January 14, 2014 5:06 pm

Failing elites threaten our future

Leaders richly rewarded for mediocrity cannot be relied upon when things go wrong

©Ingram Pinn

In 2014, Europeans commemorate the 100th anniversary of the start of the first world war. This calamity launched three decades of savagery and stupidity, destroying most of what was good in the European civilisation of the beginning of the 20th century. In the end, as Churchill foretold in June 1940, “the New World, with all its power and might”, had to stepforth to the rescue and the liberation of the old”.

The failures of Europe’s political, economic and intellectual elites created the disaster that befell their peoples between 1914 and 1945. It was their ignorance and prejudices that allowed catastrophe: false ideas and bad values were at work

These included the atavistic belief, not just that empires were magnificent and profitable, but that war was glorious and controllable. It was as if a will to collective suicide seized the leaders of great nations.

Complex societies rely on their elites to get things, if not right, at least not grotesquely wrong. When elites fail, the political order is likely to collapse, as happened to the defeated powers after first world war. The Russian, German and Austrian empires vanished, bequeathing weak successors succeeded by despotism. The first world war also destroyed the foundations of the 19th century economy: free trade and the gold standard. Attempts to restore it produced more elite failures, this time of Americans as much as Europeans. The Great Depression did much to create the political conditions for the second world war. The cold war, a conflict of democracies with a dictatorship sired by the first world war, followed.

The dire results of elite failures are not surprising. An implicit deal exists between elites and the people: the former obtain the privileges and perquisites of power and property; the latter, in return, obtain security and, in modern times, a measure of prosperity. If elites fail, they risk being replaced. The replacement of failed economic, bureaucratic and intellectual elites is always fraught. But, in a democracy, replacement of political elites at least is swift and clean. In a despotism, it will usually be slow and almost always bloody.

This is not just history. It remains true today. If one looks for direct lessons from the first world war for our world, we see them not in contemporary Europe but in the Middle East, on the borders of India and Pakistan and in the vexed relationships between a rising China and its neighbours. 

The possibilities of lethal miscalculation exist in all these cases, though the ideologies of militarism and imperialism are, happily, far less prevalent than a century ago. Today, powerful states accept the idea that peace is more conducive to prosperity than the illusory spoils of war. Yet this does not, alas, mean the west is immune to elite failures. On the contrary, it is living with them. But its failures are of mismanaged peace, not war.

Here are three visible failures.

First, the economic, financial, intellectual and political elites mostly misunderstood the consequences of headlong financial liberalisation. Lulled by fantasies of self-stabilising financial markets, they not only permitted but encouraged a huge and, for the financial sector, profitable bet on the expansion of debt. The policy making elite failed to appreciate the incentives at work and, above all, the risks of a systemic breakdown

When it came, the fruits of that breakdown were disastrous on several dimensions: economies collapsed; unemployment jumped; and public debt exploded. The policy making elite was discredited by its failure to prevent disaster. The financial elite was discredited by needing to be rescued. The political elite was discredited by willingness to finance the rescue. The intellectual elite – the economists – was discredited by its failure to anticipate a crisis or agree on what to do after it had struck. The rescue was necessary. But the belief that the powerful sacrificed taxpayers to the interests of the guilty is correct.

Second, in the past three decades we have seen the emergence of a globalised economic and financial elite. Its members have become ever more detached from the countries that produced them. In the process, the glue that binds any democracy – the notion of citizenship – has weakened. The narrow distribution of the gains of economic growth greatly enhances this development. This, then, is ever more a plutocracy. A degree of plutocracy is inevitable in democracies built, as they must be, on market economies. But it is always a matter of degree. If the mass of the people view their economic elite as richly rewarded for mediocre performance and interested only in themselves, yet expecting rescue when things go badly, the bonds snap. We may be just at the beginning of this long-term decay.

Third, in creating the euro, the Europeans took their project beyond the practical into something far more important to people: the fate of their money. Nothing was more likely than frictions among Europeans over how their money was being managed or mismanaged. The probably inevitable financial crisis has now spawned a host of still unresolved difficulties. The economic difficulties of crisis-hit economies are evident: huge recessions, extraordinarily high unemployment, mass emigration and heavy debt overhangs. This is all well known. Yet it is the constitutional disorder of the eurozone that is least emphasised

Within the eurozone, power is now concentrated in the hands of the governments of the creditor countries, principally Germany, and a trio of unelected bureaucracies – the European Commission, the European Central Bank and the International Monetary Fund. The peoples of adversely affected countries have no influence upon them. The politicians who are accountable to them are powerless. This divorce between accountability and power strikes at the heart of any notion of democratic governance. The eurozone crisis is not just economic. It is also constitutional.

