A strong eurozone needs a full banking union

Common deposit insurance will reduce the risk of future crises
 
 
 
New EU rules come into force on January 1 that will enable Europe’s financial authorities to deal with failing banks without shovelling the cost on to taxpayers. The launch of the EU’s so-called single resolution mechanism follows a significant expansion of the European Central Bank’s powers in November 2014, such that it now supervises all 5,500 eurozone banks.
 
These steps are two of the most useful initiatives that the EU adopted in response to the financial whirlwind that tore through the bloc after 2008, destabilising Europe’s banks and putting into question the survival of its monetary union. However, a third, more politically sensitive step towards a complete banking union is necessary in order to minimise the risk that fresh crises will erupt in the future and, if they do, to limit the consequences. In 2016 national governments and policymakers in Brussels should do their best to advance the goal of a common deposit insurance scheme in the 19- nation eurozone.

It will be easier said than done. Opposition to the early introduction of common deposit insurance is intense in Germany, which suspects that the scheme is a smokescreen for the proposition that its taxpayers and savers should cough up on behalf of depositors in other eurozone countries burdened with collapsing banks. Germany also contends that European policymakers should reduce excessive risk-taking in the financial sector before they proceed with risk-sharing measures, such as common deposit insurance.

Without doubt, certain precautions need to be in place before the eurozone launches common deposit insurance. Excessive risk is one issue. Some banks carry large amounts of government bonds on their balance sheets, despite the potentially lethal connection between sovereign debt and overstretched banks that was amply illustrated at the height of the eurozone crisis. More broadly, the banking sectors of some countries are still fragile and struggling with non-performing loans. They need to be on a firmer footing before the eurozone starts a common insurance scheme. Lastly, participating banks in all countries must step up and fund the scheme adequately.

All this said, Germany should recognise that a banking union which operates on two legs instead of three — common supervision, common resolution but not common deposit insurance — is a banking union that, in the last resort, will lack credibility. This is the implicit argument of the EU’s so-called “Five Presidents’ report”, which highlights common deposit insurance as a desirable and realistic objective for the financial sector.

The report, published last June, sets out a road map for full economic and monetary union by 2025, by which time the eurozone would be endowed with a common treasury and a “common macroeconomic stabilisation function” to help member states cope with shocks that cannot be managed at national level alone.

These and other proposals that envisage much greater centralisation of eurozone economic policymaking, albeit 10 years from now, lie beyond.

the boundaries of what is achievable in today’s political conditions in Europe. It may even be too ambitious to suggest, as does the Five Presidents’ report, that common deposit insurance, as well as a EU capital markets union, should be agreed as early as June 2017. However, the longer the delay in creating a common deposit insurance scheme, the longer the eurozone will remain vulnerable to financial shocks and contagion for which, one day, it may pay a far higher Price.


Why Big Oil Should Kill Itself

Anatole KaletskyPetroleum silos


LONDON – Now that oil prices have settled into a long-term range of $30-50 per barrel (as described here a year ago), energy users everywhere are enjoying an annual income boost worth more than $2 trillion. The net result will almost certainly accelerate global growth, because the beneficiaries of this enormous income redistribution are mostly lower- and middle-income households that spend all they earn.
 
Of course, there will be some big losers – mainly governments in oil-producing countries, which will run down reserves and borrow in financial markets for as long as possible, rather than cut public spending. That, after all, is politicians’ preferred approach, especially when they are fighting wars, defying geopolitical pressures, or confronting popular revolts.
 
But not all producers will lose equally. One group really is cutting back sharply: Western oil companies, which have announced investment reductions worth about $200 billion this year.
 
That has contributed to the weakness of stock markets worldwide; yet, paradoxically, oil companies’ shareholders could end up benefiting handsomely from the new era of cheap oil.
 
Just one condition must be met. The managements of leading energy companies must face economic reality and abandon their wasteful obsession with finding new oil. The 75 biggest oil companies are still investing more than $650 billion annually to find and extract fossil fuels in ever more challenging environments. This has been one of the greatest misallocations of capital in history – economically feasible only because of artificial monopoly prices.
 
But the monopoly has fallen on hard times. Assuming that a combination of shale development, environmental pressure, and advances in clean energy keep the OPEC cartel paralyzed, oil will now trade like any other commodity in a normal competitive market, as it did from 1986 to 2005. As investors appreciate this new reality, they will focus on a basic principle of economics: “marginal cost pricing.”
 
In a normal competitive market, prices will be set by the cost of producing an extra barrel from the cheapest oilfields with spare capacity. This means that all the reserves in Saudi Arabia, Iran, Iraq, Russia, and Central Asia would have to be fully developed and exhausted before anyone even bothered exploring under the Arctic ice cap or deep in the Gulf of Mexico or hundreds of miles off the Brazilian coast.
 
Of course, the real world is never as simple as an economics textbook. Geopolitical tensions, transport costs, and infrastructure bottlenecks mean that oil-consuming countries are willing to pay a premium for energy security, including the accumulation of strategic supplies on their own territory.
 
Nonetheless, with OPEC on the ropes, the broad principle applies: ExxonMobil, Shell, and BP can no longer hope to compete with Saudi, Iranian, or Russian companies, which now have exclusive access to reserves that can be extracted with nothing more sophisticated than nineteenth-century “nodding donkeys.” Iran, for example, claims to produce oil for only $1 a barrel. Its readily accessible reserves – second only in the Middle East to Saudi Arabia’s –will be rapidly developed once international economic sanctions are lifted.
 
For Western oil companies,the rational strategy will be to stop oil exploration and seek profits by providing equipment, geological knowhow, and new technologies such as hydraulic fracturing (“fracking”) to oil-producing countries. But their ultimate goal should be to sell their existing oil reserves as quickly as possible and distribute the resulting tsunami of cash to their shareholders until all of their low-cost oilfields run dry.
 
That is precisely the strategy of self-liquidation that tobacco companies used, to the benefit of their shareholders. If oil managements refuse to put themselves out of business in the same way, activist shareholders or corporate raiders could do it for them. If a consortium of private-equity investors raised the $118 billion needed to buy BP at its current share price, it could immediately start to liquidate 10.5 billion barrels of proven reserves worth over $360 billion, even at today’s “depressed” price of $36 a barrel.
 
There are two reasons why this has not happened – yet. Oil company managements still believe, with quasi-religious fervor, in perpetually rising demand and prices. So they prefer to waste money seeking new reserves instead of maximizing shareholders’ cash payouts. And they contemptuously dismiss the only other plausible strategy: an investment shift from oil exploration to new energy technologies that will eventually replace fossil fuels.
 
Redirecting just half the $50 billion that oil companies are likely to spend this year on exploring for new reserves would more than double the $10 billion for clean-energy research announced this month by 20 governments at the Paris climate-change conference. The financial returns from such investment would almost certainly be far higher than from oil exploration. Yet, as one BP director replied when I asked why his company continued to risk deep-water drilling, instead of investing in alternative energy: “We are a drilling business, and that is our expertise.
 
Why should we spend our time and money competing in new technology with General Electric or Toshiba?”
 
As long as OPEC’s output restrictions and expansion of cheap Middle Eastern oilfields sheltered Western oil companies from marginal-cost pricing, such complacency was understandable. But the Saudis and other OPEC governments now seem to recognize that output restrictions merely cede market share to American frackers and other higher-cost producers, while environmental pressures and advances in clean energy transform much of their oil into a worthless “stranded asset” that can never be used or sold.
 
