The Paradox of Central-Bank Cooperation

Harold James

03 October 2013
PRINCETON – The US Federal Reserve’s recent surprise announcement that it would maintain the current pace of its monetary stimulus reflects the ongoing debate about the desirability of cooperation among central banks. While the Fed’s decision to continue its massive purchases of long-term assets (so-called quantitative easing) was motivated largely by domestic economic uncertainty, fears that an exit would trigger interest-rate spikes in emerging economies – especially Brazil, India, Indonesia, South Africa, and Turkey – added significant pressure. But should central banks’ decision-making account for monetary policy’s spillover effects?
Discussion of central-bank cooperation has often centered on a single historical case, in which cooperation initially seemed promising, but turned out to be catastrophic. Like most of our modern cautionary tales, it comes from the Great Depression.
In the latter half of the 1920’s, there was almost constant transatlantic tension, as US monetary policy drove up borrowing costs and weakened GDP growth in Europe. In 1927, at a secret meeting on New York’s Long Island, Europe’s leading central banks convinced the Fed to cut its discount rate. Although the move helped to stabilize European credit conditions in the short term, it also fueled the speculative bubble that would collapse in 1929.
Cooperation in the 1920’s was both novel and fragile, based as it was on the friendship between Bank of England Governor Montagu Norman and Benjamin Strong, Governor of the Federal Reserve Bank of New York, and, to a lesser degree, their ties with the president of Germany’s Reichsbank, Hjalmar Schacht.
The oddly intimate and affectionate relationship between Strong and Norman included regular visits, telephone conversations (a novelty at the time), and an extensive and bizarre correspondence, in which they discussed personal matters as much as monetary issues. Strong once wrote, “You are a dear queer old duck, and one of my duties seems to be to lecture you now and then.”
By the late 1920’s, though, Strong was dying of tuberculosis and Norman was experiencing successive nervous breakdowns. Their legacy of cooperation would soon crumble, too, with most observers concluding after the Great Depression that central banks should be subject to strict national controls to block future efforts at collaboration.
Central-bank cooperation in the aftermath of the 2008 financial crisis has unfolded in a remarkably similar manner. Initially, increased cooperation seemed to be just what the doctor ordered, with six major advanced-country central banks lowering their policy rates dramatically on October 8, 2008 – three weeks after the collapse of US investment bank Lehman Brothers – in a coordinated effort to stabilize plunging asset markets. They subsequently pumped huge amounts of liquidity into the banking system, thereby averting a total collapse.
Now, as the Fed contemplates its next move, emerging-market central bankers are becoming increasingly concerned about the destabilizing effects of monetary tightening on their economies. At September’s G-20 summit in Saint Petersburg, between discussions of the security challenge posed by Syria, world leaders attempted to tackle the issue by creating a formula for international monetary cooperation. But their limited efforts resulted in a fundamentally meaningless appeal.
The modern view is that the Fed’s mandate requires it to act according to inflation and employment outcomes in the US, leaving it up to other countries to combat any spillover effects. This means that other countries must devise appropriate tools to limit capital inflows when US interest rates are low and to block outflows when the Fed tightens monetary policy. But emerging economies missed their chance to limit inflows, and impeding outflows at this point would require draconian measures that would contradict the principles of an integrated global economy.
Moreover, unanticipated shifts in market expectations make it extremely difficult to anticipate the need for such tools. In this sense, the recent G-20 injunction that advanced-country central banks “carefully calibrate and clearly communicate” monetary-policy changes is unhelpful.  Given how difficult it is to communicate coming policy changes accurately, markets tend to be skeptical about long-term forward guidance.
This highlights a fundamental difference between central-bank cooperation in the 1920’s and today. Back then, monetary policy was viewed as an “art” practiced by a “brotherhood” of central banks. Modern central bankers, recognizing the limits of such personal ties, often attempt to formulate official rules and procedures.
But adhering to rules can be difficult when policymakers are confronted with the conflicting goals of preserving stable employment and GDP growth at home and ensuring that international capital movements are sustainable. When things go wrong (as they almost inevitably do), there is a political backlash against central bankers who failed to follow the rules – and against the cooperative strategies in which they engaged.
We are thus left with a paradox: While crises increase demand for central-bank cooperation to deliver the global public good of financial stability, they also dramatically increase the costs of cooperation, especially the fiscal costs associated with stability-enhancing interventions. As a result, in the wake of a crisis, the world often becomes disenchanted with the role of central banks – and central-bank cooperation is, yet again, associated with disaster.

