The Taper Chase

Martin Feldstein

30 September 2013 

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CAMBRIDGEGlobal financial markets were stunned when the US Federal Reserve announced on September 18 that it was not ready to begin the widely anticipated reduction in the pace of its “quantitative easing” (QE) program. Fed Chairman Ben Bernanke said that the Fed would continue its monthly purchases of $85 billion of long-term securities. Understanding the reasons for the Fed’s unexpected change of plans may help to anticipate what is coming next.
 
After Bernanke announced in May that the Fed intended to “taperQE, investors began to expect that some reduction in the pace of asset purchases might begin in the early fall. As a result, the interest rate on ten-year Treasury bonds increased by nearly 50 basis points, from 1.66% on May 1 to 2.13% on at the beginning of June. Bernanke’s press conference after the next meeting of the Federal Open Market Committee (FOMC) on June 19 caused a further rise in the ten-year rate, to 2.5% on July 1 and then to 2.92% just before the Fed’s September meeting.
 
In short, the market was clearly expecting that the tapering would begin in September and that the asset-buying would end in mid-2014. There are at least three possible reasons why the Fed shifted its actions and policy guidance so dramatically.
 
One possibility is that Bernanke and the other FOMC leaders – especially Vice Chair Janet Yellen and New York Fed President Bill Dudley never intended to start tapering. Their earlier statements sought merely to reassure FOMC members who wanted to end QE that the leadership was listening to their arguments and taking them seriously. Doing that prevented QE’s opponents from voting against the majority FOMC position, something that would suggest policy disarray at the Fed and a lack of respect for Bernanke. If this explanation is correct, Fed leaders can be expected to continue with an undiminished program of buying long-term securities into next year.
 
A second possible explanation is that Bernanke and other Fed leaders were indeed anticipating that they would begin tapering QE in September but were startled at how rapidly long-term rates had risen in response to their earlier statements. Bernanke spoke about his surprise in this regard at his June press conference, when rates were up only about 50 basis points. By September, they were up 125 basis points, to nearly 3%.

The markets obviously were not convinced by Bernanke’s statements that a slower pace of asset purchases would still represent an easy-money policy. In this way, the Fed had already achieved a significant rise in rates without having to taper QE. Even if the economy were robust, this increase would dampen housing and other activities that are sensitive to long-term rates.
 
The third scenario is that economic activity was clearly slowing, with the future pace of activity therefore vulnerable to even higher interest rates. The annualized GDP growth rate in the first half of 2013 was just 1.8%, and final sales were up by only 1.2%. Although there are no official GDP estimates for the third quarter, private-sector assessments anticipate no acceleration in growth, putting the economy on a path that will keep this year’s output gain at well under 2%. In addition, the Fed’s preferred measure of inflation was much lower than its 2% target. The annual price index for personal consumer expenditure, excluding food and energy, has been rising for several months at a rate of just 1.2%, increasing the possibility of a slide into deflation.
 
Putting all of this together suggests that the Fed is likely to continue the current pace of QE through the end of this year and into 2014. Although Bernanke pointed in his September press conference to the possibility that the tapering might begin before the end of 2013, he conditioned this on the economy performing up to the FOMC’s expectations. If that is interpreted to mean that the FOMC’s members must be satisfied with the rate of real GDP growth, the Fed is highly unlikely to start tapering QE this year, because growth would have to accelerate to about 3% in the final quarter.
 
And yet, while all of this points to continued asset purchases at the current pace into 2014 (and perhaps beyond), there is one reason why some small tapering might occur in December: Bernanke is scheduled to retire in January. Since he introduced the “unconventional monetary policies” of QE and forward guidance, he might want to show before he steps down that he has put the Fed back on a path to conventional policies. But a single step in that direction would not have a significant impact on the level of interest rates and the pace of economic growth.
 
I continue to believe that the benefits of QE are no longer significant and that the low level of interest rates is driving investors and banks to take undesirable risks. In these circumstances, the Fed should move swiftly to end its long-term asset-purchase program.
 
 
Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.


September 29, 2013 6:06 pm
 
Do not kid yourself that the eurozone is recovering
 
The main constraint on the resumption of growth is the failure to clean up the banking sector
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Workers hang a giant European Union flag from La Pedrera, designed by architect Antoni Gaudi, to celebrate European Union Day in central Barcelona©Reuters
 
Europe’s political leaders have seized on the first uptick in European economic indicators as evidence that their policies are working. Who would have thought that?
 