Mark Carney, Governor of the Bank of England, has warned that the stranded-asset problem could threaten global financial stability if the “carbon budgets” implied by global and regional climate deals render worthless fossil-fuel reserves that oil companies’ balance sheets currently value at trillions of dollars. This environmental pressure is now interacting with technological progress, reducing prices for solar energy to near-parity with fossil fuels.
 
As technology continues to improve and environmental restrictions tighten, it seems inevitable that much of the world’s proven oil reserves will be left where they are, like most of the world’s coal. Sheikh Zaki Yamani, the longtime Saudi oil minister, knew this back in the 1980s. “The Stone Age did not end,” he warned his compatriots, “because the cavemen ran out of stone.”
 
OPEC seems finally to have absorbed this message and realized that the Oil Age is ending.

Western oil companies need to wake up to the same reality, stop exploring, and either innovate or liquidate.
 
 


Internal migration

Shifting barriers

The government reforms a socially divisive system, warily
..



THE pillars of social control are flaking at the edges. First came the relaxation in October of draconian family-planning restrictions. Now it is the turn of the household-registration, or hukou, system, which determines whether a person may enjoy subsidised public services in urban areas—rural hukou holders are excluded. On December 12th the government announced what state media trumpeted as the biggest shake-up in decades of the hukou policy, which has aggravated a huge social divide in China’s cities and curbed the free flow of labour. The pernicious impact of the system, however, will long persist.

As with the adjustment to the decades-old family-planning policy (now all couples will be allowed to have two children), the latest changes to the hukou system follow years of half-hearted tinkering.

They will allow migrant workers to apply for special residency permits which provide some of the benefits of an urban hukou (a booklet proving household registration is pictured above). If an urban hukou is like an internal passport, the residency permit is like a green card.

Under the arrangements, migrants will be able to apply for a permit if they have lived in a city for six months, and can show either an employment contract or a tenancy agreement. The document will allow access to state health care where the migrants live, and permit their children to go to local state schools up to the age of 15. It will also make other bureaucratic things easier, like buying a car. Such reforms have already been tried in some cities. They will now be rolled out nationwide.

For those who meet the requirements, the changes will bring two main benefits. They should allow some of the 70m children who have been left behind to attend school in their native villages to join their migrant parents. And it will allow migrants to use urban services without losing the main benefit of their rural hukou: the right to farm a plot of land. According to a survey in 2010 by the Chinese Academy of Social Sciences, 90% of migrants did not want to change their registration status because they feared losing this right.

Collar-colour counts
 
As with the two-child policy, though, there is less here than meets the eye. Most migrants are casual labourers. They rarely have any labour or tenancy contracts. The success of the reforms will also partly depend on funding. The government recently decided to tie schools’ budgets to the number of their pupils. In theory this will cover extra demand. But the system is untested.

There are other catches. In cities of between 500,000 and 1m people, applicants for urban hukou will need to have contributed to the government’s social-insurance scheme for three years. In cities of 1m-5m, the minimum is five years. And the reforms do not really apply in the biggest cities. They set their own requirements.

There are similar problems with the 13m people who have no hukou at all, which means they cannot obtain the identity card needed for everything from travelling by train or plane to obtaining a passport. About 60% of such people are “black” children, as they are often called in China, born in contravention of the one-child policy. On December 9th President Xi Jinping said those without hukou could obtain one. But it is unclear what kind of hukou they will get and whether a fine will still have to be paid for violating the family-planning rules.

The government says it hopes 100m rural migrants (there are now about 250m of them living in urban areas) will have urban hukou by 2020. That seems unlikely. Many live in the biggest cities where, to judge by the reforms proposed by the city government of Beijing, changing status will get harder: the capital’s requirements give precedence to people who have paid 100,000 yuan ($15,500) in tax a year, far more than manual labourers earn.

The hukou policy was introduced in the 1950s to prevent a rush of migrants that might destabilise cities. Since the 1990s, China has depended on migration to provide cheap labour for its manufacturing boom. But it still wants to control where labourers move. It worries that an unregulated flow, especially into the biggest cities, may fuel discontent among the urban middle classes who fear that public services will be swamped. The new reforms to the hukou system appear mainly designed to push migrants away from big coastal cities towards smaller ones inland. Zuo Xiuli, a house-cleaner who has worked in Beijing for ten years and earns 2,500 yuan a month, is not sure he will bother to apply. “Of course I hope to get a Beijing hukou,” he says. “But it’s impossible for me.”


Trying to Hide the Rise of Violent Crime

Progressives and their media allies have launched a campaign to deny the ‘Ferguson effect’—but it’s real, and it’s increasingly deadly for inner cities.

By Heather Mac Donald   
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Murders and shootings have spiked in many American cities—and so have efforts to ignore or deny the crime increase. The see-no-evil campaign eagerly embraced a report last month by the Brennan Center for Justice called “Crime in 2015: A Preliminary Analysis.” Many progressives and their media allies hailed the report as a refutation of what I and others have dubbed the “Ferguson effect”— cops backing off from proactive policing, demoralized by the ugly vitriol directed at them since a police shooting in Ferguson, Mo., last year. Americans are being asked to disbelieve both the Ferguson effect and its result: violent crime flourishing in the ensuing vacuum.

In fact, the Brennan Center’s report confirms the Ferguson effect, while also showing how clueless the media are about crime and policing.

The Brennan researchers gathered homicide data from 25 of the nation’s 30 largest cities for the period Jan. 1, 2015, to Oct. 1, 2015. (Not included were San Francisco, Indianapolis, Columbus, El Paso and Nashville.) The researchers then tried to estimate what 2015’s full-year homicide numbers for those 25 cities would be, based on the extent to which homicides were up from January to October this year compared with the similar period in 2014.

The resulting projected increase for homicides in 2015 in those 25 cities is 11%. (By point of comparison, the FiveThirtyEight data blog looked at the 60 largest cities and found a 16% increase in homicides by September 2015.) An 11% one-year increase in any crime category is massive; an equivalent decrease in homicides would be greeted with high-fives by politicians and police chiefs. Yet the media have tried to repackage that 11% homicide increase as trivial.

Several strategies are employed to play down the jump in homicides. The simplest is to hide the actual figure. An Atlantic magazine article in November, “Debunking the Ferguson Effect,” reports: “Based on their data, the Brennan Center projects that homicides will rise slightly overall from 2014 to 2015.” A reader could be forgiven for thinking that “slightly” means an increase of, say, 2%. Nothing in the Atlantic write-up disabuses the reader of that mistaken impression. The website Vox, declaring the crime increase “bunk,” is similarly discreet about the actual homicide rate, leaving it to the reader’s imagination. Crime & Justice News, published by the John Jay College of Criminal Justice, coyly admits that “murder is up moderately in some places” without disclosing what that “moderate” increase may be.

A second strategy for brushing off the homicide surge is to contextualize it over a long period.

Because homicides haven’t returned to their appalling early 1990s or early 2000s levels, the current crime increase is insignificant, the Brennan Center and its media supporters suggest, echoing an argument that arose immediately after I first documented the Ferguson effect nationally.

