December 15, 2013 8:41 pm

Why stagnation might prove to be the new normal
In the past decade, before the crisis, bubbles and loose credit were only sufficient to drive moderate growth
Is it possible that the US and other major global economies might not return to full employment and strong growth without the help of unconventional policy support? I raised that notionthe old idea of “secular stagnation – recently in a talk hosted by the International Monetary Fund.
My concern rests on a number of considerations. First, even though financial repair had largely taken place four years ago, recovery has only kept up with population growth and normal productivity growth in the US, and has been worse elsewhere in the industrial world.

Second, manifestly unsustainable bubbles and loosening of credit standards during the middle of the past decade, along with very easy money, were sufficient to drive only moderate economic growth. Third, short-term interest rates are severely constrained by the zero lower bound: real rates may not be able to fall far enough to spur enough investment to lead to full employment.

Fourth, in such situations falling wages and prices or lower-than-expected are likely to worsen performance by encouraging consumers and investors to delay spending, and to redistribute income and wealth from high-spending debtors to low-spending creditors.

The implication of these thoughts is that the presumption that normal economic and policy conditions will return at some point cannot be maintained. Look at Japan, where gross domestic product today is less than two-thirds of what most observers predicted a generation ago, even though interest rates have been at zero for many years. It is worth emphasising that Japanese GDP disappointed less in the five years after the bubbles burst at the end of the 1980s than the US has since 2008. In America today, GDP is more than 10 per cent below what was predicted before the financial crisis.

If secular stagnation concerns are relevant to our current economic situation, there are obviously profound policy implications (and I will address them in a subsequent column). But before turning to policy, there are two central issues regarding the secular stagnation thesis that have to be addressed.

First, is not a growth acceleration in the works in the US and beyond? There are certainly grounds for optimism: note recent statistics, the strong stock markets and the end at last of sharp fiscal contraction. One should also recall that fears of secular stagnation were common at the end of the second world war and were proved wrong. Today, secular stagnation should be viewed as a contingency to be insured againstnot a fate to which we ought to be resigned.

Yet, it should be recalled that the achievement of escape velocity has been around the corner in consensus forecasts for several years and we have seen several false dawns – just as Japan did in the 1990s. More fundamentally, even if the economy accelerates next year, this provides no assurance that it is capable of sustained growth at normal real interest rates. Europe and Japan are forecast to have grown at levels well below the US. Across the industrial world, inflation is below target levels and shows no signs of picking upsuggesting a chronic demand shortfall.

Second, why should the economy not return to normal after the effects of the financial crisis are worked off? Is there a basis for believing that equilibrium real interest rates have declined?
There are many a priori reasons why the level of spending at any given set of interest rates is likely to have declined. Investment demand may have been reduced due to slower growth of the labour force and perhaps slower productivity growth.
Consumption may be lower due to a sharp increase in the share of income held by the very wealthy and the rising share of income accruing to capital. Risk aversion has risen as a consequence of the crisis and as saving – by both states and consumers – has risen.
The crisis increased the costs of financial intermediation and left major debt overhangs. Declines in the cost of durable goods, especially those associated with information technology, mean that the same level of saving purchases more capital every year. Lower inflation means any interest rate translates into a higher after-tax rate than it did when inflation rates were higher; logic is supported by evidence. For many years now indexed bond yields have been on a downward trend. Indeed, US real rates are substantially negative at a five year horizon.
Some have suggested that a belief in secular stagnation implies the desirability of bubbles to support demand. This idea confuses prediction with recommendation. It is, of course, better to support demand by supporting productive investment or highly valued consumption than by artificially inflating bubbles. On the other hand, it is only rational to recognise that low interest rates raise asset values and drive investors to take greater risks, making bubbles more likely. So the risk of financial instability provides yet another reason why pre-empting structural stagnation is so profoundly important.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary


Copyright The Financial Times Limited 2013

The Volcker rule

More questions than answers

A push to make America’s banks safer creates new uncertainties

Dec 14th 2013

THE 37 words inserted into the 848-page Dodd-Frank law overhauling the regulation of America’s financial institutions seemed innocent enough. Lawmakers wanted regulators to come up with strictures that would prevent banks from gambling with deposits insured by the federal government.

The resulting rule, named after a prominent proponent, Paul Volcker, a former head of the Federal Reserve, prohibits banks from “proprietary trading”, meaning transactions conducted purely for their own gain, rather than to serve clients. On December 10th five different regulatory agencies approved the Volcker rule; it will come into force, awkwardly enough, on April 1st.

During the three years between its conception and birth, the rule has grown into something much bigger and more complicated than its origins would have suggested. The final version boasts 963 pages, and contains 2,826 footnotes as well as 1,347 questions. (Much of this is a preamble addressing public comments, but that will nonetheless serve as guidance for the rule’s implementation.)

