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HEARD ON THE STREET

August 26, 2012, 4:11 p.m. ET

Central Banks' Incredible Lightness of Easing

By RICHARD BARLEY


"Lower for longer" is the market mantra on interest rates, thanks to central banks' extraordinary responses to the global financial crisis. But from the perspective of central-bank balance sheets, the corollary is "larger for longer."



Five years into the crisis, the exit for central banks from their stimulus efforts is nowhere in sight and even may be getting further away.


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There are few signs of hawkishness. The Federal Reserve's minutes suggested a good chance of further monetary-policy action, although recent economic data may have dulled the case for it..
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The European Central Bank may be poised to engage in large-scale government-bond buying to cut the funding costs of Spain and Italy. The Bank of England is on its third round of bond buying, known as quantitative easing, raising total gilt purchases to £375 billion ($593 billion). It may yet do more. And the Swiss National Bank is printing Swiss francs to stop the currency from appreciating and to stave off deflation.




But, as central banks decide whether to print even more, their balance sheets already have swollen to enormous levels. The Bank of England leads the pack: Its balance sheet of £385 billion is 4.7 times the size it was in May 2007. The Swiss National Bank isn't far behind, with an expansion of 4.1 times to 435 billion Swiss francs ($453 billion).




The Fed has seen assets swell 3.2 times to $2.8 trillion. And its composition is almost unrecognizable, with holdings of Treasurys maturing in more than five years at $1.1 trillion, from $156 billion.



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The ECB is a relative laggard: Assets at €3.1 trillion ($3.88 trillion) are just 2.6 times the size they were in May 2007. Purchases of Spanish and Italian debt, even at the short end of the maturity curve, could change that. Combined, the two countries have €585 billion of outstanding securities with maturities of under two years, including bills, according to Barclays.




The economic impact of quantitative easing and other extreme policies remains murky and is generally discussed in terms of avoiding worse outcomes. But some strange results are emerging.



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In the U.K., the fund that holds the gilts under the bond-purchase program had £20.7 billion of cash sitting on deposit at the Bank of England as of February, thanks to coupon payments. Unlike interest payments to other investors that get reinvested, that money isn't going anywhere.




The Fed, meanwhile, is handing over its interest income to the U.S. government, making for a circular arrangement in which the central bank effectively helps the government fund itself by printing money to buy huge volumes of Treasurys in the secondary market, before paying the interest it gets on these bonds back to the government.




The Congressional Budget Office, in fact, is figuring on even higher payments of interest from the central bank to the Treasury in 2014-2016 as it expects more bond buying.


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But extreme policies also carry risks. The Swiss central bank sustained heavy losses in 2010 and the first half of 2011 after piecemeal currency intervention failed to prevent the Swiss franc from rising.


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And the ECB narrowly escaped taking losses on its holdings of Greek government bonds when the restructuring came. Both of those have raised fears that extreme central-bank policy could be a source of great damage, potentially even requiring recapitalizations and limiting room to maneuver.



Still, central banks aren't like other banks when it comes to losses. Swiss National Bank Chairman Thomas Jordan argued in 2011 that even a short period of negative equity would be tolerable. Central banks can't become illiquid, and, over time, their ability to finance themselves effectively for free—through the issuance of irredeemable, noninterest-bearing bank notes—should create a structural profit.



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But the biggest oddity about extraordinary central-bank policy is, perhaps, also the greatest danger: how swiftly market participants have come to accept such actions as normal.


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Quantitative easing, a shocking development when first implemented, has now become mainstream. Central banks may face a serious struggle if their aggressive moves ever succeed in normalizing Western economies, and they have to call time on extreme policy.



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




August 24, 2012 6:38 pm
 
The hedge funds are playing a loser’s game
 

The financial crisis trashed many reputations in the City of London and on Wall Street. But not those of the financial aristocracy – the hedge fund bosses. While the bankers took it in the neck for the carnage, some of the savvier hedgies – such as John Paulson, who made billions shorting the US housing marketactually saw their stock soar ever higher.




