Hoisington Investment Management – Quarterly Review and Outlook, Third Quarter 2014

John Mauldin

Oct 22, 2014

I featured the thinking of Dr. Lacy Hunt on the velocity of money and its relationship to developed-world overindebtedness and the potential for deflation in this week’s Thoughts from the Frontline, and I thought you’d like to peruse Lacy’s entire recent piece on the subject.

Lacy takes the US, Europe, and Japan one by one, examining the velocity of money (V) in each economy and bolstering the principle, first proposed by Irving Fisher in 1933, that V is critically influenced by the productivity of debt. Then, turning to the equation of exchange (M*V=Nominal GDP, where M is money supply), he demonstrates that we shouldn’t be the least bit surprised by sluggish global growth and had better be on the lookout for global deflation.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington US Treasury Fund (WHOSX).

I am writing this note in a car going to Athens, Texas, where I’ll join Kyle Bass and friends at his Barefoot Ranch for a huge macro fest. October is one of my favorite times of the year to be in Texas, and the ranch is a beautiful venue. I am sure I will have some challenging conversations.

Last night in Chicago I was picked up by Austyn Crites, who drove me downtown in rush-hour traffic, which gave us a lot of time to talk about his current passion, high balloons. I have been fascinated with them for some time, but there hasn’t been a lot of reliable information.

Basically, Google and Facebook are both planning to launch very large helium balloons full of radios and cameras and float them up to 60,000+ feet. The concept is working in several remote locations now. It’s a way to get full wireless internet coverage. With about 40,000 balloons you can blanket the earth. Literally. Full connectivity. Everywhere. Austyn wants to design a new type of balloon and be the manufacturer. It’s tricky as you need a VERY thin balloon envelope (that does not leak) the size of small house in order to get enough payload that high.

But he thinks the final cost of the balloons will fall dramatically and that you might be able eventually to pull off the operation for a billion or so a year (since balloons eventually come down and need to be replaced).

But if you are Google and you get the search revenue from connecting an additional five billion people? Chump change. Same for Facebook. But what if Apple or Samsung want to make it so that their phones are afforded free or very cheap access? A consortium of consumer companies could easily see free wifi as a tool for branding. Current telecoms will have to get in the business to compete.

I kept coming back to the costs and tech issues. There are new things that will have to be invented, but nothing as complex as some of the problems that have already been overcome. They will be rolling out in parts of the world in a few years. Coming to a region near you in 5-10 years. Total game changers. While a hundred other game changers are coming down the tunnel.

Austyn's company’s challenge is to be the little guys who don't know they can't invent a new process that the big guys are working on as well. Can he pull it off? He has the passion and drive. I love meeting young people like him doing their part to change the world. They are everywhere, too. It's why I’m optimistic about the future of the human experiment, if just a tad bearish on governments. You can follow Austyn at his website.

Time to hit the send button, as we are getting close and I don't want to miss a minute. I will report back what I can. Have a great week.

Your dreaming of really, really cheap, ubiquitous connectivity everywhere analyst,

John Mauldin, Editor
Outside the Box

Hoisington Investment Management – Quarterly Review and Outlook, Third Quarter 2014

Faltering Momentum

The U.S. economy continues to lose momentum despite the Federal Reserve’s use of conventional techniques and numerous experimental measures to spur growth.

In the first half of the year, real GDP grew at only a 1.2% annual rate while real per capita GDP increased by a minimal 0.3% annual rate. Such increases are insufficient to raise the standard of living, which, as measured by real median household income, stands at the same level as it did seventeen years ago (Chart 1).

Over the latest five years ending June 30, 2014, real GDP expanded at a paltry 2.2% annual rate. In comparison, from 1791 through 1999, the growth in real GDP was 3.9% per annum. Similarly, real per capita GDP recorded a dismal 1.4% annual growth rate over the past five years, 26% less than the long-term growth rate. A large contributor to this remarkable downshift in economic growth was that in 1999 the combined public and private debt reached a critical range of 250%-275% of GDP. Econometric studies have shown that a country’s growth rate will lose about 25% of its “normal experience growth rate” when this occurs. Further, as debt relative to GDP moves above critical threshold levels, some researchers have found the negative consequences of debt on economic activity actually worsens at a greater rate, thus becoming non-linear. The post-1999 record is consistent with these findings as the U.S. debt-to-GDP levels swelled to a peak as high as 360%, w ell above the critical level noted in various economic studies.  
In terms of growth, it looks as if the second half of 2014 will continue to follow this slow growth pattern. Although all of the data has not yet been reported, it appears that the year-over-year growth in real GDP for the just ended third quarter period is unlikely to exceed the 2.2% pace of the past five years. Economic vigor is absent, and the final quarter of the year looks to be weaker than the third quarter.
Poor domestic business conditions in the U.S. are echoed in Europe and Japan. The issue for Europe is whether the economy triple dips into recession or manages to merely stagnate. For Japan, the question is the degree of the erosion in economic activity. This is for an economy where nominal GDP has been unchanged for almost 22 years. U.S. growth is outpacing that of Europe and Japan primarily because those economies carry much higher debt-to-GDP ratios. Based on the latest available data, aggregate debt in the U.S. stands at 334%, compared with 460% in the 17 economies in the euro-currency zone and 655% in Japan. Economic research has suggested that the more advanced the debt level, the worse the economic performance, and this theory is in fact validated by the real world data.

Falling World Wide Inflation

In this debt-constrained environment, it is not surprising that inflation is receding sharply in almost every major economy, including China. The drop in price pressures in the U.S. and Europe is significant, and the fall in Chinese inflation to 2%, from a peak of nearly 9% in 2008, is notable.
In the latest twelve months, the CPI in the euro currency zone rose a scant 0.3% (Chart 2), the lowest since 2009, while the core CPI increased by 0.7%, near the all time lows for the series. The yearly gain in the U.S. for both core and overall CPI was 1.7%. Since 1958 when the core CPI came into existence, it and the overall CPI have increased at an average annual rate of 3.8% and 3.9%, respectively, over 200 basis points greater than the current rates. Both the overall and core personal consumption expenditures U.S. price indices rose by 1.5% in the twelve months ending August of 2014. Both of these are near the all time lows for their respective series.

The risk of outright deflation in Europe with inflation at such low levels, and the danger of similar developments in the U.S., should not be minimized as inflation has fallen in almost every previous U.S. and European economic contraction. Lower inflation is, in fact, almost as much of a hallmark of recessions as is decreasing real GDP. From peak-to-trough the rate of CPI inflation fell by an average of slightly more than 300 basis points in and around the mild U.S. recessions of 1990-91 and 2000-01. Starting from a much lower point, the CPI in Europe at those same times dropped by an average of 150 basis points. Given that inflation is already so minimal in both the U.S. and Europe, even the mildest recession could put both economies in deflation.

