Bubbles in the Broth

Nouriel Roubini

31 October 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. 

NEW YORKAs below-trend GDP growth and high unemployment continue to afflict most advanced economies, their central banks have resorted to increasingly unconventional monetary policy. An alphabet soup of measures has been served up: ZIRP (zero-interest-rate policy); QE (quantitative easing, or purchases of government bonds to reduce long-term rates when short-term policy rates are zero); CE (credit easing, or purchases of private assets aimed at lowering the private sector’s cost of capital); and FG (forward guidance, or the commitment to maintain QE or ZIRP until, say, the unemployment rate reaches a certain target). Some have gone as far as proposing NIPR (negative-interest-rate policy).
And yet, through it all, growth rates have remained stubbornly low and unemployment rates unacceptably high, partly because the increase in money supply following QE has not led to credit creation to finance private consumption or investment. Instead, banks have hoarded the increase in the monetary base in the form of idle excess reserves. There is a credit crunch, as banks with insufficient capital do not want to lend to risky borrowers, while slow growth and high levels of household debt have also depressed credit demand.
As a result, all of this excess liquidity is flowing to the financial sector rather than the real economy. Near-zero policy rates encouragecarry trades” – debt-financed investment in higher-yielding risky assets such as longer-term government and private bonds, equities, commodities and currencies of countries with high interest rates. The result has been frothy financial markets that could eventually turn bubbly.
Indeed, the US stock market and many others have rebounded more than 100% since the lows of 2009; issuance of high-yieldjunk bonds” is back to its 2007 level; and interest rates on such bonds are falling. Moreover, low interest rates are leading to high and rising home pricespossibly real-estate bubblesin advanced economies and emerging markets alike, including Switzerland, Sweden, Norway, Germany, France, Hong Kong, Singapore, Brazil, China, Australia, New Zealand, and Canada.
The collapse from 2007 to 2009 of equity, credit, and housing bubbles in the United States, the United Kingdom, Spain, Ireland, Iceland, and Dubai led to severe financial crises and economic damage. So, are we at risk of another cycle of financial boom and bust?
Some policymakers – like Janet Yellen, who is likely to be confirmed as the next Chair of the US Federal Reserveargue that we should not worry too much. Central banks, they argue, now have two goals: restoring robust growth and low unemployment with low inflation, and maintaining financial stability without bubbles. Moreover, they have two instruments to achieve these goals: the policy interest rate, which will be kept low for long and raised only gradually to boost growth; and macro-prudential regulation and supervision of the financial system (macro-pru for short), which will be used to control credit and prevent bubbles.
But some critics, like Fed Governor Jeremy Stein, argue that macro-pru policies to control credit and leveragesuch as limits on loan-to-value ratios for mortgages, bigger capital buffers for banks that extend risky loans, and tighter underwriting standardsmay not work. Not only are they untested, but restricting leverage in some parts of the banking system would merely cause the liquidity from zero rates to flow to other parts of it, while trying to restrict leverage entirely would simply drive the liquidity into the less-regulated shadow banking system. According to Stein, only monetary policy (higher policy interest rates) gets in all of the cracks of the financial system and prevents asset bubbles.
The trouble is that if macro-pru does not work, the interest rate would have to serve two opposing goals: economic recovery and financial stability. If policymakers go slow on raising rates to encourage faster economic recovery, they risk causing the mother of all asset bubbles, eventually leading to a bust, another massive financial crisis, and a rapid slide into recession.

But if they try to prick bubbles early on with higher interest rates, they will crash bond markets and kill the recovery, causing much economic and financial damage. So, unless macro-pru works as planned, policymakers are damned if they do and damned if they don’t.
For now, policymakers in countries with frothy credit, equity, and housing markets have avoided raising policy rates, given slow economic growth. But it is still too early to tell whether the macro-pru policies on which they are relying will ensure financial stability. If not, policymakers will eventually face an ugly tradeoff: kill the recovery to avoid risky bubbles, or go for growth at the risk of fueling the next financial crisis. For now, with asset prices continuing to rise, many economies may have had as much soup as they can stand.
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.

