The Tea Party tsunami and US fiscal deadlock

Alan Greenspan

January 3, 2012

The failure of the “Super Committeelast year to reach a budget deal underscored the underlying wedge in US politics. The distribution of the electorate through most of the post-1945 years has been a dominant centre, slightly to the left or right of centre. This enabled legislative compromises to be reached with relative ease.

But a political tsunami has emerged out of our past in the form of the Tea Party, with its ethos reminiscent of rugged individualism and self-reliance. That was a dominant force for over a century, but has faded since the New Deal. The Tea Party has yet to obtain sufficient traction to forge majorities for new legislation. But its influence beyond its numerical strength has created an effective veto of new legislation before the current heavily Republican House of Representatives. It has so altered the distribution of votes within Republican Party’s House caucus that the party’s centre has moved closer to the Tea Party. Moreover, the heavy House Democratic losses of moderates in 2010 shifted the centre of gravity of their caucus to the left.

This has created something of a bimodal distribution leaving a much diminished centre. The Senate, although less affected by the 2010 election has not been immune from this shift. The days of Senators Pat Moynihan, Bob Dole, and Lloyd Bentsen seem a long time ago.

The emerging fight over the future of the welfare state, a paradigm without serious political challenge in eight decades, is accentuating the centre’s decline. The welfare state has run up against a brick wall of economic reality and fiscal book-keeping.

Congress, having enacted increases in entitlements without visible means of funding them, is on the brink of stalemate. As studies by the International Monetary Fund have demonstrated, trying to solve significant budget deficits predominantly by raising taxes has tended to foster decline.
Contractions have also occurred where spending was cut as well, but to a far smaller extent.

The only viable long-term solution appears to be a shift in federal entitlements programmes to defined contribution status. The assets of private defined benefit pension plans, confronted with the same economic forces, have already fallen from 67 per cent of private pension plans at the end of 1984 to 37 per cent at the end of last September. But the political problems of such a switch can be seen in state and local governments’ attempt to trim public defined pension plans. Public sector unions have fought mightily to avoid having their pensions shrink, as they have in the private sector.

Cutting back on benefits that are “entitled” is going to be a far harder political task than curbing federal discretionary spending. We have created a level of entitlements that will require a greater share of real resources to fulfill than the economy seems likely to be able to supply. Not only is the labour force starting to lose its most productive workers (the baby boomer generation) to retirement, but the generations scheduled to replace it will be the same individuals who in 1995, shocked us by scoring so poorly on maths and science in international competitions.

America’s students had slipped badly after a long tenure at the top of the global educational ladder. The cohort of people aged 25 and younger is suffering the consequences in lower earnings and productivity when compared to earlier generations.

Fortunately the statistical weight of the erosion in overall productivity growth is still quite small, but it will mount if our education system does not improve and we don’t increase immigration quotas of skilled workers.

With rising concerns about income inequalities, it is a disgrace that these quotas are protecting upper income groups from competition. Such a slowdown in productivity growth will create, with slowed population growth, Professor Gordon of Northwestern University says, “the slowest 20-year rise in real per capita GDP in American history”.

I do not pretend to be able to forecast how this will turn out, but we face a true revolution, not so much in the streets but in the fundamental choices we will have to make to secure our fiscal future. Arithmetic demands it.

The writer was chairman of the US Federal Reserve

The Decline and Fall of the Euro?

Daniel Gros


BRUSSELS – Great empires rarely succumb to outside attacks. But they often crumble under the weight of internal dissent. This vulnerability seems to apply to the eurozone as well.

Key macroeconomic indicators do not suggest any problem for the eurozone as a whole. On the contrary, it has a balanced current account, which means that it has enough resources to solve its own public-finance problems. In this respect, the eurozone compares favorably with other large currency areas, such as the United States or, closer to home, the United Kingdom, which run external deficits and thus depend on continuing inflows of capital.

In terms of fiscal policy, too, the eurozone average is comparatively strong. It has a much lower fiscal deficit than the US (4% of GDP for the eurozone, compared to almost 10% for the US).

