The Lost Generations

Jeffrey D. Sachs

24 October 2012


 NEW YORKA country’s economic success depends on the education, skills, and health of its population. When its young people are healthy and well educated, they can find gainful employment, achieve dignity, and succeed in adjusting to the fluctuations of the global labor market.

Businesses invest more, knowing that their workers will be productive. Yet many societies around the world do not meet the challenge of ensuring basic health and a decent education for each generation of children.
Why is the challenge of education unmet in so many countries? Some are simply too poor to provide decent schools. Parents themselves may lack adequate education, leaving them unable to help their own children beyond the first year or two of school, so that illiteracy and innumeracy are transmitted from one generation to the next. The situation is most difficult in large families (say, six or seven children), because parents invest little in the health, nutrition, and education of each child.
Yet rich countries also fail. The United States, for example, cruelly allows its poorest children to suffer. Poor people live in poor neighborhoods with poor schools. Parents are often unemployed, ill, divorced, or even incarcerated. Children become trapped in a persistent generational cycle of poverty, despite the society’s general affluence. Too often, children growing up in poverty end up as poor adults.
A remarkable new documentary film, The House I Live In, shows that America’s story is even sadder and crueler than that, owing to disastrous policies. Starting around 40 years ago, America’s politicians declared a “war on drugs,” ostensibly to fight the use of addictive drugs like cocaine. As the film clearly shows, however, the war on drugs became a war on the poor, especially on poor minority groups.
In fact, the war on drugs led to mass incarceration of poor, minority young men. The US now imprisons around 2.3 million people at any time, a substantial number of whom are poor people who are arrested for selling drugs to support their own addiction. As a result, the US has ended up with the world’s highest incarceration rate – a shocking 743 people per 100,000!
The film depicts a nightmarish world in which poverty in one generation is passed on to the next, with the cruel, costly, and inefficientwar on drugsfacilitating the process. Poor people, often African-Americans, cannot find jobs or have returned from military service without skills or employment contacts. They fall into poverty and turn to drugs.
Instead of receiving social and medical assistance, they are arrested and turned into felons. From that point on, they are in and out of the prison system, and have little chance of ever getting a legal job that enables them to escape poverty. Their children grow up without a parent at home – and without hope and support. The children of drug users often become drug users themselves; they, too, frequently end up in jail or suffer violence or early death.
What is crazy about this is that the US has missed the obvious point – and has missed it for 40 years. To break the cycle of poverty, a country needs to invest in its children’s future, not in the imprisonment of 2.3 million people a year, many for non-violent crimes that are symptoms of poverty.
Many politicians are eager accomplices to this lunacy. They play to the fears of the middle class, especially middle-class fear of minority groups, to perpetuate this misdirection of social efforts and government spending.
The general point is this: Governments have a unique role to play to ensure that all young members of a generationpoor children as well as rich ones – have a chance. A poor kid is unlikely to break free of his or her parents’ poverty without strong and effective government programs that support high-quality education, health care, and decent nutrition.
This is the genius of “social democracy,” the philosophy pioneered in Scandinavia, but also deployed in many developing countries, such as Costa Rica. The idea is simple and powerful: All people deserve a chance, and society needs to help everybody to secure that chance. Most important, families need help to raise healthy, well-nourished, and educated children. Social investments are large, financed by high taxes, which rich people actually pay, rather than evade.
This is the basic method to break the intergenerational transmission of poverty. A poor child in Sweden has benefits from the start. The child’s parents have guaranteed maternity/paternity leave to help them nurture the infant. The government then provides high-quality day care, enabling the mother knowing that the child is in a safe environment – to return to work. The government ensures that all children have a place in preschool, so that they are ready for formal schooling by the age of six. And health care is universal, so the child can grow up healthy.
A comparison of the US and Sweden is therefore revealing. Using comparable data and definitions provided by the Organization for Economic Cooperation and Development, the US has a poverty rate of 17.3%, roughly twice Sweden’s poverty rate of 8.4%. And America’s incarceration rate is 10 times Sweden’s rate of 70 people per 100,000. The US is richer on average than Sweden, but the income gap between America’s richest and poorest is vastly wider than it is in Sweden, and the US treats its poor punitively, rather than supportively.
One of the shocking realities in recent years is that America now has almost the lowest degree of social mobility of the high-income countries. Children born poor are likely to remain poor; children born into affluence are likely to be affluent adults.
This inter-generational tracking amounts to a profound waste of human talents. America will pay the price in the long term unless it changes course. Investing in its children and young people provides the very highest return that any society can earn, in both economic and human terms.