October 31, 2013 8:45 am

Money mirage exposes emerging markets
The real problem for EM assets is illusion of abundant liquidity

If a shock was to hit Brazil, India, Indonesia – or any other emerging market countrytomorrow, how would investors react? Would asset values adjust smoothly, amid an explosion of trading flows? Or would markets instead freeze up, as liquidity evaporated?

It is not an academic question. Earlier this year, when investors started to speculate about an Americantaper” – or wind-down from quantitative easing – this mere conjecture was enough to spark a dramatic gyration in the value of some emerging market assets, such as Indian or Brazilian equities.
Since then, those markets have more than recovered. And with most economists still believing the taper remains many months away, investors expect this rally to continue. But behind the scenes, as the private debates in October’s meeting of the International Monetary Fund indicated, some policy makers and asset managers are getting uneasy.

For the real problem with emerging markets today, policy makers admit, is not simply that reform has slowed in places such as Brazil, or that growth rates have disappointed since the 2008 crisis. Nor is it simply that some emerging market countries have experienced spectacular capital inflows – and could thus suffer economic pain if these reverse.
Instead the third, often ignored, issue is the market ecosystem around those capital inflows. Most notably, as money has rushed into emerging markets in recent years, this has created an image of abundant liquidity. But this image may be dangerously illusory, some policy makers fear, as one of the little-noticed ironies of the 2013 financial system is that there may now be fewernot moreshock absorbers in the markets than there were before 2008. This factor may explain why this summer’s gyrations in emerging market assets were so dramatic.

The key issue at stake, as Mark Carney, Bank of England governor, indicated in a speech last week, is the question of who makes markets in a crisis. Before 2007, when the investment banking world was expanding at a breathless pace, dealers held large stocks of emerging market assets on their books. But since 2008 these inventories have shrunk more than 70 per cent, according to central bank estimates, due to the introduction of the Volcker rule in America (which restricts proprietary trading) and increases capital charges for banks to hold risky assets.
This has undermined the ability of dealers to supply trading liquidity in some asset classes. Take emerging market debt. JPMorgan estimates that since 2008 investors have gobbled up more than $315bn worth of securities. But it also estimates that dealers now hold a mere 0.5 per cent of outstanding stock, or less than one day’s worth of trading volumes. This means they cannot provide much tradinglubricant” if a crisis hits. And just to add to the problem, liquidity levels in emerging markets are already extremely uneven, with the vast majority of trading currently concentrated in a few markets such as Mexico and Korea.

So is there any solution? One option, some bankers mutter, would be to roll back some of the post-2008 financial reforms in relation to, say, banks’ trading books.
However, this seems most unlikely to happen given that regulators want to reduce the riskiness of banks. So policy makers are now hunting for alternative ideas. At October’s IMF meeting, for example, Christine Lagarde, IMF head, called on emerging market countries to accelerate reforms to make their capital markets more mature. And last week Mr Carney floated a more radical idea: he suggested that central banks should adopt new measures to ensure liquidity is maintained in a crisis, by overhauling the way that collateral is used by banks.
But though Mr Carney’s intervention reveals the level of unease about this issuenot just in relation to emerging market assets but many other securities too – his policy ideas are still at an embryonic stage. Neither they, nor the IMF appeals, will offer any solution soon. Thus for the moment the only practical answer is a fourthsolution”: asset managers themselves need to start paying more attention to the underlying liquidity issues, and pricing assets accordingly for a world without any market maker of last resort.

There are hints that this is now happening. This autumn, some asset managers are no longer blindly enthusing about the “BRICs” as a single asset class; instead, they are shunning the “BIITS” (Brazil, India, Indonesia, Turkey and South Africa) to focus on markets where there are fewer structural challenges and where the market liquidity looks much deeper. But history shows that memories about liquidity risk tend to be short; particularly when so much easy money is flooding around. Or to put it another way, even if the Fed now delays that “taper”, investors should not forget this summer’s gyrations. It was a potent warning shot, on many different levels.


Copyright The Financial Times Limited 2013

Mediobanca hints at Italian euro exit unless Germany shifts on EMU policy

The exchange rate is bringing Italy's worrying matters to a head.

