Advanced Malaise

Joseph E. Stiglitz

JAN 13, 2014

NEW YORK Economics is often called the dismal science, and for the last half-decade it has come by its reputation honestly in the advanced economies. Unfortunately, the year ahead will bring little relief.

Real (inflation-adjusted) per capita GDP in France, Greece, Italy, Spain, the United Kingdom, and the United States is lower today than before the Great Recession hit. Indeed, Greece’s per capita GDP has shrunk nearly 25% since 2008.

There are a few exceptions: After more than two decades, Japan’s economy appears to be turning a corner under Prime Minister Shinzo Abe’s government; but, with a legacy of deflation stretching back to the 1990’s, it will be a long road back. And Germany’s real per capita GDP was higher in 2012 than it was in 2007 though an increase of 3.9% in five years is not much to boast about.

Elsewhere, though, things really are dismal: unemployment in the eurozone remains stubbornly high and the long-term unemployment rate in the US still far exceeds its pre-recession levels.

In Europe, growth appears set to return this year, though at a truly anemic rate, with the International Monetary Fund projecting a 1% annual increase in output. In fact, the IMF’s forecasts have repeatedly proved overly optimistic: the Fund predicted 0.2% growth for the eurozone in 2013, compared to what is likely to be a 0.4% contraction; and it predicted US growth to reach 2.1%, whereas it now appears to have been closer to 1.6%.

With European leaders wedded to austerity and moving at a glacial pace to address the structural problems stemming from the eurozone’s flawed institutional design, it is no wonder that the continent’s prospects appear so bleak.

But, on the other side of the Atlantic, there is cause for muted optimism. Revised data for the US indicate that real GDP grew at an annual pace of 4.1% in the third quarter of 2013, while the unemployment rate finally reached 7% in November – the lowest level in five years. A half-decade of low construction has largely worked off the excess building that occurred during the housing bubble. The development of vast reserves of shale energy has moved America toward its long-sought goal of energy independence and reduced gas prices to record lows, contributing to the first glimmer of a manufacturing revival. And a booming high-tech sector has become the envy of the rest of the world.

Most important, a modicum of sanity has been restored to the US political process. Automatic budget cuts – which reduced 2013 growth by as much as 1.75 percentage points from what it otherwise would have beencontinue, but in a much milder form. Moreover, the cost curve for health care – a main driver of long-term fiscal deficits – has bent down. Already, the Congressional Budget Office projects that spending in 2020 for Medicare and Medicaid (the government health-care programs for the elderly and the poor, respectively) will be roughly 15% below the level projected in 2010.

It is possible, even likely, that US growth in 2014 will be rapid enough to create more jobs than required for new entrants into the labor force. At the very least, the huge number (roughly 22 million) of those who want a full-time job and have been unable to find one should fall.

But we should curb our euphoria. A disproportionate share of the jobs now being created are low-payingso much so that median incomes (those in the middle) continue to decline. For most Americans, there is no recovery, with 95% of the gains going to the top 1%.

Even before the recession, American-style capitalism was not working for a large share of the population. The recession only made its rough edges more apparent. Median income (adjusted for inflation) is still lower than it was in 1989, almost a quarter-century ago; and median income for males is lower than it was four decades ago.

America’s new problem is long-term unemployment, which affects nearly 40% of those without jobs, compounded by one of the poorest unemployment-insurance systems among advanced countries, with benefits normally expiring after 26 weeks. During downturns, the US Congress extends these benefits, recognizing that individuals are unemployed not because they are not looking for work, but because there are no jobs. But now congressional Republicans are refusing to adapt the unemployment system to this reality; as Congress went into recess for the holidays, it gave the long-term unemployed the equivalent of a pink slip: as 2014 begins, the roughly 1.3 million Americans who lost their unemployment benefits at the end of December have been left to their own devices. Happy New Year.

Meanwhile, a major reason that the US unemployment rate is currently as low as it is, is that so many people have dropped out of the labor force. Labor-force participation is at levels not seen in more than three decades. Some say that this largely reflects demographics: an increasing share of the working-age population is over 50, and labor-force participation has always been lower among this group than among younger cohorts.

