The Year of Betting Conservatively

Nouriel Roubini

19 November 2012

NEW YORKThe upswing in global equity markets that started in July is now running out of steam, which comes as no surprise: with no significant improvement in growth prospects in either the advanced or major emerging economies, the rally always seemed to lack legs. If anything, the correction might have come sooner, given disappointing macroeconomic data in recent months.

Starting with the advanced countries, the eurozone recession has spread from the periphery to the core, with France entering recession and Germany facing a double whammy of slowing growth in one major export market (China/Asia) and outright contraction in others (southern Europe). Economic growth in the United States has remained anemic, at 1.5-2% for most of the year, and Japan is lapsing into a new recession. The United Kingdom, like the eurozone, has already endured a double-dip recession, and now even strong commodity exportersCanada, the Nordic countries, and Australia – are slowing in the face of headwinds from the US, Europe, and China.

Meanwhile, emerging-market economies – including all of the BRICs (Brazil, Russia, India, and China) and other major players like Argentina, Turkey, and South Africaalso slowed in 2012. China’s slowdown may be stabilized for a few quarters, given the government’s latest fiscal, monetary, and credit injection; but this stimulus will only perpetuate the country’s unsustainable growth model, one based on too much fixed investment and savings and too little private consumption.

In 2013, downside risks to global growth will be exacerbated by the spread of fiscal austerity to most advanced economies. Until now, the recessionary fiscal drag has been concentrated in the eurozone periphery and the UK. But now it is permeating the eurozone’s core.

And in the US, even if President Barack Obama and the Republicans in Congress agree on a budget plan that avoids the loomingfiscal cliff,” spending cuts and tax increases will invariably lead to some drag on growth in 2013at least 1% of GDP. In Japan, the fiscal stimulus from post-earthquake reconstruction will be phased out, while a new consumption tax will be phased in by 2014.
The International Monetary Fund is thus absolutely right in arguing that excessively front-loaded and synchronized fiscal austerity in most advanced economies will dim global growth prospects in 2013. So, what explains the recent rally in US and global asset markets?
The answer is simple: Central banks have turned on their liquidity hoses again, providing a boost to risky assets. The US Federal Reserve has embraced aggressive, open-ended quantitative easing (QE). The European Central Bank’s announcement of its “outright market transactionsprogram has reduced the risk of a sovereign-debt crisis in the eurozone periphery and a breakup of the monetary union. The Bank of England has moved from QE to CE (credit easing), and the Bank of Japan has repeatedly increased the size of its QE operations.
Monetary authorities in many other advanced and emerging-market economies have cut their policy rates as well. And, with slow growth, subdued inflation, near-zero short-term interest rates, and more QE, longer-term interest rates in most advanced economies remain low (with the exception of the eurozone periphery, where sovereign risk remains relatively high). It is small wonder, then, that investors desperately searching for yield have rushed into equities, commodities, credit instruments, and emerging-market currencies.
But now a global market correction seems underway, owing, first and foremost, to the poor growth outlook. At the same time, the eurozone crisis remains unresolved, despite the ECB’s bold actions and talk of a banking, fiscal, economic, and political union. Specifically, Greece, Portugal, Spain, and Italy are still at risk, while bailout fatigue pervades the eurozone core.
Moreover, political and policy uncertainties – on the fiscal, debt, taxation, and regulatory frontsabound. In the US, the fiscal worries are threefold: the risk of a “cliff” in 2013, as tax increases and massive spending cuts kick in automatically if no political agreement is reached; renewed partisan combat over the debt ceiling; and a new fight over medium-term fiscal austerity. In many other countries or regions – for example, China, Korea, Japan, Israel, Germany, Italy, and Cataloniaupcoming elections or political transitions have similarly increased policy uncertainty.
Yet another reason for the correction is that valuations in stock markets are stretched: price/earnings ratios are now high, while growth in earnings per share is slackening, and will be subject to further negative surprises as growth and inflation remain low. With uncertainty, volatility, and tail risks on the rise again, the correction could accelerate quickly.
Indeed, there are now greater geopolitical uncertainties as well: the risk of an Iran-Israel military confrontation remains high as negotiations and sanctions may not deter Iran from developing nuclear-weapons capacity; a new war between Israel and Hamas in Gaza is likely; the Arab Spring is turning into a grim winter of economic, social, and political instability; and territorial disputes in Asia between China, Korea, Japan, Taiwan, the Philippines, and Vietnam are inflaming nationalist forces.
As consumers, firms, and investors become more cautious and risk-averse, the equity-market rally of the second half of 2012 has crested. And, given the seriousness of the downside risks to growth in advanced and emerging economies alike, the correction could be a bellwether of worse to come for the global economy and financial markets in 2013.

