Pausing for breath
The rally in risk assets is running out of steam
Mar 10th 2012

IT IS known as the “reflation trade”. The theory is that rich-world central banks will do whatever it takes to revive their economies, even if that means tolerating a period of above-target inflation. As a result, investors feel an incentive to buyreal assets”, those linked to nominal economic growth (notably equities) or to rising prices (commodities).

From October 4th to March 1st, the MSCI World equity index rose by 21.4% and the S&P GSCI commodity index rose by 23.8%, vigorous rallies by any standard. Bullish sentiment was driven by a sense that quantitative easing (QE), the creation of money to buy assets like government bonds, had become a competitive sport.

America and Britain had been in the vanguard but in September the Swiss central bank pledged to create sufficient money to peg the franc against the euro; and in February the Bank of Japan added {Yen}10 trillion ($128 billion) to its asset-purchase programme and unveiled a target inflation rate of 1%. For its part the European Central Bank has lent more than €1 trillion ($1.3 trillion) in three–year loans to banks, in what is widely seen as a case of QE by the back door.
But the reflation trade took a bit of a dent on February 29th when Ben Bernanke, the Federal Reserve’s chairman, gave no hint of a third round of QE in testimony to Congress. Admittedly, there was a bullish underpinning to Mr Bernanke’s speech: a better performance by the American economy means there is less need for further action. Nevertheless, the Fed is seen as “pump-primer in chief” by many in the markets. Gold fell by $100 an ounce after Mr Bernanke’s statement.

A setback was probably inevitable after such a strong rally. A bigger question, however, is whether the rationale behind the reflation trade makes any sense.

Central banks have undoubtedly expanded their balance-sheets during the crisis. Back in 2008 the monetary base of the euro zone (in effect notes and coins plus reserves held at the region’s central banks) was around 10% of GDP; the equivalent figures for the Federal Reserve and the Bank of England were in the 4-6% range. Now the monetary base in all three places is between 16% and 18% of GDP.


However, expansion of the monetary base does not necessarily lead to growth in broad money, which measures the supply of credit to businesses and consumers and which ultimately drives inflation. Money-supply growth still looks sluggish in Britain, Japan and the euro zone (see chart). Only in America does it look robust.

The problem is that many banks remain unwilling to extend credit given the need, among other things, to shore up their capital. Figures show that total euro-zone lending to households and non-financial firms has declined in recent months, despite the ECB’s actions. Dhaval Joshi of BCA Research says that “banks have destroyed money just as fast as the ECB has created it.” Jennifer McKeown of Capital Economics concludes from the data that “bank lending remains extremely weak, suggesting that a lack of credit will continue to hold back economic activity.”

In short, the reflation trade may be based on a false premise. The rally may well have been driven by a lifting of the intense economic gloom that enveloped the markets in the autumn of 2011 and a sense that the European authorities had removed the immediate threat of a banking collapse, while simultaneously halting the rapid rise in Italian and Spanish government-bond yields. But now that investors have paused for breath, they can see that the economic outlook is still pretty murky. On March 5th, for example, China lowered its growth target to 7.5%; survey data on activity in the euro area’s services sector were also weaker than expected.

Furthermore, the markets are starting to lose a key source of support. As the global economy emerged from recession in 2009, profit margins surged thanks to falls in borrowing costs and weak wage growth. But European profits are down by 7% compared with the previous year, according to HSBC. Even in America, which is doing rather better, Bank of America Merrill Lynch is expecting corporate profits for S&P 500 companies to grow by just 6.4% in 2012, down from 14.8% last year.

It all looks remarkably like 2011, when an early-year rally also ran out of steam. So long as the yields on other assets like bonds and cash are so low, it is hard for stockmarkets to collapse. But those yields are so low because central banks are frightened about the economic outlook. That makes it very hard for a bull run to be sustained.

