March 25, 2012 7:55 pm

How to ensure stimulus today, austerity tomorrow


Economic forecasters divide into two groups. There are those who cannot know the future but think they can – and then there are those who recognise their inability to know the future.

Major shifts in the economy are rarely forecast and often not fully recognised until they have been under way for some time. So judgments about the US economy have to be tentative. What can be said is that for the first time in five years a resumption of growth significantly above the economy’s potential now appears a substantial possibility. Put differently, after years when growth was more likely to surprise below expectations than above them, the risks are now very much two-sided.

As winter turned to spring in 2010 and 2011, many observers thought they detected evidence that the economy had decisively turned, only to be disappointed a few months later. Several considerations suggest that this time may be different. Employment growth has been running well ahead of population growth for some time now. The stock market level is higher and its expected volatility lower than at any time since 2007, suggesting that the uncertainty weighing on business has declined.

Consumers who deferred purchases of cars and other durable goods have created pent-up demand that now seems to be emerging. At last the housing market seems to be stabilising. For years now, the rate of new families setting up households has been well below normal as more and more young people have moved in with their parents. At some point they will set out on their own, creating a virtuous circle of a stronger housing market, morefamily formation” that boosts demand, further improvement in housing conditions and so on. And, assuming there is no punitive regulation, innovation in mobile information technology, social networking and newly discovered oil and natural gas seems likely to drive investment and job creation.



True, the risks of high oil prices, further problems in Europe and financial fallout from anxiety about future deficits remain salient. However, unlike the situation in 2010 and 2011, these risks are probably already priced into markets and factored into outlooks for consumer and business spending. There has already been a significant rise in oil prices.



Europe’s situation is hardly resolved but is very unlikely to deteriorate as much in the next months as it did last year. And market participants report great alarm about the deficit situation. So even modestly good news in any of these areas could drive upward revisions in current forecasts.

What are the implications for macroeconomic policy? Such recovery as we are enjoying is less a reflection of the American economy’s natural resilience than of the extraordinary steps that both fiscal and monetary policy makers have taken to offset private sector deleveraging – a process that is far from complete. A convalescing patient who does not finish their course of treatment takes a grave risk.

So too the most serious risk to recovery over the next few years is no longer financial strain or external shocks, but that policy will shift too quickly away from its emphasis on maintaining adequate demand, towards a concern with traditional fiscal and monetary prudence.

On even a pessimistic reading of the economy’s potential, unemployment remains 2 percentage points below normal levels, employment remains 5m jobs below potential levels and gross domestic product remains close to $1tn short of its potential. Even if the economy creates 300,000 jobs a month and grows at 4 per cent, it would take several years to restore normal conditions. So a lurch back this year towards the kind of policies that are appropriate in normal times would be quite premature.

Indeed, recent research suggests that, by slowing investment and increasing long-term employment, such policies could seriously damage the economy’s long-term performance. Brad Delong and I argued in a recent paper that premature and excessive fiscal contraction could even, by shrinking the economy, exacerbate budget problems in the long run.


How then to respond to valid concerns about fiscal sustainability, excessive credit creation and the time it may take to return to normality in a world where policy credibility is essential? The right approach is to use contingent commitmentspolicies that commit to action to normalise conditions, but only when certain thresholds are crossed. So, for example, it might be appropriate for the Federal Reserve to commit to maintain the current Fed Funds rate until some threshold with respect to unemployment or expected inflation is crossed. Commitments to fund infrastructure over many years might include a commitment that a financing mechanism such as a gasoline tax would be triggered when some level of employment or output growth has been achieved for a given interval. Tax reform legislation might propose that new rates be phased in at a pace that would depend on economic performance.

Contingent commitments have the virtue of giving households and businesses clarity as to how policy will play out. In areas where legislation is necessary, they can help to eliminate political uncertainty. They also allow policy makers to make a simultaneous commitment to near-term expansion and medium-term prudenceexactly what we require right now. In a volatile and uncertain world, there is always an element of contingency in policy. Recognising it explicitly is the way to provide confidence and protect credibility in a world whose future no one can gauge with precision.

The writer is former US Treasury secretary and Charles W. Eliot university professor at Harvard

Copyright The Financial Times Limited 2012.

lunes, marzo 26, 2012



China Adjusts

23 March 2012

Jeffrey Frankel

BAHRAIN – China watchers are waiting to see whether the country has engineered a soft landing, cooling down an overheating economy and achieving a more sustainable rate of growth, or whether Asia’s dragon will crash to earth, as others in the neighborhood have before it. But some, particularly American politicians in this presidential election year, focus on only one thing: China’s trade balance.

True, not long ago the renminbi was substantially undervalued, and China’s trade surpluses were very large. That situation is changing. Forces of adjustment are at work in the Chinese economy, so foreign perceptions need to adjust as well.

China’s trade surplus peaked at $300 billion in 2008, and has been declining ever since. (Indeed, official data showed a $31 billion deficit in February, the largest since 1998.) It is clear what has happened. Ever since China rejoined the global economy three decades ago, its trading partners have been snapping up its manufacturing exports, because low Chinese wages made them super-competitive. But, in recent years, relative prices have adjusted.

The change can be measured by real exchange-rate appreciation, which consists partly in nominal renminbi appreciation against the dollar, and partly in Chinese inflation. China’s government should have let more of the real appreciation take the form of nominal appreciation (dollars per renminbi). But, because it did not, it has shown up as inflation instead.

The natural price-adjustment process was delayed. First, the authorities intervened in 1995-2005, and again in 2008-2010, to keep the dollar exchange rate virtually fixed. Second, workers in China’s increasingly productive coastal factories were not paid their full value (the economy has not completed its transition from Mao to market, after all). As a result, China continued to undersell the world.

But then the renminbi was finally allowed to appreciate against the dollar – by about 25% cumulatively during 2005-2008 and 2010-2011. Moreover labor shortages began to appear, and Chinese workers began to win rapid wage increases.


Beijing, Shenzhen, and Shanghai raised their minimum wages sharply in the last three years – by 22% on average in 2010 and 2011. Meanwhile another cost of business, land prices, rose even more rapidly.

As costs rise in China’s coastal provinces, several types of adjustment are taking place. Some manufacturing is migrating inland, where wages and land prices are still relatively low, and some export operations are shifting to countries like Vietnam, where they are lower still. Moreover, Chinese companies are beginning to automate, substituting capital for labor, and are producing more sophisticated goods, following the path blazed by Japan, Korea, and other Asian countries in the “flying geeseformation.

Finally, multinational companies that had moved some operations to China from the United States or other high-wage countries are now moving   back. Productivity is still higher in the US, after all.

None of this is news to most international observers of China. But many Western politicians (and, to be fair, their constituents) are unable to let go of the syllogism that seemed so unassailable just a decade ago: (1) The Chinese have joined the world economy; (2) their wages are $0.50 an hour; (3) there are a billion of them; and (4) Chinese wages will never be bid up in line with the usual textbook laws of economics, so their exports will rise without limit. But it turns out that the basic laws of economics eventually apply after all even in China.

Like certain other aspects of the US-China economic relationship, China’s adjustment is reminiscent of Japan with a 30-year lag. Japan’s trade balance fell into deficit in 2011, for the first time since 1980. Special factors have played a role in the last year, including high oil prices and the effects of the March 2011 tsunami. But the downward trend in the trade balance is clear. Even the current account showed a deficit in January.

This development has received relatively little attention in the US and other trading partners, which is curious, given that, two decades ago, Japan’s big trade surplus was the subject of intense focus and worryjust like China’s now. At the time, some influential commentators warned that the Japanese had discovered a superior economic model, featuring strategic trade policy (among other attractions), and that the rest of us had better emulate them. Either that, or the Japanese were “cheating,” in which case we needed to stop them.

Most economists rejected these “revisionistviews, and argued that Japan’s current-account surplus was large because its national saving rate was high, which reflected demographics, not cultural differences or government policies. The Japanese population was relatively young, compared to other advanced economies, but was rapidly aging, owing to a declining birth rate since the 1940’s and rising longevity.

That view has been vindicated. In 1980, 9% of Japan’s population was 65 or older; now the ratio is more than 23%, one of the highest in the world. As a consequence, Japanese citizens who 30 years ago were saving for their retirement are now dissaving, precisely as economic theory predicted. As the national saving rate has come down, so has the current-account surplus.

China faces a similar demographic trend, and also a push to unleash household consumption in order to sustain GDP growth. As in Japan, the downward trend in China’s saving rate will show up in its current account. The laws of international economics still apply.

Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.

Copyright Project Syndicate -

March 25, 2012
The Rich Get Even Richer

NEW statistics show an ever-more-startling divergence between the fortunes of the wealthy and everybody else — and the desperate need to address this wrenching problem. Even in a country that sometimes seems inured to income inequality, these takeaways are truly stunning.

In 2010, as the nation continued to recover from the recession, a dizzying 93 percent of the additional income created in the country that year, compared to 2009$288 billionwent to the top 1 percent of taxpayers, those with at least $352,000 in income. That delivered an average single-year pay increase of 11.6 percent to each of these households.

Still more astonishing was the extent to which the super rich got rich faster than the merely rich. In 2010, 37 percent of these additional earnings went to just the top 0.01 percent, a teaspoon-size collection of about 15,000 households with average incomes of $23.8 million. These fortunate few saw their incomes rise by 21.5 percent.

The bottom 99 percent received a microscopic $80 increase in pay per person in 2010, after adjusting for inflation. The top 1 percent, whose average income is $1,019,089, had an 11.6 percent increase in income.

This new data, derived by the French economists Thomas Piketty and Emmanuel Saez from American tax returns, also suggests that those at the top were more likely to earn than inherit their riches. That’s not completely surprising: the rapid growth of new American industries — from technology to financial services — has increased the need for highly educated and skilled workers. At the same time, old industries like manufacturing are employing fewer blue-collar workers.

The result? Pay for college graduates has risen by 15.7 percent over the past 32 years (after adjustment for inflation) while the income of a worker without a high school diploma has plummeted by 25.7 percent over the same period.

Government has also played a role, particularly the George W. Bush tax cuts, which, among other things, gave the wealthy a 15 percent tax on capital gains and dividends. That’s the provision that caused Warren E. Buffett’s secretary to have a higher tax rate than he does.

As a result, the top 1 percent has done progressively better in each economic recovery of the past two decades. In the Clinton era expansion, 45 percent of the total income gains went to the top 11 percent; in the Bush recovery, the figure was 65 percent; now it is 93 percent.

Just as the causes of the growing inequality are becoming better known, so have the contours of solving the problem: better education and training, a fairer tax system, more aid programs for the disadvantaged to encourage the social mobility needed for them escape the bottom rung, and so on.
Government, of course, can’t fully address some of the challenges, like globalization, but it can help.

By the end of the year, deadlines built into several pieces of complex legislation will force a gridlocked Congress’s hand. Most significantly, all of the Bush tax cuts will expire. If Congress does not act, tax rates will return to the higher, pre-2000, Clinton-era levels. In addition, $1.2 trillion of automatic spending cuts that were set in motion by the failure of the last attempt at a deficit reduction deal will take effect.

So far, the prospects for progress are at best worrisome, at worst terrifying. Earlier this week, House Republicans unveiled an unsavory stew of highly regressive tax cuts, large but unspecified reductions in discretionary spending (a category that importantly includes education, infrastructure and research and development), and an evisceration of programs devoted to lifting those at the bottom, including unemployment insurance, food stamps, earned income tax credits and many more.

Policies of this sort would exacerbate the very problem of income inequality that most needs fixing. Next week’s package from House Democrats will almost certainly be more appealing. And to his credit, President Obama has spoken eloquently about the need to address this problem. But with Democrats in the minority in the House and an election looming, passage is unlikely.

The only way to redress the income imbalance is by implementing policies that are oriented toward reversing the forces that caused it. That means letting the Bush tax cuts expire for the wealthy and adding money to some of the programs that House Republicans seek to cut. Allowing this disparity to continue is both bad economic policy and bad social policy. We owe those at the bottom a fairer shot at moving up.

Steven Rattner is a contributing writer for Op-Ed and a longtime Wall Street executive.

A better era for global equities

March 25, 2012 5:14 pm

by Gavyn Davies

Global equities have enjoyed a very strong start to 2012, rising by about 11 per cent year-to-date. This of course has been driven mostly by the improvements in the eurozone debt crisis and in the US labour market, which have raised hopes of stronger growth in global GDP in coming quarters. But on a longer-term view, equities remain in the doldrums. Relative to government bonds, equities in the developed economies have given negative excess returns for more than a whole decade, which is an extraordinary state of affairs in a free market economic system.


As the first graph shows, the rolling 10 year excess returns in US equities relative to treasuries have been lower in recent years than at any time since the 1930s. But equities, the riskiest of all assets in the capital structure, cannot be outperformed indefinitely by government bonds, supposedly the safest of all assets. The scope for government bonds to perform strongly now looks limited. And current valuation of equities indicates that they should perform considerably better than bonds in coming years.

There is plenty of evidence that the long term future performance of equities is best when the starting valuation for the asset class is particularly attractive, and vice versa. There are many ways to measure the “value” of equities, either relative to their own history or relative to alternative assets like government bonds. At the present time, these methods give mixed results.

Relative to their own history, the valuation of US equities is roughly average, with a p/e ratio on the S&P 500 of about 13. This indicates that equity returns might be also be average from now on at about 7 per cent per annum. However, valuation in the eurozone and Asia is more attractive than in the US, suggesting that long term returns in these regions might be rather higher.

Furthermore, the case for equities looks stronger if we compare equities not with their own history, but with government bonds. With 10 year bond yields around 2.2 per cent in the US, and the earnings yield on the S&P 500 standing at 7.7 per cent, there can be little debate that equities are very cheap by historic standards compared to bonds. Part of this could be unwound by a rise in bond yields back into normal territory. But even if bond yields were to rise to 5 per cent, which is a fairly extreme assumption, equities would still be offering an above-average risk premium relative to bonds.

This implies that equities could provide significantly positive medium term real returns, even if bond yields were to rise markedly. According to Ian Scott at Nomura, the correlation between US bond and equity prices is usually negative when the treasury yield is below 5 per cent, which gives plenty of room for a “healthyrise in bond yields as economies recover, without this doing any damage to equities.

So far, so good for equity optimists. But there is one major reason for possible concern about equities, which is shown in the second graph. The ratio of after tax corporate profits to nominal GDP in the US, otherwise known as the profit margin earned in the economy, is far higher at present than it has been at any time in post war history, and the same pattern is observed in many other developed economies. The profit margin was abnormally high even before the Great Recession in 2008/09, but in the aftermath of that recession, it has entered entirely new territory.

The key question, then, is whether profit margins can be sustained at anywhere near these unprecedented levels. A recent research paper by James Montier at GMO argues that this is unlikely to be the case.

He says that profit margins are more likely to revert to their long term mean in the next few years, and that this will result in sub-par growth in corporate earnings. This, in turn, will remove most of the upside for developed equity markets as earnings persistently disappoint analysts’ expectations.

The case in favour of mean reversion in profit margins is normally very strong. After all, there has been no long term uptrend in margins in most market economies in the past century or more. Whenever new technologies have created the chance for companies to reduce costs and to earn higher margins, this has proven to be short-lived, because new firms enter these markets, and competition quite quickly erodes excess profits. This is why the share of profits in the economy, and by implication also the share of wages, remains broadly constant over time.

Why should this time be any different? There are two possible reasons. The first is that the process of globalisation has greatly added to the effective supply of labour in the global economy, and this has resulted in downward pressure on real wages in the developed world. So far, the resulting declines in labour costs have been captured and retained by companies, rather than being regained by labour in the form of higher nominal wages, or via lower consumer prices. Since the effective global labour supply will rise considerably further in the coming decade (with India taking the lead as the growth in China’s labour force slows), the phenomenon of high margins may well persist.

.The second reason is that the output gap in the developed economies is larger than it has been in the past, and is also likely to persist for quite a while. A large output gap, along with a high unemployment rate, normally depresses real wages, and results in much higher profit margins. The same seems to be happening now.

In summary, equities in developed markets are cheap, if not relative to their own history, then certainly compared to bonds. Rising bond yields are not likely to do much damage to equities in the foreseeable future. The main risk comes from today’s elevated profit margins. But if margins can stay high as globalisation continues, then equity returns should enter a better era.

MARCH 26,2012