Eurozone gross domestic product expanded 0.3 per cent in the second quarter of this year. It will probably have expanded again in the third quarter. So if you define the end of a recession as two consecutive quarters of positive growth, you might be tempted to forecast that the recession will end at precisely midnight on Monday with the end of the quarter. If you do this, you are either a fool or someone with an agenda to peddle – or both.

A recession is a broad-based downturn in economic activity. The focus on two consecutive quarters of GDP is at best a shorthand back-of-the-envelope indicator for a normal business cycle. But this is not a normal business cycle. Just look at the order of magnitudes involved. Comparing the first half of 2007 and the first half of 2013, real GDP contracted by an accumulated 1.3 per cent in the eurozone, 5.3 per cent in Spain and 8.4 per cent in Italy.

In the same period investment was down by an accumulated 19 per cent in the eurozone – and 38 per cent in Spain and 27 per cent in Italy. Between the first quarter of 2007 and the first quarter of 2013, employment fell 17 per cent in Spain and 2 per cent in Italy. I would not call the end of the recession until we see a sustained improvement in growth and employment. Once the recession ends, I would expect that we will get back to the pre-recession trendline.

The biggest drag on eurozone growth right now is Italy. The coalition of Enrico Letta, the Italian prime minister, has effectively collapsed over the weekend as Silvio Berlusconi has withdrawn his ministers. The latest political turmoil will prolong the recession as the uncertainty holds back investment.
 
Even a new government will not bring a solution. Italy is stuck with a combination of an unsustainable high level of public debt and no productivity growth. It has essentially two options to adjustbecome like Germany, or leave the eurozone. The country is unable to do the first, and unwilling to do the latter. As the economists Francesco Giavazzi and Alberto Alesina calculated in an article in Corriere della Sera last week, it would cost some €50bn to reduce the tax wedge – the difference between labour costs and net income – to German levels. There is simply no political majority in sight for such radicalism. The centre-right prioritises tax cuts on consumption and housing, while Mr Letta’s Partito Democratico vetoes spending cuts. Italy faces no immediate threat for as long interest rates remain low. The country will be able to muddle through for a while until some political or economic shock will force a decision one way or the other.
 
Meanwhile, the single largest constraint on the resumption of eurozone growth is not fiscal policy – which is broadly neutral at present across the single currency area – but the continued failure to clean up the Banks. The growth rate of loans to the non-financial sector turned negative in 2009, showed some intermittent improvements, only to then deteriorate again last year.

Things have not improved since: in August this year loans to the private sector were down 2 per cent over the past year. M3, a broad measure of money in circulation, grew by an annual rate of just 2.3 per cent in the June to August period.

The monetary and banking data are telling us that the economy will teeter on the brink of zero or low growth for the foreseeable future because the financial sector is not supplying the economy with sufficient funds to expand.




Banking union could help, but only if it were to break the relationship between banks and sovereigns and clean up the balance sheets. Yet neither is going to happen. I believe Mario Draghi, president of the European Central Bank, is serious in his determination to produce a clean and honest asset quality review, which will start next month. He certainly does not want to repeat the mistakes of the European Banking Authority, which has lost its credibility with farcical stress tests.
 
But what can he do if governments fail to agree a fiscal backstop for this exercise? Would it not be irresponsible to admit that banks need several hundred billion euros in new capital when that money is simply not there? But without a clean-up of the banking sector, I see no trend change in the monetary and bank lending indicators – and this will postpone the recovery further.

The most positive news we have had in the eurozone has been the growth of Spanish exports, which have risen 11 per cent in real terms from the first half of 2008 to the first half of this year. The improvement of Spanish export competitiveness is substantive, but mostly as a result of cuts in employment rather than wages. It is not clear to me whether an export-led growth strategy of the kind pursued by Germany would be feasible and sustainable for Spain.

Italy’s political and economic implosion, the credit crunch and past austerity are among the main factors weighing on the eurozone today. The recession that started in 2008 continues, once you ditch the silly obsession with two consecutive quarters. It is not about to end.

 
Copyright The Financial Times Limited 2013


A Systemic Approach to Financial Stability

Andrew Sheng

28 September 2013

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HONG KONGNext month, policymakers, business leaders, academics, and civil-society representatives will meet in Kiel, Germany, for the Global Economic Symposium (GES), where they will attempt to develop concrete solutions to today’s most pressing economic issues. Whether they produce effective proposals will depend on a comprehensive understanding of the factors underpinning – and underminingfinancial stability worldwide.
 
