Three “Rosetta Moments” for the Global Economy in 2015


by Christine Lagarde

Managing Director, International Monetary Fund
Washington D.C.—January 15, 2015


As prepared for delivery


Good morning!

Diana, thank you for the kind introduction, and thank you to Christopher Tuttle and the Council on Foreign Relations for the opportunity to speak today about the outlook for the global economy in this New Year 2015.

The Council and the IMF have much in common: they both take a global perspective; they were both founded after global conflicts – World War I and World War II; and they both joined the perennial quest for a more peaceful and more prosperous world. I am glad to say that we are still on the same team!

Good teamwork and strong leadership will be needed this year. The latest update of our World Economic Outlook – with all the specific numbers – will be formally presented next week. But I can already say this: despite the boost from cheaper oil and stronger U.S. growth, we see the global recovery continuing to face a very strong headwind.

But before I delve into the details of the challenges ahead, I would like to share with you a brief story that has resonated with me.

Late last year, on November 12, a little spacecraft operated by the European Space Agency made the first-ever landing on a comet after a 10-year journey covering half a billion miles. Like millions of others, I was mesmerized by the sheer audacity of this adventure.

The touchdown on the comet, called 67P, was part of the ongoing “Rosetta” mission, which is led by a multinational team of scientists. Together, these scientists have extended humanity’s reach into the cosmos and, by doing so, they have enhanced our understanding of our own planet. They embody the spirit of those 19th century scholars who used the original Rosetta Stone to decode the ancient Egyptian hieroglyphs.

Why is this story relevant right now? Because this year the global economy will face what we might call three “Rosetta moments”. These are major policy challenges that require decisions based on political courage, decisive action, and multilateral thinking—in short, true global leadership.

The first Rosetta moment is all about boosting growth and employment in the next 12 months – overcoming that “strong headwind” that I mentioned. The second Rosetta moment is about achieving more inclusive, shared growth; and the third is about attaining more sustainable, balanced growth.

These three moments are, of course, deeply interconnected and mutually dependent. All are important, all demand strong leadership, all require cooperation. But – surely – if we can catch a comet in space, can’t we address the policy challenges here on Earth?


1. Global outlook, risks, and policy actions – injecting new momentum

I will start with the immediate challenge of how to inject greater momentum into the recovery. As I said, we are still in the process of finalizing the hard numbers for our updated forecast. So I will focus on the main trends and policy recommendations.

The obvious question is this: should lower oil prices and a stronger recovery in the United States make us more upbeat about the prospects for the global economy? The answer is most likely “No,” since there are still powerful factors that weigh on the downside.

Certainly, the drop in oil prices is a welcome shot in the arm for the global economy. Cheaper oil increases consumers’ purchasing power and private demand in oil-importing countries.

Depending on how long oil prices will remain at low levels, this could provide a positive contribution to global growth for some time.

As for the U.S. economy, it performed well in 2014 and should strengthen further this year – largely due to more robust household spending. U.S. unemployment continues to decline; cheaper oil is boosting real incomes and consumer sentiment; and there is continued support from accommodative monetary policy.

So what is the catch? The oil price and U.S. growth are not a cure for deep-seated weaknesses elsewhere. Too many countries are still weighed down by the legacies of the financial crisis, including high debt and high unemployment. Too many companies and households keep cutting back on investment and consumption today because they are concerned about low growth in the future.

In fact, the United States is the only major economy that is likely to buck the trend this year, while others are being held back – mainly by lackluster investment. A promising recovery continues in the UK, but growth remains very low in the Euro Area and Japan. And emerging economies, led by China, are slowing down, relatively speaking.

Risks

Overall, we believe that global growth is still too low, too brittle, and too lopsided. Moreover, there are significant risks to the recovery. What are these? 


  • First, the asynchronous normalization of monetary policies in advanced economies. There has been a lot of talk about this, but this year we should expect it to actually begin. The U.S. could see its first rise in short-term interest rates since 2006 – an important moment. Even if this process is well-managed and well-communicated – and I believe that it has been and will be – there could be negative effects for emerging markets and global financial stability.

  • Second, emerging and developing economies could face a triple hit of a strengthening U.S dollar, higher global interest rates, and more volatile capital flows. A stronger dollar will have a significant impact on financial systems in emerging markets, because many banks and companies have increased their borrowing in dollars over the past five years. The oil price drop – and weaker commodity prices more generally – have added to these risks, with some countries such as Nigeria, Russia, and Venezuela facing huge currency pressures. Given the size of these economies, the recent developments could also have significant regional effects.

  • Third, there is a risk that the Euro Area and Japan could remain stuck in a world of low growth and low inflation for a prolonged period. This “low-low environment” would make it even harder for many Euro Area countries to reduce unemployment and excessive public and private debt, and so would raise the risk of recession and deflation.

  • Fourth, there are increased geopolitical risks. In Ukraine, for example, increased international support to complement IMF support is crucial. At the same time, there is a palpable sense that the forces of intolerance and fragmentation are gaining strength. The recent atrocities in France – my home country – in Nigeria, or in Pakistan are only the latest actions of forces that are fundamentally opposed to what we here in this room believe in.
This all points to one thing: the need for a powerful policy mix that can strengthen the recovery and provide better employment perspectives for citizens worldwide. How can policymakers deliver on this Rosetta moment?

Policy action

Broadly speaking, accommodative monetary policies remain essential. Fiscal adjustment must be as growth and job-friendly as possible. And above all, policymakers need to finally step up structural reforms. This economic mantra – support demand, growth, and structural reforms – is not new, but now takes on increased urgency. And it places increased emphasis on political leadership.

For example, the impact of lower oil prices will prove to be an immediate test for many policy makers. Not so much for oil importers, for whom the windfall provides an opportunity to strengthen their macroeconomic frameworks and may help in alleviating inflation pressures.

But oil exporters need to cushion the shock on their economies. Some are using their rainy day funds and fiscal deficits to adjust public spending more gradually. Others resort to allowing substantial exchange rate depreciation, which poses the risk of inflation and may require tighter monetary policies.

In the Euro Area, cheaper oil is contributing to a further decline in inflation expectations, which increases the risk of deflation. This bolsters the case for additional monetary stimulus, which the European Central Bank has indicated it stands ready to support as needed.

Most importantly, however, the drop in oil prices provides a golden opportunity to cut energy subsidies and use the savings for more targeted transfers to protect the poor – for which the IMF has been pushing hard. We have recently seen a successful decrease in fossil fuel subsidies in countries such as Cameroon, Côte d’Ivoire, Egypt, Haiti, India, Indonesia, and Malaysia. In some advanced countries, policymakers should also seize the moment to increase energy taxes to build fiscal buffers or reduce other taxes, especially on labor.

This, of course, requires political courage – which it has in common with the 2nd Rosetta moment: how to achieve more inclusive, more shared growth over the medium term.


2. Structural reforms, infrastructure, and trade – generating more inclusive growth

Let me be blunt: more than six years after the start of the Great Recession, too many people still do not feel the recovery. In too many countries, unemployment remains high and inequality has increased. This is why we need a decisive push for structural reforms to boost current and potential growth over the medium term.

2015 must be the year of action. This means removing deep-seated distortions in labor and product markets; it means revamping creaking infrastructures and building new ones; it means trade liberalization and pressing ahead with reforms in education, health, and social safety nets. It also means unleashing the economic power of women.

I would like to expand on two potential game changers.

