The Blurry Frontiers of Economic Policy

Michael Spence

19 September 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.

MILANAround the world, policies, technologies, and extended learning processes have combined to erode barriers to economic interaction among countries. Pick any indicator: trade relative to global GDP, capital flows relative to the global capital stock, and so forthall are rising.
But economic policies are set at the national level, and, with a few notable exceptions like trade negotiations and the tracking of terrorist funding and money laundering, policymakers set goals with a view to benefiting the domestic economy. And these policies (or policy shifts) are increasingly affecting other economies and the global system, giving rise to what might be calledpolicy externalities” – that is, consequences that extend outside policymakers’ target environment.
Of course, such externalities have always existed. But they used to be small. As they grow more significant (the result of greater global connectedness), they inevitably become harder to manage. After all, global optimization would require a global policymaking authority, which we do not have.
These external effects are particularly consequential in the financial sector, owing to the potential for large and relatively abrupt changes in capital flows, asset prices, interest rates, credit availability, and exchange rates, all of which have powerful effects on output growth and employment.
The economic crisis and its aftermath is a case in point. Defective growth models in advanced countries, based on excess credit and domestic aggregate demand (and complicated by structural flaws and limited adjustment mechanisms in Europe), led to instability, a crisis, and a large negative shock to the real economy. Emerging economies were immediately affected by credit tightening (including trade finance) and rapid declines in exports, leading to similar shocks there.
Advanced countries moved to prevent a downward spiral using monetary and fiscal policy tools. These, too, had external effects; but, at least in the short run, the medicine (distortions in capital markets) was generally considered less damaging than the disease (economic collapse in the advanced economies).
This was followed by an extended version of the assisted-growth model in the advanced countries, largely revolving around unconventional monetary policy; in the United States, this implied several rounds of quantitative easing, which is simply the government borrowing from itself – a form of price control. Savers were repressed in order to lower the costs of credit for debtors (including governments) and those seeking to borrow for business expansion.
This did not work very well, because investment was constrained by deficient domestic aggregate demand relative to capacity. So savers did what one would expect: seek higher risk-adjusted returns in emerging economies, causing increases in credit and fueling upward pressure on exchange rates and asset prices.
This obvious externality required policy responses in the emerging countries: limits on capital inflows, reserve accumulation, and measures to restrict credit and restrain asset-price inflation. Complaints from emerging-market policymakers about the distortionary effects of the advanced countries’ policies were largely ignored.
All of that has changed dramatically since May, when the US Federal Reserve began signaling its intention to “taper” its massive monthly purchases of long-term assets. Asset prices shifted, and capital rushed out of emerging markets, causing credit conditions to tighten and exchange rates to fall.
At a minimum, a short-term growth slowdown is nearly certain; some wonder whether the destabilizing impact of capital-flow reversals will have longer-term adverse effects. For the most part, the latter fear appears overblown, though the risks caused by unexpected policy shifts and related financial adjustments should not be underestimated or dismissed.
The emerging economies generally have the policy instruments, balance sheets, and expertise to respond effectively. In addition, while China’s output is affected by advanced-country economic performance, its financial system is largely insulated from monetary-policy externalities. The capital account is less open, foreign-currency reserves of $2.5 trillion mean that the exchange rate is controllable, and, with savings exceeding investment (the current-account surplus is declining but still positive), China is not dependent on foreign capital.
China’s systemic importance with respect to emerging-market growth, its relative stability, and other emerging countries’ domestic policy responses suggest that the main effect of the Fed’s coming policy shift will be a new equilibrium with less distorted asset prices. This should create opportunity for investors, especially if there is a downward overshoot as the new equilibrium emerges.
Some level of policy coordination might be achieved by an early-warning system, which would provide sufficient time for an organized response. But multilateral communication of significant policy shifts would almost inevitably result in leaks and confidence-damaging insider trading.
Given an expanded mandate and a much larger balance sheet, the International Monetary Fund, with advance notification, could in principle reliably act to stabilize volatile international capital flows, buying time for more orderly domestic responses. But that would be a rather large step in the direction of global economic governance and management.
Decentralized policy and growing externalities will result in partial de-globalization, especially in macroeconomic configurations, finance, and capital accounts. Thus, it is not a good idea to run persistent current-account deficits and become dependent on (temporarily) low-cost foreign capital.
Open capital accounts may be replaced not by whimsical ad hoc interventions that heighten uncertainty and weaken confidence, but rather by predictable rules-based constraints on financial-capital flows.
Second, as we learned from the crisis, substantial domestic ownership of the banking sector is crucial, in part because multinational resolution mechanisms in cases of insolvency are largely non-existent. Moreover, the pattern of accumulating reserves via current-account surpluses, net private capital inflows, or both – a legacy of the 1997-1998 Asian financial crisis – will continue and perhaps become even more pronounced. Finally, public purchases of domestic assets to stabilize asset prices and net capital flows will become increasingly common.
We are in the process of learning how to manage growing policy interdependence without much policy coordination. The challenge is to identify policy circuit breakers that have relatively high benefit/cost ratios. Time and experience will helpthat is, so long as high volatility does not destabilize many economies in the interim.
Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, and Academic Board Chairman of the Fung Global Institute in Hong Kong. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analyzed opportunities for global economic growth, and is the author of The Next Convergence – The Future of Economic Growth in a Multispeed World.

