Hard to be Easing

Nouriel Roubini

12 October 2012


NEW YORK – The United States Federal Reserve’s decision to undertake a third round of quantitative easing, or QE3, has raised three important questions. Will QE3 jump-start America’s anemic economic growth? Will it lead to a persistent increase in risky assets, especially in US and other global equity markets? Finally, will its effects on GDP growth and equity markets be similar or different?
Many now argue that QE3’s effect on risky assets should be as powerful, if not more so, than that of QE1, QE2, and “Operation Twist,” the Fed’s earlier bond-purchase program. After all, while the previous rounds of US monetary easing have been associated with a persistent increase in equity prices, the size and duration of QE3 are more substantial. But, despite the Fed’s impressive commitment to aggressive monetary easing, its effects on the real economy and on US equities could well be smaller and more fleeting than those of previous QE rounds.
Consider, first, that the previous QE rounds came at times of much lower equity valuations and earnings. In March 2009, the S&P 500 index was down to 660, earnings per share (EPS) of US companies and banks had sunk to a financial-crisis low, and price/earnings ratios were in the single digits. Today, the S&P 500 is more than 100% higher (hovering near 1,430), the average EPS is close to $100, and P/E ratios are above 14.
Even during QE2, in the summer of 2010, the S&P 500, P/E ratios, and EPS were much lower than they are today. If, as is likely, economic growth in the US remains anemic in spite of QE3, top-line revenues and bottom-line earnings will turn south, with negative effects on equity valuations.
Moreover, fiscal support is absent this time: QE1 and QE2 helped to prevent a deeper recession and avoid a double dip, respectively, because each was associated with a significant fiscal stimulus. In contrast, QE3 will be associated with a fiscal contraction, possibly even a large fiscal cliff.
Even if the US avoids the full fiscal cliff of 4.5% of GDP that is looming at the end of the year, it is highly likely that a fiscal drag amounting to 1.5% of GDP will hit the economy in 2013. With the US economy currently growing at a 1.6% annual rate, a fiscal drag of even 1% implies near-stagnation in 2013, though a modest recovery in housing and manufacturing, together with QE3, should keep US growth at about its current level in 2013.
But there is no broader rebound underway. In both 2010 and 2011, leading economic indicators showed that the first-half slowdown had bottomed out, and that growth was already accelerating before the announcement of monetary easing. Thus, QE nudged along an economy that was already recovering, which prolonged asset reflation.
By contrast, the latest data suggest that the US economy is performing as sluggishly now as it was in the first half of the year. Indeed, if anything, weakness in the US labor market, low capital expenditures, and slow income growth have contradicted signals in the early summer that third-quarter growth might be more robust.
Meanwhile, the main transmission channels of monetary stimulus to the real economy – the bond, credit, currency, and stock markets – remain weak, if not broken. Indeed, the bond-market channel is unlikely to boost growth. Long-term government bond yields are already very low, and a further reduction will not significantly change private agents’ borrowing costs.
The credit channel also is not working properly, as banks have hoarded most of the extra liquidity from QE, creating excess reserves rather than increasing lending. Those who can borrow have ample cash and are cautious about spending, while those who want to borrowhighly indebted households and firms (especially small and medium-size enterprises) – face a credit crunch.
The currency channel is similarly impaired. With global growth weakening, net exports are unlikely to improve robustly, even with a weaker dollar. Moreover, many major central banks are implementing variants of QE alongside the Fed, dampening the effect of the Fed’s actions on the dollar’s value.
Perhaps most important, a weaker dollar’s effect on the trade balance, and thus on growth, is limited by two factors. First, a weaker dollar is associated with a higher dollar price for commodities, which implies a drag on the trade balance, because the US is a net commodity-importing country. Second, any improvement in GDP derived from stronger exports leads to an increase in imports. Empirical studies estimate that the overall impact of a weaker US dollar on the trade balance is close to zero.
The only other significant channel to transmit QE to the real economy is the wealth effect of an equity-market increase, but there is some circularity in the argument that QE3 will lead to a persistent rise in equity prices. If persistent asset reflation requires a significant GDP growth recovery, it is tautological to say that if equity prices rise enough following QE, the resulting increase in GDP from a wealth effect justifies the rise in asset prices. If monetary policy’s transmission channels to the real economy are broken, one cannot assume that QE will have a significant effect on economic growth.
Fed Chairman Ben Bernanke has recently emphasized the importance of an additional channel: the confidence channel, through which the Fed’s commitment to maintaining generous monetary conditions for longer could improve private spending. The issue is how substantial and durable such effects will be. Confidence is fragile in an environment characterized by ongoing deleveraging, macro uncertainties, weak labor-market growth, and a fiscal drag.
In short, QE3 reduces the tail risk of an outright economic contraction, but is unlikely to lead to a sustained recovery in an economy that is still enduring a painful deleveraging process. In the short run, QE3 will lead investors to take on risk, and will stimulate modest asset reflation. But the equity-price rise is likely to fizzle out over time if economic growth disappoints, as is likely, and drags down expectations about corporate revenues and profitability.

Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank

October 23, 2012 7:25 pm

A slow convalescence under Obama

By Martin Wolf  .

Ingram Pinn illustration©Ingram Pinn

How badly has the US economy performed under President Barack Obama? Ronald Reagan posed the political version of this question in his presidential debate against Jimmy Carter in 1980, when he asked: “Are you better off than you were four years ago?” It is, naturally, the question Mitt Romney asks now.

At first glance, the answer is: just a little better off. In the second quarter of 2012, real gross domestic product was 5.2 per cent higher than in the fourth quarter of 2008, the last full quarter before Mr Obama took office. The seasonally adjusted unemployment rate of 7.8 per cent in September was the same as in January 2009. Yet, since he took office when the economy was in the throes of a huge financial crisis, analysts must ask whether this performance is decent in the circumstances, as supporters argue, or disappointing, as opponents insist.

John Taylor, professor at Stanford University, a highly regarded macroeconomist, has no doubt of the answer. In a recent blog, he argues that strong growth normally follows US financial crises, the exception to this rule being the current recovery (see chart). Moreover, he argues, bad policy is to blame. True, Prof Taylor is a member of Mr Romney’s economic team. Yet the question remains: is he right? The answer is: no. But it is important to ask why.

The first question is whether Prof Taylor is comparing like with like. Against him is widespread agreement that the aftermaths of systemic financial crises are worse than those of more normal downturns. The seminal research of Carmen Reinhart and Kenneth Rogoff in their classic book, This Time is Different, has shaped this consensus. It is also supported by the work of the economic historian Alan Taylor, of the University of Virginia, included in a recent paper entitled The Great Leveraging.

Profs Reinhart and Rogoff distinguish a “systemic financial crisis” as one characterised by a real estate bubble and high levels of debt. Neither of these preceded the recessions of 1973 and 1981, which are included in Prof Taylor’s chart. Both the precursors and results of the recent crisis were quite different from the downturns in the mid-1970s, early 1980s and early 1990s. This is true of real house prices, inflation, interest rates and debt (see chart).

The second question is whether speed of recovery is a good measure of success. The answer is: no. To understand this, focus on the systemic financial crises that began in 1893, 1907, 1929 and 2007, respectively. In his chart, Prof Taylor relies on a paper by Michael Bordo of Rutgers and Joseph Haubrich of the Federal Reserve Bank of Cleveland. My chart uses their data, in which recoveries have the same duration as prior contractions. What marks out the recent recession is not the weakness of the recovery, but that of the contraction. The main reason the recovery seems weak was that the contraction was so mild, given the scale of the financial crisis. That was a huge policy success.