But this simply recasts the problem: the US economy has never been good at retraining workers. American workers are treated like disposable commodities, tossed aside if and when they cannot keep up with changes in technology and the marketplace. The difference now is that these workers are no longer a small fraction of the population.

None of this is inevitable. It is the result of bad economic policy and even worse social policy, which waste the country’s most valuable resource – its human talent – and cause immense suffering for affected individuals and their families. They want to work, but the US economic system is failing them.

So, with Europe’s Great Malaise continuing in 2014 and the US recovery excluding all but those at the top, count me dismal. On both sides of the Atlantic, market economies are failing to deliver for most citizens. How long can this continue?

Joseph E. Stiglitz, a Nobel laureate in economics and University Professor at Columbia University, was Chairman of President Bill Clinton’s Council of Economic Advisers and served as Senior Vice President and Chief Economist of the World Bank. His most recent book is The Price of Inequality: How Today’s Divided Society Endangers our Future.

The Single Most Important Chart For Markets Right Now

by James Gruber

on January 12, 2014

Last year, developed market equities were the big winners and if you didn’t have a large dollop of them in your portfolio, you invariably under-performed. Bonds had some of their worst losses in almost two decades while gold had its poorest year since 1981. And shock, horror – the vast majority of analysts and commentators are forecasting more gains for equities and more losses for bonds and gold (the end of their respective bull markets, apparently). Investor flows have been reflecting this advice. So far this year though, things haven’t gone according to plan with bonds and gold bouncing back and stocks under-performing.

Moving beyond price action, one of the most critical issues going forward will be the ongoing battle between inflation and deflation. For five years, central banks have been fighting deflationary forces in order to spur their economies into action again. Deflation is seen as preceding recession or even depression, while inflation has the nice benefit of reducing bloated government debts (inflation leading to depreciating currencies and therefore lower local currency debts). So far, the central banks efforts have met minimal success with a weak economic recovery and disinflation (declining inflation).

There are some signs though that this may be changing. U.S. inflation expectations are ticking up, giving us the first signs that inflation could be around the corner. If this trend continues, it may prove the defining theme for markets in 2014. It would be bullish for stocks, particularly in under-performing markets such as Asia. It would also be negative for bonds and commodities, the latter at least initially. So perhaps analysts could be right after all: that the performance of the various asset classes this year mirrors that of 2013.

Or perhaps not. Count me a continued skeptic of the view that inflation is on the way, at least for now. But it would be wrong to ignore incoming data which is contrary to my view. This newsletter then is an attempt to show some of the key trends which I have my eye on for what’s head for economies and markets.

Rising inflation expectations

The world’s central bankers have fought desperately to prop up economies for the past five years, after the worst downturn (at least, in much of the developed world) since the 1930s. Undoubtedly, their massive doses of stimulus combined with interest rates near zero prevented an even greater downturn. Whether they also prevented a faster recovery will be debated for years to come.

Anyhow, the deflationary forces which preceded the downturn and continue to haunt economies is perceived as enemy number one by these bankers. They’ll do anything to prevent these forces gathering steam.

And they’ve struggled, to this day. Let’s focus on the U.S., the world’s most important economy and market. Here, the monetary base (commercial bank reserves plus total currency in circulation) has exploded more than 4x since the financial crisis, reflecting massive central bank stimulus.

US_monetary_base_since_1918 (1)

The Fed has bought bonds off commercial banks in the hope that these banks would lend the said money to the public

Unfortunately, bank loan growth has been tepid, and trending down of late. That’s indicative of weak demand for debt from consumers.


That’s resulted in money velocity dropping to more than 60 year lows. This means money isn’t changing hands and circulating in the economy. A strengthening economy has rising velocity, or the same quantity of money being used for several transactions.


The U.S. inflation rate itself has reflected the above. Inflation peaked near 4% in 2011 before declining to 1% in November last year, and a minor pick-up to 1.2% in December


The important thing to note is that these charts are all lagging indicators: they tell us what’s happened rather than what’s going to happen.

