Repressed memories

The difficulty of deciding how to invest during a time of financial repression

Feb 25th 2012               

SAVERS beware. Governments have huge deficits to fill and are worried about the fragile finances of banks and consumers. Policies are being designed to help borrowers, not creditors. A similar approach was followed after the second world war, when a period of “financial repressionreduced the debt burden by delivering poor returns to savers.

This effect can be achieved in a number of ways. Investors can be forced into holding bonds, either by law or by regulation. Current accounting rules, solvency requirements and liquidity provisions may have already done the trick for pension funds, insurance companies and banks, respectively.
An even simpler approach is for central banks to depress interest rates so that real returns to investors are negative. The Federal Reserve and the Bank of England have been very successful at achieving this feat over the past three years. Nominal rates are at record lows in both America and Britain.

Central banks have also held bond yields down, both directly and indirectly. The direct route is quantitative easing, which involves the purchase of government bonds from the private sector. But bond yields also in part represent the market’s forecast for the future level of short-term rates. By indicating that short-term rates will stay low until the end of 2014, the Fed is also having an effect on medium-term bond yields.

All this means that the risk-reward ratio for holding government bonds looks pretty skewed. Towers Watson, a consultancy which advises many a pension fund, rates government bonds as “highly unattractive” at current levels.

At best, bond investors will earn modest returns in a Japanese-style stagnation. At worst, governments might opt for outright default: note that this week’s Greek restructuring has been designed to punish private-sector creditors, leaving official creditors untouched. Even default by the world’s largest economy is no longer unthinkable. In a series of papers for the Mercatus Centre at George Mason University in Washington, DC, Jeffrey Rogers Hummel and Arnold Kling argue that the American government will eventually default, if only because politicians will never agree on a serious deficit-cutting programme.

Financial repression would chart a middle course through these outcomes, in which the real value of holdings in government bonds was steadily eroded by inflation. The same would be true for cash. So what would be the right asset to hold in such an era?

The temptation is to think that equities are the answer. After all, many analysts think shares look cheap relative to government bonds. Dividend yields are almost as high as bond yields (in some places they are higher), and equities also offer the prospect of income growth. Since equities are a claim on corporate revenues, surely they ought to be a hedge against inflation risk?

But Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, writing in Credit Suisse’s latestGlobal Investment Returns Yearbook”, find that equity returns were negatively correlated with rising prices. Worse still, equities perform badly in periods of high inflation, and governments will need quite a lot of inflation if they are really to erode their debt burdens. Messrs Marsh, Dimson and Staunton calculate that if you divide annual inflation rates into quintiles, real equity returns in the years with the highest inflation averaged –1.7%. Real equity returns in the lowest quintile for inflation were 11.7% a year.

Just as surprisingly, perhaps, the professors find that returns from commercial property and residential housing are also negatively correlated with inflation. The only asset class they could find with a positive correlation was gold but the long-term real return of gold has been just 1% a year, barely better than cash. Inflation-linked bonds also offer protection but their current real yields are very low or even negative.

If the prospects seem bleak for savers, there is at least some good news. The post-war period of financial repression occurred under the Bretton Woods system of fixed exchange rates, which was marked by tight capital controls. It was very hard to escape the squeeze.

Now savers have the freedom of the globe and there are plenty of countries where real interest rates are positive and growth prospects are more attractive than in the developed world. There are risks in these places, of course, but they need to be set against the certainty that rich-world central banks are trying to make savers lose out.

February 26, 2012 7:49 pm

The US tax system needs rebuilding

Matt Kenyon TAX illustration

Whoever wins this year’s US election, the combined effect of three events – the expiry of former president George W. Bush’s tax cuts, a renewal of the legally binding limit on federal borrowing and the start of a Congressionally mandated sequester, a mechanism that will automatically cut domestic spending from 2013 – will force the president and Congress to engage deeply with fiscal issues. The decisions made will do much to determine the country’s future.

For many observers, the central question in debates over deficit reduction is what can be done about entitlements. Growth in spending associated with an ageing population will be the major factor fuelling the growth of federal spending.


The rising number of retirees to workers means that Social Security benefits at the current ratio to wages and salaries will not be sustainable without some kind of tax increase. Sooner or later revenues will have to rise or outlays will have to be curtailed.

But it is the trajectory of healthcare costs that will be the single most important determinant of the budgetary picture. While almost everyone agrees on the desirability of containing federal spending, achieving this is likely to be more difficult than many suppose.

Certainly, some beneficiaries can bear more of the cost of their government insurance. There are also steps such as malpractice reform and the further encouragement of preventative medicine that should be taken. Yet without intrusions into the private healthcare system that are unlikely to be politically acceptable, there are severe limits on what can be done to curb federal health spending.

The consequence of not acting, however, will be unacceptable reductions in the availability of care for the clients of federal programmes. And given all the uncertainties associated with new technologies, changing lifestyles and ongoing changes in the private system, healthcare reform will and should be a continuing project.

Less discussed in the context of major deficit reduction is tax reform. For a variety of reasons, 2013 should be the year when the tax code is overhauled in a substantial way.

First, the US will need to mobilise more revenue. This year, the federal government will collect less than 16 per cent of gross domestic product in taxesfar below the post-second world war average.

The reality is that the combination of an ageing society, rising healthcare costs, debt service costs that will skyrocket whenever interest rates normalise, a still dangerous world in which our allies defence spending is falling even as that of potential adversaries rises rapidly, and a growing fraction of the population unable to hold steady work means that, in all likelihood, federal spending will need to be larger relative to GDP in the future.

Increasing marginal corporate rates or increasing individual rates beyond their Clinton-era level raises serious questions about incentive effects or the encouragement of shelter activities. It is in any event unlikely to be politically feasible.

A much better strategy for raising revenue would start from the premise adopted by the Simpson-Bowles bipartisan commission: that tax expenditures are a form of government expenditure and presumptively should be cut back unless they can be justified in the current environment.

Second, the current tax system is in certain ways manifestly unfair at a time of rising inequality. As is well recognised, America’s rich have become richer with the share of income going to the top 1 per cent increasing from about 10 per cent to about 20 per cent over the last generation while middle class incomes have stagnated.

There is plenty of room for discussion about the causes of this growing gap, the extent to which reducing inequality should be a central objective of government policy and the possible disincentive effects of excessively progressive taxes. But it is undeniable that certain fairly expensive aspects of the current tax system favour the most fortunate and border on the indefensible. Recent political debates, for example, have highlighted loopholes that permit a few to accumulate tens of millions of dollars in a tax-free individual retirement account (IRA) when almost everyone else is constrained by a $2,000 contribution limit.

Can the observation that Ireland, Bermuda and Luxembourg are three of the five jurisdictions where the US corporate sector earned the most profits reflect anything other than rampant tax sheltering? Anyone who doubts this should ponder the fact that in 2007, US corporate profits in Bermuda totalled 646 per cent of Bermuda’s GDP. The treatment of profit incentives paid to investment operators who do not use their own money but simply receive the “carry” as they invest other people’s money is another example of an inappropriate provision.

These examples, and the many more that could be adduced, are significant not only because of revenue the US Treasury could recoup while also making the tax system fairer. They also point to the power of special interests to shape fundamental aspects of economic policy. Reform could be an important step towards rebuilding confidence in the federal government that is sorely lacking today.

Third, even while raising too little revenue and giving much away to various shelter efforts, the current tax system places an excessive burden on economic activity. Corporate rates in jurisdictions at the very high end of the world range encourage businesses to manage their affairs in order to minimise reported US profitsusing devices such as transfer pricing – and support the use of debt rather than equity finance. Employers who know that their workers face high tax rates endeavour to find ways of providing compensation in the form of tax-free perquisites, rather than money income. High marginal rates on individuals, along with a substantial capital gains differential, encourages them to devote a disproportionate amount of time that could be better spent to the problem of converting ordinary income into capital gains.

While the US tax code is altered frequently, serious reform is no more than a once in a generation occurrence. The last serious tax reform effort took place in 1986, so another is long overdue. The Simpson-Bowles proposal for eliminating all tax expenditures and radically reducing tax rates provides an excellent starting point for discussion.

The delicate question is how Washington should prepare for serious tax reform during what is likely to be a unique window of opportunity in late 2012-2013. The timing is essential both because of all the deficit reduction activity and because spending side reforms will have a much more difficult time becoming reality if the revenue side is not addressed as well.

It is tempting to say presidential candidates should put forward their tax reform proposals in detail and allow voters to choose. But this is unlikely to work. The more tax issues are discussed during the campaign, the more the candidates will be driven to make pledges about the things they will never dopledges that might make tax reform that much more difficult.

So, here is an alternative. Leaders in both parties should commit themselves to the goal of tax reform for growth, fairness and deficit reduction. They should acknowledge that every tax expenditure or special break has to be on the table. They should ensure their staffs are compiling a large inventory of options. The relevant Congressional committees should take testimony from experts of all persuasions. And then, right after the election, the negotiations should begin. Nothing that is likely to be done during the next presidential term will be more important.

The writer is Charles W. Eliot university professor at Harvard University and a former US Treasury Secretary

Copyright The Financial Times Limited 2012

Lost economic time

The Proust index

Advanced economies have gone backwards by a decade as a result of the crisis

Feb 25th 2012

NOW almost five years old, the economic crisis rumbles on. In order to assess how much economic progress it has undone, The Economist has constructed a measure of lost time for hard-hit countries. It shows that Greece’s economic clock has been turned back furthest: it has been rewound by over 12 years. Elsewhere in the euro area, Ireland, Italy, Portugal and Spain have lost seven years or more. Britain, the first country forced to rescue a credit-crunched bank, has lost eight years. America, where the trouble started, has lost ten (see left-hand chart).

Our clock uses seven indicators of economic health, which fall into three broad categories. Household wealth and its main components, financial-asset prices and property prices, are in the first group. Measures of annual output and private consumption are in the second category. Real wages and unemployment make up the third. A simple average of how much time has been lost in each of these categories produces our overall measure.