In their response to Prof Bordo and Mr Haubrich, Profs Reinhart and Rogoff also note that the economic contraction after the recent crisis was smaller than after prior systemic crises. Moreover, five years on, real GDP per head, relative to the baseline, is higher than in the average of prior systemic crises.
That is what matters. A stronger recovery from a steeper plunge is hardly a better outcome than a slower recovery from a milder plunge.

The third question is whether it makes sense to focus on US experience alone. Prof Bordo has complained that Profs Reinhart and Rogoff lump together countries “with diverse institutions, financial structures and economic policies”. But it beggars belief that the US of the late 19th or early 20th centuries, with the gold standard, no deposit insurance, no central bank before 1913 and minimal federal spending is more similar to today’s US than Japan or Sweden in the 1990s or Spain and the UK today. Profs Reinhart and Rogoff are surely right to reject this appeal to American exceptionalism. Beyond that, limiting the analysis to US experience also limits the range of comparisons, thereby forcing the researchers to include many US recessions that are of borderline relevance, at best, to the needed focus on systemic crises.

The international comparisons made by Profs Reinhart and Rogoff turn out to be quite revealing. The performance of the US in this crisis has been markedly better than the average of the other high income countries that were hit by the recent wave of systemic banking crises (see chart). Again, the analysis supports the view that systemic financial crises do cause deeper and longer-lasting recessions. Using a database of more than 200 recessions over 140 years in 14 high-income countries, Prof Taylor argues that the combination of a credit boom with a financial crisis imposesabnormally severe downward pressures on growth, prices and capital formation for sustained periods”.

In sum, we have no reason to regard the performance of the US economy under President Obama as poor, given the conditions he inherited. But this does not mean that recovery could not have been far stronger. Policy was insufficiently supportive of a stronger recovery. That is partly because the administration underestimated the forces for contraction. It is still more because of the opposition of the Republicans to any stimulus. In an economy afflicted by the implosion of a huge credit boom, the forces for contraction were bound to be both strong and enduring. With interest rates at zero, the effectiveness of monetary policy was limited. Given this, the American Recovery and Reinvestment Act, which amounted to an average of a little under 2 per cent of GDP in the years it was effective, was plainly too small.

The great achievement of policy was to limit the severity of the post-crisis recession. This is largely due to the Federal Reserve and the decision to prevent a financial collapse in the autumn of 2008. But it is also due to sensible, albeit limited, action by the administration. Moreover, by historical and international comparisons, the US economy has performed quite well. Focusing on the recovery, without looking at the contraction, is clearly misleading. Finally, to the extent that the recovery was not stronger, the obstructionism of Republicans in Congress has to bear a sizeable part of the blame.

But the big question is: what comes next? Who has the policies to ensure a strong and sustained US recovery? I intend to examine that question next week.

Copyright The Financial Times Limited 2012.

miércoles, octubre 24, 2012


Happiness Is Equality

Robert Skidelsky

19 October 2012


 LONDONThe king of Bhutan wants to make us all happier. Governments, he says, should aim to maximize their people’s Gross National Happiness rather than their Gross National Product. Does this new emphasis on happiness represent a shift or just a passing fad?

It is easy to see why governments should de-emphasize economic growth when it is proving so elusive. The eurozone is not expected to grow at all this year. The British economy is contracting. Greece’s economy has been shrinking for years. Even China is expected to slow down. Why not give up growth and enjoy what we have?

No doubt this mood will pass when growth revives, as it is bound to. Nevertheless, a deeper shift in attitude toward growth has occurred, which is likely to make it a less important lodestar in the future – especially in rich countries.

The first factor to undermine the pursuit of growth was concern about its sustainability. Can we continue growing at the old rate without endangering our future?

When people started talking about the “naturallimits to growth in the 1970’s, they meant the impending exhaustion of food and non-renewable natural resources.
Recently the debate has shifted to carbon emissions. As the Stern Review of 2006 emphasized, we must sacrifice some growth today to ensure that we do not all fry tomorrow.

