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?

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.”


Niall Ferguson Takes on the World

Ferguson sees more trouble ahead for Europe, China, and Saudi Arabia. But countries with cheap stocks and political stability could beckon investors..

By Vito J. Racanelli

“There are deleterious consequences if the leading power in the world abdicates its leadership role.“—Niall Ferguson Photo: Jared Leeds for Barron’s

Niall Ferguson, the historian, Harvard professor, and author of more than a dozen books on the nexus of economics, finance, and geopolitics, argues that America’s abdication of its role as the world’s policeman is one cause of the global economic malaise. U.S. policies, or lack thereof, have allowed terrorism to breed and dictatorial states such as Russia and China to assume a larger role in world affairs.
The author of Civilization: The West and the Rest, Ferguson says China’s attempt to move to a true market economy probably will fail, potentially causing serious disruptions to other markets. He likens Saudi Arabia to Iran in 1979—a state ripe for destabilization. In the U.S., he sees tax reform coming, but worries that America’s love affair with regulation will continue to dampen its growth prospects. India gets a thumbs-up, but Europe’s prospects are bleak.
Ferguson recently announced that he’ll leave Harvard next year to become a senior fellow at Stanford University’s Hoover Institution. He spoke with Barron’s at our offices just after November’s terrorist attacks in Paris, and was every bit as thoughtful and provocative as when we last chatted, three years ago.
Barron’s: The U.S. economy has been growing by only 2% to 3% a year. Why isn’t it firing on all cylinders?
Ferguson: There are at least three theories. The seven-year hangover theory suggests that the U.S. will shake off the effects of the 2008 financial crisis next year. The secular-stagnation theory posits that, for a variety of reasons, the economy is in a depressed state. That is most obviously [expressed] in interest rates.
I’m attracted to a third argument, the geopolitical one, that says growth in modern American history has tended to be high at times of national strength and low at times of national weakness, because our weakness has ramifications for the world as a whole. One has to combine the three theories to understand why growth is lower than expectations. It isn’t low based on a pretty long-term average, but it is sluggish compared with the glory days of the Cold War.
What was so glorious about the Cold War?
There were two phases of growth, one associated with the Eisenhower and Reagan administrations, and one with the depressed period in between. Since 9/11, things have gone from bad to worse. We find ourselves in a deflationary version of the 1970s, marked by stagnation, not stagflation. [Russian President Vladimir] Putin is doing his best to give us reasons to man up. But we’re not really doing so.
The global economy needs a strong hegemonic power to reduce conflict, ensure freedom of the seas, and so forth. In the 19th century, it was Great Britain, and for much of the 20th, the U.S.

But in 2013, President Obama said there was no global policeman. There are deleterious consequences if the leading power in the world abdicates its leadership role.
What are some of these ramifications?
Part of the reason the world isn’t as buoyant as it might be is that Europe is doing much worse than the U.S. It doesn’t help Europe to have a massive influx of real and “not so real” refugees.