“Today’s murder rates are still at all-time historic lows,” write the Brennan researchers. “In 1990 there were 29.3 murders per 100,000 residents in these cities. In 2000, there were 13.8 murders per 100,000. Now, there are 9.9 murders per 100,000 residents. Averaged across the cities, we find that while Americans in urban areas have experienced more murders this year than last year, they are safer than they were five years ago and much safer than they were 25 years ago.”

The Atlantic is similarly reassuring about today’s homicide rate: “The relative uptick”—which, again, the magazine never specifies—“is still small compared with the massive two-decade drop that preceded it.” True enough, though irrelevant—good policing over the past two decades produced an extraordinary 50% drop in crime. America isn’t going to give all that back in one year. The relevant question: What is the current trend? If this year’s homicide and shooting outbreak continues, those 1990s violent crime levels will return sooner than anyone could have imagined.

The most desperate tactic for discounting the homicide increase is to disaggregate the average.

“Fears of ‘a new nationwide crime wave’ are premature at best and wildly misleading at worst,” asserts the Atlantic, because the “numbers make clear that violent crime is up in some major U.S. cities and down in others.”

But such variance is inherent in any average. If there weren’t variation across the members of a set, no average would be needed. Any national crime increase or decrease will have counterexamples of the dominant trend within it, yet policy makers and analysts rightly find the average meaningful. The Ferguson effect’s existence does not require that every city experience depolicing and a resulting crime increase. Enough cities—in particular, those with significant black populations and where antipolice agitation has been most strident—are experiencing murder increases that cannot be ignored.

Baltimore’s per capita homicide rate, for example, is now the highest in its history, according to the Baltimore Sun: 54 homicides per 100,000 residents, beating its 1993 rate of 48.8 per 100,000 residents. Shootings in Cincinnati, lethal and not, were up 30% by mid-September 2015 compared with the same period in 2014. Homicides in St. Louis were up 60% by the end of August. In Los Angeles, the police department reports that violent crime has increased 20% as of Dec. 5; there were 16% more shooting victims in the city, while arrests were down 9.5%.

Shooting incidents in Chicago are up 17% through Dec. 13.

The Brennan Center report also tries to underplay the homicide increase by folding it into crime overall. The report projects that in 19 cities the 2015 average for all seven of the FBI’s index crimes—murder, rape, robbery, aggravated assault, burglary, larceny and car theft—will be 1.5% less than in 2014. The FBI’s crime index is dominated by property crimes, which outnumber offenses committed against persons by a magnitude of nearly 8 to 1. The Ferguson effect is about violent crime, not theft. Proactive police stops and low-level misdemeanor enforcement deter young men from carrying guns, thus heading off violent felonies before they can erupt.

Career burglars are less affected by whether a cop is likely to get out of his car and question someone hitching up his waistband on a known drug corner at 1 a.m. If property crimes haven’t increased as much as homicides, that’s good news for homeowners but no disproof of depolicing’s role in the violent-crime spike.

To the Brennan Center and its cheerleaders, the nation’s law-enforcement officials are in the grip of a delusion that prevents them from seeing the halcyon crime picture before their eyes.

For the past several months, police chiefs have been sounding the alarm about rising violent crime. In August the Major Cities Chiefs Association convened an emergency session to discuss the homicide and shooting surge. “We have not seen what we’re seeing right now in decades,” Washington, D.C., Police Chief Cathy Lanier said after the summit.

In early October U.S. Attorney General Loretta Lynch brought together more than 100 mayors, police leaders and federal prosecutors to strategize privately over the violent-crime increase. According to the Washington Post, attendees broke out in applause when mayors attributed the increase to officers’ sinking morale.

Later in October FBI Director James Comey said in a speech: “Most of America’s 50 largest cities have seen an increase in homicides and shootings this year, and many of them have seen a huge increase.” He noted “a chill wind blowing through American law enforcement over the last year,” and called it “deeply disturbing.” The next month the acting chief of the Drug Enforcement Administration, Chuck Rosenberg, seconded Mr. Comey’s crime analysis and his hypothesis that the demonization of the police was likely responsible for the violent-crime increase.

President Obama wasn’t happy with his FBI director. In a speech on Oct. 27 to a gathering of international police chiefs in Chicago, he accused Mr. Comey of “cherry-picking data” and ignoring “the facts” on crime in pursuit of a “political agenda.” When the DEA’s Mr. Rosenberg endorsed Mr. Comey’s views about the Ferguson effect, the White House lashed out again: Press Secretary Josh Earnest said Mr. Rosenberg had “no evidence” for his assertions.

Critics of the Ferguson-effect analysis ignore or deny the animosity that the police now face in urban areas, brushing off rampant resistance to lawful police authority as mere “peaceful protest.” A black police officer in Los Angeles tells me: “Several years ago I could use a reasonable and justified amount of force and not be cursed and jeered at. Now our officers are getting surrounded every time they put handcuffs on someone. The spirit and the rhetoric of this flawed movement is causing more confrontations with police and closing the door on the gains in communication we had made before it began.”

St. Louis Alderman Jeffrey Boyd, at a news conference in July after his nephew was slain, made a poignant plea: “We march every time the police shoot and kill somebody. But we’re not marching when we’re killing each other in the streets. Let’s march for that.”

The St. Louis area includes Ferguson, the site of the police shooting that was so utterly distorted by protesters and the media. The Justice Department later determined that the officer’s use of force was justified, but the damage to the social fabric had already been done.

Now cops making arrests in urban areas are routinely surrounded by bystanders, who swear at them and interfere with the arrests. The media and many politicians decry as racist law-enforcement tools like pedestrian stops and broken-windows policing—the proven method of stopping major crimes by going after minor ones. Under such conditions, it isn’t just understandable that the police would back off; it is also presumably what the activists and the media critics would want. The puzzle is why these progressives are so intent on denying that such depolicing is occurring and that it is affecting public safety.

The answer lies in the enduring commitment of antipolice progressives to the “root causes” theory of crime. The Brennan Center study closes by hypothesizing that lower incomes, higher poverty rates, falling populations and high unemployment are driving the rising murder rates in Baltimore, Detroit, Milwaukee, New Orleans and St. Louis. But those aspects of urban life haven’t dramatically worsened over the past year and a half. What has changed is the climate for law enforcement.

‘Proactive policing is what keeps our streets safe,” Chief William Bryson, chairman of the Delaware Police Chiefs Council, tells me. “Officers will not hesitate to go into a situation that is obviously dangerous, but because of recent pronouncements about racism, they are not so likely to make a discretionary stop of a minority when yesterday they would have.”

To acknowledge the Ferguson effect would be tantamount to acknowledging that police matter, especially when the family and other informal social controls break down. Trillions of dollars of welfare spending over the past 50 years failed to protect inner-city residents from rising predation. Only the policing revolution of the 1990s succeeded in curbing urban violence, saving thousands of lives. As the data show, that achievement is now in jeopardy.


Ms. Mac Donald is the Thomas W. Smith fellow at the Manhattan Institute. This op-ed was adapted from the forthcoming winter issue of City Journal, where she is a contributing editor.


