A Tale of Two Countries

Andres Velasco

14 March 2013

This illustration is by Margaret Scott and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

SANTIAGOBarely two years ago, Brazil’s rapid economic growth and expanding middle class made it the darling of financial markets, whereas Mexico was better known for drug gangs and violence. With slow growth and stalled economic reforms, financial markets were about to write off Mexico as a lost cause.
How quickly countries’ reputations can change. Today, the Brazilian economy is stagnating, and no amount of infrastructure investment for the World Cup and the Olympics seems able to pull it out of its rut. Mexico’s economy, by contrast, is expanding at a steady clip, pushed along by a recent boom in industrial exports to the United States.
So Brazil has become the star that disappoints, while Mexico is the underperformer that suddenly shines. What is going on?
For starters, financial markets’ behavior says more about them than it does about the countries in question. With analysts focused more on short-term figures than on structural trends, it is not surprising that financial markets often fail to comprehend the real story.
That said, there are important differences in the way that Brazil and Mexico have run their economies. And those contrasts suggest useful lessons for other emerging countries.
One difference is that Mexico’s economy is much more open than Brazil’s. Mexico is not only a part of the North American Free Trade Agreement (NAFTA) with the United States and Canada, but also participates in a web of other agreements extending to Europe and Asia. Brazil’s openness, by contrast, is limited by the strictures of Mercosur, a regional grouping whose commitment to growth through trade is shaky at best.
Of course, this difference between the two countries is mostly old news. What is novel is our understanding of how long these differences in trade policies can take to yield appreciable gaps in economic performance. Back in 1994, when NAFTA entered into force, its advocates promised that the gains in jobs and growth would come quickly. They did not. Nearly two decades had to pass before a sufficient number of firms established operations in Mexico to take advantage of access to the US market.
Other gurus predicted that China had an overwhelming advantage and would eventually suck all trade-related jobs out of Mexico. They, too, were wrong. Jobs were lost to China in the first half of the 2000’s, but in recent years – as Chinese wages (measured in dollars) rose quickly – the advantages of producing in Mexico reasserted themselves. Mexico has also profited from the rise of just-in-time production in the US, which puts a premium on proximity and ready access to imported inputs.
A second crucial difference lies in the two countries’ mix of monetary and fiscal policies. Mexico and Brazil both implemented anti-crisis fiscal packages in 2009. But Mexico withdrew the stimulus promptly as its economy recovered, and has pursued a tighter fiscal policy than Brazil in the years since.
This is not desirable for its own sake, as conservatives might argue, but rather for the additional scope that it creates for monetary policy. Mexico has been able to keep interest rates much lower – the basic policy rate is 4.5%, compared to 7% in Brazil (which is unusually low for the country) – while maintaining a lower inflation rate as well.
Both countries are vulnerable to inflows of “hotmoney from rich countries, but Mexico’s lower interest rates have better insulated it from the resulting threat of upward exchange-rate pressure. Brazil’s real exchange rate has appreciated considerably in the last three years (with some ups and downs in recent months), while Mexico’s has remained basically flat. And, of course, Mexico’s competitive exchange rate is a key reason why it has become an export powerhouse, with the manufacturing sector accounting for 80% of merchandise exports.
A third crucial difference consists in how the two countries have positioned themselves in the world economy. Setting aside the recent African commodity boom, most economic growth has happened in three world regions with similar productive arrangements.
In East Asia, a host of countries produce components for assembly in China (or elsewhere in the region) and subsequent re-export; in Central and Eastern Europe, a similar phenomenon occurs with Germany as the hub; and, of course, in North America, both Canada and Mexico are increasingly integrated into the US market.
Auto parts and finished vehicles are the largest components of that shift in North America, but the story does not end there: electronics, telecommunications equipment, and many other goods are also part of the growth. Mexico’s export basket is dramatically larger and more diverse than it was three decades ago. The same cannot be said of Brazil – or, indeed, of any of South America’s fast-growing economies.
These South American countriesBrazil included – ought to be thinking about what will fuel economic growth if and when the commodity boom ends. What new goods and services will Brazil and the others export a decade from now, and to which markets? Unfortunately, the region’s political and business leaders have little to say on this issue.
Of course, we should be wary about jumping to definitive conclusions. In recent months, Mexican exports have been slowing, while domestic consumption is picking up as a source of demand. And, given Brazil’s capable professionals and quality firms, its potential to sell stuff around the world, while relatively limited by its trade relationships, should not be underestimated.
Perhaps Mexico and Brazil will one day become the northern and southern anchors of Latin American growth. That would give financial markets – and the citizens of the region – a genuine reason to cheer.
Andrés Velasco, a former finance minister of Chile, is a visiting professor at Columbia University's School of International and Public Affairs. He has consulted for the International Monetary Fund, the World Bank, and the Inter-American Development Bank, as well as for several Latin American governments.

