The Trapdoors at the Fed’s Exit

Nouriel Roubini

29 April 2013
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MUMBAI – The ongoing weakness of America’s economy – where deleveraging in the private and public sectors continues apace – has led to stubbornly high unemployment and sub-par growth. The effects of fiscal austerity – a sharp rise in taxes and a sharp fall in government spending since the beginning of the year – are undermining economic performance even more.
 
Indeed, recent data have effectively silenced hints by some Federal Reserve officials that the Fed should begin exiting from its current third (and indefinite) round of quantitative easing (QE3). Given slow growth, high unemployment (which has fallen only because discouraged workers are leaving the labor force), and inflation well below the Fed’s target, this is no time to start constraining liquidity.
 
The problem is that the Fed’s liquidity injections are not creating credit for the real economy, but rather boosting leverage and risk-taking in financial markets. The issuance of risky junk bonds under loose covenants and with excessively low interest rates is increasing; the stock market is reaching new highs, despite the growth slowdown; and money is flowing to high-yielding emerging markets.
 
Even the periphery of the eurozone is benefiting from the wall of liquidity unleashed by the Fed, the Bank of Japan, and other major central banks. With interest rates on government bonds in the US, Japan, the United Kingdom, Germany, and Switzerland at ridiculously low levels, investors are on a global quest for yield.
 
It may be too soon to say that many risky assets have reached bubble levels, and that leverage and risk-taking in financial markets is becoming excessive. But the reality is that credit and asset/equity bubbles are likely to form in the next two years, owing to loose US monetary policy. The Fed has signaled that QE3 will continue until the labor market has improved sufficiently (likely in early 2014), with the interest rate at 0% until unemployment has fallen at least to 6.5% (most likely no earlier than the beginning of 2015).
 
Even when the Fed starts to raise interest rates (some time in 2015), it will proceed slowly. In the previous tightening cycle, which began in 2004, it took the Fed two years to normalize the policy rate. This time, the unemployment rate and household and government debt are much higher. Rapid normalization – like that undertaken in the space of a year in 1994 – would crash asset markets and risk leading to a hard economic landing.
 
But if financial markets are already frothy now, consider how frothy they will be in 2015, when the Fed starts tightening, and in 2017 (if not later), when the Fed finishes tightening? Last time, interest rates were too low for too long (2001-2004), and the subsequent rate normalization was too slow, inflating huge bubbles in credit, housing, and equity markets.
 
We know how that movie ended, and we may be poised for a sequel. The weak real economy and job market, together with high debt ratios, suggest the need to exit monetary stimulus slowly. But a slow exit risks creating a credit and asset bubble as large as the previous one, if not larger. Pursuing real economic stability, it seems, may lead again to financial instability.
 
Some at the FedChairman Ben Bernanke and Vice Chair Janet Yellen – argue that policymakers can pursue both goals: the Fed will raise interest rates slowly to provide economic stability (strong income and employment growth and low inflation) while preventing financial instability (credit and asset bubbles stemming from high liquidity and low interest rates) by using macro-prudential supervision and regulation of the financial system. In other words, the Fed will use regulatory instruments to control credit growth, risk-taking, and leverage.
 
But another Fed faction led by Governors Jeremy Stein and Daniel Tarullo – argues that macro-prudential tools are untested, and that limiting leverage in one part of the financial market simply drives liquidity elsewhere. Indeed, the Fed regulates only Banks, so liquidity and leverage will migrate to the shadow banking system if banks are regulated more tightly. As a result, only the Fed’s interest-rate instrument, Stein and Tarullo argue, can get into all of the financial system’s cracks.
 
But if the Fed has only one effective instrumentinterest rates – its two goals of economic and financial stability cannot be pursued simultaneously. Either the Fed pursues the first goal by keeping rates low for longer and normalizing them very slowly, in which case a huge credit and asset bubble would emerge in due course; or the Fed focuses on preventing financial instability and increases the policy rate much faster than weak growth and high unemployment would otherwise warrant, thereby halting an already-sluggish recovery.
 
The exit from the Fed’s QE and zero-interest-rate policies will be treacherous: Exiting too fast will crash the real economy, while exiting too slowly will first create a huge bubble and then crash the financial system. If the exit cannot be navigated successfully, a dovish Fed is more likely to blow bubbles.
 
 
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.


The Great Divide

April 27, 2013, 6:15 pm

No Rich Child Left Behind

By SEAN F. REARDON

Here’s a fact that may not surprise you: the children of the rich perform better in school, on average, than children from middle-class or poor families. Students growing up in richer families have better grades and higher standardized test scores, on average, than poorer students; they also have higher rates of participation in extracurricular activities and school leadership positions, higher graduation rates and higher rates of college enrollment and completion.