The Kingdom Beyond Oil

Gassan Al-Kibsi

 Modern corporate building in Saudi Arabia 
RIYADH – Over the past few weeks, the government of Saudi Arabia has been engaged in an unprecedented strategic policy review that could have ramifications for every aspect of the country’s social and economic life. The full details are expected to be announced in January, but it is already clear that the kingdom – the world’s nineteenth-largest economy – is in desperate need of far-reaching reform.
 
There are two reasons why change has become urgent. The first is the dramatic drop in global oil prices, from above $100 per barrel in the middle of 2014 to below $40 today. With oil exports accounting for nearly 90% of government revenue, the pressure on Saudi finances has been intense; the fiscal balance has swung from a small surplus in 2013 to a deficit of more than 21% of GDP in 2015, according to projections by the International Monetary Fund.
 
The second reason is demographic. In the next 15 years, some six million young Saudis will reach working age, putting enormous pressure on the labor market and potentially doubling its size.
 
It is easy to be pessimistic about this confluence of circumstances, and many international commentators are. But there are also good reasons for optimism, most notably the new Saudi leadership’s recognition of the challenge and the possibilities that addressing them could create.
 
According to research by the McKinsey Global Institute, Saudi Arabia has the potential to double its GDP and create six million additional jobs by 2030, enough to absorb the influx of young men – and, increasingly, young women – entering the labor market. To accomplish this however, the kingdom will have to dramatically reduce its unhealthy dependence on oil – a strategic goal that has been long discussed, but never implemented.
 
Saudi Arabia has many sectors with strong potential for expansion. The country has substantial untapped deposits of metals and non-metallic minerals, including phosphate, gold, zinc, bauxite, and high-quality silica. Its retail sector is already growing quickly, but it lags behind in areas like e-merchandizing and supply-chain efficiencies.
 
The country’s tourism sector could be developed and upgraded, not only for the millions of Muslim pilgrims who visit the holy sites of Mecca and Medina every year, but also for leisure tourists. Saudi Arabia has a long coastline on the Red Sea, as well as other unspoiled areas of natural beauty that could attract visitors. The manufacturing sector, too, could be built up; at the moment, the kingdom has only small-scale domestic manufacturing, despite being one of the largest markets in the region for cars, machinery, and other capital goods.
 
Exploiting these opportunities will require trillions of dollars in investment, radical improvements in productivity, and the government’s firm, sustained commitment. Doubling GDP over the next 15 years will necessitate about $4 trillion in investment, two-and-a-half times the amount of money that flowed into the kingdom’s economy during the 2003-2013 oil boom.
 
Attaining this level of investment will require radical policy reforms. During the oil boom, the state increased public-sector wages and social-welfare transfers – and thus was a major contributor to households’ growing prosperity. The public sector continues to dominate most aspects of the economy, especially employment; about 70% of Saudi nationals work for the state.
 
But transforming the economy will require the participation of investors and businesses; indeed, we calculate that by 2025, at least 70% of the investment should come from the private sector. Achieving this will require overhauling the country’s regulatory and legal framework.
 
It will also require large improvements in productivity. Saudi Arabia’s productivity growth has lagged behind that of most other G-20 countries, rising by just 0.8% in the past decade. Jump-starting productivity growth will require reworking the kingdom’s restrictions on business and labor practices. For now, the Saudi economy relies heavily on low-wage and low-productivity foreign workers on limited contracts; indeed, such workers hold more than half the jobs in the country. That will have to change if the economy is to raise productivity and modernize its non-oil sectors.
 
The kingdom’s new leadership has some difficult but important choices to make as it formulates a detailed economic strategy. The most important priorities include boosting the efficiency of government spending and developing new sources of revenue to replace oil exports. The government has a number of options for new revenue, including a reform of wasteful energy subsidies and the introduction of levies that are standard in the G-20, such as value-added tax.
 
Weaning Saudi Arabia’s economy off oil will not be easy, and the kingdom has an uneven track record in this regard. But there are encouraging early signs about the government’s focus, energy, and determination. One is the recent decision to levy a tax on unused land that could be developed for housing. Another is the new inter-ministerial coordination and cooperation that appears to be taking place under the auspices of the Council of Economic and Development Affairs, a body established in January 2015. If the government is able to sustain its resolve over the years it will take to set the economy firmly on a new trajectory, the kingdom will be thoroughly transformed – for the better.
 

Read more at https://www.project-syndicate.org/commentary/saudi-arabia-more-than-oil-economy-by-gassan-al-kibsi-2015-12#aw6Thu5EMULgsLXy.99


The Perils of Fed Gradualism

Stephen S. RoachTwo hands holding a US dollar

NEW HAVEN – By now, it’s an all-too-familiar drill. After an extended period of extraordinary monetary accommodation, the US Federal Reserve has begun the long march back to normalization. It has now taken the first step toward returning its benchmark policy interest rate – the federal funds rate – to a level that imparts neither stimulus nor restraint to the US economy.
 
A majority of financial market participants applaud this strategy. In fact, it is a dangerous mistake. The Fed is borrowing a page from the script of its last normalization campaign – the incremental rate hikes of 2004-2006 that followed the extraordinary accommodation of 2001-2003. Just as that earlier gradualism set the stage for a devastating financial crisis and a horrific recession in 2008-2009, there is mounting risk of yet another accident on what promises to be an even longer road to normalization.
 
The problem arises because the Fed, like other major central banks, has now become a creature of financial markets rather than a steward of the real economy. This transformation has been under way since the late 1980s, when monetary discipline broke the back of inflation and the Fed was faced with new challenges.
 
The challenges of the post-inflation era came to a head during Alan Greenspan’s 18-and-a-half-year tenure as Fed Chair. The stock-market crash of October 19, 1987 – occurring only 69 days after Greenspan had been sworn in – provided a hint of what was to come. In response to a one-day 23% plunge in US equity prices, the Fed moved aggressively to support the brokerage system and purchase government securities.
 
In retrospect, this was the template for what became known as the “Greenspan put” – massive Fed liquidity injections aimed at stemming financial-market disruptions in the aftermath of a crisis. As the markets were battered repeatedly in the years to follow – from the savings-and-loan crisis (late 1980s) and the Gulf War (1990-1991) to the Asian Financial Crisis (1997-1998) and terrorist attacks (September 11, 2001) – the Greenspan put became an essential element of the Fed’s market-driven tactics.
 
This approach took on added significance in the late 1990s, when Greenspan became enamored of the so-called wealth effects that could be extracted from surging equity markets. In an era of weak income generation and seemingly chronic current-account deficits, there was pressure to uncover new sources of economic growth. But when the sharp run-up in equity prices turned into a bubble that subsequently burst with a vengeance in 2000, the Fed moved aggressively to avoid a Japan-like outcome – a prolonged period of asset deflation that might trigger a lasting balance-sheet recession.
 
At that point, the die was cast. No longer was the Fed responding just to idiosyncratic crises and the market disruptions they spawned. It had also given asset markets a role as an important source of economic growth. The asset-dependent economy quickly assumed a position of commensurate prominence in framing the monetary-policy debate.
 
The Fed had, in effect, become beholden to the monster it had created. The corollary was that it had also become steadfast in protecting the financial-market-based underpinnings of the US economy.
 
Largely for that reason, and fearful of “Japan Syndrome” in the aftermath of the collapse of the US equity bubble, the Fed remained overly accommodative during the 2003-2006 period.
 
