Central banks

Crazy aunt on the loose

For central bankers in the rich world, unconventional is the new conventional

Jan 7th 2012

THERE was a time when the Federal Reserve wouldn’t say whether it had changed interest rates. Soon it will say where it thinks rates will be years from now. Beginning with its policy meeting on January 24th-25th, Fed officials will disclose when they expect to start raising their short-term interest-rate target, which is at near-zero now, and what they expect its path to be over the coming years.
Behind such radical transparency is a grim fact: at the start of a fourth successive year of extraordinarily low short-term rates and a still-moribund economy, the Fed is desperate for new ways to stimulate demand.

Central banks have never been comfortable with unconventional monetary policies such as verbal interest-rate commitments and quantitative easing (QE), the purchase of assets by printing money. Alan Blinder, a Princeton economist and former Fed official, has likened them to a family that lets its crazy aunt out of the closet only on special occasions. QE is “best kept in the locker markedFor Emergency Use Only”, is how Charlie Bean, the Bank of England’s deputy governor, put it in 2010.

The unconventional, however, is now conventional. In a presentation to this year’s annual meeting of the American Economic Association, Mr Blinder will argue that the circumstanceslow inflation and low nominal interest rates, persistent excess capacity, and fiscal policy paralysed by large debts—that have forced central banks to operate through unconventional policy will be a recurring feature of the economic landscape. “We can’t stuff the crazy aunt back in the closet,” he says.

How long could she stay out? In Japan, interest rates have been near zero almost continuously since 1999. Since then the Bank of Japan has bought government and corporate bonds, commercial paper, exchange-traded funds and real-estate investment trusts. Last year it offered targeted loans to spur long-term investment and rebuild areas damaged by the earthquake and tsunami. Such measures have prevented a deeper recession but not deflation or stagnant employment.

That outcome is not yet likely in Western countries. But 2012 will nonetheless require more unconventional policy. The Fed’s decision to include interest rates in its quarterly projections of key economic indicators, announced this week, emulates central banks in New Zealand, Norway and Sweden.

But whereas this trio sought transparency for its own sake, the Fed’s main motivation is practical. It has been saying since August that it would hold rates near zero at least until mid-2013. Its new projections should persuade investors to expect no tightening before 2014, thereby nudging down long-term rates.

Whether the stimulative impact will be sufficient is another matter. In November Fed officials thought the economy would grow between 2.5% and 2.9% in 2012. The private sector projects growth of just 2%. The Fed may yet be proven right, given the upbeat tone of recent data. But if it is not, it will probably launch another round of QE, on top of its two previous rounds and “Operation Twist,” under which it swapped short-term for long-term bonds.

A similar sort of dynamic is at work in Britain, where the Bank of England’s most recent forecast was for growth of 1.2% in 2012. As in America, private-sector forecasts are gloomier as recession in Europe and austerity at home bite. The bank is likely soon to resume QE.

Most eyes are on the ECB. It has bought government bonds reluctantly and lent to banks enthusiastically, and portrayed both actions as ways of restoring liquidity to the financial system so that monetary policy can work, not as monetary policy itself. Yet now that it is lending huge sums to euro-zone banks for up to three years, this distinction is becoming meaningless. The idea is for banks to use this money to buy peripheral government debt; to lend more to households and business; or to reduce the amount of debt that they must refinance.

In all instances that would raise the price and lower the yields on government or private debt, which is how QE is supposed to work. Asked recently if the ECB was conducting QE, Mario Draghi, the bank’s president, sidestepped the question: “Each jurisdiction has not only its own rules, but also its own vocabulary.”

The ECB could yet explicitly embrace QE if it saw inflation falling short of its goal of just below 2%. Elga Bartsch of Morgan Stanley thinks that could happen this year. The ECB already expects inflation of only 1.5% in 2013 and that number could drop as the bank brings its growth projections into line with the gloomier private consensus. Ms Bartsch thinks the ECB will cut its policy rate to 0.5% from 1% now in the first half of the year, about as low as it can go for technical reasons. Asset purchases would be the next logical step.