That brings us to what we consider the most important chart in the world right now: inflation expectations

US inflation expectations

Inflation expectations are measured by the difference between U.S. Treasury yields and Treasury Inflation Protected Securities (TIPS). TIPS are indexed to CPI and as the latter increases, so does the value of TIPS. In other words, you own TIPS as a hedge against inflation.

As you can see from the chart, the spread between the two is rising. What this indicates is that investors are expecting inflation ahead. The chart is crucial because it’s normally a forward looking indicator ie. these expectations filtering through to official inflation statistics. In other words, it’s suggesting that investors see the pace of economic recovery in the U.S. picking up and that filtering through to inflation.

Winners, if the trend holds

The rise in U.S. inflation expectations is consistent with recent market action. Markets are forward-looking and the considerable out-performance of stocks versus bonds in 2013 has been telling us that a U.S. recovery may be gaining hold and inflation is coming.

It’s important to note that inflation expectations and stock market multiples (price-to-earnings multiples) are closely correlated

US expectations key driver of equity multiples

Inflation only becomes bad for equity multiples in the U.S. once it reaches above 4%. More than 6% inflation leads to the more dramatic de-rating of stocks.

  inflation correlation with equities

Therefore, rising inflation without a concomitant rise in interest rates is very bullish for stock markets. Given developed market central banks are pledging to hold interest rates near zero for a considerable period of time, there may be a sweet spot for equities to outperform further.

If bond yields rise sharply, and interest rates with them, that would be negative for stock markets. The first rate hike in the previous six rate cycles in the U.S. has resulted in corrections of 2-9% to the S&P 500.

If the sweet spot of rising inflation expectations and low interest rates continues though, what can we expect from markets? Well, we’ve mentioned that this environment would be bullish for equities. But more specifically, you’re likely to see Asian equities explode higher, substantially outperforming stocks in developed markets. Asia has been a considerable laggard and any global recovery scenario would be very positive for the export-dependent economies in the region (think South Korea, Singapore, Malaysia and China).

Bonds would obviously suffer under this scenario, heralding the end of a huge bull market. Many bond markets haven’t seen such low yields in hundreds of years and therefore the rise in these yields could prove a painful event.

Lastly, commodities are likely to under-perform, at least initially. That’s because rising U.S. yields would result in a higher U.S. dollar, which is normally inversely correlated to commodity prices. However, if inflation really does take off, commodities could increase considerably from current depressed levels.

Why I’m not buying it yet

The question then becomes: do you buy into this scenario? Asia Confidential doesn’t and here’s why:

1) Central bankers and sell-side strategists want us to believe that a normal business cycle is about to ensue after the most extraordinary global stimulus measures, probably in history but certainly since the Great Depression. Normality after grotesquely abnormal central bank policies, in other words. The central bankers themselves have all but admitted that they don’t have a clue about the end-results of their post-crisis policies. I’m betting on more unintended consequences over a return to normality in 2014.

2)  In the debate over inflation versus deflation, I’m still in the latter camp, at least for the next few years. Weak demand and global excess capacity are likely to weigh on inflation. Japan yen depreciation and a China downturn won’t help either.

3) But I could be wrong and if recovery does take hold, serious inflation is likely to follow. All those bank reserves will make their way into economies and money velocity will spike accordingly

Put simply, I’m betting on the unintended consequences of either a deflationary shock (my preference) or conversely serious inflation. Mild inflation from here seems like a central bank (wet) dream.

4) If I’m right about deflation, then over-sold bonds could make a significant comeback and prove the doomsayers (99% of pundits right now) wrong again. But given the risks from current policies, making grand bets on such things is a mugs game and it’s best to diversify your assets (beyond just stocks and bonds) as much as possible at this juncture.

AC Speed Read

Inflation expectations in the U.S. are rising, indicating inflation may be around the corner.

- If that trend continues, stocks are likely to continue to out-perform, but Asia should start to play catch-up to developed market equities.

Asia Confidential isn’t buying into the coming inflation and global recovery thesis. Deflation remains the primary risk in our view.

- If that view is right, bonds could stage a big comeback, defying the doomsayers (99% of pundits) once again.