The immediate impact of all this verbiage will be small. America’s biggest banks had already eliminated the most obvious forms of proprietary trading in anticipation of the rule. Their share prices rose slightly after its release, perhaps out of relief that it was not as burdensome as some had expected.

By June large banks must begin reporting some data; full compliance with the rule is not required until July 21st 2015. The rule aims not just to curb risk-taking directly, but to enhance monitoring of it too. Bosses will have to sign statements attesting to the existence of compliance schemes, although not to compliance itself—the kind of carefully constructed arrangement that underscores how very conscious bank executives are of risk, if only on their own account, as it were.

The final rule could have been more onerous than it was. An earlier draft had proposed prohibiting banks from buying securities unless they knew that their clients wanted to buy them. In effect, this would have prevented market-making”, whereby banks keep a supply of securities on hand, so that they can sell them to a customer on demand, or buy them from one even when they do not have another client lined up to pass them on to.

Without the liquidity banks provide in this way, pension funds and insurers would find it harder, more time-consuming and more expensive to buy and sell bonds and other financial instruments. The rule alleviates this worry somewhat by allowing banks to buy securities to meetreasonably expected demand from customers.

In practice banks will probably respond by making markets for a narrow range of securities that already trade frequently, and thus might reasonably be expected to do so in future. Meanwhile, the securities that now change hands less frequently are likely to be shunned, making them even harder to trade. Government bonds are exempted from these rules, so banks may pile into them, although they are currently trading at unusually high prices, and so are far from risk-free.

Another worry relates to the rule’s treatment of hedging. Banks often try to offset some of the risks they incur by, for instance, buying derivatives that would rise in value if defaults on loans or bonds were to increase. The new rule will force banks to tie each hedge to the risks of specific positions they have taken. Yet there are few perfect hedges that zig exactly as the countervailing investment zags. Instead, banks often resort to bigportfolio hedges”, designed to protect against broad risks such as an economic downturn or a rise in interest rates, even though they may not perfectly correlate with its trading posture. Regulators, however, see such hedges as risky proprietary trading in disguise (JPMorgan Chase, an American bank, lost $6 billion on one last year).

The Volcker rule bans them.

Where, precisely, the line will be drawn between market-making and proprietary trading, or between legitimate and specious hedging, is anyone’s guess. “A specific trade”, explained Daniel Tarullo, the governor of the Federal Reserve responsible for bank supervision, “may be either permissible or impermissible depending on the context and circumstances within which the trade is made.” This subjectivity hints at the to-ing and fro-ing to come, as regulators and courts gradually clarify the rule with precedents.

Unpleasant surprises may yet emerge. The American Banking Association, a pressure group, worries that the rule unintentionally bars small banks, which are largely exempted from its strictures, from investing in financial instruments that currently form a big part of their capital. Jeb Hensarling, chairman of the relevant committee of the House of Representatives, claims it will increase electricity prices, dent pensions and constrict credit. “We are left with one more incomprehensible Washington regulation”, he said, “that will do nothing to help our nation.”

Daniel Gallagher, a dissenting member of the Securities and Exchange Commission (SEC), one of the five agencies that approved the rule this week, complained that he and his colleagues had been given only five days to review the revised draft of the rule before deciding on it.All we can say for sure is that the final rule set jettisons scores of flawed assumptions and incorrect conclusions in favour of new, unproven assumptions and conclusions,” he noted dryly, calling its hasty adoption “the height of regulatory hubris”.

The SEC’s rush to vote, Mr Gallagher claimed, was the result of “intense pressure to meet an utterly artificial, wholly political end-of-year deadline.” The administration of Barack Obama has been urging regulators to get a move on, to fulfil its promise to rein in reckless bankers. Whereas prior versions of the rule had been released for comment, the final one was made public only after it had been adopted, despite significant changes.

The SEC also did not conduct a cost-benefit analysis of the rule, as it normally does for new regulations. Officials say the laws from which the rule derives its authority do not require such a study, but there was nothing to stop the agencies involved from requesting one. Their failure to do so deepens suspicions that the rule will cause more trouble than it averts.