Some 220,000 people arrived in the European Union in October, a direct consequence of the disintegration of order in a whole bunch of countries, Syria principally, but not only.
The U.S. walking away from the Middle East has had a direct impact. We’re only beginning to see the ramifications, in Paris most recently. It isn’t going to stop there. There is growing anxiety in East Asia about the rise of China. Japan remains a large economy, but a depressed one in yet another recession. Economists tend to underestimate geopolitical factors because they aren’t in their models. Global order and stability need to be underwritten. It doesn’t just happen spontaneously.
Are you suggesting that the U.S. ought to be the world’s policeman?
Somebody’s got to do it. It better not be the Chinese or Russians. The market system requires an effective state that enforces the rule of law. That is true internationally, as well. As the world becomes less secure, it becomes a less safe place to do business.
A world in which the U.S. yields regional power to China or Russia is one in which the rule of law is driven back. We underestimate the extent to which the age of globalization depended on an American underwriting, and that is gradually unraveling.
Can the U.S. afford to keep the peace?
The U.S. has a fundamental problem: Gradually, its national security is being squeezed by Social Security, particularly its health-care system. It will be squeezed by the burden of interest payments on Federal debt as interest rates go up. In theory, as the biggest economy in the world, the U.S. should be able to afford to build up its military power. In practice, the congressional budget sequester was a blunt instrument applied to the defense budget, cutting it indiscriminately.
The U.S. should be investing to maintain its lead, particularly in areas where it is vulnerable, such as cybersecurity. No matter how many aircraft carriers we have, it might not be that big of a technological leap for us to be matched in the new theaters of war that are emerging.
But as you note, our finances are hobbled.
Entitlements are the obvious problem. Republicans discovered that if you want to cut entitlements, it is hard to win the presidency. I’m optimistic that the U.S. can make its health-care system far more efficient and less expensive as new technology comes into place. With the application of technology, we will start seeing not only stuff about our own health, but also which doctors and hospitals do which things best.
The employer-pays insurance system is loopy and ripe for revolution, in the way that Uber is revolutionizing transportation. We will see similar types of companies revolutionizing health care. At that point, you may be surprised to find that costs start coming down. I can’t imagine in 10 years’ time that when you visit your doctor, someone will hand you a clipboard with a badly photocopied form that you’ll have to fill out for nth time. That’s ludicrous.
You have written about the toxic combination of litigation and regulation in the U.S. What are the odds of reform?
I don’t see any light at the end of the tunnel. The Federal Register has never been so large. The Dodd-Frank and Affordable Care Acts alone produced a staggering volume of regulation. Now we have the Trans-Pacific Partnership Agreement, with a document even larger than Dodd-Frank. It is really disheartening. That there hasn’t been more rapid U.S. growth is due at least in part to these head winds.
Many U.S. companies won’t bring home the cash they have overseas because it would be subject to a hefty tax. Is there any chance this might change soon?
The income-tax code has to be simplified, and corporate tax has to be reduced to some internationally competitive rate. Otherwise, corporations are going to continue to emigrate to wherever the tax burden is lower. Tax reform must be on the agenda of the next president in year one. Tax reform will happen. The political class gets it; the voters get it. It is much harder to tackle excessively complex regulation because there are too many people who benefit from it.
Let’s turn to Asia. You have said that regarding China as an emerging market is absurd. Why?
It is now the second-largest economy in the world, or the largest based on purchasing-power parity, with an influence on the global economy second only to the U.S. China is sui generis. Is China is going to go further in the direction of a market economy? Will it reduce the importance of state-owned enterprises and remove the state from the financial system? Is it going to open its capital account and allow the Chinese to invest abroad freely? Each answer has ramifications for the rest of us like no other economy.
Give us your answers.
We don’t know whether China will be more of a market economy 10 years from now. It is risky for a one-party state to continue increasing the economic freedom of its citizens. President Xi Jinping, who is more interested in power than anything else, understands this well.

Consequently, plans for privatization of state-owned enterprises, liberalization of the financial system, and the opening of the capital account will remain plans, but won’t be implemented.
China has created the biggest middle class in history, but middle-class people want property rights. That implies law courts and officials who aren’t corrupt. The moment you demand these things, you are asking the one-party state to loosen its grip on power. The Chinese are terrified of anything like that.

What impact might Jinping’s foreign policy have on markets around the world?
To ensure the one-party state’s legitimacy, Jinping won’t shy away from a relatively saber-rattling foreign policy, because this plays well [domestically]. There is also an element that isn’t propaganda. China is building up its naval capability, modernizing its pretty antiquated army.

It has a financial diplomacy that has proved effective. The Chinese have been using their considerable resources to win friends and influence people around the world, including in Central Asia and Africa. China says, “Let us build your infrastructure.” That increases its leverage over a whole bunch of countries that the U.S. has neglected.
What is the outlook for India?
The Indian economy looks to be growing faster than the Chinese economy. India is good for a couple of reasons, including demographics, which turn out to be a lot more important than most people thought. India didn’t have the one-child policy, unlike China, whose workforce is shrinking.
India has rule of law—slow, maybe, but it is there, and a representative government and free press. Unless you think the success of the West is pure luck, which I don’t, those are advantages. There are many thickets of vested interest, but I’m broadly bullish about India’s prospects. The problems India faces are fixable, like infrastructure and housing. China’s problems are much more difficult.
Will the Middle East roil markets in the years ahead?
I expect next year to be more violent than 2015. Many investors don’t realize that since the outbreak of the Arab Spring in 2011, fatalities due to armed conflicts are up by about a factor of four; terrorism is up by a factor of six.
The events in Paris are a reminder that the jihadist network doesn’t confine itself to the majority-Muslim world. It is now embedded in minority-Muslim communities all over Europe.

There will be more such attacks, and at some point the terrorists will be successful in the U.S. again. [This interview was conducted before radicalized Islamists killed 14 people in San Bernardino, Calif.] The resources that go into producing radicalism aren’t about to disappear. Networks are difficult to decapitate.
The president has failed to understand this because his model is decapitation. You think, let’s take out the boss. Then you are amazed to find the network [still] grows. We won’t see this go away in the next 10 years. The threat of violent instability in the region will go up, and probably will affect Saudi Arabia. Support for the Islamic State is high among the Saudi population.
Why is that?
An Islamic state can credibly argue that the Saudi royal family is corrupt, Westernized, and hypocritical.
The family itself is divided. Saudi Arabia is a weak link, the way Iran was in 1979. If you had to ask what headline would move markets tomorrow morning, a revolution in Riyadh, especially a messy one, would be a pretty good answer. You could see a big terrorist attack on Saudi facilities, and markets would move the price of oil up.
The dollar is strong, and commodity prices are weak. What does that mean for countries like Brazil and Russia?
There comes a point when an investor says, “Hey, that’s attractively priced.” Argentina has been one of the great trades of the year. You might ask, “Where is the political problem horrible, and where is it about to get solved?” It is pretty horrible in Brazil, and I don’t see a fix in the short run. Things will be solved in Argentina, more or less. South Africa? No, that looks bad politically. Turkey? [Prime Minister Recep Tayyip] Erdogan is a dodgy customer.

Egypt? I don’t like the way that’s going.
The key is attractive prices and political stability. Money is going to start flowing back into emerging markets that don’t have a political problem, such as Indonesia and maybe Malaysia.

In Russia, suppose the sanctions get relaxed, as seems likely next year. Russian bonds have been one of the great performers this year. Everybody was too negative about Russia. There are some interesting opportunities in the rest of the world. It is hard to see the dollar- strength story continuing indefinitely.
What is the biggest risk to global markets?
China. It was so crucial as an engine of growth through the financial crisis. If there is a policy error in China, it could cause huge instability. The government could ease restrictions on cross-border capital flows, which would result in a great wall of money coming out of China. Money would be deployed in Western assets, and it might be difficult for China to cope. Imagine the devaluation impact on the renminbi, and the effect on all other emerging markets, if China suddenly devalues by 20% or 30%.
On the other hand, if Jinping turns the clock back, this could lead to a big downside shock.
Will Europe get its act together?
Europe faces three extraordinary challenges. It wants to have a foreign policy to be able to influence the fate of Syria, but it can’t act independently of the U.S. because it has slashed its defense capability. Secondly, Europe can’t stop this huge wave of refugees. The border is enormous, vastly larger than the Mexican border with the U.S., and much of it is a sea border.
The biggest problem is the fifth column within Europe—people who aren’t loyal to their European states even though they are citizens, second- and third-generation. Potentially, there are thousands of jihadists or sympathizers.
Europe’s problems are unsolvable. Anybody who thinks this great wave of immigration solves Europe’s demographic deficit hasn’t been to the suburbs of Paris.
On that cheerful note, thank you.

miércoles, diciembre 30, 2015



French Children Add to ISIS Ranks

Some young men and women leave France to start families in Syria, according to those who study the radicalization of French residents

By Noemie Bisserbe and Stacy Meichtry

The French government says about 50 children have been taken from France to Syria since 2012 and some have been put into ISIS training camps. Image: ISIS propaganda via Al-Furqa media.
NICE, France—Valérie Aubry-Dumont got the news in a WhatsApp message from deep inside Islamic State territory. “Mom, you’re going to be a grandmother,” wrote her teenage daughter, Cléa.

When Ms. Aubry-Dumont last saw her daughter, Cléa was a 16-year-old girl attending Catholic school in a Paris suburb. After a breakup, Cléa met a young man online and within months the couple fled France to live in a stretch of northern Syria ruled by Islamic State.

“I wish Cléa never had children,” Ms. Aubry-Dumont, a child-care worker, says now that her grandson has been born. Her daughter talks some days of returning to France, Ms. Aubry-Dumont said, but is afraid of losing her baby if she tries to leave. “She is trapped.”

In France, the West’s biggest supplier of foreign fighters in Syria, the loss of sons, daughters and grandchildren to Islamic State has been a slow-motion tragedy. For some French families, the Paris attacks, while deepening the wedge between militants and the West, were a painful reminder of their ties to the enemy.

The French wife of Foued Mohamed-Aggad—who along with two others killed 90 people in Paris’s Bataclan concert hall on Nov. 13—is living in Islamic State territory and ready to give birth “any day now,” said Françoise Cotta, a lawyer Mr. Mohamed-Aggad’s mother approached in an attempt to bring the child back to France.

“An alarming number of young men and women are leaving France to start a family in Syria,” said Alain Ruffion, director at Unimed, a group that works to prevent the radicalization of residents around the southern French city of Nice.

Raising children in Islamic State-held territory bolsters its ranks. More than 1,100 children under age 16 joined its training camps this year, according to the Syrian Observatory for Human Rights, a U.K.-based opposition monitor. The alleged ringleader of the Paris attacks, Abdelhamid Abaaoud, had brought his 13-year-old brother to Syria to join the militants. Mr. Abaaoud was killed last month by police.

The number of children born of a French parent joined to Islamic State is nearly impossible to tally, authorities said. The French government estimates that about 50 children have been taken to Syria since 2012.

Among them was a 5th-grade boy named Rayan, who stopped showing up at his redbrick elementary school on the outskirts of Toulouse in April 2014. He resurfaced nearly a year later—in an Islamic State video.

Rayan appears clad in military fatigues, holding a handgun. At his side is Sabri Essid, a radical who married Rayan’s French mother and moved her and her four children to northern Syria, French officials said.

In the video, Mr. Essid calls Rayan a “lion cub” prepared to kill Islamic State enemies. An Israeli Arab hostage is shown kneeling before the boy. Moments later, Rayan shoots the hostage.

Last year in Nice, a French family of 11 people, including four children between the ages of 6 months and 6 years, left for Syria.

“I went to pick up my two grandsons at school as usual,” said Ivano Sovieri whose daughter, Andrea, married into the Muslim family several years ago. “But I was told the entire family had left for Tunisia after a relative died.”

Mr. Sovieri eventually learned his daughter, who converted to Islam, had gone to Syria. She left behind a message with her best friend: “I shouldn’t have left, but I couldn’t back down in front of Allah.”

Ms. Aubry-Dumont said she tagged along on the first date between her daughter, Cléa, and a young bearded man from a dating website. “Who’s this guy who won’t look me in the eye or shake my hand?” she recalled asking her daughter after the date in December 2012.

The couple disappeared a few months later. Ms. Aubry-Dumont said she later recognized her daughter’s suitor in a video posted by Islamic State. He called himself Abdul Wadud, and, brandishing a rifle, swore revenge against French President François Hollande.

Ms. Aubry-Dumont said she tried to persuade her daughter to come home. The teenager instead asked her parents to join her in Syria. “If it was dangerous here, I wouldn’t ask you to come,” Ms. Aubry-Dumont recalled her daughter saying. Eventually, the teenager told her mother why she wanted her: She was pregnant.

“I almost collapsed when I got the news,” said Ms. Aubry-Dumont, who was so angry she cut off communication. A few weeks later, when U.S. forces started airstrikes in Syria, a frantic Ms. Aubry-Dumont called Cléa.

The runaway couple and their son now live in a villa in northern Syria. “They are given everything they need,” Ms. Aubry-Dumont said, “a house, money and even formula for the baby.”

The two women now chat on WhatsApp and sometimes talk by phone. The daughter sends baby pictures. “I try to continue to play my role as mother, somehow,” Ms. Aubry-Dumont said.

Some grandparents weigh the risks of trying to see family members, including those they have never met. Beyond personal loss, these families face government surveillance and risk prosecution if they try to meet with their loved ones abroad.

Annie-Claude, a French retiree from the southern town of Avignon, said her son left home two years ago to join militants in northern Syria, where he fathered a child with a young Syrian woman. He was killed fighting for Islamic State in March, said Annie-Claude, who declined to give her last name.

A few months ago, the child’s widowed mother contacted Annie-Claude about meeting her new grandson. The Syrian woman suggested they rendezvous in Gaziantep, a Turkish town near the Syrian border.

“He’s all I have left from my son, and the only grandchild I’ll ever have,” Annie-Claude said. “I want to see him.”

Under Islamic State rules, the young woman isn’t allowed to travel without male guards, said Annie-Claude: “I want to go, but I’m scared.” France has banned travel to Syria and Iraq.

The 17-year-old Syrian woman who Annie-Claude considers her daughter-in-law speaks no French or English. The two women communicate via a mobile messaging service, trading emoticons: smiley or sad faces, puckered lips and hearts.

Zora, a shy junior-high student from a Paris suburb, left France after her 14th birthday, said her father, a vendor at a local market. She wound up in a villa in Deir Ezzour, near Syria’s border with Iraq.

Police later told her father she had been recruited over Facebook FB 0.37 % by three young women in southern France. The girl traveled to Syria on a circuitous route through Belgium, the Netherlands and Turkey.

For months, Zora used the mobile messaging service Viber to communicate with her father. She described life in the villa that was home to about 50 girls from foreign countries including the U.S., U.K. and Belgium, said the father.

Surrounded by armed guards, the girls were rarely allowed to step out, the father said. Zora told her father she had been forced to watch beheadings. Bomb blasts woke her at night. “I can’t stop crying,” she wrote.

Six months ago, Zora’s text messages seemed more upbeat. “She talked about her plans for when she’d be back in France, asked for advice on which studies to pursue,” her father said. “When she was a little girl, she wanted to be a nurse. Now, she says she can’t see any more blood.”

The father pleaded with Zora to find someone who could arrange an escape. “I’ll pay anything,” he wrote. He sent a scanned copy of her French birth certificate to use if she managed to reach the Turkish border.

That was the last time he heard from her, he said. Standing in his market stall, he dialed his daughter from his cellphone. No one answered.

“I call every morning,” he said. “I’m waiting for her to get back online.”

The Political Consequences of Financial Crises

Howard Davies

Street signs in London

LONDON – I may not be the only finance professor who, when setting essay topics for his or her students, has resorted to a question along the following lines: “In your view, was the global financial crisis caused primarily by too much government intervention in financial markets, or by too little?” When confronted with this either/or question, my most recent class split three ways.
Roughly a third, mesmerized by the meretricious appeal of the Efficient Market Hypothesis, argued that governments were the original sinners. Their ill-conceived interventions – notably the US-backed mortgage underwriters Fannie Mae and Freddie Mac, as well as the Community Reinvestment Act – distorted market incentives. Some even embraced the argument of the US libertarian Ron Paul, blaming the very existence of the Federal Reserve as a lender of last resort.
Another third, at the opposite end of the political spectrum, saw former Fed Chairman Alan Greenspan as the villain. It was Greenspan’s notorious reluctance to intervene in financial markets, even when leverage was growing dramatically and asset prices seemed to have lost touch with reality, that created the problem. More broadly, Western governments, with their light-touch approach to regulation, allowed markets to career out of control in the early years of this century.
The remaining third tried to have it both ways, arguing that governments intervened too much in some areas, and too little in others. Avoiding the question as put is not a sound test-taking strategy; but the students may have been onto something.
Now that the crisis is seven years behind us, how have governments and voters in Europe and North America answered this important question? Have they shown, by their actions, that they think financial markets need tighter controls or that, on the contrary, the state should repudiate bailouts and leave financial firms to face the full consequences of their own mistakes?
From their rhetoric and regulatory policies, it would appear that most governments have ended up in the third, fence-sitting camp. Yes, they have implemented a plethora of detailed controls, scrutinizing banks’ books with unprecedented intensity and insisting on approving cash distributions, the appointment of key directors, and even job descriptions for board members.
But they have ruled out any future government or central-bank support for ailing financial institutions. Banks must now produce “living wills” showing how they can be wound down without the authorities’ support. The government will wash its hands of them if they run into trouble: the era of “too big to fail” is over.
Perhaps this two-track approach was inevitable, though it would be good to know the desired end-point. Is it a system in which market discipline again dominates, or will regulators sit on the shoulders of management for the foreseeable future?
But what have voters concluded? In the first wave of post-crisis elections, the message was clear in one sense, and clouded in another. Whichever government was in power when the crisis hit, whether left or right, was booted out and replaced by a government of the opposite political persuasion.
That was not universally true – see Germany’s Angela Merkel – but it certainly was true in the United States, the United Kingdom, France, and elsewhere. France moved from right to left, and the UK went from left to right. But voters’ verdict on their governments was more or less identical: things went wrong on your watch, so out you go.
But now we can see a more consistent trend developing. Three German economists, Manuel Funke, Moritz Schularik, and Christoph Trebesch, have just produced a fascinating assessment based on more than 800 elections in Western countries over the last 150 years, the results of which they mapped against 100 financial crises. Their headline conclusion is stark: “politics takes a hard right turn following financial crises. On average, far-right votes increase by about a third in the five years following systemic banking distress.”
The Great Depression of the 1930s, which followed the Wall Street crash of 1929, is the most obvious and worrying example that comes to mind, but the trend can be observed even in the Scandinavian countries, following banking crises there in the early 1990s. So seeking to explain, say, the rise of the National Front in France in terms of President François Hollande’s personal and political unpopularity is not sensible. There are greater forces at work than his exotic private life and inability to connect with voters.
The second major conclusion that Funke, Schularik, and Trebesch draw is that governing becomes harder after financial crises, for two reasons. The rise of the far right lies alongside a political landscape that is typically fragmented, with more parties, and a lower share of the vote going to the governing party, whether of the left or the right. So decisive legislative action becomes more challenging.
At the same time, a surge of extra-parliamentary mobilization occurs: more and longer strikes and more and larger demonstrations. Control of the streets by government is not as secure. The average number of anti-government demonstrations triples, the frequency of violent riots doubles, and general strikes increase by at least a third. Greece has boosted those numbers recently.
The only comforting conclusion that the three economists reach is that these effects gradually peter out. The data tell us that after five years, the worst is over. That does not seem to be the way things are moving now in Europe, if we look at France’s recent election scare, not to mention Finland and Poland, where right-wing populists have now come to power. Maybe the answer is that the clock starts ticking on the five years when the crisis is fully over, which is not yet true in Europe.
So politics seems set to remain a difficult trade for some time. And the bankers and financiers who are widely blamed for the crisis will remain in the sin bin for a while yet, until voters’ expectations of economic and financial stability are more consistently satisfied.