None of these failures matches in any way the follies of 1914. But they are big enough to cause doubts about our elites. The result is the birth of angry populism throughout the west, mostly the xenophobic populism of the right. The characteristic of rightwing populists is that they kick down. If elites continue to fail, we will go on watching the rise of angry populists. The elites need to do better. If they do not, rage may overwhelm us all.

Copyright The Financial Times Limited 2014.

The Financial Fire Next Time

Robert J. Shiller

JAN 14, 2014
Newsart for The Financial Fire Next Time

NEW HAVENIf we have learned anything since the global financial crisis peaked in 2008, it is that preventing another one is a tougher job than most people anticipated. Not only does effective crisis prevention require overhauling our financial institutions through creative application of the principles of good finance; it also requires that politicians and their constituents have a shared understanding of these principles.

Today, unfortunately, such an understanding is missing. The solutions are too technical for most news reporting aimed at the general public. And, while people love to hear about “reining in” or “punishingfinancial leaders, they are far less enthusiastic about asking these people to expand or improve financial-risk management. But, because special-interest groups have developed around existing institutions and practices, we are basically stuck with them, subject to minor tweaking.

The financial crisis, which is still ongoing, resulted largely from the boom and bust in home prices that preceded it for several years (home prices peaked in the United States in 2006). During the pre-crisis boom, homebuyers were encouraged to borrow heavily to finance undiversified investments in a single home, while governments provided guarantees to mortgage investors. In the US, this occurred through implicit guarantees of assets held by the Federal Housing Administration (FHA) and the mortgage agencies Fannie Mae and Freddie Mac.

At a session that I chaired at the American Economic Association’s recent meeting in Philadelphia, the participants discussed the difficulty of getting any sensible reform out of governments around the world. In a paper presented at the session, Andrew Caplin of New York University spoke of the public’s lack of interest or comprehension of the rising risks associated with the FHA, which has been guaranteeing privately-issued mortgages since its creation during the housing crisis of the 1930’s.

Caplin’s discussant, Joseph Gyourko of the Wharton School, concurred. Gyourko’s own 2013 study concludes that the FHA, now effectively leveraged 30 to one on guarantees of home mortgages that are themselves leveraged 30 to one, is underwater to the tune of tens of billions of dollars. He wants the FHA shut down and replaced with a subsidized saving program that does not attempt to compete with the private sector in evaluating mortgage risk.

Similarly, Caplin testified in 2010 before the US House Committee on Financial Services that the FHA was at serious risk, a year after FHA Commissioner David Stevens told the same committee that “We will not need a bailout.” Caplin’s research evidently did not sit well with FHA officials, who were hostile to Caplin and refused to give him the data he wanted. The FHA has underestimated its losses every year since, while proclaiming itself in good health. Finally, in September, it was forced to seek a government bailout.

At the session, I asked Caplin about his effort, starting with his co-authored 1997 book Housing Partnerships, which proposed allowing homebuyers to buy only a fraction of a house, thereby reducing their risk exposure without putting taxpayers at risk. If implemented, his innovative idea would reduce homeowners’ leverage. But, while it was a highly leveraged mortgage market that fueled the financial crisis 11 years later, the idea, he said, has not made headway anywhere in the world.

Why not, I asked? Why can’t creative people with their lawyers simply create such partnerships for themselves? The answer, he replied, is complicated; but, at least in the US, one serious problem looms large: the US Internal Revenue Service’s refusal to issue an advance ruling on how such risk-managing arrangements would be taxed. Given the resulting uncertainty, no one is in a mood to be creative.

Meanwhile, there is strong public demandangry and urgent – for a government response aimed at preventing another crisis and ending the problem of “too big to failfinancial institutions. But the political reality is that government officials lack sufficient knowledge and incentive to impose reforms that are effective but highly technical.

For example, one reform adopted in the US to help prevent the “too big to failproblem is the risk retention rule stipulated by the 2010 Dodd Frank Act. In order to ensure that mortgage securitizers have someskin in the game,” they are required to retain an interest in 5% of the mortgage securities that they create (unless they qualify for an exemption).

But, in another paper presented at our session, Paul Willen of the Federal Reserve Bank of Boston argued that creating such a restriction is hardly the best way for a government to improve the functioning of financial markets. Investors already know that people have a stronger incentive to manage risks better if they retain some interest in the risk. But investors also know that other factors may offset the advantages of risk retention in specific cases. In trying to balance such considerations, the government is in over its head.

