fact de-lever instead of relever the financial system, creating contraction instead of expansion in the real economy. Just as Newtonian physics breaks down and Einsteinian concepts prevail at the speed of light, so too might easy money policies fail to stimulate at the zero bound.


Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. Near zero policy rates and a series of “quantitative easings” have temporarily succeeded in keeping asset markets and real economies afloat in the US, Europe, and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health.

Importantly, Gresham’s corollary is not another name for “pushing on a string” or a “liquidity trap”. Both of these concepts depend significantly on perception of increasing risk in credit markets which in turn reduce the incentive of lenders to expand credit. Rates at the zero bound do something more. Zero-bound money credit quality asidecreates no incentive to expand it. Will Rogers once fondly said in the Depression that he was more concerned about the return of his money than the return on his money. But from a system wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may breakdown.

A good example would be the reversal of the money market fund business model where operating expenses make it perpetually unprofitable at current yields. As money market assets then decline, system wide leverage is reduced even if clients transfer holdings to banks, which themselves reinvest proceeds in Fed reserves as opposed to private market commercial paper.

Additionally, at the zero bound, banks no longer aggressively pursue deposits because of the difficulty in profiting from their deployment. It is one thing to pursue deposits that can be reinvested risk free at a term premium spreadtwo/three/even five year Treasuries being good examples. But when those front end Treasuries yield only 20 to 90 basis points, a bank’s expensive infrastructure reduces profit potential. It is no coincidence that tens of thousands of layoffs are occurring in the banking industry, and that branch expansion is reversing industry wide.

In the case of low yielding Treasuries the Gresham’s corollary at first blush seems illogical. If a bank can borrow at near 0 per cent then theoretically it should have no problem making a profit. What is important, however, is the flatness of the yield curve and its effect on lending across all credit markets.

Capitalism would not work well if Fed funds and 30-year Treasuries co-existed at the same yield, nor if commercial paper and 30-year corporates did as well. It is not only excessive debt levels, insolvency and liquidity trap considerations that delever both financial and real economic growth; it is the zero-bound nominal yield, the assumption that it will stay there for an “extended period of time” and the resultant flatness of yield curves which are the culprits.

Conceptually, when the financial system can no longer find outlets for the credit it creates, then it de-levers. The point should be understood from a yield as well as a credit risk point of view. When both yield and credit are at risk from the standpoint of “Gresham’s law,” the mix can be toxic. The recent example of MF Global emphasises the concept, as does the behaviour of depositors in some struggling European economies. If an investor has money on deposit with an investment bank/broker that not only appears to be at risk but returns nothing, then why maintain the deposit? Perhaps an investor would be more comfortable with a $100 bill at home in a mattress than a $100 bill on deposit with a brokerSecurities Investor Protection Corporation notwithstanding. If so, system wide delevering takes place as opposed to the credit extension historically necessary for an expanding economy.

Historical examples and central bank staff models will likely not validate this new Gresham’s corollary. Fed chairman Ben Bernanke blames policy rate increases in the midst of the 1930s for an economic relapse, and a lack of credit expansion for Japan’s lost decades 60 years later. But all central banks should commonsensically question whether ultra-cheap money continually creates expansions as opposed to destroying liquidity, delevering and obstructing recovery. Gresham as opposed to Keynes may become the applicable economist of this new day.

Bill Gross is founder and co-chief investment officer of Pimco

Copyright The Financial Times Limited 2011.

December 19, 2011 7:52 pm

Weaker euro will help solve Europe deficit woes

The large current account deficits of Italy, Spain and France can be reduced without lowering their incomes or requiring Germany to accept inflationary increases in its domestic demand. The key is to expand the net exports of those trade deficit countries to the world outside the eurozone.

Those current account imbalances are the result of imposing a single currency on 17 eurozone countries. If their exchange rates were free to vary, normal market pressures would cause the currencies of Italy, Spain and France to decline relative to Germany’s, stimulating exports and reducing their imports while also shrinking Germany’s trade surplus.

The politicians who planned the euro generally did not think about future current account imbalances or other economic problems. They wanted the euro as a means of accelerating political integration.

Although the exchange rates at which countries entered the eurozone were negotiated to avoid initial trade imbalances, different future rates of wage increase would inevitably lead to trade imbalances.

Those politicians and bureaucrats who recognised this problem believed that the single currency would somehow eliminate it by causing productivity trends to converge.


But convergence clearly has not happened. Productivity in Germany rose much faster than it did in Italy, Spain and France. Germany also placed limits on wage growth. Those two factors mean that labour costs in Germany’s tradable sector have risen some 30 per cent less since the start of the euro than labour costs and prices in those countries with slower productivity growth. The result is that Germany has a current account surplus of 5 per cent of gross domestic product while Italy, Spain and France each have current account deficits of about 3.5 per cent of GDP.