At last year’s summit, dialogues on central banking’s future, which pitted inflation targeting against financial stability, produced three solutions: central banks should adopt a counter-cyclical policy approach; a world monetary authority should be created to promote multilateral cooperation among central banks; and price stability must remain central banks’ primary goal. Although these solutions have some merit, they are inadequate to address effectively the complex and far-reaching failings that led to the 2007-2009 global financial crisis.
 
The crisis represented a comprehensive systemic failure, involving breakdowns at almost all levels, from macroeconomic theory to micro-level incentives to institutions. The economics profession (and institutions within the existing financial architecture, including regulators) had become excessively specialized, rigid, and self-interested. As a result, it could no longer account for the evolution of economic systems, with their constant adaptation of rules, tools, and behaviors.
 
In order to develop effective policies, central bankers must adopt an entirely new approachone that is comprehensive, systems-oriented, flexible, and socially conscious. They must recognize that, despite the cyclical nature of economic activity, not all cycles are the same; counter-cyclical measures must account for the factors that gave rise to the cycle. Moreover, any solution to the crisis must incorporate a wide array of instruments and reforms.
 
Monetary policy, together with other financial stability-enhancing tools like regulatory policy, aims to protect the real value of money and its effectiveness as a medium of exchange and store of value. Whereas monetary stability presupposes price stability, financial stability ensures that the value of money is not eroded through credit, operational, or other risks.
 
Fortunately, the premise of this year’s dialogue on central banking and financial stability suggests a more complete understanding of the problem. Indeed, the theme, The Future of Monetary Policy and Financial-Market Reform,” implies recognition that monetary policy must change over time, while highlighting that institutional reform should be aimed at enhancing monetary policy’s effectiveness.
 
Potential solutions must account for the unintended consequences of efforts to ensure financial stability. For example, stability can be achieved by allowing the largest banks to dominate, while requiring that they hold large amounts of high-quality capital to cushion against shocks. But, in the long run, the real sector would probably suffer from monopolistic rents, inadequate competition, and a lack of innovation.
 
A more comprehensive solution would focus on securing systemic stability in the real and financial sectors through the use of long-term tools and targets, based on the principle that finance should serve the real sector. In other words, monetary policy and financial-market reform should act in tandem to deliver the real-sector objectives of economic efficiency, social inclusivity, and environmental sustainability.
 
The unspoken allegation against current monetary policy is that, in rescuing the financial sector from its follies (paid for by the real sector), it has enabled policymakers to defer financial-sector reforms that would close regulatory and supervisory gaps and eliminate incentives to game the system. But monetary policy and financial-sector reform are subject to severe constraints, rooted in the mismatch between the scope of financial activities and that of monetary and regulatory policy.
 
Money and finance have gone global, through technology, innovation, and financial liberalization. But regulatory and monetary instruments remain national and, thus, incomplete. With capital flowing freely across borders, national authorities have lost the ability to protect their currency’s value and safeguard financial stability.
 
This model is based on the assumption of a frictionless global financial market, in which actors are free to speed up transactions and increase their leverage through off-balance-sheet and off-shore transactions, in order to escape regulation. If they fail, the system rescues the key players through expansionary monetary policy, spreading the costs globally.
 
While a centralized global monetary or financial authority would offer a more complete solution, the requirement that countries yield some sovereignty over fiscal, monetary, and regulatory matters raises issues of legitimacy, making it an unlikely option. Indeed, the world’s current monetary and financial architecture would have to collapse before such a global scheme could become feasible.
 
In the absence of such an authority, a modular approach to systemic reform is neededresembling, for example, America’s repealed Glass-Steagall rules, which barred commercial banks from engaging in investment banking. Macro-prudential regulations, which are essentially capital controls, could be used to minimize the negative spillover effects of unrestricted, leveraged capital flows. Financial-transaction taxes and higher margin requirements would slow down transactions, while higher capital and lower leverage ratios would reduce the debt load in the system.
 
In a systemic reality, everything is relative, because all players act in response to one another. Diverse, flexible arrangements – with the interaction among various standards, rules, and behaviors fostering competition, innovation, and experimentation – are thus more stable than rigid, compartmentalized systems.
 
