November 3, 2013

Those Depressing Germans


But Treasury was right, and the German reaction was disturbing. For one thing, it was an indicator of the continuing refusal of policy makers in Germany, in Europe more broadly and for that matter around the world to face up to the nature of our economic problems. For another, it demonstrated Germany’s unfortunate tendency to respond to any criticism of its economic policies with cries of victimization.
First, the facts. Remember the China syndrome, in which Asia’s largest economy kept running enormous trade surpluses thanks to an undervalued currency? Well, China is still running surpluses, but they have declined. Meanwhile, Germany has taken China’s place: Last year Germany, not China, ran the world’s biggest current account surplus. And measured as a share of G.D.P., Germany’s surplus was more than twice as large as China’s.
Now, it’s true that Germany has been running big surpluses for almost a decade. At first, however, these surpluses were matched by large deficits in southern Europe, financed by large inflows of German capital. Europe as a whole continued to have roughly balanced trade.
Then came the crisis, and flows of capital to Europe’s periphery collapsed. The debtor nations were forcedin part at Germany’s insistence — into harsh austerity, which eliminated their trade deficits. But something went wrong. The narrowing of trade imbalances should have been symmetric, with Germany’s surpluses shrinking along with the debtors’ deficits. Instead, however, Germany failed to make any adjustment at all; deficits in Spain, Greece and elsewhere shrank, but Germany’s surplus didn’t.
This was a very bad thing for Europe, because Germany’s failure to adjust magnified the cost of austerity. Take Spain, the biggest deficit country before the crisis. It was inevitable that Spain would face lean years as it learned to live within its means. It was not, however, inevitable that Spanish unemployment would be almost 27 percent, and youth unemployment almost 57 percent. And Germany’s immovability was an important contributor to Spain’s pain.
It has also been a bad thing for the rest of the world. It’s simply arithmetic: Since southern Europe has been forced to end its deficits while Germany hasn’t reduced its surplus, Europe as a whole is running large trade surpluses, helping to keep the world economy depressed.
German officials, as we’ve seen, respond to all of this with angry declarations that German policy has been impeccable. Sorry, but this (a) doesn’t matter and (b) isn’t true.
Why it doesn’t matter: Five years after the fall of Lehman, the world economy is still depressed, suffering from a persistent shortage of demand. In this environment, a country that runs a trade surplus is, to use the old phrase, beggaring its neighbors. It’s diverting spending away from their goods and services to its own, and thereby taking away jobs. It doesn’t matter whether it’s doing this maliciously or with the best of intentions, it’s doing it all the same.
Furthermore, as it happens, Germany isn’t blameless. It shares a currency with its neighbors, greatly benefiting German exporters, who get to price their goods in a weak euro instead of what would surely have been a soaring Deutsche mark. Yet Germany has failed to deliver on its side of the bargain: To avoid a European depression, it needed to spend more as its neighbors were forced to spend less, and it hasn’t done that.
German officials won’t, of course, accept any of this. They consider their country a shining role model, to be emulated by all, and the awkward fact that we can’t all run gigantic trade surpluses simply doesn’t register.
And the thing is, it’s not just the Germans. Germany’s trade surplus is damaging for the same reason cutting food stamps and unemployment benefits in America destroys jobs — and Republican politicians are about as receptive as German officials to anyone who tries to point out their error. In the sixth year of a global economic crisis whose essence is that there isn’t enough spending, many policy makers still don’t get it. And it looks as if they never will.

Workers’ share of national income

Labour pains

All around the world, labour is losing out to capital

Nov 2nd 2013

ON AN enormous campus in Shenzhen, in the middle of China’s manufacturing heartland, nearly a quarter of a million workers assemble electronic devices destined for Western markets. The installation is just one of many run by Foxconn, which churns out products for Apple among other brands, and employs almost 1.5m people across China. In America Foxconn has become a symbol of the economic threat posed by cheap foreign labour. Yet workers in China and America alike, it turns out, face a shared threat: they have captured ever less of the gains from economic growth in recent decades.

The “labour share” of national income has been falling across much of the world since the 1980s (see chart). The Organisation for Economic Co-operation and Development (OECD), a club of mostly rich countries, reckons that labour captured just 62% of all income in the 2000s, down from over 66% in the early 1990s. That sort of decline is not supposed to happen. For decades economists treated the shares of income flowing to labour and capital as fixed (apart from short-run wiggles due to business cycles). When Nicholas Kaldor set out six stylised facts” about economic growth in 1957, the roughly constant share of income flowing to labour made the list. Many in the profession now wonder whether it still belongs there.

A falling labour share implies that productivity gains no longer translate into broad rises in pay. Instead, an ever larger share of the benefits of growth accrues to owners of capital. Even among wage-earners the rich have done vastly better than the rest: the share of income earned by the top 1% of workers has increased since the 1990s even as the overall labour share has fallen. In America the decline from the early 1990s to the mid-2000s is roughly twice as large, at about 4.5 percentage points, if the top 1% are excluded.

Workers in America tend to blame cheap labour in poorer places for this trend. They are broadly right to do so, according to new research by Michael Elsby of the University of Edinburgh, Bart Hobijn of the Federal Reserve Bank of San Francisco and Aysegul Sahin of the Federal Reserve Bank of New York. They calculated how much different industries in America are exposed to competition from imports, and compared the results with the decline in the labour share in each industry. A greater reliance on imports, they found, is associated with a bigger decline in labour’s take. Of the 3.9 percentage-point fall in the labour share in America over the past 25 years, 3.3 percentage points can be pinned on the likes of Foxconn.

Yet trade cannot account for all labour’s woes in America or elsewhere. Workers in many developing countries, from China to Mexico, have also struggled to seize the benefits of growth over the past two decades. The likeliest culprit is technology, which, the OECD estimates, accounts for roughly 80% of the drop in the labour share among its members. Foxconn, for example, is looking for something different in its new employees: circuitry. The firm says it will add 1m robots to its factories next year.

Cheaper and more powerful equipment, in robotics and computing, has allowed firms to automate an ever larger array of tasks. New research by Loukas Karabarbounis and Brent Neiman of the University of Chicago illustrates the point. They reckon that the cost of investment goods, relative to consumption goods, has dropped 25% over the past 35 years. That made it attractive for firms to swap labour for software whenever possible, which has contributed to a decline in the labour share of five percentage points. In places and industries where the cost of investment goods fell by more, the drop in the labour share was correspondingly larger.

Other work reinforces their conclusión. Despite their emphasis on trade, Messrs Elsby and Hobijn and Ms Sahin note that American labour productivity grew faster than worker compensation in the 1980s and 1990s, before the period of the most rapid growth in imports. Studies looking at the increasing inequality among workers tell a similar story. In recent decades jobs requiring middling skills have declined sharply as a share of total employment, while employment in high- and low-skill occupations has increased. Work by David Autor of MIT, David Dorn of the Centre for Monetary and Financial Studies and Gordon Hanson of the University of California, San Diego, shows that computerisation and automation laid waste mid-level jobs in the 1990s. Trade, by contrast, only became an important cause of the growing disparity in wages in the 2000s.

Trade and technology’s toll on wages has in some cases been abetted by changes in employment laws. In the late 1970s European workers enjoyed high labour shares thanks to stiff labour-market regulation. The labour share topped 75% in Spain and 80% in France. When labour- and product-market liberalisation swept Europe in the early 1980smotivated in part by stubbornly high unemploymentlabour shares tumbled. Privatisation has further weakened labour’s hold.

Such trends may tempt governments to adopt new protections for workers as a means to support the labour share. Yet regulation might instead lead to more unemployment, or to an even faster shift to automation. Trade’s impact could become more benign in future as emerging-market wages rise, but that too could simply hasten automation, as at Foxconn.

Accelerating technological change and rising productivity create the potential for rapid improvements in living standards. Yet if the resulting income gains prove elusive to wage and salary workers, that promise may not be realised.

The ECB confronts the zero lower bound

November 3, 2013 2:51 pm

by Gavyn Davies


The startling success of this action has tended to shift attention away from more mundane matters, such as the overall stance of monetary conditions for the euro area as a whole. But the recent decline in inflation has raised serious questions about whether the monetary stance is anywhere near appropriate for an economy in such a depressed state.

This is problematic for the ECB, since it has already fired almost all of the conventional monetary ammunition available to it. And it has never followed the example of other major central banks in considering that quantitative easing is needed to ease policy at the zero lower bound for interest rates. It may soon have to face up to this issue.

Many of the economic symptoms displayed by the euro area in recent months suggest that monetary conditions have remained overly tight, despite a reduction in policy rates in May, and Mr Draghi’s limited use of forward guidance in July. Nominal GDP is rising at only 1 per cent per annum, which is nearer the Japanese than the American rate. Unemployment has been rising along with the exchange rate, and the central bank’s balance sheet has been declining rapidly. Excess liquidity held by the banking sector at the ECB has fallen by over E600 billion in about a year. Broad monetary growth has been subdued, with credit to the corporate sector continuing to decline at an annual rate of -5 per cent.

Most central banks would take these symptoms as proof that monetary policy should be eased, and eased significantly. But the ECB has always ploughed its own furrow. Although the Governing Council may well be ready to indicate on Thursday that a 25 basis points reduction in policy rates is in the offing, there is no sign that they think that a more drastic re-appraisal of their monetary stance is appropriate. If the central bank is in the wrong ball-park for monetary conditions, it seems to have every intention of staying there.

The ECB’s Policy Reaction Function

This conclusion follows from the monetary policy reaction functions which they have tended to use in the past. When Mr Draghi promised to keep interest ratesat present or lower levels for an extended period of time”, he suggested that the precise length of time could be gauged by extracting

“a reaction function and, from there, estimate what would be a reasonable extended period of time”.

In other words, the ECB is expecting to follow its normal policy rule, which is used for translating inflation and unemployment (or the output gap) into the appropriate level of interest rates.

A problem with Mr Draghi’s guidance, however, is that there are many such reaction functions that can be estimated, with very different implications for the appropriate level of short rates. Furthermore, the size of the output gap is very uncertain, given the extent of the post-2008 decline in real GDP relative to its previous trends.

By plugging in a relatively large estimate for the output gap, it is certainly possible to derive reaction functions which suggest that ECB interest rate policy is several hundred basis points too high. David Mackie at J.P. Morgan published a paper last week with just such an estimate. Given the constraint of the zero lower bound, this suggests that they should be contemplating a more dramatic shift in strategy, such as area-wide quantitative easing, if only to get the exchange rate down.

There is no evidence, however, that the ECB thinks that this is necessary or appropriate. One reaction function that is close to the one that the ECB itself probably uses is outlined in this recent paper by Tilman Bletzinger and Volker Wieland at the Institute for Monetary and Financial Stability in Frankfurt. It builds on work done with Athanasios Orphanides, who recently stepped down from the Governing Council.

Their estimate of the reaction function side-steps the difficulty of estimating the size of the output gap by relating changes in policy rates (not levels) to changes in inflation and in GDP growth, relative to potential growth:

As the graph shows, this rule has explained ECB policy changes very accurately in the past, with the exception of a short period after the 2008 crash when the rule suggested much larger policy changes were desirable than those the ECB actually pursued. In recent months, this rule has suggested that policy rates should be edging downwards, but not any more rapidly than has actually occurred.

Menu of Policy Options

The fall in inflation in October, which encompassed both the headline and the core rates, was a fairly sizeable shock. This is likely to lead the ECB to reduce its inflation forecasts for 2014, published in December, by as much as 0.3 percentage points, from 1.3 percent to about 1.0-1.1 percent.
Plugging this into the Orphanides/Wieland reaction function suggests that the policy rate should be reduced by about 0.15 per cent more than previously, a smaller reduction than the 0.25 per cent cut in the refi rate that the market now expects to see in the next month or two.

In addition to this cut in rates, Governing Council members have frequently suggested that other conventional measures are still available to them, such as announcing a new LTRO, or a decision not to sterilize all of the government bonds that have been purchased in earlier support operations. (See Joerg Asmussen here.)

All of these options have one thing in common: they would represent relatively limited relaxations in monetary conditions at a time when something more dramatic might become necessary to pull the euro area away from the risk of deflation. The ECB’s preferred reaction function will only reveal this very slowly, if at all, as inflation persistently comes in lower than the target.

The risk is that, by then, a lot of additional economic damage might have been done.


Margin for error

American corporate profits seem to have defied gravity

Nov 2nd 2013

THIS time is different. It is one of the oldest mottos in the financial markets. When Japanese shares traded at intimidating multiples of profits in the late 1980s, sceptics were told that Western valuation methods simply did not apply to Tokyo stocks. During the dotcom bubble, bulls laughed at those who worried about the absence of profits, let alone dividends, at some of the hottest technology companies. The newkey metrics”, believers explained, were price-per-user or price-per-click.

Investors were relieved of their optimism and their cash on both of those occasions. But the old canard is being trotted out again. American profits are at a post-war high as a proportion of GDP (see chart). Given the cyclical nature of profits, a bit of caution about future growth might be in order. But analysts are forecasting that companies in the S&P 500 will achieve a further 10.9% growth in earnings per share in 2014.

There is an element of charade about this forecast. Analysts often start the year in optimistic mode and then revise down their numbers as they get guidance from the companies they cover. Take the third-quarter results season, which is now under way. Analysts solemnly report how many companies have beaten forecasts, an optimistic sign. But companies are beating forecasts that have already been revised lower. Back in May, says Zacks Investment Research, analysts were forecasting annual earnings growth of 5.1% in the third quarter; the outcome now looks like being a rise of just 2.1%. Compared with the second quarter of this year, earnings per share may be flat.

Even that number puts a gloss on the figures. In dollar terms, the profits of S&P 500 companies are set to fall, according to Zacks, from $260.3 billion in the second quarter to $255.2 billion in the third. But those earnings are divided among fewer shares thanks to the widespread use of share buyback programmes.

In other words, profit growth seems to have stalled. Whether it can start motoring again depends, in large part, on why profits are at such historic highs.

The most common explanation for the strength of profits is that economic power has moved in favour of capital, and away from labour. In a report issued earlier this year, Martin Barnes of BCA Research showed that the rise in profit margins is linked to the sluggish growth of unit labour costs. In the four years up to the first quarter of 2013, hourly pay rose at an annual rate of just 2.1%, compared with 3.4% in the previous four years. In real terms, compensation is stuck at 2008 levels.

Although productivity growth has been sluggish in the past three years, that was not true in the immediate aftermath of the recession, when there was a huge leap. As Mr Barnes points out, had pay kept pace with productivity in recent years, profit margins would be around their historic average, not close to a 50-year high.

Even if workers continue to lose out in their battle with capital, that does not mean profit margins will remain elevated. Other factors have played their part. The fall in the dollar has boosted the foreign earnings of American companies while sharp falls in interest rates have reduced corporate borrowing costs. The dollar’s future direction is anyone’s guess but interest rates are likely to turn from a tailwind into a headwind: bond yields have been edging higher and companies have been borrowing more, in part to buy back their shares.

Another reason why margins have been high in recent years is that business investment has fallen. As companies have put off replacing old equipment, software and so on, the depreciation charges they take against such assets in their profit-and-loss accounts have fallen. The effect of this is to flatter the bottom line. In his recent book, “The Road to Recovery”, Andrew Smithers, an economist, argues that share options have given bosses a strong incentive to favour buybacks over capital expenditure.

This may well have been the crucial factor in propping up profits. Normally, one would expect the existence of high profit margins in an industry to attract new companies to it, or to persuade established businesses to invest more. The resulting competition would then drive profits down. That has not happened this time round. But perhaps the revival in economic confidence might persuade executives that the time is right for expansion, and for more capital spending. Good news for the economy might then not be good news for investors. In a sense, that would be different, although not the sort of difference that bulls like.

Sprott's John Embry: Dollar Decline, Inflation, Debt, QE Could Send Gold, Silver Soaring

Nov 3 2013, 11:20           

by: James Montes

The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed, lest Rome will become bankrupt. People must again learn to work instead of living on public assistance.