Copyright Project Syndicate - www.project-syndicate.org

Markets Insight

March 13, 2013 11:54 am
Long-term battle to drive out short-term risk
Risk metrics should be based on asset cash flows

Hardly a day passes without some high-profile call for long-term investment to be encouraged. A Green Paper is due from the European Commission, UK parliamentarians are probing the subject in the wake of the Kay review and the G30 last month published an authoritative paper, “Long-term finance and economic growth”.

The most striking proposal so far comes from the G30: national regulators and international bodies, such as the International Monetary Fund and Financial Stability Board, should draw up best-practice guidelines for investors with long-term liabilities or horizons. The proposal is directed at public pension plans and sovereign wealth funds, and aims to influence private funds. If acted upon, this would have profound implications for the asset management industry and investment returns worldwide.

The main obstacle to change seems to be one of definition and terminology. Short-termism is not just about a holding period and long-termism does not equate to buy-and-hold. The distinction that matters lies in the investor’s choice between the two basic investment strategies of momentum trading and fundamental investing.

Momentum involves riding trends and ignoring the underlying worth of assets. Momentum investors buy when prices are rising and sell when they are falling. They do this for short-term gain or to reduce short-term risk of poor performance.

In contrast, fundamental investors purchase assets based only on the expected future cash flows. This calls for patience as they wait for prices to recover from undershooting generated by momentum.

Momentum is the embodiment of short-termism and has become the dominant strategy. Asset owners have not only allowed this to occur but encourage it through the terms on which they delegate to fund managers. The use of market capitalisation-based indices as benchmarks, the specification of risk as divergence from such benchmarks, and the targeting of short-term performance objectives, including in fee structures, all lead inevitably to its use.

Nobody has explained to the asset owners quite how damaging this is to their returns. One reason is that there is no place for a distinction between momentum and fundamental investing in the standard theory of efficient, or nearly efficient, markets. Surprisingly, this theory still informs our understanding of how finance works and provides the basis for setting benchmarks and analysing risk.

A second is that even those wishing to concentrate on fundamental value are prevented by the career risk of short-term underperformance against their peers.

A code of best practice should make clear that funds focusing on getting the best return each year are unlikely to achieve the best risk-adjusted return over the long-run. Momentum is a succession of independent bets, whereas long-term investing benefits from prices reverting to the mean, reducing risk over time.

The code should also spell out the need to adopt fundamental benchmarks, such as real global GDP growth plus local inflation. Risk metrics should be based on the cash flows of assets, not on their market prices. Derivatives are short-term instruments mostly used to implement momentum-type strategies, so their use should be limited. The easiest way to ensure managers are taking a long-term view is to cap turnover at around 30 per cent per annum. Contracts with agents should avoid performance fees based on short-term results.

The G30’s call to action should influence policy makers and regulators, but a key incentive for long-term funds to change lies in the interests of the asset owners. They would achieve higher returns if their funds were released from the inhibitions of momentum-skewed benchmarks and short-term measures of relative performance.

As large funds adopt the new practices, a new comparator universe of long-termist funds will be created. This will do much to ease the concerns of those who fear short-term underperformance in the event of a new momentum-fuelled bubble.

The other side of the coin is that members of pension schemes will be able to challenge trustees who fail to comply with the new code and suffer underperformance as a result.

Writing the heads of a new code will be relatively straightforward. The complications come in the detail, especially in the recommendations on benchmarks and the development of new risk metrics. Then there is the need to establish a new monitoring process. But this proposal marks a huge step towards improving the functioning of capital markets and the returns to savers.

Paul Woolley is a Senior Fellow at the London School of Economics; Dimitri Vayanos, Professor at the LSE, is co-writer

Copyright The Financial Times Limited 2013

The Economist’s Stone

Jeffrey Frankel

13 March 2013
This illustration is by Paul Lachine and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

CAMBRIDGEThis year marks the 100th anniversaries of two distinct institutional innovations in American economic policy: the introduction of the federal income tax and the establishment of the Federal Reserve. They are worth commemorating, if only because we are at risk of forgetting what we have learned since then.

Initially, neither the income tax nor the Fed was associated with the explicit concepts of fiscal and monetary policy. Indeed, it wasn’t until after the experience of the 1930’s that they came to be viewed as potential instruments for macroeconomic management. John Maynard Keynes pointed out the advantages of fiscal stimulus in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed for allowing the money supply to fall.