The Age of Authoritarian Democracy

Sergei Karaganov


MOSCOW – The world is currently being shaken by tectonic changes almost too numerous to count: the ongoing economic crisis is accelerating the degradation of international governance and supranational institutions, and both are occurring alongside a massive shift of economic and political power to Asia. Less than a quarter-century after Francis Fukuyama declared “the end of history,” we seem to have arrived at the dawn of a new age of social and geopolitical upheaval.

Dramatically, the Arab world has been swept by a revolutionary spring, though one that is rapidly becoming a chilly winter. Indeed, for the most part, the new regimes are combining the old authoritarianism with Islamism, resulting in further social stagnation, resentment, and instability.

Even more remarkable, however, are the social (and antisocial) grassroots demonstrations that are mushrooming in affluent Western societies. These protests have two major causes.

First, social inequality has grown unabated in the West over the last quarter-century, owing in part to the disappearance of the Soviet Union and, with it, the threat of expansionist communism. The specter of revolution had forced Western elites to use the power of the state to redistribute wealth and nurture the growth of loyal middle classes. But, when communism collapsed in its Eurasian heartland, the West’s rich, believing that they had nothing more to fear, pressed to roll back the welfare state, causing inequality to rise rapidly. This was tolerable as long as the overall pie was expanding, but the global financial crisis in 2008 ended that.

Second, over the past 15 years, hundreds of millions of jobs shifted to Asia, which offered inexpensive and often highly skilled labor. The West, euphoric from its victory over communism and its seemingly unstoppable economic growth, failed to implement necessary structural reforms (Germany and Sweden were rare exceptions). Instead, Western prosperity relied increasingly on debt.

But the economic crisis has made it impossible to maintain a good life on borrowed money. Americans and Europeans are beginning to understand that neither they, nor their children, can assume that they will become wealthier over time.

Governments now face the difficult task of implementing reforms that will hit the majority of voters hardest. In the meantime, the minority that has benefited financially over the past two decades is unlikely to give up its advantages without a fight.

All of this cannot fail but to weaken Western democracy’s allure in countries like Russia, where, unlike in the West or to a large extent the Arab world, those who are organizing the massive demonstrations against the government belong to the economic elite. Theirs is a movement of political reformdemanding more freedom and government accountabilitynot of social protest, at least not yet.

A few years ago, it was fashionable to worry about the challenge that authoritarian-style capitalism (for example, in China, Singapore, Malaysia, or Russia) presented to Western democratic capitalism. Today, the problem is not only economic.

Western capitalism’s model of a society based on near-universal affluence and liberal democracy looks increasingly ineffective compared to the competition. Authoritarian countries’ middle classes may push their leaders toward greater democracy, as in Russia, but Western democracies will also likely become more authoritarian.

Indeed, measured against today’s standards, Charles De Gaulle, Winston Churchill, and Dwight Eisenhower were comparatively authoritarian leaders. The West will have to re-adopt such an approach, or risk losing out globally as its ultra-right and ultra-left political forces consolidate their positions and its middle classes begin to dissolve.

We must find ways to prevent the political polarization that gave rise to totalitarian systemscommunist and fascist – in the twentieth century. Fortunately, this is possible. Communism and fascism were born and took root in societies demoralized by war, which is why all steps should be taken now to prevent the outbreak of war.

This is becoming particularly relevant today, as the smell of war hangs over Iran. Israel, which is facing a surge of hostile sentiment among its neighbors in the wake of their “democratic” upheavals, is not the only interested party. Many people in the advanced countries, and even some in Russia, look increasingly supportive of a war with Iran, despite – or perhaps owing to – the need to address the ongoing global economic crisis and failure of international governance.

At the same time, huge opportunities beckon in times of far-reaching change. Billions of people in Asia have extricated themselves from poverty. New markets and spheres for applying one’s intellect, education, and talents are appearing constantly. The world’s power centers are beginning to counterbalance each other, undermining hegemonic ambitions and heralding a creative instability based on genuine multipolarity, with people gaining greater freedom to define their fate in the global arena.

Paradoxically, today’s global changes and challenges offer the potential for both peaceful coexistence and violent conflict. Whether fortunately or not, it is up to usalone – to determine which future it will be.