Japan’s recent quantitative easing has helped devalue its currency by 44% versus the dollar, since the 2011 lows. This import- dependent country has therefore seen its costs rise dramatically. This, along with higher consumption taxes, has created a current year- over-year inflation rate of 3.3%. These higher prices are an enormous drag on economic growth as incomes fail to rise commensurately. Thus negative GDP growth will result in a continuing pattern of deflation. Japan’s CPI has been zero or negative on a year-over-year basis in 16 of the last 23 quarters.

Declining Money Velocity A Global Event

One factor that connects poor growth with the low inflation and low bond yields evident in the U.S., Europe and Japan is that the velocity of money (V) is falling in all three areas.
Functionally, many things influence V. The factors that could theoretically influence V in at least some minimal fashion are too numerous to count. A key variable, however, appears to be the productivity of debt. Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then V will rise since GDP will rise by more than the initial borrowing. If the debt is unproductive or counterproductive, meaning that a sustaining income stream is absent, or worse the debt subtracts from future income, then V will fall. Debt utilized for the purpose of consumption or paying of interest, or debt that is defaulted on will be either unproductive or counterproductive, leading to a decline in V.
The Nobel laureate Milton Friedman, as well as economist Irving Fisher, commented on the causal determinants of V. Friedman thought V was stable while Fisher believed it was variable. Presently, the evidence suggests that Fisher’s view has prevailed. Fisher would not be at all surprised by the current impact of excessive debt since he argued in his famous 1933 paper “The Debt-Deflation Theory of Great Depressions”, that falling money velocity is a symptom of extreme over-indebtedness.
Tracking that theory, it is interesting to note that velocity is below historical norms in all three major economic areas with existing over indebtedness. The U.S. V is higher than European V, which in turn is higher than Japanese V. This pattern is entirely consistent since Japan is more highly indebted than Europe, which is more highly indebted than the U.S. Unfortunately, broad monetary conditions (M2 money growth and velocity) are deteriorating, with 2014 displaying conditions worse than at the end of last year. The poor trend in the velocity for all three areas indicates that monetary policy for these countries is not a factor in influencing economic activity in any meaningful way.
United States. The U.S. year-over-year M2 growth has remained at about 6%, an annual growth level that has been consistent since 2008 (Chart 3), and the velocity of money has trended downward by about 3%. In the first half of 2014, V declined at a rate of 3.6%, but it is still too early to tell if this represents a new V deceleration to the downside (Chart 4).

According to the equation of exchange (M*V=Nominal GDP), the expected growth of nominal GDP is constrained to no more than a 3% increase with velocity declining by 3% and money supply expanding by 6%. However, when assessing the type of debt currently being employed (unproductive, at best) the risks are for lower growth levels. 2014 has witnessed a resurgence of consumer auto and mortgage lending that was achieved by a lowering of credit standards. The percentage of subprime consumer auto loans (31%) returned to the peak levels reached prior to 2008. Such lending has historically turned counterproductive. If this were to occur again, velocity would accelerate to the downside, resulting in a sub 3% path for nominal GDP.

Europe. V has only been available in Europe since 1995 as that is the starting date for GDP in the euro-currency zone. During the span from 1995 through 2013, V averaged 1.4, dropping from a peak of about 1.7 in 1995 to 1.03 in 2013 (Chart 5). Over that span, therefore, euro V has been trending lower at about a 2.6% per annum rate. On the money side, euro M2 increased by 2.4% in 2013, which is weaker than the average growth in the last four years (Chart 6). If the trend rate of decline in V remains intact, then nominal GDP in the euro zone could be flat. Inflation of any magnitude would result in a negative real GDP outcome.

Japan. From the start of the comparable M2 and nominal GDP statistics in 1969 in Japan, V in Japan has averaged 1.0, dropping from 1.54 in 1968 to a record low of 0.57 in the latest year (Chart 7). Thus, over this period V was falling at an average rate of 2.2% per annum. M2 in Japan increased 3.6% in 2013, which is slightly higher than the growth rate of recent years (Chart 8). If V’s downward trend remains intact, nominal GDP would be estimated to grow by 1.2%. However, inflation is currently running at 3.3%, suggesting real GDP could decline by over 2% in the next twelve months. This circumstance illustrates the double-edged sword caused by a sharply depreciating currency. The weaker yen boosts exports but raises domestic inflation. Japanese inflation is already exceeding the rise in wages and household spending. These events are consistent with a contraction in economic activity and are the expectation derived from the analysis of money gro wth and its velocity.

Debt Research

Important new research by four distinguished economists (three in Europe and one in the U.S.) is contained in a report titled "Deleveraging? What Deleveraging?" (Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart, Geneva Reports on the World Economy 16, September 2014). It provides additional evidence on the role of “debt dynamics” and the state of the global debt overhang. They write, “Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP is still growing, breaking new highs.” Further, it is a "poisonous combination" when world growth and inflation are lower than expected and debt is rising. “Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former exacerbating the economic slowdown.”

This research also identifies two other highly significant trends. First, global debt accumulation was led by developed economies until 2008. Second, the debt build-up since 2008 has been paced by the emerging economies. The authors write that the rise in Chinese debt is especially “stunning”. They describe China as “between a rock (rising and high debt) and a hard place (lower growth).” In addition to China they identify India, Turkey, Brazil, Chile, Argentina, Indonesia, Russia and South Africa as belonging to the “fragile eight” group of countries that could find themselves in the unwanted role of host to “the next leg of the global leverage crisis.”

We interpret this research to mean that the monetary policy may begin to become ineffective at emerging market central banks, just as has happened in the U.S., Europe and Japan. Weaker growth conditions in the emerging markets are thus likely to accentuate, rather than ameliorate, poor business conditions in the major economies. Indeed, this year’s downturn in global commodity prices is consistent with the beginning of such a phase. The huge jump in emerging market debt is also significant because research has found the severity of economic contractions is directly related to the leverage in the prior expansion.

Asset Bubbles

Historically, in our judgment, the most important authority on the subject of asset bubbles was the late MIT professor Charles Kindleberger, author of 20 books including the one of the greatest books on capital markets Manias, Panics and Crashes (1978). He found that asset price bubbles depend on the growth of credit. Atif Mian (Princeton) and Amir Sufi (University of Chicago) provided confirmation for Kindleberger’s pioneering work and expanded on it in their 2014 book House of Debt. Chapter 8, entitled “Debt and Bubbles,” contains the heart of their insights. Mian and Sufi demonstrate that increasing the flow of credit is extremely counterproductive when the fundamental problem is too much debt, and excessive debt can fuel asset bubbles.

Based on our reading of these two books we would define an asset bubble as a rise in prices that is caused by excess central bank liquidity rather than economic fundamentals. As Kindleberger clearly stated, the process of excess liquidity fueling higher prices in the face of faltering fundamentals can run for a long time, a phase Kindleberger called “overtrading”. But eventually, this gives way to “discredit”, when the discerning few see the discrepancy between prices and fundamentals. Eventually, discredit yields to “revulsion”, when the crowd understands the imbalance, and markets correct.

Economists have commented on the high correlation between the S&P 500 and the Fed’s balance sheet since 2009. From 2009 to the latest available month, the monetary base (MB) surged from $1.7 trillion to $4.1 trillion. We ran the MB increase against the S&P 500 and found a very high correlation of 0.69. While correlation does not prove causality, the high correlation is certainly not inconsistent with the idea that the Fed liquidity played a major role in boosting stock prices. However, even as the MB has exploded since 2009 and stock prices have soared, the U.S. economy has experienced the worst economic expansion on record. In spite of a further large rise in the base this year, the GDP growth has subsided noticeably and corporate profits after taxes and adjusted for inventory gains/losses (IVA) and over/under depreciation (CCA) has declined 10% in the latest four quarters. Such discrepancy between the liquidity implied by the base and measures of econ omic performance could indicate the process of bubble formation. Kindleberger’s axiom that asset price bubbles depend on excess liquidity may yet face another test.
Still Bullish on Treasury Bonds

With the nominal growth trajectory extremely soft, U.S. Treasury bond yields are likely to continue working lower as similar circumstances have created declines in government bond yields in Europe and Japan. Viewing the yields overseas, it is evident that ample downside still exists for long U.S. Treasury bond yields, as the higher U.S. yields offer global investors an incentive to continue to move funds into the United States.

Another factor suggesting lower long- term U.S. Treasury yields is the strength of the U.S. dollar. In many industries, the price leader for certain goods in the U.S. is a foreign producer. A rising dollar leads to what economists sometimes call the “collapsing umbrella”. As the dollar lifts, the foreign producer cuts U.S. selling prices, forcing domestic producers to match the lower prices. This reinforces the prospect for lower inflation as nominal GDP wanes. This creates a favorable environment for falling U.S. Treasury bond yields.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

The euro zone

The world’s biggest economic problem

Deflation in the euro zone is all too close and extremely dangerous

Oct 25th 2014

THE world economy is not in good shape. The news from America and Britain has been reasonably positive, but Japan’s economy is struggling and China’s growth is now slower than at any time since 2009. Unpredictable dangers abound, particularly from the Ebola epidemic, which has killed thousands in West Africa and jangled nerves far beyond. But the biggest economic threat, by far, comes from continental Europe.

Now that German growth has stumbled, the euro area is on the verge of tipping into its third recession in six years. Its leaders have squandered two years of respite, granted by the pledge of Mario Draghi, the European Central Bank’s president, to do “whatever it takes” to save the single currency. The French and the Italians have dodged structural reforms, while the Germans have insisted on too much austerity. Prices are falling in eight European countries.

The zone’s overall inflation rate has slipped to 0.3% and may well go into outright decline next year. A region that makes up almost a fifth of world output is marching towards stagnation and deflation.

Optimists, both inside and outside Europe, often cite the example of Japan. It fell into deflation in the late-1990s, with unpleasant but not apocalyptic consequences for both itself and the world economy. But the euro zone poses far greater risks. Unlike Japan, the euro zone is not an isolated case: from China to America inflation is worryingly low, and slipping. And, unlike Japan, which has a homogenous, stoic society, the euro area cannot hang together through years of economic sclerosis and falling prices. As debt burdens soar from Italy to Greece, investors will take fright, populist politicians will gain ground, and—sooner rather than later—the euro will collapse.

This parrot has ceased to be
Although many Europeans, especially the Germans, have been brought up to fear inflation, deflation can be still more savage. If people and firms expect prices to fall, they stop spending, and as demand sinks, loan defaults rise. That was what happened in the Great Depression, with especially dire consequences in Germany in the early 1930s.

So it is worrying that, of the 46 countries whose central banks target inflation, 30 are below their target. Some price falls are welcome. Tumbling oil prices, in particular, have given consumers’ incomes a boost. But slowing prices and stagnant wages owe more to weak demand in the economy and roughly 45m workers are jobless in the rich OECD countries. Investors are starting to expect lower inflation even in economies, such as America’s, that are growing at reasonable rates. Worse, short-term interest rates are close to zero in many economies, so central banks cannot cut them to boost spending. The only ammunition comes from quantitative easing and other forms of printing money.

The global lowflation threat is a good reason for most central banks to keep monetary policy loose. It is also, in the longer term, a prompt to look at revising inflation targets a shade upwards. But the immediate problem is the euro area.

Continental Europe’s economy has plenty of big underlying weaknesses, from poor demography to heavy debt and sclerotic labour markets. But it has also made enormous policy mistakes. France, Italy and Germany have all eschewed growth-enhancing structural reforms.

The euro zone is particularly vulnerable to deflation because of Germany’s insistence on too much fiscal austerity and the ECB’s timidity. Even now, with economies contracting, Germany is still obsessed with deficit reduction for all governments, while its opposition to monetary easing has meant that the ECB, to the obvious despair of Mr Draghi, has done far less than other big central banks in terms of quantitative easing (notwithstanding this week’s move to start buying “covered bonds”).

If there was ever logic to this incrementalism, it has run out. As budgets shrink and the ECB struggles to convince people that it can stop prices slipping, a descent into deflation seems all too probable. Signs of stress are beginning to appear in both the markets and politics. Bond yields in Greece have risen sharply, as support for the left-wing Syriza party has surged. 

France and Germany are trading rhetorical blows over a new budget proposal coming out of Paris.

Joining the bleedin’ choir invisible
If Europe is to stop its economy getting worse, it will have to stop its self-destructive behaviour. The ECB needs to start buying sovereign bonds. Germany’s chancellor, Angela Merkel, should allow France and Italy to slow the pace of their fiscal cuts; in return, those countries should accelerate structural reforms. Germany, which can borrow money at negative real interest rates, could spend more building infrastructure at home.

That would help, but not be enough. It is a bit like the early years of the euro debacle, before Mr Draghi’s whatever-it-takes pledge, when half-solutions only fed the crisis. Something radical is needed. The hitch is that European law bans many textbook solutions, such as ECB purchases of newly issued government bonds. The best legal option is to couple a dramatic increase in infrastructure spending with bond-buying by the ECB.

Thus the European Investment Bank could launch a big (say €300 billion, or $383 billion) expansion in investments such as faster cross-border rail links to more integrated electricity grids—and raise the money by issuing bonds, which the ECB could buy in the secondary market. Another possibility would be to redefine the EU’s deficit rules to exclude investment spending, which would allow governments to run bigger deficits, again with the ECB providing a backstop.

Behind all this sits a problem of political will. Mrs Merkel and the Germans seem prepared to take action only when the single currency is on the verge of catastrophe. Throughout Europe people are hurting—in Italy and Spain youth unemployment is above 40%. Voters vented their fury with the established order in the EU’s parliamentary elections earlier this summer, and got very little change. Another descent into the abyss will test their patience. And once deflation has an economy in its jaws, it is very hard to shake off. Europe’s leaders are running out of time.

Oil slump leaves Russia even weaker than decaying Soviet Union

Russia had the chance at the end of the Cold War to build a modern, diversified economy, with the enthusiastic help of the West. That chance has been squandered

By Ambrose Evans-Pritchard

8:48PM BST 22 Oct 2014

.A woman walks past posters showing Russian President Vladimir Putin reading
A woman in Belgrade walks past posters showing Russian President Vladimir Putin and featuring the words "Welcome, President" Photo: AFP

It took two years for crumbling oil prices to bring the Soviet Union to its knees in the mid-1980s, and another two years of stagnation to break the Bolshevik empire altogether.
Russian ex-premier Yegor Gaidar famously dated the moment to September 1985, when Saudi Arabia stopped trying to defend the crude market, cranking up output instead. "The Soviet Union lost $20bn per year, money without which the country simply could not survive," he wrote.
The Soviet economy had run out of cash for food imports. Unwilling to impose war-time rationing, its leaders sold gold, down to the pre-1917 imperial bars in the vaults. They then had to beg for "political credits" from the West. That made it unthinkable for Moscow to hold down eastern Europe's captive nations by force, and the Poles, Czechs and Hungarians knew it.
"The collapse of the USSR should serve as a lesson to those who construct policy based on the assumption that oil prices will remain perpetually high. A seemingly stable superpower disintegrated in only a few short years," he wrote.
Lest we engage in false historicism, it is worth remembering just how strong the USSR still seemed.

It knew how to make things. It had an industrial core, with formidable scientists and engineers.

Vladimir Putin's Russia is a weaker animal in key respects, a remarkable indictment of his 15-year reign. He presides over a rentier economy, addicted to oil, gas and metals, a textbook case of the Dutch Disease.
The IMF says the real effective exchange rate (REER) rose 130pc from 2000 to 2013 during the commodity super-cycle, smothering everything else. Non-oil exports fell from 21pc to 8pc of GDP.

"Russia is already in a perfect storm," said Lubomir Mitov, Moscow chief for the Institute of International Finance. "Rich Russians are converting as many roubles as they can into foreign currencies and storing the money in vaults. There is chronic capital flight of 4pc to 5pc of GDP each year but this is no longer covered by the current account surplus, and now sanctions have caused foreign capital to turn negative, too."
"The financing gap has reached 3pc of GDP, and they have to repay $150bn in principal to foreign creditors over the next 12 months. It will be very dangerous if reserves fall below $330bn," he said. 
"The benign outcome is a return to the stagnation of the Brezhnev era [Застой in Russian] in the early 1980s, without a financial collapse. The bad outcome could be a lot worse," he said.

Mr Mitov said Russia is fundamentally crippled. "They have outsourced their brains and lost their technology. The best Russian engineers go to work for Boeing. The Russian railways are run on German technology. It looked as if Russia was strong during the oil boom but it was an illusion and now they are in an even worse position than the Soviet Union," he said.
The Saudi drama of 1985 has powerful echoes today. We do not know exactly why the Saudis decided to drive down the oil price, though they were clearly frustrated by OPEC cheating, and needed extra revenue themselves.
Ronald Reagan biographer Paul Kengor says the chief motive was to nurture their strategic alliance with Washington, doing a favour for the US at an inflexion point in the Cold War. The former President's son, Michael Reagan, makes the same claim. "My father got the Saudis to flood the market with cheap oil," he said. The plans were allegedly hatched by CIA Director William Casey. 
By then President Reagan was spending 6.6pc of GDP on defence and building his 15 aircraft carrier battle groups (never quite achieved), inviting ruinous attempts by the USSR to keep up.
The "Reagan Doctrine" twisted the knife further by backing guerrilla insurgencies against Soviet client states: in Afghanistan, Nicaragua and Angola, among others. The Pentagon’s rule of thumb was that it cost Moscow 10 times as much to defend these regimes as it cost Washington to take pot shots. Hawk anti-aircraft missiles were cheap. Soviet MIG 24 helicopters were expensive.
The Saudis were again helpful. They bankrolled the Nicaraguan Contras when House Democrats cut off funding, quietly paying for an off-books operation by US intelligence. The go-between was Prince Bandar bin Sultan, then Saudi ambassador in Washington.
This is the same Prince Bandar - later head of the Saudi secret service - who spent four hours with Mr Putin last year at his dacha outside Moscow. A transcript of their talk was leaked by the Kremlin, in order to embarrass Riyadh. It suggests that the prince offered Russia a deal to carve up global oil and gas markets, but only if it sacrificed Syria’s Assad regime. He purported to speak with the full backing of Washington.
While nothing came of the meeting, it gives a glimpse into the raw geopolitics of oil. It explains why they think the worst in Moscow today as the Saudis cheerfully shrug off a 24pc plunge in Brent crude prices since June. "This is political manipulation, and Saudi Arabia is being manipulated, which could end badly," said Mikhail Leontyev from Russia's oil arm, Rosneft.

Events never repeat themselves. The Saudis lack the spare capacity these days to dictate prices with 1980s panache. They have their own pain threshold. Their welfare blitz since the Arab Spring has run to $130bn. The Shia minority in the Eastern Province has a score to settle, and they are sitting on the giant oil fields.
Brent oil has settled at around $85 a barrel. Deutsche Bank said the "break-even price" for the Saudi budget is $99, rising to $100 for Russia and Oman, $126 for Nigeria, $136 for Bahrain and $162 for Venezuela. There is a widely-held view that the Saudis are bluffing in order to force the rest of OPEC to agree to output cuts. If so, we will find out in November.
What is clear is that the Saudis can withstand two or even three years at the current price by dipping into their $745bn foreign exchange reserves. This would have the added bonus (for them) of chilling fresh shale ventures, and perhaps killing some deep water forays in the Atlantic.
Whatever the Saudi motive, Russia is already reeling. The central bank governor Elvira Nabiulina told the Duma last week that plans are afoot to cope with a protracted slide in oil prices to $60. "We are working on a stress scenario, an emergency scenario so to speak," she said.
Moody's said the central bank has burned through $60bn of foreign reserves since the end of last year propping up companies starved of dollar liquidity. The total has dropped to $396bn on its estimates (leaving aside the Reserve Fund) and is becoming a sovereign credit risk.
This time Russia is not facing Reaganesque rearmament, but it is facing nuclear-tipped sanctions, more destructive than many realise in a globalised banking system. It is not a stretch to say that American regulatory power has never been so far-reaching, or imperial. The result is that Russian banks, companies and state bodies are shut out of the global capital markets, unable to roll over $720bn of external debt.
Russia's reserves of cheap crude in West Siberian fields are declining, yet the Western know-how and vast investment needed to crack new regions have been blocked. Exxon Mobil has been ordered to suspend a joint venture in the Arctic. Fracking in the Bazhenov Basin is not viable without the latest 3D seismic imaging and computer technology from the US. China cannot plug the gap.
Andrey Kuzyaev, head of Lukoil Overseas, said it costs $3.5m to drill a 1.5 km horizontal well-bore in the US, and $15m or even $20m to drill the same length in Russia. "We're lagging by 10 years.

Our traditional reserves are being exhausted. This is the reality for our country," he said.
Lukoil warns that Russia could ultimately lose a quarter of its oil output if the sanctions drag for another two or three years.
The IMF's latest "Article IV" report on Russia is an acid verdict on the Putin era. Product market barriers are the worst of any large country in the world. The economy is a tangle of bottlenecks. Russia's development model has "reached its limits".
For details, try the World Economic Forum's index of competitiveness. Russia ranks 136 for road quality, 133 for property rights, 126 for the ability of firms to absorb technology, 124 for availability of the latest technology, 120 for the burden of government regulation, 119 for judicial independence, 113 for the quality of management schools, 107 for prevalence of HIV, 105 for product sophistication, 101 for life expectancy and 56 for quality of maths and science education. This is the profile of decline.
Russia had a window of opportunity at the end of the Cold War to build a modern, diversified economy, with the enthusiastic help of the West, before the ageing crisis hit and the workforce began shrink by 1m a year. This chance has been squandered. Mr Putin's rash decision to pick a fight with the democratic world has made matters infinitely worse. Cheap oil could prove to be the death knout. 

Up and Down Wall Street

Do the Fed's Forecasts Get Marked to Market?

Yellen & Co. forecast bigger rate hikes than futures contracts. Will they finally be right?

By Randall W. Forsyth           

September 17, 2014

"Don't fight the Fed" is one of the oldest adages on Wall Street. But the financial markets remain at odds with the central bank's own projections for interest rates.
To little surprise of the markets, the Federal Open Market Committee Wednesday reaffirmed its intention that short-term interest rates would remain ultralow for a "considerable time," a bit of verbiage that some observers thought could be excised from the panel's policy statement.
But given the FOMC still saw "significant underutilization of labor resources" even job market conditions "improved somewhat further" since its last get-together in July, the panel kept policy on its glide path. That meant further tapering of its asset purchases, to $15 billion a month, with completion slated after the October confab.
Despite the FOMC's retention of the "considerable time" expectation for ultralow short-term rates, the various Fed officials' projections for the key federal-funds rate targets for the end of 2015 and 2016 were nudged up since their set of forecasts were released following the June meeting.
The median projection for the fed-funds target for the end of next year was 1.38%, up from 1.13% three months ago, according to the "dot plot" from the graph of the individual Fed officials' rate expectations. For end-2016, their median projection is 2.88%, up from 2.50% previously.
While still ultralow by historical standards, those rates are considerably higher than what the fed-funds futures market is pricing in. The December 2015 contract implicitly says the funds rate will average 0.775%—some 60 basis points (0.6 percentage points) less than the Fed officials' median expectation.
Given that the fed-funds rate is starting near absolute zero (technically, 0-0.25%), where it's stood since the nadir of the financial crisis in December 2008, 60 basis points is a significant difference of opinion.
For December 2016, the fed-funds futures contracts are discounting a funds target of 1.86%—more than 100 basis points lower than the Fed solons. Lengthier fed-funds futures contracts tend to be relatively lightly traded, however. The December 2016 is pricing in a three-month Libor (London interbank offered rate) of 2.225%, which would be consistent with an overnight funds rate of just under 2%, but close enough to what the fed-funds futures are saying.
A recent paper from the San Francisco Fed highlighted the difference between the expectations of the FOMC and the markets. "The public might not give enough weight to how dependent the central bank's guidance is on both current and incoming data," the researchers wrote.
Fed Chair Janet Yellen repeatedly made this point in her post-meeting press conference, as colleague Michael Aneiro detailed. The discrepancy between the expectations of Fed and the market, she observed, may have to do with the latter's different views on the economy.
While the FOMC shaved its "central tendency" of forecasts of gross domestic product for 2014—to a range of 2.0%-2.2% from 2.1%-2.3% previously—that mainly was to reflect the revisions of data already reported,, first quarter's weather-related 2.1% annual rate of contraction. The predictions for the next two years, which are far more important, were adjusted slightly . For 2015, the forecast was trimmed, to 2.6%-3.0% from 3.0%-3.2%. Meanwhile, the range for 2016 was tightened to 2.6%-2.9% from 2.5%-3.0%, leaving the midpoint of the forecast essentially unchanged.
As for unemployment, the FOMC trimmed its projections, again to mark them down in line with the sharper-than-expected decline this year. From a range of 6.0-6.1% for 2014, it sees the jobless rate dipping to 5.4%-5.6% in 2015 (from 5.4%-5.7% previously) and 5.1%-5.4% in 2016 (from 5.1%-5.5% previously). Moreover, that means the unemployment rate will be at or near to the FOMC's "longer run" projection of 5.2%-5.5%sometime in the next two years.
Inflation, meanwhile, is projected to remain well contained, below the Fed's 2% target for the next two years. That forecast got some bolstering with the drop in the consumer price index in July, the first in almost one and a half years, of 0.2%. On a year-on-year basis, the CPI is up 1.7%.
Even so, two FOMC members—Richard Fisher and Charles Plosser, respectively presidents of the Dallas and Philadelphia district banks, both dissented from the decision. Fisher thought an earlier first fed-funds rate hike was warranted by the economy while Plosser reiterated his dissent that the "considerable period" phrase was "time dependent" and didn't reflect the economy's recovery.
But the futures market is casting its dissent in the other direction—that the Fed officials are wrong in expecting faster and bigger rate hikes. That would seem to be a reflection of the markets' recognition that the Fed's forecasts for economic growth have proved mostly too optimistic.
Thus, the central bank thinks the U.S. economy is on a path for sustainable 3% growth while the futures market thinks it remains in its "New Normal" path around 2%. The latter seems okay with the stock market as the major averages edged up, with the Dow Jones Industrial Average ending at another record.
The market is implicitly betting the forecasting abilities of Yellen & Co. haven't improved. If so, better to watch what the Fed does than what it says it will do.

The dangers of deflation

The pendulum swings to the pit

Politicians and central bankers are not providing the world with the inflation it needs; some economies face damaging deflation instead

Oct 25th 2014

IT IS a pernicious threat, all the more so because, at its onset, it seems almost benign. After two generations of fighting against inflation, why be worried if the victory looks just a bit too complete, if the ancient enemy is so cowed as to no longer strain against the chains in which it is bound? But the stable low inflation fought for in the 1980s and 1990s and inflation hazardously close to zero are not so far apart. And as inflation drops, slipping into deflation becomes ever easier. It is in that dangerous position that the world now stands.

In America, Britain and the euro zone central banks have a 2% target for inflation. In all three, it is below that target. In Italy, Spain and Greece, which have experienced wrenching crises and recessions, it is below zero (as it also is in Sweden and Israel). Japan, which finally escaped from deflation in 2013 after more than a decade of struggle, is battling not to return. Leave out the effects of a consumption-tax increase and inflation there is barely half way to its 2% target. Even in China inflation is below 2%, compared with a 4% central government target (see chart 1).

The lowflation of being consistently below an already low target is bad in itself; the deflation it could easy lead to is even worse. There are several reasons.

The belief that money made tomorrow will be worth less than money today stymies investment; the belief that goods bought tomorrow will be cheaper than goods bought today chokes consumption. Central bankers can no longer set real (that is, inflation-adjusted) interest rates low enough to restore demand. Wages, incomes and tax revenue all stall, undermining the ability of households, businesses and governments to pay their debts—debts which, in real terms, will grow more burdensome under deflation.

The threat is especially acute because central banks in much of the rich world have already lowered their interest rates to zero. Alternative paths to stimulate spending, such as fiscal policy, are blocked by politicians seeking to look tough. Increasing anxiety about this was a central factor in the plunge in equities, bond yields and commodity prices which shook markets in the week that began October 13th.

The perversity of the low-inflation world is shown by the fact that the catalyst for the latest deflation scare is in itself a largely positive development. The price of a barrel of oil has fallen from $115 at the end of June to about $85 today, prompting a sharp drop in headline inflation (core inflation, which excludes energy, is not quite as low). Across the board lower commodity prices will knock another 0.4 percentage points off global inflation in coming months, according to J.P. Morgan.

This poses problems for various oil exporters but for oil importers it is tantamount to a gigantic tax cut. An IMF rule of thumb has it that a $20 drop in the oil price adds about 0.4 percentage points to global growth.

A descent into the maelstrom
But let joy be confined. The drop in oil prices is in part due to higher supply, but it is also the product of slowing growth around the world. China’s slackened appetite for raw materials has hit emerging-market commodity suppliers particularly hard. And an energy-induced drop in prices, though good for consumer purchasing power, risks reinforcing expectations of lower inflation overall; it is part of the threat’s pernicious nature that such expectations easily become self-fulfilling.

In recent months investors have lost faith in either the ability or the will of central banks to get inflation rates back up. The inflation rate they expect can be inferred by looking at derivatives contracts linked to inflation or by subtracting the yields of inflation-indexed bonds from yields on ordinary, nominal, bonds. The spread represents expected inflation in coming years.

Both measures are subject to other influences, too, like the level of liquidity in the markets; such factors probably explain some wild fluctuations of the expected rate during the recent market turmoil. Look beyond such volatility, though, and there is a steady pattern: inflation expectations in America, Europe and Japan have been on the slide since the summer (see chart 2).

In Europe, expected inflation in five years’ time has dropped from 2.1% in July to 1.82%, well below the 2% inflation target set by the European Central Bank. It was this drop that prompted Mario Draghi, the president of the ECB, to promise in August that the bank would “use all the available instruments” to get it back up.

Inflation in the euro zone promptly slipped further, to 0.3% in September, and though that may have been largely due to oil, core inflation at 0.8% remains uncomfortably low. The IMF recently put the odds of deflation in the euro zone—defined as two quarters of falling prices in a 12-month span—at 30% in the coming year.

A short spell of deflation driven by cheaper oil would in some circumstances be a tolerable thing. Indeed there are times when deflation can be a symptom of encouraging underlying developments. It can, for example, be brought about when advancing productivity enables the economy to produce more goods and services at lower cost, raising consumers’ real incomes.

There were several such periods of “good deflation” while the world was on the gold standard; with growth in the money supply constrained, prices were pushed down whenever the volume of output grew rapidly. Michael Bordo and Andrew Filardo, two economic historians, point to America’s 1880s as a period of “good deflation”, with output rising by 2% to 3% a year from 1873 to 1896. For all the aggregate benefit, though, falling real wages hurt workers in many sectors.

By contrast bad deflation results when demand runs chronically below the economy’s capacity to supply goods and services, leaving an output gap. That prompts firms to cut prices and wages; that weakens demand further. Debt aggravates the cycle: as prices and incomes fall, the real value of debts rise, forcing borrowers to cut spending to pay down their debts, which ends up making matters worse. This pathology did great harm during America’s Great Depression, which was when Irving Fisher, an economist, diagnosed it under the name “debt deflation”.

Deflation in Germany at the same time, though eclipsed in the common memory by the damage done by the hyperinflation of the 1920s, caused a number of multiple bank collapses. The resulting unemployment, wage cuts, and credit crunch helped radicalise workers and fed support for the Nazis.

The premature burial
What swings one way swings back the other. Memories of the 1930s lent an inflationary bias to fiscal and monetary policy in the years after the second world war that helped bring about the collapse of fixed exchange rates in the 1970s. It then took decades to squeeze unacceptable levels of inflation out of the system. Deflation disappeared from the memories and concerns of policymakers—until Japan slipped into deflation in the late 1990s as a collapsed property bubble left the banking system choking with bad debt.

One of the lessons of Japan’s deflation is that it took economists by surprise. During the run-up economists expected merely to see low inflation, not deflation—just as they do today. They could be wrong again. Even if they are not, the problems of low inflation are quite similar to, if not as severe as, those of deflation proper.

Firms hit with weak sales often adjust by freezing nominal wages and allowing higher prices to restore profits. That is, they cut real wages. If prices aren’t rising, that won’t work. Cutting nominal wages is hard, so firms may sack workers instead. A recent staff paper by the Federal Reserve Bank of San Francisco argues this wage stickiness hampered American firms’ ability to adjust costs during the last recession, probably exacerbating unemployment. Mr Draghi argues that wage stickiness explains why unemployment got so much worse in Spain, where until recently wages were relatively rigid, than in Ireland.

This points to another problem. For the euro zone, lowflation overall means genuine deflation for the weakest. Countries in the periphery need to redress their loss of competitiveness against the core—which is to say, Germany. Since they can’t devalue, their prices and wages must rise more slowly. If Germany’s inflation is already quite low—it stands today at 0.8%—wages and prices have to fall outright in the periphery. This is indeed what is happening in Spain, Italy and Greece.

Like deflation, lowflation raises the burden of private debt; incomes grow more slowly than firms, consumers and governments expected when they took out their loans. This may cause firms to reduce investment and households to trim their spending. “This is fertile ground for a pernicious negative spiral, which then also affects expectations,” Mr Draghi noted in May. As for governments, the IMF has studied four previous episodes of lowflation—Italy in 1912, Switzerland in 1996 and 2001, and Japan in 1986—and found on average they boosted public debt to GDP ratios by 1.25 percentage points per year.

This is not a good time for such boosts. Since the financial crisis struck in 2008 the world has become more leveraged; total public and private debt reached 272% of developed-world GDP in 2013, according to a report put out under the aegis of the Geneva Reports on the World Economy.

Household debt may no longer be as high as it was in Britain and America, but governments have taken up the slack. In those countries, where governments can print their own money, this does not raise solvency concerns, and in the euro zone, where they cannot, public debt has risen less than in Britain and America. But again that overall figure masks differences within the group. Debt has gone down in Germany, but it has risen sharply in the periphery.

These debts are bearable so long as governments can borrow at their current, low rates—2.5% in Italy, 2.2% in Spain. But if deflation sets in and nominal GDP stagnates they will become unsustainable. Investors will insist on much higher interest rates, debt will spiral upward and fears of default will fulfil themselves. As Peter Berezin of the Bank Credit Analyst, a forecast journal, says, the ECB can help a country that’s illiquid, but not one that’s insolvent. “It’s why Greece defaulted and ECB was helpless to do anything about it.”

Loss of breath
The most troubling effect of low inflation is on monetary policy. Central banks stimulate spending by reducing the real interest rate, which is the nominal interest rate minus the rate of inflation. This boosts investment and discourages saving, reducing the output gap. The real rate required to raise demand enough to balance investment and saving is called the equilibrium real rate.

When demand is weak, the equilibrium real rate may be negative, and under low inflation it is difficult for a central bank to set a nominal rate that brings this about. And because nominal rates are in practice never less than zero (you can always just keep money in cash) deflation proper makes a negative real rate not just hard but arithmetically impossible: subtract a negative number (the inflation rate, in circumstances of deflation) from a number that has to be zero or higher and you always get something positive.

While economists disagree on the current level of the equilibrium real rate, they broadly agree it is lower than in the past. According to a widely followed methodology developed by Thomas Laubach and John Williams of the Federal Reserve, America’s equilibrium real rate fell from above 4% in the 1960s, to 2% in the 1990s, and is now slightly negative. Markets seem to share that verdict. Andy Haldane, the Bank of England’s chief economist, recently noted that British markets expect real rates to remain negative for the next 40 years, probably a good approximation of the expected equilibrium real rate.

This long term difficulty in matching savings and investment has been attributed to “secular stagnation”, a term coined by Alvin Hansen in the 1930s to describe the inability of the American economy to return to full employment. Those using it to describe today’s woes see it as having come about in part as a response to the recent global crisis, which made firms and households less able or willing to borrow at any given interest rate, and in part as the result of longer term trends.

Since 2008 corporate investment in America, the euro zone and Japan has fallen short of cashflow, notes ISI Group, an investment-research provider, making firms net savers rather than borrowers.

This reflects both subdued expectations about near term sales and a more deep seated belief that, as populations age, markets will shrink and good opportunities for investment will become rare. Rising inequality may aggravate the process: the rich save more than the poor. Efforts by emerging markets to hold down their currencies and plough the resulting trade surpluses into rich-world bond markets do further harm.

Secular stagnation makes low inflation more costly because it lowers the real interest rate necessary to achieve full employment. Larry Summers of Harvard University argues that there is no possible nominal interest rate that could balance investment and saving at today’s inflation rates. It also makes lowflation and deflation more likely: the lack of demand further depresses prices and wages.

This makes it all the more urgent that central banks get inflation back up. But the markets do not think they can or will: hence those falling inflation-rate expectations. Michael Pond of Barclays points out that, when America’s core inflation has stayed at just 1.5% despite three rounds of quantitative easing (QE) putting trillions of newly created dollars into the financial system, it is easy to understand why the markets might think that way.

But markets may be selling central banks short. Japan’s multi-front attack on deflation was yielding results until a second-quarter tax increase set the economy back. The Fed’s QE and zero-rate policy have helped pull unemployment below 6% and kept inflation from falling further in the face of deflationary headwinds.

The ECB has put its hopes in targeted loans to banks, purchases of covered bonds that began on October 20th and purchases of asset-backed securities that are yet to start. Those efforts have yet to change the market’s psychology by much, in part because they will not significantly expand the ECB’s balance-sheet, which has been shrinking as banks pay off previous loans. Investors associate larger central-bank balance sheets with a greater commitment to lifting up inflation.

If that doesn’t work, the ECB could directly buy corporate bonds. There is €1.1 trillion ($1.4 trillion) of non-financial corporate debt and €7.8 trillion of financial corporate debt outstanding. Buying up some of this debt would allow a significant expansion of the ECB’s balance-sheet. The next step would then be purchases of government bonds. The German government and the country’s central-bank chief, Jens Weidmann, remain deeply opposed to such steps, but that opposition could melt in the face of euro-zone-wide deflation. Whether QE would work, though, is another matter. “If it didn’t work for the Fed, why should it work for the ECB?” Mr Pond imagines pessimistic investors asking themselves.

If European QE were to help, one of the ways in which it would do so would be by pushing the euro lower. Having watched the Fed weaken the dollar and push up the euro through its own QE, “the ECB thinks, ‘Now it’s our turn’,” says Elga Bartsch of Morgan Stanley. That in turn will make the Fed’s job harder; the dollar’s recent rise will nudge inflation a bit lower.

Fed officials will confront that issue when they meet on October 28th. They have already said they plan to bring QE, now running at $15 billion a month, to an end. That robs them of one tool with which to weaken the dollar and convey their determination to get inflation back up. Instead, they will have to rely on forward guidance—promising if necessary to leave interest rates at zero for a year or more.

That job has been complicated by suspicions that the Fed considers 2% a ceiling rather than a target. In their own projections, almost no Fed policymaker expects inflation to top 2%, and many think it will fall short in the next few years. A more explicit verbal commitment that inflation could exceed 2% might dispel suspicions that the Fed will tighten as soon as it approaches that level.