Keynes is associated with a belief in activist economic policy aimed at ensuring counter-cyclical responses to economic fluctuationsexpansionary policies during recessions and policy tightening during upswings. Friedman, by contrast, opposed discretionary policymaking, believing that government institutions lacked the ability to get the timing right. But both opposed pro-cyclical policy, such as the misguided US fiscal and monetary tightening of 1937: before the economy had fully recovered, President Roosevelt raised taxes and cut spending, while the Federal Reserve raised reserve requirements, prolonging and worsening the Great Depression.

After World War II, students and policymakers internalized the lessons of the 1930’s. But episodes in recent decades – for example, high inflation in the 1970’soverwhelmed much of what was learned. As a result, many advanced countries today are repeating the mistake of 1937, despite facing similar macroeconomic conditions: high unemployment, low inflation, and near-zero interest rates.

The pros and cons of austerity nowadays have been thoroughly debated. Austerity’s proponents correctly point out that permanently expansionary macroeconomic policies lead to unsustainable deficits, debts, and inflation. Advocates of stimulus are right to note that in the aftermath of a recession, when unemployment is high and inflation is low, the immediate consequences of policy contraction are continued unemployment, slow growth, and rising debt/GDP ratios. And pro-cyclicalists, both in the US and Europe, represent the worst of all worlds by pursuing expansionary policies during booms, such as in 2003-07, and contractionary policies during recessions, such as in 2008-2012.

But, if counter-cyclicalists are right to favor moderating, rather than exacerbating, upswings and downswings in the economy, we still need to know what works best. Given recent conditions, is monetary or fiscal stimulus the more effective instrument?

John Hicks addressed this question clearly in a once-famous 1937 article called Mr. Keynes and the Classics.” Under the conditions that prevailed then, and that prevail again now (high unemployment, low inflation, and near-zero interest rates), monetary expansion is relatively less effective, because it cannot push interest rates below zero.

Moreover, firms are less likely to respond to easy money by investing in new physical capital and labor if they cannot sell what they already produce in the factories they already have with the workers they already employ. Fiscal stimulus is relatively more effective in these conditions, because it creates demand for goods without driving up those rock-bottom interest rates and crowding out private-sector demand (as it would in normal times).

None of this should be controversial. Introductory economics used to emphasize the Keynesian multiplier effect: recipients of government spending (or of consumer spending stimulated by tax cuts or transfers) respond to the increase in their incomes by spending more, as do the recipients of that spending, and so on. Again, the multiplier is much more relevant under current conditions, because it does not fuel higher inflation and interest rates (and thus crowd out private spending).

Unfortunately, many economists and politicians have forgotten much of what they knew (or have been blinded by new theories of policy ineffectiveness). Indeed, by the time the 2008-2009 global recession hit, even advocates of fiscal stimulus had lowered their estimates of the multiplier. But the continuing severity of recessions in the United Kingdom and other countries pursuing fiscal contraction has suggested that multipliers are not just positive, but greater than onejust as the old wisdom had it. The International Monetary Fund has responded by forthrightly confessing that official forecasts, including its own, had underestimated the multiplier’s size.

Of course, the effects of fiscal policy are uncertain. One never knows, for example, when rising debt levels might alarm international investors, who then start demanding sharply higher interest rates, as happened to countries on the European periphery in 2010. We are also uncertain about the magnitude of the negative long-term effects of high tax rates on growth. And monetary policy is much better understood than it was in the past. Indeed, a much-admired recent paper characterized monetary policy as science and fiscal policy as alchemy.

To be sure, the state of knowledge and practice at central banks is close to the best that modern society has to offer, whereas fiscal policy is set in a highly political process that is poorly informed by economic knowledge and largely motivated by officials’ desire to be re-elected. But the problem with the ancient alchemists and their search for the philosopher’s stone was not that they were stupid or selfish people. Nor was their problem that political leaders refused to listen to them. Rather, the state of knowledge at the time simply fell far short of the modern science of chemistry.

In this sense, the term alchemy could be applied to pre-Keynesians like US Treasury Secretary Andrew Mellon, whose prescription at the start of the Great Depression was to “liquidate labor, liquidate stocks, liquidate farmers, [and] liquidate real estate” in order to “purge the rottenness out of the system.” It could also be applied to those today who favor returning monetary policy to the pre-1914 gold standard.

This does not mean that either fiscal policy or monetary policy has graduated to the status of a science like chemistry, underpinned by natural laws that generate precisely foreseeable outcomes. But surely we have learned since 1913 that fiscal expansion is appropriate under some conditions, even if it is inappropriate under others.

Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery. .

Copyright Project Syndicate - www.project-syndicate.org


March 12, 2013, 7:06 p.m. ET

Easing the Angst About Fed Easing

By paying less interest on excess bank reserves, the Federal Reserve would reduce its liabilities. Then it could sell an equal amount of assets.


