Blaming the Fed

Kenneth Rogoff

04 February 2013

 This illustration is by Pedro Molina and comes from <a href=""></a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

FRANKFURTCritics of the US Federal Reserve are having a field day with embarrassing revelations of its risk assessments on the eve of the financial crisis. By law, the Fed is required to publish the transcripts of its Federal Open Market Committee (FOMC) meetings with a five-year lag.

While the full-blown crisis did not erupt until the collapse of Lehman Brothers in September 2008, it was clear by the summer of 2007 that something was very wrong in credit markets, which were starting to behave in all sorts of strange ways. Yet many Fed officials clearly failed to recognize the significance of what was unfolding. One governor opined that the Fed should regard it as a good thing that markets were starting to worry about subprime mortgages. Another argued that the summertime market stress would most likely be a hiccup.
Various critics are seizing on such statements as evidence that the Fed is incompetent, and that its independence should be curtailed, or worse. This is nonsense. Yes, things could and should have been done better; but to single out Fed governors for missing the coming catastrophe is ludicrous.
The Fed was hardly alone. In August 2007, few market participants, even those with access to mountains of information and a broad range of expert opinions, had a real clue as to what was going on. Certainly the US Congress was clueless; its members were still busy lobbying for the government-backed housing-mortgage agencies Fannie Mae and Freddie Mac, thereby digging the hole deeper.

Nor did the International Monetary Fund have a shining moment. In April 2007, the IMF released its famousValentine’s DayWorld Economic Outlook, in which it declared that all of the problems in the United States and other advanced economies that it had been worrying about were overblown.
Moreover, it is misleading to single out the most misguided comments by individual governors in the context of an active intellectual debate over policy. It is legitimate to criticize individual policymakers who exercised poor judgment, and they should have a mark on their record. But that does not impugn the whole FOMC, much less the entire institution.

Central banks’ state-of-the-art macroeconomic models also failed miserably – to a degree that the economics profession has only now begun to acknowledge fully. Although the Fed assesses many approaches and indicators in making its decisions, there is no doubt that it was heavily influenced by mainstream academic thinking – including the so-called real business cycle models and New Keynesian models – which assumed that financial markets operate flawlessly. Indeed, the economics profession and the world’s major central banks advertised the idea of the “great moderation” – the muting of macroeconomic volatility, owing partly to monetary authorities’ supposedly more scientific, model-based approach to policymaking.
We now know that canonical macroeconomic models do not adequately allow for financial-market fragilities, and that fixing the models while retaining their tractability is a formidable task. Frankly, had the models at least allowed for the possibility of credit-market imperfections, the Fed might have paid more attention to credit-market indicators as a reflection of overall financial-market conditions, as central banks in emerging-market countries do.

Last but not least, even if the Fed had better understood the risks, it would not have been easy for it to avert the crisis on its own. The effectiveness of interest-rate policy is limited, and many of the deepest problems were on the regulatory side.
And calibrating a response was not easy. By late 2007, for example, the Fed and the US Treasury had most likely already seen at least one report arguing that only massive intervention to support subprime loans could forestall a catastrophe. The idea was to save the financial system from having to deal with safely dismantling the impossibly complex contractual edifices – which did not allow for the possibility of systemic collapse that it had constructed.
Such a bailout would have cost an estimated $500 billion or more, and the main beneficiaries would have included big financial firms. Was there any realistic chance that such a measure would have passed Congress before there was blood in the streets?
Indeed, it was precisely this logic that led me to give a very dark forecast in a widely covered speech in Singapore on August 19, 2008, a month before Lehman Brothers failed. I argued that things would not get better until they got much worse, and that the collapse of one of the world’s largest financial firms was imminent. My argument rested on my view that the global economy was entering a major recession, and I had the benefit of my quantitative work, with Carmen Reinhart, on the history of financial crises.
I was not trying to be sensational in Singapore. I thought that what I was saying was completely obvious. Nevertheless, my prediction gained bold front-page headlines in many major newspapers throughout the world. It gained headlines, evidently, because it was still far from a consensus view, although concerns were mounting.
Were concerns mounting at the Fed as well in the summer of 2008? We will have to wait until next year to find out. But, when we do, let us remember that hindsight is 20-20.


Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. His most recent book, co-authored with Carmen M. Reinhart, is This Time is Different: Eight Centuries of Financial Folly.

