The global crash
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Japanese lessons
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After five years of crisis, the euro area risks Japanese-style economic stagnation
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Aug 4th 2012

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FIVE years ago, things looked rosy. In the first week of August 2007 forecasts by investors and major central banks predicted growth rates of 2-3% in America and Europe. But on August 9th 2007 everything changed. A French bank, BNP Paribas, announced big losses on subprime-mortgage investments. The same day, the European Central Bank (ECB) was forced to inject €95 billion ($130 billion at the time) of emergency liquidity. The crisis had begun.





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During the first year, policymakers looked to Japan as a guide, or rather a warning. Japan’s debt bubble had caused a “lost decade”, from 1991 to 2001. Analysts commonly drew three lessons. To avoid Japanese-style stagnation it was vital, first, to act fast; second, to clean up battered balance-sheets; and, third, to provide a bold economic stimulus. If Japan is taken as the yardstick, America and Britain have a mixed record. The euro area looks as if it might be turning Japanese.

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Debts took years to build up. Take the American consumer. Debt was around 70% of GDP in 2000, and grew at around 4 percentage points a year to reach close to 100% of GDP by 2007. The same was true of European banks and governments: debts rose hugely but steadily. It was not hard to spot debt mountains forming.





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The crisis erupted with the realisation that subprime exposures were widespread. Many assets were worth less in the market than they had been bought for. Debts started to look unsustainable and interest rates jumped. This meant governments, consumers and banks, after building up debt slowly, suddenly faced much higher costs, as debts matured and they were forced to refinance at higher rates.





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The reaction was quick. By the end of 2008 the Federal Reserve, the ECB and the Bank of England had slashed official interest rates.



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Their aim was to offset the spike in debt costs that companies and consumers were facing. The cuts were fast by Japanese standards (see top right-hand chart). It seemed the first lesson had been learnt.
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Falling asset prices meant that many banks and firms had debts that outweighed their assets. The Japanese experience showed that the next job was to deal with these broken balance-sheets. There are three main options: renegotiate debt, raise equity or go bankrupt.





In the efforts to reinvigorate balance-sheets, debt investors have reigned supreme. Debts have been honoured. Indeed, a recent report from Deutsche Bank shows that even investors in risky high-yield debt have had five great years. Bank bonds in America have returned 31%; in Europe, 25%.





As asset values fell, debt maintained its fixed value. This meant that equity, the balance-sheet shock-absorber, had to fall in value. So although debt caused the problem, equity took the pain. A Dow Jones index of bank equity is down by more than 60% since 2007, according to Deutsche Bank. Some banks’ share prices are down by more than 95%.





In many cases, the equity buffers were too small, so governments stepped in, taking equity stakes in banks. In both America and Europe governments stood behind their financial sectors. Balance-sheets were repaired. It seemed the second lesson from Japan had been learnt too.






But the clean-up just moved the problem on. Governments borrowed to fund the bail-outs. So banks’ balance-sheets were strengthened at the expense of public ones.



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America’s support for the banks cost 5% of GDP; Britain’s cash injection into its ailing banks was 9% of GDP. And household debt was still high.





A third lesson from Japan was to seek a strong stimulus: in a growing economy, high debt need not be a problem. Take a household’s finances. A large mortgage is fine as long as breadwinners’ incomes are sufficient to pay the interest and leave some to spare. Inflation helps too, as debts are fixed at their historical values but wages should rise with inflation.





Following Japan’s example, central banks engaged in “quantitative easing” (QE), buying bonds for newly created cash (see bottom left-hand chart). This aims to drive up bond prices, lowering yields and making debt manageable. The QE programmes have been bolder than Japan’s and corporate-bond yields have indeed fallen (see Buttonwood).





But although policymakers learnt some lessons from Japan, there are reasons to worry about the next five years. In Britain and America there are two main concerns.



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First, the fiscal stimulus may not be bold enough and in Britain is being withdrawn before the economy is back on its feet. Having supported banks, governments are trying to cut deficits and have little to spend. Richard Koo of Nomura, a bank, reckons Japan’s experience shows that governments should increase borrowing to mop up private-sector savings.