By Ambrose Evans-Pritchard

9:07PM GMT 30 Oct 2013

Italy remains stuck in depression. We now know that the spectacular spike in consumer confidence in June was a ruse, a white lie to talk up prospects and hold back the debt-deflation tide.

Hedge funds, banks and investors from around the world poured into Italian assets without reading the fine print. They made quick money, of course. Yields on 10-year Italian bonds fell 40 basis points within a week. Milan's MIB index of stock touched bottom near 14,860 just before the release. It then surged, reaching 19,496 this week.

The euphoria was understandable. The economy component of the confidence index jumped miraculously from 71.7 to 91.6 in one month. If Italy really was turning the corner so dramatically after a peak-to-trough fall in GDP of 9pc and two years of double-dip recession, it would indeed mean that Europe's crisis was behind us. We could breathe a little easier about Italy's €2 trillion debt, the world's largest after the US and Japan.
In reality, Italy's data agency Istat changed the survey. It looked at a different "socio-demographic structure" and "sample structure". Istat quietly revealed some details a month later, but only a handful of Italian economists were paying attention. "They played with the data and I am shocked," said one.

He described the episode as an attempt to talk up momentum and lift growth to "escape velocity". Italy's authorities - in thrall to the Bocconi Boys, free-marketeers from Milan's Bocconi University - give great weight to theories that confidence alone can overpower fiscal austerity, an overvalued currency and tight money.
And money is certainly tight. Italian M3 has contracted over the past five months (falling from €1.329 trillion to €1.312 trillion). Simon Ward from Henderson Global Investors says his gauge - six-month real M1 - has rolled over. "Italy is flashing red," he said.
It is true that market confidence can grease the economic wheels in certain circumstances. But to rely on morale alone to pull an economy out of full-blown depression is like a bayonet charge into Krupp guns, the St Cyr spirit of "elan vital" in 1914, so brave and yet so futile. Nobel laureate Paul Krugman derides this sub-branch of economics as the "confidence fairy".
The hard data catch up soon enough in any case. Industrial production fell 4.4pc in August, and new orders fell 6.8pc. The Bank of Italy said credit to non-financial firms fell 4.6pc in August (year-on-year), worse tan in July. Business confidence fell back to 79.3 in September and is now at post-Lehman crisis levels. Istat said this week that the economy is weaker than previously thought. GDP will shrink yet again in the third quarter.

"The recession has flattened, that is all," says Antonio Guglielmi from Mediobanca. "The debt-to-GDP ratio has risen by 15 percentage points [to 133pc] over the past 15 months because there is no growth. It is all because of the effects of austerity and the fiscal multiiplier. We are making the same mistake they made in Greece."

Mr Guglielmi said the government has pencilled in growth of 1pc next year, rising to 1.7pc, 1.8pc and 1.9pc thereafter. It is make-believe. (Citigroup said it would be closer to zero all way to 2017). "We barely grew 1pc a year during the best years of the global boom. How are we going to do this now in much harder times?"

Professor Giuseppe Ragusa from Rome's Luiss Guido Carli University said the government is clutching at straws, hoping that a world recovery will somehow lift Italy out of the slump. "They are not doing anything. The policy is completely passive but it is not going to work because we are in a debt trap, and unlike Spain we have continued to lose labour competitiveness against Germany over the past three or four years."

Prof Ragusa calculates that the debt will jump by another 5pc of GDP each year even if growth returns to pre-crisis level of around 0.6pc. This would send the ratio spiralling up to nearly 150pc, beyond the point of no return for a country with no sovereign currency.

He said the European Central Bank's rescue policies have induced the Italian treasury to borrow on short maturities, since the ECB-backstop only covers debt up to three years. This has cut the average debt maturity from 7.6 to 6.4 years, storing up ever greater "roll-over" risk. "I fear that all of this is going to be tested by the first quarter of next year," he said.

The exchange rate is bringing matters to a head. The euro has has risen almost 8pc against the dollar - and therefore the Chinese yuan - since June. This is a bizarre state of affairs for a region mired in record unemployment and likely to trail the rest of world yet again next year by wide margin, according to the EU authorities themselves.