The constraints on monetary policy have shifted attention to fiscal policy. One radical way to boost demand and push inflation back up takes its name from a tongue-in-cheek prescription for ending deflation offered by Milton Friedman: drop money from helicopters.

In the modern variant this “helicopter money” would consist of governments initiating significant new spending, perhaps on infrastructure, or cutting taxes, and the central bank buying the bonds used to finance the resulting deficit. If the central bank promises never to get rid of those bonds, then neither the public nor investors need worry about how the money gets repaid.

Willem Buiter of Citigroup thinks this would be a “no-brainer” for America, which badly needs better public infrastructure and which can issue virtually unlimited volumes of treasury bills thanks to the dollar’s reserve currency status. In Europe, Mr Buiter says, the equivalent would be for the EU to permit peripheral countries to run larger deficits with the ECB independently initiating QE to buy the resulting bonds. Peripheral countries would have to commit to structural reforms that raise their long-term growth rate and thus their ability to support more borrowing.

Although the economics of such schemes are straightforward, the politics are anything but.

Governments remain fixated on reining in deficits. In America, Republicans may control both houses of Congress after November’s elections, and they steadfastly oppose new stimulus. In Europe, the peripheral countries can’t afford stimulus and Germany doesn’t want it. Absent such action, Mr Buiter says, debt restructuring looms for several peripheral countries, including Italy, and a euro break-up can’t be ruled out. “Politically, it would be a failed economic area.”

10/23/2014 04:48 PM

EU Banking Stress Tests

'Far-Reaching Reforms Are Needed'

Interview Conducted by Martin Hesse

On Sunday, Europe will release the results of its banking stress tests. In an interview, former PIMCO head Mohamed El-Erian speaks with SPIEGEL about what to expect and how Europe's core countries are failing to adequately confront a flagging economy.

SPIEGEL: Mr. El-Erian, the results of the stress test on European banks will be published on Sunday. If you had a billion dollars to bet for or against European banks, what would you do?

El-Erian: Stock markets are altogether overvalued; people took risks in financial markets that were too high. Banking stocks often exaggerate the development: If stock markets rise, bank shares rise higher. If stock markets fall, they fall deeper. Therefore, I would buy neither stocks nor bank bonds prior to a correction. I would focus on highly secured banking bonds.

SPIEGEL: How poorly are Europe's banks doing?

El-Erian: Soon, banks will no longer be the biggest risk to the financial system and the economy. And five years from now, many credit institutions will be smaller than they are today, having discontinued some types of business, and will better support the real economy.

SPIEGEL: Why only then? What has to happen first?

El-Erian: Not all banks will pass the ECB comprehensive assessment with flying colors. Some need capital, others need to downsize. Many banks haven't yet solved their culture problems and legal disputes. Foul credits and securities need to be further reduced. This is even more of a problem as the economic environment is now getting worse again.

SPIEGEL: In Germany there is an expectation that banks from the periphery of the European Union will prove weaker than financial institutions in core EU countries. Do you share that view?

El-Erian: That is putting it too simply. Peripheral countries like Ireland and Greece are at different stages of mastering the crisis. There will be banks in core countries of the euro zone that won't look very good in the test and others that will pass with ease. But this is exactly the problem: So far investors have been badly informed and couldn't distinguish between healthy and less healthy banks -- and therefore had less trust in all of them.

SPIEGEL: Will this examination of their balance sheets change that?

El-Erian: The exercise will provide a good momentary assessment of the system's condition. I'm convinced that the test is serious and strict. Furthermore, the comprehensive, and henceforth better comparable, balance sheet data will allow investors and analysts to run their own tests, with their own assumptions, if they consider these more realistic than the ECB scenarios. That is why this test will drive away thecloud of uncertainty which is hovering over the European economy.

SPIEGEL: Was Europe's reaction to the financial crisis wrong?

El-Erian: Of course the euro zone could have done better. The high unemployment rate, particularly among the youth, is alarming. But the same applies for the US, UK or Japan -- there is too little investment overall, and reforms to labor and production markets are incomplete. With the exception of Germany, the highly developed economies slept through their opportunity to renew themselves.

SPIEGEL: Why is that?

El-Erian: The US, the UK, Ireland, Iceland, Greece and other countries fell in love with the wrong growth model. They believed that -- following the agrarian economy, industrialization and the service economy -- the primacy of financial industries represented the next step of capitalism. Financial service providers that supported the rest of the economy turned into banks serving only their own interests.

SPIEGEL: What has changed in that regard? Central banks in Europe are still mainly focused on supporting the banks.

El-Erian: No. Neither the Fed nor the ECB believe anymore that this model is sustainable on the long term. With their loose fiscal policy, they merely want to build a bridge until a system has been established in which banks play a serving role again.

SPIEGEL: They've been building this bridge for quite some time.

El-Erian: Correct. And I'm afraid that the malaise and the weak growth will be here for a long time. Some politicians still don't realize how serious the situation is. They believe it's only a cyclical problem, just as there have always been periods of economic downturn and periods of boom. But the long-term tendency points downwards; the capacity to grow is declining continuously.

SPIEGEL: The ECB has now begun buying securities from banks on a large scale. Will that help the economy?

El-Erian: The far-reaching reforms that are needed can only come from governments. They have every opportunity to avoid a new downward spiral. That's why this is so frustrating. It's merely a question of political will and lasting implementation.

SPIEGEL: Should Germany take on more leadership responsibility?

El-Erian: The three biggest economies of the euro zone -- Germany, France and Italy -- are facing headwinds. But instead of pulling together, the three insist on opposing positions. In the end, all sides will have to move. Structural reforms are required in almost all European countries. But it is good that Germany has now started to talk more about investments, such as into infrastructure, for example.

October 23, 2014, 7:54 AM ET

Majority of Bank Risk Managers Are Worried About the Wealth Gap

A majority of risk managers at North American financial institutions are worried that the growing wealth gap poses a risk to the financial system.

The Professional Risk Managers’ International Association and FICO, the credit analytics firm, polled bank risk managers on the consequences of inequality during their quarterly survey. It showed that more than 62% believe the wealth gap could undermine the North American financial system. Just 14% said they didn’t think it posed a threat.

The survey found that 41%, a plurality, of bank risk managers believe unemployment or underemployment is the greatest risk to consumers’ credit health over the coming six months. Some 22% were more worried about rising consumer indebtedness. Other concerns, including a sudden financial-system shock (16%), rising interest rates (12%) and the weakening of the housing market (8%), drew less consensus.

Home loans were the only asset class where a majority of risk managers didn’t see supply meeting demand. More than one quarter of those surveyed see the supply of mortgage credit falling short of demand, the highest of any consumer borrowing category.