Second, government bail-outs can have long-term costs. In some cases, broken balance-sheets are a sign of a broken business model; bankruptcy is then a better option, cleansing the economy of unproductive firms. Japan kept too many bad firms going. There are signs of that in America and Britain too. The American government’s bail-outs ran to over $601 billion, with 928 recipients across banking, insurance and car industries. Britain has large stakes in two of its four big banks and has no clear plans to sell them.




The euro area is in a more dangerous position. Its recovery has been painfully slow (see bottom right-hand chart). Its prospects look grim: data released on August 1st showed German, French and Italian manufacturing contracting at an increasing rate (dragging Britain down with them).



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And to the meagre stimulus and zombification of industry can be added a third Japanese trait—policy indecision. On August 2nd Mario Draghi, the ECB's head, indicated the bank's readiness to buy bonds again as part of a co-ordinated rescue plan.



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Stockmarkets initially fell, suggesting the investors are unconvinced that it will save the euro area from aping Japan.



August 2, 2012 7:15 pm

Now for a dose of Draghi’s monetary medicine
The eurozone crisis may have started out as a fiscal crisis but it is now most definitely also a monetary crisis. The eurozone’s monetary system has begun to fragment. No longer is the European Central Bank able to set interest rates for the eurozone as a whole. Paranoia about an eventual eurozone break-up has persuaded financial institutions – with some encouragement from national regulators – to keep their money at home. So, the cross-border interbank market is more or less shut and peripheral nations are suffering.



An Italian bank hoping to borrow money for a year or so has to pay an interest rate of 2.7 per cent. A Spanish bank pays 3.8 per cent. A German bank pays nothing at all (indeed, others are now paying Germans to look after their money). Something has gone horribly wrong. There may be a single currency but its constituent parts are in danger of slipping towards a messy divorce.




In earlier phases of the eurozone crisis, government bond spreads widened not so much because the euro itself was seen to be in terminal decline but, instead, because countries had their own idiosyncratic local difficulties: Greek government debt was spiralling out of control, the Irish banking system was heading to the rocks and Spain’s autonomous regions were, as it turns out, just a bit too autonomous. The choices were simple: austerity, bailout or default. These were specifically fiscal – indeed, politicaloptions providing the perfect excuse for the ECB to take a back seat.






No longer can the ECB afford to do so. Mario Draghi, the ECB President, admitted as much when he observed last week that “these premia have to do more and more with convertibility they come into our mandate”. In other words, as the ultimate guardian of the single currency, the ECB has to act to avoid terminal fragmentation. The problem is simple. The ECB’s job is to deliver price stability in the medium term. It can do this only if its decisions feed through to the economy at large. Policies made in Frankfurt should trickle down to Barcelona, Berlin and Brindisi in roughly the same way. That no longer seems to be the case.





A central bank that can no longer set the monetary policy agenda is fairly useless. It is no surprise, then, that Mr Draghi has dangled so many treats before investors. He talked on Thursday about the ECB undertakingoutright open market operations of a size adequate to reach its [price stability] objective” while accepting the need to address bondholder seniority issues.






These are important developments. The ECB has accepted it is no longer properly in control of monetary conditions across the eurozone. It is happily considering a variety of measures to fix what has become a broken transmission mechanism for eurozone monetary policy. And it is increasingly focused on the interest rates traditionally determined by the actions of the central bank, not on those mostly influenced by the creditworthiness of individual sovereigns. All this begs the obvious question: if the ECB is doing the right thing – or at least planning towhy did investors take fright as its press conference drew to a close?





Five explanations stand out. First, the ECB’s proposals are very much a work in progress: the instant gratification investors hoped for – and which they thought Mr Draghi had promised last weekdidn’t materialise. Second, ECB help appears contingent on actions from others: in Mr Draghi’s words “the adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions”. Third, even with a bond-buying programme, there is no guarantee of economic success. The US and UK experience in recent years, after all, has hardly been encouraging; both are once again hitting economic brick walls. Fourth, it is blindingly obvious that the Bundesbank is not on board.




