The Great American Mirage

Stephen S. Roach

27 June 2012




NEW HAVENIn September 1998, during the depths of the Asian financial crisis, Alan Greenspan, the United States Federal Reserve’s chairman at the time, had a simple message: the US is not an oasis of prosperity in an otherwise struggling world. Greenspan’s point is even closer to the mark today than it was back then.


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Yes, the US economy has been on a weak recovery trajectory over the past three years. But at least it’s a recovery, claim many – and therefore a source of ongoing resilience in an otherwise struggling developed world. Unlike the Great Recession of 2008-2009, today there is widespread hope that America has the capacity to stay the course and provide a backstop for the rest of the world in the midst of the euro crisis.



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Think again. Since the first quarter of 2009, when the US economy was bottoming out after its worst postwar recession, exports have accounted for fully 41% of the subsequent rebound. That’s right: with the American consumer on ice in the aftermath of the biggest consumption binge in history, the US economy has drawn its sustenance disproportionately from foreign markets. With those markets now in trouble, the US could be quick to follow.


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Three regions have collectively accounted for 83% of America’s export-led growth impetus over the past three yearsAsia, Latin America, and Europe. (Since regional and country trade statistics assembled by the US Department of Commerce are not seasonally adjusted, all subsequent comparisons are presented on the basis of a comparable seasonal comparison from the first quarter of 2009 to the first quarter of 2012.)


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Not surprisingly, Asia led the way, accounting for 33% of the total US export surge over the past three years. The biggest source of this increase came from the 15-percentage-point contribution of Greater China (the People’s Republic, Taiwan, and Hong Kong). Needless to say, China’s unfolding slowdown – even under the soft-landing scenario that I still believe is most credible – is taking a major toll on the largest source of America’s export revival. The remainder of the Asian-led US export impetus is spread out, led by South Korea, Japan, and Taiwanall export-led economies themselves and all heavily dependent on a slowing China.


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Latin America provided the second-largest source of America’s export resurgence, accounting for another 28% of the total gains in US foreign sales over the past three years. Brazil and Mexico collectively accounted for 19 percentage points of that increase. Growth in both economies is now slowing significantly, especially in Brazil. But, given the close linkages between Mexican production and US consumption (which is now sputtering again), any resilience in the Mexican economy could be short-lived.


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Finally, there is the sad case of Europe, which has accounted for 21% of the cumulative growth in US exports over the past three years. Here, the US Commerce Department statistics are not as helpful in pinpointing the source of the impetus, because only a partial country list is published. What we do know is that the United Kingdom, Germany, and France – the so-called core economiescollectively accounted for just 3.5% of total US export growth since early 2009, with the UK grabbing the bulk of that increase. That suggests that most of America’s European export gain was concentrated in the region’s so-called peripheral economies. And that is clearly a serious problem.
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Forecasts are always hazardous, but somewhat-ifscenarios shed considerable light on what all of this means for the world’s largest economy. Since the second quarter of 2009, US annualized real GDP growth has averaged 2.4%. With roughly 40% of that increase attributable to exports, that means the remainder of the economy has grown at an anemic 1.4% pace.
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Under a flat-line export scenario, with no rise in US exports, and if everything else remains the same (always a heroic assumption), overall real GDP growth would converge on that 1.4% bogey. That is a weak growth trajectory by any standardlikely to result in rising unemployment and further deterioration in consumer confidence.


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Alternatively, in a moderate export-downturn scenario, with real exports falling by 5% over a four-quarter period, real GDP growth could slip below the 1%stall speedthresholdleaving the US economy vulnerable to a recessionary relapse. By way of reference, the assumption of a 5% export downturn pales in comparison with the precipitous 13.6% decline in real exports that occurred in 2008-2009. As such, this “what if” is a cautiously optimistic assessment of the downside risks stemming from weak external demand.



All of this underscores one of the more obvious, yet overlooked, implications of an increasingly interdependent world: we are all in it together. The euro crisis is a serious shock, and is now producing ripple effects around the world. Europe is export-led China’s largest source of external demand; as China goes, so goes the rest of China-centric Asia; and, from there, the ripples reach the shores of an increasingly export-dependent US economy. As recent weakness in employment and retail sales suggests, that may already be happening.


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Greenspan’s warning in 1998 came at a time when US exports accounted for only about 10.5% of GDP. Today, that share stands at a record-high 14%, as post-crisis America has made a big bet on an export-led revival. The current global slowdown is not on a par with what occurred in the late 1990’s or the more wrenching shocks of 3-4 years agoat least not yet. But today’s global downturn can hardly be dismissed as unimportant for the US or anyone else.


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In an era of globalization, there are no innocent bystanders. There are certainly no oases of prosperity in the face of yet another major shock in the global economy. America’s growth mirage is an important case in point.