December 13, 2013 7:42 pm

The old banks are returning but without their managers
The public face of an industry in desperate need of a reputational makeover will live on
illustration of a bank manager©Jonathan McHugh
The news that HSBC is considering floating its UK arm – the high street bank formerly known as Midland – is a further sign of banks returning to the past. As they try to repair their damaged reputations, old names such as TSB and Williams & Glyn’s are reappearing and the talk is of restoring virtues such as trust, integrity and reliability.
So will suchcompletely cleanbanks (in the words of António Horta-Osório, chief executive of Lloyds Banking Group) revive the old-fashioned branch, with the manager behind a desk reviewing loans and deposits? Will there be an army of bankers such as George Mainwaring, the branch manager at Walmington-on-Sea who doubled as commander of the Home Guard platoon in Dad’s Army?
The answer, despite the rhetoric, is no. For good or ill, the classic high street branch is not going to return to what it used to be. There will be fewer of them, with fewer decisions made by humans and more by computers. The staff may smile more and the branches may become nicer places, but Captain Mainwaring is the ghost of banking past.

Branches are banks’ public face and best form of promotion – “money is intangible and branches are a cultural symbol of trust”, says Shaun French, associate professor of economic geography at the University of Nottingham. But many functions have been stripped away by technology and changes in society, leaving expensive shells.
Banks will not go back to devolving decisions to branches – that role has been subsumed by automated credit scoring. Credit decisions are not taken in branches and won’t be,” says David Nicholson, group director of Halifax Community Bank, the former building society owned by Lloyds. Local managers are there to explain the decisions to customers rather tan change them.

The rise of the automated teller machine and others that can count notes and coins and take deposits has undermined another of the branches’ former roles. People used to visit branches often to cash and deposit cheques but electronic payments have heavily reduced this foot traffic, especially in cities and middle-class suburbs.

Nor can banks plunge into “bancassurance” – selling insurance and mortgages – without great care. Lloyds was fined £28m this week by regulators for “serious failings” in how it operated. Its staff were offered bonuses to “sellas many of them as possible to customers, whether or not they were suitable. Along with other banks, it has scrapped these incentive schemes and insists that the era of high-pressure sales is in the past.
What does that leave? Not enough activity to support so many branches has been the banks’ view for the past two decades. The number of main bank branches peaked in 1988 at about 16,800 and has fallen to half this number, according to Bernstein Research. HSBC has been the most aggressive in trimming, as it has focused on the “mass affluent”, cutting 14 per cent of UK branches between 2009 and 2011.
There are still a lot compared with countries in southeast Asia and Scandinavia which have switched faster to online banking. “If you walk down Tottenham Court Road, it is bizarre how many branches there are,” says Chirantan Barua, an analyst at Bernstein in London. “If KKR [the US private equity group] were running Lloyds, I would bet my pension that it would have 30 per cent fewer branches.”
In practice, Lloyds is still partly state-owned, which introduces another complexity for such Banks. They are so unpopular – and so indebted to the taxpayer after the 2007-08 crisisthat they cannot slash networks too fast. Not only would it damage the effort to present a customer-friendly face, but it would alienate politicians.

Indeed, critics such as Mr French argue that such state-supported banks have a social responsibility to keep branches open, even if they are not very profitable. Given that all the banks have been bailed out in one way or another, the quid pro quo should be that they cross-subsidise branches.”

He wants them to retain branches in towns with high unemployment and public housing hurt by the shrinkage of manufacturing and blue-collar occupations. Two-thirds of closures have come in such districts, with the slack being taken up by payday lenders and pawnbrokers such as The Money Shop, which has expanded to 550 branches.
Others are betting that closures of branches and changes in how they work leaves a gap in the market. Metro Bank, billed as “Britain’s first new high street bank in 100 years”, yesterday opened its 24th store”, in west London. It was founded by Vernon Hill, an entrepreneur who pioneered his customer-friendly approach to branches at Commerce Bancorp in the US.

“If John Lewis said: ‘You cannot come into our stores because it is too expensive and you should use the internet,’ it would be ridiculous. No other service industry would tell that to its customers,” says Craig Donaldson, Metro Bank’s chief executive. Metro opens until 8pm and offers instant account opening as well as branch managers who “can overrule the computer”.

But branches are expensive. McKinsey has estimated that the average cost for a bank to attract a new current account customer at a branch is about $330, while an online customer costs less than half of that. Richer customers, who tend to be more profitable for banks, are more likely to bank online than go into branches, which further tips the financial balance.

Banks walk a fine line in keeping enough branches open to retain a physical presence while shifting toward digital. The rise of mobile has made the line even finer – the number of counter transactions in Halifax branches is now falling by 5-10 per cent a year. “Our staff’s role is increasingly going be to teach customers to be active users, so they can do things easily for themselves,” says Mr Nicholson.

One thing is clear: no matter how the new breed of high street banks present themselves, putting the old name above the door does not mean returning to tradition inside. Captain Mainwaring was pompous but he wielded power in Walmington-on-Sea. His successors will be more pleasant and they will take their marching orders from a computer.

Copyright The Financial Times Limited 2013.