Sergei A. Karaganov is Dean of the School of World Economics and International Affairs at Russia’s National Research University Higher School of Economics.

.Copyright: Project Syndicate, 2012.

What’s Wrong with Transformational Leadership?

Joseph S. Nye


CAMBRIDGE – This year’s presidential campaign in the United States has been marked by calls from Barack Obama’s would-be Republican challengers for a radical transformation of American foreign policy. Campaigns are always more extreme than the eventual reality, but countries should be wary of calls for transformational change. Things do not always work out as intended.

Foreign policy played almost no role in the 2000 US presidential election. In 2001, George W. Bush started his first term with little interest in foreign policy, but adopted transformational objectives after the September 11, 2001, terrorist attacks. Like Woodrow Wilson, Franklin Roosevelt, and Harry Truman before him, Bush turned to the rhetoric of democracy to rally his followers in a time of crisis.

Bill Clinton had also talked about enlarging the role of human rights and democracy in US foreign policy, but most Americans in the 1990’s sought normality and a post-Cold War peace dividend rather than change. By contrast, Bush’s 2002 National Security Strategy, which came to be called the Bush Doctrine, proclaimed that the US would “identify and eliminate terrorists wherever they are, together with the regimes that sustain them.” The solution to the terrorist problem was to spread democracy everywhere.

Bush invaded Iraq ostensibly to remove Saddam Hussein’s capacity to use weapons of mass destruction and, in the process, to change the regime. Bush cannot be blamed for the intelligence failures that attributed such weapons to Saddam, given that many other countries shared such estimates. But inadequate understanding of the Iraqi and regional context, together with poor planning and management, undercut Bush’s transformational objectives.
Although some of Bush’s defenders try to credit him with the “Arab Springrevolutions, the primary Arab participants reject such arguments.

Bush was described by The Economist as “obsessed by the idea of being a transformational president; not just a status-quo operator like Bill Clinton.” Then-Secretary of State Condoleezza Rice praised the virtues of “transformational diplomacy.” But, while leadership theorists and editorial writers tend to think that transformational foreign-policy officials are better in either ethics or effectiveness, the evidence does not support this view.

Other leadership skills are more important than the usual distinction between transformational and “transactionalleaders. Consider President George H.W. Bush, who did not do “the vision thing,” but whose sound management and execution underpinned one of the most successful US foreign-policy agendas of the past half-century.
Perhaps genetic engineers will one day be able to produce leaders equally endowed with both vision and management skills; comparing the two Bushes (who shared half their genes), it is clear that nature has not yet solved the problem.

This is not an argument against transformational leaders. Mohandas Gandhi, Nelson Mandela, and Martin Luther King, Jr., played crucial roles in transforming people’s identity and aspirations. Nor is this an argument against transformational leaders in US foreign policy. Franklin Roosevelt and Truman made crucial contributions. But, in judging leaders, we need to pay attention to acts of both omission and commission, to what happened and to what was avoided, to the dogs that barked and to those that did not.

A big problem in foreign policy is the complexity of the context. We live in a world of diverse cultures, and we know very little about social engineering and how to “build nations.” When we cannot be sure how to improve the world, prudence becomes an important virtue, and grandiose visions can pose grave dangers.

In foreign policy, as in medicine, it is important to remember the Hippocratic Oath: first, do no harm. For these reasons, the virtues of transactional leaders with good contextual intelligence are very important. Someone like George H. W. Bush, unable to articulate a vision but able to steer successfully through crises, turns out to be a better leader than someone like his son, possessed of a powerful vision but with little contextual intelligence or management skill.

Former Secretary of State George Shultz, who served under Ronald Reagan, once compared his role to gardening –“the constant nurturing of a complex array of actors, interests, and goals.” But Shultz’s Stanford colleague, Condoleezza Rice, wanted a more transformational diplomacy that did not accept the world as it was, but tried to change it. As one observer put it, “Rice’s ambition is not just to be a gardener – she wants to be a landscape architect.” There is a role for both, depending on the context, but we should avoid the common mistake of automatically thinking that the transformational landscape architect is a better leader than the careful gardener.