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.

Fiscal cliff lessons from the eurozone crisis

Lorenzo Bini Smaghi

November 19, 2012


As the deadline to avert the fiscal cliff gets closer, US policy makers may want to learn some lessons from the way eurozone authorities managed their crisis. Let’s consider four.

The first is that policy authorities tend to act too late, after financial markets have lost confidence. This is because of a belief among policy makers that the unpopularity of decisions will diminish only when voters understand that the alternative is much worse. Only on the verge of disaster do citizens understand that unpalatable policies are necessary. But by that point, financial markets start questioning the determination and ability of policy makers to face the situation and tend to lose confidence. At that point, even more unpalatable actions may be required.

The eurozone experience has shown how costly such a strategy can be. For instance, finding a consensus in Germany for providing financial support for Greece became possible only when the crisis reached a peak, in May 2010, and the euro seemed at risk. But at that point the size of the overall package required to stabilise the markets had risen substantially.

If the US authorities follow the same path and wait for market pressure to force a compromise, the decision might be more acceptable to both sides, being the last resort, but the burden on the economy might be dear. The sooner a solution is found, the less costly it is.

The second lesson to be learned from the European experience is that open political brinkmanship fuels financial instability. Games of chicken are won by the party which convinces the other that it will not compromise, even if it makes everybody worse off.

Negotiations should ideally take place confidentially, and the result would be known only when it is reached. This is obviously difficult to achieve in democratic systems.

In the eurozone, brinkmanship has been frequently used to convince the other party in the negotiation. In particular, eurozone authorities had at times to threaten openly that they would let Greece fall out of the euro, in order to make the Greek policy-makers understand that there was no room for compromising on conditionality. This might have been effective in convincing the Greek government to stick to their commitments, but it also scared the markets away from Greece, and the eurozone.

If the opposing parts in the US start negotiating in public, from their apparently uncompromising positions, the risk of catastrophe will increasingly be discounted by the markets, with negative effects on confidence.

The third lesson is that partial solutions may temporarily solve problems but ultimately a piecemeal approach requires more comprehensive action later on, generally much earlier than expected. The political cost of such a strategy has been quite high.

European summits have had less and less impact on market sentiment, as the prospected solutions appeared to be partial and lacking a comprehensive plan. For instance, markets reversed the initial positive reaction to the agreement on the ESM last June, when they understood that the agreement on the banking union and fiscal union was still vague.

In the US, much emphasis has been put recently on the need to avoid the fiscal cliff, but less so on how to achieve the result in a sustainable way. Confidence is likely to vanish if policy makers do not come up with a credible medium term plan, based on realistic assumptions about growth and interest rates.

The fourth lesson which can be drawn from the eurozone crisis is that fiscal and structural problems can ultimately be settled only by the respective policies. Monetary policy can only help buying time for the relevant political sphere to design and implement concrete solutions.

Experience shows, however, that if the time is too long the authorities in charge tend to relax, thinking that favorable market conditions are there to last, and ignoring that these conditions are partly the result of a deliberately accommodative monetary policy.

Each time the ECB succeeded in calming the markets with extraordinary measures, either the Securities Market Program or the Long Term Refinancing Operations, the pressure eased on the eurozone political authorities to pursue the adjustment and complete the institutional framework underlying the euro. This is the reason why the ECB’s Open Market Transactions had to be made conditional on the political authorities’ signed commitment to do their part of the job. Acting without such conditionality would entail the risk of losing credibility and compromising the effectiveness of monetary policy.

If a central bank gives the impression that it stands ready to be the “only game in town”, it will end up being played. The other policy makers will have no incentive to take on their own responsibilities. This will ultimately drag the central bank into monetising the debt and lose its reputation.