September 19, 2013 5:14 pm
West’s debt explosion is real story behind Fed QE dance
Western finance cannot be fixed without tackling credit addiction
The danger with addictions is they tend to become increasingly complusive. That might be one moral of this week’s events. A few days ago, expectations were sky-high that the Federal Reserve was about to reduce its current $85bn monthly bond purchases. But then the Fed blinked, partly because it is worried that markets have already over-reacted to the mere thought of a policy shift. Faced with a choice of curbing the addiction or providing more hits of the QE drug, in other words, it chose the latter.
In many ways this is understandable; the real economic data is still soft. But as investors try to fathom what the Fed will (not) do next, it is worth pondering a timely speech made recently by former UK regulator Lord Turner. As he told Swedish economists last week, and repeated to central bankers and economists in London this week, the real story behind the recent dramatic financial sagasbe that the market dance around QE or the crisis at Lehman Brothers five years ago – is that western economies have become hooked on ever-expanding levels of debt.
Until this situation changes it is delusional to think that anyone has really fixedwestern finance with post-Lehman reforms, or created truly healthy growth, Lord Turner insists. Put another wayalthough he did not say so bluntlyone way to interpret this week’s dance around QE is that policy makers are continuing to prop up a financial system that is (at best) peculiar and (at worst) unstable.

Such criticisms, of course, are not new: maverick far-right and far-left economists have been making them for years. But what makes Lord Turner’s contribution notable is that until recently he was sitting at the centre of the global financial system – and post-Lehman reform process – he now thinks is so flawed. And from that perspective he points out some curious contradictions. Take what banks do. A standard economics text book, Lord Turner writes, claims that banks exist to “raise deposits from savers and then make loans to borrowers” ... and “primarily lend to firms/entrepreneurs to fund investment projects”. Thus “demand for money is a crucial issue” in terms of growth.
But this depiction is a fiction, he says. The reason? He calculates that today in the UK a mere 15 per cent of total financial flows actually go into “investment projects”; the rest support existing corporate assets, real estate or unsecured personal finance to “facilitate lifecycle consumption smoothing”.
Some non-investment finance is socially useful, Lord Turner admits; but much is not. In real estate, for example, most credit just “funds the purchase of already existing houses” rather than investment in new homes (ie construction). And what is really striking about the non-investment piece of this financial picture is that it has exploded; as a result, as the Bank of England’s Andy Haldane also pointed out in a debate in London last week, the size of private credit, relative to GDP, has doubled to 200 per cent in the past 50 years.

This makes a mockery of existing textbooks and official policy assumptions. But the explosion in credit has another peculiar implication, both Mr Haldane and Lord Turner note: since total credit keeps rising inexorably, even as growth remains flat, the “productivity” of money is falling, even as the propensity of the over-leveraged system to have booms and busts, amid investor sentiment swings, has risen.