The question is: which assets? Mr Blinder notes QE can work by narrowing the spread between long-term and short-term rates or between private and government rates. The first is best conducted by purchasing government debt, the second by purchasing private debt.

The Bank of England has stuck firmly to the first route, leaving it to the Treasury to extend credit to the private sector. The Fed has done a bit of both by purchasing federally-backed mortgage bonds as well as Treasuries, but avoided purchases of private assets because of legal and political constraints.

The ECB is in the opposite position to the Fed: circumscribed in its ability to fund governments but at liberty to buy private debt. Although expanded purchases of peripheral government bonds would be more effective, Ms Bartsch therefore reckons the bank is likely first to conduct QE through expanded purchases of private debt such as bank and corporate bonds (assuming its three-year loans to banks prove ineffective at expanding credit).
It could also purchase bonds of all euro-zone governments, in the process relieving pressure on struggling peripheral sovereigns.

Whatever central bankers do, they cannot repair problems best fixed by politicians, such as America’s incoherent fiscal policy or Europe’s fractured institutions. Asked about the ECB’s aggressive new lending to banks, Masaaki Shirakawa, the governor of the Bank of Japan, said it could “buy time”. But he warned it could backfire if politicians fritter away whatever time the central bank has bought. Unfortunately, that risk is never low.

After America

How does the world look in an age of U.S. decline? Dangerously unstable.


JAN/FEB 2012

Not so long ago, a high-ranking Chinese official, who obviously had concluded that America's decline and China's rise were both inevitable, noted in a burst of candor to a senior U.S. official: "But, please, let America not decline too quickly." Although the inevitability of the Chinese leader's expectation is still far from certain, he was right to be cautious when looking forward to America's demise.

For if America falters, the world is unlikely to be dominated by a single preeminent successor -- not even China. International uncertainty, increased tension among global competitors, and even outright chaos would be far more likely outcomes.

While a sudden, massive crisis of the American system -- for instance, another financial crisis -- would produce a fast-moving chain reaction leading to global political and economic disorder, a steady drift by America into increasingly pervasive decay or endlessly widening warfare with Islam would be unlikely to produce, even by 2025, an effective global successor. No single power will be ready by then to exercise the role that the world, upon the fall of the Soviet Union in 1991, expected the United States to play: the leader of a new, globally cooperative world order. More probable would be a protracted phase of rather inconclusive realignments of both global and regional power, with no grand winners and many more losers, in a setting of international uncertainty and even of potentially fatal risks to global well-being. Rather than a world where dreams of democracy flourish, a Hobbesian world of enhanced national security based on varying fusions of authoritarianism, nationalism, and religion could ensue.   

The leaders of the world's second-rank powers, among them India, Japan, Russia, and some European countries, are already assessing the potential impact of U.S. decline on their respective national interests. The Japanese, fearful of an assertive China dominating the Asian mainland, may be thinking of closer links with Europe. Leaders in India and Japan may be considering closer political and even military cooperation in case America falters and China rises. Russia, while perhaps engaging in wishful thinking (even schadenfreude) about America's uncertain prospects, will almost certainly have its eye on the independent states of the former Soviet Union.

Europe, not yet cohesive, would likely be pulled in several directions: Germany and Italy toward Russia because of commercial interests, France and insecure Central Europe in favor of a politically tighter European Union, and Britain toward manipulating a balance within the EU while preserving its special relationship with a declining United States. Others may move more rapidly to carve out their own regional spheres: Turkey in the area of the old Ottoman Empire, Brazil in the Southern Hemisphere, and so forth. None of these countries, however, will have the requisite combination of economic, financial, technological, and military power even to consider inheriting America's leading role.

China, invariably mentioned as America's prospective successor, has an impressive imperial lineage and a strategic tradition of carefully calibrated patience, both of which have been critical to its overwhelmingly successful, several-thousand-year-long history. China thus prudently accepts the existing international system, even if it does not view the prevailing hierarchy as permanent. It recognizes that success depends not on the system's dramatic collapse but on its evolution toward a gradual redistribution of power. Moreover, the basic reality is that China is not yet ready to assume in full America's role in the world.