Given this, at next month’s GES, global leaders must emphasize adaptable, forward-looking solutions that account for the shifting forces affecting monetary and financial stability. After all, when it comes to monetary policy and financial-sector reform, there are no permanent tools or targets, only permanent interests.
 
 
Andrew Sheng, President of the Fung Global Institute, is a former chairman of the Hong Kong Securities and Futures Commission, and is currently an adjunct professor at Tsinghua University in Beijing. His latest book is From Asian to Global Financial Crisis.


September 29, 2013

Rebels Without a Clue

By PAUL KRUGMAN

 
 

This may be the way the world ends not with a bang but with a temper tantrum.
      
O.K., a temporary government shutdown — which became almost inevitable after Sunday’s House vote to provide government funding only on unacceptable conditionswouldn’t be the end of the world. But a U.S. government default, which will happen unless Congress raises the debt ceiling soon, might cause financial catastrophe. Unfortunately, many Republicans either don’t understand this or don’t care.
      
Let’s talk first about the economics.
      
After the government shutdowns of 1995 and 1996 many observers concluded that such events, while clearly bad, aren’t catastrophes: essential services continue, and the result is a major nuisance but no lasting harm. That’s still partly true, but it’s important to note that the Clinton-era shutdowns took place against the background of a booming economy.

Today we have a weak economy, with falling government spending one main cause of that weakness. A shutdown would amount to a further economic hit, which could become a big deal if the shutdown went on for a long time.
      
Still, a government shutdown looks benign compared with the possibility that Congress might refuse to raise the debt ceiling.
      
First of all, hitting the ceiling would force a huge, immediate spending cut, almost surely pushing America back into recession. Beyond that, failure to raise the ceiling would mean missed payments on existing U.S. government debt. And that might have terrifying consequences.
      
Why? Financial markets have long treated U.S. bonds as the ultimate safe asset; the assumption that America will always honor its debts is the bedrock on which the world financial system rests. In particular, Treasury bills — short-term U.S. bonds — are what investors demand when they want absolutely solid collateral against loans. Treasury bills are so essential for this role that in times of severe stress they sometimes pay slightly negative interest ratesthat is, they’re treated as being better than cash.
      
Now suppose it became clear that U.S. bonds weren’t safe, that America couldn’t be counted on to honor its debts after all. Suddenly, the whole system would be disrupted. Maybe, if we were lucky, financial institutions would quickly cobble together alternative arrangements. But it looks quite possible that default would create a huge financial crisis, dwarfing the crisis set off by the failure of Lehman Brothers five years ago.
      
No sane political system would run this kind of risk. But we don’t have a sane political system; we have a system in which a substantial number of Republicans believe that they can force President Obama to cancel health reform by threatening a government shutdown, a debt default, or both, and in which Republican leaders who know better are afraid to level with the party’s delusional wing. For they are delusional, about both the economics and the politics.
      
On the economics: Republican radicals generally reject the scientific consensus on climate change; many of them reject the theory of evolution, too. So why expect them to believe expert warnings about the dangers of default? Sure enough, they don’t: the G.O.P. caucus contains a significant number of “default deniers,” who simply dismiss warnings about the dangers of failing to honor our debts.
      
Meanwhile, on the politics, reasonable people know that Mr. Obama can’t and won’t let himself be blackmailed in this way, and not just because health reform is his key policy legacy. After all, once he starts making concessions to people who threaten to blow up the world economy unless they get what they want, he might as well tear up the Constitution. But Republican radicals — and even some leadersstill insist that Mr. Obama will cave in to their demands.
      
So how does this end? The votes to fund the government and raise the debt ceiling are there, and always have been: every Democrat in the House would vote for the necessary measures, and so would enough Republicans. The problem is that G.O.P. leaders, fearing the wrath of the radicals, haven’t been willing to allow such votes. What would change their minds?
      
Ironically, considering who got us into our economic mess, the most plausible answer is that Wall Street will come to the rescuethat the big money will tell Republican leaders that they have to put an end to the nonsense.
      
But what if even the plutocrats lack the power to rein in the radicals? In that case, Mr. Obama will either let default happen or find some way of defying the blackmailers, trading a financial crisis for a constitutional crisis.
      
This all sounds crazy, because it is. But the craziness, ultimately, resides not in the situation but in the minds of our politicians and the people who vote for them. Default is not in our stars, but in ourselves.