So is there any solution? Lord Turner offers a few ideas. He wants a radical overhaul of the intellectual models that economists use (including, presumably, those in central banks.) He also wants policy makers to deliberately reduce credit. Thus the Basel III framework for banks should have tough counter-cyclical capital requirements, he argues, and regulators should reintroduce into the policy toolkit quantitative reserve requirements, which more directly constrain banking multipliers and thus credit growth than do increases in capital requirements”.

Now, of course, that is not happening; on the contrary, British banks are under political pressure to provide more mortgages, as house prices hit new peaks, and the Fed is so determined to kickstart the US housing market it keeps gobbling up those mortgage bonds. Of course, the official policy line is that this is just a temporary affair: once there is strong, sustainable growth, this will stop.

But don’t bet on that soon; or not in a world where asset prices and animal spirits are now so dependent on cheap money, and so central in driving growth. Either way, as investors celebrate this week’s QE decision, they would do well to remember that 15 per cent estimate for productive investment. And it would be fascinating if somebody tried to work out what the ratio for the US economy is today. Particularly if that calculation was to emerge from the Fed.

Copyright The Financial Times Limited 2013.

Barron's Cover


Seeking Higher Returns


Taking financial risks has supplanted the defensive crouch in cash.

     Illustration by James Bennett

After years of playing defense in cash, bonds, and large U.S. dividend-paying stocks, the nation's 40 largest wealth-management firms are recommending investments that, until lately, have been considered far too volatile, too illiquid, or simply too susceptible to economic setbacks. And we're not talking about tentative toeholds up the cliff face of risk. Consider some of the investments that are back in play in clients' portfolios at the biggest wealth-management firms: Stocks in troubled European nations such as Spain, subinvestment-grade European bank loans, subprime mortgages, and hedge funds that use derivatives and other instruments whose performance and liquidity problems terrorized investors in 2008 and 2009.

Now, interestingly, it is wealthy clients themselves who, behind the scenes, are helping to drive this more robust appetite for risk. Back in May, U.S. Trust, the private-banking arm of Bank of America, released a study of 711 folks with more tan $3 million in investable assets; 60% of the respondents said that asset growth was a higher priority than asset preservation. They were tired of not earning a decent return.

That's a complete repudiation of the defensive crouch they assumed since the 2008 financial crisis began. So it's quite simple, really. The path to higher returns in a low-interest environment naturally leads deep-pocketed investors -- and their wealth managers -- into more risky territory. "The guy who bought T-bills -- he can't get any return anymore, so he migrated to T-bonds," Omega Advisors' Leon Cooperman told Penta recently ("Cues From Cooperman," May 20).

"The guy who bought T-bonds has migrated into industrial credits. The buyers of industrial credits have migrated into high yield. The high-yield buyers have migrated into structured credit...and the structured-credit people are increasingly looking at equities. So everybody is moving up the risk curve."     

At the same time, methods for mitigating overall portfolio risk have become more complicated -- and unpredictable. It used to be that more risk could be offset by using core bonds as a portfolio ballast. But wealth managers have been drastically reducing bond exposure out of concern of rising interest rates. Instead, they have been trying to replace portfolios' safety nets with alternative investment strategies.

While this can be effective, "alternative strategies can go either way -- they balance risk or add more," says Tobias Moskowitz, a finance professor at the University of Chicago Booth School of Business. What often happens is, alternatives start out being used to manage risk, but then "part of the objective of alternatives becomes to get more return, and that's a dangerous game to play."

It is indeed. So what, precisely, are folks buying at these higher and riskier altitudes? That's what we wanted to know from this year's list of the top 40 wealth-management firms.

A CENTRAL THEME of the risk-on story is -- no surprise here -- continued and expanded exposure to stocks. Wealth-management firms started recommending that investors buy more blue-chip U.S. stocks about a year ago, but back then it was more out of a distaste for bonds than a sudden hankering for risky investments. Concerned about dismally low yields and the prospect of rising interest rates, they padded portfolios with large U.S. dividend payers, the most defensive of all stocks. What's different now is a growing optimism about stocks beyond just U.S. large-cap stocks.

The change in sentiment is shared almost across the board by the 40 biggest wealth-management firms in our annual ranking.