Copyright Project Syndicate -

February 3, 2013 8:15 pm

The eurozone crisis is not finished
What does it tell us about a eurozone banking union if the member states are rushing to pass unilateral legislation on financial regulation? France and Germany have, in short succession, proposed measures to ringfence banks’ proprietary trading activities. The two countries have co-ordinated their moves with each other, but with nobody else. Would not a ringfence be a power any self-respecting banking union would want to usurp?

The answer is that banking will remain a national activity in the eurozone for all economically relevant purposes. The European Central Bank will become the common bank supervisor. This has indeed been agreed. But there will be no common deposit insurance.

The resolution system likely to emerge later this year is also flawed. It will end up protecting only the taxpayer of the creditor countries from bank failures in the debtor countries. But it will not accelerate the resolution of the eurozone’s undercapitalised banks. My suspicion is that the ultimate intent of the Franco-German legislation is to secure the position of their national champion banks.
The proposed legislation aims to force banks to put their proprietary trading (that is, trades made on their own accounts rather than on behalf of a customer) into separate legal entities. But this does not affect market making, for example. Erkki Liikanen, the governor of the Finnish central bank, proposed a full separation in his European Commission report, published in October. The commission has been planning an EU-wide directive, but the Franco-German action has now pre-empted the outcome.

The current banking scandal in Italy is a reminder of why a comprehensive regime is needed. Banca Monte dei Paschi di Siena is the world’s oldest bank – but this long history has not prevented rogue traders from undertaking reckless derivatives trades, which have led the Italian government to step in with a guarantee of €3.9bn.

A separation of investment and commercial banking along the lines of America’s Glass-Steagall Act will, of course, not solve all problems in banking. Even if the act had not been partially repealed, Lehman Brothers would still have gone under in 2008, and the world economy would still have crashed. But at the very least, a full separation of investment and retail banking would have saved the Italian taxpayer from the MPS scandal.

The most important signal sent by the unilateral legislation in France and Germany is the lack of political will to sort out the banking mess, which is at the heart of the eurozone crisis. Instead, governments are seeking refuge in symbolic gestures.

In the wake of the immediate crisis, the priority should have been the recapitalisation of the banks with public money, the closure and merger of weak banks, and to ensure that banks are not trying to adjust their balance sheets by running down loans to companies. This is what is happening in southern Europe now.

My estimate is that the eurozone’s banking system is undercapitalised to the tune of €500bn to €1tn. The problem is not only Spanish banks, but also German and French ones, which have been more skilful at hiding their losses. If the recovery turns out to be as shallow as I expect, these losses will show up not too long from now.

The priority now should be to end the continuing fragmentation. The ECB’s Outright Monetary Transactions programme was officially justified as an effort to unclog the eurozone’s transmission of monetary policy.

After six months, we know that it brought down government bond yields, but did absolutely nothing to improve the transition mechanisms. Companies in northern Italy continue to suffer from higher interest rates on bank loans than their Austrian neighbours. Only a fully-fledged banking union could end such discrimination. But that would require common deposit insurance and effective bank resolution policies. Neither is going to happen.

The other priority should be to do what the Franco-German legislation purports to do, but on a grander scale: provide adequate insurance that banks do not bring down the economy and hold taxpayers at ransom. A combination of full separation of investment and commercial banking, bail-in rules, and transparency requirements would be a useful, yet possibly still incomplete, series of steps.

None of this is happening – and yet a lot of people have become more optimistic about the eurozone, in some cases even euphoric. Hardly a day passes by without someone declaring the end of the crisis. But its two most dangerous aspects are unresolvedzombie banks and macroeconomic adjustment. OMT has actually contributed to making the banking crisis worse, by taking away the political pressure to create a genuine banking union. The pressure was clearly present in July last year, but had evaporated by September.

The renationalisation of banking means that the monetary union is as unsustainable today as it was in July last year – and now the policies needed to fix this problem have been abandoned.

Copyright The Financial Times Limited 2013.