Jeffrey D. Sachs, Director of the United Nations Millennium Project from 2002 to 2006, is a professor at Columbia University, Director of its Earth Institute, and a special adviser to UN Secretary-General Ban Ki-Moon. His books include The End of Poverty and Common Wealth.

Copyright Project Syndicate -


Signal failure

Why illiquidity in one asset can spread quickly to others

Oct 27th 2012

THE flash crash of May 6th 2010 titillated financial academics and lovers of mystery alike. Within the space of about 20 minutes the prices of thousands of securities on Wall Street collapsed, sometimes by more than 60%, before recovering almost as quickly. It is not so much a whodunnit as a whydidit?

An official report pointed to a sell order in the futures market as the spark. But that still raises the question of why, in a supposedly efficient market, a single transaction caused so much chaos.
The answer, according to a recent paper* by Giovanni Cespa of the Cass Business School and Thierry Foucault of HEC Paris, lies in the way that market participants try to control their risks. Like a retailer on the high street, securities dealers carry an inventory so they can fulfil their customers’ orders. That means they incur the risk that a sudden price plunge will cause them to offload their inventory at a loss, just as greengrocers suffer when they try to flog pumpkins after Halloween.

To safeguard themselves dealers monitor liquidity signals in other asset classes. These, they reason, may give them useful information about the assets they hold on their own books. If one asset suddenly becomes illiquid, that may indicate a change in the risk appetite of investors. As a result dealers will become less willing to provide liquidity in other markets, too. That will mean either that the gap between bids and offers will widen, or that individual buy-and-sell orders will have a much bigger effect on prices.

In consequence a liquidity shock in one asset class may have an effect in others, as dealers become ever more risk-averse. In the words of Mr Cespa and Mr Foucault, “dealersbeliefs about the informativeness of the prices and liquidity of other securities are self-fulfilling.” In short order markets can turn from being very liquid to being highly illiquid.

In some circumstances—a bad piece of economic news, say, or a default by a large debtor—a sudden loss of liquidity may be quite understandable. All assets sometimes have to be repriced to take account of a change in fundamentals. But sometimes an individual asset may fall for entirely idiosyncratic reasons—a software glitch on a dealer’s computer, for example. The effect on other markets may be similar, however, because dealers still interpret the liquidity decline as conveying useful information.

What role do high-frequency traders play in this process? Lots of them look for examples of mispriced securities, hoping to make profits by buying and selling them but adding liquidity to the markets in the process. But they, too, depend on being able to trade with the dealers: if liquidity dries up, the high-frequency traders will also become less active.

The authors say that the disappearance of high-frequency traders during the flash crash was most obvious in the world of exchange-traded funds (ETFs). These funds consist of baskets of securities, usually linked to an index. In theory the value of an ETF should closely follow the value of the securities it owns.

When the two prices get out of line, high-frequency traders are often the ones stepping in to make a profit. But ETFs were among the most illiquid assets during the flash crash, suggesting that high-frequency traders had pulled back from this market.

All this can happen very rapidly, as the flash crash demonstrated. But what can be done about it?

Many exchanges already have circuit-breakers in place so that trading is halted once prices have fallen by a significant amount. These safeguards date back to “Black Monday25 years ago, when the Dow Jones Industrial Average fell by almost 23%.

The authors suggest that a liquidity circuit-breaker should apply as well. A version already exists on the Chicago Mercantile Exchange. Trading is halted if there is a huge imbalance in buy and sell orders that is likely to lead to an exaggerated change in price. Something similar could be designed for other markets.