Some economists and officials in countries with trade deficits argue that Germany should expand to increase demand for their products and allow a faster rise in wages to reduce its trade advantage. Not surprisingly, Germany rejects these suggestions.

German officials and the European Central Bank argue that the trade deficit countries need an “internal devaluation” – ie, cutting wages and prices to make their products competitive. Estimates differ but many suggest this would require a 30 per cent wage cut followed by permanently slower wage growth than in Germany. This would mean a decade or more of high unemployment and declining GDP – an economically wasteful and politically dangerous strategy.

An alternative proposal might be to reduce consumer spending in countries with trade deficits, since each nation’s current account balance is the difference between its national saving and investment. But reduced consumer spending would just cause GDP to decline unless there was also a fall in the exchange rate to stimulate net exports – something precluded within the eurozone.

So this brings me to the action that can shrink the current account deficits of Italy, Spain and France without austerity, internal devaluations, or German expansionary policies. The solution is a lower value of the euro leading to an improved trade balance with countries outside the eurozone.

The overall trade-weighted value of the euro has already declined 12 per cent since the beginning of 2010. Although fundamental factors imply that the euro should eventually appreciate relative to the dollar(primarily because of overweight dollar positions of most sovereign wealth funds and large US current account deficit), concerns about the euro and the European economy more generally have caused the currency to decline relative to the dollar by 10 per cent in the past six months.

Further declines of the euro’s trade-weighted value would cause the exports of all eurozone countries to rise and the imports from outside the region to decline. More specifically, the lower value of the euro would help Italy, Spain and France because about 50 per cent of their imports and exports are with countries outside the eurozone. Germany’s export surplus would rise, giving Germany the opportunity to increase financial or real foreign investment or to increase domestic consumption.

It is not clear how much further the euro would have to fall to eliminate existing current account deficits, but it might take a trade-weighted decline of 20 per cent or more. That could imply a euro-dollar exchange rate below its initial value of $1.18 per euro.

What might cause such a substantial decline of the euro? The recent momentum alone might cause that to happen. So also could the ECB’s increased supply of euros to deal with credit and banking problems. Even statements by Mario Draghi, ECB president, expressing a lack of concern about the declining euro might cause the financial market to drive the currency lower.

A decline of the euro cannot be a permanent solution to differences in productivity trends within the eurozone. But it would give those countries time to improve productivity growth before the euro’s fundamental strength returned. If those relative improvements in productivity do not happen, there may be no choice but to end the eurozone as we know it today.

The writer is professor of economics at Harvard University and former chairman of the Council of Economic Advisers and President Ronald Reagan’s chief economic adviser

Copyright The Financial Times Limited 2011.

Austerity and the Modern Banker

Simon Johnson


WASHINGTON, DC – Santa Claus came early this year for four former executives of Washington Mutual (WaMu), a large US bank that failed in fall 2008. The Federal Deposit Insurance Corporation (FDIC) had brought a lawsuit against the four, actions that included taking huge financial risks while “knowing that the real estate market was in a ‘bubble.’” The FDIC sought to recover $900 million, but the executives have just settled for $64 million, almost all of which will be paid by their insurers; their out-of-pockets costs are estimated at just $400,000.

To be sure, the executives lost their jobs and now must drop claims for additional compensation. But, according to the FDIC, the four still earned more than $95 million from January 2005 through September 2008. So they are walking away with a great deal of cash. This is what happens when financial executives are compensated for “return on equityunadjusted for risk. The executives get the upside when things go well; when the downside risks materialize, they lose nothing (or close to it).

At the same time, their actions – and similar actions by other bankers – are directly responsible for both the run-up in housing prices and the damaging collapse that followed. That collapse has impacted non-bankers in many negative ways, including through the loss of more than eight million jobs.

It is also leading to austeritytaxes are increasing and government spending is falling at the local and state level around the country. A difficult fiscal conversation still lies ahead at the federal level, but cuts and contractions of various types seem likely.

Some people argue that Americans need to tighten their belts.
That’s an interesting discussion, particularly at a time with unemployment is still above 8% (with recent declines largely the result of many jobless workers’ decision to stop looking and drop out of the labor force altogether). Precipitate austerity is hardly likely to help the economy find its way back to higher employment levels.

But what about government support for the big banks? Is this contracting in the light of our current fiscal pressures? Unfortunately, it is not; much government support remains, implicitly through allowing banks to be “too big to fail,” and explicitly through various kinds of backing provided by the Federal Reserve.