The End of Convergence ?

Kemal Derviş

03 October 2013
WASHINGTON, DC – Until recently, there was a broad consensus that this was to be the emerging countries’ century. But financial markets’ reaction to the US Federal Reserve’s warning in May that it may wind down its unconventional monetary policies led many analysts to question how rapid emerging-market growth would be. At this month’s Annual Meetings of the World Bank Group and the International Monetary Fund, the emerging countries’ prospects will be a topic of heated debate.
Until mid-2013, the IMF and the World Bank had projected aggregate per capita GDP growth rates for the emerging and developing countries (EMDEVs) to be almost three percentage points higher than in the world’s advanced countries over the next few years. Most commentators expected a substantial difference inper capita growth to continue beyond this decade, disagreeing only about the magnitude of the emerging countries’ growth advantage.
Arvind Subramanian’s estimates for China, and Uri Dadush’s for EMDEVs more generally, represented the upper range of these projections. Others, such as Dani Rodrik, have always been more cautious, arguing that much of the past rapid growth in major EMDEVs was due to a period of technological “catch-up” growth in manufacturing, which was reaching its limits, and could not be easily extended to the large service sector or other parts of developing economies.
As it turned out, a “mini-crisis” followed Federal Reserve Board Chairman Ben Bernanke’s announcement that the Fed might “taper” its quantitative-easing (QE) policy – its open-ended commitment to monthly purchases of long-term assets worth $85 billion – before the end of 2013. Many emerging economies’ stock markets and currencies took a large hit, and headlines were soon announcing the end of the emerging-market boom.
To be sure, many emerging-market asset values have recovered ground since, and in September the Fed changed its mind about the imminence of “tapering” QE. But the mood had changed, and the “median” projection of emerging economies’ growth prospects has shifted. Latin American economists are particularly pessimistic. After revising downward in July its growth projections for emerging countries, the IMF is about to do so again (though only moderately) ahead of the Annual Meetings.
Do recent events mean that “convergence” is ending? Is the world reverting to a growth pattern whereby the percentage gap between income levels in the aggregate “North” and “South” does not decrease? Or is the current talk about “the end of convergence” merely a reflection of financial markets’ usual overreaction to both good and bad news?
The future, of course, is uncertain. But I continue to believe that convergence is here to stay, though it will not occur at the extraordinary pace of the 2008-2012 period, when the global financial crisis and the eurozone’s difficulties led to particularly slow growth in the advanced economies. What is likely is a return to the pre-crisis differential: from 1990 to 2008 (excluding the 1997-1998 Asian financial crisis), aggregate per capita growth in the emerging world was about 2.5 percentage points higher than that in the advanced countries. In the 2008-2012 period, that differential increased to more than four percentage points. It now appears set to fall back to about 2.5 percentage points.
China will continue to account for a big part of the differential. While China’s annual growth may decline to 6%-7%, from the 9%-10% rate recorded until 2010, China’s economic weight is increasing. Moreover, emerging Asia as a whole has remained on a convergence path, as have countries like Turkey, Colombia, Peru, and Chile. Technological “catch-up” will remain the underlying driver of convergence, beyond the short-term shocks and temporary problems that capital-flow volatility may cause.
Of course, “prudent” countries, with small current-account deficits or surpluses, will be much more immune to temporary shocks. Diversified economies will also tend to do better relative to primary-goods exporters. Moreover, countries that invest 25% or more of their national income will be able to grow faster than those – including many in Latin America – with low levels of savings and investment. Asia will grow faster because it is accumulating physical and human capital more rapidly, which not only increases output directly, but also facilitates technological progress and diversification of the type that Ricardo Hausmann and Cesar Hidalgo identify as the key to sustained growth.
Convergence has never taken hold for all EMDEVs; but it has already changed the nature and structure of the world economy, particularly in terms of the traditional North-South divide, and it will continue to do so. Aggregate growth trends have decoupled, though cycles within these trends are correlated, owing to financial globalization and trade interdependencies. A serious slowdown in emerging economies would lead to another marked slowdown in the advanced economies, too, so that the growthdifferential would likely remain relatively stable, at least in yearly data.
Long-term growth is determined by the ability to accumulate technological and institutional capacities and the quality of national policies. Over the last two decades, many emerging countries, including some of the largest, have performed well in this respect. Their efforts will remain the basis for aggregate convergence. We should not allow the many exceptions or temporary financial-market worries to obscure this underlying reality.