The federal funds rate was held at a 46-year low of 1% through June 2004, before being raised 17 times in small increments of 25 basis points per move over the two-year period from mid-2004 to mid-2006. Yet it was precisely during this period of gradual normalization and prolonged accommodation that unbridled risk-taking sowed the seeds of the Great Crisis that was soon to come.
 
Over time, the Fed’s dilemma has become increasingly intractable. The crisis and recession of 2008-2009 was far worse than its predecessors, and the aftershocks were far more wrenching.
 
Yet, because the US central bank had repeatedly upped the ante in providing support to the Asset Economy, taking its policy rate to zero, it had run out of traditional ammunition.
 
And so the Fed, under Ben Bernanke’s leadership, turned to the liquidity injections of quantitative easing, making it even more of a creature of financial markets. With the interest-rate transmission mechanism of monetary policy no longer operative at the zero bound, asset markets became more essential than ever in supporting the economy. Exceptionally low inflation was the icing on the cake – providing the inflation-targeting Fed with plenty of leeway to experiment with unconventional policies while avoiding adverse interest-rate consequences in the inflation-sensitive bond market.
 
Today’s Fed inherits the deeply entrenched moral hazard of the Asset Economy. In carefully crafted, highly conditional language, it is signaling much greater gradualism relative to its normalization strategy of a decade ago. The debate in the markets is whether there will be two or three rate hikes of 25 basis points per year – suggesting that it could take as long as four years to return the federal funds rate to a 3% norm.
 
But, as the experience of 2004-2007 revealed, the excess liquidity spawned by gradual normalization leaves financial markets predisposed to excesses and accidents. With prospects for a much longer normalization, those risks are all the more worrisome. Early warning signs of troubles in high-yield markets, emerging-market debt, and eurozone interest-rate derivatives markets are particularly worrisome in this regard.
 
The longer the Fed remains trapped in this mindset, the tougher its dilemma becomes – and the greater the systemic risks in financial markets and the asset-dependent US economy. It will take a fiercely independent central bank to wean the real economy from the markets. A Fed caught up in the political economy of the growth debate is incapable of performing that function.
 
Only by shortening the normalization timeline can the Fed hope to reduce the build-up of systemic risks. The sooner the Fed takes on the markets, the less likely the markets will be to take on the economy. Yes, a steeper normalization path would produce an outcry. But that would be far preferable to another devastating crisis.
 


South Africa’s democracy

The hollow state

Two decades after South Africa’s transition to non-racial democracy, its institutions are being sorely tested by President Jacob Zuma. Can they hold?
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THE words a luta continua shine in garish orange neon from the artwork in the lobby of South Africa’s Constitutional Court. The Portuguese slogan, “the struggle continues”, was popular during the country’s fight for non-racial democracy. It remains apt. A fierce battle is now being fought for the survival of that democracy.

There has not been a coup, or anything like that. But the president, Jacob Zuma, rules in a way that perturbs even many of his former allies. Consider the events of the past week. On December 9th, without warning or explanation, he fired his respected finance minister, Nhlanhla Nene, and replaced him with an obscure backbencher and former mayor so unpopular that his townsfolk had burned his house down in protests against changes to a provincial boundary.

Mr Nene’s sacking was seen as an attack on fiscal prudence. He had, for example, objected to Mr Zuma’s unaffordable plan to buy nuclear power stations costing 1 trillion rand ($65 billion) from Vladimir Putin’s Russia. It was also seen as an attempt to capture the Treasury, a part of the state that has stood firm against corruption and cronyism, by a president who has stood firm against neither.

Shortly before Mr Nene was sacked he had blocked attempts by Dudu Myeni, the chair of South African Airways (SAA), to renegotiate a deal to buy aircraft. Ms Myeni is an ally of Mr Zuma.

(Indeed, she is such a close pal that Mr Zuma’s office issued a statement denying that he has a “romance and a child” with her.) Her plan was to insert a local middleman between SAA and Airbus, which was neither in the interests of the airline nor the taxpayers who guarantee its debts.

On news of Mr Nene’s sacking, the currency dropped by 9% and South Africa’s bonds posted a record slump, driving up the country’s cost of new borrowing by about 15%. After four days of panic Mr Zuma reversed course, fired his new finance minister and brought back an old hand, Pravin Gordhan, who did the job capably between 2009 and 2014.

All this left many South Africans as perplexed as they were relieved. Had Mr Zuma seen sense?

Or had senior members of the ruling African National Congress (ANC) clipped his wings? Was this a triumph for democracy or a Kremlinesque subversion of it, with real power now residing behind the throne?

The great subordination
 
That no one knows shows how opaque the Rainbow Nation has become. This was the country that in 1994 inspired democrats the world over when it avoided a racial war, ended the world’s most notorious system of racial segregation and elected the magnanimous Nelson Mandela as its president. The flowering of freedom in a place that had seen precious little of it helped seed a great bloom of democratic change across much of Africa. South Africa’s efforts to reconcile abusers of human rights and their victims galvanised others to do the same.

South Africa’s changes ran deep. This was partly because of the ANC’s determination that the terrible abuses of human rights under apartheid would never be repeated. When talks were held on the country’s new constitution, the party was an enthusiastic supporter of limits on state power. Its view came through experience. Thousands of its supporters had been detained, tortured and killed.

After 1994 the security forces were overhauled and retrained to protect rather than oppress civilians.

A parliament reserved for whites was filled with the country’s many tribes and races. A judiciary that had energetically upheld immoral laws was subordinated to a Constitutional Court sworn to protect human rights. In some ways it put more mature democracies to shame. In 1995 the court abolished the death penalty; a year later it ensured South Africa was among the first countries in the world to allow gay couples to marry.

Yet, after more than two decades in charge, the ANC’s wariness of untrammelled state power has turned into frustration at the checks on it. The party is now undermining some of the democratic institutions that it fought so hard to establish.

In 2012 the police massacred 41 striking mineworkers, shooting some in the back. In February armed police stormed into parliament to remove members of the opposition, who were heckling Mr Zuma about the colossal mansion he had built for himself at taxpayers’ expense. In June the government flouted the rule of law when it ignored an order of its own high court to detain Omar al-Bashir, the blood-soaked ruler of Sudan, for whom the International Criminal Court had issued an arrest warrant.

These examples are part of a deeper malaise. The distinction between the ruling party and the state has been eroded. The executive arm of government (and its state-owned firms) is being corroded into incompetence by corruption and cronyism. Independent bodies meant to safeguard democracy are being subordinated.

Lawson Naidoo, who runs the Council for the Advancement of South Africa’s Constitution, a pressure group, frets that the country is sliding “towards majoritarianism at the expense of principled constitutionalism”. Kgalema Motlanthe, who served as president in 2008 and 2009, recently said the ANC had abandoned its democratic principles. Desmond Tutu and F.W. de Klerk, both Nobel laureates, have lambasted the government, too. Justice Malala, a journalist and former ANC activist, summed it up well in a recent book: “One day you look around and realise that everything is broken, that your country has been stolen.”

For the moment South Africans worry more about the economy than about the health of democratic institutions. Growth has slumped to little more than 1% this year, a rate that does not keep pace with the increase in population, of about 1.3%. Unemployment has climbed above 35%, if you include the millions of people who have given up looking for work.