Debasement of the currency is another sign of weakness that often precedes decline and breakup. But, again, this is not the case for the eurozone, where the inflation rate remains low – and below that of the US and the UK. Moreover, there is no significant danger of an increase, as wage demands remain depressed and the European Central Bank will face little pressure to finance deficits, which are low and projected to disappear over the next few years. Refinancing government debt is not inflationary, as it creates no new purchasing power. The ECB is merely a “central counterparty” between risk-averse German savers and the Italian government.

Much has been written about Europe’s sluggish growth, but the record is actually not so bad. Over the last decade, per capita growth in the US and the eurozone has been almost exactly the same.

Given this relative strength in the eurozone’s fundamentals, it is far too early to write off the euro. But the crisis has been going from bad to worse, as Europe’s policymakers seem boundlessly capable of making a mess out of the situation.

The problem is the internal distribution of savings and financial investments: although the eurozone has enough savings to finance all of the deficits, some countries struggle, because savings no longer flow across borders. There is an excess of savings north of the Alps, but northern European savers do not want to finance southern countries like Italy, Spain, and Greece.

That is why the risk premia on Italian and other southern European debt remain at 450-500 basis points, and why, at the same time, the German government can issue short-term securities at essentially zero rates. The reluctance of Northern European savers to invest in the euro periphery is the root of the problem.

So, how will northern Europe’sinvestors strikeend?

The German position seems to be that financial markets will finance Italy at acceptable rates if and when its policies are credible. If Italy’s borrowing costs remain stubbornly high, the only solution is to try harder.

The Italian position could be characterized as follows: “We are trying as hard as humanly possible to eliminate our deficit, but we have a debt-rollover problem.”

The German government could, of course, take care of the problem if it were willing to guarantee all Italian, Spanish, and other debt. But it is understandably reluctant to take such an enormous risk – even though it is, of course, taking a big risk by not guaranteeing southern European governments’ debt.

The ECB could solve the problem by acting as buyer of last resort for all of the debt shunned by financial markets. But it, too, is understandably reluctant to assume the risk – and it is this standoff that has unnerved markets and endangered the euro’s viability.

Managing a debt overhang has always been one of the toughest challenges for policymakers. In antiquity, the conflicts between creditors and debtors often turned violent, as the alternative to debt relief was slavery. In today’s Europe, the conflict between creditors and debtors takes a more civilized form, seen only in European Council resolutions and internal ECB discussions.

But it remains an unresolved conflict. If the euro fails as a result, it will not be because no solution was possible, but because policymakers would not do what was necessary.

The euro’s long-run survival requires the correct mix of adjustment by debtors, debt forgiveness where this is not enough, and bridge financing to convince nervous financial markets that the debtors will have the time needed for adjustment to work. The resources are there. Europe needs the political will to mobilize them.

Daniel Gros is Director of the Center for European Policy Studies.

January 3, 2012 8:12 pm

The 2012 recovery: handle with care

What does 2012 hold in store for the world economy? Let us start by looking at the battered high-income countries. Is there a good reason to expect healthy recoveries? Not really. The outcome in the eurozone might be a disaster that spreads around the world. Even the US recovery is likely to be fragile. The shadow cast by events before 2007 passes slowly.

The December consensus of forecasts is gloomy (see chart). The most recent views on likely growth this year are far below those expected a year ago. This is particularly true for the eurozone, which is expected to fall into recession. The economies of Italy and Spain are expected to contract, while France and Germany are expected to produce negligible growth. The UK is forecast to be in the same state as the eurozone's two largest members.

Only Japan and the US are forecast to show anything close to reasonable economic growth this year. In the case of the US, growth was forecast at 2.1 per cent in December, up from 1.9 per cent in November.
Click to enlarge

Let us put this performance in context. In the third quarter of 2011, Canada was the only member of the Group of Seven leading high-income countries whose gross domestic product was much above its pre-crisis peak (see chart).

The US and German economies were marginally above their pre-crisis peaks, while France was marginally below it. The UK, Japan and Italy were still far below their pre-crisis peaks. Recovery? What recovery?

Yet the highest interest rate now applied by the four most important central banks is the European Central Bank’s only 1 per cent. The balance sheets of these central banks have also expanded dramatically. Moreover, between 2006 and 2013, the ratio of gross public debt to GDP will jump by 56 percentage points in the UK, 55 points in Japan, 48 points in the US and 33 points in France. Why have such drastic policy actions brought forth such modest results?

On this ideologically charged debates rage. The dominant theoretical paradigm holds that a financial crisis cannot happen and cannot matter if it does happen, at least provided broad money is not allowed to collapse. In this view, the only things now holding economies back are structural rigidities and policy-induced uncertainties. This is, in my view, a fairy story, based on theories that reduce capitalism to a barter economy under a thin monetary veil.

Far more persuasive, to me, are views that accept that people make important mistakes. The big divide is between those – the Austrians – who hold that the mistakes are made by governments while the solution is to let the distorted financial edifice collapse and those – the post-Keynesianswho hold that a modern economy is inherently unstable, while letting it collapse would take us back to the 1930s. I am decidedly in the latter camp.

In his prescient 1986 masterpiece, Stabilizing an Unstable Economy, the late Hyman Minsky laid out his financial instability hypothesis. Janet Yellen, vice-chair of the US Federal Reserve, remarked in 2009 that “with the financial world in turmoil, Minsky’s work has become required reading”.

What makes his work compelling is that it ties investment decisions oriented to an inherently uncertain future to the balance sheets that finance them and so to the financial system. In Minsky’s view, leverage – and so fragility – are determined by the economic cycle. A lengthy period of tranquillity will raise fragility: people will underestimate dangers and overestimate opportunities. Minsky would have warned that the “great moderation” contained seeds of its own destruction.

The years before 2007 saw an extraordinary private credit cycle, notably in the US, UK and Spain, backed by rising prices of housing. The bursting of these bubbles led to an explosion of fiscal deficits, largely automatically, as Minsky foretold.

This was one of the three policy mechanisms that prevented collapse into a great depression, the others being the financial and monetary interventions. Economies are still struggling with the post-collapse adjustment. With interest rates close to zero, fiscal deficits of creditworthy sovereigns offer three forms of help – to demand, to deleveraging and to raising the quality of private assets.

How far then has the deleveraging proceeded? In the US, quite a long way. By the third quarter of 2011 the ratio of financial sector gross debt to GDP was where it was in 2001 and the ratio of household debt to GDP was where it was in 2003 (see chart). Furthermore, notes Goldman Sachs: “We believe that housing starts have probably bottomed already, while nominal house prices are likely to bottom in the course of 2012.” The US is now set for recovery, albeit one limited by the premature fiscal tightening, ongoing deleveraging, risks in the eurozone and, perhaps, higher oil prices. Recovery will also be built on what is still an unbalanced economy.

Yet the fragility of the eurozone is far greater. The Organisation for Economic Co-operation and Development forecasts a reduction in the underlying fiscal deficit of the eurozone by 1.4 per cent of GDP between 2011 and 2012, against just 0.2 per cent of GDP in the US. Yet the big danger for the eurozone’s weaker economies is that public and private sectors will seek to retrench simultaneously.

This is a recipe for deep and prolonged slumps. The uncreditworthy sovereigns are trapped in a probably doomed effort to tighten their fiscal positions in the absence of adequate private sector and external offsets. For these countries, a eurozone-wide recession is a calamity: it must greatly hinder the external adjustment they need. Against this background, the ECB’s offer of cheap three-year financing of banks that might relend to battered sovereigns is little more than a palliative clever, but inadequate.

The high-income countries have been running a series of fascinating experiments. One was with financial sector deregulation and housing-led growth. It failed. Another was with a strongly interventionist response to the financial crisis of 2008. It worked, more or less. Yet another is with post-crisis deleveraging and a return to more normal fiscal and monetary settings. The jury is out on this effort. In the eurozone, however, this shift to fiscal austerity is running alongside a still bigger experiment: the construction of a currency union around a structurally mercantilist core among countries with negligible fiscal solidarity, fragile banking systems, inflexible economies and divergent competitiveness. Good luck for 2012. Everybody will need it.

