Friday, October 15, 2010
Make sure that your financial advisor properly explains the affect that a secular bear market, deleveraging, debt default, and asset-price deflation will have on your investments.
In the meantime, I hope you will find the articles below to be an informative read.
Beware those who think the worst is past
By Carmen Reinhart and Vincent Reinhart
Published: August 30 2010 20:23 Last updated: August 30 2010 20:23
The landscape of Jackson Hole, Wyoming, where central bankers gathered at their annual conference last week, is spectacular and forbidding. Jagged peaks and vast empty spaces stretch across the horizon. For the attendees, however, it was both a vista and a metaphor. Having lived through a precipitous global economic drop, they now must forecast how steep or flat will be the incline of recovery.
Ben Bernanke, chairman of the Federal Reserve, painted a sober but reassuring picture of US prospects. The basis for sustained recovery is in place, and canny Fed officials are now alive to the dangers of both deflation and inflation. Similarly Jean Claude Trichet, head of the European Central Bank, spoke about how the dust had begun to settle on the crisis. Policymakers and financial markets seem to be looking at what comes next.
Our research found real per capita gross domestic product growth tends to be much lower during the decade following crises. Unemployment rates are higher, with the most extreme increases in the most advanced economies that experienced a crisis. In 10 of the 15 episodes we studied, unemployment never fell back to its pre-crisis level, not in the following decade nor right up to the end of 2009.
It gets worse. Where house price data are available, 90 per cent of the observations over the decade after a crisis are below their level the year before the crisis. Median prices are 15 to 20 per cent lower too, with cumulative declines as large as 55 per cent. Credit is also a problem. It expands rapidly before crises, but post-crash the ratio of credit to GDP declines by an amount comparable to the pre-crisis surge. However, this deleveraging is often delayed and protracted.
Our review of the historical record, therefore, strongly supports the view that large destabilising economic events produce big changes in long-term indicators, well after the upheaval of the crisis. Up to now we have been traversing the tracks of prior crises. But if we continue as others have before, the need to deleverage will dampen employment and growth for some time to come.
Part of these changed prospects after a crisis simply reflects the correction of expectations. During episodes of financial euphoria – from the diving bell, through the steam engine and thereafter – the old rules seem not to apply. Lenders provide easy credit, investors bid up asset prices, and businesses invest unwisely. Spending advances rapidly, and debt builds up. Yet recent discussions about the “new normal” leave the misleading impression that the pre-crisis environment was “normal”.
Perceptions aside, at Jackson Hole, policymakers debated whether further measures to stimulate demand were needed. History shows that today’s problems could certainly materialise as a consequence of the failure to provide sufficient economic stimulus. In particular, a collapse in financial intermediation can reduce the availability of loans. This lack of access to credit, in turn, makes households and business less able to spend, lengthening and deepening the downturn. In such circumstances slow growth often becomes a self-fulfilling prophecy produced by timid authorities, who neither supported spending nor dealt with the capital-adequacy problems at large banks.
However, it is also possible that economic contraction and a slow recovery can dent aggregate supply, otherwise known as an economy’s ability to produce efficiently. In this scenario, much less discussed in current debates, a sustained stretch of below-trend investment, alongside the depreciation of human capital that comes from high unemployment, hits the level and growth rate of potential output. That is, the unemployment rate stays high because it has been high.
Importantly, this reduction in supply can also be caused by policy. In adverse economic circumstances, political leaders grasp for quick fixes that impair, not improve, the situation. The list of unfortunate interventions includes not recognising bank losses, as well as restricting trade (both domestically and internationally) and credit. In these cases the effects of crises might be persistent because we make them so.
A prudent post-crisis policy, therefore, must be alert to threats both to supply and demand, not demand alone. But the bigger worry remains the assumption that dust has begun to settle; that the shock from the crisis is temporary, when it is likely to be deep and persistent. Today, as in the past, over-optimistic fiscal authorities are over-estimating tax revenues. Financial supervisors want to believe that troubled banks are temporarily illiquid, not permanently insolvent. And central bankers like Mr Bernanke may soon attempt to restore employment to unattainably high levels. If they do so, the road to recovery will be long, and the lessons of history will have been ignored once more.