The writer is a visiting scholar at Harvard’s Weatherhead Center for International Affairs and a former member of the ECB’s executive board

America’s Trouble with China

Harold Brown

19 November 2012

WASHINGTON, DCXi Jinping, China’s newly anointed president, made his first visit to the United States in May 1980. He was a 27-year-old junior officer accompanying Geng Biao, then a vice premier and China’s leading military official. Geng had been my host the previous January, when I was the first US defense secretary to visit China, acting as an interlocutor for President Jimmy Carter’s administration.


Americans had little reason to notice Xi back then, but his superiors clearly saw his potential. In the ensuing 32 years, Xi’s stature rose, along with China’s economic and military strength. His cohort’s ascent to the summit of power marks the retirement of the last generation of leaders designated by Deng Xiaoping (though they retain influence).


Despite China’s greater weight in world affairs, Xi faces internal strains that make China more fragile than is generally understood. China’s export-led economic model has reached its limits, and the transition to domestic-led growth is intensifying internal frictions.

Managing unrest through repression is more difficult than in the past, as rapid urbanization, economic reform, and social change roils a country of 1.3 billion people. Ethnic conflicts in outlying regions will also test Xi’s political control.
China’s foreign policy is another cause for concern – especially for the US. History teaches us that rising powers inevitably compete with status quo leading powers, and that this conflict often leads to war.
For now, the large bilateral trade imbalance has exacerbated US-China tensions, and can be safely reduced only by changes in behavior on both sides – or, unsafely, though a dangerous crisis-driven correction.
More immediately, China’s territorial claims – particularly in the South China Sea, but also regarding its border with India – and its efforts to expand its influence over neighboring countries will force the US to navigate two overarching risks. The first is confrontation, which could occur directly or as a result of the US being drawn into conflicts between China and its neighbors.
The other risk is that Japan, South Korea, Vietnam, the Philippines, Thailand, or Myanmar could fall into China’s strategic orbit. Many of these countries will look to the US as a strategic counterweight should China seek to assert local dominance. But some may conclude that it is safer to steer closer to China than away from it, because their economies depend so strongly on Chinese trade.
As recent events in the East and South China Seas show, China sometimes attempts to strong-arm its neighbors. The US will need to defend its allies and interests by pushing back, but with actions modulated to limit Chinese concerns.
One way to do this is to understand China’s motives. China’s drive for economic and political leadership in East Asia, and its increased military capability there, is inevitable.

But the world can be confident that the US will remain stronger, wealthier, and more influential in global affairs than China even in 2030. That argues against American overreaction, which could fuel the kind of self-reinforcing downward spiral in bilateral relations that occurred between Great Britain and Germany prior to the conflagrations of the first half of the twentieth century.
Perhaps the best way to avoid confrontation is to cooperate on shared external threats, most notably nuclear proliferation, global climate change, and Islamic extremism. But getting to 2030 without a major confrontation will be a major achievement. While the US is likely to maintain the upper hand in terms of military power for at least another 15-20 years, asymmetric warfare could undercut America’s advantage should China engage in cyber-attacks on US electronic and satellite systems, along with attacks on infrastructure.
In response to China’s capability to project power many hundreds of miles from its borders, the US (as I have suggested for the last 25 years) should develop a long-range bomber capable of penetrating sophisticated defenses and delivering great force. As US security interests shift to the Pacific, Americans now rely on increasingly vulnerable forward land bases and carrier fleets with tactical aircraft that have a combat radius of 300-500 miles (482-805 kilometers). But a long-range bomber would be more cost-effective than standoff bombers with cruise missiles, and, unlike shorter-range tactical bombers, its bases would be invulnerable to attack.
That said, America’s most serious challenge right now is to get the US economy and its governance in order. I believe that it can do that. But, unless and until it does, thereby giving President Barack Obama a firm basis from which to engage Xi on issues requiring international statesmanship, the prospect of trouble between the US and China will continue to grow.

Harold Brown was US Secretary of Defense under President Jimmy Carter and is a member of the Defense Policy Board, which advises current Secretary of Defense Leon Panetta. He is an emeritus trustee of the Rand Corporation and the author with Joyce Winslow of Star Spangled Security, Lessons Learned Over Six Decades Safeguarding America.