Curiously, the one taboo area in this discussion is population. The fewer people there are, the less risk we face of heating up the planet. But, instead of accepting the natural decline in their populations, rich-country governments absorb more and more people to hold down wages and thereby grow faster.

A more recent concern focuses on the disappointing results of growth. It is increasingly understood that growth does not necessarily increase our sense of well-being. So why continue to grow?

The groundwork for this question was laid some time ago. In 1974, the economist Richard Easterlin published a famous paper, Does Economic Growth Improve the Human Lot? Some Empirical Evidence.” After correlating per capita income and self-reported happiness levels across a number of countries, he reached a startling conclusion: probably not.

Above a rather low level of income (enough to satisfy basic needs), Easterlin found no correlation between happiness and GNP per head. In other words, GNP is a poor measure of life satisfaction.

That finding reinforced efforts to devise alternative indexes. In 1972, two economists, William Nordhaus and James Tobin, introduced a measure that they called Net Economic Welfare,” obtained by deducting from GNPbadoutputs, like pollution, and adding non-market activities, like leisure. They showed that a society with more leisure and less work could have as much welfare as one with more work – and therefore more GNP – and less leisure.


More recent metrics have tried to incorporate a wider range of “quality of lifeindicators. The trouble is that you can measure quantity of stuff, but not quality of life. How one combines quantity and quality in some index of “life satisfaction” is a matter of morals rather than economics, so it is not surprising that most economists stick to their quantitative measures of “welfare.”

But another finding has also started to influence the current debate on growth: poor people within a country are less happy than rich people. In other words, above a low level of sufficiency, peoples’ happiness levels are determined much less by their absolute income than by their income relative to some reference group. We constantly compare our lot with that of others, feeling either superior or inferior, whatever our income level; well-being depends more on how the fruits of growth are distributed than on their absolute amount.

Put another way, what matters for life satisfaction is the growth not of mean income but of median income – the income of the typical person. Consider a population of ten people (say, a factory) in which the managing director earns $150,000 a year and the other nine, all workers, earn $10,000 each. The mean average of their incomes is $25,000, but 90% earn $10,000. With this kind of income distribution, it would be surprising if growth increased the typical person’s sense of well-being.

That is not an idle example. In rich societies over the last three decades, mean incomes have been rising steadily, but typical incomes have been stagnating or even falling. In other words, a minority – a very small minority in countries like the United States and Britain – has captured most of the gains of growth. In such cases, it is not more growth that we want, but more equality.

More equality would not only produce the contentment that flows from more security and better health, but also the satisfaction that flows from having more leisure, more time with family and friends, more respect from one's fellows, and more lifestyle choices. Great inequality makes us hungrier for goods than we would otherwise be, by constantly reminding us that we have less than the next person. We live in a pushy society with turbo-charged fathers and “tigermothers, constantly goading themselves and their children to “get ahead.”

The nineteenth-century philosopher John Stuart Mill had a more civilized view:

“I confess I am not charmed with the ideal of life held out by those who think that the trampling, crushing, elbowing, and treading on each other's heels, which form the existing type of social life, are the most desirable lot of human kind. The best state for human nature is that in which, while no one is poor, no one desires to be richer, nor has any reason to fear being thrust back, by the efforts of others to push themselves forward.”

That lesson has been lost on most economists today, but not on the king of Bhutan – or on the many people who have come to recognize the limits of quantifiable wealth.

Robert Skidelsky, Professor Emeritus of Political Economy at Warwick University and a fellow of the British Academy in history and economics, is a member of the British House of Lords. The author of a three-volume biography of John Maynard Keynes, he began his political career in the Labour party, became the Conservative Party’s spokesman for Treasury affairs in the House of Lords, and was eventually forced out of the Conservative Party for his opposition to NATO’s intervention in Kosovo in 1999.