domingo, octubre 06, 2013



What I would like for my birthday, today, October 4, is to discuss the "gold is underowned" argument.
This argument comes from legendary Hedge Fund manager Ray Dalio of Bridgewater Associates: "Gold is a very underowned asset, even though gold has become much more popular. If you ask any central bank, any sovereign wealth fund, any individual what percentage of their portfolio is in gold in relationship to financial assets, you'll find it to be a very small percentage. It's an imprudently small percentage, particularly at a time when we're losing a currency regime."
What should we think about Dalio's argument?
First, it is true that gold and precious metals have become much more popular as a result of 12 consecutive years of boom. Gold (GLD) rose 500 per cent from $265 an ounce in January 2000 to $1,660 an ounce in December 2012 while silver (SLV) surged as well 500 per cent from $5 an ounce in January 2000 to $30 in December 2012.
Consequently, some investors such as legendary investor Warren Buffet call gold price a bubble today: "What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth - for a while. But bubbles blown large enough inevitably pop."
As a value investor, Warren Buffet believes that a gold purchaser is only inspired by his/her belief that someone else will pay more for gold in the future given that gold is an unproductive asset.
By saying that, he seems to ignore the importance of gold in institutional strategic allocation. Indeed, gold is a valuable tactical asset as it provides long-term diversification. According to World Gold Council, holding gold in a portfolio results in increased diversification due to gold's lower correlation to other assets. As seen in Exhibit 1, on average, gold's correlation to U.S. equities and Treasury Bills has been 0.1 over the past ten years.
Exhibit1: Average correlation of gold to US equities and Treasury bills (2000-2010)

(Click to enlarge)
Second, to examine whether or not gold is underowned, let's compare the appropriate allocation to gold with gold's current share of financial assets.
1/Gold's current share of financial assets
World Gold Council estimates suggest that in 2012:
-The global financial assets held by investors were about $149tn
-The global equity and fixed income markets (central bank holdings were excluded) were about $131tn
- The private investment stock of gold was about $1.9tn with the average gold price of $1,651.34 an ounce during the first half of 2012, representing just 1 per cent of financial assets.
Exhibit2: Distribution of investor global holdings by asset class as percentage of total

(Click to enlarge)
Source: WGC
2/The optimal allocation to Gold
How much gold should investors hold? Theoretically, investors should hold the "market portfolio" according to the Capital Asset Pricing Model.
Now comes the tricky question: how to define and measure the size of the gold market in the "market portfolio"?
It is fair to say that the size of the gold market in the "market portfolio" should be the size of the investable gold market, which represents the private investment and official sector holdings. The investable gold market can also be considered as the financial market for gold.
As gold held by central banks is worth about $1.5tn and gold held by private investors is worth $1.9tn, the investable gold market is worth $3.4tn (with the average gold price of $1,651.34 an ounce during the first half of 2012).
Consequently, the optimal allocation to gold should be 2 per cent ($3.4tn/$150.5tn) according to the Capital Asset Pricing Model.
The objective was to examine the "gold is underowned" versus the "gold is overowned" arguments. The evidence indicates that even though the gold market has experienced 12 years of boom from 2000 to 2012, on average, investors are under-allocated to gold relative to the results from the Capital Asset Pricing Model. Consequently, if investors decide to re-allocate to an optimal 2 per cent gold allocation, demand for gold ETFs such as the SPDR Gold Trust or Sprott Asset Management's Physical Gold Trust (PHYS) will surge gold will rise significantly.
As Ray Dalio said, "Buffett is making a big mistake".