The rationale – or perhaps we should call it ideology – behind supporting big banks is that they are needed for the economy to recover. But this position looks increasingly doubtful when the banks are sitting on piles of cash while creditworthy consumers and businesses are reluctant to borrow.

The same situation exists in Europe today, where the reality is even starker. Banks are receiving ever-larger bailouts, while countries that borrowed are cutting social programs and face rising social tensions and political instability as a result.

Countries like Greece, Italy, and arguably Portugal over-borrowed, and now their citizens face severe consequences. But the bankers face no consequences whatsoever for over-lending.

To be sure, some major European financial institutions may now face difficulties, and – who knows – perhaps some of their executives will end up being fired. But does anyone think that the people who ran European banks into the ground will leave their positions with anything less than considerable wealth? There is no real austeritynow or possibly in the future – for leading bank executives.
The protesters of “Occupy Albanyissued a powerful consensus statement recently, which reads in part:

“The interests of those who purchase influence are rewarded at the expense of the People, from whom the government’s just power is derived. We believe that this failure in our system is at the core of many interconnected issues we face as a society, and its resolution is key to a just future. We therefore demand true democracy, decoupled from the corrosive influence of concentrated economic power, and we call all who share in this common goal to stand with us and take action toward this end.”

Big banks represent the ultimate in concentrated economic power in today’s economies. They are able to resist all meaningful reform that could really change their compensation schemes. Their executives want to get all the upside while facing none of the true downside.

But capitalism without the prospect of failure is not any kind of market economy. We are running a large-scale, nontransparent, and dangerous government subsidy scheme for the benefit primarily of a very few, extremely wealthy people.

Jon Huntsman, a candidate for the Republican presidential nomination, is addressing this directly – insisting that we should force the largest banks to break up and to become safer. No other candidate for the presidency is seriously confronting this issue head-on: just sayingwe’ll let them fail” is no kind of answer when the failure of megabanks would cause so much damage.

We should learn from both the WaMu and the Occupy movement. In both cases, the lesson is the same: concentrated financial power is a gift that keeps on giving – but not to you.

Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog,, a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-author, with James Kwak, of 13 Bankers.


Emerging Markets’ Decade of Disruption

Javier Santiso


Over the past decade, emerging markets have become the global economy’s main growth engine. According to HSBC, 19 of today’s emerging-market countries will be among the world’s 30 largest economies in 2050, and they will be more important than the current OECD countries.

Emerging markets have already captured 40% of world GDP and 37% of global foreign direct investment. And, while OECD countries continue to stagnate in 2011, emerging markets are growing strongly. China this year jumped ahead of Japan as the world’s second-largest economy, while India attracted a record $80 billion in FDI, double that of 2010. Brazil’s Petrobras, already one of the world’s largest petroleum companies, had a record-setting $67 billion IPO last year.

These economies’ growing wealth is attracting a rising number of OECD multinationals. In Asia, the middle class now represents 60% of the total population (1.9 billion people). China became the world’s top car market in 2010. The world’s richest person is from Mexico. And rapid economic growth is occurring in an environment of small deficits, low debt, and controlled inflation.

But there is another, quieter revolution bringing companies from OECD countries to emerging markets: disruptive innovation. On one hand, emerging-market multinationals are excelling even in high-value-added and technology-intensive sectors; on the other hand, firms from OECD countries are increasingly re-importing innovation from emerging-market companies.

According to the United Nations, there are roughly 21,500 multinationals based in emerging markets. Some, such as the Mexican cement company Cemex, the Indian IT outsourcing firm Infosys, and the Chinese battery manufacturer BYD, are already leaders in their sectors. The main suppliers to the world’s telecoms companies are found in China, where Huawei is now head to head with Sweden’s Ericsson. In 2008, Huawei registered more patents than any other company in the world, and finished second to Japan’s Panasonic in 2009.

In the telecommunications sector, there are now a half-dozen emerging-market multinationals in the global top ten. Brazil’s Embraer revolutionized airplane manufacturing with a business model that others have imitated. India’s Tata sells cars for 75% less than its European competitors.

China’s Mindray has developed medical equipment at 10% of the cost of its Western competitors. Kenya’s Safaricom is transforming the market with its M-Pesa mobile-banking service, just as Indian outsourcing multinationals such as TCS and Wipro have done.