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Stephen S. Roach was Chairman of Morgan Stanley Asia and the firm's Chief Economist, and currently is a senior fellow at Yale University’s Jackson Institute of Global Affairs and a senior lecturer at Yale’s School of Management. His most recent book is The Next Asia.

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OPINION

Updated June 27, 2012, 7:22 p.m. ET

A Weaker Euro Could Rescue Europe

Devaluation is the only way to save the single currency

By MARTIN FELDSTEIN
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        Getty Images      A discount '1 Euro' shop in Athens, Greece.



The only way to prevent the dissolution of the euro zone might be a sharp decline in the value of the euro relative to the dollar and to other currencies. European politicians' dreams of political union and permanent fiscal transfers are not realistic solutions to the multiple problems of the euro zone's peripheral countries—especially on the tight schedule needed to halt the collapse of the single currency. The European Central Bank (ECB) may continue to provide additional liquidity, but experience has already shown that it cannot reduce sovereign bond yields to sustainable levels.



The peripheral countriesItaly and Spain, as well as Portugal, Ireland, Greece, Cyprus and perhaps others—can only remain in the euro zone if they solve four difficult problems. First, fiscal deficits must be permanently lowered to reduce the interest rates on sovereign bonds to levels that can be financed in the long run. Second, economic growth must be revived to create employment and sustain political support for that fiscal consolidation. Third, commercial banks must be recapitalized to stop the deposit runs and preserve lending capacity. Finally, large trade deficits must be eliminated so that these countries are not permanently seeking transfers or loans from foreign creditors.



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Politically difficult decisions could solve the first three of these problems. Less government spending and higher taxes could reduce fiscal deficits. Changes in labor laws and other institutional barriers to productivity could produce stronger economic growth. And sufficient growth would give governments the fiscal capacity to recapitalize their commercial banks.



But implementing these policies would not solve the fourth problem: the periphery's staggering trade and current-account deficits. Those deficits reflect the peripheral countries' lower competitiveness after a decade of slow productivity growth compared to Germany and other northern euro-zone members.



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If the peripheral countries were not locked into the euro but had their own individual currencies, they could follow the strategy of combining devaluation and fiscal consolidation that has been successfully adopted by countries in Latin America and East Asia and more recently by Britain. Devaluing currencies would boost exports and reduce imports, simultaneously eliminating trade deficits and spurring growth. Higher GDP would offset the depressing effect on aggregate demand caused by the higher taxes and reduced government spending needed to eliminate the fiscal deficit.




This route out of the trade and current-account deficits is not currently available because the members of the euro zone are locked into a single currency. That's why euro-zone officials argue that member countries must force wage levels to decline under the pressure of unemployment so as to achieve "real devaluations" of as much as 20%. But even with persistent unemployment rates of more than 20% in Spain and Greece, there has been little progress in reducing real wages. A strategy of massive real devaluation through high unemployment is simply not feasible in democratic nations.



This structural impasse could be bypassed if the peripheral countries left the euro zone, returned to national currencies and devalued. But that dissolution of the wider euro zone could be avoided by a substantial decline in the value of the euro versus other non-euro-zone currencies.


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Euro devaluation would not change the trade imbalances within the euro zone but would increase the global exports of the peripheral countries and decrease their imports from non-euro-zone nations. This in turn would raise the GDP of peripheral countries, allowing them to achieve positive growth while also reducing fiscal deficits.



A weaker euro would also render German products even more competitive in global markets than they are today, increasing Germany's already large trade surplus with the rest of the world. Increased demand in Germany might put upward pressure on German wages and prices. But the net effect would be an even stronger German economy.



Although a decline of the euro would mean higher import prices in euro-zone countries, it need not mean higher inflation or even a higher overall price level. The ECB could in principle continue to aim at a 2% inflation rate with lower prices of domestic goods and services offsetting the higher prices of imports from outside the euro zone. At worst, the ECB could allow a one-time pass-through of the higher import costs but prevent any further increases in inflation rates.



A one-time fall of the euro that eliminates the current-account deficits of the peripheral countries would not solve the ongoing competitiveness problem caused by stronger productivity growth in Germany and other northern countries. But a combination of policies that accelerate productivity growth in the periphery and slightly slower wage increases there would prevent a return of large current-account deficits. Eliminating today's large current-account deficits would make small annual adjustments in the future feasible.



A major decline of the euro does not require explicit action by the ECB or other euro-zone institutions. If major global investors in euro bonds conclude that there will be either a breakup of the euro zone or a sharp decline in the value of the euro, they will reduce their holdings of euros, driving down its value. In that way, the bond market may by itself deliver the conditions needed to eliminate the current-account deficits of the peripheral countries and prevent the dissolution of the euro zone.