Last month, a flurry of ill-informed speculation swept through the markets: The Federal Reserve might start backing away from its program of large-scale asset purchases ("quantitative easing"), or maybe even begin to raise the federal funds rate, before the end of the year. The talk was fueled by the release, on Feb. 20, of the minutes of the Federal Open Market Committee's January meeting.
Those minutes included these words: "Many participants also expressed some concerns about potential costs and risks arising from further asset purchases." Many?

Might Chairman Ben Bernanke's dovish majority be losing its hold on the Fed's policy-making body? Turns out he isn't, as Mr. Bernanke made clear in his testimony to the Senate Banking Committee on Feb. 26.

"The FOMC has indicated that it will continue purchases until it observes a substantial improvement in the outlook for the labor market," he said, making it clear that no such improvement has been seen. He also asserted that "the benefits of asset purchases, and of policy accommodation more generally, are clear: Monetary policy is providing important support to the recovery."

Mr. Bernanke acknowledged that "highly accommodative monetary policy also has several potential costs and risks," but he immediately and emphatically debunked them. Basically, he didn't give an inch.

This is not at all surprising. Fed watchers should have remembered the FOMC's last published Survey of Economic Projections, issued in December. Only two of the committee's 19 participants thought any sort of Fed tightening was appropriate in 2013. Two is a long way from "many." Could Fed opinion have changed massively between December and January? If so, on what grounds?

Which brings me to the main point: The fundamental case for extreme monetary ease has hardly changed. Mr. Bernanke and the FOMC majority believe deeply in the Fed's dual mandate, to keep both inflation and unemployment low. They know they are succeeding on the first but failing on the second. They also learned long ago that cutting the federal funds rate by over 500 basis points (five percentage points) was inadequate to combat the recession. Rather than give up, they opted for "unconventional" monetary policies like quantitative easing.

Mr. Bernanke's testimony also conveyed to Congress, albeit subtly, that fiscal policy is now restraining growth via higher taxes and lower spending. When it comes to supporting growth, the Fed is the only game in town.

These "fundamentals" apply just as well today as they did six and 12 months ago. So what has changed?

Well, the Fed's balance sheet keeps growing, currently at a rate of about $85 billion a month. It's now about $3.1 trillion but rising steadily. Critics claim that this growth will make the eventual exit more difficult. In some tautological sense, they must be right: If the Fed wants to get back to, say, a $1 trillion balance sheet, it has more work to do if it starts from $4 trillion than if it starts from $3 trillion.

Yet the basic exit mechanism is the same. The Fed built a big balance sheet by buying assets. It will shrink this balance sheet by selling assets and by letting assets run off as they mature.

Mr. Bernanke has noted repeatedly that, when the time for exit from super-easy monetary policy comes, the Fed can induce banks to hold on to more reserves by paying higher interest rates on those reserves. The more reserves the banks keep idle at the Fed, the less the Fed's balance sheet must shrink.

These arguments have not convinced everyone, however. Some—check that, "many"—people remain worried. Why?

First, the Fed faces a potential hazard in persuading banks to hold more reserves by paying them more interest. If the necessary interest rate turns out to be high relative to what the Fed earns on its portfolio, the central bank could find itself transformed from a highly profitable operation—to the tune of nearly $90 billion last year—to a loss-maker. That means less (or no) money flowing into the Treasury's coffers.

Second, the more bonds the Fed sells, and the more quickly it sells them, the more it will drive down bond prices. That, in turn, will inflict capital losses on bondholders—a diverse group that includes individual investors, most pension funds, many foreign governments, and the Fed itself. In worst-case scenarios, the central bank could wind up with negative net worth on a mark-to-market basis.

At first glance, that sounds horrible. A central bank with negative net worth and losing money? But hold on. The Fed isn't a private corporation that seeks profits and goes out of business once its net worth turns negative. It can still perform all of its essential functions with negative net worth. Indeed, some central banks have done so.

But bondholders will lose a lot of money when interest rates return to normal. That's for sure. The only questions are when and how fast the losses will accrue.

It's not a pretty picture. But then again, neither is unemployment lingering above 7% indefinitely. This is why Ben Bernanke and the FOMC majority keep plugging away.

Is there a way out? Here's one thing that could help. As I have argued for some time, the Fed should reduce the interest rate it pays on the roughly $1.7 trillion of banks' excess reserves. If it did so, banks would keep less cash on deposit at the Fed. The liberated funds would probably flow mainly into the money markets, but some would probably find their way into increased lending—which would give the economy a little boost.

In either case, if banks wanted to hold fewer reserves—a Fed liability—the Fed could, and naturally would, shrink its assets by an equal amount. Balance sheets do, after all, balance. And that would make the eventual exit easier.

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of "After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead" (Penguin, 2013).