Austria's ECB governor Ewald Nowotny says there is little Frankfurt can about this. Yet the Bank of Japan has just driven down the yen some 22pc by embarking on a massive reflation strategy. The Swiss National Bank is holding the franc at €1.20, vowing to defend it against the entire world. It is very easy to weaken a currency. What Mr Nowotny means is that the EMU is politically incapable of mounting such a campaign.

For Italy this is excruciating. Mediobanca says Italy economy's has 67pc "gearing" to the exchange rate due to the kinds of products it makes (price sensitive), compared with 40pc for Germany. Its latest report traces how Italy's productivity growth and competitiveness has faltered each time it pegged its currency to Germany over the past 40 years, and how it roared back with each devaluation.
The report said EMU had allowed a "Chinese-like" Germany to lock in trade advantage, accumulating a surplus of €1.4 trillion, or 50pc of German GDP, and that this amounts to "a dangerousbeggar-thy-neighbourzero-sum game for the eurozone".

It said Italy entered a "negative productivity spiral" only after it fixed the pre-EMU exchange rates in 1996. Refusing to acknowledge this "means denying the evidence". It accused the EU authorities of forcing the entire burden of post-crisis adjustment on the weaker Club Med states, of refusing to see the risk of a "negative recessionary spiral" in the South, or to see that these countries cannot stabilise their debt trajectories with a minimum of growth. The North must "meet the periphery halfway".

The report said the risk is a repetition of Argentina's fate as the dollar-peg fell apart in 2001. It cited the so-called "Frenkel Cycle" as it moves into its final seventh phase of "collapse", the brutal denouement of every fixed-exchange rate system and every monetary union that fails to meet the four basic conditions of an optimal currency area. These are labour mobility across borders, wage and price flexibility, fiscal transfers and aligned business cycles. The euro area meets none of them.

Mediobanca is Italy's second biggest bank. It does not call for a withdrawal from EMU and a return to the lira, stocially accepting that discipline is the only way forward. Yet the logic of their Magnum Opus is that Italy would be far better off outside EMU, and the implicit threat is that Italy will have to do so if the Northern creditor powers persist with their destructive regime.

Italy is not a basket case. Its net international investment position is -30pc of GDP, compared with -92pc for Spain, and -100pc for Portugal. It has very low mortgage debt. Their median wealth is €173,500, making them four times richer than Germans at €51,400.

It is the most virtuous of the big EMU states, with a primary surplus of 2.5pc of GDP. This of course means it can leave the euro whenever it wants without a funding crisis, and it is big enough to weather the shock.

Everything comes down to the national mood in the end. There was a time when the cause of Europe was unquestioned in Italy, but the long slump has taken its toll. An Ipsos poll this week found that a record 74pc of Italians are dissatisfied with the euro. It is a loveless marriage now. One more spat with Berlin and it will turn acrid.

Europe's leaders can stop the rot at any time by embarking on a reflation strategy that entirely changes the contours of the crisis and lifts the South off the reefs. But if they do not do so - and there is no sign yet - Italians will be forced to take back their own sovereign destiny.

China News

U.S. Blasts Germany's Economic Policies

By Ian Talley and Jeffrey Sparshott

Updated Oct. 31, 2013 4:15 a.m. ET

Employing unusually sharp language, the U.S. on Wednesday openly criticized Germany's economic policies and blamed the euro-zone powerhouse for dragging down its neighbors and the rest of the global economy.

In its semiannual currency report, the Treasury Department identified Germany's export-led growth model as a major factor responsible for the 17-nation currency bloc's weak recovery. The U.S. identified Germany ahead of its traditional target, China, and the most-recent perceived problem country, Japan, in the "key findings" section of the report.

The U.S. is itself dealing with persistently weak growth and has faced complaints from some countries about its attempts at reviving a sluggish economy, including the Federal Reserve's easy money policies. Finance leaders have also taken aim at the U.S. over the global economic impact of fiscal wrangling between the White House and Congress, including the government shutdown and debt-ceiling fight.


With the latest report, the Treasury Department has now criticized the world's three largest economies after the U.S. for their economic policies.