Copyright The Financial Times Limited 2012.

Jan. 2, 2012, 12:01 a.m. EST

Gold bugs’ unmerry Christmas

Commentary: But radical bugs say they know why

.By Peter Brimelow, MarketWatch


NEW YORK (MarketWatch) — Santa brought the gold bugs quite a present last week. It was very big and extremely nasty. But maybe they can send it back.

From the previous Friday’s close to the low on Thursday, the CME February gold contract /quotes/zigman/656382 GC2G -0.11% plunged $82.10 or 5.1%. The gold shares, as tracked by the NYSE Arca Gold Bugs Index /quotes/zigman/6015494 XX:HUI +4.71% , were down 6.6% at their worst.

Recoveries into the week’s end enabled gold to finish down only 2.44% and the HUI down 2.54%. But by then, no doubt, most gold bulls were disgustedly drowning their sorrows.

This was the reverse of what was supposed to happen. Thus, on the Friday before Christmas, the Japanese bullion dealer Mitsui remarked: “The gold price has gone up during the period between Christmas and New Year in 8 of the last 9 years (2004 being the exception), by just over 2% on average. If this trend continues, gold would stand around $1,650 by the year’s end.”

Gold had in fact staged a nice $70 rally from the beating it took earlier in the month — a possibility that veteran gold bugs anticipated. ( See Dec. 19, 2011, column. )

What happened? The group I like to call the “radical gold bugs” (because they make not merely the traditional inflation argument, but also claim gold’s price has long been artificially repressed by public and private interests) cried foul, of course.

For example, Thursday’s remarks at the website Jesse’s Café Americain referring to “…this obvious bear raid on the paper precious-metals market over past four weeks. One has to be a bit naive or disingenuous to ignore the blatant bombing of the market with large numbers of contracts for sale during thinly traded markets. This is the not the sort of trading that a profit-seeking trader would do.”

Greeks fear 2012 will be even worse than 2011

Greeks fear 2012 will be worse than 2011 as their debt-laden country enters its fifth year of recession. With soaring unemployment and further cuts expected to wages and pensions, the mood is bleak

What now? The technical damage, of course, is tremendous. Chartist Martin Pring says in his weekly: “Gold has now completed this upward sloping head-and-shoulders top and re-confirmed the break by tracing out a new low. [Momentum measures] are getting oversold, and we may see a bounce.

However, I think precious metals are in a primary bear market, and that is probably where we should keep our focus.”

Pring may be right about gold’s being oversold. On Thursday, MarketVane’s Bullish Consensus for gold fell to 56%, the lowest since Dec. 5, 2008. The lowest reading in that tumultuous year was 49% a couple of weeks earlier, so this really is extreme.

An influential observer noted this. On Friday, The Gartman Letter (TGL) said: “We did not expect to see gold hold as well as it has or did in the past 24 hours, and we were not prepared yesterday to issue buying orders as soon as we shall be doing so. We’ve been neutral of since mid-November. We are about to become bullish once again. ... This is a warning.”

TGL sold its large gold holdings earlier this month in its perhaps best-timed gold exit ever. Although widely denigrated by gold bugs (it’s mutual), TGL actually has a pretty good gold purchase record.

Another equally surprising bullish voice was raised on Friday by analyst Frank Veneroso, reporting on

He said: “I think what we may be seeing right now is a bunch of traders trying to break a multi-year trend line in gold during the thinnest trading of the year in order to hit stops.”

“I have a hunch that some big central banks who are under-positioned in gold are buying into this break.”

Veneroso has an important place in gold history for conceptualizing, in the 1990s, the importance of Eastern physical demand to the gold price, then a new factor. But for several years he has dismayed gold enthusiasts by ignoring the metal.

On Friday, however, he concluded forcefully: “If my hunch is right, after the current year-end chart-manipulation games, and with the turn of the year, gold will rise sharply in price.”