The Outlook

Tough Question for Fed: Time to Act?

Officials Could Decide This Week Whether to Begin Pulling Back on Bond Purchases

By Pedro Nicolaci da Costa and Jon Hilsenrath

Updated Dec. 16, 2013 3:25 p.m. ET

Federal Reserve officials face a delicate decision at their policy meeting this week, with stronger economic figures and a Washington budget deal adding fuel to the debate over whether to pull back on their signature bond-buying program.

Fed Chairman Ben Bernanke in June set out a three-part testbased on employment, growth and inflation—for reducing the $85 billion in monthly bond buys. He said the Fed's policy committee wants to see progress in the job market, supported by improving economic activity and an inflation rate rising toward its 2% target.

Recent data show progress on the first two criteria, but not on the third. The inflation rate has been persistently below the Fed's objective and reflects weak consumption and wage growth, which bode poorly for the economic recovery. Fed officials will likely differ on whether the gains overall are good enough to clear Mr. Bernanke's hurdles.

Ben Bernanke listens during an open meeting of the Board of Governors of the Federal Reserve on Dec. 10. Bloomberg News

Donald Kohn, former Fed vice chairman, said Friday he would hold off until next year before reducing the bond buys. However, he sees better-than-even odds the central bank will move Wednesday. "I think I would wait. But it's a very close call," he said.

Improving employment numbers appear to broadly meet Mr. Bernanke's first benchmark. Employers added 203,000 jobs in November, which means job growth averaged 195,000 a month in the past 12 months. That is well above the pace of around 150,000 monthly in the year ended in September 2012, when the bond-buying program was launched.

Meanwhile, the unemployment rate fell to 7% in November from 7.8% in September 2012. That is much better than the Fed's forecast in September 2012 that the jobless rate would be between 7.6% and 7.9% by the end of this year. That could be called a substantial improvement in the labor-market outlook since the program began.

The economic-growth outlook also looks better. Solid November retail sales showed consumer spending holding up. And the budget deal expected to pass the Senate this week would ease the uncertainty and federal spending constraints that exerted an economic drag in the past year. The deal would remove the danger of another government shutdown in January and allow for federal spending increases in 2014 and 2015.

The Congressional Budget Office estimates spending cuts and tax increases this year shaved about 1.5 percentage points off growth in 2013. Fed officials will release their new economic forecasts Wednesday after their meeting.

The brighter outlooks come with important caveats. The unemployment rate has fallen in part because of people leaving the labor force, which means they are no longer counted as jobless. U.S. gross domestic product jumped at a 3.6% annual rate in the third quarter, but the increase was driven largely by a buildup in inventories.

"We expect the FOMC to question the sustainability of the pickup in growth and hiring and thus to refrain" from cutting the bond buys, said Laura Rosner, economist at BNP Paribas, referring to the policy-setting Federal Open Market Committee.

One argument against taking action this week is that inflation isn't moving toward the Fed's target. If anything, it is going the wrong way. The Fed's preferred measure—the Commerce Department's personal consumption expenditures price indexfell to an annual clip of just 0.7% in October, less than half the 2% target rate.

"My sense is that inflation will move back toward 2% over the next year or two, in part because measures of expected inflation remain well contained," Richmond Fed President Jeffrey Lacker said in a recent speech. "This is not a certainty, however, and I believe the FOMC will want to watch this closely."

With mixed results on Mr. Bernanke's three-part test, other factors could play into the committee's decision this week.

The Fed has another condition for continuing the bond-buying program, which is aimed at holding down long-term rates to spur growth and hiring. Officials say they will halt it if the costs of continuing exceed the benefits. Policy makers worry the costssuch as the risks of financial bubbles or other market disruptionsrise as their bond holdings grow. They also believe the benefits diminish over time.

Fed officials haven't explained how they will know when they have reached the point where costs outweigh benefits. They aren't there yet, Fed Vice Chairwoman Janet Yellen said last month, at a hearing on her nomination to become Fed chairwoman in February. The Senate is expected to confirm her this week.

Because of this trade-off, Fed officials seem inclined to move away from the bond-buying approach as a tool for influencing long-term borrowing costs and rely more on providing verbal guidance about their plans for short-term rates. The Fed has said it won't raise short-term rates until the unemployment rate falls to at least 6.5%, as long as inflation is contained.

Of 43 economists polled recently by The Wall Street Journal, just 11 expected the Fed to cut its bond purchases this week, while 30 said it would wait until early next year.

Whenever the Fed starts winding down the bond program, it is clear it is on the way toward removing a tool that has been the market's crutch for more than a year. Mr. Bernanke might start the process, but it will be Ms. Yellen's job to finish it.

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