We should keep this in mind as we assess the current US presidential debates, with their constant reference to American decline.

Decline is a misleading metaphor. America is not in absolute decline, and, in relative terms, there is a reasonable probability that it will remain more powerful than any other country in the coming decades. We do not live in a “post-American world,” but we also do not live in the American era of the late twentieth century.

The US will be faced with a rise in the power resources of many others – both states and non-state actors. It will also confront a growing number of issues that require power with others as much as power over others in order to obtain the country’s preferred outcomes. America’s capacity to maintain alliances and create cooperative networks will be an important dimension of its hard and soft power.

The problem of America’s role in the twenty-first century is not one of (poorly specified) “decline,” but rather of developing the contextual intelligence to understand that even the largest country cannot achieve what it wants without others’ help. Educating the public to understand this complex globalized information age, and what is required to operate successfully in it, will be the real transformational leadership task. Thus far, we are not hearing much about it from the Republican candidates.

Joseph S. Nye, Jr., a former US assistant secretary of defense, is a professor at Harvard and the author of The Future of Power.
Copyright: Project Syndicate, 2012.

Oil and the world economy

The new grease?

How to assess the risks of a 2012 oil shock

Mar 10th 2012

WITH the euro crisis in abeyance, high oil prices have become the latest source of worry for the world economy. Oil is the new Greece” is a typical headline on a recent report by HSBC analysts.

The fear is understandable. Oil markets are edgy; tensions with Iran are high. The price of Brent crude shot up by more than $5 a barrel on March 1st, to $128, after an Iranian press report that explosions had destroyed a vital Saudi Arabian oil pipeline. It fell back after the Saudis denied the claim, but at $125, crude is still 16% costlier than at the start of the year.

Assessing the dangers posed by dearer oil means answering four questions: What is driving up the oil price? How high could it go? What is the likely economic impact of rises so far? And what damage could plausible future increases do?

The origins of higher prices matter. Supply shocks, for instance, do more damage to global growth than higher prices that are the consequence of stronger demand. One frequent explanation of the current rise is that central-bank largesse has sent oil prices higher. In recent months the world’s big central banks have all either injected liquidity, expanded quantitative easing (printing money to buy bonds) or promised to keep rates low for longer.


This flood of cheap money, so the argument goes, has sent investors into hard assets, especially oil. But since markets are forward-looking, the announcement rather than the enactment of QE should move oil prices; indeed, the chairman of the Federal Reserve, Ben Bernanke, disappointed markets last month by not signalling another round of QE (click here). Moreover, if rising prices are being driven by speculators you should see a rise in oil inventoriesexactly the opposite of what has happened.


Central banks may have affected oil indirectly, by raising global growth prospects, which in turn buoy expectations for oil demand. Circumstantial evidence supports this thesis. The recent rise in oil prices has coincided with greater optimism about the world economy: a euro-zone catastrophe and a hard landing in China both appear less likely and America’s recovery seems on stronger ground.

But slightly rosier growth prospects are only part of the story. A more important driver of dearer oil has been disruptions in supply. All told, the oil market has probably lost more than 1m barrels a day (b/d) of supply in recent months. A variety of non-Iranian troubles, from a pipeline dispute with South Sudan to mechanical problems in the North Sea, have knocked some 700,000 b/d off supply. Another 500,000 b/d or so of Iranian oil is temporarily off the market thanks both to the effects of European sanctions and a payment dispute with China.

The cushion of spare supply is thin. Oil stocks in rich countries are at a five-year low. The extent of OPEC’s spare capacity is uncertain. Saudi Arabia is pumping some 10m b/d, a near-record high (see chart 1). And there is the threat of far bigger supply disruptions if Iran were ever to carry out its threat to close the Strait of Hormuz, through which 17m barrels of oil pass every day, some 20% of global supply. Even a temporary closure would imply a disruption to dwarf any previous oil shock. The 1973 Arab oil embargo, for instance, involved less than 5m b/d.