"The first stage of the move into risk had to do with the fear of rising yields," says Chris Hyzy, managing director and chief investment officer at U.S. Trust. "Now we're in the second stage, in which there are real fundamental reasons why you should add risk."

As Barron's illustrated in its recent cover about Europe bouncing back, developed foreign markets are strengthening. ("Europe's Economy Will Rebound," July 22.) Many companies in recovering regions have strong balance sheets, valuations on many of their stocks are wildly attractive, and correlations between and within asset classes are lower than they have been since prior to 2008, creating opportunity for careful stockpickers.

The global investing mentality that has returned after years in the wilderness is largely based on Europe, the United Kingdom, and Japan. While year-over-year gross-domestic-product growth is still negative in Europe, much has been made of the fact that second-quarter growth was up above expectations over the first quarter. European stocks have already posted strong gains -- the MSCI Europe Index has returned 21% over the past year -- but they are still 10% below their 2007 highs and deeply undervalued by any measure.

"European stocks always trade at a discount to U.S. stocks, but now they're trading at about a 12% to 18% discount to the average discount," says Hans Olsen, Barclays Wealth and Investment Management's chief investment officer of the Americas. "I think it's still a little premature to say Europe is on the mend, but I'd rather be in early."

Furthermore, it appears that the focus in Europe is increasingly shifting away from the macro story to micro tales, says Scott Clemons, chief investment strategist at Brown Brothers Harriman. "When we can find the macro negative, but a good micro story about a company, usually there is a very compelling valuation," he says.

Among Brown Brothers Harriman's top 10 international holdings as of midsummer were shares of Iberdrola (ticker: IBDRY), the leading Spanish electric utility that happens to earn over half of its revenue outside its home market. The company's shares are trading at 10 times earnings and offer a dividend yield of 4.2%.

Spanish stocks in general are being favored by Goldman Sachs, even while it has actually pared back its overall portfolio risk due to concerns that many stock valuations have risen too fast. "We like the European trade but specifically think more emphasis on Spain is warranted, since it has done a remarkable job in terms of structural reform," says Sharmin Mossavar-Rahmani, chief investment officer of Goldman Sachs Private Wealth Management.

While building European stock exposure, Jeff Weniger, senior investment analyst at BMO Private Bank, is carefully hedging his position's currency risk. After a yearlong strengthening against the dollar, "at some point the euro is going to self-correct," he says. "The last thing you want is for your European stock to go up but you're not fully participating in its appreciation because of the euro."

Investors in Japanese stocks should be equally wary of currency risks. Many wealth managers have been recommending Japanese stocks, some for the first time in years, believing that Prime Minister Shinzo Abe's reform measures will be successful in paving the way to long-term growth. Last week's upward revision to 3.8% in second- quarter GDP growth is encouraging.

"Exports are starting to lift, and earnings are starting to come through. There's a lot of profit potential in Japanese companies that have been dealing with a very high currency and rigid labor market," says Olsen. "Think of the operating margins they can achieve when these conditions improve."

But shield yourself from currency risk, he says. The MSCI Japan Index has produced a stunning 17% run-up between April 2 and May 21, but folks with mutual funds or ETFs that hedge exposure to the yen wore the biggest smiles. The iShares MSCI Japan ETF (EWJ), which doesn't hedge, gained 17% between April 2 and May 21, and was up 21% for the past four quarters. But DBX Strategic Advisors' MSCI Japan Hedged Equity fund (DBJP) was up 26% between those dates and 45% for the year through June.

As for emerging markets, wealth managers spent much of 2012 building up their exposures, only to get hit hard on fears of a slowdown in growth. The MSCI Emerging Market Index is down nearly 4% this year. Still, most wealth managers are hanging tight to their recommended exposure; some say it's actually a good time to buy more shares, while they're cheap.

"When I see the MSCI Emerging Markets Index trading at 11 times earnings, versus the S&P 500 at 15 times, I think this is a better entry point than exit," says Leo Grohowski, chief investment officer at BNY Mellon Wealth Management.