The indebted country
 
Anaemic growth is largely the result of policy failures. The performance of Eskom, the state-owned electricity company, provides a useful illustration. Back in the 1990s its planners realised that it would have to build many more power stations to meet rising demand, or the country would suffer power cuts. It failed to do so. Power shortages now often shut factories and mines. Economists reckon that this has trimmed a whole percentage point a year from economic growth.

One reason why Eskom is so badly run is that many of its managers and engineers had been replaced by unqualified political appointees. This was partly owing to a policy of promoting blacks, who in some cases lacked experience. But a more pernicious subversion of meritocracy is the ANC’s insistence on appointing party hacks to senior positions. The government calls this “cadre deployment”. “I’ve said to [Mr Zuma], ‘you don’t deploy cadres to play in the national football team, so why do you deploy them to Eskom?’ ” says a grandee of African politics. “He just won’t listen.”
  From unchecked power to power cuts


Cronyism hobbles the 700 or so firms owned by the state. Congested railways and ports—also run by state-owned monopolies—have constrained exports, trimming another percentage point or so from South Africa’s annual growth.

Stagnation, coupled with wanton spending, threatens to create a fiscal crisis. Pay for civil servants has increased far faster than inflation. Perks for ministers have ballooned. Over the past decade the number of civil servants has increased by about 25%, even as all other non-farm employment has stayed reasonably stable. A whopping one in five working people now works for the government.

Over the past 15 years state spending has increased from 23% of GDP to 29%. That is dangerous in a country with a thin tax base. More than 50% of personal income tax is paid by less than 5% of taxpayers. If the country goes sour, many of these people could emigrate—as many whites already have.

Sustained deficits of about 4% of GDP mean that debt has climbed rapidly from about 26% of GDP in 2008 to almost 50% in this fiscal year. Investors fret that the country’s liabilities may soon become unsustainable. Its credit rating is one notch above junk. Without a change in course, further downgrades are likely. The ensuing sell-off would probably send interest rates soaring and force the country to ask the IMF for a bail-out.

Until recently the main reason to think that South Africa would avoid this fate was that macroeconomic policy was in the hands of a credible central bank and a sound finance minister who had pledged to contain spending. The recent game of musical chairs in the finance ministry makes many wonder if that is still true.

Rotting from the top
 
Cronyism and corruption are hollowing out the foundations of the state itself. Government procurement at all levels is now riddled with graft. Start with schools. Corruption Watch, an NGO, says it has received more than 1,000 reports over the past few years relating to crooked school principals, many of whom have been stealing cash from their school’s bank accounts or looting funds intended to feed hungry children. Their jobs are now so lucrative that they are worth killing for. In 2015 one head teacher was hacked to death and another was shot after they refused to make way for people who had “bought” their posts. Officials of the teachers’ union have also been implicated in selling posts. At least the bribe-takers can do sums, unlike many of their pupils. A 2011 study into the maths and science knowledge of children around the world ranked South Africa second from last.

Officials feel a sense of impunity, since few are ever fired, let alone jailed. The auditor general has given “clean” audits to less than one-fifth of local governments and a third of the national government’s departments. Some of the money set aside for Nelson Mandela’s funeral in 2013 simply vanished. “Nothing was sacred,” laments R.W. Johnson in “How Long Will South Africa Survive?”, a polemic.

The National Prosecuting Authority (NPA) has been under sustained attack since the end of 2007, when Mr Zuma was elected head of the ANC (although he became president only in 2009). At the time the NPA had charged Mr Zuma with 783 counts of corruption, fraud, money-laundering and tax evasion. These charges were dropped just weeks before his election as president.

Since then, Mr Zuma has tried to defang the agency, usually by appointing compromised people to run it. Mr Zuma’s first appointment was subsequently ruled “irrational” by the Constitutional Court and overturned after his catspaw was caught lying to a commission of inquiry. His next appointee was forced to step down after it transpired that he had previously been convicted of assault. Many interpret Mr Zuma’s efforts to get the ANC to nominate his ex-wife, Nkosazana Dlamini-Zuma, to be his successor as an effort to ensure that his protection from prosecution will outlast his term.
Other institutions that have been tarnished include the Independent Electoral Commission. In December 2015 the Constitutional Court ruled that it had endorsed rigged local elections two years earlier. The Office of the Public Protector, an anti-corruption watchdog, is being starved of resources.

Its fiery head, Thuli Madonsela, has been accused by the ANC of being “counter-revolutionary” and a CIA agent.

“Zuma has a pre-capitalist notion of power,” says one insider. “He just can’t understand why he can’t have access to state resources.” Another says that Mr Zuma complained after a tour of African capitals that his counterparts were not required to appear before parliament to answer questions.

“Why do I have to?” he apparently said. His view of economics is far from the mainstream, too: he recently said that the value of commodities should depend on “the labour time taken in production”.

Given Mr Zuma’s foibles, it is unfortunate that the framers of South Africa’s constitution, for all its checks and balances, granted enormous powers to the president. “When we wrote the constitution we had in mind figures like Mandela,” says Patricia de Lille, who led the Pan Africanist Congress delegation in talks over the constitution ahead of the 1994 election and is now a leading figure in the opposition Democratic Alliance (DA).

Parliament has also proven toothless, partly as an unfortunate consequence of the transition from white-minority rule. When the constitution was being negotiated, whites worried that they would be swamped in a first-past-the-post system. So instead the country adopted proportional representation.

This means that MPs owe their positions to those who draw up party lists, rather than to voters in a constituency. If they annoy the president, they may lose their jobs—and the opportunities for patronage that come with them.

That leaves the judiciary, civil society and a vibrant free press with a tradition of raking muck. The government is attempting to restrain the last of these, both with repressive laws (one act awaiting a presidential signature, for instance, threatens whistle-blowers and journalists with long prison terms) as well as more subtle means. Among these was using money from a government employees’ pension fund to help an ally of Mr Zuma buy Independent Newspapers, a large media group.

Judges are still fiercely critical of the government. The Constitutional Court often rules against the executive. Partly because the courts function so well, there has been a dangerous reliance on them to settle matters that would normally be dealt with through politics. NGOs often ask the court to force the government to provide citizens with free housing, electricity and water, for example.

Thus far the appointment of judges has remained remarkably free from political interference and the courts have been resilient. When Mogoeng Mogoeng was named chief justice by Mr Zuma, many worried that he would be a patsy. Yet he has steadfastly overseen rulings that thwart or chide the president.

A worry, though, is that the government may ignore rulings. Stuart Wilson, a lawyer at the Socioeconomic Rights Institute, an NGO that often sues the government, says it now has court orders issued against named officials rather than departments: that way, judges can hold the individuals in contempt of court if their orders are not honoured.

Yet when a court ordered the arrest of Mr Bashir, the government brazenly looked the other way as he stepped onto a plane. And at some point soon the courts are expected to rule on whether prosecutors erred in dropping corruption charges against Mr Zuma. An order to reinstate the charges and press ahead with a prosecution would “test to destruction” the constitution, says Alison Tilley of the Open Democracy Advice Centre, an NGO in Cape Town. A second case that may be as controversial is over whether Mr Zuma should be ordered to repay the state for money spent on his home (pictured).

