Markets Insight

January 7, 2013 10:55 am
Beware the ‘central bank put’
Mohamed El-Erian asks how far central banks can divorce prices from fundamentals

The investment recommendations made by many financial commentators are now dominated by cross-asset class relative valuation rather than the fundamentals of the investment itself. A typical refrain runs something like this: buy X because it is cheaper than other things out there.

This is an understandable approach as unusual central bank activism has artificially elevated certain asset prices. Yet the dominance of this increasingly popular advice comes with potential risks that need to be well understood and well managed.

Several asset classes now have highly manipulated prices due to experimental central bank activities, both actual and signalled. The more this happens, the more investors come under pressure to migrate to higher risk investments in search of returns.

Ben Bernanke, Federal Reserve chairman, said as much at his latest press conference, noting that the aim of policy is to “pushinvestors to take more risk. True to his wish, many pundits seem eager to discard fundamentals in favour of searching for (and levering) anything that “yieldsmore.

This situation is reminiscent of 2006-07, when hyperactive liquidity factories also pushed some asset prices to artificial levels, thus contributing to a generalised and indiscriminate compression of risk premia. In the process, investors were comforted by the then-popular notion of the Great Moderation (the belief that central banks and governments had conquered the business cycle). We all know what happened next.

This historical parallel is not perfect, however. As I wrote in March 2007 in the Financial Times, the liquidity factories then were endogenous to the markets. Leverage was created by private participants (particularly investment banks) taking on greater risk.

Today, the major liquidity factory is exogenous to the markets. The sizeable balance sheet expansion is in the official sector, most importantly, central banks. Just a few weeks ago, the Federal Reserve announced it is targeting a further $1tn in asset purchases in 2013, representing a third of its existing balance sheet. Other central banks – particularly the Bank of England, the Bank of Japan and the European Central Bank – are also expected to expand their balance sheets again in the months ahead.

This makes the current cycle relatively less dangerous given the greater inherent stability of a central bank’s balance sheet. Unlike private sector institutions, it is hard to force a central bank to delever without some dramatic combination of exchange rate, inflationary and political pressure.

But, critically for both economic prospects and investors, greater relative stability does not guarantee absolute stability. There is a limit to how far central banks can divorce prices from fundamentals. Moreover, as illustrated in the minutes of the latest Fed meeting, there is already discomfort among some policy makers due to the costs and risks of unconventional policies.
Also, at some point, and it is hard to tell when exactly, the private sector will increasingly refuse to engage in situations deemed excessively artificial and overly rigged.

This is particularly relevant for asset classes (such as high yield corporate bonds, equities and certain highly leveraged products) outside the direct influence of central banks – an influence that is applied through direct market purchases and forward-looking policy guidance. With the weaker central bank impact, prices need to have greater consistency with the realities of balance sheets and income statements.

In such a world, investors should expect security and sector selections to get repeatedly overwhelmed by macro correlations. Since a growing number of asset classes are now exposed in a material fashion to the belief that central banks will deliver macroeconomic as well as market outcomes, investors have assumed considerable macro-driven correlations across their holdings. Moreover, with seemingly endless liquidity injections, the scaling of such exposure can easily disconnect from the extent to which prices deviate from fundamentals.

Investors should also expect greater volatility in their portfolios as a whole. With the Fed’s move to quantitative thresholds, and particularly its use of historical unemployment data (as opposed to the forecasts that will be used for inflation, the other threshold), routine data releases will lead to greater fluctuations in asset prices.

Have no doubt: central banks are both referees and players in today’s markets. With 2013 starting with so many liquidity-induced deviations, investors would be well advised to take greater care when pursuing opportunities that rely mainly on the “central bank put”.

Mohamed El-Erian is the chief executive and co-chief investment officer of Pimco

Copyright The Financial Times Limited 2013

The Post-Crisis Crises

Joseph E. Stiglitz

07 January 2013

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         Illustration by Paul Lachine

NEW YORKIn the shadow of the euro crisis and America’s fiscal cliff, it is easy to ignore the global economy’s long-term problems. But, while we focus on immediate concerns, they continue to fester, and we overlook them at our peril.