Other investment vehicles may have become pariahs but hedge funds have remained stubbornly fashionable. Since 2009, investors have pumped nearly $150bn of net new money into them, allowing the industry not only to rebound from the crisis but to resume its expansion. At last count, hedge funds managed $2.1tn in assets, more than they did on the eve of the financial crisis five years ago.



Among the most enthusiastic buyers of hedge fund services have been pension funds. Driven by the need to fulfil past promises made to beneficiaries, trustees have been prepared to punt ever more money on so-called alternative investments. Some US retirement funds intend to put up to 15 per cent of their assets into hedge funds in coming years against the 5-10 per cent many have invested now.




This is an ill-judged bet that gets ever harder to justify as hedge funds get bigger. For all its self-proclaimed brainpower, there is little evidence that the industry has the capacity to earn superior returns on the vast ocean of cash it already has at its disposallet alone all this new money. Even before the financial crisis, results were fairly lacklustre and they are worse now.




Far from carrying all before him, Mr Paulson is making thumping losses. Othermasters of the universe” – most recently Louis Bacon of Moore Capital – have been handing funds back to investors, in part because of the difficulty of earning satisfactory returns. George Soros, fabled as the “man who broke the Bank of England”, gave his investors all their money back last year.




Hedge fund bosses blame many of their difficulties on the dire financial environment and it is true that low interest rates and limited liquidity have conspired to crimp trading opportunities. But it is hard to avoid the impression that hubris is also a factor: hedge funds are now too big and numerous for their own good.




While the industry seems loath to accept the idea that there should be any limits to its size, there are clear problems associated with scale. It becomes harder to devise distinctive strategies. Funds find it more difficult to trade in and out of markets without moving prices against themselves.




An even bigger concern is that size has turned the industry into what is known as a “loser’s game”. This is one in which victory goes not to the player with the best offensive strategy but to the one who makes the fewest mistakes – and has the lowest costs. Hedge fundery has become a loser’s game because the funds themselves are no longer the exotic and small offshoot of mainstream fund management they were in the 1990s. Increasingly, they are the market.




Although hedge fund assets account for less than 10 per cent of investment funds worldwide, they account for a far bigger proportion of all trading on UK and US stock exchanges. The industry is increasingly engaged in a zero-sum game in which one fund’s profit is another’s loss, less the costs of the transaction. Given the high fees and trading expenses incurred by hedge funds, the majority are mathematically likely to disappoint.




This is not a problem the industry finds easy to address. Although some star managers such as Mr Bacon – may have the self-confidence to limit the size of their funds, many are beguiled by the industry’s lucrative fee structure into gathering assets without much thought as to whether they can put them to profitable use.




Discipline can only be imposed by outside investors. A good place to start would be to take a hard look at the way hedge funds report returns. This has obscured the size-related decline in performance.
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The industry usestime-weightedfigures that simply record the return of each fund irrespective of how big it is. So a huge return on a tiny fund has the same weighting as a mediocre return on a giant one.



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This, given the constant budding of tiny spin-off funds, which (if they report figures publicly at all) tend to perform well at least in their early years, has flattered the indices.


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A better way to assess the merit of a hedge fund investment is to use a “dollar-weighted approach, meaning looking at what happens to dollars when they are actually invested. This is more akin to calculating a profit and loss account for hedge funds and, as such, takes size into account.




At the start of this year, Simon Lack, a hedge fund investor, performed precisely this analysis for the whole industry going back to the 1990s. The results were miserable. Mr Lack concluded that investors would have been better off putting their money in US Treasury bills yielding just 2.3 per cent a year.




Roughly 98 per cent of all the returns generated by hedge funds, he estimated, had been eaten by fees.



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Tellingly, the Alternative Investment Management Association, the hedge fund industry body, has devoted a great deal of effort to rubbishing Mr Lack’s claims, recently publishing a 24-page paper (after six months of study) seeking to rebut his argument point by point. But far from demolishing his analysis, the series of quibbles the organisation ultimately offered actually (if unwittingly) reinforced it.



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There are great hedge funds and investors have done well by backing them. It is not clear, however, that there would be many more such funds were the industry to have $3tn of assets rather than the current $2.1tn. “Large amounts of money under management and high fees spell eventual performance disappointment,” observed the late investor Barton Biggs. If the pension fund industry does not learn this lesson then it – and its beneficiaries – may face a rude awakening.



