The euro must prepare for future shocks

Monetary policy is not enough on its own — fiscal co-ordination is essential

Laurence Boone

Eurozone finance ministers at the Eurogroup Finance Ministers' meeting in Brussels last December © EPA

For the past year, the OECD has been warning about the accumulation of risks and uncertainty that undermines investment and the world economic outlook. Its 2019 global growth projections fell from 3.7 per cent in September 2018 to 3.2 per cent in the latest forecast in May, well below the growth rates seen over the past three decades.

The summer is providing little respite amid heightened trade tensions, the possibility of a no-deal Brexit and renewed market volatility. Brexit alone illustrates the magnitude of these risks: if the UK were to start trading with the EU on World Trade Organization rules, gross domestic product in the remaining EU27 area would contract by around three-quarters of 1 per cent over a few years, with steeper declines in some countries and individual sectors.

In such a challenging environment, Europe will be in a stronger position if further progress is made on economic management across the bloc.

Speakers at the European Central Bank’s annual conference earlier this summer reviewed the first 20 years of the euro, judging it against benchmarks for outcomes, institutions and policymaking. The consensus view was that outcomes, in terms of the convergence of living standards, have been uneven. However, the eurozone has been strengthening its institutions and policy toolbox. Looking back in this way can help disentangle policy mistakes from institutional constraints. And it will make it easier to build political support for joint action across the eurozone in the future.

On the monetary side, the ECB has been impressive and continues to fight stubbornly low inflation. It was instrumental in lifting the eurozone out of the financial and sovereign debt crises, and fulfilled its role of lender of last resort, providing liquidity to banks.

Yet the central bank was not as quick to react to the slowdown in activity at the same time. It did not initiate quantitative easing, on top of larger liquidity support and negative interest rates, until March 2015. Why did it take so long for the ECB to start quantitative easing when growth was anaemic, inflation falling and other central banks had already increased their balance sheets? The US Federal Reserve, for example, started QE on a large scale five years earlier.

There were institutional reasons for the delay. It took time to forge a consensus amid legal uncertainty. And there were entrenched opposing views in the ECB’s governing council. There were also concerns about the asymmetry of the central bank’s mandate to ensure price stability.

Mario Draghi, the president of the ECB, addressed the question of asymmetry at a press conference in July, insisting that there was “no question” of accepting permanently lower inflation rates. But a firmer consensus on the governing council and policy support from the eurogroup of EU finance ministers, while respecting the independence of the ECB, would permit a swifter response to new developments.

It is on fiscal policy that support from the eurogroup will be most crucial. After a large synchronised stimulus in 2009, the fiscal stance reversed quickly. Tightening started much too early, while the output gap in the eurozone was still widening.

Adjustment measures were decided at the country level, ignoring cross-border spillovers. Since then, rules have been reformed but the lack of co-ordination remains.

Fiscal co-ordination is challenging and spillovers are difficult to measure. But there is little doubt that cross-border fiscal effects are significant in an integrated currency area such as the eurozone. In addition, political incentives are weak. Some member countries have been reluctant to respect the fiscal rules, while others have neglected the EU’s macroeconomic imbalance procedure. The combined effect has been to undermine incentives to co-ordinate policy.

However, looming threats to growth in the eurozone should encourage member states to put their differences aside and formalise greater fiscal co-ordination. This would boost confidence in the ability of the eurozone to deal with shocks and assume some of the burden currently borne by monetary policy.

External shocks could be caused by a no-deal Brexit (the likelihood of which is growing), or escalating trade and currency tensions. They would call for a co-ordinated fiscal response, parallel with monetary accommodation. The OECD’s estimates of the impact of these shocks show that individual countries will struggle to absorb them without such a package.

Over its first two decades, the euro has proved to be impressively resilient. The next few years will bring further tests. But they will also be an opportunity to improve the single currency’s governance structures, allowing the eurozone to make a more positive contribution to global economic and financial stability.

The writer is chief economist at the OECD

Locating Equality

For years, wealth and income inequalities have been rising within industrialized countries, kicking off a broader debate about technology and globalization. But at the heart of the issue is a fundamental good that has been driving social and economic inequality for centuries: real estate.

Harold James


MUNICH – Inequality is the leading political and economic issue of the current era, yet debates about it have long suffered from a degree of imprecision. For example, the standard measure of inequality, the Gini coefficient, reduces a country’s entire income distribution to a single number between zero and one, and is thus highly abstract.

Similarly, while inequality is rising in many parts of the world, there is no simple correlation between that trend and social discontent or unrest. France is much less unequal than the United States, and yet it has similar or even greater levels of social polarization.

Today’s inequality debate effectively began in 2013 with the publication of French economist Thomas Piketty’s Capital in the Twenty-First Century, which found that the rate of return on capital tends to outpace the rate of growth, thereby causing inequality to increase over time. Specifically, appreciating real-estate values seem to be a fundamental driver of rising inequality. But here, too, one encounters a degree of imprecision. Real estate, after all, is not a homogenous good, because its value famously depends on “location, location, location.” There are elegant castles and palaces that now cost less than small apartments in major cities.

Wealth stirs the most controversy where it is most tangible, such as when physical spaces become status goods: the corner office is desirable precisely because others cannot have it. More broadly, as major cities have become magnets for a global elite, they have become increasingly unaffordable for office workers, policemen, teachers, nurses, and the like. While the latter must endure long, tiresome commutes, elites use global cities as they see fit, often hopping around from place to place. Large swaths of Paris and London are eerily shuttered at night. Manhattan now has nearly a quarter-million vacant apartments.

Whenever violence and revolution have consumed unequal societies, real estate has been a focus of discontent. In the later years of the Western Roman Empire, vast estates catered solely to an aristocratic elite. In a famous homily from this period, St. Ambrose of Milan, reflecting on the Old Testament story of Naboth’s vineyard, decries elites for making “every effort to drive the poor person out from his little plot and turn the needy out from the boundaries of his ancestral fields.”

Likewise, the French social historian Marc Ferro has demonstrated that many urban Russians were driven to the Bolsheviks in 1917 not out of ideological zeal, but because the old regime and the new constitutional parties had proved incapable of providing food and housing. Over the course of World War I, Petrograd had developed an enormous munitions industry, manned by peasant labor conscripted in the countryside and brought to the newly expanded factories. But production planners had neglected the question of where these workers would be housed, and in 1917, the worker committees (soviets) offered an answer: apartments would be confiscated from the aristocrats and bourgeoisie.

A similar pattern played out in other cities where rapid, unplanned wartime industrialization had occurred (Budapest, Munich, Turin). Today’s equivalents are the centers of the new economy, such as Silicon Valley and its high-tech imitators in Europe and Asia. These cities have produced many jobs, but they have utterly failed to accommodate the people who actually live there. As a result, even middle-class professionals are living in cars, vans, and trailers.

And this malaise is not limited to the global cities themselves. Support for Brexit in southeastern England owes something to the perception that London and its immediate surroundings have become unaffordable as a result of too much immigration, international financial activity, and tourism – in short, globalization.

Needless to say, the political response to the real-estate problem has so far been inadequate, even counterproductive. Some large European cities are introducing rent controls, despite the poor track record of such policies. When New York tried similar measures in the twentieth century, the open market dried up, and property was hoarded or traded at a premium on the black market. When the UK rolled out a fiscal subsidy for first-time homebuyers, home prices rose accordingly, offsetting any potential benefit.

Removing tax privileges – as the US did recently by imposing a $10,000 cap on the state- and local-tax deduction – is a slightly better approach. But it will not solve the fundamental problem of supply. Not surprisingly radical, even Bolshevik-style, proposals are making a reappearance. A popular initiative in Berlin, for example, would socialize the holdings of large-scale real-estate owners (those managing more than 3,000 apartments).

The obvious solution to the supply problem, of course, is to build more housing. But new construction can conflict with environmental protections and a city’s architectural heritage, and is often opposed by existing property owners, who do not want the value of their own property to fall.

Sometimes, new construction can create alternative urban magnets, such as when the Spanish city of Bilbao was transformed by the addition of a Frank Gehry-designed Guggenheim Museum. But many declining industrial cities have already tried this solution, and only a few have succeeded. Those that have failed are still run down, and now have the added burden of maintaining new arts infrastructure.

Eventually, the cities and urban areas that are driving the bulk of new wealth creation will provoke a counter-movement. If they price out or otherwise exclude those who earn less, they will have sacrificed the openness that made them attractive in the first place. So, if they want to survive and thrive in today’s egalitarian political climate, they will need to come up with bold solutions.

During a previous period of urban-based dynamism, in the early sixteenth century, rich merchant families built low-rent housing that was then allocated to the poor. One such project, the Fuggerei complex in Augsburg, Germany, still provides low-rent social housing to this day.

If enough such housing cannot be supplied, might a lottery allocation of public accommodation help to stem the encroaching homogeneity of today’s global cities? It is certainly worth a try.

Harold James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation. A specialist on German economic history and on globalization, he is a co-author of the new book The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Union.

How Hong Kong Can Save Itself

Maintaining the city’s position as a global financial powerhouse requires a resolution to the political stalemate and an economic overhaul

By Nathaniel Taplin

Hong Kong is the most free economy in the world—in theory. In reality, most residents struggle to get by, and have little say in their political or economic future. Photo: isaac lawrence/Agence France-Presse/Getty Images 

Hong Kong is in the midst of its worst political violence since the semiautonomous city’s handover to China in 1997. Defusing the crisis—and maintaining its status as a global financial powerhouse and conduit for capital into China—requires urgent action not only on grievances including police accountability and stalled electoral reforms but also on deep, festering problems with the city’s economic model.

That means curbing the power of Hong Kong’s property tycoons and monopolies, finding a government-revenue model that doesn’t depend on sky-high property prices, and spending far more state resources immediately on public housing and public assistance. By some measures, Hong Kong is already among the most unequal societies in the world.

Most of Hong Kong’s most urgent economic problems relate to land. Median income growth has been modest over the past decade, but residential property prices nearly doubled in real terms from 2010 to 2018, according to the Bank for International Settlements. That far outpaces increases even in other notoriously bubbly markets such as Canada, where prices are up about 40%. Hong Kongers live in tinier apartments and pay more for them than nearly anywhere else.

Part of the issue is Hong Kong’s hilly geography, which means new space for building is limited. But an arguably much bigger problem is the vested interests of the government and big property developers in keeping prices high.

Hong Kong’s low tax rate and big fiscal surplus—the government over the past three years earned on average close to 20% more than it spent—is in fact funded largely by government land sales, which were 27% of total revenues in fiscal year 2017/2018. To make matters worse, the proceeds of land sales go into the Capital Works Reserve Fund, which is slated for infrastructure development. Hong Kong already has exemplary infrastructure. Residents watch in frustration as the authorities splurge on Beijing-backed political white-elephant projects like the multibillion-dollar sea bridge to Macau and high-speed rail link to Shenzhen, all while they can’t afford basic housing.

High property prices also make it hard to start small businesses—particularly since antimonopoly enforcement is already weak. Hong Kong, unlike most of its global peers, didn’t even have a comprehensive competition law in substantive effect until 2015. That has enabled property tycoons to fortify their empires with near-monopolies in areas such as utilities, transport and grocery stores, raising prices and stifling growth.

The government’s main solution to exorbitant property prices is the Lantau Tomorrow Vision, a proposed land-reclamation project near the territory’s largest island with an estimated cost of about $80 billion. New apartments, however, wouldn’t be available until the early 2030s—meaning a whole generation of young people could essentially remain priced out of the market even if the plan works. Critics say land supply could be boosted much more rapidly and cheaply by redeveloping existing brownfield commercial and agricultural sites as housing.

Mainland China’s political model works to the extent it does because citizens sacrifice a direct say in their future with the understanding that things will continue to improve. Denying people a say while simultaneously offering no real hope that things can improve is a far tougher sell.

US yield curve sends strongest recession warning since 2007

Bond market indicator worsens as questions swirl about Federal Reserve’s next move

Colby Smith in New York and Brendan Greeley in Washington


A widely watched bond market indicator sent its strongest recession warning in more than a decade on Wednesday, as the global growth outlook dimmed and questions swirled about the Federal Reserve’s commitment to cut interest rates in light of rising US-China trade tensions.

The yield on three-month US Treasury traded as much as 41.23 basis points above that on the benchmark 10-year government bond — the widest gap since March 2007. Such an inversion of the yield curve — in which short-term yields are higher than longer-term ones — has preceded every recession of the last half century.

The difference narrowed by about 10bp later in the day as US stock prices gained ground and a government bond market rally lost steam, but the persistence of the yield curve inversion underscored the anxieties in global financial markets.

Analysts said fears about global growth were exacerbated by interest rate cuts by New Zealand, India and Thailand, a dismal industrial production report in Germany and the growing likelihood that the UK will leave the EU without a deal in October.

“The next recession couldn’t have been better telegraphed,” said Mark Holman at TwentyFour Asset Management. “There is a trade war between the two global superpowers with both sides digging in their heels and the clock is ticking towards a hard Brexit, so it really does make sense to take risk off the table.”

Michael de Pass, the global head of US Treasury trading at Citadel Securities, said the deeper inversion of the yield curve traced back to concerns the Fed is moving too slowly to lower rates.

“The message that the market appears to be sending is that the Fed is behind the curve and is at risk of a policy error,” he said. “It is too early to say whether it actually is behind the curve but that line of thinking has certainly been a key driver of price action over the last few sessions.”

Comments by James Bullard, St Louis Fed president, on Tuesday, deepened these concerns, according to John Briggs, the head of strategy for the Americas at NatWest Markets. At an event for the National Economic Club in Washington, Mr Bullard said it was unrealistic to expect the Fed to react to trade rhetoric.

“If you tried to respond every time there’s a threat or counter-threat in a tit-for-tat trade war, you would destabilise monetary policy,” he said.

Mr Bullard said the Fed had already responded in July to what he called “trade uncertainty.” July’s rate cut, he said, was “insurance” against what was not known about the trade situation.

Chicago Fed President Charles Evans toed a more dovish line on Wednesday, signalling to Reuters his support for further rate cuts given that inflation remains persistently below the Fed’s 2 per cent target.

But investors are still worried that the Fed will deliver when it comes to easing monetary policy in line with market expectations.

“Until we get some sort of indication that the Fed is open to additional action, the yield curve will continue to invert,” Mr Briggs said.

Traders are pricing in a more than 60 per cent chance the Fed slashes its benchmark interest rate by 25bp in September, with nearly 40 per cent betting on a more aggressive 50bp cut.

Powell, Tariffs And Trump: A Friday Tragicomedy

by: The Heisenberg

- On Friday morning, China retaliated against forthcoming tariffs from the Trump administration, throwing equities and risk assets for a loop.

- Jerome Powell's Jackson Hole speech was acceptable, and briefly stabilized things.

- Then, President Trump weighed in on Twitter, chancing a conflagration in "tinderbox" markets.

Here's a quick take, including a brief recap of why this is a dangerous setup.
On Thursday afternoon, in a somewhat cautious post for this platform, I gently suggested that one of the major risks headed into Jerome Powell's closely-watched speech at Jackson Hole was that the Fed Chair wouldn't come across as dovish enough to satisfy President Trump, setting the stage for a scenario in which the White House refuses to accept the implicit pushback, instead opting to escalate the trade war further in a bid to test Powell's mettle.
As I write these lines, we're still hours away from the closing bell on Wall Street, but it's been an eventful day. China announced retaliatory tariffs on $75 billion in US goods, including new 5% levies on soybeans and oil from September 1, and the reinstatement of 25% duties on autos starting on December 15.
That news sent equity futures tumbling, but fortunately, Powell's Jackson Hole speech was replete with references to the darkening global growth outlook and allusions to geopolitical turmoil. He specifically mentioned weakness in the data out of China and the worsening situation in Germany, and he checked all the boxes when it comes to letting the market know he's apprised of the potential for political frictions to boil over, with negative ramifications for investors. To wit, from the speech:
We have seen further evidence of a global slowdown, notably in Germany and China. Geopolitical events have been much in the news, including the growing possibility of a hard Brexit, rising tensions in Hong Kong, and the dissolution of the Italian government.

Crucially, Powell said the Fed's "assessment of the implications of these developments" will inform the effort to sustain the expansion. Although not overtly "dovish", per se, that was most assuredly a sign that the Fed will assign a heavier weight than they otherwise might to international developments when deciding how best to ensure that the longest US expansion on record gets even longer.
US equities (and risk assets in general) recovered most of their morning swoon as traders digested Powell's remarks.
And then the president started tweeting. I don't think I have to quote directly from Trump's tweets (nor do I want to), but suffice to say he took his irritation with China's retaliatory measures out on Powell, who he explicitly called an "enemy" on par with "Chairman Xi". The President also said he would "respond" soon to China's retaliatory tariffs.
Irrespective of what form that response ends up taking, the fact of the matter is that Powell delivered what could reasonably be expected of him, especially in light of the hawkish setup from regional Fed presidents as discussed in the linked post above.

That is, there was every indication that Powell's remarks in Jackson Hole would lean overtly hawkish, betraying a desire for the Fed to stick to the "mid-cycle adjustment" script, but instead, we got a Fed chair who emphasized the myriad international developments weighing on growth and investor sentiment. That market-friendly lean was reflected in the bounce off the morning lows.
Have a look at this chart:
Powell did his job. He stabilized both equities and the yuan. Trump wanted more, although as I noted elsewhere, it's not entirely clear what the President expected. It's not as though Powell could re-write his speech an hour ahead of the public release and he certainly can't just cut rates from the podium in Wyoming.
In any event, that chart says it all, and the only saving grace as of lunchtime on Friday in New York is that the curve bull steepened a bit as the market still seems to think that trade escalations will be enough to force a Fed relent, especially in light of Powell's internationally-focused comments.

The dollar came off pretty sharply as well, and all else equal, that's a positive development for risk assets, but right now it doesn't matter - markets are spooked.
Barring a turnaround (which is possible depending on what the President says later), this will be the fourth consecutive week of losses for US equities. The last time that happened was, of course, in May, when Trump's decision to break the Buenos Aires trade truce threw stocks for a loop after Powell engineered a mammoth four-month rally.
Far be it from me to question the White House's trade policies, but I would suggest that the administration is wading into dangerous waters with markets. As Nomura's Charlie McElligott wrote on Friday morning, we'll be dealing with "still-weak post-summer holiday volumes [and] depth of book" along with "tight liquidity and VaR constraints from dealers" for weeks to come. Market depth has dried up in both rates and equities at various intervals in August, exacerbating the price action.
Dealers' gamma profile now looks to have flipped negative again (see visual below) and on some models, we're back near de-leveraging levels for some trend-following strats.
If the White House doesn't exercise some restraint, we good see equities careen through key levels and strikes, triggering systematic flows (both from trend-follower de-leveraging and dealer hedging) into a thin, August market.

At the same time, any further rally in bonds could bring more hedging flow, catalyzing another forced duration grab, which could push long-end yields even lower, sending a further risk-off signal to the market and, if the short-end can't keep up, inverting the 2s10s again, only this time sustainably.
This is something of a tragicomedy. China's retaliation was expected and, as alluded to above, Powell's speech in Jackson Hole was generally fine. Friday's drama was wholly unnecessary, and entirely dangerous when markets are, as I described them here a few days ago, a "tinderbox."