Even the digital world is being affected by emerging-market growth. Facebook could have been Latin American: one of its founders is Brazilian. The Chinese Internet group Tencent Holdings is the world’s third largest in terms of market capitalization ($45 billion in 2011). Its top financial shareholder is another emerging-market multinational, South Africa’s Naspers. The two companies invest in start-ups togethernot in California, like Google, but in emerging markets. In 2010, they invested $700 million in Russian Internet giant Russian Digital Sky Technologies (which owns is present in key US Internet start-ups such as Facebook, Zynga, and Groupon.

These emerging-market multinationals are not only disruptively innovative; they are also massively frugal, making them lethal competitors. And they are rapidly climbing the value chain: in 2010, [WA1] according to Booz & Company, South Korea’s Samsung became one of the world’s top ten companies in terms of R&D investment. Israel has launched more than 4,000 start-upsranking second in the world in the number of companies quoted on the NASDAQ.

As a result, reverse innovation by OECD multinationals is now common practice. Indeed, the OECD Fortune 500 multinationals now have nearly 100 R&D centers based in emerging markets, mainly in China and India. GE’s R&D center in India is the company’s biggest worldwide. Cisco spent a billion dollars on another one in India. Microsoft’s largest outside of the US is in Beijing. IBM now employs more people in India than in the US, and Germany’s Siemens has based 12% of its 30,000 R&D engineers in emerging Asia.

To grasp the speed of this global rebalancing, consider that in 1990, more than 95% of R&D was carried out in developed countries; a decade later, the developed countries’ share had dropped to 76%. Today, emerging markets account for 40% of the world’s researchers. As a report from UNESCO recently highlighted, China, which now spends more than $100 billion annually (2.5% of GDP) on R&D, is on the verge of surpassing the US and Europe in terms of the number of researchers. In 2010, 40% of all Chinese university students were studying for science or engineering degrees, more than double the share in the US.

Emerging-market countries will not only claim the lion’s share of global growth in the coming decade; they will also increasingly be the source of disruptive and frugal innovation. By 2020, the geography of innovation, in addition to that of the wealth of nations, will have undergone a massive rebalancing process.

Javier Santiso is Professor of Economics at ESADE Business School and Director of the ESADE Center for Global Economy and Geopolitics (ESADEgeo).

Copyright: Project Syndicate, 2011.

December 20, 2011 6:32 pm

US oil boom town prompts crude glut fears

Oil pipelines
Crude estimates: one company sends a helicopter above the Cushing complex to gauge inventory levels, another uses a satellite

The boom in North American oil production has triggered a race to expand the US’s main oil storage centre, raising concerns among some industry executives of potential glut in capacity.

By next year, the capacity of tanks around Cushing, an Oklahoma town that calls itself the pipeline crossroads of the world, will equal to nearly a day’s of global oil production as refineries, trading houses, Wall Street banks and pipeline companies build or lease hundreds of thousands of barrels of new tanks.

Climbing US and Canadian oil production and price patterns that have made it profitable to store oil underline the building boom in this remote town of 7,800. The town has seen the arrival of an army of workers from welders to tank inspectors in X-ray trucks. With apartments fully occupied, oil workers are living in temporary trailer parks.

New construction will raise the hub’s tank capacity to a record 79m barrels by the end of next year, up nearly a fifth from this year and and 2½ times from 2006, according to consultants Lipow Oil Associates. Cushing is the delivery point for US oil futures and, thus, the most crucial point in the country’s oil trading.

But the race is raising concerns about overbuilding, which could hurt conservative investors. Several tank owners are structured as master limited partnerships, an increasingly popular option for investors seeking steady yields.

“It’s hard for me to rationalise why you’d build any more,” said James Dyer, chief executive of Blueknight Energy Partners, with 6.4m barrels of capacity at Cushing.

Lease rates may come under pressure as capacity grows, hitting the profitability of master limited partnerships. Rose Rock Midstream, which is building tanks, said average rates are down from 2010. Andy Lipow of Lipow Oil Associates said every tank in Cushing had been rented, but added: “The question is: as tankage comes up for renewal, what is the new lease rate going to be?” The worry about an overbuild is not mainstream, however. Some executives see growing demand for storage as North American oil output continues to increase.

Pete Schwiering, president of SemCrude, which operates Rose Rock, said: “There’s still demand out there. I think there will continue to be as we see this boom in domestic production coming online. You’re going to need tanks.”

Mike Mears, head of Magellan Midstream Partners, which leases tanks in Cushing to BP and others, added: “Is this a short-term phenomenon? We don’t think it is.”

Oil stocks at Cushing were earlier this month at 31.2m barrels, suggesting that half of the tanks were empty. Yet, new pipelines, such as the projected Keystone XL linking Canada with Cushing, could bring more oil to the hub.

Copyright The Financial Times Limited 2011