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Copyright The Financial Times Limited 2012



America’s Exceptional Fiscal Conservatism
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Simon Johnson
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23 August 2012

 

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WASHINGTON, DCIn most countries, to befiscally conservative” means to worry a great deal about the budget deficit and debt levels – and to push these issues to the top of the policy agenda. In many eurozone countries today, “fiscal conservatives” are a powerful group, insisting on the need to boost government revenue while bringing spending under control.


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In Great Britain, too, leading Conservatives have recently proved willing to raise taxes and attempted to limit future spending.



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The United States is very different in this respect. There, leading politicians who choose to call themselvesfiscal conservatives” – such as Paul Ryan, now the Republican Party’s presumptive vice-presidential nominee to run alongside presidential candidate Mitt Romney in November’s electioncare more about cutting taxes, regardless of the effect on the federal deficit and total outstanding debt. Why do US fiscal conservatives care so little about government debt, relative to their counterparts in other countries?


 
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It has not always been this way. For example, in 1960, President Dwight D. Eisenhower’s advisers suggested that he should cut taxes in order to pave the way for his vice president, Richard Nixon, to be elected to the presidency. Eisenhower declined, partly because he did not particularly like or trust Nixon, but mostly because he thought it was important to hand over a more nearly balanced budget to his successor.



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The framework for US macroeconomic policy changed dramatically when the international monetary system broke down in 1971. The US could no longer maintain a fixed exchange rate between the dollar and gold – the cornerstone of the postwar Bretton Woods system. The arrangement collapsed because the US did not want to tighten monetary policy and run more restrictive fiscal policy: keeping US voters happy was understandably more important to President Nixon than maintaining a global system of fixed exchange rates.



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Ironically, however, rather than undermining the predominant international role of the US dollar, the end of Bretton Woods actually boosted its use around the world. Much has been written, and many hands wrung, about the dollar’s decline over the last four decades, but the fact remains that holdings of US dollar assets by foreigners today are vastly greater than they were in 1971.



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This turns out to be a mixed blessing, because it has allowed the US to become less careful about its fiscal accounts. Foreigners now hold roughly half of all US federal government debt, and they are willing to hold it when it yields a very low return in dollars (and even when the dollar depreciates).



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In fact, whenever the world looks unstable, investors want to hold more dollar assets – even when the US is the cause of the instability. When big US banks are in trouble or Americans are having another debilitating political fight over their public finances, global investors scramble into US Treasuries. Last year’s congressional showdown over the federal debt ceiling may have cost the US its AAA sovereign rating with Standard & Poor’s, but the federal government’s borrowing costs are actually lower now than they were then.



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What has America done with this opportunityarguably the lowest-cost funding in the history of humankind? Not much, in terms of productive investment, strengthening education, or maintaining essential infrastructure. But the US has done a great deal in terms of adopting tax cuts that boost consumption relative to income and lower government revenue relative to expenditure. This is the lasting legacy of the “temporarytax cuts adopted by George W. Bush’s administration in the early 2000’s.


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And Americans have shifted greatly toward political philosophies – on the right and on the left – that regard public debt merely as a distraction. Or, as former vice president Dick Cheney put it, “Reagan taught us that deficits do not matter” – meaning that Ronald Reagan cut taxes, ran bigger deficits, and did not suffer any adverse political consequences.



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Ryan and members of the Tea Party wing of the Republican Party undoubtedly want to cut the size of the federal government, and they have articulated plans to do this over several decades. But, in the near term, what they promise is primarily tax cuts: their entire practical program is front-loaded in that direction. The calculation is that this will prove politically popular (probably true) while making it easier to implement spending cuts down the road (less obvious). The vulnerability caused by higher public debt over the next few decades is simply ignored.



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For example, Ryan supported George W. Bush’s spending spree. He also supports maintaining defense spending at or near its current levelresisting the cuts that were put in place under the Budget Control Act of 2011.



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The assumption hereunstated and highly questionable – is that the US will be able to sell an unlimited amount of government debt at low interest rates for the foreseeable future. There is no other country in the world where fiscal conservatives would want to be associated with such a high-stakes gamble.
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Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog, http://BaselineScenario.com, a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.