Beijing's leaders themselves have repeatedly emphasized that on every important measure of development, wealth, and power, China will still be a modernizing and developing state several decades from now, significantly behind not only the United States but also Europe and Japan in the major per capita indices of modernity and national power. Accordingly, Chinese leaders have been restrained in laying any overt claims to global leadership.

At some stage, however, a more assertive Chinese nationalism could arise and damage China's international interests. A swaggering, nationalistic Beijing would unintentionally mobilize a powerful regional coalition against itself. None of China's key neighbors -- India, Japan, and Russia -- is ready to acknowledge China's entitlement to America's place on the global totem pole.

They might even seek support from a waning America to offset an overly assertive China. The resulting regional scramble could become intense, especially given the similar nationalistic tendencies among China's neighbors. A phase of acute international tension in Asia could ensue. Asia of the 21st century could then begin to resemble Europe of the 20th century -- violent and bloodthirsty.

At the same time, the security of a number of weaker states located geographically next to major regional powers also depends on the international status quo reinforced by America's global preeminence -- and would be made significantly more vulnerable in proportion to America's decline. The states in that exposed position -- including Georgia, Taiwan, South Korea, Belarus, Ukraine, Afghanistan, Pakistan, Israel, and the greater Middle East -- are today's geopolitical equivalents of nature's most endangered species. Their fates are closely tied to the nature of the international environment left behind by a waning America, be it ordered and restrained or, much more likely, self-serving and expansionist.

A faltering United States could also find its strategic partnership with Mexico in jeopardy. America's economic resilience and political stability have so far mitigated many of the challenges posed by such sensitive neighborhood issues as economic dependence, immigration, and the narcotics trade. A decline in American power, however, would likely undermine the health and good judgment of the U.S. economic and political systems. A waning United States would likely be more nationalistic, more defensive about its national identity, more paranoid about its homeland security, and less willing to sacrifice resources for the sake of others' development. The worsening of relations between a declining America and an internally troubled Mexico could even give rise to a particularly ominous phenomenon: the emergence, as a major issue in nationalistically aroused Mexican politics, of territorial claims justified by history and ignited by cross-border incidents.

Another consequence of American decline could be a corrosion of the generally cooperative management of the global commons -- shared interests such as sea lanes, space, cyberspace, and the environment, whose protection is imperative to the long-term growth of the global economy and the continuation of basic geopolitical stability. In almost every case, the potential absence of a constructive and influential U.S. role would fatally undermine the essential communality of the global commons because the superiority and ubiquity of American power creates order where there would normally be conflict.

None of this will necessarily come to pass. Nor is the concern that America's decline would generate global insecurity, endanger some vulnerable states, and produce a more troubled North American neighborhood an argument for U.S. global supremacy. In fact, the strategic complexities of the world in the 21st century make such supremacy unattainable. But those dreaming today of America's collapse would probably come to regret it. And as the world after America would be increasingly complicated and chaotic, it is imperative that the United States pursue a new, timely strategic vision for its foreign policy -- or start bracing itself for a dangerous slide into global turmoil.

Markets Insight

Last updated: January 5, 2012 6:32 pm

Meddling in credit swaps poses sizeable stability risks

The costs of credit protection on the big US banks have come down from their peak levels five weeks ago, reflecting the belief that the probability of a European meltdown, with all the contagion that would imply, has diminished.

That means concerns around the potential shocks that could come from the credit default swap market have also receded – at least temporarily. But the potential for future shocks is still there. 

Central bankers and analysts say they are convinced that there are no major financial institutions in the US that have sold massive amounts of protection on European sovereigns or on European banks with huge concentrated bets in the credit default swap market. In other words, they are convinced that there are no AIGs out thereinstitutions that have sold massive amounts of credit insurance without any offsetting positions or hedges on what was once highly rated debt.

But the fact is that more than three years after the AIG debacle nobody knows for sure. Trading remains opaque, an indication of how little progress has been made in making the market more transparent. That is ironic because part of the debacle with AIG was that AIG had actually disclosed its exposure in its financial statements – it was just that nobody had ever bothered to look at them.

Readers who bothered to do so would have learnt, for example, that in the second quarter of 2008, AIG had sold about $450bn in credit insurance.

Today, the best information on the CDS market comes from the Bank for International Settlements. That information, though stale, contains some interesting data points, nevertheless.

For example, Wall Street risk officers fret that there may be hedge funds that have such exposures. Indeed, hedge funds have sold over three times as much protection on sovereign risk$111bn – as they have bought, according to data from the BIS as of the end of June. Meanwhile American banks in aggregate have providedguarantees” of more than $500bn on all debts in the periphery countries of Greece, Portugal, Italy and Ireland, or three times their exposure, the BIS adds.

Still, the fear of another AIG is not the only fear hanging over the CDS market today. Recently, European regulators decided that private sector creditor losses on Greek sovereign debt in any restructuring should be voluntary, meaning that even a loss of 50 cents on the dollar wouldn’t trigger payments in the CDS market. That led some players to conclude that the rules of the game had changed in an effort to protect European banks or insurers that had sold protection and would lose money on that insurance.

The fear that CDS protection may prove worthless is already leading to unintended consequences in the real world. Since this Eurocrat ruling, the chief risk officer at one major Wall Street company says his organisation has concluded that the contracts are too risky and is either tearing them up or trying to trade out of them. But because the process is expensive and difficult to hedge this company is also shorting sovereign bond issues, driving down their value and contributing to eurozone jitters. And because those bonds are used as collateral in the interbank market, the ruling that CDS is not triggered in a “voluntaryrestructuring makes that collateral less valuable, which contributes in turn to pressures in the funding market and falling liquidity.

Weeks before the Russian default in 1998, senior executives at the former Donaldson, Lufkin & Jenrette became concerned about their exposure to the debt of that country and bought credit insurance from a myriad of counterparties, mostly Russian banks in an effort to protect the Wall Street company (now part of Credit Suisse) from the possibility that the government would renege on its debt. It didn’t work. The Russian government prohibited the Russian firms from honouring the claims of the foreign creditors and DLJ had to tear up the worthless insurance it held, nursing substantial losses.

“The European Central Bank balance sheet may have to grow by another €1tn to support sovereigns and undercapitalised, under-reserved banks,” noted JPMorgan’s Michael Cembalest in his Eye on the Markets publication earlier this week, adding that it is possible that many private investors will use that to sell European exposure to “non-economicbuyers.

After a grim start to December, which saw the iTraxx Europe index for financials widen more than 100 basis points in 10 days, the ECB calmed the markets with its three-year refinancing facility. But if regulators attempt to intervene with initiatives such as their proposal to make a Greek restructuringvoluntary”, they will become a bigger risk to stability than the markets themselves this year.

Copyright The Financial Times Limited 2012.

The world economy

Self-induced sluggishness

This year will probably be a pretty bad one for the world economy; it doesn’t have to be

Jan 7th 2012

POLITICIANS like to promise better times ahead. But these days many are peddling gloom. In her new year’s address, Angela Merkel, Germany’s chancellor, predicted that 2012 would be more difficult for the euro zone than 2011.

Nicolas Sarkozy, France’s president, spoke of “the year of all risks”. Half a world away, Manmohan Singh, India’s prime minister, warned Indians not to take fast growth for granted.

In one way this pessimism looks a little overdone. The worst outcomes—a collapse of Europe’s single currency or a hard landing in China—are avoidable. The latest crop of statistics, particularly better-than-expected figures on global manufacturing prospects, argue against a sudden slump.

America may do a bit better than forecast. The overall effect should be sluggish, not dire: global output may grow by 3%, the slowest since 2009 and well below the average of the past decade.