The most serious is global warming. While the global economy’s weak performance has led to a corresponding slowdown in the increase in carbon emissions, it amounts to only a short respite. And we are far behind the curve: Because we have been so slow to respond to climate change, achieving the targeted limit of a two-degree (centigrade) rise in global temperature, will require sharp reductions in emissions in the future.

Some suggest that, given the economic slowdown, we should put global warming on the backburner. On the contrary, retrofitting the global economy for climate change would help to restore aggregate demand and growth.

At the same time, the pace of technological progress and globalization necessitates rapid structural changes in both developed and developing countries alike. Such changes can be traumatic, and markets often do not handle them well.

Just as the Great Depression arose in part from the difficulties in moving from a rural, agrarian economy to an urban, manufacturing one, so today’s problems arise partly from the need to move from manufacturing to services. New firms must be created, and modern financial markets are better at speculation and exploitation than they are at providing funds for new enterprises, especially small and medium-size companies.

Moreover, making the transition requires investments in human capital that individuals often cannot afford. Among the services that people want are health and education, two sectors in which government naturally plays an important role (owing to inherent market imperfections in these sectors and concerns about equity).

Before the 2008 crisis, there was much talk of global imbalances, and the need for the trade-surplus countries, like Germany and China, to increase their consumption. That issue has not gone away; indeed, Germany’s failure to address its chronic external surplus is part and parcel of the euro crisis. China’s surplus, as a percentage of GDP, has fallen, but the long-term implications have yet to play out.

America’s overall trade deficit will not disappear without an increase in domestic savings and a more fundamental change in global monetary arrangements. The former would exacerbate the country’s slowdown, and neither change is in the cards. As China increases its consumption, it will not necessarily buy more goods from the United States. In fact, it is more likely to increase consumption of non-traded goods – like health care and education – resulting in profound disturbances to the global supply chain, especially in countries that had been supplying the inputs to China’s manufacturing exporters.

Finally, there is a worldwide crisis in inequality. The problem is not only that the top income groups are getting a larger share of the economic pie, but also that those in the middle are not sharing in economic growth, while in many countries poverty is increasing. In the US, equality of opportunity has been exposed as a myth.

While the Great Recession has exacerbated these trends, they were apparent long before its onset. Indeed, I (and others) have argued that growing inequality is one of the reasons for the economic slowdown, and is partly a consequence of the global economy’s deep, ongoing structural changes.

An economic and political system that does not deliver for most citizens is one that is not sustainable in the long run. Eventually, faith in democracy and the market economy will erode, and the legitimacy of existing institutions and arrangements will be called into question.

The good news is that the gap between the emerging and advanced countries has narrowed greatly in the last three decades. Nonetheless, hundreds of millions of people remain in poverty, and there has been only a little progress in reducing the gap between the least developed countries and the rest.

Here, unfair trade agreements – including the persistence of unjustifiable agricultural subsidies, which depress the prices upon which the income of many of the poorest depend – have played a role. The developed countries have not lived up to their promise in Doha in November 2001 to create a pro-development trade regime, or to their pledge at the G-8 summit in Gleneagles in 2005 to provide significantly more assistance to the poorest countries.

The market will not, on its own, solve any of these problems. Global warming is a quintessentialpublic goodsproblem. To make the structural transitions that the world needs, we need governments to take a more active roleat a time when demands for cutbacks are increasing in Europe and the US.

As we struggle with today’s crises, we should be asking whether we are responding in ways that exacerbate our long-term problems. The path marked out by the deficit hawks and austerity advocates both weakens the economy today and undermines future prospects. The irony is that, with insufficient aggregate demand the major source of global weakness today, there is an alternative: invest in our future, in ways that help us to address simultaneously the problems of global warming, global inequality and poverty, and the necessity of structural change.