Stockmarkets give some of the starkest results. American equities lost a quarter of their value in the month after the collapse of Lehman Brothers in September 2008. Shares are an important component of households’ pension-fund wealth, and in that month alone five years of gains were eradicated. The main indices have improved markedly since then: the S&P 500 is back to around 90% of its peak value. But they were at these levels back in the late 1990s, too, so some investors will have made no capital gains in 13 years. Greek stocks were higher in 1992 than today: 20 years have been wiped away.

Recent performance is actually quite good from a historical perspective: five years on from both Wall Street’s 1929 crash and Japan’s 1989 asset bust, equities were at just 50% of their peak values in real terms. But history also offers a warning: it took 25 years for American stocks to regain their 1929 highs and Japanese stocks have never made it back to their peak.

House prices have gone backwards, too. The average American homeowner is living in 2001, judging by inflation-adjusted property values. Britain has suffered less dramatic drops in house prices, but has still lost seven years. The costs of this lost time are huge: British households’ property wealth, in today’s prices, is around £500 billion ($785 billion) short of its peak; American households have lost a whopping $9.2 trillion.

How quickly economies make up lost time will depend on where they have ceded ground. Some indicators may bounce back quickly: share prices are forward-looking measures of expected returns that are constantly being reassessed. Just as they can crash down they can jump back up, boosting wealth.

Other indicators are more sluggish. Measures of output tend to crawl, not jump. One such measure, nominal GDP, is a vital metric of governments’ debt sustainability. Since debts are set at past values, growth and inflation tend to make the burden of borrowing more manageable; a shrinking economy makes the problem worse. There are 14 countries that have gone back in time, according to the nominal GDP indicator. This group includes eight members of the European Union, all of which have to repay their debts from an eroded tax base. Portugal and Spain have been sucked back to 2008 on this measure; Ireland was richer in 2006.

A different measure of GDP is needed to see how well consumers are doing. Inflation needs to be stripped out since it is higher output, not higher prices, that make people better off. Population growth also needs to be taken into account, since living standards are best measured on a per-person basis. Measured by real GDP per person a third of the 184 countries the IMF collects data for are poorer than they were in 2007. These 61 countries have each lost at least five years.

The type and location of the economies still underwater on this measure are striking (see right chart). The EU has done very badly: 22 of its 27 members have lost time. Of the G7 group of large economies, only Germany has not gone backwards. The Caribbean and eastern Europe also have their fair share of submerged countries. Asia has performed much more strongly.

Our labour-market indicators provide more estimates of lost time. The OECD, a think-tank, publishes wage data for 25 rich countries. In ten of them real wages were lower in 2010 than previously, with four years lost on average by those that went backwards. Workers in Greece and Hungary had lost six years, with pay below its 2004 level.

Unlike income and GDP, there is no reason why unemployment statistics should improve year on year. But many advanced countries had managed to reduce joblessness to new lows in the years before 2007. The crisis blew all those gains away. In America the unemployment rate stands at 8.3% of the labour force, its 1983 level. In Britain it is at its worst for 17 years. In the euro area job prospects diverge hugely: unemployment is falling in Germany but Greece, Ireland and Portugal have joblessness rates not seen since the early 1990s (see bottom chart).

These measures are the most worrying of all. Growth will reset the economic clock, providing new jobs and the resources to pay down debts. The IMF predicts that in three years Italy will be the only G7 country with real GDP lower than in 2007. Within this group, America, which is already growing again, is in a better position than Britain, which is not. But periods of unemployment scar workers even after economies have crawled back to health. For some, the time lost to the crisis will never be recovered.

What To Expect in the Final Week Of February for Precious Metals, Gold Stocks ; Oil & Dollar

February 27th, 2012 at 8:45 am

This morning we are seeing the US Dollar index move higher retesting a short term breakdown resistance level. What this means is that the dollar fell below support and is not slowing drifting back up to test the breakdown level. As we all know once a support level is broken it then becomes resistance. So if that holds true with the current move in the dollar we should see stocks and commodities find a short term bottom and continue higher today or tomorrow from the looks of things.

Gold has been pulling back the past couple trading session on light volume which healthy price action. It has done the opposite of what the dollar did above. Gold broke through a key resistance level and is slowly drifting back down to test the breakout level to see if it is support. If so then gold should continue higher in the coming days.

Both silver and gold miner stocks are lagging he price of gold. They have yet to break through their key resistance levels. That being said it could happen any day now as they have both been flirting with that level for a couple trading sessions now.

Crude oil continues to hold up strong and is headed straight for its key resistance levels without any real pullback. Chasing price action like this is not something do often because risk: reward is not in your favor. I am staying on the sidelines for oil until I see a setup that has more potential and less risk.

The equities market remains in a strong uptrend at this time. I do feel a 1-3 weeks pause/pullback could take place at any time but in the grand scheme of things we could be only half way through this runaway stock market rally as noted in the video.

The equities market is going to gap down this morning which is typical in a bull market. Remember, in an uptrend the stock market tends to gap lower at the open and close higher into the close. And it’s the opposite in a down trend with stocks gapping higher and sell off through the trading session.

Watch my detailed video analysis for this week: http://www.thetechnicaltraders.com/ETF-trading-videos/

Chris Vermeulen