Whether you think it deeply unjust, lamentable but inevitable, or obvious and unproblematic, this is hardly news. It is true in most societies and has been true in the United States for at least as long as we have thought to ask the question and had sufficient data to verify the answer.

What is news is that in the United States over the last few decades these differences in educational success between high- and lower-income students have grown substantially.

One way to see this is to look at the scores of rich and poor students on standardized math and reading tests over the last 50 years. When I did this using information from a dozen large national studies conducted between 1960 and 2010, I found that the rich-poor gap in test scores is about 40 percent larger now than it was 30 years ago.

To make this trend concrete, consider two children, one from a family with income of $165,000 and one from a family with income of $15,000. These incomes are at the 90th and 10th percentiles of the income distribution nationally, meaning that 10 percent of children today grow up in families with incomes below $15,000 and 10 percent grow up in families with incomes above $165,000.

In the 1980s, on an 800-point SAT-type test scale, the average difference in test scores between two such children would have been about 90 points; today it is 125 points. This is almost twice as large as the 70-point test score gap between white and black children. Family income is now a better predictor of children’s success in school than race.

The same pattern is evident in other, more tangible, measures of educational success, like college completion. In a study similar to mine, Martha J. Bailey and Susan M. Dynarski, economists at the University of Michigan, found that the proportion of students from upper-income families who earn a bachelor’s degree has increased by 18 percentage points over a 20-year period, while the completion rate of poor students has grown by only 4 points.

In a more recent study, my graduate students and I found that 15 percent of high-income students from the high school class of 2004 enrolled in a highly selective college or university, while fewer than 5 percent of middle-income and 2 percent of low-income students did.

These widening disparities are not confined to academic outcomes: new research by the Harvard political scientist Robert D. Putnam and his colleagues shows that the rich-poor gaps in student participation in sports, extracurricular activities, volunteer work and church attendance have grown sharply as well.

In San Francisco this week, more than 14,000 educators and education scholars have gathered for the annual meeting of the American Educational Research Association. The theme this year is familiar: Can schools provide children a way out of poverty?

We are still talking about this despite decades of clucking about the crisis in American education and wave after wave of school reform. Whatever we’ve been doing in our schools, it hasn’t reduced educational inequality between children from upper- and lower-income families.

Part of knowing what we should do about this is understanding how and why these educational disparities are growing. For the past few years, alongside other scholars, I have been digging into historical data to understand just that. The results of this research don’t always match received wisdom or playground folklore.

The most potent development over the past three decades is that the test scores of children from high-income families have increased very rapidly. Before 1980, affluent students had little advantage over middle-class students in academic performance; most of the socioeconomic disparity in academics was between the middle class and the poor. But the rich now outperform the middle class by as much as the middle class outperform the poor. Just as the incomes of the affluent have grown much more rapidly than those of the middle class over the last few decades, so, too, have most of the gains in educational success accrued to the children of the rich.

Before we can figure out what’s happening here, let’s dispel a few myths.

The income gap in academic achievement is not growing because the test scores of poor students are dropping or because our schools are in decline. In fact, average test scores on the National Assessment of Educational Progress, the so-called Nation’s Report Card, have been risingsubstantially in math and very slowly in reading — since the 1970s. The average 9-year-old today has math skills equal to those her parents had at age 11, a two-year improvement in a single generation.

The gains are not as large in reading and they are not as large for older students, but there is no evidence that average test scores have declined over the last three decades for any age or economic group.

The widening income disparity in academic achievement is not a result of widening racial gaps in achievement, either. The achievement gaps between blacks and whites, and Hispanic and non-Hispanic whites have been narrowing slowly over the last two decades, trends that actually keep the yawning gap between higher- and lower-income students from getting even wider. If we look at the test scores of white students only, we find the same growing gap between high- and low-income children as we see in the population as a whole.

It may seem counterintuitive, but schools don’t seem to produce much of the disparity in test scores between high- and low-income students. We know this because children from rich and poor families score very differently on school readiness tests when they enter kindergarten, and this gap grows by less than 10 percent between kindergarten and high school. There is some evidence that achievement gaps between high- and low-income students actually narrow during the nine-month school year, but they widen again in the summer months.

That isn’t to say that there aren’t important differences in quality between schools serving low- and high-income students — there certainly are — but they appear to do less to reinforce the trends than conventional wisdom would have us believe.

If not the usual suspects, what’s going on? It boils down to this: The academic gap is widening because rich students are increasingly entering kindergarten much better prepared to succeed in school than middle-class students. This difference in preparation persists through elementary and high school.