The most fundamental reform of housing markets remains something that reduces homeowners’ overleverage and lack of diversification. In my own paper for the session, I returned to the idea of the government encouraging privately-issued mortgages with preplanned workouts, thereby insuring them against the calamity of ending up underwater after home prices fall. Like housing partnerships, this would be a fundamental reform, for it would address the core problem that underlay the financial crisis. But there is no impetus for such a reform from existing interest groups or the news media.

One of our discussants, Joseph Tracy of the Federal Reserve Bank of New York (and co-author of Housing Partnerships), put the problem succinctly: “Firefighting is more glamorous than fire prevention.” Just as most people are more interested in stories about fires than they are in the chemistry of fire retardants, they are more interested in stories about financial crashes than they are in the measures needed to prevent them. That is not a recipe for a happy ending.

Robert J. Shiller, a 2013 Nobel laureate in economics, is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of Irrational Exuberance, the second edition of which predicted the coming collapse of the real-estate bubble, and, most recently, Finance and the Good Society.

Markets Insight

January 15, 2014 6:31 am

The only way is up for commodities

Confluence of factors suggests asset class due to turn round

Numerous factors suggest commodity prices are poised for a cyclical recovery this year.

First, commodities have underperformed in the past two years, restoring value to most. Also, artificial and temporary distortions keeping prices overextended have recently been eliminated.

The haven premium embedded in precious metals’ prices since the crisis of 2008 was dissolved in the past year, as demonstrated by the price of gold collapsing from almost $1,900 to about $1,200.

A year ago many agricultural commodity prices were temporarily boosted due to drought conditions that have subsequently reversed. The energy sector experienced a generational surge in pricing just before the contemporary recovery began, leaving it overextended

Most energy prices have been rangebound since 2010, though, restoring some value to this sector. Finally, industrial prices have cheapened considerably in the past two years, weakening once growth among emerging economies slowed.

Second, the biggest challenge facing commodity markets has been weak and spotty global economic growth. Within the US, real GDP growth seems likely to exceed 3 per cent this year and may rival the fastest growth of the economic recovery. Moreover, until recently, economies were either still in contraction (for example, Europe and Japan), experiencing a major recovery slowdown (emerging economies) or growing only slowly (US). Economic growth has strengthened nearly everywhere as we enter 2014, which should produce a better year for commodity investors.

Third, global economic activity has broadened and improved at a time when slack in the US resource markets has lessened. The unemployment rate recently dropped to 6.7 per cent and should near 6 per cent before the year is over. Moreover, the US capacity utilisation rate is set to rise above the 80 per cent level, which historically has been associated with cost-push pressures.

Fourth, as it has since last summer, the US dollar is likely to weaken further this year. A weak US currency directly pushes dollar-based commodity prices higher. It should also improve US exports, boost US manufacturing activity and thereby increase the domestic demand for commodities.

Fifth, indicators suggest money velocity (the rate at which the money supply is turned over via transactions) may rise this year, after declining throughout this recovery. Even though the Federal Reserve has started to taper its quantitative easing programme, should velocity unexpectedly rise it may not be able to taper fast enough to keep growth in the US money supply from accelerating. Moreover, should velocity climb for the first time in this recovery, concerns surrounding overheated economic growth and whether Fed policy was overdone are likely to emerge, and the commodity markets would be major beneficiaries of such fears.

Sixth, commodity prices are already showing some signs of bottoming. Since October, responding to better economic growth, industrial commodity prices have risen about 4 per cent. Indeed, the CRB raw industrial commodity price index recently reached its highest level since April. Moreover, the Baltic freight rate index (a measure of global rates charged to transport materials) has surged since last summer, suggesting international commerce in commodities is strengthening.

Even stocks point to an improvement in the commodity market. The S&P 500 materials sector stock price index has been outpacing the overall stock market since late summer. The relative price of the Dow Jones Transport Index (companies that haul commodities and materials) also just rose to its highest level since mid-2011.

Finally, most investment portfolios remain significantly underweight commodities. A consensus mostly concerned with deflationary potential and weak economic growth shows little interest in an asset class where prices have been on a downward trend for more than three years. Surely commodities in 2014 qualifies as a contrarian play. If the asset class surprises to the upside, many investors will be scrambling to establish at least some minimal position.

The commodity markets are unlikely to return to the secular advance made during the past decade. That era, tied mainly to the evolution of emerging world economies, is probably past. Rather, they simply represent a cyclical investment opportunity for 2014. At a minimum, investors should consider some allocation to commodities if only for diversification. However, a confluence of factors could make commodities one of the best performing asset classes this year.

James W. Paulsen is chief investment strategist at Wells Capital Management, a business of Wells Fargo Asset Management

Copyright The Financial Times Limited 2014.