Joseph E. Stiglitz, a Nobel laureate in economics and University Professor at Columbia University, was Chairman of President Bill Clinton’s Council of Economic Advisers and served as Senior Vice President and Chief Economist of the World Bank. His most recent book is The Price of Inequality: How Today’s Divided Society Endangers our Future

January 6, 2013 6:51 pm
US joins misguided pursuit of austerity

When viewing the US fiscal stand-off from Europe, it all looks eerily familiar. The US has become very European. But for me the main problem is not an inability to deal with the structural deficit, as the Economist argued in its latest cover story, but rather the contrary. I fear that the US is blindly rushing into semi-automated austerity, which is exactly the mistake we have made in Europe. The problem is not the size of the national debt as such, which is manageable in both cases, but our policies in dealing with it.

The various measures in last week’s US budget deal imply revenue increases in the order of about 2 per cent of gross domestic product. This is the absolute size of the agreed measures. It does not include any further spending cuts that may, or may not, come as part of an agreement on a debt ceiling. The gross fiscal contraction of the US will be larger than the UK’s in 2013, though not as large as that in Spain, Portugal or Greece. Still, this would make the US an honorary member of Europe’s austerity club.

If there has been an overriding lesson from the eurozone crisis, then it must be that the fiscal multipliers – the effect of austerity on growthbecome very high when monetary policy has reached the zero bound, and when everyone pursues austerity at the same time. The International Monetary Fund started a debate on the multiplier last year, culminating in a recent paper by Olivier Blanchard and Daniel Leigh, explaining why economic forecasts have been so persistently wrong during the crisis. Just how large the multiplier will be this year is difficult to say exactly and may vary across countries, but it is certainly higher now than before the crisis.

I would expect the multiplier to become smaller as the economy returns to normal, but that has not happened yet, and will probably not happen for a while. In Europe, a recession started in the middle of 2012 and is likely to persist for most of this year.

The latest US data show that manufacturers may have come out of recession and that employment is rising modestly. But the size of these fiscal measures may well undo this incipient recovery.

The medium-term dynamics are even worse. This is because austerity is not a one-off shock, whose negative effects would dissipate over time, but a multi-annual programme. What spooks me is the likely austerity pursued even in a moderated form over longer periods. That is already happening, at least in Europe. The German finance ministry is already planning an austerity budget for 2014 to meet the constitutional target of a structurally balanced budget. The eurozone’s fiscal pact will have exactly the same effect on the other countries. Its prescription of a near-zero structural deficit will force everyone to continue austerity indefinitely. It leaves room for automatic stabilisers, but only up to a point. If long-run growth falls, as I would expect, the structural deficit would be revised upwards, requiring further austerity.

In Europe, “perma-austerity”comes primarily in the form of social entitlements cuts. In most countries, the scope for tax increases is relatively small.

There are a few genuine structural fiscal reforms that may well be worth undertakingcuts in levels of regional government, plugging tax loopholes, or ending subsidies. But these are hard to do, and governments find it more expedient to cut welfare benefits, which is what European conservatives usually mean when they talk abouteconomic reforms”.

In southern Europe, austerity has already led to a big increase in poverty and inequality. A report by Oxfam in Spain says that if the current policies are not reversed, Spain could see an increase in the percentage of the population below the poverty line from 27 per cent to 40 per cent in a decade. I find it hard to see how Spain could maintain its current course politically if that prediction turns out to be true.

All over Europe, governments have pushed themselves into a corner where austerity has become the default choice. George Osborne, the UK chancellor, said recently he expected austerity to continue until 2018. I would take this as a ballpark estimate for most of the North Atlantic region. This is not an environment in which companies invest, or in which consumers step up spending. My conclusion is that we are not going to see a return to pre-crisis growth rates in the austerity club for several years. If the US becomes a fully paid subscriber to this club, then I would expect the same to happen there.

There is a deeper reason why we are all in this mess. It has become more difficult for political systems to defend the collective interest – which I would define as the pursuit of policies to end the recession, then deal with the debt overhang vigorously afterwards. The collective action problem is a natural deficiency of a monetary union with decentralised decision making. But it can also occur at the level of sovereign nation states when society lacks broad consensus over economic policy. In their respective pathologies, the US and the eurozone have become remarkably similar.

Copyright The Financial Times Limited 2013.