November 19, 2012, 2:07 p.m. ET

Markets Still Fear a Steep Fall Off Cliff



These days, Washington political gatherings resemble a tax accountants' convention. As the nation hurtles toward the "fiscal cliff," the capital's corridors of power echo with questions on corporate tax rates, balanced budgets and sequesters. (I heard them all mentioned repeatedly during the politics-heavy WSJ's CEO Council in Washington last week).

Outside the Beltway, the markets and the corporate world are watching, puzzled, worried and less than impressed.

The tussle over the "cliff"—a $500-billion combination of tax increases and spending cuts that will come into effect in January absent a bipartisan deal—is unsettling investors and spooking corporations right when the global economy needs the U.S. to do its part to drive growth and rebuild confidence.
Associated Press
President Barack Obama, accompanied by House Speaker John Boehner, speaks to reporters at the White House on Friday.
Before Democratic and Republican honchos disappear behind close doors to play "deal or no deal" until the wee hours of Dec. 31, they should consider the following: Investors, traders, bankers and executives won't like half-baked compromises, or cans kicked down the road.

The dozen or so chiefs of financial companies who attended the CEO Council identified the instability brought about by the cliff's negotiations as their paramount concern, trumping longtime favorites such as regulation and economic sluggishness.

As Stephen Schwarzman, the chairman and chief executive of the private equity group Blackstone Group LP BX +5.28% said, "What we concluded, pretty much across the board, is that driving off the fiscal cliff has unpredictable outcomes, few of which could be good. And that it's unclear how consumers, markets and other constituencies would react to that, which adds an additional dynamic to trying to get a deal done."

If that sounds obvious to you, then you aren't a Washington power broker. My sojourn in the capital provided some worrisome evidence that the two sides are fully prepared to engage in a game of political football right on the edge of the fiscal cliff.

There was the former member of President Obama's economic team who asked who would care if political stalemate caused a credit downgrade of the U.S. (Answer: a lot of investors), the politicians from both sides who talked of the need to strike "the right deal" rather than "any deal" and the Congressman who confidently predicted that markets "would understand" if a resolution were to be delayed by a week or two into 2013.

Despite Monday's rally, there are few signs of the markets' capacity for "understanding." Before Monday's gain of more than 207 points, the Dow Jones Industrial Average had dropped in six of the last eight sessions since the Nov. 6 presidential election put the cliff on the horizon.

Blue-chips aren't the only ones feeling the pinch. The technology-heavy Nasdaq Composite Index and the Russell 200 index of small-cap stocks both slid into "correction" territory last week—a 10%-plus fall from recent highs.

Cliff-related volatility was on display Friday when news of a cordial discussion between the two sides helped the Dow erase earlier losses and close 0.4% higher after a 100-plus-point round trip.
There are, of course, other reasons for the stocks' malaiseEurope's never-ending woes, China's political transition and the fogs of war descending on the Middle East, among others. But fears over lawmakers' ability to tackle an issue that is both technically complex and politically fraught are overwhelming.

A poll of participants at the WSJ event revealed that CEOs who believed New Year's Eve would arrive without a deal outnumbered the optimists by two to one.

Market psychology and recent history play a part here. While many laypeople believe common sense will prevail and a deal will be struck, traders and bankers hark back to two traumatic examples of Washington's ineffectiveness.

The first was the "TARP crash" of Sept. 29, 2008, when, in the middle of the financial crisis, Congress saw fit to reject the Troubled Asset Relief Program to bail out banks, sending stocks into a tailspin. The Dow lost 778 points, or nearly 7%, that day. The stunning decision was reversed days later, but for many investors the damage had already been done.

The second was the unseemly haggling over the "debt ceiling" last year. The affair ended with an 11th-hour deal but it set up a period of investor unease that culminated in Standard & Poor's decision to strip the U.S. of its AAA rating. In fact, the current four-week losing streak by the Dow is the longest since August 2011, the month of the debt-ceiling deal and S&P's downgrade.

Over the next few weeks, politicians and commentators will saturate the airwaves with "cliff-talk." But from where the markets are standing, what lies ahead looks a lot more like a roller coaster than a cliff.

—Francesco Guerrera is The Wall Street Journal's Money & Investing editor.

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