REVIEW & OUTLOOK

Updated August 24, 2012, 6:53 p.m. ET

Negative $4,019

The Obama years have been brutal on middle-class incomes.



 

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The Presidential race is boiling down to one dominant issue: which party's policies will do more to help the financially stressed American middle class. President Obama's campaign theme is that Mitt Romney and the Republicans cater to the rich, while Mr. Obama cares about struggling families.




He may care, but he sure hasn't done much for them. New income data from the Census Bureau, tabulated by former Census income specialists at the nonpartisan economic consulting firm Sentier Research, reveal that the three-and-a-half years of the Obama Presidency have done enormous harm to middle-class households.
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In January 2009, the month President Obama entered the Oval Office and shortly before he signed his stimulus spending bill, median household income was $54,983. By June 2012, it had tumbled to $50,964, adjusted for inflation. (See the chart nearby.) That's $4,019 in lost real income, a little less than a month's income every year.




Unfair, you say, because Mr. Obama inherited a recession? Well, even if you start the analysis when the recession ended in June 2009, the numbers are dismal. Three years after the economy hit its trough, median household income is down $2,544, or nearly 5%.



Add the authors: "The overall decline since June 2009 was larger than the 2.6 percent decline that occurred" during the recession from December 2007 to June 2009. For household income, in other words, the Obama recovery has been worse than the Bush recession.




It's true that the Bush years overall were also not great for household incomes. According to Sentier's analysis, real median household income is down about 8% from $55,470 in 2000 before the dot-com bubble burst. Some of this decline is due to the continuation of a trend of smaller family size, lower fertility rates and more Americans living alone. But some was also due to the subpar economic growth across the 2000s.




That slow growth trend has become worse since the latest recession, and this is where Mr. Obama is implicated. The President portrays the financial decline of American families on his watch as part of a decades-long trend. He's wrong.



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Real income for middle-income households rose by roughly 30% from 1983 to 2005, according to the Congressional Budget Office. The political left likes to blame the ebbing of union power. But nongovernment unionization fell dramatically in the 1980s and '90s, and incomes rose.



So what does explain falling real incomes? Slow growth, yes, but another culprit has been rising prices—especially for food, gasoline, medical procedures and college tuition—that have eroded worker purchasing power. The Federal Reserve claims this is no problem because "core inflation" has been relatively contained. But core inflation excludes food and energy prices, which are two of the biggest components of consumer budgets.
 



The big pay freeze is also the bitter fruit of public schools that have failed to teach the basic skills and knowledge needed to succeed in a competitive global economy. Rising health-care costs have also forced employers to take money that used to go into higher wages to pay higher premiums.




A key driver of higher wages in the 1980s and 1990s was a surge of capital investment in computers, plant and equipment, which made Americans workers more productive. When Mr. Obama pledges to raise taxes on investment income (capital gains, dividends and small-business profits), he is making it costlier to innovate and modernize. That plays out over time into slower gains in productivity and wages.



Consider the toll from America's corporate tax rate, which is the highest in the industrial world. A 2011 study by economists at the American Enterprise Institute found that because of the capital flight from the U.S. as a result of this high rate, "every additional dollar of tax revenue [from the corporate tax] leads to a $4 decrease in aggregate real wages." American workers would be the biggest beneficiaries of tax reform.




The new income data reveal other eye-opening trends. The group that has suffered the most during the Obama Presidency has been black Americans, whose real incomes have fallen by more than 11%.



Mr. Obama also likes to say that government workers like teachers are hurting and the private economy is doing "just fine." But the data indicate that over the past three years households with government workers saw their incomes decline less than households with private workers. The public-private pay gap is now wider than ever ($77,998 government versus $63,800).




Every age group has seen a decline in incomeexcept the elderly. Those between the ages of 65 and 75 saw an average 6.5% gain in income, though most are not working and collect Medicare and Social Security.



The last time incomes fell this fast was during the late 1970s under Jimmy Carter, and it's no coincidence that economic policies then and now are so similar. If Mr. Obama succeeds in convincing voters that he really is the tribune of the middle class, it will be the political conjurer's trick of the century.