Begin with Europe, the weakest cog in the global engine. The euro zone has almost certainly already slipped into recession, which most forecasters expect to be short and shallow: a group of seers polled regularly by The Economist estimates that output will fall by 0.5% in 2012. The case for a mild downturn assumes that Europe’s policymakers, however haltingly, are on course to solve their debt crisis; that the European Central Bank (ECB) has reduced the risk of a debt calamity with its recent provision of three-year liquidity to banks; and that the impact of fiscal austerity on growth will be brief and modest.

Those hopes may be misplaced. Uncertainty about the euro zone’s future is still acute, not least because its politicians are more focused on preventing future profligacy than supporting embattled economies today. Despite the ECB’s liquidity injection, banks seem reluctant to buy many government bonds. And since Italy and Spain alone need to roll over €150 billion ($195 billion) of debt in the first three months of this year, the odds are that worries about sovereign debt will intensify.

A pernicious circle of weak growth, bigger deficits and more austerity is setting in. Look at Spain, where the new government revealed that the 2011 budget deficit would be worse than expected (8% of GDP rather than 6%) and immediately announced new spending cuts and tax increases to compensate. If these contractionary forces feed on themselves, Europe’s downturn could be ghastly.

Some emerging concerns

The euro zone is thus the darkest shadow hanging over the world economy; but it is not the only one. Emerging markets may stumble. China’s economy is clearly cooling. And even if, as seems likely, Beijing loosens macroeconomic policy deftly enough to prevent a sharp slowdown, growth this year is likely to be no more than 8%. Slower growth in China is dampening commodity prices, hitting exporters in Latin America. Add in some home-grown problems (India, for example, faces a big budget deficit, declining confidence and high inflation) and the ripple effects of the euro crisis (which will hit growth in eastern Europe and Turkey hard) and it is plausible that emerging economies will grow by only about 5%. That would be their weakest performance in a decade, aside from the global slump of 2009.

If there is a positive surprise, it is likely to come from the United States. That is not because growth there will soar, but because expectations for the world’s biggest economy are so low. The consensus among professional forecasters is that America’s GDP will grow by 2% in 2012, below its underlying speed limit, and far too slow to bring the jobless rate down.

That could prove a bit too gloomy. Unlike Europe, America has moderated the pace of its fiscal tightening, thanks to the temporary extension of the payroll-tax cut. Household-debt burdens have fallen, the housing market shows signs of stability and the labour market is showing flickers of life.

But America’s outlook, like Europe’s, is darkened by political uncertainty. The payroll-tax cut has only been extended for two months, ensuring that the rest of the year will be punctuated with fiscal skirmishes, even as nothing is done to deal with America’s medium-term fiscal mess, or to smooth the huge tax hikes and spending cuts that loom at the end of 2012 under current law. It is a recipe for crushing confidence and scaring off investors.

History teaches that financial crises are followed by years of weakness. But some of the current pain is unnecessary. There is no excuse for the lack of clarity around the euro zone’s future, nor for America’s fiscal paralysis.

Europeans do not need to compound the peripheral economies’ problems with even deeper austerity. A more calibrated approach with more financing and more structural reforms makes far more sense.

Inept politicians have placed a big burden on central banks, which will have to take more unconventional measures, such as quantitative easing.

That will ease the agony, but it won’t make up for politicians’ mistakes. It looks like 2012 will be the year of self-induced sluggishness.

January 5, 2012 7:50 pm

A Hungarian coup worthy of Putin

Ingram Pinn illlustration

You could say that Europe has crises enough without worrying too much about a Hungarian dissident turned petty tyrant. Hungary, after all, is not even a member of the euro. To overlook Viktor Orban’s journey from anti-communist progressive to populist xenophobe would, however, be to repeat a mistake made about Greece. The troubles of Europe’s small powers can be a harbinger of bigger dangers around the corner.

Hungary’s prime minister presents a reminder – should anyone on this continent need one – of the familiar trajectory from economic chaos to political authoritarianism. The European Union has had two grand projects since the fall of the Berlin Wall: the single currency and the advance of democracy eastwards.

The euro is now in serious trouble. Mr Orban sends a powerful message about the perils facing democracy.