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Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.

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Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

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June 27, 2012 8:32 pm

A manifesto for economic sense

By Paul Krugman and Richard Layard

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More than four years after the financial crisis began, the world’s major advanced economies remain deeply depressed, in a scene all too reminiscent of the 1930s. The reason is simple: we are relying on the same ideas that governed policy during that decade. These ideas, long since disproved, involve profound errors both about the causes of the crisis, its nature and the appropriate response.



These ideas have taken root in the public consciousness, providing support for the excessive austerity of fiscal policies in many countries. So the time is ripe for a manifesto in which mainstream economists offer the public a more evidence-based analysis of our problems.
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The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptionssuch as Greece – this is false. Instead, the conditions for the crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The bursting of this bubble led to large falls in output and thus in tax revenue. Today’s government deficits are a consequence of the crisis, not a cause.



The nature of the crisis. When property bubbles burst on both sides of the Atlantic, many parts of the private sector slashed spending in an attempt to pay down past debts. This was a rational response on the part of individuals, but has proved to be collectively self-defeating, because one person’s spending is another person’s income. The result of the spending collapse has been an economic depression that has worsened the public debt.


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The appropriate response. At a time when the private sector is engaged in a collective effort to spend less, public policy should act as a stabilising force, attempting to sustain spending. At the very least, we should not be making things worse with big cuts in government spending or big increases in tax rates on ordinary people.



The big mistake. After responding well in the first, acute phase of the crisis, policy took a wrong turnfocusing on government deficits and arguing that the public sector should attempt to reduce its debts in tandem with the private sector. Instead of playing a stabilising role, fiscal policy has ended up reinforcing the damping effects of private-sector spending cuts.



In the face of a less severe shock, monetary policy could take up the slack. But with interest rates close to zero, monetary policy – while it should do all it cancannot do the whole job. There must of course be a medium-term plan for reducing the government deficit. But if this is too front-loaded it can easily be self-defeating by aborting the recovery. A key priority is to reduce unemployment, before it becomes endemic, making recovery and future deficit reduction even more difficult.



How do those who support the existing approach respond to ours? They typically use two arguments.




The confidence argument. Their first argument is that government deficits will raise interest rates and thus prevent recovery. By contrast, austerity will increase confidence and encourage recovery. But there is no evidence in favour of this argument. Despite exceptionally high deficits, interest rates are unprecedentedly low in all major countries where there is a normally functioning central bank. Interest rates are only high in some eurozone countries, because the European Central Bank is not allowed to act as lender of last resort to the government. Elsewhere the central bank can always, if needed, fund the deficit, leaving the bond market unaffected.



Experience includes no relevant case where budget cuts have actually generated increased economic activity. The International Monetary Fund has studied 173 cases of budget cuts in individual countries and found that the consistent result is economic contraction. That is what is happening: the countries with the biggest budget cuts have experienced the biggest falls in output.



For the truth, as we can now see, is that budget cuts do not inspire business confidence. Companies will only invest when they can foresee enough customers with enough income to spend. Austerity discourages investment.




The structural argument. A second argument against expanding demand is that output is in fact constrained on the supply side – by structural imbalances. If this theory were right, however, at least some parts of our economies ought to be at full stretch, and so should some occupations. But in most countries that is not the case. So the problem must be a general lack of spending and demand.



In the 1930s the same structural argument was used against proactive spending policies in the US. But as spending rose between 1940 and 1942, output rose by 20 per cent. So the problem in the 1930s, as now, was a shortage of demand, not of supply.



As a result of their mistaken ideas, many western policy makers are inflicting massive suffering on their peoples. But the ideas they espouse about how to handle recessions were rejected by nearly all economists after the disasters of the 1930s. It is tragic that in recent years the old ideas have again taken root.



The best policies will differ between countries and will require debate. But they must be based on a correct analysis of the problem. We therefore urge all economists and others who agree with the broad thrust of this manifesto for economic sense to register their agreement online and to publicly argue the case for a sounder approach. The whole world suffers when men and women are silent about what they know is wrong.


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The writers are professors at Princeton University and the London School of Economics



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Copyright The Financial Times Limited 2012

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June 28, 2012, 2:30 am
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JPMorgan Trading Loss May Reach $9 Billion
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By JESSICA SILVER-GREENBERG and SUSANNE CRAIG

Losses on JPMorgan Chase's bungled trade could total as much as $9 billion, far exceeding earlier public estimates, according to people who have been briefed on the situation.



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When Jamie Dimon, the bank's chief executive, announced in May that the bank had lost $2 billion in a bet on credit derivatives, he estimated that losses could double within the next few quarters. But the red ink has been mounting in recent weeks, as the bank has been unwinding its positions, according to interviews with current and former traders and executives at the bank who asked not to be named because of investigations into the bank.



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The bank's exit from its money-losing trade is happening faster than many expected. JPMorgan previously said it hoped to clear its position by early next year; now it is already out of more than half of the trade and may be completely free this year.



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As JPMorgan has moved rapidly to unwind the position - its most volatile assets in particular - internal models at the bank have recently projected losses of as much as $9 billion. In April, the bank generated an internal report that showed that the losses, assuming worst-case conditions, could reach $8 billion to $9 billion, according to a person who reviewed the report.




.With much of the most volatile slice of the position sold, however, regulators are unsure how deep the reported losses will eventually be. Some expect that the red ink will not exceed $6 billion to $7 billion.




.Nonetheless, the sharply higher loss totals will feed a debate over how strictly large financial institutions should be regulated and whether some of the behemoth banks are capitalizing on their status as too big to fail to make risky trades.



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JPMorgan plans to disclose part of the total losses on the soured bet on July 13, when it reports second-quarter earnings. Despite the loss, the bank has said it will be solidly profitable for the quarter - no small achievement given that nervous markets and weak economies have sapped Wall Street's main businesses. To put the size of the loss in perspective, JPMorgan logged a first-quarter profit of $5.4 billion.



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More than profits are at stake. The growing fallout from the bank's bad bet threatens to undercut the credibility of Mr. Dimon, who has been fighting major regulatory changes that could curtail the kind of risk-taking that led to the trading losses. The bank chief was considered a deft manager of risk after steering JPMorgan through the financial crisis in far better shape than its rivals.




."Essentially, JPMorgan has been operating a hedge fund with federal insured deposits within a bank," said Mark Williams, a professor of finance at Boston University, who also served as a Federal Reserve bank examiner.



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A spokesman for the bank declined to comment.



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In its most basic form, the losing trade, made by the bank's chief investment office in London, was an intricate position that included a bullish bet on an index of investment-grade corporate debt. That was later combined with a bearish wager on high-yield securities.




.The chief investment office - which invests excess deposits for the bank and was created to hedge interest rate risk - brought in more than $4 billion in profits in the last three years, accounting for roughly 10 percent of the bank's profit during that period.




.In testimony before the House Financial Services Committee last week, Mr. Dimon said that the London unit had "embarked on a complex strategy" that exposed the bank to greater risks even though it had been intended to minimize them.



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JPMorgan executives are briefed each morning on the size of the trading loss. The tally could shrink if the market moves in JPMorgan's favor, the people briefed on the situation cautioned.



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But hedge funds and other investors have seized on the bank's distress, creating a rapid deterioration in the underlying positions held by the bank. Although Mr. Dimon has tried to conceal the intricacies of the bank's soured bet, credit traders say the losses have still mounted.





While some hedge funds have compounded the bank's woes, others have been finding it profitable to help JPMorgan get clear of the losing credit positions.



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One such fund, Blue Mountain Capital Management, has been accumulating trades over the last couple of weeks that might help reduce the risk of the bets made by JPMorgan in a credit index, according to interviews with more than a dozen credit traders. The hedge fund is then selling those positions back to the bank. A Blue Mountain spokesman declined to comment.



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As traders in JPMorgan's London desk work to get out of the huge bet, which started generating erratic losses in late March, the traders based in New York are largely sitting idle, according to current traders in the unit.




"We are in a holding pattern," said one current New York trader who asked not to be named.
Long before the losses started mounting, senior executives at the chief investment office in New York worried about the trades of Bruno Iksil, according to the current traders.



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Now known as the London Whale for his outsize wagers in the credit markets, Mr. Iksil accumulated a number of trades in 2010 that were illiquid, which means it would take the bank more time to get out of them.



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In 2010, a senior executive at the chief investment office compiled a detailed report that estimated how much money the bank stood to lose if it had to get out of all Mr. Iksil's trades within 30 days. The senior executive recommended that JPMorgan consider putting aside reserves to deal with any losses that might stem from Mr. Iksil's trades. It is not known how much was recommended as a reserve or whether Mr. Dimon saw the report, but the warning went unheeded.



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The losses are the most embarrassing fumble for Mr. Dimon since he became chief executive in 2005.



In appearances before Congress, Mr. Dimon has taken pains to assure investors and lawmakers that the overall health of JPMorgan remained strong and that it had more than sufficient amounts of capital to weather any economic dislocation.



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Even as he apologized for the trade, calling it "stupid," Mr. Dimon emphasized to lawmakers that the loss was an "isolated incident."



.The Federal Reserve is currently poring over the bank's trades to examine the scope of the growing losses and the original bet.