Europe’s Hidden Stimulus

Eric Labaye

01 February 2013

 This illustration is by Paul Lachine and comes from <a href=""></a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

LONDONWhen the European Council next meets, on February 7, it should look at private investment as a means to kick-start Europe’s stagnant economy. With the usual drivers of GDP growth constrained across Europe, the one economic sector able to spend is the non-financial corporate sector.
Indeed, publicly traded European companies had excess cash holdings of €750 billion ($1 trillion) in 2011, close to a 20-year high. Unlocking that cash would give Europe a much larger stimulus package than any government can provide. In 2011, for example, private investment in Europe totaled more than €2 trillion, compared to government investment of less than €300 billion.
And yet, while trends among European economies have varied, private investment was, overall, the hardest-hit component of GDP during the crisis, plunging by more than €350 billion ten times greater than the fall in private consumption and four times more than the decline in real GDP – between 2007 and 2011. The magnitude of the private-investment downturn was, in fact, unprecedented – and lies at the heart of Europe’s economic malaise.
Likewise, by historical standards, the private-investment recovery is running late. In more than 40 past episodes in which GDP fell and private investment declined by 10%, recovery took an average of five years. Europe is four years removed from the onset of recession, but private investment in 2011 was still lower than its 2007 level in 26 of the European Union’s 27 member states.
To be sure, the fact that companies are holding on to their cash, rather than paying it out in dividends, signals that they expect investment opportunities to return – a far more positive situation than in Japan, for example, where companies lack cash to invest. But European companies remain hesitant, despite low interest rates, keeping private investment well below its previous peak.
Governments can help to persuade companies to let go of their cash by removing regulatory barriers such as zoning regulations in retail and a plethora of requirements in the construction sector concerning everything from the height of ceilings to the size of staircase areas. They should also address the lack of uniform standards across Europe’s internal borders; for example, there are 11 separate signaling systems for rail freight in the EU-15.
After Sweden eased planning laws in its retail sector during the 1990’s, the country posted the strongest retail productivity growth in Europe (and outstripped that of the United States) between 1995 and 2005. Standardization and liberalization in European telecoms underpinned 9% growth in value added and productivity in this period, compared to 6% growth in the US.
The largest scope for renewed private investment is in capital-intensive sectors in which government has a major presence as regulator. Even if European countries were to close only 10% of the variation in capital stock per worker at the subsector level, the impact could be more than €360 billion in additional investmentoffsetting the €354 billion difference in private investment between 2007 and 2011.
Many projects, from airports to university campuses, benefit from returns over decades, which implies that weak demand in the short term will have only a limited impact on their overall viability.
Even among more near-term projects, some – for example, retrofitting buildings with more energy-efficient features – could become viable with action from policymakers. Some degree of investment will add to demand, which may persuade others to invest – a virtuous circle.
This approach is not about “picking winners and losers.” It is about targeted microeconomic reforms that reduce or remove barriers to private investment, thereby encouraging the non-financial corporate sector to propel European GDP growth. But it is important to get this policy activism right.
First, governments need to focus on sectors in which action is likely to trigger renewed investment on a scale large enough to boost GDP – and quickly enough to enable private investment to drive the recovery. Governments often become enamored of innovative sectors, such as semiconductors, that account for only a very small share of total investment. Policymakers may wish to develop these sectors as a catalyst to innovation, but they should not expect that such initiatives alone can spur a recovery in private investment.
In fact, construction and real estate are the most promising candidates, as they account for roughly one-third of European fixed investment and more than 17 million jobs. Although these sectors are unlikely to rebound to pre-crisis levels in Greece, Ireland, and Spain for many years, other European economies, including the United Kingdom, Italy, and Sweden, as well as some Eastern European economies, have scope for further investment.
To meet Europe’s ambitious 2020 energy targets, retrofitting existing buildings and improving new buildings’ energy efficiency, including the use of more energy-efficient materials and equipment, could lead to roughly €37 billion in additional annual investment between now and 2030. In most European countries, action to spur private investment in local services and transport – both large sectors – should also be considered.
Governments, however, need to understand the barriers to investment: regulatory failures; weak enablers, including financial and human capital; poor infrastructure; and substandard technology. And they must undertake rigorous cost-benefit analyses, in order to ensure that any intervention translates into private investment that promotes productivity growth.
It is here – at the level of execution – that governments often perform poorly. Too often, they spend money to support private-sector projects that fail to provide a positive return for the broader economy.
Three ingredients are vital to getting it right: backing for initiatives at the highest political level; participation by all key stakeholders in deciding what action to take and driving its implementation; and establishing small, high-powered delivery units with clear mandates to coordinate interventions.

Europe’s leaders need to put private investment at the center of their growth strategy by devising policies that open the gates to large potential flows. The European Council meeting on February 7 is an ideal opportunity to make a start.
 Eric Labaye is Chairman of the McKinsey Global Institute.

February 3, 2013 11:12 pm

How Berlin and Beijing tilted world trade

In pinning the blame on surplus countries’ policies, a bearish analysis of the global economy overlooks the role of history
The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy, by Michael Pettis, (Princeton, RRP£19.95, $29.95)

Examining the global economic crisis, it is easy to focus on specific issues – the US housing bubble, China’s trade surplus, Greece’s rotten public finances. It is even easier to single out specific villainsgreedy Wall Street bankers, Beijing officials manipulating the renminbi and lazy Mediterraneans living off thrifty Germans.

It is much harder to put the whole puzzle together, as Michael Pettis does in The Great Rebalancing. The former Wall Street banker, now living and teaching in Beijing, argues that in a globalised economy everything connects with everything else.

One country’s trade deficit must be matched by other countries’ surpluses, and cannot be blamed only on a deficit country’s supposed failings. A surplus country’s policies also matter. So Greek deficits are born not of the population’s imagined laziness.

Rather, they result from Berlin’s policies to boost competitiveness to cut the job losses created by unification. Wages were held down, limiting domestic consumption. Extra production had to be exported notably to the eurozone, where a favourable exchange rate benefited Germany.

The same argument applies to the key US-China relationship. The US trade deficit is not generated mainly by Americans gorging on consumer products made by hardworking Chinese. It is also created by Beijing’s sustained promotion of production and suppression of consumption, creating surpluses for export. Chinese goods flow to the US because it is the world’s biggest open economy.

These arguments are familiar. But Pettis’s book stands out in its emphasis on the surplus countries’ responsibility for producing these imbalances – and the role they should play in correcting them.

In China, the authorities not only suppressed consumption by restraining wages; they also limited returns on household savings to create huge flows of cheap finance for investment. This “financial repression”, writes Pettis, created a savings glut even bigger than the huge domestic investment need. In economics, since everything must balance, the excess is exported in the form of China’s huge accumulation of US dollars.

Pettis underlines that China is notchoosing” to buy US bonds. Its purchases are the automatic result of its domestic policies. This leads Pettis to debunk popular fears of a possible Beijing boycott of US bonds plunging America into a public debt crisis.

Chinese bond-buying, he writes, is matched by increases in the supply of US bonds because Washington has boosted the fiscal deficit to counter the effect of jobs going abroad. If Chinese bond-buying falls, it will be because there are fewer savings to export, and that will happen only when China boosts consumption, creating demand for, among other things, US goods. US unemployment will fall and so will the fiscal deficit.

The problem is that orderly rebalancing takes time and a disorderly rebalancing through future crises could be catastrophic. In his emphasis on the mechanics of the global economy, Pettis pays too little attention to the role of history in shaping events. The reasons why the Chinese Communist party opted for investment-led growth can help explain why it now finds it so hard to change tack. Ditto Germany and exports.

Something on the critical role of investor expectations would also have been useful. For instance, even if theory dictates a Chinese bond-buying boycott is not possible, a boycott scare is – as is the mayhem it might bring.

Pettis’s followers will not be surprised that his conclusions are bearish, not least for China: Beijing has takentoo long” to address its imbalances and “is running out of time”. He predicts growth to fall from about 8 per cent last year to 3 per cent over “the decade of adjustment”.

For Germany, the outlook is worse, with slow growth “for many years” and “significant losses” for banks. He warns that trade-surplus nations have historically suffered most in global recessions, drawing ominous parallels with 1930s’ France. Meanwhile, Spain, Italy, Greece and others will be forced to leave the euro and restructure debt. Perhaps, says Pettis, only a German Marshall plan for the Mediterranean (unlikely) could save the eurozone.

The US outlook is brighter because it is alreadyslowly and painfully rebalancing”. But global prospects are gloomy with demandweak for many years”. Trade tensions are rising and policy makers are doing too little. So imbalances “will reverse, but in possibly disorderly and even more painful ways than necessary.”

Investor hopes have risen markedly since last year, when Pettis completed his book. Perhaps he underestimates the growing willingness of EU leaders to reform the eurozone. But he is right to say that radical change is essential. His book is a call to action.

The writer is the FT’s emerging markets editor

Copyright The Financial Times Limited 2013.