                In Nkandla did Jacob Zuma a stately pleasure-dome decree


South Africa’s democratic institutions are battered. But as long as the courts can uphold the law there is hope that other arms of government can regain their vigour under a new and (with luck) more democratically minded president. In next year’s local elections the ANC is likely to lose its majority in most of the big cities, including Johannesburg, Pretoria and Port Elizabeth, to the DA (which won 22% of the national vote in 2014) and a newer party, the populist Economic Freedom Fighters (EFF), which won 6%. Mr Zuma will probably hang onto power until his second and final term expires in 2019, unless a crisis prompts the ANC to replace him with his able deputy, Cyril Ramaphosa.

The challenge for democrats will be to protect the independence of the courts and what remains of other institutions. Mr Zuma has shown an inclination to wreck them. Unless checked, the danger is that when he goes he will leave only the husk of a democracy behind.


The End Is Near, Part 7: Governments Become (Really Bad) Money Managers, Screw Up Markets

By: John Rubino


2015 was a year Brazil would like to forget. Its economy crashed, its political class was decapitated by a corruption scandal, a huge iron mine dumped toxic waste onto a bunch of villages -- and the sludge is now seeping into the ocean. See In the Year's Final Indignity, Slime Coats Brazil's Pristine Beaches.

But the Brazilian development with the widest ramifications involves its sovereign wealth fund.

This is an investment fund set up and run by the government and funded with the revenues from commodity sales, that was supposed to increase national wealth by buying things that would then rise in value. This too, has not gone as planned.
Brazil Dips Into Sovereign Wealth Fund as Finances Deteriorate 
(Bloomberg) - Brazil dipped into its $620 million sovereign wealth fund on Tuesday as the government struggles to shore up public accounts that have been hit by the deepest economic recession in 25 years. 
The government withdrew 855 million reals ($216 million) from the fund, or about one-third of its assets, as part of a strategy to boost public coffers, the Finance Ministry said in a statement Wednesday. The decision was made "in a context of economic contraction with a sharp drop in fiscal revenue and difficulties to cut mandatory expenses," the statement read. 
The move was expected after the fund earlier this year started unloading shares of state-owned Banco do Brasil SA, which account for most of its holdings. The fund raised 134 million reals by selling those shares in the first half of July.

Why do we care about Brazil's sovereign wealth fund? Because these days such things are everywhere. Dozens of countries have set them up and released them into the financial markets, to the point that governments -- perhaps the worst money managers that have every existed -- now run in excess of $7 trillion, or more than venture capital and private equity funds combined. Here are the top ten, according to the Sovereign Wealth Fund Institute:

Soverign Wealth Funds

There are at least two major problems with governments becoming hedge funds:

They're infinitely corruptible. Note that the Brazilian fund owned mostly shares of a big state-run bank. That's probably not because Banco do Brazil was the most attractive of all the world's investments. More likely it's because local elites worked for or owned shares in the bank and wanted its price to go up.

One of the complaints about sovereign wealth funds is that they're opaque compared to, say, mutual funds that have to publish updated lists of their holdings. This is not an oversight. It's how the people profiting from the funds' activities like it. So to the extent that governments run lots of money, the system becomes correspondingly more corrupt -- which is another way of saying the invisible hand of market price signaling becomes increasingly crippled, converting everyone -- not just governments -- into dumb money.

Here, for instance, is how Brazil's sovereign fund did with its Banco do Brazil investment in 2015:

Banco do Brazil

They're surprisingly volatile. National governments tend to see these funds as big pots of ready cash whenever budgets fail to balance. This is happening on a vast scale right now, as falling commodity prices crimp the previously robust finances of exporters like Saudi Arabia -- which took back $70 billion from third-party managers this year. Those third-party funds will now have to sell investments to raise the required cash, and $70 billion is a lot of selling.

Sovereign funds have about $4 trillion of oil and gas related investments, so this is just the beginning.

To sum up, the rise of sovereign wealth funds has both impaired financial markets' price signalling and increased their volatility, while making it easier for governments to avoid the hard choices necessary for long-term stability. And 2016 is when they'll really start causing trouble.


Why The Fed Will Never Succeed
     


Furthermore, it's not just the American people who are affected the Fed's monetary management, because the Fed's actions affect nearly everyone on the planet. The Fed does not even admit to having this wider responsibility, except to the extent that it might have an impact on the US economy.

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system.

The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed's group-think.

This is the context in which we need to clarify the effects of the Fed's monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, overvalues financial assets, and encourages businesses to take on projects that are not genuinely profitable.

Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Besides the disruption to healthy business development, monetary inflation also transfers wealth from the owners of the existing money stock into the hands of the initial beneficiaries of extra money and credit. The transfer of wealth is predominantly from savers and wage earners in the non-financial part of the economy, reducing their ability to spend. The beneficiaries of this wealth transfer are the banks and their favoured borrowers, for whom the credit has been created. How it is that destroying widespread ownership of wealth is meant to provide meaningful, lasting improvement to an economy is a mystery never properly explained.

Monetary inflation not only encourages malinvestment, but by destroying the purchasing power of savings it encourages consumers to turn from being savers into borrowers. They have learned that money no longer retains its value. The madness of weak-money policies becomes even more clear when one contrasts empirical evidence of the post-war success of Germany's economy, which was rebuilt on the accumulation of savings, compared with the failure of the other European economies that tried unsuccessfully to inflate their way to prosperity.

Eventually, the tendency for monetary inflation to undermine the purchasing power of a currency leads to a shift in consumer preferences away from holding cash and bank deposits in favour of accumulating physical goods. This is actually the effect that central banks try to achieve, in the mistaken belief they can control the outcome. However, only a small change in this balance of preferences is enough to trigger a dramatic downward shift in the currency's purchasing power, raising the rate of price inflation to far higher levels than previously thought likely by the monetary planners. It is the threat, or even the actuality of this development, that always forces the central bank to raise interest rates to the point where the balance of preferences between money and goods is restored. Inevitably, this triggers a crisis where malinvestments and their associated debt threaten to come dramatically unstuck.

One would have thought it blindingly obvious that the boom and the bust are two sides of the same coin. In other words, if the artificial boom had not been created by monetary stimulus, the crisis of a bust could not occur either.

Where are we in the credit cycle?

The last crisis was triggered by the Fed's increase in the Fed Funds rate in 2006, when it peaked at 5¼% that August. It was held at that level until the following June and reduced sharply thereafter, specifically to stop the unwinding of widespread malinvestments made by industry, investors, and the banks. Interest rates have now been increased this month for the first time since being reduced to the zero bound in December 2008.

We must put ourselves in the Fed's shoes to try to understand why it has raised rates. It has seen the official unemployment rate decline for a prolonged period, and more recently energy and commodity prices have fallen sharply. Assuming it believes government unemployment figures, as well as the GDP and its deflator, the Fed is likely to think the economy has at least stabilised and is fundamentally healthy. That being the case, it will take the view the business cycle has turned. Note, business cycle, not credit-driven business cycle: the Fed doesn't accept monetary policy is responsible for cyclical phenomena. Therefore, demand for energy and commodities is expected to increase on a one or two-year view, so inflation can be expected to pick up towards the 2% target, particularly when the falls in commodity and energy prices drop out of the back-end of the inflation numbers.

Note again, inflation is thought to be a demand-for-goods phenomenon, not a monetary phenomenon, though according to the Fed, monetary policy can be used to stimulate or control it.

Unfortunately, the evidence from multiple surveys is that after nine years since the Lehman crisis the state of the economy remains suppressed while debt has continued to increase, so this cycle is not in the normal pattern. It is clear from the evidence that the American economy, in common with the European and Japanese, is overburdened by the accumulation of malinvestments and associated debt.

Furthermore, nine years of wealth attrition through monetary inflation (as described above) has reduced the purchasing power of the average consumer's earnings significantly in real terms. So instead of a phase of sustainable growth, it is likely America has arrived at a point where the economy can no longer bear the depredations of further "monetary stimulus". It is also increasingly clear that a relatively small rise in the general interest rate level will bring on the next crisis.

Therefore, we are on the edge of the bust of the boom-bust credit-driven business cycle, when all historically accumulated malinvestments begin to liquidate. We are already seeing low-quality borrowers facing difficulties in trying to extend their debt. We are already seeing global trade, which is not immune to the Fed's debt-perpetuation and wealth-transfer policies, contract. We are already seeing the collapse of collateralised loan obligation prices (CLOs) in the low-grade corporate bond market, and the halts called to investor redemptions. If rates for corporate borrowers rise by three or four percent as they have for some recently, you already have a developing debt crisis.

As to whether or not the Fed should be raising rates, it matters not. Instead of the hoped-for gently rising path for interest rates through 2016, it is more than likely this month's rise will be soon reversed, and a whole new round of "extraordinary measures" introduced. The Fed will probably feel greater confidence it can manage a crisis this time than it did at the time of the Lehman crisis, because despite the rapid expansion in the Fed's balance sheet, the dollar is stronger today than in 2008. The fear that open-ended monetary intervention deployed to save the banks and large corporations from insolvency would undermine the currency proved to be unjustified.

Yet more extraordinary methods will probably extend to renewed talk of the Taylor rule and even negative interest rates. From the Fed's narrow point of view, negative interest rates have the virtue of not only transferring wealth by monetary stealth from increasingly impoverished inhabitants of Main Street to those in Wall Street, but it will also rob their bank accounts more directly as well. For an answer as to why the Fed thinks this will save us all, I have no idea. Ask the Fed.


Central Banks’ Shock Therapy Has Investors on Edge

Policy makers had a habit of delivering surprises that jolted markets during 2015

By Tommy Stubbington in London, Min Zeng in New York, and Lingling Wei in Beijing

Central bankers triggered wild swings in markets in 2015. From left, People’s Bank of China Gov. Zhou Xiaochuan, ECB President Mario Draghi, Fed Chairwoman Janet Yellen and Bank of Japan Gov. Haruhiko Kuroda. Photo: l. to r.: Getty Images, Zuma Press, Getty Images, Zuma Press


Behind the biggest market meltdowns of 2015 were familiar culprits: central banks.

And more volatility is likely to follow in 2016 as investors navigate the Federal Reserve’s gradual exit from easy-money policies after the U.S. central bank raised rates for the first time in nearly a decade.

From the Swiss National Bank SNBN 1.20 % ’s shock decision in January to abandon the Swiss franc’s link to the euro, to the European Central Bank’s disappointing stimulus package in December, a series of central bank decisions have provoked extreme market reactions. In between, the decision by China’s central bank in August to weaken the value of its currency fueled fears about the state of the Chinese economy that spurred a global stock selloff.

The bouts of turmoil highlight markets’ growing reliance on the words and actions of central banks in the years following the financial crisis. Rock-bottom interest rates and massive asset purchases designed to kick-start ailing economies have encouraged investors to push into ever-riskier assets in search of returns. That has left many markets vulnerable to sharp reversals when popular trades turn sour.

“This year was a sign of things to come, and it will probably get worse before it gets better,” said Paul Lambert, head of currency at London-based asset manager Insight Investment.

“Central bank policy has pushed many investors beyond their comfort zone. Now we’re seeing the consequences.”
 

Meanwhile, the ECB and the Bank of Japan 8301 -4.64 % continue to grapple with weak economies and low inflation that may force them to ramp up stimulus. Japan’s central bank jolted markets when it announced a modest expansion of its quantitative-easing program on Dec. 18, initially boosting Japanese stocks before they turned sharply lower.

“I think 2016 will be quite challenging for central banks,’’ said Stephen Jen, managing partner at SLJ Macro Partners LLP and a former economist at the International Monetary Fund.

“This is like an 18-wheeler trucker not being sure when and where to turn, but has promised the world that he would use the turn signal in ample time.”

Compounding the problem are tighter regulations that have limited investment banks’ ability to trade large quantities of stocks, bonds and currencies. For investors, that means less liquidity—or the ability to buy or sell assets without moving prices appreciably—and wild market swings when a central bank delivers a surprise.



“Investors are vulnerable to more episodes like these in the future,’’ said Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management Inc., which has $20 billion in assets under management. “Central bank actions have been fueling volatile trading, and in the current low-liquidity environment, holding a crowded position is a recipe for disaster.”

On Jan. 15, the Swiss franc rocketed by more than 40% against the euro after the SNB abruptly removed its cap on the currency’s value—the sharpest one-day move for a major currency in more than 40 years of floating exchange rates. The SNB had been intervening in markets to prevent the franc from climbing too far and hurting Swiss exporters, but threw in the towel after growing uneasy with the enormous pile of euros it had bought. The decision caught out many investors who had bet on a falling franc.

December brought another bout of whiplash for currency investors that spilled into stock markets. The euro climbed more than 4% against the dollar after the ECB delivered a smaller stimulus package than many had expected. The surge—a massive daily move for euro-dollar, the world’s most heavily traded financial instrument—was just the latest in a series of sharp swings in 2015 as investors tried to second guess the rate at which ECB and Fed policy were headed in opposite directions.

The episode highlights another issue for major central banks: how to guide market expectations in a time of uncertainty.

In China, monetary-policy makers caused several rounds of market gyrations this year, as investors struggled to interpret signals from a central bank that often fails to clarify its intentions.

The People’s Bank of China, together with other Chinese regulators, helped fuel an epic run-up in share prices early this year, only to contribute to a dramatic stock-market crash over the summer through a series of conflicting messages. The slump wiped out $5 trillion of value in June and July.

The central bank was then front and center in an unprecedented government effort aimed at propping up share prices, pledging to provide unlimited liquidity to aid stock purchases by state companies.

As stock investors were still licking their wounds, the central bank stunned the world with a devaluation of the Chinese yuan in mid-August. The PBOC said the move was intended to bring the yuan’s value more in line with market expectations, but the surprise action triggered a sharp selloff of the yuan and the currencies in some of China’s trading partners. Many saw the devaluation as an attempt to shore up China’s export sector and a sign that the country’s economy was slowing more sharply than thought.

If China is serious about its push to open up its financial markets and internationalize the use of its currency, “improving PBOC’s communication with investors is very important,” said Puay Yeong Goh, a senior economist at Neuberger Berman, an investment-management firm in New York.

The tumultuous year has left many investors wary of the risks of placing too much faith in central banks.

“Credibility, or rather confidence in central banks has diminished,’’ said Jim Caron, global fixed income portfolio manager at Morgan Stanley Investment Management, which had $404 billion in assets under management at the end of September. “The consequence is that they may not be able to stabilize prices as effectively as they have in the past.”