Lastly, even if Mr Draghi has correctly identified the nature of his monetary problem, that won’t be enough to solve the eurozone’s difficulties. The transmission mechanism is certainly worth fixing. But anyone who’s owned an unreliable car will surely agree that fixing the transmission mechanism alone provides no guarantee that the journey can be completed.





The writer is HSBC’s chief economist



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Copyright The Financial Times Limited 2012.


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OPINION
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August 1, 2012, 7:02 p.m. ET
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Glenn Hubbard: The Romney Plan for Economic Recovery
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Tax cuts, spending restraint and repeal of Obama's regulatory excesses would mean 12 million new jobs in his first term alone.
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By GLENN HUBBARD







We are currently in the most anemic economic recovery in the memory of most Americans. Declining consumer sentiment and business concerns over policy uncertainty weigh on the minds of all of us. We must fix our economy's growth and jobs machine.





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We can do this. The U.S. economy has the talent, ideas, energy and capital for the robust economic growth that has characterized much of America's experience in our lifetimes. Our standard of living and the nation's standing as a world power depend on restoring that growth.








But to do so we must have vastly different policies aimed at stopping runaway federal spending and debt, reforming our tax code and entitlement programs, and scaling back costly regulations. Those policies cannot be found in the president's proposals. They are, however, the core of Gov. Mitt Romney's plan for economic recovery and renewal.






In response to the recession, the Obama administration chose to emphasize costly, short-term fixesineffective stimulus programs, myriad housing programs that went nowhere, and a rush to invest in "green" companies.








As a consequence, uncertainty over policy—particularly over tax and regulatory policyslowed the recovery and limited job creation. One recent study by Scott Baker and Nicholas Bloom of Stanford University and Steven Davis of the University of Chicago found that this uncertainty reduced GDP by 1.4% in 2011 alone, and that returning to pre-crisis levels of uncertainty would add about 2.3 million jobs in just 18 months.
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The Obama administration's attempted short-term fixes, even with unprecedented monetary easing by the Federal Reserve, produced average GDP growth of just 2.2% over the past three years, and the consensus outlook appears no better for the year ahead.





Moreover, the Obama administration's large and sustained increases in debt raise the specter of another financial crisis and large future tax increases, further chilling business investment and job creation. A recent study by Ernst & Young finds that the administration's proposal to increase marginal tax rates on the wage, dividend and capital-gain income of upper-income Americans would reduce GDP by 1.3% (or $200 billion per year), kill 710,000 jobs, depress investment by 2.4%, and reduce wages and living standards by 1.8%. And according to the Congressional Budget Office, the large deficits codified in the president's budget would reduce GDP during 2018-2022 by between 0.5% and 2.2% compared to what would occur under current law.







President Obama has ignored or dismissed proposals that would address our anti-competitive tax code and unsustainable trajectory of federal debt—including his own bipartisan National Commission on Fiscal Responsibility and Reform—and submitted no plan for entitlement reform. In February, Treasury Secretary Tim Geithner famously told congressional Republicans that this administration was putting forth no plan, but "we know we don't like yours."





Other needed reforms would emphasize opening global markets for U.S. goods and services—but the president has made no contribution to the global trade agenda, while being dragged to the support of individual trade agreements only recently.





The president's choices cannot be ascribed to a political tug of war with Republicans in Congress. He and Democratic congressional majorities had two years to tackle any priority they chose. They chose not growth and jobs but regulatory expansion. The Patient Protection and Affordable Care Act raised taxes, unleashed significant new spending, and raised hiring costs for workers.





The Dodd-Frank Act missed the mark on housing and "too-big-to-fail" financial institutions but raised financing costs for households and small and mid-size businesses.
These economic errors and policy choices have consequencesrecord high long-term unemployment and growing ranks of discouraged workers. Sadly, at the present rate of job creation and projected labor-force growth, the nation will never return to full employment.





It doesn't have to be this way. The Romney economic plan would fundamentally change the direction of policy to increase GDP and job
creation now and going forward.