It may seem perverse to respond to market illiquidity by halting all trading. It sounds a bit like responding to food shortages by closing down all supermarkets. But the idea is to give investors and traders time to pause and reflect. This should prevent illiquidity from spreading.

It is surely in the long-term interest of the markets that events like the flash crash are avoided. Investors have had enough bad news about equities to contend with over the past decade. It will do nothing to restore their confidence in stockmarkets if the price-setting mechanism appears to be a lottery.

* “Illiquidity Contagion and Liquidity Crashes”, May 2012

Heed churlish Mervyn King on limits of QE

Stephen King

October 25, 2012


In Apocalypse Now, Wagner’sRide of the Valkyries” provides the soundtrack to the dirty deeds of American helicopter crews. I don’t know whether Sir Mervyn King, Governor of the Bank of England and avid classical music buff, has been listening to Wagner recently but he clearly shares Francis Ford Coppola’s horror of helicopters. In Sir Mervyn’s case, however, the source of his angst is monetary, not military, helicopters.

In a speech on Tuesday night, Mr King outlined the limits to monetary policy. Following all the talk from the International Monetary Fund about magical multipliers, Mr King offered a much-needed dose of economic reality. Taking a leaf out of Japan’slost decade experience, he warned of the dangers of rising non-performing loans, implying that the banking sector would take many years to recover. He was dismissive of the idea that the Bank of England should cancel giltsUK government debt – that it has purchased as part of its programme of quantitative easing. And he sneered at the idea of dropping money from the aforementioned helicopters. Mr King, is not a believer in “get rich quickschemes.

It’s not so much that monetary policy is ineffective. Rather, people expect too much from it. Those who hope for a return to the good old days choose to ignore the rather obvious fact that, back then, economic activity was heavily distorted: economic growth in the years preceding Lehman was driven by a housing boom, a sub-prime lending boom, financial market shenanigans, ever-higher levels of public spending and, frankly, not much else.

Early doses of quantitative easing were consistent with the desire to rebalance the UK economy. In anticipation of the first round of unconventional policies, sterling fell, offering the opportunity for an export-led recovery. In reality, however, the UK ended up with little in the way of extra growth and rather too much in the way of inflation. Sterling’s decline amplified the impact on the UK of higher global commodity prices. That wasn’t really part of the plan: the resulting squeeze on real incomes made deleveraging that much more difficult. Meanwhile, the much-heralded export recovery failed to materialise. Relative to the BoE’s own economic forecasts made towards the end of 2010 – and conditioned on the positive effects of QEthe UK economy’s performance has been very disappointing.

It may well be that unconventional monetary policy can prevent the worst outcome – the avoidance of another Great Depression, let’s say – but it is not obvious that it can take us back to the sunny uplands of the pre-crisis years.

Indeed, I would argue that unconventional policies create distortions that make an early return to economic health rather unlikely.

I have three concerns. First, QE delivers a flat yield curve – that is interest rates for long-term loans are not much higher than for short-term loans. That should certainly help boost the demand for credit. But a flat yield curve makes it difficult for banks to make money by borrowing cheaply at short-term interest rates and lending profitably at higher long-term rates. Lower bank profitability will restrict the supply of credit. During the early-1990s credit crunch, the Federal Reserve deliberately engineered a positively-sloped yield curve to “fix” the banks, the polar opposite of today’s policies.

Second, as the BoE now well knows, QE increases pension fund shortfalls. Admittedly, fully-funded pensions shouldn’t have many problems but, today, these are few and far between. Underfunded schemes have seen the net present value of their liabilities rise more quickly than their assets, creating uncertainty over future pension entitlements and contributions, dampening household confidence in the process.

Third, despite Mr King’s insistence that monetary and fiscal policy are entirely separate, this is no longer the case. In the upcoming pre-Budget Report, George Osborne will be able to delay fiscal consolidation thanks in part to the behaviour of the Bank of England, whose gilt buying has kept yields low allowing the government to borrow cheaply to fund deficits. QE has become the Chancellor’s lifeline, sparing him from a 21st century Greek tragedy.