This week saw the introduction of Mr Orban’s new constitution. Suffused with ethnic nationalism, it reeks of an ambition for one-party rule. It promises repression of personal freedoms within Hungary and, through an extension of citizenship to Hungarian minorities elsewhere, threatens instability in ethnically-diverse neighbours.

The constitution has to be seen alongside a slew of new basic laws and the gerrymandering of the electoral system. Together, they bestow inordinate power on the ruling Fidesz party. The prime minister can claim to have won the 2010 election fairly. Now he is deploying a two-thirds majority in parliament to deny opponents the same possibility.

The authority of the courts has been limited and the judiciary subjected to closer political supervision. The constitution asserts state control over personal conscience and faith. Abortion and same-sex marriages are outlawed and recognised religions limited.

Paradoxically for a politician so visceral in his hostility to post-Soviet Russia, Mr Orban’s version of democracy is one that would surely win plaudits from Vladimir Putin. Much as in Mr Putin’s Russia, the rule of law is subordinated to the entrenchment of one-party rule. As in Russia, Hungarians can still vote; citizens can protest and privately owned media can criticise Mr Orban. But this is faux democracy. State institutions, the courts and the national broadcaster are firmly in Fidesz hands.

Mr Orban’s supporters point to the economic chaos inherited from previous socialist administrations, which mixed manifest incompetence with corruption. But the prime minister has reached beyond any reasonable effort to create a stable backdrop for recovery. Autocrats do not draw legitimacy from the sins of democratic predecessors.

Mr Orban is a gifted politician. Ivan Krastev, the chairman of the Sofia-based Centre for Liberal Strategies and a leading central European scholar, describes him not so much as an ideologue as a “radical opportunist”. In moving from left to right across the political spectrum, Mr Orban has grabbed the chance to tap into Hungarian nationalism at a moment of crisis.

Some would-be autocrats, Mr Krastev notes, play to people’s hopes and aspirations. He mentions Turkey’s Recep Tayyip Erdogan in this respect. Others prefer to harness fear and prejudice. Mr Orban belongs to this second category. A go-it-alone economic strategybreaking loose from the EU and International Monetary Fund – has been drawn from the same nationalist playbook.

As things have turned out, his economic prescription has failed. Tax cuts have not brought down Hungary’s debt and deficits.

Government bonds have junk status. Foreign investors can no longer rely on the rule of law. For all Mr Orban’s blustering about negotiating with the IMF on his terms, Hungary is heading towards bankruptcy.

None of this makes Fidesz less dangerous. Centrist opposition parties have gained little from Mr Orban’s waning popularity. The ultra-right Jobbik party, with which Mr Orban has lately been flirting, has seen its support grow.

This week’s protests in Budapest, which saw many tens of thousands rally against the constitution, may have marked a change in this political dynamic. For the first time disparate opposition parties and civil society groups showed a united front.

The protesters, though, need leadership at home and support from abroad. If the west can call for political freedom in the Maghreb – or, for that matter, Belarus – it can surely do likewise in central Europe.

So far the response has been muted. True, the European Commission has said that future financial help will be conditional on the restoration of central bank independence. Hillary Clinton has voiced US misgivings about threats to individual freedoms. Tut-tutting is not enough, however.

A better start would be for other EU leaders to make public their dismay. Democracy is at the heart of Hungary’s bargain with the rest of the EU. Where are the tough statements from Angela Merkel, Nicolas Sarkozy and David Cameron? 

A second step would see Hungarian ministers shunned at EU meetings in Brussels. There is a fine line to be negotiated. The quarrel is with Mr Orban not the Hungarian people. But it should not be beyond the wit of European leaders to make clear this distinction.

Greece should have served as a warning signal for the eurozone. Hungary is now shining a light on the political risks of economic failure. The nationalist right is on the rise across much of Europe – from the “True Finns” to the Dutch Freedom party and France’s National Front. Countries with weaker, democratic traditions are especially vulnerable. Europe should know by now the perils of contagion.

Copyright The Financial Times Limited 2012.