My research suggests that one part of the explanation for this is rising income inequality. As you may have heard, the incomes of the rich have grown faster over the last 30 years than the incomes of the middle class and the poor.
Money helps families provide cognitively stimulating experiences for their young children because it provides more stable home environments, more time for parents to read to their children, access to higher-quality child care and preschool and — in places like New York City, where 4-year-old children take tests to determine entry into gifted and talented programsaccess to preschool test preparation tutors or the time to serve as tutors themselves.

But rising income inequality explains, at best, half of the increase in the rich-poor academic achievement gap. It’s not just that the rich have more money than they used to, it’s that they are using it differently. This is where things get really interesting.

High-income families are increasingly focusing their resources — their money, time and knowledge of what it takes to be successful in school — on their children’s cognitive development and educational success. They are doing this because educational success is much more important than it used to be, even for the rich.

With a college degree insufficient to ensure a high-income job, or even a job as a barista, parents are now investing more time and money in their children’s cognitive development from the earliest ages. It may seem self-evident that parents with more resources are able to invest moremore of both money and of what Mr. Putnam calls “‘Goodnight Moon time” — in their children’s development. But even though middle-class and poor families are also increasing the time and money they invest in their children, they are not doing so as quickly or as deeply as the rich.

The economists Richard J. Murnane and Greg J. Duncan report that from 1972 to 2006 high-income families increased the amount they spent on enrichment activities for their children by 150 percent, while the spending of low-income families grew by 57 percent over the same time period. Likewise, the amount of time parents spend with their children has grown twice as fast since 1975 among college-educated parents as it has among less-educated parents. The economists Garey Ramey and Valerie A. Ramey of the University of California, San Diego, call this escalation of early childhood investment “the rug rat race,” a phrase that nicely captures the growing perception that early childhood experiences are central to winning a lifelong educational and economic competition.

It’s not clear what we should do about all this. Partly that’s because much of our public conversation about education is focused on the wrong culprits: we blame failing schools and the behavior of the poor for trends that are really the result of deepening income inequality and the behavior of the rich.

We’re also slow to understand what’s happening, I think, because the nature of the problem — a growing educational gap between the rich and the middle class — is unfamiliar. After all, for much of the last 50 years our national conversation about educational inequality has focused almost exclusively on strategies for reducing inequalities between the educational successes of the poor and the middle class, and it has relied on programs aimed at the poor, like Head Start and Title I.

We’ve barely given a thought to what the rich were doing. With the exception of our continuing discussion about whether the rising costs of higher education are pricing the middle class out of college, we don’t have much practice talking about what economists callupper-tail inequality” in education, much less success at reducing it.

Meanwhile, not only are the children of the rich doing better in school than even the children of the middle class, but the changing economy means that school success is increasingly necessary to future economic success, a worrisome mutual reinforcement of trends that is making our society more socially and economically immobile.

We need to start talking about this. Strangely, the rapid growth in the rich-poor educational gap provides a ray of hope: if the relationship between family income and educational success can change this rapidly, then it is not an immutable, inevitable pattern. What changed once can change again. Policy choices matter more than we have recently been taught to think.

So how can we move toward a society in which educational success is not so strongly linked to family background? Maybe we should take a lesson from the rich and invest much more heavily as a society in our children’s educational opportunities from the day they are born. Investments in early-childhood education pay very high societal dividends. That means investing in developing high-quality child care and preschool that is available to poor and middle-class children. It also means recruiting and training a cadre of skilled preschool teachers and child care providers. These are not new ideas, but we have to stop talking about how expensive and difficult they are to implement and just get on with it.

But we need to do much more than expand and improve preschool and child care. There is a lot of discussion these days about investing in teachers and “improving teacher quality,” but improving the quality of our parenting and of our children’s earliest environments may be even more important. Let’s invest in parents so they can better invest in their children.

This means finding ways of helping parents become better teachers themselves. This might include strategies to support working families so that they can read to their children more often.. It also means expanding programs like the Nurse-Family Partnership that have proved to be effective at helping single parents educate their children; but we also need to pay for research to develop new resources for single parents.

It might also mean greater business and government support for maternity and paternity leave and day care so that the middle class and the poor can get some of the educational benefits that the early academic intervention of the rich provides their children. Fundamentally, it means rethinking our still-persistent notion that educational problems should be solved by schools alone.

The more we do to ensure that all children have similar cognitively stimulating early childhood experiences, the less we will have to worry about failing schools. This in turn will enable us to let our schools focus on teaching the skillshow to solve complex problems, how to think critically and how to collaborateessential to a growing economy and a lively democracy.


Sean F. Reardon is a professor of education and sociology at Stanford.


April 29, 2013, 12:04 p.m. ET

German Bonds Send Worrying Signal

By RICHARD BARLEY

 
 
 
From one perspective, the euro-zone crisis is firmly in abeyance: Spanish and Italian bond yields are at their lowest level since late 2010, racking up another big rally Monday after Italy finally formed a government. But another crisis indicator is flashing red: German 10-year bond yields also fell Monday, to 1.19%, their lowest since July 2012, when Spain was at risk of losing market access and investors were fretting about a euro-zone breakup. What can explain this?