Markets Insight

October 23, 2012 2:04 pm

Collateral reuse risks contagion

By John Plender

How much do we really know about what is going on in the financial system? I ask, in the light of work done by Manmohan Singh, a senior economist at the International Monetary Fund, on what he calls the “otherdeleveraging – that is, the deleveraging of the financial system that stems from the shortening of collateral chains.

While the sting has been taken out of bank balance sheet shrinkage as a result of central bank injections of liquidity over the past 12 months, Mr Singh argued at the annual meeting of the European Capital Markets Institute last week that markets continue to impose strong contractionary pressure via this different avenue and that the reuse rate or velocity of collateral in the system has declined substantially since the collapse of Lehman Brothers.

This matters because the numbers involved are big. At Lehman at the end of November 2007 the fair value of securities received as collateral that were permitted to be sold or repledged was $798bn, which was significantly larger than the doomed investment bank’s total balance sheet of $691bn. These important numbers are tucked away in the notes to the voluminous accounts of the big financial institutions, which means they attract less attention than they deserve.

The story is substantially about hedge funds, which finance their positions by pledging collateral to their prime brokers for reuse or by passing collateral to other dealers via the repo market. But mainstream financial institutions such as pension funds, insurance companies, asset managers and sovereign wealth funds are also involved, most notably through securities lending.

At the level of the overall system, the IMF has identified up to 14 large banks active in global collateral management. It has taken the total amount of collateral these banks received at the end of 2007 and compared it with primary sources of collateral from hedge funds and other non-banks. The ratio of the two shows the reuse rate or velocity of collateral, which is a proxy for the lubricating effect of collateral on the financial system. Between 2007 and 2011 this ratio fell from 3.0 to 2.5. In dollar terms the fall was from $10tn to $6.2tn – a substantial contraction of liquidity.

The shrinkage is partly the result of the heightened awareness of counterparty risk since the Lehman collapse, partly of the disappearance from the pool of collateral of all those structured products that were wrongly rated triple A. No doubt a tougher regulatory climate will have exercised an influence.

Interestingly, Mr Singh thinks a rebound in the pledged collateral market would be a better way to stimulate economies than quantitative easing because, unlike central bank asset purchasing programmes, it would not involve the central banks in a quasi-fiscal role, with all the related exit problems. I am not so sure.

Some of this business, such as securities lending, is relatively simple and should not pose systemic threats. Yet many hedge fund strategies are another matter. And I wonder how much of the banks’ collateral business is directed at regulatory and jurisdictional arbitrage. In the US, the Securities and Exchange Commission restricts prime brokers’ use of rehypothecated collateral from their clients. English law, by contrast, imposes no such constraint.

Certainly a portion of the business is related to window dressing. Currently banks are offering pension funds and other institutional investors liquidity trades whereby, for example, pension funds are invited to make secured loans of gilt-edged stock to the banks in exchange for illiquid collateral over three years. The pension fund earns a return of up to 1.5 per cent per annum for this accommodation. How far bank supervisors are aware of the extent of the resulting prettification of bank balance sheets is an interesting question.

The more fundamental point is that these collateral chains were shown to be systemically toxic in the Lehman collapse. They can become an awesome engine of contagion.

Clearly collateral is a necessary part of the operations of the financial system. Yet it is hard to be sure what the optimal level of collateral should be. Many would certainly argue that the financial system would be a great deal safer if it were significantly lower than today’s level.

The IMF has nonetheless shone an important light on an opaque part of the system. It is undoubtedly right that monetary policy needs to take into account what is going on in this huge marketplace. Many central bankers claim, naturally enough, that they are on top of the issue and closely monitoring levels of collateral. Maybe so. Yet in opaque professional markets of this kind things can change fast. Given the systemic issues involved, the watchdogs undeniably need to be on the qui vive.

The writer is an FT columnist

Copyright The Financial Times Limited 2012.