Separating out these various factors is not easy, but Jeffrey Currie of Goldman Sachs reckons that the fundamentals of supply and demand have pushed oil prices to around $118 a barrel. He thinks the remaining increase is down to fears about Iran. If so, should relations with Iran improve, the oil price might go down by a few dollars, but stay close to $120.

Globally, the damage from price increases to date is likely to be modest. A rule of thumb is that a sustained 10% rise in the price of oil shaves around 0.2% off global growth in the first year, largely because dearer oil shifts income from oil consumers to producers, who tend to spend less. For now any impact is almost certainly outweighed by improvements elsewhere, particularly in the easing of the euro crisis. Despite dearer oil, the prospects for global growth are still better than they were at the beginning of the year.

But the impact on growth and inflation in individual countries will differ. In America, a net importer which taxes fuel lightly, the standard rule is that a $10 increase in oil prices (which corresponds to a 25-cent rise in the price of petrol) knocks around 0.2% off output in the first year and 0.5% in the second year. That would slow, but hardly fell, an economy that is widely expected to grow by more than 2% this year.

There are in any case several reasons why America may be more resilient to dearer oil than in recent years. The jump in petrol prices has been far smaller than in 2011 or 2008. Rising employment gives consumers more income with which to pay for fuel. And America’s economy is becoming ever less energy-intensive, and less dependent on imports. Oil consumption has fallen in the past two years, even as GDP has risen.

Americans are driving less, and they are buying more fuel-efficient cars. Net oil imports are well below their 2005 peak, which means more of the money Americans spend on costlier oil stays within its borders. The development of copious amounts of natural gas means gas prices have plunged. That, coupled with an unusually mild winter, has kept bills for home heating unusually low. In January the share of consumers’ spending on energy products was the second-lowest in 50 years. These factors do not imply that America is impervious to spiking oil, but they do suggest the impact of price rises to date will be modest.

Europe is more exposed. European countries, which tax oil more heavily than America, have typically seen a smaller impact on growth from changes in the oil price. But this time they may be relatively more affected, because most economies are already stagnant or shrinking. Worse, Europe’s weakest peripheral economies are also some of the biggest net importers (see chart 2). Greece, for instance, is highly dependent on imported energy, of which 88% is oil. Even the price rises to date will worsen the euro-zone recession; a big jump could spawn a deep downturn and fracture the confidence of markets.

Britain is relatively insulated. Although it is a net oil importer, it has significant resources in the North Sea. Any losses to the consumer from dearer fuel are partially offset by gains in the oil and gas sector itself. But even in Britain the net effect of price increases to date could be more damaging than usual, particularly since they reduce the odds of sharply falling inflation. Lower inflation, and a rise in real incomes, are one reason British policymakers hoped to see the economy improve this year.

.Barrels, no laughs

.In emerging economies the picture is even more disparate. Oil exporters, from Venezuela to the Middle East, are gaining; oil importers will see worsening trade balances. In 2008 and 2011, the main effect of dearer fuel in emerging economies was on inflation. That is less of a worry now, largely because food prices, which make up a much bigger part of most emerging economies’ consumption basket, are stable.

But some countries will face problems. In the short term, some of the hardest-hit emerging economies will be in eastern Europe. They will suffer not only from more expensive oil but also from the weakening of European export markets.

India is also a concern. Fuel is a big component of its wholesale-price index, for example, so inflation will rise as higher oil prices are passed through to domestic fuel costs. To the extent they are not, the budget will be hit. India regulates—and heavily subsidises—the price of diesel and kerosene.

According to Deutsche Bank, diesel prices have risen by only 31% since January 2009, whereas the price of crude oil in rupees is up by 180%. The difference is a result of subsidies, frustrating India’s efforts to reduce its budget deficit.

So oil is not the new Greece. More expensive oil is, for now, doing little harm to global growth. But it is not helping Europe’s more fragile economies. And if the Strait of Hormuz is threatened, the resulting surge in oil prices will spell the end of the global recovery.