German bunds sold off sharply in January, driven by a global pickup in risk appetite. But since late February, yields have steadily fallen; in the past two weeks, Germany has sold 10- and 30-year bonds at the lowest yields on record to decent demand. That has occurred even as talk of a "search for yield" has become widespread: Corporate "junk" bond issuance has been on a tear, and investors have even snapped up sovereign bonds from Rwanda.

Germany has a number of structural supports. It is a rarity among developed-market governments in running a budget surplus, which came in at 0.2% of GDP in 2012. That means very low German net bond issuance: For investors simply to maintain their exposure to Germany, they have to keep rolling over their holdings by buying at auctions. After steep ratings downgrades for southern Europe, some of the money that has flowed into Germany won't flow back again, either. Spanish and Italian bonds are now more about credit risk tan interest-rate risk.

But more important is the economic data. The euro-zone remains mired in recession, and even Germany's economic engine is sputtering.

Global conditions have weakened, with questions being asked of the U.S. recovery. Meanwhile, German inflation has slumped to just 1.1% on a European Union harmonized basis. The case for a bond-friendly European Central Bank rate cut Thursday is strong, even if on its own it may have little impact on the euro-zone economy.

The tension is clear: If the euro-zone economy picks up again, German bonds will look vulnerable. But if it continues to worsen, then risky assets could take a tumble. The jury is out. But when it returns its verdict, one of the two could look badly mispriced.


April 29, 2013 7:11 pm
 
Fed faces calls for radical reform
 

A senior Republican congressman has called for everything from the gold standard to a price level target to be on the table in a 100th anniversary review of the Federal Reserve’s mandate.
Kevin Brady, who chairs the joint economic committee, wants Congress to appoint a bipartisan commission that could lead to a radical change in the mandate of the world’s largest and most important central bank.

By setting up a process that has a chance of passing Congress, Mr Brady’s bill marks one of the most serious bids to revamp the Fed for years, on the centenary of its founding legislation in 1913.

“This isn’t an ‘End the Fedgambit – just the opposite,” Mr Brady told the Financial Times in an interview. “We want a very thoughtful, very constructive analysis of the last 100 years. When the house isn’t on fire we want a discussion of what role the fire department should play.”

The proposed Centennial Monetary Commission would have instructions to look at more aggressive mandates to fight unemployment, such as a target level for nominal gross domestic product, as well as more conservative regimes such as an inflation-only objective.

That could make the idea acceptable to Democrats. Previous Republican proposals – such as ex-presidential candidate Ron Paul’s demand to “audit” the Fed and Mr Brady’s own bill to give the Fed an inflation-only mandate – have won only partisan support.

Mr Brady and other Republicans worry that the Fed’s aggressive programme of asset purchases, carried out to meet its current dual mandate of maximum employment and stable prices, could lead to inflation or financial stability problems in the future.

But some Democrats would like to see the Fed do more to tackle an unemployment rate that is still high at 7.6 per cent almost four years after the end of a recession. There has also been a broad global move to look again at central bank mandates. The Bank of England and the Bank of Japan have made recent changes.

Mr Brady said that initial reaction to his proposal has been positive because the crisis has given the Fed a higher profile than ever. Both lawmakers in Washington and the public are now genuinely interested in who the Fed is, what they do, and how they are given the authority to do it,” he said.

So far his bill has 12 cosponsors, all of them Republicans in the House, and to make progress it will have to attract Democratic support and interest from the Senate.

Mr Brady is proposing a commission of six Democrats and six Republicans, half of them legislators, and half of them appointees. The Fed and the Treasury would each appoint one non-voting member. Congress would still have to vote on anything a commission proposed.

“We think – because it is so balanced and sets up a bipartisan composition – we think we can draw support,” said Mr Brady. “We’re just starting that process and that outreach.”

Mr Brady is trying to attract support for his commission in a year when a new chairman is likely to be nominated to the Fed if Ben Bernanke steps down when his current term ends in January 2014.

That would mean a Senate confirmation process in the autumn with a new chairman setting out their views of the role of the Fed. If Mr Brady’s bill gains traction then it could be drawn into that debate.

“That would not be the intent,” said Mr Brady. “We would want the commission to be set aside so it has that objectivity.” If the president’s nominee for Fed chairman proves to be controversial, however, it could boost a proposal to examine the institution more broadly.

Officials at the Fed tend to argue that policy would be quite similar under an inflation-only mandate, because with unemployment so high there is little upward pressure on prices.
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Copyright The Financial Times Limited 2013.