This, however, is another example of avoiding the worst, rather than providing a path towards recovery. QE has allowed the government to live with high – and risinglevels of debt. It has not, however, delivered the kind of recovery that would, eventually, allow those debt levels to decline. In this way, the UK is emulating Japan’s experience: low rates, high government debt and disappointing growth.

Perhaps, then, the helicopters should, after all, take flight. Might a stirring rendition of some choice Wagner do the trick? Should we demand fiscal stimulus funded by the printing press – through the cancellation of government debt held by the BOE or some other form of “money drop”?

Roosevelt pursued such policies in the 1930s. They seemed to work. From the depths of Depression, the US staged a solid recovery accompanied by a dose of inflation. Yet Roosevelt’s inflation was only acceptable because of the earlier deflation.

As Roosevelt said in one of his fireside chats, “The Administration has the definite objective of raising prices to such an extent that those who have borrowed money will, on the average, be able to repay that money in the kind of dollar which they borrowed. We do not seek to let them get such a cheap dollar that they will be able to pay back a great deal less than they borrowed”. In other words, in the absence of deflation, it’s difficult to justify the pursuit of inflation.

Helicopters are all very well, but they should be used sparingly. Mr King may protest too much about the independence of monetary from fiscal policy. He is surely right, however, to warn of monetary policy’s limitations.

The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. He is a member of the Financial Times Economists’ Forum.

Bundesbank slashed London gold holdings in mystery move

Germany withdrew two thirds of its vast holdings of gold from Bank of England vaults shortly after the launch of the euro more than a decade ago, according to a confidential report by German auditors.
By Ambrose Evans-Pritchard, International business editor
8:24PM BST 24 Oct 2012

Germany withdrew two thirds of its vast holdings of gold from Bank of England vaults shortly after the launch of the euro more than a decade ago, according to a confidential report that emerged on Wednesday.
Germany has 3,396 tons of gold worth €143bn (£116bn), the world's second-largest holding after the US. Nearly all of it was shifted to vaults abroad during the Cold War in case of a Soviet attack. Photo: ALAMI

The revelation came as Germany's budget watchdog demanded an on-site probe of the country's remaining gold reserves in London, Paris, and New York to verify whether the metal really exists. The country has 3,396 tons of gold worth €143bn (£116bn), the world's second-largest holding after the US. Nearly all of it was shifted to vaults abroad during the Cold War in case of a Soviet attack.

Roughly 66pc is held at the New York Federal Reserve, 21pc at the Bank of England, and 8pc at the Bank of France. The German Court of Auditors told legislators in a redacted report that the gold had "never been verified physically" and ordered the Bundesbank to secure access to the storage sites. 

It called for repatriation of 150 tons over the next three years to test the quality and weight of the gold bars. It said Frankfurt has no register of numbered gold bars.

The report also claimed that the Bundesbank had slashed its holdings in London from 1,440 tons to 500 tons in 2000 and 2001, allegedly because storage costs were too high. The metal was flown to Frankfurt by air freight.
The revelation has baffled gold veterans. The shift came as the euro was at its weakest, slumping to $0.84 against the dollar. But it also came as the Bank of England was selling off most of Britain's gold reserves – at market lows – on orders from Gordon Brown.

Peter Hambro, chair of the UK-listed gold miner Petropavlovsk, said the Bundesbank may have withdrawn its bullion in self-protection since it did not, apparently, have its own specifically allocated bars in London. "They may have decided that the Bank of England had lent out too much gold, and decided it was safer to bring theirs home.

This is about the identification. Can you identify your own allocated gold, or are you just a general creditor with a metal account?"

The watchdog report follows claims by the German civic campaign group "Bring Back our Gold" and its US allies in the Gold Anti-Trust Committee that official data cannot be trusted. They allege central banks have loaned out or "sold short" much of their gold.

The refrain has been picked up by German legislators. "All the gold must come home: it is precisely in this crisis that we need certainty over our gold reserves," said Heinz-Peter Haustein from the Free Democrats (FDP).

The Bundesbank said it had full trust in the "integrity and independence" of its custodians, and is given detailed accounts each year. Yet it hinted at further steps to secure its reserves. "This could also involve relocating part of the holdings," it said.