But getting the most out of emerging-market stocks is no longer as simple as buying a broad index. "The salad days of buying China just because it's growing are behind us," says Chris Wolfe, chief investment officer of Merrill Lynch's private-banking arm. "It's time to be more active in approach to emerging markets and less focused on indexes. Now, it's about choosing individual opportunities by region or company."

Furthermore, it's always wise to size up opportunities by comparing their relative value with what's on offer around them. As Wilmington Trust's Rex Macey points out, "Emerging markets will regain footing, but at the moment there is simply more opportunity in the developed markets."

We were intrigued to hear, from Merrill Lynch's Wolfe, that some of the more exciting opportunities can be found in "frontier markets." These are nations with embryonic capitalist systems -- like Bangladesh, Lithuania, and Albania -- that are about 15 years behind emerging markets in terms of economic development. As the global economy improves, many of these markets stand to benefit, Wolfe claims.

How so? There is a migration of manufacturing capacity from China to other parts of Asia under way, driven out by Chinese wage inflation and other factors, which is creating investment prospects in Malaysia, Vietnam, Indonesia, and the Philippines. "They've run a lot already, but they're being driven by organic growth," Wolfe says. Such investments "aren't going to pay off between now and Christmas. This is a 10-year theme. You'll have a lot of volatility, but the opportunity is dramatic."

BEYOND ADDING STOCKS, wealthy investors are also increasingly interested in alternative investments. According to a study by Northern Trust, more than half of the 1,700 wealthy Americans surveyed said they are interested in taking more calculated risks, and more are interested in alternatives than they have been since prior to 2008.
Wealth managers have plenty of ideas to oblige, some of which can roam through some pretty risky territory. Bill Stone, chief investment officer at PNC Asset Management Group, says he has added absolute-return-oriented fixed-income strategies that hedge interest-rate exposure, using BlackRock Strategic Income Opportunities (BSIIX), Pimco Unconstrained Bond fund (PFIUX), and Driehaus Active Income fund (LCMAX). These funds' goals are to provide downside protection; but to achieve this, fund managers can graze on global high-yield credit and derivatives, which contributed to the collapse or near-collapse of financial institutions in 2008.

Many wealth managers are also continuing to expand private-equity exposure -- a trend that started about a year ago -- and they recently started adding hedge funds. Investors are giving up liquidity, true, but "as rates rise, bonds will fall off, and hedge funds should give positive returns," says Joe Kenney, U.S. head of investments at JPMorgan Private Bank. Historically, hedge-fund returns have spiked during periods of rising rates, thanks to their ability to minimize interest-rate risk and favor strategies with more credit risk.

July saw $8.2 billion in net inflows into hedge funds, bringing assets to a five-year high of $1.97 trillion, according to TrimTabs Investment Research. Prime conditions for global macro funds are developing. Larry Adam, chief investment strategist at Deutsche Bank's American wealth-management outfit, says, "This is an environment for those hedge funds to be more nimble, to take advantage of a huge dichotomy between emerging markets and developed markets, and between regions and sectors. And to be able to go long-short commodities and currencies can add a lot of value."

The mortgages-gone-bad market is also getting attention. Many banks are still carrying soured residential loans on their books, and they're looking to unload them. Some opportunistic hedge-fund managers are buying the loans at a deep discount to the currently appraised value of the homes, then making money off of either a reconstructed mortgage deal or a sale. Also hot: making private loans to small companies that can't secure bank loans.

These loans have yields of between 7% and 12%, says Merrill's Wolfe. But warning: Assets are tied up for about 10 years, and the loans are below-investment-grade. Old-school private equity -- buy businesses, make improvements, then sell them for a profit to larger companies–is also back in favor.

"The opportunities for arbitrage between what you can buy small businesses for in the private market and what you can sell [them] for up the food chain to strategic acquirers are quite attractive," says Jason Pride, director of investment strategy at Glenmede. Strong equity markets means "public companies are in a better position to use their stock to finance acquisitions. The structure wasn't as feasible back in 2008 and 2009." Most opportunities are in middle-market companies valued below $250 million, Pride says. We can only hope that an unexpected storm blowing in doesn't drive investors back down the mountain of risk.   
Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved