Global Economy

There is no easy escape from secular stagnation

Stephen King

November 25, 2013

For all the better-than-expected economic news this year, the volume of economic activity across the developed world remains remarkably depressed. The language of recession and recovery no longer seems relevant. Instead, we are faced with persistent economic stagnation. Those who wonder whether the west risks entering a Japanese-stylelost decade” have missed the point. The question is whether we can escape from the lost decade that is already suffocating our economies.

Wages are depressed; interest rates have every prospect of staying at rock-bottom; government debt is incredibly high (and, in some cases, persistently rising); companies prefer to hoard cash than invest; and, despite the hum of the printing press, inflation is surprising on the downside. Policy makers did well to avoid another Great Depression following the 2008 collapse of Lehman Brothers and the ensuing financial meltdown. They have not, however, prevented the Great Stagnation.

As the Japanese have discovered, escaping from a lost decade is not easy. Too often, Japan’s problems have been seen in the west as “merely macroeconomic” and, by implication, easily solved with an aggressive tweak of monetary or fiscal policy. Yet the west remains stuck in the same kind of rut. Admittedly, fiscal policy has offered little support in recent years but, on the monetary side, central bankers have bent over backwards. The results of their generosity have been disappointing.

A new version of the “macroeconomic failure story was provided by Lawrence Summers, former US Treasury secretary, just the other day. In a speech to the International Monetary Fund research conference on November 8, Professor Summers talked about the dangers of “secular stagnation”, offering an intriguing explanation for why the developed world may have to get used to a combination of low nominal interest rates and financial bubbles into perpetuity if policy makers are to deliver anything approaching full employment.

His argument is based on a simple observationnamely that inflation over the past two decades has mostly been lower than expected, regardless of cyclical highs and lows. Price pressures were low at the end of the 1990s and lower still in the years preceding the global financial crisis. As a result, Prof Summers believes it makes no sense to suggest that, at any point, there was excess domestic demand.

Throughout the period, the danger was always of deficient demand, largely because interest ratesalready very low – could not drop to levels that might deliver full employment. Instead, higher levels of activity could be met only by creating or nurturing financial bubbles, from the dotcom boom of the late 1990s through to the madness of the subprime world pre-Lehman.

Prof Summers suggests the level of real interest rates required to generate full employment might be, say, -2 or -3 per cent. In a low inflation environment, that is basically unachievable. Put another way, if Prof Summers is right, he may never be able to prove it. This rather reduces the power of the analysis unless central bankers prove both willing and able to pursue higher inflation than we have become accustomed to, a hard task in societies where populations are ageing and people are keen to hang on to their (nominal) savings.

There are two other problems with Prof Summers’ approach. First, he assumes that the absence of inflation somehow “proves” that there was not a problem with excess demand. This seems odd.

Plenty of economies have suffered unsustainable economic and financial booms in the absence of inflation. Think of the US in the roaring 1920s, Japan in the late 1980s or Thailand (by the standards of the time) in the mid-1990s. All of them later suffered the consequences. Too often, persistently low or stable inflation sometimes the result of favourable external circumstances creates the false impression that activity can be sustained at too high a level, leading to excessive risk taking, financial bubbles and balance of payments crises.

Second, Prof Summers assumes his “secular stagnation” is primarily a demand problem. That is not at all clear. There are lots of other entirely plausible reasons for persistently lower-than-expected growth. In terms of economic performance, the late 20th century increasingly looks to have been a one-offgolden age” for the developed world, because of an end to the protectionism of the interwar period, a huge increase in labour supply thanks to the increased participation of women in the workforce, a dramatic rise in the numbers in tertiary education, a massive expansion of household debt (which, in turn, paved the way for more mass production) and, most obviously, the impact on labour supply of the baby boomers.

Technology continues to advance, of course, but technology alone does not fully explain the golden age. This one-off adjustment led to a period of unusually rapid economic growth that took the developed world closer to its productive potential. The same process is now happening in the emerging world even as the developed world stagnates.

This provides a completely different perspective on the secular stagnation. There is no magic interest rate (whether or not it can be reached). The absence of inflation over the last two decades may not indicate a chronic shortage of demand.

Instead, developed economies no longer offer the supply dynamism of old. Worse, because policy makers have not recognised this new reality, they continue to pretend golden age growth rates may still be within reach, a convenient way to ignore the tough fiscal decisions that will eventually be needed.

A gap is growing between political and financial hope and the new economic reality. That gap will have to close. As it does so, some will lose out. Levels of mistrust will rise. Risk aversion will spread. Growth will remain stagnant. And the developed world is at risk of succumbing to Adam Smith’smelancholy state” — a world in which one person’s gain is regarded as the cause of another person’s loss — whatever the level of interest rates.

Stephen King is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. He is a member of the Financial Times Economists’ Forum

11/25/2013 06:20 PM

Growing Risks

Government Bond Holdings Could Burden Banks

By Martin Hesse and Christoph Pauly

 Photo Gallery: ECB Concerned About Banks' Sovereign Bonds
European banks hold increasingly large shares of government bonds as a result of the debt crisisIf those states default and can no longer service their debt, it could lead to massive losses. Germany's Bundesbank is pushing for new rules at the ECB. 

German consulting firm Roland Berger did its bit for German-Italian relations last week when it named the head of Italy's UniCredit, Federico Ghizzoni, as "Italo-German Manager of the Year."

The ego massage is expected to boost strained ties between Germany and Italy. A manager for UniCredit, Italy's largest bank, recently accused Jens Weidmann, president of Germany's central bank, the Bundesbank, of harboring a basic mistrust of Italy. The rift was quickly patched up following a flurry of diplomacy, but potentially deeper divisions loom on the horizon.

UniCredit, which has €46 billion ($62.1 billion) of sovereign debt on its books, is one of a number of European banks that have purchased enormous quantities of government bonds from their own country. In Italy, Spain and elsewhere the lending institutions have become the leading financiers of their own states. This may please their respective governments, but it also entails risks. If, at a certain point, a state can no longer service its debts, the banks could suffer huge losses. Consequently, many economists -- above all Bundesbank President Weidmann -- are urging the introduction of new regulations to break the so-called feedback loop between governments and private banks.

Graphic: Excessive Increase

A Dilemma for the ECB

The Bundesbank proposal is well-intentioned, but it has drawbacks: It puts cash-strapped banks and crisis-ridden states in a bind. And, perhaps more urgently, it creates a dilemma for the European Central Bank (ECB), which is set to evaluate the stability of the euro zone's largest banks. Before the ECB assumes its new supervisory authority over euro-area banks in 2014, it intends to review their balance sheets, weed out toxic assets and evaluate whether these institutions are adequately prepared to weather future market turbulence.

While the ECB wants to test the potential impact that losses from sovereign bonds would have on euro banks, there is debate over how rigorously sovereign holdings should be assessed. Weidmann's proposal, which could mean more banks would ultimately fail the tests, is likely to compound the challenges facing the ECB.

A team of 15 economic and financial advisers to the ECB's European Systematic Risk Board -- founded by the EU in late 2010 and tasked with recognizing and eliminating risks in the financial system -- were recently reminded of the politically sensitive nature of the topic of sovereign bonds. Doing their due diligence, the advisers had presented the board with recommendations on how to unravel the intricate ties between banks and sovereigns.

The experts came to the conclusion that when, for example, Spanish banks primarily hold Spanish sovereign bonds, and Irish financial institutions predominately hold Irish government bonds, this poses a risk that is comparable to when a bank grants a large proportion of its loans to a single company. To avoid such concentrations of risk, the advisers suggested that the banks be required to limit their sovereign bonds to a predetermined proportion of their investments. Another possibility would be to buttress these bonds with capital reserves, which would at least make it possible to adequately contain the risk over the medium term.

However, if such rules were introduced for banks, euro-zone states would have to find entirely new ways to finance themselves in the future. ECB President Mario Draghi immediately recognized the potentially explosive nature of these proposals. He returned the recommendations "for revision" to the financial advisory committee, which includes German economists Martin Hellwig, of the Max Planck Institute for Research on Collective Goods in Bonn, and Claudia Buch, the head of the Halle Institute for Economic Research. The economists declined to comment on Draghi's request.

Credit Limits?

Central bank officials are concerned that a fundamental debate on the risky system of state financing could come at an inopportune momento. Still, Draghi is also worried that the ECB's authority could be undermined before it even takes over banking supervision, if the risks of a national bankruptcy are simply ignored during the stress test.
"We have to make a decision here," he told the Committee on Economic and Monetary Affairs at the European Parliament in September, and promised that there would be an "initial communication" in mid-October.

But Europe's banks and governments have been waiting in vain for Frankfurt to lay down the law on sovereign bonds. Part of the reason for hesitation is that Draghi doesn't have a majority on the ECB Governing Council to back a plan for risk-weighting sovereign debt on bank balance sheets. "The battle lines are drawn according to the degree of impact," says an individual who is taking part in the discussions.

Southern European countries are particularly reticent to change the current standards. Until now, banks have had to maintain absolutely no capital reserves to safeguard sovereign bonds, as if there were no risk involved. For instance, Italian bank Intesa Sanpaolo has acquired some €100 billion ($135 billion) in bonds issued by its own government.

ECB monetary policy plays a role in all of this, too. For years, it has been supplying euro-zone banks with cheap liquidity in a bid to boost the economy. But instead of using those funds to grant loans to Italian companies, banks there have increased their holdings of sovereign bonds since late 2011 from €240 billion to €415 billion.

"We are observing an evasive reaction that we have caused ourselves through monetary policy interventions," argues Weidmann. Indeed, he thinks it is necessary "that we treat sovereign bonds the way we treat corporate bonds." According to normal banking practice, financial institutions are only allowed to grant companies loans up to a certain limit. In Weidmann's opinion, a similar credit limit should also be introduced for states -- specifically, the bonds issued by each individual country.

A Political Issue

Experts like Daniel Gros, the director of the Center for European Policy Studies in Brussels, take a similar view. "The most consistent instrument for dealing with sovereign bonds would be the use of credit limits," says Gros, who is also a member of the advisory committee of the European Systematic Risk Board. Gros notes that it may be advisable to set aside capital to cover the sovereign debt, depending on the level of risk. "We should not orient ourselves according to ratings here, but simply according to the level of sovereign debt in relation to the gross domestic product."

The ECB does not plan to include such fundamental considerations in next year's stress test. But to make the test credible, the central bank has to somehow take into account the risk of sovereign debt on banks' balance sheets. The financial markets realized long ago that sovereign bonds constitute a risk for the banks.

The rating agency Standard&Poor's (S&P) already calculates deductions for these risks when it assesses the creditworthiness of banks. This is one reason why S&P says that European financial institutions are generally not as well-capitalized as they portray themselves.

"There are banks whose risks are too strongly concentrated on the sovereign loans of individual countries," says S&P bank analyst Markus Schmaus. He thinks it would make sense for the stress test to simulate possible losses, and thus identify the corresponding need for capital.

Nevertheless, Schmaus realizes that this is a highly political issue: "By adjusting the sovereign bond lever, you can fairly well control the result of the entire stress test."

Translated from the German by Paul Cohen

Olivier Blanchard: Monetary Policy Will Never Be the Same

November 19th, 2013 

By Olivier Blanchard—Chief Economist, IMF

Two weeks ago, the IMF organized a major research conference, in honor of Stanley Fischer, on lessons from the crisis. Here is my take. I shall focus on what I see as the lessons for monetary policy, but before I do this, let me mention two other important conclusions.

One, having your macro house in order pays off when there is an (external) crisis. In contrast to previous episodes, wise fiscal policy before this crisis gave emerging market countries the room to pursue countercyclical fiscal policies during the crisis, and this made a substantial difference.

Second, after a financial crisis, it is essential to rapidly clean up and recapitalize the banks. This did not happen in Japan in the 1990s, and was costly. But it did happen in the US in this crisis, and it helped the recovery.

Now let me now turn to monetary policy, and touch on three issues: the implications of the liquidity trap, the provision of liquidity, and the management of capital flows.

On the liquidity trap: we have discovered, unfortunately at great cost, that the zero lower bound can indeed be binding, and be binding for a long timefive years at this point. We have also discovered that, even then, there is still some room for monetary policy. The bulk of the evidence is that unconventional policy can systematically affect the term premia, and thus bend the yield curve through portfolio effects. But it remains a fact that compared to conventional policy, the effects of unconventional monetary policy are very limited and uncertain.

There is therefore much to be said for avoiding the trap in the first place in the future, and this raises again the question of the inflation rate. There is wide agreement that in most advanced countries, it would be good if inflation was higher today.

Presumably, if it had been higher pre-crisis, it would be higher today. To be more concrete, if inflation had been 2 percentage points higher before the crisis, the best guess is that it would be 2 percentage points higher today, the real rate would be 2 percentage points lower, and we would probably be close in the United States to an exit from zero nominal rates today.

We should not dismiss the possibility, raised by Larry Summers that we may need negative real rates for a long time. Countries could in principle achieve negative real rates through low nominal rates and moderate inflation. Instead, we are still facing today the danger of an adverse feedback loop, in which depressed demand leads to lower inflation, lower inflation leads to higher real rates, and higher real rates lead in turn to even more depressed demand.

Turning to liquidity provision: in advanced countries (but, again, the lesson is more general), we have learned that runs are relevant not only for banks, but also for other financial institutions, and for governments. In an environment of high public debt, rollover risks cannot be excluded. An implication, and one of the themes emphasized by Paul Krugman, is that it is essential to have a lender of last resort, ready to lend not only to financial institutions but also to governments. The evidence on periphery sovereign bonds in the Euro area, pre and post the European Central Bank’s announcement of outright monetary transactions, is quite convincing on this point.

Finally, turning to capital flows. In emerging markets (and, more generally, in small advanced economies, although these were not explicitly covered at the conference), the evidence suggests the best way to deal with volatile capital flows is by letting the exchange rate absorb most—but not necessarily all—of the adjustment.

The standard argument in favor of letting the exchange rate adjust was stated by Paul Krugman at the conference. If investors want to take their funds out, let them: the exchange rate will depreciate, and this will lead, if anything, to an increase in exports and an increase in output.

Three arguments have traditionally been given, however, against relying on exchange rate adjustment. The first is that, to the extent that domestic borrowers have borrowed in foreign currency, the depreciation has adverse effects on balance sheets, and leads to a decrease in domestic demand that may more than offset the increase in exports. The second is that much of the nominal depreciation may simply translate into higher inflation. The third is that large movements in the exchange rate may lead to disruptions, both in the real economy and in financial markets.

The evidence, however, is that the first two are much less relevant than they were in previous crises. Thanks to macroprudential measures, to the development of local currency bond markets, and to exchange rate flexibility and thus a better perception by borrowers of exchange rate risk, foreign exchange exposure in emerging market countries is much more limited than it was in previous crises. And thanks to increased credibility of monetary policy and inflation targets, inflation expectations appear much better anchored, leading to limited effects of exchange rate movements on inflation.

However the third argument remains relevant. And this is why central banks in emerging market countries have not moved to full float, but to “managed float,” that is the joint use of the policy rate, foreign exchange intervention, macroprudential measures, and capital controls. This has allowed them to reduce the old dilemma that arises when the only instrument used is the policy rate: an increase in the policy rate may avoid the overheating associated with capital inflows, but at the same time, it may make it even more attractive for foreign investors to come in. 

Foreign exchange intervention, capital controls, and macro prudential tools can, at least in principle, limit movements in exchange rates, and disruptions in the financial system without recourse to the policy rate. Countries have used all of these tools in this crisis. Some have relied more on capital controls, some more on foreign exchange intervention. And the evidence, both from the conference, but also from work at the IMF, suggests that these tools have worked, if not perfectly. Looking forward, the clear (and quite formidable) challenge is to understand how best to combine them.

In short, monetary policy will never be the same after the crisis. The conference helped us understand how it had moved, and where we have to focus our research and policy efforts in the future.