Infrastructure investment

One is infrastructure investment – where it is carefully chosen and efficient. Let me be clear: I am not referring to the proverbial “bridges to nowhere”. IMF research shows that increased public infrastructure investment raises output in the short term by boosting demand; and in the long term by raising the economy’s productive capacity. Indeed, lifting quality infrastructure investment is a major part of the G-20 growth agenda, which is estimated to add more than US$2 trillion to the global economy over the next four years.

The scope for such investments varies across countries, depending on their fiscal space and infrastructure gaps. India and Brazil, for example, would need to focus on removing bottlenecks – in transportation and energy – that constrain their growth. In the U.S. and Germany, it is more about fixing up existing infrastructure after decades of under-investment.

Whatever the need, now is the time to show determination – for example, by following through on the European Commission’s ambitious €315bn investment plan, which holds out the promise of stronger growth and job creation.

Gender policies

Another potential game changer is to unleash the economic power of millions of women who are currently locked out of the labor market. Excluding these women is not just morally wrong, it is bad economics. Gender gaps in labor force participation exist all over the world, ranging from 12 percent in the OECD economies to 50 percent in the Middle East and North Africa.

Countries like Chile and the Netherlands, for example, have shown that you can sharply increase female labor force participation through smart policies that emphasize affordable childcare, maternity leave, and workplace flexibility. Again, one of the key goals of the G-20 growth strategy is to close the gender gap by 25 per cent over the next decade. This would bring more than 100 million women into the labor force, thus increasing global growth and reducing poverty and inequality.

Trade reform

The next question is: how can we better leverage the gains from various structural reforms? Trade liberalization may well provide the right answer!

After years of slowing growth in global trade, 2015 could be a make-or-break year for negotiations on an ambitious Transpacific trade deal – the Trans-Pacific Partnership (or TPP). Policymakers also need to press ahead with negotiations on a Transatlantic deal, known as TTIP, which is less advanced but could provide just as many benefits as its Pacific cousin.

In the United States, these important trade deals are areas of potential cooperation between the new Congress and the President. For the European Union, progress on trade would be immensely helpful in lifting growth and confidence. The Japanese government is keen to use the TPP to inject greater competition into its low-growth economy. And emerging and developing economies would benefit from better integration into the global economy. So what’s there not to like?

On all sides, there are incentives to cut deals. Political will is now needed to get to the finish line.

Here we arrive at the 3rd Rosetta moment: how to achieve more sustainable, balanced growth over the long term? Financial regulation, international development, and environmental policy are key.


3. Financial regulation, international development, and climate change – engendering more sustainable growth

If there is one lesson from the Great Recession, it is that you cannot have sustainable economic growth without a sustainable financial sector. So we must complete the agenda on financial sector reform.

There has been progress, especially on banking regulation and – to a lesser extent – on addressing too-important-to-fail financial institutions. The global banking system is now less leveraged and therefore less vulnerable to contagion. But shadow banking has yet to be transformed into a resilient source of finance for the economy.

The big challenge now is to implement reforms and improve the quality of supervision. For example, the two most important financial markets – the United States and the European Union – have diverged in their implementation of the Basel III framework. These differences will need to be carefully monitored. We also need to make progress in setting rules for complex derivatives transactions that stretch across borders.

Above all, we have yet to see a sea change in the culture of the financial sector. Some important actions are being taken: for example, the first jury trials related to the LIBOR trading scandal will be held this year. But fully restoring trust needs an all-out effort to promote and enforce ethical behavior throughout the industry.

Sustainable Development and Climate Change

Another example of how to engender more sustainable growth is through international development. Later this year, in September, the United Nations will host a major conference that will seek to replace the Millennium Development Goals, adopted in 2000, with a new set of Sustainable Development Goals. We, the IMF, will play a significant role in helping countries meet the new development goals, building on our long-standing work in developing countries.

2015 will also be make-or-break for efforts to strike an international agreement on climate change, which is on a collision course with the global economy. Average temperatures are rising – 2014 was the warmest year on record – and so is the risk of more frequent natural disasters and of more food and water insecurity.

Again, we need greater political courage to reach a comprehensive deal to cut carbon emissions at the Paris summit in December. A successful agreement could usher in a new energy era that could help save the planet.

Conclusión

This brings me back to the beginning. While I was speaking, the Rosetta spacecraft has continued to circle the dark, icy object that is comet 67P. As the comet proceeds closer to the sun, we may yet learn more of its secrets. Given the diversity of its staff and backers, the Rosetta mission is a true testament to global cooperation.

Policymakers should take inspiration from that. There are no secrets about what can engender growth. But if they are to deliver on the three Rosetta moments, they need to enhance global cooperation. They need to embrace what I have called the “new multilateralism”. This is the year when it should be put into practice.

The new multilateralism also requires institutions that are efficient, credible, and representative of a changing global economy. This is why the international community agreed to reform the IMF to increase the representation of emerging market countries. The 2010 quota and governance reforms would also help sustain the Fund’s financial firepower to meet the challenges ahead.

The IMF’s membership had called on the United States to ratify the 2010 reforms by the end of last year, which did not happen. As I have spoken much about leadership today, I cannot but express my profound disappointment in the political powers who have so far failed to grasp the benefits of the reform both for their own country and for the world at large. We have seen better from the United States over the last 70 years.

We will now be working on interim solutions to address some of the concerns of our other 187 member countries. But let me be clear: given the challenges that 2015 and the following years will bring, there is no alternative to completing the 2010 reforms – and we continue to call on Congress to approve them without delay.

I would like to end with a quote that encapsulates my call for greater leadership and cooperation in service of the global public good.

It is attributed to Pericles, the Athenian statesman and orator:

“What you leave behind is not what is engraved in stone monuments, but what is woven into the lives of others.”

There is a lot of weaving to be done this year. Thank you.


Switzerland 'capitulates' on franc as global currency wars take next victim

The franc soared 30pc in one of the wildest days in Swiss history after the central bank abandoned its currency cap to avert mounting losses

By Ambrose Evans-Pritchard

9:13PM GMT 15 Jan 2015
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table football with players substituted by replicas of Swiss Franc notes in Lausanne
Table football with players substituted by Swiss franc notes. The Swiss monetary base has exploded from 80bn francs to almost 400bn francs since mid-2011 Photo: AFP
 
 
Switzerland’s currency defences have been smashed by safe-haven flows from across Europe, setting off a day of historic mayhem on Swiss financial markets and threatening to engulf the country in a deflationary vortex.  
The franc surged 30pc against the euro in early trading after the Swiss National Bank stunned traders by scrapping its three-year currency floor and freeing the exchange rate, forcing a desperate scramble by hedge funds to cover exposed positions on the futures markets.
 
"If the SNB thought that it could make this adjustment in an orderly manner, then it has failed miserably," said Kathleen Brooks, from Forex.com. The franc ended the day up 17pc.
 
The SNB slashed its key interest rate to an unprecedented level of -0.75pc to offset the shock effect of automatic monetary tightening, but even this may not be enough to deter capital. Willem Buiter, from Citigroup, said the Swiss could cut rates to -5pc. “That would bring down the franc,” he said.
 
The move came three days after a top SNB official vowed that the peg would “remain a pillar of our monetary policy”, and a month after the bank warned of a dangerous deflationary spiral and “drastic cost cuts” if the 1.20 floor against the euro were broken.