- Cicero , 55 BC

In a recent interview, John Embry, Chief Investment Strategist at Sprott Asset Management, argued that gold and silver are poised for a major move up as the US dollar declines, debt increases, governments print more money, and interest rates rise.

For the first time the US dollar fell below 80, another sign of the decline of the US dollar as the world's reserve currency. Embry said that the role of the US dollar as the world's reserve currency is "The most important thing currently in the outlook for gold." He predicted that the "US government will move heaven and earth to try to keep the US dollar from losing its reserve currency status," but "I don't think they will be successful." He argues, and I agree, that China is already planning to usurp the American role as the world's reserve currency. Embry said, "When it becomes more evident…the impact on silver and gold is going to be extremely good."

As he has mentioned in other interviews, Embry said that inflation is "understated by the government. The amount of money being created is going somewhere; it just doesn't show in the CPI." He argued that the money being created is going into the upper part of society, which is why prices for fine art are skyrocketing. He also pointed out that the "turnover of money has dropped precipitously to almost record lows." However, he argued, "At some point, people who put money into various financial assets are going to realize the value of money is being systematically destroyed by central banks." When that happens, there will be a rush to spend that money and "inflation could not just pick up, it's going to just explode in the next two to three years."

Turning to the US debt, Embry agreed that the debt is "the problem." It is already enormous and if you take in unfunded liabilities, "It's preposterous compared to the size of the economy." The result? "Interest rates will have to rise," which will make the debt problem even worse. Embry argues that "gold and silver are so dramatically underpriced, when more of the public realizes what is going on, when money starts flowing into those markets, the impact over two to three years is going to be spectacular." He predicted that in the future, today will be seen as "The finest opportunity in history to purchase gold and silver at great prices."

According to John Embry, Quantitative Easing (QE) is just "a fancy term for printing money." Embry argues that QE is "keeping the banking system liquid, not only in the US, but in the world." The size of QE is enormous, especially if you add QE in Japan and Europe to the US QE policy. Embry said, "A money printing blizzard is going on." Governments, he said, "Try to use semantics to hide this from the public." He does not believe the United States or anyone else can afford to taper at all. He said, "Even the talk of taper drove interest rates up." He predicted that QE "Might even increase it at some point in the future. If this thing starts to implode, it will require more QE….This could be imminent in the next six to twelve months."

Embry sees the combination of high debt levels, QE and the potential for interest rates to rise as a sign that gold and silver are poised for major moves up. He explained that in the late 1970s, interest rates were rising sharply, and gold and silver had their biggest increase in history. Paul Volker came in and changed the psychology by raising interest rates several basis points. Embry predicted that such a policy "Can't happen again." With so much debt, if the government raised interest rates several basis points, "US debt would collapse." Embry predicts that interest rates will rise, governments will keep printing money, and we will enter a period of hyperinflation.

Discussing the spread between the paper and physical gold and silver markets, Embry said, "At some point the West is going to run out of gold." At that point, the West will no longer be able to support "the chicanery in the paper market." He is surprised that the difference between the price of gold in the paper and physical markets has gone on so long; "It has gone on a lot longer than a rational mind would have thought." But, he said, "I'd be shocked if it lasted another 6 to 12 months."

Turning to gold mining shares, which have been pummeled recently, Embry said, "The single best buying opportunity in the history of buying gold and silver mining shares is right now." He warned, however, that you can't buy them all. Some mining companies are so badly damaged, they will never come back. He urged investors to do their research or find a fund that is run by a good manager. He said that the potential profits in investing in carefully selected gold and silver mining shares are huge.

Although Embry has "always loved gold," he believes that "silver will outperform gold." He argued that "silver is the poor man's gold." He predicts that central banks and the wealthy will buy gold, driving the price out of reach of the poor, who will then flood the silver market. Furthermore, there is not a lot of above-ground inventory in silver and a lot of silver is being consumed for good uses. He predicts that gold may go up three fold, while silver may rise "three, five or eight fold." Although, he said, "I hate putting time frames on things…This is a great place to be positioned at this point." In conclusion, he said, "The size of the move is less important than being there." If you wait too long, the move may price you out of the gold and silver markets.