The governor's plan puts growth and recovery first, and it stands on four main pillars:
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Stop runaway federal spending and debt. The governor's plan would reduce federal spending as a share of GDP to 20%—its pre-crisis average—by 2016. This would dramatically reduce policy uncertainty over the need for future tax increases, thus increasing business and consumer confidence.




Reform the nation's tax code to increase growth and job creation. The Romney plan would reduce individual marginal income tax rates across the board by 20%, while keeping current low tax rates on dividends and capital gains. The governor would also reduce the corporate income tax rate—the highest in the world—to 25%. In addition, he would broaden the tax base to ensure that tax reform is revenue-neutral.





Reform entitlement programs to ensure their viability. The Romney plan would gradually reduce growth in Social Security and Medicare benefits for more affluent seniors and give more choice in Medicare programs and benefits to improve value in health-care spending. It would also block grant the Medicaid program to states to enable experimentation that might better serve recipients.




 
Make growth and cost-benefit analysis important features of regulation. The governor's plan would remove regulatory impediments to energy production and innovation that raise costs to consumers and limit new job creation. He would also work with Congress toward repealing and replacing the costly and burdensome Dodd–Frank legislation and the Patient Protection and Affordable Care Act. The Romney alternatives will emphasize better financial regulation and market-oriented, patient-centered health-care reform.





In contrast to the sclerosis and joblessness of the past three years, the Romney plan offers an economic U-turn in ideas and choices. When bolstered by sound trade, education, energy and monetary policy, the Romney reform program is expected by the governor's economic advisers to increase GDP growth by between 0.5% and 1% per year over the next decade. It should also speed up the current recovery, enabling the private sector to create 200,000 to 300,000 jobs per month, or about 12 million new jobs in a Romney first term, and millions more after that due to the plan's long-run growth effects.





But these gains aren't just about numbers, as important as those numbers are. The Romney approach will restore confidence in America's economic future and make America once again a place to invest and grow.






Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. He is an economic adviser to Gov. Romney.

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



Buttonwood

Money for nothing

Companies are taking advantage of cheap borrowing

Aug 4th 2012

 

IT IS not just America’s Treasury that is benefiting from ultra-low borrowing costs. On July 30th Unilever, an Anglo-Dutch consumer-goods group, borrowed $1 billion in the bond markets, in two tranches: 0.45% for three-year money and 0.85% over five years, both record lows for corporate debt. A week earlier IBM had raised ten-year money at a rate of just 1.875%. The Spanish and Italian governments can only dream of funding at such a low cost.





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Multinational companies have some advantages over governments. Although they can be subject to punitive taxation, they have the potential to move their operations to more welcoming jurisdictions.






Their revenues are not dependent on the fortunes of an individual economy. And large companies have been able to strengthen their balance-sheets over the past five years, whereas governments have been forced deep into deficit to prop up their economies.
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In the first half of 2012 European companies raised more money from the bond markets than from bank loans, according to Dealogic (see chart). In the past, European companies have relied more on banks than their American counterparts. But the crisis has led to a reduction in the “middlemanrole of banks, a process given the ugly namedisintermediation”.






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Banks have two problems. First, regulators are pressuring them to make their balance-sheets safer, by improving their capital ratios.




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Ideally they would do this by raising new capital in the form of equity; but investors are reluctant to buy new bank shares. So the banks are tempted to shrink their balance-sheets instead, which means restricting the supply of new loans.






European banks would be more than happy to lend money to most of the companies that are currently tapping the bond market. But the second problem is that doubts about the bad debts banks may have on their own books have caused their own financing costs to rise. As Fitch, a ratings agency, puts it: “Banks now pay roughly the same—or higher—rates to borrow as the corporates they lend to.”





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Although it should still, in theory, be profitable for banks to lend to small and medium-sized companies, they seem unwilling to do so. The latest figures from the European Central Bank show that bank loans to the private sector were down by 0.2% in the year to June. In Britain corporate lending has fallen by almost 5%. Nor is it economic, given the issuing costs, for small companies to borrow money in the bond market.






So it is very much a two-tier market: the big companies are gorging on the chance to raise money at very low rates ($10 billion of bonds was raised on June 30th alone) while the minnows starve. These bonds are bought by a wide range of investors, including insurance companies and hedge funds. But Marcus Hiseman, the head of European corporate-debt capital markets at Morgan Stanley, says there is increasing demand from other companies, which need somewhere to put their cash piles. Such money used to be invested in bank deposits, either directly or indirectly via money-market funds. So this is another form of “disintermediation”, with companies lending to each other and leaving out the banks.






Retail investors, desperate to find alternative sources of income in the face of record-low yields on bank deposits, are another source of demand for corporate bonds. Most issues are not designed for Aunt Agatha; the minimum investment is $100,000. But over the past couple of years a number of British issues, from the likes of Tesco and National Grid, have specifically targeted small investors.





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Justin Urquhart Stewart of Seven Investment Management says investors are happy to own bonds directly, provided the issuer is a well-known name. Corporate-bond funds are seen as having high fees, he says, and gilts (British-government bonds) have “turned from a no-risk yield into a no-yield risk”.





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There are dangers. Corporate bonds are less liquid than government debt; they are no less vulnerable to the ravages of inflation; and they are more likely to default if the global economy slides back into recession. But finance directors can hardly be blamed for taking advantage of such a favourable climate.



HEARD ON THE STREET

August 2, 2012, 1:35 p.m. ET


ECB Follows Words With More Words


By RICHARD BARLEY





The market verdict was clear: Mario Draghi had written a check he couldn't cash.




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The European Central Bank president promised last week to do "whatever it takes" to save the euro but the ECB didn't actually do anything at Thursday's meeting. Ten-year Spanish bond yields promptly rose back above 7%, and stock markets and the euro fell.
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 Spain will now come under great pressure to ask the euro-zone bailout funds for help with lowering its borrowing costs, something it has been desperate to resist. Above, the Frankfurt stock exchange on Thursday.




But the market reaction isn't entirely fair. Mr. Draghi's previous comments may have raised expectations too high, but he has provided the broad outlines of a plan for ECB intervention in government-bond markets. That certainly is a step forward.





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In particular, Mr. Draghi made two important points. First, that the ECB would intervene in markets only alongside the euro zone's bailout funds. This is crucial for the ECB because only the European Financial Stability Facility and its successor, the European Stability Mechanism, can ensure binding conditionality. A weakness of the ECB's previous bond-buying programs was that it relied on policy promises that politicians then failed to keep.




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Second, Mr. Draghi said investor concerns over ECB seniority would be addressed. The ECB's old Securities Markets Program has been effectively unusable since the central bank refused to take losses on its Greek bonds, leading to even bigger write-downs for private-sector bondholders. But how the ECB will structure any new program to avoid this problem is unclear.




.There still are plenty of other unanswered questions, too. Mr. Draghi said any intervention would be of a size "adequate to meet its objective." But what form will any future intervention take? How will the ECB define its objective? Is the ECB's commitment open-ended? Mr. Draghi hinted that any new program would focus on the shorter part of the yield curve, which would appear to have put a constraint on the scale of any ECB operation.





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Mr. Draghi said these details would be discussed in coming weeks. But a concern for investors is whether the ECB can deliver on these plans given the clear opposition of Germany's central bank, the Bundesbank. Mr. Draghi acknowledged that one country opposes bond-market interventions. The Bundesbank has only one vote out of 23 on the ECB's Governing Council so has no formal right of veto. But in practice, Mr. Draghi will be wary of defying his biggest shareholder.


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Spain will now come under great pressure to ask the euro-zone bailout funds for help with lowering its borrowing costs, something it has been desperate to resist. That, in turn, will reignite questions about the capacity of these funds. Worse, ratings firms may decide that asking for aid is enough to justify further downgrades, causing more problems.





Mr. Draghi's credibility is on the line. At the very least, the euro zone faces a long hot summer until his plans become clearer.



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