Thomas Jordan, the SNB’s president, denied that the volte-face was a “panic reaction” and apologised for the subterfuge. "You can only end a policy like this by surprise. The whole international situation has changed,” he said.
 
“The SNB has lost the trust of the markets” was the angry headline across the front page of the Neue Zürcher Zeitung. Even the economy minister, Johann Schneider-Ammann, was shocked, grumbling bitterly that it would make it even harder for exporters to keep afloat.
 
A flow of money from Russia – and lately Greece and even Italy – has made it increasingly hard for the SNB to hold the line. Full quantitative easing by the European Central Bank as soon as next week threatens to overwhelm Switzerland and may have been the final trigger.





Jeremy Cook, from World First, said the retreat was a “total capitulation” in the face of forces that are too big even for a central bank with plenty of firepower. “Nobody wins when you stand in the way of a freight train, except for the train.”
 
The SNB could in theory have held the line forever by printing unlimited amounts of money but the side-effects had already become toxic. Spasms of currency intervention have caused foreign reserves to reach 73pc of GDP.





This in turn has caused the Swiss monetary base to explode from 80bn francs to almost 400bn francs since mid-2011, accompanied by a torrid property boom and jump in bank loans to a modern-high of 170pc of GDP.
 
“They have had to throw in the towel. This is going to cause extreme pain for parts of the Swiss economy but the SNB are trapped,” said David Owen from Jefferies.



Nick Hayek, head of watch maker Swatch, said the collapse of the floor would cause havoc for Swiss manufacturers. "Words fail me. Today's SNB action is a tsunami; for the export industry and for tourism, and for the entire country," he said.
 
"It’s a serious threat for tens of thousands of Swiss jobs," said Christian Levrat, leader of the Swiss Social Democrats party.
 
The Swiss stock market plummeted 8.7pc, at one point suffering the biggest one-day crash in a quarter of a century. Exporters and banks were hit hardest, with Swatch down 15pc and UBS down 11pc.
 
Analysts were baffled as the SNB tried to play down the drama and as it suggested that the rising dollar has reduced the overvaluation of the franc. Citigroup said the real exchange rate had in fact appreciated by 1pc over the past year even before Thursday’s move. It is now trading at 38pc above its decade-long average.




The Swiss economy is growing at 1.5pc but the KOF index of business sentiment has been trending down for almost two years. The country faces the risk of a nasty hangover from its domestic credit boom that could prove treacherous at a time when the franc is soaring and monetary levers no longer work.
 
Gabriel Stein, from Oxford Economics, said the franc is now likely to strengthen relentlessly, pushing the country into a “prolonged bout of deflation”. If the currency reaches $0.70 to the US dollar it would cause a deep recession, with deflation nearing -3pc by 2016.
 
Professor Ernst Baltensperger, Switzerland’s leading currency expert, said the euro floor worked well at first but was becoming a danger in itself. The greater the excess liquidity, the harder it is to mop up when the tide turns, and monetary velocity rises.
 
The SNB’s meddling with market forces has set off a populist backlash from the cantons.

Voters fear that the bank will be swamped by losses on its books, tantamount to a fiscal liability. There are already reports in the Swiss press that the bank "lost" 60bn francs in Thursday’s trading.
 
“Huge foreign exchange reserves with a non-permanent peg always carry an inherent loss, due to materialise when the peg is abolished,” said Mr Stein. The SNB may have decided to take its punishment before it is too late.
 
The traumatic day in Switzerland has exposed limits of central bank power. It is a foretaste of how difficult it is becoming for countries to resist the tidal force of devaluation policies and currency warfare as deflationary forces sweep the world. The monetary hegemons are left having to pick their poisons.
 

Markets

Swiss Move Prompts Fears of Sustained Market Tumult

By Landon Thomas Jr. and Neil Gough

January 16, 2015 12:28 am

The Swiss central bank’s surprise decision to remove the cap on its currency has incited investor fears that a spate of bank and fund losses could lead to a sustained bout of market turmoil beyond the ability of central banks to ride yet again to the rescue.
 
The Swiss franc soared against the euro, which tumbled in value against the dollar after the move by the central bank on Thursday. The yen pushed upward, emerging market currencies gyrated and the price of oil rose sharply, reversing its recent fall.
 
The last few days have been a time of “volatile volatility,” to use the words of a top Citigroup executive — trader jargon for a series of sharp, disorienting moves in stocks, currencies and bonds that can ultimately lead to market-rattling events like the collapse of a major bank or investor.
 
This was the explanation used by FXCM, one of the largest foreign exchange trading platforms for individual investors in the United States, when it said on Thursday that “unprecedented volatility” after the Swiss franc’s surge against the euro had led to $225 million in customer losses that might put it in breach of capital requirements. On Friday, the company announced that it would receive a $300 million loan from the parent company of the investment bank Jefferies to allow it to keep operating.
 
There were other casualties in the currency markets, including several small brokerage firms in Britain and New Zealand.
 
The question now is whether the much larger players in the $5 trillion-a-day foreign exchange market, global banks like Barclays, Deutsche Bank and others, might have been caught short in significant ways.
 
   Drew Niv, chief executive the online currency trading service FXCM.Credit Lucas Jackson/Reuters
 

Citigroup sustained more than $150 million in losses on its currency trading desks in the turmoil after the Swiss move, a person with knowledge of the matter said on Friday.
 
The possibility of a big bank suffering a crippling blow as a result of the recent market gyrations appears remote. Yet the losses by big and small players is troubling to market participants because they were instigated by none other than a central bank.
 
For investors who have taken on increasing amounts of risk in the belief that the aggressive actions of the Federal Reserve, the European Central Bank and others would always bail them out, this comes as a rude shock.
 
One sales trader at a large European bank said that at a dinner of large investors Thursday night, he had never seen such a “stunned look” on the faces of his clients as they tried to come to terms with the Swiss central bank’s move.
 
“You could really feel the hurt out there,” said this person, who spoke on the condition of anonymity to publicly discuss his clients’ fluctuating moods.
 
The only thing that gave these investors — some of the largest in the world — hope is the belief that this action by the Swiss central bank would put even more pressure on Mario Draghi, the president of the European Central Bank, to deliver on a widespread expectation that the E.C.B. will buy eurozone government bonds in bulk.
 
“We have had this long period in which quantitative easing and zero interest rates have squeezed volatility out of the system,” said Kit Juckes, a foreign exchange strategist at the French bank Société Générale. “Now when you release it, it does not come out smoothly or predictably. This can eat away at investor confidence.”
 
This is why FXCM absorbed large losses along with its clients and why it said Thursday evening that it might be in breach of its regulatory capital requirements. The Swiss central bank had long said it was committed to buying euros and selling francs, so hedge funds and many others followed blindly in its wake — to their detriment.
 
FXCM was a small player on Wall Street, but its troubles could hit a handful of larger banks that had lent to the firm. A public filing by FXCM in August last year said that the company could borrow up to $150 million from Bank of America, Capital One, Credit Suisse, Morgan Stanley, UBS, Barclays and Bank Hapoalim, which is based in Israel. At the end of September, FXCM had borrowed only $30 million under the loan facility, according to another recent securities filing. FXCM has not borrowed more than that since, according to people at two banks with knowledge of the loan who spoke on the condition of anonymity.
 
The $300 million loan from the Jefferies parent, Leucadia National, may help ease any cash flow problems at FXCM. But the Leucadia loan may give limited comfort to FXCM’s other creditors. Leucadia said that its loan was “senior” and “secured,” which means that Leucadia may have priority over other lenders and that it has the right to assume ownership of FXCM’s assets if it does not pay back the loan.
 
Other small brokers ran into trouble.
 
Alpari UK, a foreign currency broker in Britain, said on Friday that it had entered insolvency as a majority of its clients sustained losses in excess of their account equity. “Where a client cannot cover this loss, it is passed on to us,” the firm said in a statement on its website.
 
The broker sponsors the English professional soccer team West Ham United and is featured prominently on the team’s jerseys. It is an independent entity within the association of the Alpari companies, which include affiliates in Japan, Russia, the United States and other parts of the world, according to the company’s website.
 
In New Zealand, Global Brokers NZ, another online foreign exchange broker, said it was shutting down.
 
“The dramatic move on the Swiss franc fueled by the Swiss National Bank’s unexpected policy reversal of capping the Swiss franc against the euro has resulted in rare volatility and illiquidity,” David Johnson, the director of the company, said in a statement posted online on Thursday.
Some foreign exchange brokers did better in the face of the tumult.
 
Oanda, a large online currency trading specialist based in Toronto, said that because of its strong capital position, the firm was able to forgive the losses that some of its clients incurred.
 
“Some of our clients went negative,” said Ed Eger, the chief executive of Oanda. “But we decided to forgive them and bring their balances back to zero — even though we suffered losses.”

 
Reporting was contributed by Chad Bray, Peter Eavis, Michael Corkery, David Jolly and Jack Ewing.

Energy

Seize the day

The fall in the price of oil and gas provides a once-in-a-generation opportunity to fix bad energy policies

Jan 17th 2015
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MOST of the time, economic policymaking is about tinkering at the edges. Politicians argue furiously about modest changes to taxes or spending. Once in a while, however, momentous shifts are possible. From Deng Xiaoping’s market opening in 1978 to Poland’s adoption of “shock therapy” in 1990, bold politicians have seized propitious circumstances to push through reforms that transformed their countries. Such a once-in-a-generation opportunity exists today.

The plunging price of oil, coupled with advances in clean energy and conservation, offers politicians around the world the chance to rationalise energy policy. They can get rid of billions of dollars of distorting subsidies, especially for dirty fuels, whilst shifting taxes towards carbon use. A cheaper, greener and more reliable energy future could be within reach.

The most obvious reason for optimism is the plunge in energy costs. Not only has the price of oil halved in the past six months, but natural gas is the cheapest it has been in a decade, bar a few panicked months after Lehman Brothers collapsed, when the world economy appeared to be imploding. There are growing signs that low prices are here to stay: the rising chatter of megamergers in the oil industry is a sure sign that oilmen are bracing for a shake-out. Less noticed, the price of cleaner forms of energy is also falling, as our special report this week explains. And new technology is allowing better management of the consumption of energy, especially electricity. That should help cut waste and thus lower costs still further. For decades the big question about energy was whether the world could produce enough of it, in any form and at any cost. Now, suddenly, the challenge should be one of managing abundance.

Clean up a dirty business
 
That abundance provides the potential for reform. Far too many economies are littered with the detritus of daft energy policies, based on fears about supply. Even though fracking has boosted America’s oil output by two-thirds in just four years, the country still bans the export of oil and restricts exports of natural gas, a legacy of the oil shocks of the 1970s—and a boondoggle for American refiners and petrochemical firms. Congress also keeps handing out money to Iowa’s already coddled corn farmers to produce ethanol and has not reviewed generous subsidies for nuclear power despite the Fukushima disaster and ruinous cost over-runs at new Western plants. Instead, it has spent four long years bickering about whether to allow the proposed Keystone XL pipeline to Canada’s tar sands. In Europe the giveaways are a little different—billions have gone to wind and solar projects—but the same madness often prevails: Germany’s rushed exit from nuclear power ended up helping boost American coal and Russian gas.

The most straightforward piece of reform, pretty much everywhere, is simply to remove all the subsidies for producing or consuming fossil fuels. Last year governments around the world threw $550 billion down that rathole—on everything from holding down the price of petrol in poor countries to encouraging companies to search for oil. By one count, such handouts led to extra consumption that was responsible for 36% of global carbon emissions in 1980-2010.

Falling prices provide an opportunity to rethink this nonsense. Cash-strapped developing countries such as India and Indonesia have bravely begun to cut fuel subsidies, freeing up money to spend on hospitals and schools. But the big oil exporters in the poor world, which tend to be the most egregious subsidisers of domestic fuel prices, have not followed their lead.

Venezuela is close to default, yet petrol still costs a few cents a litre in Caracas. And rich countries still underwrite the production of oil and gas. Why should American taxpayers pay for Exxon to find hydrocarbons? All these subsidies should be binned.

What a better policy would look like
 
That should be just the beginning. Politicians, for the most part, have refused to raise taxes on fossil fuels in recent years, on the grounds that making driving or heating homes more expensive would not only annoy voters but also hurt the economy. With petrol and natural gas getting cheaper by the day, that excuse has gone. Higher taxes would encourage conservation, dampen future price swings and provide a more sensible way for governments to raise money.

An obvious starting point is to target petrol. America’s federal government levies a tax of just 18 cents a gallon (five cents a litre)—a figure that it has not dared change since 1993. Even better would be a tax on carbon. Burning fossil fuels harms the health of both the planet and its inhabitants. Taxing carbon would nudge energy firms and consumers towards using cleaner fuels. As fuel prices fall, a carbon tax is becoming less politically daunting.

That points to the biggest blessing cheaper energy brings: the chance to inject some coherence into the world’s energy policies. Governments have a legitimate role in making sure that energy is abundant, clean and secure. But they need to learn the difference between picking goals and deciding how to reach them. Broad incentives are fine; second-guessing scientists and investors is not. A carbon tax, in other words, is a much better way to reduce emissions of greenhouse gases than subsidies for windmills and nuclear plants.

By the same token, in the name of security of supply, governments should be encouraging the growth of seamless global energy markets. Scrapping unfair obstacles to energy investments is just as important as dispensing with subsidies. The more cross-border pipelines and power cables the better. America should approve Keystone XL and lift its export restrictions, while European politicians should make it much easier to exploit the oil and gas in the shale beneath their feet.

This ambitious to-do list will drive regiments of energy lobbyists potty. But for the first time in years it is within the realm of the politically possible. And it would plainly lead to a more efficient and greener energy future. So our message to politicians is a simple one. Seize the day.

Up and Down Wall Street

Listen to Dylan -- the Winds Are Blowing Toward Deflation

Markets from stocks to bonds to currencies and commodities suggest pressures on prices are downward.

By Randall W. Forsyth           

January 14, 2015

 
 
You don’t need a weatherman to know which way the wind’s blowing, Bob Dylan sagely advised some years ago. And for the markets, the wind seemed to be blowing the same way across a number of fronts -- that is, from a deflationary direction.
 
Most dramatic were the swings in the U.S. stock market, which initially soared only to relinquish their gains and ultimately end lower. That would simply seem to fulfill J.P. Morgan’s famous observation that markets will fluctuate, but the session was more telling to observers of such things.
 
The seemingly minor 0.26% decline in the Standard & Poor’s 500 would appear almost banal were it not the result of wild swings. After opening strongly and having been up a hefty 1.4%, the big-stock benchmark gave that back and more.
 
The significance is that the moves constituted what technicians call an “outside down day” -- a higher high than the previous session plus a lower low, and ultimately ending lower. Such outside days tend to produce what’s dubbed as key reversals in the market trends, depending on how the session resolves itself. In this case, it was to the downside.
 
Leading the way lower were homebuilding stocks and KB Homes  in particular, which plunged some 16%. While the builder reported strong earnings and a decent backlog of orders, it also warned of some margin pressures owing to rising costs and increased need for price cuts.
 
KB noted weaker-than-expected sales in inland California, a second-tier region that prospered during the past decade’s bubble from demand from homebuyers who flocked to its suburban sprawl because they were priced out of the more desirable coastal areas. The New York Times last year highlighted the so-called Inland Empire in a feature as a center of new poverty in what had been seen as a middle-classed enclave.
 
Weakness invariably shows up first in the more marginal sectors of any market, especially residential real estate.
 
Economic data released Tuesday, which reflects past conditions rather than the present let alone the future, continued to suggest apparent strength, however. The Job Openings and Labor Turnover Survey -- JOLTS to the economic-data junkies -- showed more openings and a greater willingness on the part of job-holders to quit in November. That provides circumstantial evidence of a more robust labor market. That, however, was belied by the slump in average hourly earnings in December, according to the employment report released last Friday.
 
Meanwhile, the National Federation of Independent Business reported optimism among small businesses rose again in December, reaching the highest level since December 2006, a year before the last recession began. While their plans to hire rose four percentage points, to 15%, some 80% of employers who were looking for staff said they were getting few or no qualified applicants for openings. Yet, for whatever reason, there’s no bidding war for talent, which would be a sign of inflation in the labor market.
 
Price pressures also remain to the downside in the commodities market, with U.S. crude falling to a 5½-year low, trading down below $46 a barrel. Meanwhile, the premium for so-called Brent crude, the European benchmark, was eliminated amid the glut in the oil market. Brent had commanded about $10 more at the market’s peak in mid-2014 owing to geopolitically inspired supply concerns.
 
The negative effects of the oil-price plunge continued to ripple through the industry with Canada’s Suncor Energy announcing it will slash one billion Canadian dollars ($836 million) from its 2015 spending while cutting 1,000 jobs. It remains to be seen if the lift to spending from consumers’ windfall at the gas pumps offset the loss of these hefty paychecks. Meanwhile, industrial metals slid across the board with copper traded on the New York Comex dropping another 1.7% while grains such as wheat and corn remained under pressure.
 
Despite the strong economic data, the bond market sees things as the commodities markets do. Treasury yields continue to hover at historic lows, which isn’t news, but various market interrelationships reveal more. The inflation premium in T-note yields shriveled further, evidenced in the TIPS spread (discussed here last week), indicating expectations inflation will average only 1.55% over the next decade. (If you the consumer price index will rise more, consider TIPS, as the Wall Street Journal suggested recently.)
 
The Treasury market also expressed its considered opinion that bond yields will remain lower for longer by sending the 30-year long bond to equal its record low of 2.50%. That further shrank the spread between the benchmark 10-year note, which ended Tuesday at 1.90%, to just 60 basis points (0.6 percentage points.) A year ago, the long bond yield provided half-again the yield pick-up.
 
Such a flattening of the yield curve is a classic market signal of disinflation. And, in the spirit of the times, there’s an exchange-traded product to play that trend. The iPath U.S. Treasury Flattener exchange-traded note (FLAT) is up 11.35% over the past year versus 10.01% for the S&P 500, according to Yahoo Finance. And that’s bested by the greenback, which players at home can trade via the PowerShares DB US Dollar Bullish ETF, which is up 12.9% over the span.
 
Despite the stronger economic data, which mainstream economists insist should push the Federal Reserve into raising its short-term interest-rate target by mid-year, the markets keep pushing that eventuality farther out in the future.
 
According to the CME’s FedWatch site, it’s now just a hair less than even money the federal funds target rate will be 0.5% by the time of the Sept. 17 meeting of the Federal Open Market Committee. (The key rate has been pegged at 0-0.25% for just over six years since the financial crisis.) It’s also a bit less than even money the fed funds rate will be 0.75% by the Dec. 16 FOMC meeting, with that target attained at the Jan. 27, 2016 confab.
 
The sum total of the markets’ message is surprisingly uniform: stocks, bond, commodities and currencies all indicate the winds are blowing toward disinflation.
 
Dylan was right. Weathermen and women and economists may insist their forecasts are correct, but the markets are the telltale that tells you which way the winds are blowing.


The "Gnomes of Zürich" Created a Financial Nightmare

By Michael E. Lewitt, Special Contributor, Money Morning

January 17, 2015

 

At that point, the world entered the terminal phase of central banking that unleashed heightened volatility in stocks, bonds and currencies.

This week, the Swiss National Bank effectively abandoned the euro by removing the peg between the Swiss franc and the common European currency. With this move, which shocked financial markets and inflicted huge losses on currency traders around the world, the terminal phases accelerated to a dangerous new level.

Make These Moves Before the Next Shock

Next Thursday, the European Central Bank (ECB) is expected to announce a massive QE program (sources are targeting €500 billion in bond purchases) in its own attempt to stop European deflation in its tracks.

The odds of such a program creating sustainable economic growth in the region while fiscal policymakers do nothing is roughly akin to the odds of Bill Gross returning to work at PIMCO.

And once markets come to lose faith in the ECB's ability to do its job, the world will be down to just one central bank to whom it can continue to genuflect – Janet Yellen's Federal Reserve.

We all know what comes after the terminal phase of an illness – and investors need to prepare now by sharply reducing their exposure to the most expensive parts of the stock and junk bond markets, buying gold and municipal bonds, and increasing their cash positions to be in a position to take advantage of future bargains.

They can also earn huge profits by going long the dollar and shorting the euro and the yen by buying the PowerShares DB US Dollar Index Bullish (NYSEArca:UUP) ETF or the ProShares Short Euro (NYSEArca:EUFX) ETF.

The Franc's "Deadly" Allure Trapped Many

The Swiss National Bank's move was not just another stumble by a central bank. Those happen all the time. The Swiss franc holds a special status in global finance despite Switzerland's small size.

For many, Switzerland still holds the veneer of financial stability despite the fact that its central bank balance sheet has grown to 80% of its GDP. Ultra-low interest rates lured a wide cast of characters including Russian oligarchs and average Eastern Europeans to borrow Swiss francs to buy or finance their real estate.

Speculators around the world engaged in carry trades in which they borrowed Swiss francs and invested in other higher yielding assets. All of these investments came crashing down this week when the Swiss franc collapsed by 20% against the euro and the U.S. dollar.

A number of forex trading firms went belly-up, literally overnight, with one of largest U.S. retail firms, FXCM Inc. (NYSE:FXCM), having to be bailed out to the tune of $300 million by Leucadia National Corp. (NYSE:LUK) (the parent of investing banking house Jefferies) on Friday. Other brokers, including Alpari (UK) Limited and Global Broker NZ Ltd. also vaporized after their customers were wiped out and their lenders refused to rescue them.

This is what happens in a crisis and is a small preview of what could happen if the global economy deteriorates further.

The Swiss Bank Made an Impossible Promise

Even worse than the financial losses, however, was the damage inflicted on the image of central bank competence. Only a month earlier, on December 18, the SNB had promised to defend its currency and maintain its peg to the euro.

Apparently, having had occasion over the holidays to study Emerson and come to the conclusion that "a foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines," the gnomes of Zürich realized they were fighting a losing battle and threw in the towel.

It was not this week's announcement that was the blunder so much as the December promise to keep fighting an unwinnable fight that set up markets for a shock. The move has delivered a serious blow to the confidence in central banks that is the thin tissue that has held markets together since the financial crisis. The news is still being absorbed by markets and further knock-on effects are sure to surface.

Coming after the oil shock and the collapse in global interest rates, the Swiss shock is another nail in the coffin of the global recovery thesis. And stocks reacted accordingly despite recovering on Friday.

The Dow Jones Industrial Average shed 226 points or 1.3% on the week to close at 17,511.57 while the S&P 500 dropped 25 points or 1.3% to end the week at 2,109.42. The Nasdaq Composite Index lost 70 points or 1.5% to 4634.38.

These moves hide the volatility that rocked markets during the week, however, with stocks making huge intraday percentage moves as investors wrestle with increasing uncertainty.

Bond Yields Extend Their "Disappearing Act"

While stocks were weakening, bonds were again rallying with the yield on the benchmark 10-year Treasury collapsing by 15 basis points to 1.82% (after trading as low as 1.75%). Of course, this looks like a high yield bond compared to the rest of the world. Swiss yields are negative out to 10 years.

German 10-year rates fell to a record low of 0.411% while France's followed to 0.635%. Spanish and Italian 10-year yields fell to 1.5% and 1.659%, respectively. One has to ask what Europe can possibly accomplish with rates already so low – and the answer is obviously very little.

QE may well drive these yields lower, no doubt setting up an eventual opportunity to short weak sovereign European bonds once markets tire of the fallacy that monetary policies that have failed to generate economic growth over the past six years are miraculously going to become effective. Japanese yields continued their disappearing act as well, ending the week at 0.23%.

Countdown to Zero

When interest rates are at the zero bound – that is, when central banks have dropped their benchmark rates to zero – the adjustments necessary to properly reflect underlying economic conditions have to occur in currencies and other financial instruments.

When the U.S. dollar started rallying in 2014 against other major currencies, that was the signal that those adjustments were beginning to occur. That triggered the collapse in oil and other commodity prices. Now it is only a matter of time before global stock prices adjust. Right now the S&P is only down 3.4% from its closing high of 2,090.57 on December 29, 2014.

In contrast, bond yields are at or near record lows around the worlds and commodity prices have collapsed. Such an obvious disconnect between equity prices, which are supposed to reflect the earnings power and economic health of the economy, and bond and commodity prices, which are extremely sensitive readings of the same economic fundamentals, is unsustainable.

Experience demonstrates that bonds and commodities usually lead the stock market downward. Investors should prepare accordingly.

It All Comes Back to the Fed in the End

All eyes will no doubt turn back to the Fed. The yield on the two-year Treasury note has dropped sharply to 0.47% Friday from 0.75% last month. The Chicago Mercantile Exchange's Fed Watch site shows that Fed Funds futures aren't pricing in a rate increase to 0.5% until October.

Markets are again expecting the Fed to delay its already belated interest rate hike. Having already promised not to move for at least its next two meetings (January and March), markets will remain on pins-and-needles as they watch for any hint of the Fed's intentions.

At the zero bound, however, they are dancing in the tip of a pin because there is less and less that the Fed can do to stimulate economic growth. Placing too much faith in what central banks say rather than what they do can be dangerous to investors' health as those who were on the wrong side of the Swiss National Bank's about-face learned this week.

Heard on the Street

ECB Can No Longer Duck the QE Question

By Richard Barley

Jan. 16, 2015 11:46 a.m. ET
 .



 

Philly Fed Crashes From 21 Year Highs To 12 Month Lows, Employment Tumbles

by Tyler Durden

01/15/2015 10:08 -0500


With the biggest miss since August 2011, The Philly Fed Factory Index crashed from 21 year highs in November to the lowest since Feb 2014. The headline 6.3 print, missing expectations of 18.7, follows last month's drop for the biggest 2-month drop since Lehman. Under the surface things are even worse with the employment sub-index plunging to its worsdt since June 2013 and the outlook for CapEx slashed in half from 24.8 to 13.2. But but but fundamentals...
 
From best in 21 years to total carnage and biggest 2-month slump since Lehman...


 

And under the covers its ugly...




Charts: Bloomberg

Europe's imperial court is a threat to all our democracies

The European Court of Justice has this time departed a long way from the rule of the law, even by its own elastic standards

By Ambrose Evans-Pritchard

7:12PM GMT 14 Jan 2015

Closeup of the map of Europe seen on the face of a 10 Euro Cent coin in Paris

The political destiny of Europe should not be decided in this fashion, lurching from crisis to crisis towards a sovereign union that no citizen has ever voted for Photo: Reuters
 
 
The European Court of Justice has declared legal supremacy over the sovereign state of Germany, and therefore of Britain, France, Denmark and Poland as well. 
 
The ECJ's advocate-general has not only brushed aside the careful findings of the German constitutional court on a matter of highest importance, he has gone so far as to claim that Germany is obliged to submit to the final decision. "We cannot possibly accept this and they know it," said one German jurist close to the case.
 
The matter at hand is whether the European Central Bank broke the law with its back-stop plan for Italian and Spanish debt (OMT) in 2012. The teleological ECJ - always eager to further the cause of EU integration - did come up with the politically-correct answer as expected. The ECB is in the clear.

The opinion is a green light for quantitative easing next week, legally never in doubt.
 
The European Court did defer to the Verfassungsgericht in Karlsruhe on a few points. The ECB must not get mixed up with the EU bail-out fund (ESM) or take part in Troika rescue operations. But these details are not the deeper import of the case.
 
The opinion is a vaulting assertion of EU primacy. If the Karlsruhe accepts this, the implication is that Germany will no longer be a fully self-governing sovereign state.
 
The advocate-general knows he is risking a showdown but views this fight as unavoidable. "It seems to me an all but impossible task to preserve this Union, as we know it today, if it is to be made subject to an absolute reservation, ill-defined and virtually at the discretion of each of the Member States," he said.

In this he is right. "This Union" - meaning the Union to which EU integrationists aspire - is currently blocked by the German court, the last safeguard of our nation states against encroachment. This is why the battle is historic.
 
"His opinion is a direct affront to the German court. It asserts that the EU court has the final say in defining and creating the EU's own powers, without any national check," said Gunnar Beck, a German legal theorist at the University of London.

"This would be a fundamental transformation of the EU from a treaty organisation, which depends on the democratic assent of the sovereign states, into a supranational entity."

Germany's judges have never accepted the ECJ's outlandish claims to primacy. Their ruling on the Maastricht Treaty in 1993 warned in thunderous terms that the court reserves the right to strike down any EU law that breaches the German Grundgesetz or Basic Law.

They went further in their verdict on the Lisbon Treaty in July 2009, shooting down imperial conceits. The EU is merely a treaty club. The historic states are the “masters of the Treaties” and not the other way round.

They set limits to EU integration. Whole areas of policy “must forever remain German”. If the drift of EU affairs erodes German democracy - including the Bundestag's fiscal sovereignty - the country must “refuse further participation in the European Union”.

The opinion of the ECJ's advocate-general is not binding. But he works alongside the judges in the same building on the Kirchberg Plateau and it is fair to assume that he is cleaving closely to the court's outlook in such a pivotal case.
 
In a free speech case that I once covered - Connolly v Commission (C-274/99 P) - another advocate-general suggested that criticism of the EU is akin to "blasphemy" and may legitimately be suppressed. His musings on blasphemy did not reach the final judgment, but everything else did.

The European Court has this time departed a long way from the rule of the law, even by its own elastic standards. The opinion contradicts previous ECJ case law in the 2012 Pringle case, when the court ruled that the ECB's purchases of government bonds amount to economic policy, and implies fiscal union by the back door.

It gives the ECB almost unfettered discretion, adding for good measure that the courts should refrain from meddling in monetary policy. Not only is this an attempt to tie the hands of the Verfassungsgericht when the inevitable case against QE is filed, it is also enthrones the ECB over a monetary dictatorship answerable to nobody.

From a strictly economic view, my sympathies lie with the advocate-general and the ECB's Mario Draghi. The eurozone needs QE a l'outrance to avert a deflation trap. It also needs the OMT to reassure markets that there is a lender-of-last-resort in case a crisis erupts in Greece and sets off contagion. But the political destiny of Europe should not be decided in this fashion, lurching from crisis to crisis towards a sovereign union that no citizen has ever voted for.
   
The difficulty for the ECJ is that Verfassungsgericht ruled a year ago that Mr Draghi's OMT "manifestly violates" the Treaties and was most likely "Ultra Vires", creating "an obligation of German authorities to refrain from implementing it”.
 
Germany's judges said OMT “infringes the powers of the Member States, and violates the prohibition of monetary financing of the budget”. In short, the ruling was ferocious.
 
The Verfassungsgericht did not refer the case to the ECJ for superior guidance. It pre-judged the case and sent it to the ECJ for ratification.

The advocate-general acknowledged that the German court's referral was double-edged, and almost treats the ECJ as a mere think-tank. He protested that no national court should be allowed to request a ruling from the ECJ while also refusing to give up its "own ultimate responsibility to state what the law is".
 
"Therein lies all the ambiguity with which the Court of Justice is faced. In such circumstances, a request to the Court of Justice to give a preliminary ruling could even end by having the undesirable effect of embroiling the Court in the chain of events ultimately leading to the breakdown in the ‘constitutional compact’ underlying European integration," he said.

That is the heart of the matter. The ECJ has been drawn into a dangerous dispute with the very powerful court of Europe's most powerful country. It has done so on the weakest possible terrain, failing to address fully the objections raised by Karlsruhe.

It claims that OMT is a monetary policy tool that does not breach the Treaties by rescuing specific insolvent states, when everybody can see that it does. Instead of pushing its claims on an abstruse case - the usual salami tactic - it is fighting over an incendiary issue that has German eurosceptics up in arms.
 
It is far from clear what will happen when the case goes back to Karlsruhe for a final ruling.

The Verfassungsgericht may capitulate, but you never know. "In extremis, the court may prohibit German institutions from taking part in bond purchases," said the Frankfurter Allgemeine.

This is the Investiture Contest of our times, echoing the 11th century clash between the German emperor Henry IV and the imperial papacy of Gregory VII over supremacy in Europe.
 
Gregory choose to challenge the settled dominance of secular princes, angling for an absolutist and unworkable theocracy. He won a Pyrrhic victory when Henry prostrated himself in the snow at Canossa, but only to stir up forces that he could not control.
 
It was Henry who conquered Rome. It was a deposed Pope Gregory who died in exile.

lunes, enero 19, 2015

BLOOD IN THE WATER / THE ECONOMIST

|

BP

Blood in the wáter

The oil giant’s troubles could make it a takeover target, especially if the price of crude keeps falling

Jan 17th 2015
.



INVESTORS in BP are a patient bunch, and well rewarded for it. Britain’s third-largest company pays generous and reliable dividends, making it a mainstay of many private and institutional portfolios. But in the run-up to the oil giant’s quarterly results on February 3rd, some investors are jittery. Although BP’s dividend yield is a juicy 5.8%, its shares have fallen by a fifth over 10 years, greatly underperforming the broader market (see chart) and making total shareholder returns slightly negative. This is mainly because of the Deepwater Horizon disaster in the Gulf of Mexico in April 2010, which cost 11 lives and a stonking $43 billion (and maybe more) in fines, legal bills, compensation and clean-up.



BP has slimmed since then. It has sold more than $40 billion of assets, cutting its size by a third, as it continues to fight (and mainly lose) lawsuits and appeals. Now cheap oil is adding a new edge to its woes. Until recently BP made plans based on an oil price of $100 a barrel. When it announced its latest $1 billion restructuring plan in December, it tried to reassure investors that its investment plans assumed an oil price of $80, but with a fallback level of $60. The price was $65 then. Now it is below $50. As we went to press on January 15th BP was announcing further job cuts.

Not only does existing capital spending (an annual $24 billion-plus) look unaffordable, but those generous dividends—the top priority—will gobble cash. An institutional shareholder wonders if BP may resort to paying next month’s dividend in new shares (or “scrip”). “They are being overwhelmed by events,” he says.

So the chances have grown that one of BP’s rivals will seek to capitalise on its weakness and bid for it. Although its value has fallen sharply, its market capitalisation is still $107 billion, so the list of possible buyers is short. The most talked-about potential suitors are Exxon Mobil (market value $380 billion) and Shell ($197 billion), with Chevron ($196 billion) as a possible “white knight” merger partner to fend off the other two. There are some state oil and gas firms big enough to afford BP (the Saudi, Qatari or Kuwaiti ones, say), but none seems to be in shopping mood just now.

All the firms involved decline to comment. But it is easy to see some advantages to a takeover by Exxon. The two companies fit, in that Exxon’s American business is smaller than its international operations. And BP, though nominally British, is strongest in America. Exxon has lots of cash and low borrowing costs. It did a good job of absorbing Mobil, another rival, in 1999. Moreover, the biggest blight on the BP share price is its American lawsuits. It has handled these badly. Exxon, with its unrivalled political clout, might do better.

Another attraction is BP’s nearly 20% stake in Rosneft, Russia’s biggest and best-connected oil company. Rosneft is in trouble: heavily indebted, cut off from Western capital markets by sanctions, and bailed out by the Russian state in December. But for a far-sighted outsider, Russia’s oil and gas reserves are hard to ignore. BP has made a lot of money there so far.

Sanctions forced Exxon, which has deep ties with Russia, to cancel its Arctic drilling project with Rosneft. Buying BP could offer a way back in. It would take a brave boss to do this; but Exxon’s Rex Tillerson is made of stern stuff.

Perhaps the strongest reason for a takeover is not BP’s plight, but the oil industry’s general gloom. The S&P Global Oil index has performed only marginally worse than BP over the past 10 years—it is up just 2.6%. All the big energy companies were wrestling with rising costs and falling reserves even before the oil-price fall. Now they are grappling with its consequences.

Mergers offer a chance to cut costs and save money. Prices are low. BP, now fit, lean and cheap, is not best placed to go shopping itself. So it could be on someone else’s list.

BP wants to stay independent. Its bosses believe they have done well since 2010, ending an era of bloat, excessive ambition and corner-cutting on safety. Any buyer would have to surmount some big obstacles. Britain’s former imperial oil company has close ties to the establishment. A sale to an American buyer would mean a political row, in an election year.

It is also uncertain that Exxon would be able to solve BP’s remaining American lawsuits. The biggest headaches are in Louisiana, a state where outsiders tend to fare poorly, whether they are foreigners or just from out of state. Many legal wheels have turned since Barack Obama ostentatiously referred to BP as “British Petroleum” in what some saw as opening the hunting season on the company. One would have to believe that the American legal system was open to influence from politics and money to think that switching ownership would help. Some might say it is, but Exxon would hesitate to argue that case publicly. Boards are usually nervous about buying a company embroiled in lawsuits.

You can’t be sure of Shell
 
Nor does the idea of Shell taking over its old partner and rival look quite so attractive when examined in detail. BP’s former chief executive, Lord (then John) Browne, did once consider a merger, at a time when his company was top dog. Shell is now the stronger party. It has a solid balance-sheet, and there are some attractive synergies and cost savings to be had.

But big, hostile bids are not the Anglo-Dutch company’s style. It has a lot on its plate. Its big bets on gas and Alaskan drilling are not going well. Whereas BP sold assets when oil prices were high, Shell is now scrambling to do the same at a time when takers are few. This week it had to scrap a huge petrochemicals project in Qatar.

Melding together the two firms’ cultures might be no easier than if Exxon were the buyer. BP has never quite shed its imperial ways, including a climate in which employees feel nervous about bringing the boss bad news. Shell is an engineering-driven company, which sees itself as flatter and more collaborative. Anti-monopoly worries would require complicated and risky untangling of downstream assets—and in hard times.

The risks and costs of trying to buy BP, and then absorbing it, may be enough to make potential predators think twice about having a go right now. And there are plenty of other oil firms they could buy, that would not come with BP’s baggage. But if the oil price stays low, or if BP’s condition worsens for other reasons, all bets are off. The company has changed a lot in the past decade. To guarantee its independence it will have to do even more now.

Hi, I’m Charles Evans, and Welcome to Jackass

By Jared Dillian

January 15, 2015


One of the things I always try to remember is that government employees (and this includes the folks at the Federal Reserve) are people just like you and me, most of whom work very hard to do what they believe is right.

 

The Fed is often maligned, sometimes unfairly. No matter what it does, it’s going to be criticized, often loudly, by someone.

 

So I don’t think Chicago Fed President Charles Evans is a bad person… just a very wrong person, one of the wrongest people on earth, when he says that it would be a “catastrophe” if the Fed raised rates.

It would not.

First, a Little Background

Evans has been in the top job since 2007 and has been a creature of the Chicago Fed for many years. He’s a trained economist with a PhD from Carnegie Mellon (a “freshwater” school). He’s very accomplished, with a long list of publications in respected journals. He arguably knows more about central banking than I do, me being some dude living in South Carolina with an MBA from a third-tier school, but at least I got an A+ in my macroeconomics class.

 
 
 

While not as dovish perhaps as Rosengren or Dudley (or especially Kocherlakota), Evans has always been a reliable dovish vote on the Federal Open Market Committee (FOMC). He’s also a pretty good indicator of which way the political winds are blowing at the Fed, so when he says it would be a “catastrophe” if the Fed raised rates, he speaks not just for himself, but many other members of the FOMC.

 
 
 

This is where I dust off my third-tier MBA and go back to 2002, when I was a trader at Lehman Brothers.

 

As you might imagine, as an index arbitrage trader with an $8 billion balance sheet that I was funding on an overnight basis, I cared very much about short-term interest rates. I spent a lot of time trying to figure out what the Fed was going to do. Back then in 2002, there was a general rule of thumb that if the NAPM (now ISM) was above 50, the Fed would be hiking.

 

Well, right now the ISM is well above 50—and has been for a while—and the Fed is not hiking.

 

GDP growth is also 5%.

 

Unemployment is 5.6%, and we’ve had solid job growth for years.

 

Pretend it’s 2004. I give you these numbers, and I ask you what you think the Fed is going to do. Naturally, you’re like, “They’re ripping rates higher.”

 

Au contraire. They are not. Evans (and others) want to let the economy run hot.

 

The Curious Case of New Zealand

 

If you know a little about New Zealand’s economic history, you know it had a pretty massive inflation problem, like most of the developed world in the 1970s. But its politicians devised a very effective way of dealing with it: the inflation target.

 

Inflation targeting was once a very controversial central banking technique. Not anymore. Basically, New Zealand said, “We want inflation to be 2% instead of 10%,” or whatever it was. So the government tightened monetary policy and didn’t stop until inflation reached the 2% target.

 

None of this wishy-washy discretionary Greenspan stuff. They just cranked on rates until inflation was fixed.

 

Funny thing about inflation targets is they work in both directions. Like if inflation is under 2%, you ease monetary policy until it gets back up there. That’s kind of what’s going on right now in the US and elsewhere.

 

But the Kiwis just chose the 2% number randomly. Like, “2% sounds like a good idea, so let’s go for that.” But there wasn’t any empirical reason to choose that number. It was arbitrary.

 

The New Inflation Target

 

So central banks are looking around and saying, “You know, maybe the 2% inflation target is too low. Maybe we should have something higher—like 4%.” And in fact, someone at the International Monetary Fund (IMF) recently published a working paper arguing for just that.

 

Only about 10 years ago, we actually had 4% inflation. It wasn’t that bad, right? Of course, we had 4% inflation on the way down from 14% to 2%, and path dependency is important.

 

The other thing I think people might not be thinking clearly about is that 4% inflation compounds very quickly. You would think that someone at the Federal Reserve would be able to drop this into Microsoft Excel and figure it out.

 

At 4% inflation, prices will double in 18 years. The Fed is supposed to be, above all, the guardian of our purchasing power.

 

I don’t think 4% inflation is very fun at all.

 

Nobody has talked explicitly about a 4% inflation target in the US, not even Evans. But he did say that it would not be a catastrophe if inflation were allowed to exceed the 2% target for a while. And Yellen has said something similar.

 

Yes, the Fed is actually trying to create inflation. And not just a little inflation. A lot.

 

A Little Inflation Is Fun

 

One thing the Fed doesn’t understand is state-dependent central banking. Let me put it this way: if we manage to create 4% inflation, the economy is going to be roaring. And post-financial crisis, people are really going to like what will be the first sustained economic boom in about 10 years.

 

Inflation is fun at the beginning. Then it becomes not so fun.

 

I was born in the middle of what would have been the Burns Fed, which by all accounts, is considered very unsuccessful. Arthur Burns liked inflation a little too much. And his successor, G. William Miller… well, that was a complete disaster.

 

These are black marks on the Fed’s history. Evans and many others think that they can control or even reverse inflation once it gets to 4%. They can’t and won’t. The political pressure not to do so will be enormous. A good way to prevent high inflation is not to screw around with low inflation.

 

A Fed economist would probably lecture me on the ills of deflation. Okay. Name one deflation, one liquidity trap, where there has been food or fuel shortages. Or riots. Or that has led to a world war. Your approaches to inflation and deflation should be asymmetrical, because inflation is far more dangerous.

 

With all due respect to Dr. Evans, I think it’s very irresponsible to say that raising rates even a single basis point would be a catastrophe. I think we’re sowing the seeds for far higher inflation 10-20 years in the future.

 

I also think now would be a great time to take out a huge mortgage.

Jared Dillian
Jared Dillian
Editor, The 10th Man