The focus on Germany represents a stark shift in the Obama administration's economic engagement with one of its most important allies. Since the early stages of the euro-zone debt crisis in 2010, U.S. officials often avoided public criticism of Germany given its central role in keeping the currency bloc intact. President Barack Obama and his top officials worked carefully behind the scenes to prod Germany without antagonizing it publicly.

The currency report comes at a time when officials in Berlin and Washington are already clashing over other issues including allegations about U.S. spying.
"Germany's anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment," Treasury said in its report. "The net result has been a deflationary bias for the euro area as well as for the world economy."

A spokesman for the German finance ministry said international organizations including the International Monetary Fund, Organization for Economic Cooperation and Development and European Commission have recently evaluated Germany's economic policies favorably. The IMF found no policy distortions, the spokesman said. Strong domestic demand is driving Germany's growth, he added.

The IMF, however, has consistently urged Germany to boost domestic demand, saying its large trade surplus came at the expense of its southern peers.

Some critics have called Treasury's assessments toothless, pointing to the fact that no major trading partner has been labeled a currency manipulator in nearly two decades. Still, the U.S. has employed the report as a diplomatic tool to sway countries over their economic and trade policies.

The complaints about Germany's economic model aired in the report are well-known and have been conveyed quietly by U.S. officials over the years. The latest venue for the comments were unusual, however, in a report that typically focuses on currencies rather than broader economic policies.

The euro, in fact, has strengthened 4% this year due to rising investor confidence in the currency union's recovery and signs that the Federal Reserve is on course to continue its extraordinary easy-money policies. The euro, which settled at $1.3736 at 5 p.m. in New York, fell slightly in late trading after the Treasury released the report Wednesday evening.

A stronger euro helps the U.S. economy by making American products more competitive abroad. But U.S. officials appear to be more worried about German economic policies creating longer-run distortions in the global economy.

As Germany helps define economic policy for the rest of the euro zone, Washington wants to ensure the euro zone doesn't rely too heavily on exports—rather than domestic demand—to pull itself out of its economic doldrums.

The Obama administration heightened its criticism of Germany markedly from April, when the last currency report was released. At the time, the Treasury broadly noted that Germany and the Netherlands maintained large trade surpluses and briefly mentioned a shortfall in demand within Europe. Now, the Treasury pointedly noted that Germany's surplus now exceeds China's.

Jacob Kirkegaard, an expert on the euro zone at the Peterson Institute for International Economics, said the timing of the criticism is likely an attempt to influence economic policy in Germany while a new coalition government is being formed and is debating its agenda for the next several years.

The euro zone's reliance on exports makes it more difficult for the U.S. and other countries to address their own economic problems. "The euro area is sucking demand from the rest of the world rather than making up for the declining growth in emerging markets," Mr. Kirkegaard said.

Regardless of the blunt criticism from abroad, German politicians are discussing how to boost public and business investment in the country. But there is also a widespread consensus in Germany that the country's big trade surpluses are a sign of health and competitiveness.

The U.S. Treasury's semiannual currency report is designed to ensure major trading partners aren't using their currencies to gain a competitive edge over U.S. exports, undermining the American economy. By holding down the value of its currency, a country can make its manufactured products cheaper to sell internationally.

Treasury maintained its concerns over China, Japan and South Korea's currency policies. It didn't name any country a currency manipulator.

The U.S. reiterated its criticism of Beijing, saying the Chinese government needs to allow a "significantly undervalued" yuan to appreciate faster. Geng Shuang, a spokesman for the Chinese embassy in Washington, said "there is no evidence that the Chinese currency is significantly undervalued," pointing to a 34% appreciation of the yuan against the dollar since 2005.

And while the Treasury said Japan appeared to be abiding by recent international currency agreements, it said it would continue to "closely monitor" Tokyo's policies.

Treasury also warned South Korea to limit its intervention in the currency markets.

Representatives from the Japanese and Korean embassies in Washington didn't immediately return requests for comment.

—Anton Troianovski,  Marcus Walker, Sudeep Reddy and Sarah Portlock  contributed to this article.

Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved