Future of Food

Industrialisation of China threatens global food supply

Industrialisation of China threatens global food supply
By Sarah Hills, 27-Jan-2009

Related topics: Financial & Industry

Global grain markets are facing breaking point because of drought and mass urbanisation in China which is diverting land-use away from crops, according to a new study from researchers at the University of Leeds.

The study exposes the fragility of the global grain supply and states that if China’s recent urbanisation trends continue, and the country imported just five per cent more of its grain due to a shortfall, the entire world’s grain export would be “swallowed whole”.

The research, published in the journal Environmental Science and Policy, said that the pressure on the availability of grains for international grain markets could have a “huge” knock-on effect on the food supply and prices to developing nations.

It follows a year when food manufacturers faced soaring commodity costs in 2008 as prices for key raw materials such as corn and wheat reach unprecedented figures, putting intense pressure on company balance sheets.

Dr Simelton, lead author of the study and research fellow at the Sustainability Research Institute, University of Leeds, said: “China is a country undergoing a massive transformation, which is having a profound effect on land use.

“Growing grain is a fundamentally low profit exercise, and is increasingly being carried out on low quality land with high vulnerability to drought.

“Ultimately the limiting factor for grain production is land, and the quality of that land.”

However, she added that quality land is increasingly being used for high profit crops, such as vegetables and flowers.

Global grains production in 2008/09 is expected to climb to about 1,800m tonnes.

China produces about 500m tonnes of grain a year and, according to the Chinese government, the country is 95 per cent self sufficient in terms of grain supply.

The study looked at China’s three main grain crops - rice, wheat and corn - and how socio-economic factors affected their vulnerability to drought over the past 40 years using statistics of harvests and rainfall and qualitative case studies.

The report said that if China were to start importing just five per cent of its grain to make up a shortfall produced by low yields or change of land use to more profitable crops, the demand would “hoover up” the entire world’s grain export.

It added that increased urban development in previously rich farming areas would be the likely cause.

The report concluded that vulnerability to drought seems related to underlying population economic and land-use factors.

Volatile markets

Commodity prices have been rising since 2005, according to a report last year by consultancy firm Deloitte.

This has been blamed on increasing consumer demand from emerging markets and increasing populations, a competing demand for grains from biofuels, the rising cost of oil and poor weather conditions.

Possible solutions to help ease the problem include genetically engineered (GE) crops, which have potential for enhanced yields.

However, opponents argue that not enough is known about the safety of GE crops and food.

Source: Journal of Environmental Science & Policy

doi:10.1016/j.envsci.2008.11.005

“Typologies of crop-drought vulnerability: an empirical analysis of the socio-economic factors that influence the sensitivity and resilience to drought of three major food crops in China (1961–2001)”

Authors: Elisabeth Simeltona, Evan D.G. Frasera, Mette Termansena, Piers M. Forsterb and Andrew J. Dougilla

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Dollar as reserve of value

FT.com / Markets - View of the Day: The untouchable dollar

View of the Day: The untouchable dollar

By David Bloom

Published: January 27 2009 15:11 | Last updated: January 27 2009 15:11

The cost of insuring Californian debt relative to the US is miles higher than Spain versus Germany.

This does not seem to be a concern to the FX market and is the type of inconsistency that David Bloom, global head of FX strategy at HSBC, finds difficult to come to terms with.

He says he expected fears over sovereign risk to become a driver of the currency market. Indeed, both the euro and sterling have suffered as those worries have come to the fore in recent weeks.

But, the FX market is not pricing in any concerns over the US.

Mr Bloom says this is irrational, meaning either the US is beyond risk, or, when it is priced in, the dollar will suffer.

“We find it odd that the market seems to be ignoring the issue of sovereign risk in the US,” he says. “The market makes no allowance for any US problems as far as the currency is concerned.”

But Mr Bloom says once the euphoria over Barack Obama’s inauguration as US president passes, focus will shift to the reality of the US fiscal deficit.

“The US seems to be untouchable. We believe a sudden and dramatic shift in sentiment will occur when the market questions US sovereign [risk] , just like it has with the eurozone and the UK,” he says.

When this happens, the dollar will move lower argues Mr Bloom.

“The dollar’s reserve currency status will wear a bit thin as the US fiscal deficit balloons.”

Copyright The Financial Times Limited 2009

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Crisis causes

The crisis and how to fix it: Part 1, causes | vox - Research-based policy analysis and commentary from leading economists

A global perspective on the great financial insurance run: Causes, consequences, and solutions (Part 1)

Ricardo Caballero
23 January 2009

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In a pair of Vox columns, one of the world’s most respected macroeconomists suggests that the consensus view of the crisis’s causes and cures is flawed. This first column focuses on the crisis’s deep causes. Global excess demand for safe assets played a role in building the ‘accident waiting’ to happen. Now, investors’ fears of unknown unknowns – Knightian uncertainty – is why the waiting mountains of cash are not acting as “stabilising speculation”.

This is a financial crisis to remember. The financial losses are measured in trillions of dollars; elite financial institutions have fallen; fear and mistrust are widespread among investors and lenders; credit markets are not operating except for those with very short maturities; massive and unorthodox policy interventions are an every day occurrence; and we have been, and continue to be, on the verge of a global financial meltdown.

How did we get into this situation? What should we do to get out of it and to prevent a relapse?

This pair of Vox columns addresses these questions, suggesting that the consensus view of the crisis’s causes and cures is flawed. (These columns are based on a talk at MIT’s 20 January 2009 Economics Alumni dinner in New York City.)
The emerging consensus

There is an emerging consensus on the causes of the crisis which essentially rehashes an old list of complaints about potential excesses committed in the phase prior to the crisis. The sins include uncontrolled global imbalances, unscrupulous lenders, and an insatiable Wall Street, all of them lubricated by an ever expansionary Federal Reserve.

It follows from this perspective that the appropriate policy response is to focus on reducing global imbalances, boosting financial regulation, bringing down leverage ratios, and adding bubble-control to the Fed’s mandate.
I do not share this consensus view and its policy prescriptions.

The rest of this column develops my view of the crisis’s causes. I start with the pre-crisis phase and then portray the current crisis as primarily a run on all forms of private insurance.

My second column discusses optimal economic policy in this environment.

The pre-crisis phase: Global excess demand for safe assets

For quite some time, but in particular since the late 1990s, the world has experienced a chronic shortage of financial assets to store value. The reasons behind this shortage are varied. They include the rise in savings needs by aging populations in Japan and Europe, the fast growth and global integration of high saving economies, the precautionary response of emerging markets to earlier financial crises, and the intertemporal smoothing of commodity producing economies.

The immediate consequence of the high demand for store-of-value instruments was a sustained decline in real interest rates. Conventional wisdom blames these low rates on loose monetary policy, but this position is difficult to reconcile with facts from the period of the so-called “Greenspan conundrum’’ – when tightening monetary policy had virtually no impact on long rates. In my view, the solution to the apparent conundrum is that low long rates were driven by the large demand for store-of-value instruments, not short-term monetary policy considerations.

Global imbalances were created by the demand for safe US assets

Low real interest rates are an equilibrium response by which the market creates value out of existing financial assets. Yet another mechanism to increase asset supply is the creation of new assets, including the emergence of the many speculative bubbles that we have seen over the last decade (some of which are legal and some are not – e.g., the NASDAQ bubble and the Madoff scheme, respectively).

Moreover, because of the US’s role as the centre of world capital markets, much of the large global demand for financial assets has been channelled toward US assets. This has been the main reason for the large global “imbalances” observed in recent years. The large current account deficits experienced by the US are simply the counterpart of the large demand for its assets.

How the subprime mortgage market fits in

Under this perspective, there is a more subtle angle on subprime mortgages than simply being the result of unscrupulous lenders. The world needed more assets and the subprime mortgages were helping to bridge the gap. So far so good.

However, there was one important caveat that would prove crucial later on. The global demand for assets was particularly for very safe assets – assets with AAA credit ratings. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety became even more pronounced after the NASDAQ crash.

Soon enough, US banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets; the market moved to create synthetic AAA instruments. This consisted of pooling subprime mortgages on the asset side of a Structured Investment Vehicle (SIV), and to tranch (slice) the liability side to generate a AAA component buffered by the now ultra volatile “toxic” residual. The latter was then pooled again into Collateralized Debt Obligations (CDOs), tranched again, and then into CDO-squared, and so on. At the end of this iterative process, many new AAA assets were produced out of some very risky subprime mortgages.

Safe and risky tranches: An accident waiting to happen

The AAA tranches so created were held by the non-levered sector of the world economy, including central banks, sovereign wealth funds, pension funds, etc. They were also held by a segment of the highly-levered sector, especially foreign banks and domestic banks that kept them on their books, directly and indirectly, as they provided attractive “safe” yields. The small toxic component was mostly held by agents that could handle the risk, although highly levered investment banks also were exposed.

Much of the focus on the regulatory and credit agency mistakes highlights the fact that the AAA tranch seems to have been too large relative to the “true” capacity of the underlying risky instruments to create such a tranch. While I agree with this assessment, I believe it is incomplete and, because of this, it does not point to the optimal policy response.

Individual default risk vs severe macro risk

Instead, I believe the key issue is that even if we give the benefit of the doubt to the credit agencies and accept that these instruments were indeed AAA from an unconditional probability of default perspective (the only one that counts for credit agencies), they were not so with respect to severe macroeconomic risk.

This created a highly volatile concoction where highly levered institutions of systemic importance were holding assets that were very vulnerable to aggregate shocks. This was an accident waiting to happen.

The (insurance) crisis: Triple A turns toxic, fear of the unknown spreads

And happen it did. It started without much fanfare sometime in 2006, limited to the housing sector and the associated subprime mortgage market. Eventually, it spread to the financial sector as the securitisation markets supported by these mortgages and other risky loans began to freeze. As this happened, conventional margin and collateral feedback mechanisms amplified the incipient liquidity problem. Then suddenly, the soundness of the AAA instruments created from risky loans in the previous phase were questioned. In particular, economic agents realised that they didn’t quite understand what was behind these instruments (Caballero and Krishnamurthy 2008a).

This confusion was the first inkling of something that would later ravage global financial markets. Financial institutions specialise in handling risk but are not nearly as efficient in dealing with uncertainty.
Uncertain versus risk

To paraphrase a recent secretary of defence, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction is not only linguistically interesting, but also has significant implications for economic behaviour and policy prescriptions.

There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner make the dreaded scenarios all the more likely.

US Treasury’s uncertain response makes things worse

Worsening the situation, until very recently, the policy response from the US Treasury exacerbated rather than dampened the uncertainty problem.

Early on in the crisis, there was a nagging feeling that policy was behind the curve; then came the “exemplary punishment” (of shareholders) policy of Secretary Paulson during the Bear Stearns intervention, which significantly dented the chance of a private capital solution to the problem; and finally, the most devastating blow came during the failure to support Lehman. The latter unleashed a very different kind of recession, where uncertainty ravaged all forms of explicit and implicit financial insurance markets.

In the next column I discuss what should be done in light of my analysis of the causes of this financial crisis.
References

Knightian Uncertainty and its Implications for the TARP
Ricardo J. Caballero and Arvind Krisnamurthy
Financial Times, November 24, 2008

Paulson Plan: "Exemplary Punishment" Could Backfire
Ricardo J. Caballero and Pablo Kurlat
Financial Times, The Economists' Forum, Monday, 29 September, 2008

"Musical Chairs.pdf"
Ricardo J. Caballero and Arvind Krishnamurthy
February 2008a

Global Imbalances and Financial Fragility
Ricardo J. Caballero and Arvind Krishnamurthy
December 16, 2008b

Financial Crash, Commodity Prices and Global Imbalances
Ricardo J. Caballero, Emmanuel Farhi, Pierre-Olivier Gourinchas
November 17, 2008 (forthcoming, Brookings Papers on Economic Activity)

Flight to Quality and Bailouts: Policy Remarks and a Literature Review
Ricardo J. Caballero and Pablo Kurlat
October 2008

Collective Risk Management in a Flight to Quality Episode
Ricardo J. Caballero and Arvind Krisnamurthy
Journal of Finance, Vol. 63, Issue 5, October 2008

An Equilibrium Model of "Global Imbalances" and Low Interest Rates

Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas
American Economic Review 2008, 98:1, pgs 358-393.

On the Macroeconomics of Asset Shortages
The Role of Money: Money and Monetary Policy in the Twenty-First Century
The Fourth European Central Banking Conference 9-10 November 2006, Andreas Beyer and Lucrezia Reichlin, editors. Pages 272-283.

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Politics

Bremmer and Roubini: Expect the World Economy to Suffer Through 2009 - WSJ.com

Politics will make matters worse, primarily because governments in both the rich and the developing worlds are intervening in their economies more broadly and deeply than at any time since the end of World War II. Policy makers around the world are hard at work crafting stimulus packages filled with subsidies and protections they hope will breathe new life into their domestic economies, and preparing to rewrite the rules and regulations that govern global markets.

Why is this dangerous? At the G-20 summit a few weeks ago, world leaders pledged to address the crisis by coordinating their economic policy responses. That's not going to happen, because politicians design stimulus packages with political motives -- to satisfy the needs of their constituents -- not to address imbalances in the global economy. This is as true in Washington as in Beijing. That's why politics will drive the global economy more directly (and less efficiently) in 2009 than at any point in decades. Its politics that is creating the biggest risk for markets this year.

This is part of a worrisome long- term trend. In China and Russia, where histories of command economics predispose governments toward what we've come to call state capitalism, the phenomenon is especially obvious. National oil companies, other state-owned enterprises, and sovereign wealth funds have brought politicians and political bureaucrats into economic decision-making on a scale we haven't seen in a very long time.

Now the U.S. has gotten in on the game. New York, once the financial capital of the world, is no longer even the financial capital of the U.S. That honor falls on Washington, where lawmakers are now injecting populist politics into economics decisions. Companies and sectors that should be left to drown are being floated lifeboats. This drama is also playing out across Europe and Asia. As engines of economic growth, Shanghai is losing ground to Beijing, Mumbai to Delhi, and Dubai to Abu Dhabi.

Global markets will also face the more traditional forms of political risk in 2009. Militancy in an increasingly unstable and financially fragile Pakistan will continue to spill across borders into Afghanistan and India. National elections in Israel and Iran risk bringing the international conflict over Iran's nuclear program to a boil, injecting new volatility into oil markets. The impact of the financial crisis on Russia's economy could produce significant levels of unrest across the country. And Iraq may face renewed civil violence, as recently dormant militia groups compete to fill the vacuum left by departing U.S. troops.

The world's first global recession is just getting started.

Mr. Bremmer, president of Eurasia Group, is co-author of the forthcoming book "The Fat Tail: The Power of Political Knowledge for Strategic Investing" (Oxford University Press). Mr. Roubini is a professor of economics at New York University's Stern School of Business and chairman of RGE Monitor.

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Brutally simple

FT.com / Columnists / Martin Wolf - Why Obama must mend a sick world economy

The implosion of demand from the private sectors of financially enfeebled deficit countries can end in one of two ways, via offsetting increases in demand or via brutal contractions in supply.

If it is going to be through contractions in supply, the surplus countries are particularly at risk, since they depend on the willingness of deficit countries to keep markets open. That was the lesson learnt by the US in the 1930s. Surplus countries enjoy condemning their customers for their profligacy. But when the spending stops, the former are badly hurt. If they try to subsidise their excess supply, in response to falling demand, retaliation seems certain.

Obviously, expansion of demand is much the better solution. The question, though, is where and how? At present much of the expansion is expected to come from the US federal budget. Leave aside the question whether this will work. Even the US cannot run fiscal deficits of 10 per cent of GDP indefinitely. Much of the necessary expansion in global demand must come from surplus countries.

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New bank model just ATMs

By Mohamed El-Erian

Published: January 20 2009 19:32 | Last updated: January 20 2009 19:32

http://www.ft.com/cms/s/0/a7939ca8-e727-11dd-aef2-0000779fd2ac.html

The transformation of the banking system into a utility model has
become inevitable in light of the risks that banks’ damaged balance
sheets pose for the broader economy
Under the utility model, banks will perform narrow functions within
well-defined and constrained leverage. They will be less risky, but
also less innovative and less able to lend imaginatively. This will
inevitably reduce the speed limit for medium-term economic growth in
the US and beyond. It is too late to stop the transformation of banks
into utilities. But it is not too late to start working on a subsequent
reinvigoration in the context of a more effective regulatory structure.

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Pressure on the euro

The euro is torture instrument for Spain - Telegraph

The euro is torture instrument for Spain
Ten years of euro membership have lured Spain into a terrible trap.


By Ambrose Evans-Pritchard
Last Updated: 10:26AM GMT 20 Jan 2009

Real interest rates of minus 2pc set by Frankfurt for German needs led to a Spanish property bubble of fearsome scale. Construction rose to 16pc of GDP, trumping the British and US bubble by large margins.

Spanish companies tapped the euro capital markets as if there was tomorrow. Reliance on foreign borrowing reached 10pc of GDP, among the world's highest. Wages went up and up. The result is a current account deficit that is also 10pc of GDP.

Now what? A country with full control over all levers of economic policy can claw its way out of such a hole. Spain can do almost nothing.

A key reason why Standard & Poor's has stripped Spain of its AAA credit rating is that the country no longer sets its own interest rates and cannot devalue its currency to restore balance.

S&P did not say explicitly that EMU has become an instrument of debt-deflation torture for Spain. That would be breaking the great euro taboo. It insisted that EMU provides an anchor of stability. But that is pro-forma dressing. The sub-text is that Spain cannot recover until it breaks its chains.

It is true that Germany regained competitiveness by screwing down wages in the early part of this decade, but it did so when southern Europe was inflating merrily.

Spain faces a much harder task. It has to claw back 20pc to 30pc in labour competitiveness against a stern Germany that will not inflate. Therefore, Spain must deflate. It must embark on a 1930s policy of draconian wage cuts.

It remains to be seen whether this will be tolerated by a democracy. Brussels expects Spanish unemployment to reach 19pc - or 4.5m people - by late next year. This is a depression.

Workers are already rising up against the ruling socialists. An angry march by trade unions in Zaragoza on Sunday is the first shot across the bows.

As yet, no Spanish heavyweight has questioned the orthodoxy of EMU membership. That may change, as it is changing in Ireland. The euro system is starting to inflict very grave hardship on ordinary people. This is exactly what critics always feared. In the end, it will breed conflict.

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Europe down

European Commission - Economic and Financial Affairs - EU interim forecasts for 2009-2010: sharp downturn in growth

EU interim forecasts for 2009-2010: sharp downturn in growth
The European Commission is expecting GDP in the European Union to fall by about 1.8% in 2009 before recovering moderately to 0.5% in 2010.

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Bad bank or nationalisation, only two choices

Germany’s financial crisis much worse than previously reported

Der Spiegel has the story this morning that German banks are sitting on toxic assets worth €300bn, of which so far only a quarter has been written off. This figure is signficantly worse than anything reported so far, and is almost certainly likely to trigger the creation of bad banks –institutions that suck up toxic papers to allow the “good bank” to get back on its feet again. The information, according to Der Spiegel, was contained in an unpublished poll conducted by the Bundesbank and Bafin, the bank supervisory authority, among the country’s 20 largest banks.

The UK banks are in a similarly bad position, according to British newspapers. The Independent reports that British banks are technically insolvent. This morning, the government will present a scheme to extend the bank bailout package signficantly. Britain, too, is moving towards a bad bank.

Paul Krugman this morning has two posts (here and here) why bad banks, or at least the kind currently under discussion, are a bad idea. For him it is like rearranging deck chairs on the Titanic.

Willem Buiter is also hostile to the idea of a bad bank, and he insteads pleads for full nationalisation.

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Second article on debt jubilee

Biblical debt jubilee may be the only answer - Telegraph

Biblical debt jubilee may be the only answer
Once again, Britain leads the world in the macabre speciality of saving banks.


By Ambrose Evans-Pritchard
Last Updated: 6:08AM GMT 19 Jan 2009

Comments 57 | Comment on this article

The Treasury's £200bn plan to soak up toxic debt will be followed within days by a US variant from the Obama team. Germany cannot be far behind.

As one bail-out succeeds another at ever more inflated price tags, rescue fatigue is becoming palpable. People are bewildered, fearing that good money is being thrown after bad.

The doubts are understandable but there are tentative signs of a thaw in the global credit system. Libor lending rates in the US, Britain and Europe have fallen sharply. US mortgage rates have dropped from 6.5pc to 4.88pc since October. Companies can issue bonds again.

"It is easy to conclude that none of the Government's policies are working," said Professor Peter Spencer from York University. "We must not lose sight of the fact that they have prevented the collapse of the monetary system."

This is not does mean that recovery is imminent. Nothing can prevent a long purge as years of credit leverage give way to debt deflation.

It means only that the downward spiral – the "adverse feedback loop" feared by central banks – has been arrested.

The first three pillars of the global bail-out are in place. Government money is rebuilding the annihilated capital of banks. This has further to run. Core lenders in the US, Europe and parts of Asia will be nationalised, but that is a detail at this point. It scarcely matters who owns the banks – unless you are a shareholder – so long as they lend.

The Fed has cut rates to zero. It is buying mortgage securities on the open market, and eying Treasury debt next. Fellow central banks are exploring their own ways to print money.

The $3 trillion (£2 trillion) fiscal blitz by the US, China, Japan and Europe plugs an emergency gap. With luck, it will keep the world economy on life-support just long enough to stop recession and banking crises from feeding on each other with lethal effect, as they did in 1931.

The latest plans to "ring-fence" bad debts in sceptic tanks puts in place the fourth pillar. The UK Treasury's version involves a state insurance scheme, letting banks shuffle off their crippling loads and escape mark-to-market torture.

The US version is a "bad bank" for mortgage debt. It is more or less the old "TARP" passed by Congress, before the funds were diverted into bank recapitalisations. This method worked after the Savings & Loan crisis in the 1980s. The market found a floor. The Treasury even made a profit.

German finance minister Peer Steinbrück said he "could not imagine" a bad bank in his country. Time will tell. Der Spiegel reports that Germany's top 20 banks have €300bn (£270bn) of bad debt, booked at "illusory" prices. They have written down just a quarter of their losses.

Taken together, the rescues may make the difference between global recession and a deeper slump that causes mass unemployment and social turmoil, perhaps destroying the open global order we take for granted. We can only guess.

There is no guarantee that the measures will succeed. The vast scale of government borrowing may exhaust the stock of global capital. Markets are already beginning to question the credit-worthiness of sovereign states. The Fed may find it harder than it thinks to disengage from colossal intervention in the bond markets.

In the end, the only way out of all this global debt may prove to be a Biblical debt Jubilee.

Creditors are not going to like that.

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Euro woes

FT.com / Columnists / Wolfgang Munchau - ‘What if’ becomes the default question

‘What if’ becomes the default question

By Wolfgang Münchau

Published: January 18 2009 19:26 | Last updated: January 18 2009 19:26

What if one of the member states of the eurozone were to default on its debt? On the occasion of the euro’s 10th birthday, this has become the most frequently asked question about the single currency zone.

The probability of a default is low but clearly rising. The decision by Standard & Poor’s, the ratings agency, to downgrade Greek sovereign debt and to put Spanish and Irish debt on watch seriously rattled investors last week, for good reason. If the financial crisis has taught us one thing, it is to take perceived tail-risks more seriously.

Before I answer the question, it is best to consider what would not happen. For a start, the eurozone would not fall apart. A government about to default would be mad to leave the eurozone. It would mean that, in addition to a debt crisis, the country would also face a currency and banking crisis. Bank customers would simply send their euros to a foreign bank to avoid a forced conversion into a new domestic currency.

So if a default were to happen, it would almost certainly happen within a eurozone that remained intact. If you put your mind to it, it is quite difficult, even in theory, to think of a circumstance in which the eurozone would blow apart. One theoretical possibility would be for the European Central Bank to generate massive inflation, prompting Germany to leave in disgust – not exactly the most likely scenario right now.

So we are stuck with the eurozone for better or for worse. If a default happens, the central banks and governments of the eurozone would be forced to co-ordinate their policies whether they liked it or not. Under its statutes, the euro system, which includes the ECB and the national central banks, is not allowed to monetise (that is, buy) new sovereign debt or to grant overdraft facilities. But the ECB is allowed to buy debt in the secondary markets, which is a way of monetising debt. All it would take is a decision by the ECB’s governing council.

What about a direct fiscal bail-out by other member states? I suspect that the non-defaulting governments would be reluctant initially. Many of them had difficulty selling austerity-type policies to their domestic electorates and they might not achieve the parliamentary majorities needed for a bail-out. Some would no doubt argue that a bail-out would carry the risk of moral hazard.

But governments would soon discover that simply saying No was not going to work either. Back in the real world, governments would have to take into account the risk of contagion. For example, a sovereign default by a small country could wreak havoc on the markets for credit default swaps and might even destroy financial institutions in other eurozone countries.

A default could also trigger a panic rise in bond yields elsewhere, which could turn the threat of contagion into a self-fulfilling prophecy.

If confronted with this more realistic situation, governments would, I suspect, react similarly to the way they responded in the aftermath of the collapse of Lehman Brothers, the US investment bank. Complacency would be followed by anger and by grandstanding lectures on the virtues of fiscal discipline (I can see a speech coming by the German finance minister).

This would be followed by an emergency meeting one weekend in Brussels in which the European Union, perhaps together with the International Monetary Fund, would agree a package of credits to stabilise the defaulter.

The recipient would, in turn, have to accept an austerity programme, perhaps even the temporary loss of fiscal sovereignty, to ensure that the loan was repaid and to reduce moral hazard. In other words, the Europeans would bail out one of their own, but it would not be fun for anyone, especially not for the defaulter.

In the long run, a conditional bail-out combined with persistently positive bond spreads could even be a healthy development for the eurozone. Putting roughly the same value on Greek and German debt – which is what financial markets did for most of the last 10 years – never made sense.

If that situation had been allowed to persist, it would have produced serious difficulties for the eurozone further down the road. When the euro was launched in 1999, many commentators, including me, predicted that the markets would exert sufficient pressure on member states to run responsible fiscal policies. It took 10 years for that prediction to prove correct (which means, of course, that it was not such a great prediction).

A far more serious threat would be a cascading series of defaults that would eventually include one or more of the eurozone’s large countries. That would be a momentous challenge for the system but the policy response would be no different, only faster.

In extremis, you could conceive of a scenario under which the bail-out had to be so large that it would bring down the entire system. This could then provide the non-defaulters with an economic incentive to leave.

But dream on. If Germany, for example, had such an incentive to leave, it would almost certainly forgo that perceived economic benefit and stay for political reasons. If you assume the worst-case scenario of a default by five or six countries, a full fiscal union would be more probable than a break-up.

Most likely, we will see neither, but we may see conditional bail-outs.

Send your comments to munchau@eurointelligence.com

More columns at www.ft.com/wolfgangmunchau

Copyright The Financial Times Limited 2009

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Great Roubini prognosis

RGE - RGE Monitor - 2009 U.S. Economic Outlook

RGE Monitor - 2009 U.S. Economic Outlook
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RGE Lead Analysts | Jan 13, 2009

It is clear that 2008 was a dismal year for the economy and financial markets and it is now official that the current U.S. recession started already in December 2007. So, how far are we into this recession that has already lasted longer than the previous two (the 1990-91 and 2001 recessions lasted 8 months each)? We forecast that the U.S. economy is only half way through a recession that will be the longest and most severe in the post war period. U.S. GDP will continue to contract throughout all of 2009 for a cumulative output loss of 5% and a recession that will thus last about two years. Our forecast is much worse than the current consensus forecast expecting a growth recovery in the second half of 2009; we also predict significantly weak growth recovery – well below potential - in 2010.

One final look at 2008 will reveal a very weak fourth quarter with GDP growth contracting -6%, in the wake of a sharp fall in personal consumption and private domestic investments. We see the real GDP growth contraction playing out through the year as follows: Q1 2009 -5%; Q2 2009 -4%; Q3 2009. -2.5%; Q4 2009 -1%, adding up to a yearly real GDP growth of -3.4% for the U.S. in 2009.

Personal Consumption

A shopped-out, saving-less and debt-burdened U.S. consumer lost its resilience and started to give up in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up over two-thirds of aggregate demand, the outlook for the U.S. consumer is at the center of the dynamics that will play out in the real economy in 2009.

In our view, personal consumption will continue to contract quite sharply throughout 2009 as a result of negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008 on, mounting job losses, tighter credit conditions and high debt servicing ratios (the debt to income ratio went from 70% in the 90s, to 100% in 2000 to 140% now). This retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will eventually restore the household saving rate of a decade ago to increase the now sharply depleted net worth of the household sector.

The wealth losses for households related to the fall in home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall –eventually reaching the $6-8 trillion range (compatible with a 30-40% fall in home prices peak to trough). With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500bn. And negative wealth effect from fall in equity prices – on the wake of a bleak 2009 for corporate profits – will also contribute to the contraction in personal consumption by an estimated $100bn (compatible with a 20% contraction in the stock markets from the level at the beginning of 2009.)

This adjustment is consistent with a rebalancing of the economy that will over time bring the saving rate to a positive level of roughly 5-6% where it was a decade ago, for this to happen consumption has to contract by an amount close to $800bn.

Housing Sector

The 4th year of housing recession – and the worst housing recession since the Great Depression - is well on course.

Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate (SAAR) peak of January 2006 all the way to the 625 thousand SAAR of November 2008 (the last data point available), an all time low for the time series that started in January 1959. Single-family starts built for sale are down 75% from their Q4 2005 peak (seasonally adjusted data are not available, we performed our own seasonal adjustment).

On the demand side, new single-family home sales are down 70% from their July 2005 peak. Both demand and supply of homes are therefore still falling very sharply which does not bode well for inventories. Inventories are the mortal enemy of prices for any goods-producing sector, including housing.

Starts need to fall substantially below sales so that the excess supply in the housing market is reabsorbed. Inventories persist at record highs and the gap between one-family starts (for sale) and one-family sales (-92K annual rate in Q3 2008 according to our estimates) is at levels that cannot promote a fast work–off of inventories. To put these numbers in perspective, compare this with a measure of vacant homes for-sale-only. Vacant homes for-sale-only were at 2.2 million in Q3 2008, an all time high. In the decade between 1985 and 1995 it oscillated around 1 million units on average and 1.3 million units between 2001 and 2005. This implies that we have to deal with an excess supply that ranges between 0.9 and 1.2 million units, of which roughly 85% are single-family structures.

The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side of housing is bound to persist and we believe that supply will have to fall further, given also the great wave of foreclosures that is adding to the excess of supply in the market. We see starts falling another 20% from current levels.

We believe that home prices will not bottom out until the middle of 2010. Our target is a 38% peak to trough (so far prices have fallen 25% from the peak) but given the worsening conditions on the real side of the economy, we see a meaningful chance for over-correction that would bring prices down 44% from the peak reached in the first half of 2006 (Case-Shiller is the reference index for these predictions.)

Labor Markets

With continued credit crunch and significant cut down in consumer and business spending, the monthly job losses will continue in the 400-600k range during the first two quarters of 2009, pushing the unemployment rate to over 8% by mid-2009. The severe contraction in private demand through 2009 will keep lay-offs high so that the unemployment rate will reach 9% by the end of 2009.

Economy wide job cuts are expected, with big corporations and small and medium enterprises, residential and commercial construction, financial services and manufacturing continuing to shed jobs at a strong pace. Moreover, with structural shifts in the economy since the last recession, job losses this time will be more severe in the service sector, including retail, business and professional services, and leisure and hospitality. Unless the fiscal stimulus addresses the deficit problem for state and local governments, job losses at the government level will also gain pace. In turn, income and job losses will further push up the default and delinquency rates on mortgages, consumer loans and credit cards. Moreover, the loss of high paying corporate and financial sector jobs will be a big negative for tax revenues over the next two years.

As cost-cutting gains pace with the beginning of the (sluggish) recovery period in early 2010, lay-offs are bound to continue. Even as consumer demand might show some signs of recovery at some point in 2010, firms will most likely begin by hiring only part-time and temporary workers initially. The unemployment rate might get close to 10%, peaking in the middle of 2010 over two years after the recession began. However, the hiring freeze across industries that began in late 2007 will continue at least until 2010 causing discouraged workers to leave the work force and containing the extent of spike in the unemployment rate. Further, the decline in labor utilization will add to the deflationary pressure in the economy. An aging labor force, lower capital spending and potential growth over the next few years might also result in lower productivity growth and an increase in the natural rate of unemployment (NAIRU).

Capital Expenditure

Firms have been drawing down inventories beginning in Q4 2008 given the build-up of inventories of unsold good; this process will continue in 2009 dragging down production. As the slump in domestic and foreign demand and difficulty in accessing short-term credit persist over the next four quarters, business investment is bound to contract in the high double-digits throughout 2009. Industrial production, spending on equipment and durable goods will also remain in red through 2009. Moreover with a sluggish recovery in private demand even during 2010, firms will start building inventories and increase capex plans only at a slower pace.

Trade

Exports contraction that began in late 2008 will gain pace in 2009 as more and more emerging economies slip into slowdown following the G-7 countries. On the other hand, easing oil prices and secular downward trend in consumer spending and business investment will help imports to shrink. In fact, this might cause the trade deficit to contract in 1H 2009 since the contraction in imports might well exceed the decline in exports, thus containing any negative contribution of trade to GDP growth.

Dollar Outlook

The fate of the U.S. dollar in 2009 rests on the global growth outlook relative to the U.S. downturn. After profit-taking on long USD positions ends and trading volumes pick up as investors return from their holidays, the dollar may temporarily recover its relative safe haven status in part of H1 2009. Since markets have yet to fully appreciate the impact of the commodity slump and financial crisis on the rest of the world, risk appetite may collapse again on signs of a deeper- or longer-than-expected recession outside the U.S. Further de-leveraging of USD-denominated liabilities could provide an additional boost to the dollar as a funding currency. The bond yield outlook could be a further source of strength: while the Fed is already at ZIRP, other central banks will cut rates further to stimulate growth, putting downward pressure on currencies like the Euro. Alternating with these upside risks to the dollar may be downside risks from 1) a supply crunch in commodities that lifts commodity prices and producers' economies, 2) inability of the market to absorb increased Treasury supply at low yields; 3) massive quantitative easing by the Fed; 4) large twin fiscal and current account deficits; 5) a worse than expected recession in the U.S.

Downside risks to the dollar seem more likely to outweigh upside risks in the latter half of 2009 and in 2010. Yet at the same time, similar downside risks exist for other currencies – growing fiscal deficits will weaken a range of currencies. With emerging markets continuing to have trouble attracting capital and Asian economies, hammered by export contractions, will be reluctant to allow their currencies to appreciate against or with the dollar – China allowed some depreciation of the RMB at the recent euro-dollar peak.

Once crucial support from deleveraging wanes, however, the dollar may be left with only foreign central bank reserve accumulation – which has already waned on the reversal of capital flows – to finance the large U.S. current account deficit. Yet, continued repatriation of assets and higher enforced domestic savings rates will at least reduce pressure on the dollar in the short-term.

Inflation/Deflation

Annual U.S. inflation, as measured by official producer and consumer price indices, is likely to slow in 2009 and even fall into technical deflation despite increases in the monetary base and fiscal measures to boost spending power. Slumping commodity prices may drag down the average annual headline CPI inflation rate to around -2% - a technical deflation which may morph into genuine deflation if falling prices generate expectations that they will continue to fall. Meanwhile, the growing slack in product and labor markets will keep core consumer inflation subdued at an average year-over-year rate of 1-2%. Steep discounts to get rid of unsold retail inventory, rising job losses and lower wage growth will reinforce the trend of stagnant or falling prices. Rising slack in labor markets and weak demand for commodities and goods/services will keep producer prices at bay. Upside risks to the inflation outlook include 1) a commodity supply crunch or geopolitical shock that leads to a sustained rise in oil/energy and commodity prices and 2) an earlier than expected global economic recovery.

Credit Losses Still Ahead

Back in February 2008, Nouriel Roubini warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion. As of mid-November 2008, the threshold of $1 trillion in global financial writedowns was finally reached. Given that national house prices expected to drop another 20%, we expect credit losses of $1.6 trillion on unsecuritized loans alone, much larger if we include mark-to-market losses on securitized instruments.

An in-depth analysis of current and expected loan losses per asset class and separately of mark-to-market writedowns per securities class based on current prices indeed confirms RGE’s initial loss range estimates (outstanding loan and securities amounts as in IMF Global Financial Stability Report, Table 1.1) For our calculations we assume a further 20% fall in house prices, and an unemployment rate of 9%. With respect to credit losses on unsecuritized loans, recent research by the Federal Reserve Board using comparable assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are going to default (i.e. $150bn out of $300bn). The loss trajectories for Alt-A loans are similar resulting in a 25% default rate ($144bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies, implying an approximate 7% default rate when the potential for ‘jingle mail’ is taken into account ($105bn out of $3,800bn).

The cycle has also turned in the commercial real estate (CRE) arena with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (net recovery, via Fed data) are projected to increase to up to 17% by Fitch assuming a 25% fall in prices ($142bn out of $2.4 trillion.) In the consumer loan area, we estimate credit card charge-off rate could increase to 13% in the worst case scenario. Adding a typical 5% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $252bn out of $1.4 trillion (see The U.S. Credit Card Industry in 2009, by RGE’s Mathias Kruettli.)

The IMF warned that commercial and industrial loans (C&I) charge-off and delinquency rates are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and serious delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn out of $170bn unsecuritized leverage loans.

Based on these calculations, RGE expects total loan losses to reach about $1.6 trillion out of $12.4 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. The IMF assumes that the U.S. banking system carries about 60-70% of unsecuritized loan losses (and about 30% of mark-to-market losses on securitizations). Even assuming that future loan losses are fully discounted at current market prices, deploying all the remaining TARP funds – and much more – towards recapitalizing the banking system would be warranted as the expected credit losses imply that the U.S. banking system (commercial banks and broker dealers) is effectively insolvent as a whole.

The Disconnect Between Bond and Equity Markets

U.S. government bonds were on a tear in 2008, while equities plummeted in the worst bear market since the Great Depression. Bond yields at the long end hit all-time record lows, while the short end even dipped into negative territory. Only TIPS suffered as deflation risks rose. Stocks, on the other hand, had their worst year since the Great Depressions: DJIA lost 34%, S&P 500 -38.5%. At its 2008 low on November 20, the S&P 500 was down 49% for the year and 52% from its October 2007 peak. Stocks rallied in December though, resulting in an apparent disagreement between the stock and bond markets over the outlook for the U.S. economy. Bond markets seemed to be discounting a recession in 2009 while stock markets have gained since late November. This disconnect may vanish in 2009 though if the stock market rally was really just a bear market rally due to portfolio re-balancing and thin year-end trade volumes.

However, there have been intimations that the bond market is a bubble about to burst in 2009. Indeed, with ultra low bond yields, investors may be tempted to switch into higher-yielding equities - which are now considered by many to be undervalued. Valuation, however, is not the be-all and end-all of asset performance. The credit freeze needs to end before equities can see the end of the bear market. However, considering the likely economic stagnation and deflationary forces ahead, bonds should be a better bet than equities for some time. We see meaningful downside risks to stock prices as bad macro news – worse than expected – continues to dominate in 2009. Using the S&P 500 as benchmark, earnings per share will stay in the $50-60 range – and earnings have further to fall. If, as is not unusual during recessions, P/E ratio falls in the 12-14 range, we could see another 20% slide in stock prices from the level at beginning of 2009.

Fiscal and Monetary Policy Fiscal Policy

A lot of hope is being placed on the expected fiscal stimulus package of around $775 bn spread over 2009-10 including 40% of the stimulus in tax cuts for households and firms. Around half of the stimulus is expected to kick-in starting Q2 2009 and through 2010. But this will fall short of the pull-back in private demand of close to $1 trillion during this period.

Infrastructure spending, in spite of being highly effective, might not be timely, stimulating the economy only in late-2009 and 2010 when it has well passed the severe recession phase only to exacerbate the ballooning fiscal deficit. Nonetheless, around $100bn of infrastructure investment might be able to kick-in during 2009. Moreover, job creation in infrastructure might be overestimated given limitations in moving laid-off workers from other sectors to the infrastructure projects. As such, any job creation via government spending and tax incentives for firms will significantly fall short of the ongoing lay-offs.

Given the drawback of the ‘spending’ component of the stimulus, the government may be enticed to implement more tax cuts. While tax incentives for households like payroll and child tax credit might be well-targeted at the group with high propensity to spend, tax cuts in general will be less effective in stimulating demand given a secular rise in the saving rate expected over the next few years. Likewise, tax breaks for firms hiring new workers or investing in new equipment will be rather ineffective since businesses see little viability in doing so during a slump in domestic and export demand. At most, tax stimulus in spite of being timely and well-targeted will cause only a temporary rebound in the economy for a month or a quarter merely shifting the spending decision period just like tax rebates did in 2Q 2008.

Expansion of unemployment benefits, food stamps and other incentives will have a high bang-for-buck effect in 2009 and will only assuage the impact of the recession. The stimulus will also include up to $100 bn for state and local governments to meet their severe budget shortfalls including grants, Medicaid and unemployment insurance funds, preventing cutbacks in public services, investment and jobs in several recession-hit states. But again, fiscal aid for states often suffers from time lags.

Fiscal stimulus, TARP spending, GSEs-related expenditure along with further slowdown in corporate and individual income tax revenues will push the fiscal deficit to around $1.3 trillion in FY2009.

Taming the Foreclosure Problem

There have been growing calls in the Congress recently to use some of the remaining TARP funds to refinance mortgages for homeowners facing foreclosure or default due to negative home equity and unaffordable monthly interest payments.

Given the excess supply of homes in the market, home prices will fall at least 15% (from current levels) by 2010, pushing the number of homeowners with negative home equity from over 12 million currently to over 14-19 million. While price correction can help stimulate home demand and pave the way for market clearing, the ongoing credit crunch and consumer wealth erosion will continue to constrain home demand in the short-term. Households are facing tighter credit conditions, higher lending standards and mortgage terms (such as higher credit scores requirements, income requirements and down payments) due to the credit crisis. All these factors along with mounting job losses, falling wage income, negative wealth effect from the stock market and rising saving rate will keep home demand subdued and will indeed increase mortgage default and foreclosures in the coming months. Foreclosures will continue to increase the stock of home supply leading home prices to overcorrect and preventing market clearing. This might push over 25 million homeowners into negative home equity creating a vicious circle of foreclosures and downward spiral in home prices, bank losses and consumer-led recession.

As stated above, we believe home prices are still overvalued based on the price/rent and price/income ratios. But we are concerned that the possible overcorrection in home prices and increase in the excess home supply will prolong the recession and the contraction in consumer spending. This calls for greater government intervention on the supply side of the market to close the excess supply gap. The government recently announced plans to buy MBSs to help reduce the interest rate on the 30-year mortgages and stimulate home demand. However, demand-side measures will be largely ineffective and insufficient to deal with the increasing foreclosures. Reducing mortgage rates and offering tax credits are a smaller factor in determining home demand relative to credit conditions and lending standards. Moreover, many potential buyers are reluctant to step into this market while expecting further prices correction.

Since 2007, the government has introduced several programs to modify loans: The Hope Now Program (Oct 2007), the Housing Retention Bill (Oct 2008), IndyMac loan modification by FDIC (2008), FDIC and Federal Housing Finance Agency (FHFA) program (Nov 2008). However, these programs have rather suffered from slow implementation and have ended up modifying a lesser number of mortgages than initially estimated and also relative to the total ‘at-risk’ mortgages. This is because the voluntary nature of most programs has restricted lender and borrower participation. Moreover, a large share of the modifications was carried out via interest rate reduction or maturity extension, rather than via principal reduction – therefore not solving the inherent problem of high debt/income ratio and insolvency of households. These factors, added to the increasing financial headwinds faced by households, have led to a default rate of up to 40-50% on the refinanced mortgages. Also, around 80% of the troubled loans have more than one lender or rather a pool of lenders with varying degrees of flexibility in loan modification – with any modification requiring consent by at least 60% of the lenders. Problems of securitization of mortgages and disagreements between first and second-liens, where a homeowner has two mortgages, have tended to restrict lender participation.

Recently, many banks including JPMorgan, Bank of America and Citigroup have begun to modify loans as they realize that the costs from foreclosure runs much higher than losses from loan modification, and also that inaction will only lengthen the housing crisis and bank losses. As a result, they have been targeting the “at-risk” groups: homeowners with high debt-income ratio in states most affected by the housing crisis and rising unemployment. However, loans modifications are still mostly being done via lowering of interest rates, replacement of ARMs with fixed-rate loans or by extending the maturity period – rather than by reducing the principal.

To make government intervention more effective, several proposals have been made recently. These include: Congressional intervention to allow bankruptcy judges to change mortgage terms and reduce the mortgage principal. The government should refinance the mortgage into a longer term mortgage at a low and fixed interest rate. The reduction of the mortgage principal can be based on the extent of decline in home prices in a given region. The new interest rate can be based on the 1.6% spread between the 30-year fixed rate mortgage and the 10-year Treasury bonds. Monthly payments can be “interest-only” payments for the first few years. This would help establish positive equity for the homeowner and fix the problem of insolvency thereby making the monthly payments more affordable and reducing the risk of default on refinanced mortgage.

To increase participation, the program would be mandatory for lenders. Government can also condition capital injection into banks and purchase MBSs on banks’ willingness to modify mortgages. Also to attract lenders, the government should share the cost of modifying the loan with the lender by matching the cut in principal or interest rate by a proportionate or less than proportionate amount. As an incentive, the lender will be entitled to a share in profit from home appreciation if the homeowner sells the house in the future. The refinanced mortgages will be a ‘full-recourse’ loan. Or the government can share any losses due to default by homeowners on the modified mortgage.

Estimates suggest that a program to help those with negative home equity currently will cost over $600 bn. However, as prices overcorrect, more homes fall into negative equity and defaults on the refinanced mortgages continue, the cost would exceed a trillion. But in order to reduce the fiscal costs, the government should be the senior debt holder of the modified mortgage. With an equity position, it can benefit from the future home appreciation.

The eligibility criteria to qualify for the government program will be stringent: The homeowner should have a high debt/income ratio, the current mortgage should have a high interest rate or a high outstanding principal relative to the current home value; or the homeowner should be facing legal action for mortgage default or foreclosure. The program should target first-time homeowners in regions/states that are witnessing the largest home price correction and foreclosure rate. Those unable to meet monthly payments due to interest rate re-sets or facing higher monthly payments due to the recession (credit constraint, unemployment, falling wage and asset incomes) can also be targeted.

However, homeowners who won’t be capable of servicing the monthly payments even after modifying the loans can be converted into tenants for the same house for a given period of time under an agreement with the lender. The lender would release the homeowner from the mortgage obligations and will require the homeowner to just pay the rent during the given time period. At the end of the period as the homeowner’s income position and financing options improve, he will have the option to re-acquire the house from the lender at the then market value of the house, or even take a new mortgage to finance the house based his ability to pay. Hence, rather than forcing foreclosure on homeowners who fail to qualify for the government program, this alternative will prevent further foreclosures and excess home supply in the market. Moreover, it offers at least some cash flow for the lenders and avoids any fiscal risk for the government.

Monetary Policy

The Fed has enacted a wide and unprecedented range of measures to mitigate the credit crisis and stimulate the economy. It has already cut its target range for the Fed funds rate to 0-0.25% (essentially ZIRP) but, more importantly, it has created swap lines and an alphabet soup of programs to provide liquidity to the financial system and clean out toxic financial assets. The Fed experimented with different forms of financing itself in order to enable a sharp expansion of its balance sheet to accommodate these liquidity facilities. In addition to rate cuts and quantitative easing, the Fed has directly aided failing financial institutions. Now, the Fed is considering issuing its own debt and/or purchasing long-dated Treasuries and Agency debt. Will the monetary easing work? So far, the increase in money supply has not been accompanied by an increase in the velocity of money. In other words, credit growth remains stagnant as banks are reluctant to lend back out the money provided by the Fed and, at the same time, borrower demand has fallen. Since the problems of the private sector – households, financial institutions and corporate firms – are most of insolvency (excessive debt) monetary policy and liquidity support – even of a non-traditional form cannot resolve fundamental credit issues that require debt restructuring and reduction.

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Soft commodities

FT.com / Lex / Macroeconomics & markets - Worried about inflation?

Worried about inflation?


The weather channel didn’t exist in 1971. If it had, Richard Nixon might have paid close attention to the characteristic thermal swirls of El Niño. Then, as it can do now, the “Southern Oscillation” led to poor crop harvests worldwide, higher food prices, and rising inflation. That August – two years before the oil price spike that is credited with causing the 1970’s high inflation – Nixon imposed wage and price controls. Four decades later, it is possible that food could cause another price shock. For any investor who is knee-deep in government bonds and worried about inflation, the price of wheat, rice and other soft commodities is one place to look.

CommoditiesOstensibly, there is little to fear. Like other commodities, “softs” have been hit by the financial crisis, with prices down by a quarter since their peak last July. Yet this is peanuts compared to other commodities, such as oil, that have dropped by three quarters. It also sets a high base from which prices could rise again.

There are some signs that this is happening already. Consumers in the developing world are cutting back on meat to buy cheaper staples. But at the same time farmers, hit by recent price falls and scarcity of credit, are reducing plantings. The Philippines has cut its estimate of rice production this year by 4 per cent. In the US, winter wheat plantings have fallen by 9 per cent; in Europe, by 3 per cent. Lower production would matter less if world food stocks were plentiful. Yet they remain near the depressed levels of the 1970s. Bad weather or crop disease could easily cause prices to spike. That is what happened to cocoa, up by more than 72 per cent since the start of last year.

Food price inflation would be a headache for policymakers. Food accounts for a sixth of the US consumer price index, one and a half times more than energy. And while consumers can drive less or turn down the thermostat, they must eat. Potentially, this is where the financial crisis meets the Malthusian world of Al Gore.

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Karl Marx 1867

"Owners of capital will stimulate the working class to buy more

and more expensive goods, houses and technology, pushing them

to take more and more expensive credits, until their debt

becomes unbearable. The unpaid debt will lead to bankruptcy of

the banks, which will have to be nationalized, and the State

will have to take the road which will eventually lead to

Communism."

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Putting pressure on Obama

FT.com / Columnists / Martin Wolf - Why Obama’s plan is still inadequate and incomplete

Why Obama’s plan is still inadequate and incomplete

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Ag subsidies will remain

FT.com / Comment / Opinion - Obama and trade: an alarm sounds

Obama and trade: an alarm sounds

By Jagdish Bhagwati

Published: January 8 2009 19:10 | Last updated: January 8 2009 19:10

In the Financial Times, I argued that, unlike with Hillary Clinton, there were several reasons why one could be optimistic that Barack Obama would follow a pro-trade policy despite “prudential” protectionist talk on the primaries circuit (“Obama’s free-trade credentials top Clinton’s”, March 3 2008). But the US president-elect’s eloquent silence on trade issues – and his failure to balance his protectionist appointments with powerful trade proponents – require that we abandon these illusions and sound an alarm.

Consider Mr Obama’s support for the multilateral trading system. It must be admitted that the Doha round is on hold and Mr Obama could not move it forward even if he so desired. A principal problem is that its completion turns critically on the US making further reductions in its distorting agricultural subsidies. But the issue has become even more difficult with the collapse of commodity prices and hence increases in support payments. Besides, history shows that the freeing of trade is nearly impossible to achieve in times of macroeconomic crisis.

But Mr Obama (unlike Gordon Brown) missed the opportunity, provided by the Group of 20’s affirmation of trade’s importance, to affirm that he attaches the highest priority to closing the Doha round and will work on this urgent task throughout his first year.

More important, Mr Obama has missed the bus on preventing a slide back into protectionism. His pronouncements on the car bail-out disregard the lessons of the early 1930s when the Smoot-Hawley tariff was signed into law and a competitive raising of tariff barriers ensued. We learnt then that tariffs and trade restrictions could indeed increase our national income by diverting a given amount of insufficient world demand to our markets. But then others could do the same to divert our demand to their goods, so that the result was reduced trade and deepened depression. Far better to keep markets open and increase aggregate world demand. So, the architects of the General Agreement on Tariffs and Trade (merged in 1995 into the World Trade Organisation) built into it institutionalised obstacles to an outbreak of mutually harmful trade policies.

But what trade barriers did after 1930 can be done also by subsidies. So we now have strict rules on subsidies as well. Under a 1995 WTO agreement, export subsidies and “local content” requirements are prohibited as directly damaging to trade and all other subsidies that are specific to companies or industries are open to complaint; and this applies even when they are claimed to be environmentally friendly.

There is no doubt that a bail-out just of cars, and within that specifically of Detroit, would qualify for countervailing action and dispute settlement challenges. It is important therefore that Mr Obama declare unambiguously that any bail-out will be WTO-consistent, because every other country will otherwise be emboldened to follow suit. Mr Obama, who has properly denounced unilateralism, should also not be the president who undermines respect for the rule of law that the WTO embodies at the multilateral level.

If Mr Obama’s silences on multilateral trade are disturbing, should we be pleased by his strictures against bilateral free-trade agreements? On closer examination, though, this is not a vote for multilateralism but just the opposite. To understand this paradox, consider that labour union lobbies and their political friends have decided that the ideal defence against competition from the poor countries is to raise their cost of production by forcing their standards up, claiming that competition with countries with lower standards is “unfair”. “Free but fair trade” becomes an exercise in insidious protectionism that few recognise as such.

This cynical tactic can work only when the US is engaged in negotiating FTAs, typically with weak countries. It does not work for the multilateral system where powerful, democratic countries such as India and Brazil reject such trade-unrelated demands. So, the “fair trade” lobbies, which Mr Obama continues to embrace, gravitate towards FTAs rather than the WTO. The Democrats’ opposition to occasional FTAs – including the latest one with Colombia – reflects, then, a recurring attempt at imposing yet more draconian demands on small countries rather than a preference for the multilateral trading system. If he is to embrace multilateralism and free trade forcefully, Mr Obama needs a stellar crew that will understand the protectionist nature of “fair trade” demands and dispel the unions’ baseless fear that trade with poor countries harms American workers’ wages.

Alas, his cabinet appointments include Mrs Clinton, whose trade scepticism is badly muddled at best, as secretary of state, and Hilda Solis, who reflects the anti-trade sentiments of the union federation, AFL-CIO, as labour secretary. His advisers include Robert Rubin, whose credibility on policy issues is undermined by Citigroup’s receipt of large bail-out funds, and Larry Summers, the brilliant former Treasury secretary whose recent FT columns on trade and wages suggest prudence in the current political environment. The US trade representative position was offered to Congressman Xavier Becerra, a trade sceptic at best, and has now gone to Mayor Ron Kirk with credentials only as a supporter of the North American Free Trade Agreement, hardly suggesting a forceful presence in support of the open, multilateral trading regime.

The writer is a university professor, economics and law, at Columbia and senior fellow in international economics at the Council on Foreign Relations. His latest book is Termites in the Trading System: How Preferential Agreements Undermine Free Trade (Oxford, 2008)

Copyright The Financial Times Limited 2009

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Commodity Consensus

MarketBeat : Commodity Rebalancing Rally Tails Off

Commodity Rebalancing Rally Tails Off
Posted by David Gaffen

OilThe recent rally in commodities, particularly the metals and grains, is in part the result of expectations for the rebalancing in major commodity indexes that will increase the weight of certain commodities, such as copper and live cattle. But as the rebalancing takes place over the next few days, analysts are skeptical of the recent surge due to the sour outlook for the world economy.

The price of copper, oil, and other major traded commodities have rallied sharply of late. But it comes in the face of a poor economic outlook. “Given the outlook for the economy over the year, I’m not getting overly excited about owning commodities,” says Stephen Schork, publisher of the Schork Report, a newsletter on the oil and gas industries.

Wednesday, commodities were pulling back, losing some of the recent gains. March copper futures fell 6.10 cents to $1.522 per ounce, while corn was down 8.25 cents to $4.1925 a bushel, and the volatile crude oil contract was off by $3.70 to $44.88. Oil and copper (the commodity with the economics degree, as it is said) have moved with a greater degree of correlation with equities of late, as asset managers take positive moves in stocks to indicate a better feeling about the economic outlook, and apply those expectations to commodities (and vice versa).

The Dow Jones-AIG Commodity Index’s new weightings become effective by January 15. Crude oil will rise to 13.8% of the index, from 13.1% in January of 2008. However, J.P. Morgan Chase analysts estimate that losses in oil during the year have dropped its weighting now to about 9.6%, so the re-weighting is providing quite the boost. Copper, meanwhile, will rise to 7.3% from 4.5%.

Copper has been buoyant over the past 10 days.

The Standard & Poor’s/Goldman Sachs Commodity Index shows similar effects. Crude’s weighting will rise to 33.8% from 32% at the end of December; it was 38% at the beginning of 2008, but declined as oil declined.

“Investors do want to have the ability to be ready to take advantage of a future rally in commodities, and you have to reflect it in your positions,” says Bart Melek, global commodity strategist at BMO Capital Markets. “But we’re in a holding pattern — we have to see what happens with a stimulus package, and certainly what happens in China.”

While commodities might ease off in the early part of the year, if the Federal Reserve succeeds at re-inflating the economy through the various efforts to pump money into the financial system, it could benefit raw materials such as copper and other metals, says Michael Hoeft, CEO of Panacea Capital Management. For now, however, he says hedge funds have not finished liquidating positions, and that may pressure commodities.

“I think we’re going to see a bout of deflation and once that’s over, then we’ll see hyperinflation,” he says. “There’s a deflationary bent to the economy that will keep commodities kind of in a range…but then we’re going to see major hyperinflation.”

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Gold in the medium term

FT.com / Comment / Opinion - There is only one alternative to the dollar

As a result of the global scope of the recession, there is no country that wants its exchange rate to appreciate. The clear alternative to the dollar in 2009 is not other currencies but that ancient form of money: gold. Precious metals could emerge as a hedge for investors suspicious of central banks and fearful that inflation will be the simplest solution to the challenge of global deleveraging.

The writer is chairman of David Hale Global Economics

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Watch the dollar

Foreign Policy: Watch the Dollar

Watch the Dollar
By Dean Baker


January/February 2009
“If housing prices fall back in line with the overall rate price level ... it will eliminate more than $2 trillion in paper wealth and considerably worsen the recession. The collapse of the housing bubble will also jeopardize the survival of Fannie Mae and Freddie Mac.” – Dean Baker, September 2002


The housing bubble was the first to burst, but it will not be the last in this global recession. These days, it’s the impending bust of the dollar bubble that should be getting more attention.

The U.S. dollar has been severely overvalued since the late 1990s, which has led to an enormous trade deficit that peaked at almost 6 percent of U.S. GDP in 2006 ($900 billion in today’s economy). This is unsustainable. Eventually, it will force the dollar to fall to a level where trade is close to balance.

That process was already gradually underway. The recent crisis, however, has sent investors scrambling to the dollar for safety, causing it to soar against most other currencies. The rising dollar, coupled with recessions in much of the rest of the world, will cause the trade deficit to rise again.

But once the financial situation begins to return to normal (which might not be in 2009), investors will be unhappy with the extremely low returns available from dollar assets. Their exodus will cause the dollar to resume the fall it began in 2002, but this time, its decline might be far more rapid. Other countries, most notably China, will be much less dependent on the U.S. market for their exports and will have less interest in propping up the dollar.

For Americans, the effect of a sharp decline in the dollar will be considerably higher import prices and a reduced standard of living. If the U.S. Federal Reserve becomes concerned about the inflation resulting from higher import prices, it might raise interest rates, which could lead to another severe hit to the economy.

As for 2009, the ongoing collapse of the housing bubble, the coming collapse of the commercial real estate bubble, and the ensuing wave of bad debt will all be major sources of drag on the U.S. economy—even if the dollar bust happens later.

Indeed, subprime mortgages were just the trigger for a much broader crisis. Plunging house prices are now leading to record default rates on prime loans as well, with most of the fallout ahead of us. We’ll also see much higher default rates on car loans, credit card debt, and other forms of consumer debt, because homeowners can no longer draw on their home equity to pay other debt.

Commercial real estate faces its own reckoning. When the housing market began to fade at the end of 2005, it kicked off a boom in nonresidential construction. In less than three years, this sector expanded more than 40 percent. There is now considerable excess capacity in retail space, office space, hotels, and other nonresidential sectors—leading to falling prices, plunging construction, and another major source of bad debts for banks.
Click Here!

In short, beware the happy talk from those who say we are “turning the corner,” ignore the daily ups and downs of the market, and tighten your belts. This is going to hurt.

Dean Baker is codirector of the Center for Economic and Policy Research.

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Predictions for 2009 Stephen Roach

Foreign Policy: A Lethal Shakeout

But don’t count on a vigorous (V-shaped) rebound from the post-bubble global recession of 2009. With no other major consumer likely to step up and fill the void left by the United States, a lopsided, bubble-distorted world will experience an anemic recovery at best. It will be a long time before global growth returns to the nearly 5 percent rate of the four and a half years that ended in mid-2007. Post-bubble shakeouts are lethal for any individual economy—to say nothing for the world as a whole.

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Good article

FT.com | Willem Buiter’s Maverecon | Can the US economy afford a Keynesian stimulus?

Can the US economy afford a Keynesian stimulus?
January 5, 2009

Economic policy is based on a collection of half-truths. The nature of these half-truths changes occasionally. Economics as a scholarly discipline consists in the periodic rediscovery and refinement of old half-truths. Little progress has been made in the past century or so towards understanding how economic policy, rules, legislation and regulation influence economic fluctuations, financial stability, growth, poverty or inequality. We know that a few extreme approaches that have been tried yield lousy results - central planning, self-regulating financial markets - but we don’t know much that is constructive beyond that.

The main uses of economics as a scholarly discipline are therefore negative or destructive - pointing out that certain things don’t make sense and won’t deliver the promised results. This blog post falls into that category.

Much bad policy advice derives from a misunderstanding of the short-run and long-run impacts of events and policies. Too often for comfort I hear variations on the following statements: “The long run is just a sequence of short runs, so if we make sure things always make sense in the short run, the long run will take care of itself.” This fallacy, which I shall, unfairly, label the Keynesian fallacy, compounds three errors.

The first error is the leap from the correct assertion that a long interval of time is the sum of successive short intervals of time to the incorrect impact that the long-run impact of a policy or event is in any sense the sum of its short-run impacts. The second error is the failure to recognise that our models (formal or implicit) of how the economy works are inevitably incomplete. Parts of the transmission mechanism - positive or negative feedbacks and other causal links between actions today, future outcomes and anticipations today of future outcomes and future actions - that can safely be ignored when we consider the impact of a policy over a year or two can come back to haunt us with a vengeance over a three-year or longer horizon. The third error is that, when economic agents, households, firms, portfolio managers and asset market prices are even in part forward-looking, the long run is now. More precisely, the long-run consequences of current policies can, through private sector expectations and through forward-looking asset prices influence consumption behaviour, employment and investment decisions and asset prices today.

Matching the Keynesian fallacy is the view that just because a certain set of policies is not sustainable, in the sense that it cannot be maintained indefinitely, such policies should not be implemented even temporarily. I will call this the sustainability fallacy. It rests on the simple error that identifies a sustainable policy rule or programme, with a specific constant policy action. A sustainable, sensible or even optimal contingent policy programme, or contingent sequence of policy actions, will in general involve specific actions that will be undone, reversed or even neutralised by later contingent policy actions in the opposite direction. These specific actions may be eminently sensible, even from a long-run perspective, provided they are not maintained indefinitely and are, and are expected to be, reversed in due course, according to the rule, when the state of the economy has evolved or when a new unexpected contingency arises.

US fiscal policy: the Keynesian fallacy on steroids

How does this apply to the macroeconomic stabilisation policy and the financial stability support policies being pursued in the US today?

First, the fiscal policy actions pursued thus far by the Bush administration, but even more so the policy proposals leaked by Obama’s proto-administration are afflicted by the Keynesian fallacy on steroids. They appear to exist outside time, with neither the long-run consequences of the actions like to be implemented over the next couple of years, nor the history that brought the US to its current predicament, the initial conditions, being given any serious attention.

A nation in fundamental disequilibrium: the disappearance of American ‘alpha’

Even before the crisis erupted, around the middle of 2007, the US economy was in fundamental disequilibrium. The external primary deficit (the external current account deficit plus US net foreign investment income) was running at around five or six percent of GDP. The US was also a net external debtor. Its net external investment position (at fair value, or the statisticians best guess at it) was somewhere between minus 20 percent and minus 30 percent of annual GDP. The US economy managed to finance this debt and deficit position quite comfortably because it gave foreigners an atrocious rate of return on their investment in the US - a rate of return much lower, when expressed in a common currency, than the rate of return earned by US-resident investors abroad.

Some of this lousy ex-post average return on foreign investment in the US was no doubt unexpected and one-off. If risk premia on foreign investment in the US and on US investment abroad were the same, the appearance of excess returns to US investment abroad relative to foreign investment in the US may simply have been an example of the “peso problem” - a “small-sample bias” in expected returns. Assume expected returns are equal using the true distribution of returns. The true distribution may, however, have fat or long tails, with extreme negative values that occur infrequently (e.g. the collapse of a currency peg). The term ‘peso problem’ came from observations on realised returns on US dollar-denominated securities and Mexican peso-denominated securities during the 1970s. The forward premium on the Mexican peso relative to the US dollar was positive through 22 years of a pegged exchange rate, until August 1976, of eight Mexican pesos to the US dollar. On September 1, 1976, the peso devalued by 45 percent vis-à-vis the US dollar.

The term peso problem was, according to Paul Krugman, invented by a bunch of MIT graduate students of the late Rudi Dornbusch. William S. Krasker published the first paper using the expression (”The ‘peso problem’ in testing the efficiency of forward exchange markets”, Journal of Monetary Economics, Volume 6, Issue 2, April 1980, pages 269-276), long before fat tails, black swans and related regurgitations of the same phenomenon became current. The attribution of the expression “peso problem” to Milton Friedman is almost certainly incorrect.

When the disaster scenario (a collapse of the currency peg) materialises, the roof caves in for peso investments. Before the collapse, statisticians, unlike market participants, don’t know the true distribution but base their calculation of the expected return on a sample during which the extreme event has not (yet) materialised. The result is that statisticians overestimate the expected return on the peso (there has been no depreciation of the peso during my sample, therefore the future expected depreciation rate is zero) and attribute the positive (risk-adjusted) rate of return differential on the peso to “alpha”. It is, of course, “false alpha”, as the September 1, 1976 collapse of the peso (repeated a number of times since then) made clear.

Some of the excess returns on US investment abroad relative to foreign investment in the US, may have been anticipated, and may have reflected a low or even a negative risk-premium on US investment. In that case, if risk-adjusted rates of return to foreign investment in the US and on US investment abroad are the same, we would expect that the so far unrealised risk will in due course materialise and blow a large hole in the US external asset position. Even with a very long enough sample, ex-post realised average rates of return on investing in the US will still be lower than ex-post realised rates of return on investment abroad, but the (ex-post) positive correlation between the return on foreign investment and consumption growth could be stronger for foreign investment in the US than for US investment abroad.

Some of the excess returns on US investment abroad relative to foreign investment in the US may have reflected true alpha, that is, true US alpha - excess risk-adjusted returns on investment in the US, permitting the US to offer lower financial pecuniary risk-adjusted rates of return, because, somehow, the US offered foreign investors unique liquidity, security and safety. Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run. This is the “dark matter” explanation proposed by Hausmann and Sturzenegger for the “alpha” earned by the US on its (negative) net foreign investment position. If such was the case (a doubtful proposition at best, in my view), that time is definitely gone. The past eight years of imperial overstretch, hubris and domestic and international abuse of power on the part of the Bush administration has left the US materially weakened financially, economically, politically and morally. Even the most hard-nosed, Guantanamo-bay-indifferent potential foreign investor in the US must recognise that its financial system has collapsed. Key wholesale markets are frozen; the internationally active part of its financial system has either been nationalised or underwritten and guaranteed by the Federal government in other ways. Most market-mediated financial intermediation has ground to a halt, and the Fed is desperately trying to replace private markets and financial institutions to intermediate between households and non-financial operations. The problem is not confined to commercial banks, investment banks and universal banks. It extends to insurance companies (AIG), Quangos (a British term meaning Quasi-Autonomous Government Organisations) like Fannie Mae and Freddie Mac, amorphous entities like GEC and GMac and many others.

The legal framework for the regulation of financial markets and institutions is a complete shambles. Even given the dismal state of the legal framework, the actual performance of key regulators like the Fed and the SEC has been appalling, with astonishing examples of incompetence and regulatory capture.

There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future. A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain. It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations. I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets - both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations - will make this clear.

There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard. The US dollar and US Treasury bills and bonds are still viewed as a safe haven by many. But learning takes place. The notion that the US Federal government will be able to generate the primary surpluses required to service its debt without selling much of it to the Fed on a permanent basis, or that the nation as a whole will be able to generate the primary surpluses to service the negative net foreign investment position without the benefit of “dark matter” or “American alpha” is not credible.

So two things will have to happen, on average and for the indefinite future, going forward. First, there will have to be some combination of higher taxes as a share of GDP or lower non-interest public spending as a share of GDP. Second, there will have to be a large increase in national saving relative to domestic capital formation.

The need for a massive resource transfer towards the public sector

As regards the required massive transfer of resources from the public to the private sector in the US, it has long been recognised by those who look at long-term prospects for taxes and public spending in the US, that a combined permanent increase in the tax share/reduction in the share of public spending in GDP of around ten percentage points would be required to fund existing Medicare and Medicaid commitments (and to a lesser extent Social Security commitments). In the past decade the US has legislated for its citizens (though Medicare, Medicaid and Social Security retirement) a West European-style welfare state. Obama’s proposals for universal health care will complete this process. The US has done so with a general government public expenditure share in GDP that is about 10 percentage points below the West European average (in the mid-thirties for the US, in the mid-forties in for Western Europe. Evolving demographics and entitlement will drive US welfare state expenditure towards the West-European levels, in the absence of political decisions in the US to limit coverage and entitlements.

This resource shift from the private to the public sector would only manifest itself gradually however, and no doubt, there will be changes in (whittling down of) these commitments before their full impact is felt.

The US Federal government has taken on massive additional contingent liabilities through its bail out/underwriting of the US financial system (and possibly other bits of the US economic system that are too politically connected to fail). Together will the foreseeable increase in actual Federal government liabilities because of vastly increased future Federal deficits, this implies the need for a future private to public sector resource transfer that is most unlikely to be politically feasible without recourse to inflation. The only alternative is default on the Federal debt. There is little doubt, in my view, that the Federal authorities will choose the inflation and currency depreciation route over the default route.

If I can figure this out, so can anyone in the US or abroad who follows recent economic developments. The dawning of the realisation will lead to the dumping of the assets.

Even if the US Federal government decides to go the inflation route for “paying off” public debt is would be too politically difficult to service through tax increases or spending cuts, it is unlikely that some, not insignificant, resource transfer from the private to the public sector will have to take place. And there we have the short run-long run conundrum. If the economy were at full employment and a high rate of capacity utilisation today, it would still require a permanent resource transfer from the private sector to the public sector, that is, higher taxes or lower public spending. But for cyclical purposes, lower taxes and higher public spending are indicated - provided the authorities have the credibility to commit themselves to future tax increases and/or spending cuts that would not just take care of the existing obligation, but also of the additional debt that would be incurred as a result of the Keynesian stimulus.

The latest gurgling about the magnitude of the Obama fiscal stimulus are certainly impressive: $775bn or so (around 5 per cent of GDP) over two years. This on top of a Federal deficit that even absent these stimuli could easily top $750bn. I now anticipate a Federal deficit of between $1.5 trillion and $2.0 trillion for 2009 and something slightly lower for 2010. With both the Fed and the Treasury exposed to trillions of private assets and institutions of doubtful quality and solvency, the stock of US Federal debt could easily increase by many more trillions of US dollars during the next couple of years.

Those familiar with the post World War I and post-World War II public debt levels will not be impressed with even a doubling of the public (Federal) debt held by the public as share of GDP, from its current level of around 40 per cent of annual GDP (gross public debt, including debt held by other government agencies, like the Social Security Trust Fund, stands at around 70 per cent of GDP). Chart 1 is taken from Wikepedia. Following World War II public debt stood at more than 100 percent of annual GDP.

Chart 1

usdebt.png

A simple (coarse?) indicator of “tax tolerance” - willingness to pay taxes or to make others pay taxes - is the highest marginal rate of personal income tax. For the US this is shown in Table 2 below. It is taken from the website of TruthAndPolitics.org.

Chart 2

top-rates-graphphp.png

That, however, was then. The debt was incurred to finance a temporary bulge in public spending motivated by a shared cause: defeating Japan and the Nazis. The current debt is the result of the irresponsibility, profligacy and incompetence of some. Achieving a political consensus to raise taxes or cut spending to restore US government solvency is going to test even the talents of that Great Communicator, Barack Obama.

If you add to the Keynesian fiscal stimulus package Obama’s ambitions for increasing infrastructure investment to stimulate growth, to fund (not quite) universal healthcare and to stimulate alternative energy production and use, the incompatibility of US public spending ambitions and the political capacity to raise the necessary revenues is glaring. So the government would borrow. From whom? Not from the domestic private sector. They are saving rather little and are being discourage from saving what little they are saving by the fiscal stimulus package. So the US government will borrow abroad to finance its infrastructure, health ambitions and green agenda? Some day perhaps. But not during Obama’s presidency.

So will the Keynesian demand stimulus work? For a while (a couple of years, say) it may. When the consequences for the public debt of both the Keynesian stimulus and the realisation of the losses from the assets and commitments the Fed and the Treasury have taken onto their balance sheets become apparent, the demand stimulus will fade and may be reserved as precautionary behaviour takes over in the private sector. My recommendation is to go easy on the fiscal stimulus. The US government is ill-placed financially and fiscally, to engage in short-term fiscal heroics. All they can really do is pray for a stronger-than-expected revival of global demand, without any major stimulus from the US.

The need for a massive resource transfer towards the rest of the world

Beggars can’t be choosers. The US has been able to get away with decades of private sector improvidence because of two unique and time-limited factors. The first is a sequence of capital gains on household assets (stocks and real estate) that provided a lovely substitute for saving to provide for retirement, old age and a rainy day. The second was the excess returns earned by the US on its net foreign investment (its ability to borrow at an unbelievably low rate of interest/rate of return) because of the unique position of the US as the ultimate source of liquidity and security.

Both rational drivers of a low US saving rate are gone. The US housing market and global stock markets have imploded. It will take years, even decades, to restore household financial wealth-income ratios to levels that don’t guarantee retirement in poverty for much of the US population. The rest of the world will also no longer lend to the US at a negative nominal (and real) interest rate, as it has done for years.

So the US has to shift aggregate demand from domestic demand to external demand. And it has to shift production from non-tradables to tradables - exportable and import-competing goods and services. By how much? At full employment, probably at least six and more likely by around eight percent of GDP.

As regards shifting production towards tradables, this will not be easy. And policy is pushing in the wrong direction. The Bushbama administrations have decided to bail out the US car industry. That industry does not produce cars the rest of the world wants. If and when the global economy recovers and oil prices rise to $150 per barrel again, US consumers also won’t want the cars produced by Detroit. Sure, they can change. They could have changed in 1973, in 1980 and at any time since then. If they could change, they probably would have by now.

Other US industries are more competitive internationally. But shifting resources towards tradables and away from non-tradables will require re-training and re-education as well as a significant depreciation of the US dollar’s real exchange rate - which amounts to a significant cut in real wages. Chart 3, which shows the US broad real effective exchange rate index, provided by the Fed, shows the behaviour of one measure of the real exchange rate since 1973.

Chart 3

chart3.gif



In the past year, the effective real exchange rate of the US dollar has in fact strengthened rather than weakened, thus impeding the necessary external adjustment. With the short risk-free nominal interest rate effectively at the zero floor, conventional expansionary monetary policy cannot be used any longer to weaken the exchange rate. The effect of quantitative easing and qualitative easing on the exchange rate are ambiguous. If they succeed in stimulating spending by credit-constrained businesses and households, it could well strengthen the currency and weaken the trade balance.

In the decades since I first lived in the US, the quality of secondary education and of vocational training appears to have worsened. Despite the excellence of some institutions, including the wide range and variety of community colleges that give a second chance to so many Americans, the educational system of the US increasingly resembles that of the UK: islands of excellence in a sea of mediocrity. This means that, to become competitive, if you cannot compete on quality and innovation, you will have to compete on price. A larger real exchange rate depreciation and cut in real consumer wages will be required to achieve a given shift of resources to the external sector.

With all the talk about investing in the future, improving infrastructure and creating a dynamic competitive economy, I don’t think the Obama administration will want to achieve the necessary shift of resources towards the rest of the world by reducing domestic investment. In fact, in the one area where domestic investment could and should be reduced (residential construction), there is bipartisan support for boosting investment in residential housing. That leaves an increase in national saving as the only way to achieve the required primary external surplus. The government is, however, planning to boost its spending and cut taxes. No increase in public saving therefore can be anticipated for many years to come.

The private sector in the US is, at last, saving. We have gone from a declining growth rate of private consumption to a declining level of private consumption. But what do the policy authorities do? Rising household saving equals falling household consumption equals declining effective demand equals longer and deeper recession. Can’t have that. Here is a tax cut. If you can no longer borrow from your bank, we may guarantee your mortgage so you can borrow after all. Everything that is desirable from a short-run Keynesian aggregate demand perspective (assuming these measures are indeed effective) is a step in the wrong direction from the perspective of restoring external equilibrium and raising the US national saving rate.

One obvious response to this opposition between what is desirable now and what is necessary in the longer run is to say: let’s do now what is desirable now and let’s take care of what is necessary tomorrow. That might be viable if the US private sector and the US policy makers had the necessary credibility to head south when the destination is north, because they can commit themselves to a timely reversal. If the authorities go ahead with the short-run Keynesian stimulus without having convinced the global capital markets and domestic producers and consumers that there will be a timely reversal, the policies will not work.

This failure of expansionary fiscal policy is not for Ricardian reasons (Mr. Jean-Claude Trichet gets this wrong all the time - the Ricardian model has as one of its key assumptions that the government always satisfies its intertemporal budget constraint, that is, the government when it cuts taxes or raises spending today, is believed to raise taxes or cut spending by the same amount, in present discounted value, in the future; the second key assumption is that postponing taxes, while keeping their present discounted value constant, does not stimulate consumer demand. There either is no redistribution (from the young to the old, from those currently alive to the unborn and from those who are constrained by permanent income to those constrained by current income) or this redistribution does not have aggregate spending effects. Instead the failure of expansionary fiscal policy is because of the fear, uncertainty and higher risk premia caused by the higher risk of sovereign default caused by expansionary policy.

If the government is believed to be fiscally continent (future taxes will be raised and/or future public spending will be cut by enough to safeguard the solvency of the state) but turns out not be so after all, the Keynesian fiscal policy will be effective in the short run (as long as the public believes in the fiscal virtue of the government) but will become highly contractionary once the truth dawns.

Conclusion

Given the bad fiscal position of the US Federal government and given the vulnerability of the external position of the US and its growing reliance on foreign funding, the scope for expansionary fiscal policy in the US is much more limited than president-elect Obama’s advisers appear to realise. Underneath the effective demand problem is a deep structural rot, especially in household sector and financial sector balance sheets. Keynesian cyclical policy options that would be open to more structurally sound economies should therefore not be tried on anything like the same scale by the US authorities.

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