November 25, 2013 11:21 am
Washington turns bond market upside down
The financial market world order is in upheaval. The past few weeks have seen a telling change: longer-term Spanish and Italian government bonds have become more stable than US Treasuries.
The shift, shown in the volatility of total returns, highlights the relative calm enjoyed by global bond investors – but also how Washington has become a bigger source of instability than the eurozone.

Treasuries in transition
Volatility of 7-10 year government debt (To enlarge graph click here)
The risk is of being thrown into unfamiliar territory and of volatility suddenly spiking again, with the effects spreading into other markets and the real economy.

Back in mid-2011, Italian and Spanish bond markets became the centre of world concern, with changes in total returnstaking account of price changes and interest paymentsvarying wildly, especially compared with US Treasuries.

Since the middle of October, however, as the US Federal Reserve has moved closer to scaling down, or “tapering”, its emergency asset purchase programme, US seven- to 10-year bonds have seen larger average fluctuations.
“We’re in a low-risk world for eurozone periphery bonds and a high-risk world for US Treasuries because of ‘tapering talk – when it [tapering] starts we will see a big pick-up in US Treasury volatility,” says Ramin Nakisa, strategist at UBS.

The volatility of US Treasuries “is picking up because of uncertainty over the US economic cycle and future Fed policy”, adds Didier Saint-Georges, investment committee member at Carmignac, the French fund manager.

So far, the switch is more the result of the crisis in the eurozoneperipheryeconomies becoming less acute, rather than worries over the US. Short-term US debt markets, over which the central bank has greater control, remain stable. In equity markets, the Vix index of expected volatility in US shares – the Wall Streetfear gauge” – has dropped to pre-crisis levels, as has its European equivalent.

However, the volatility of Italian and Spanish bonds has been falling steadily since last year’s pledge by Mario Draghi, European Central Bank president, to do whatever it takes” to preserve the eurozone. The ECB’s indicator of systemic financial risks in the eurozone has fallen sharply.
Italy and Spain have also seen an increasing share of government debt being held by domestic, rather than foreign, investors, which are less likely to sell at times of stress.

The decline mattershigh volatility increases risks for investors.

Less market variation has created a virtuous circle, says Laurence Mutkin, head of global rates strategy at BNP Paribas. “The fall in volatility in the eurozone periphery bond markets since the middle of last year explains why investors are more confident about these bonds. The risk-reward ratio can remain favourable even as yields fall.”

Forces driving US debt markets are working in the opposite direction. Volatility could be the result of the self-correcting nature of the Fed taper talk,” argues Mr Saint-Georges. “When yields rise, the threat to the economy persuades the Fed to go slower on tapering. So you get increased volatility both on bond markets and on economic activity readings.”


In turn, US volatility could feed back into Europe. “When you really get some volatility in the US then, yes, you will get more volatility in Europe,” says Laurent Fransolet, head of fixed income research at Barclays. However, he argues it is a different kind of volatility.

In crises that followed the collapse of Lehman Brothers in late 2008 and then the eurozone’s debt woes from 2010, markets rode a commonrisk on, risk offrollercoaster. “We’ve had five years of extreme volatility in fixed income and financial markets generally. But ‘risk on, risk off has gone and it is back to volatility driven by monetary policy,” says Mr Fransolet.

The next set of US jobs data could determine whether the Fed will starttapering” its asset purchases in December – or wait until next year. Bond prices will probably yo-yo as the central bankers make up their minds.

Still, the process may prove less disruptive than many fear. Mr Mutkin at BNP Paribas argues: “With sufficient guidance from central banks, the ending of asset purchases doesn’t have to be associated with higher yields or much higher bond market volatility, if the central bank gets its communication policy right.”

And even if global volatility does pick up, it could prove shortlived. Once tapering is finished, calm might quickly be restored, especially if the first Fed interest rate rise still looks a long way off. By that time, attention could have switched back to the eurozone, or elsewhere.
“It is not going to last very longTreasury volatility will fall when tapering ends,” says Mr Nakisa at UBS. “We are in a transition. It is the wood between the worlds.”


Copyright The Financial Times Limited 2013.