Carmen Reinhart is a professor at the University of Maryland and Vincent Reinhart is resident scholar at the American Enterprise Institute. This is based on a paper presented at the Jackson Hole Symposium.
IMF admits that the West is stuck in near depression
If you strip away the political correctness, Chapter Three of the IMF's World Economic Outlook more or less condemns Southern Europe to death by slow suffocation and leaves little doubt that fiscal tightening will trap North Europe, Britain and America in slump for a long time.
By Ambrose Evans-Pritchard
Published: 8:00PM BST 03 Oct 2010
The IMF report – "Will It Hurt? Macroeconomic Effects of Fiscal Consolidation" – implicitly argues that austerity will do more damage than so far admitted.
Normally, tightening of 1pc of GDP in one country leads to a 0.5pc loss of growth after two years. It is another story when half the globe is in trouble and tightening in lockstep. Lost growth would be double if interest rates are already zero, and if everybody cuts spending at once.
"Not all countries can reduce the value of their currency and increase net exports at the same time," it said. Nobel economist Joe Stiglitz goes further, warning that damn may break altogether in parts of Europe, setting off a "death spiral".
The Fund said damage also doubles for states that cannot cut rates or devalue – think Spain, Portugal, Ireland, Greece, and Italy, all trapped in EMU at overvalued exchange rates.
"A fall in the value of the currency plays a key role in softening the impact. The result is consistent with standard Mundell-Fleming theory that fiscal multipliers are larger in economies with fixed exchange rate regimes." Exactly.
Let us avoid the crude claim that spending cuts in a slump are wicked or self-defeating. Britain did exactly that after leaving the Gold Standard in 1931, and the ERM in 1992, both times with success. A liberated Bank of England was able to cut interest rates. Sterling fell. The key point is whether you can offset the budget cuts.
But by the same token, it is fallacious to cite the austerity cures of Canada, and Scandinavia in the 1990s – as the European Central Bank does – as evidence that budget cuts pave the way for recovery. These countries were able export to a booming world. They could lower interest rates, and were small enough to carry out `beggar-thy-neighbour' devaluations without attracting much notice. We were not then in our New World Order of "currency wars".
Be that as it may, it is clear that Southern Europe will not recover for a long time. Portuguese premier Jose Socrates has just unveiled his latest austerity package. He has capitulated on wage cuts. There will be a rise in VAT from 21pc to 23pc, and a freeze in pensions and projects. The trade unions have called a general strike for next month.
Mr Socrates has already lost his socialist majority, leaking part of his base to the hard-Left Bloco. He must rely on conservative acquiescence – not yet forthcoming. Citigroup said the fiscal squeeze will be 3pc of GDP next year. So under the IMF's schema, this implies a 3pc loss in growth. Since there wasn't any growth to speak off, this means contraction.
Spain had a general strike last week. Elena Salgado, the defiant finance minister, refused to blink. "Economic policy will be maintained," she said. There will be another bitter budget in 2011, cutting ministry spending by 16pc.
Mrs Salgado has ruled out any risk of a double-dip. But the Bank of Spain fears the economy may contract in the third quarter.
The lesson of the 1930s is that politics can turn ugly as slumps drag into a third year, and voters lose faith in the promised recovery. Unemployment is already 20pc in Spain. If Mrs Salgado is wrong, Spanish society will face a stress test.
We are seeing a pattern – first in Ireland, now in Greece and Portugal – where cuts are failing to close the deficit as fast as hoped. Austerity itself is eroding tax revenues. Countries are chasing their own tail.
The rest of EMU is not going to help. France and Italy are cutting 1.6pc GDP next year. The German squeeze starts in earnest in 2011.
Given the risks, you would expect the ECB to stand by with monetary stimulus. But no, while the central banks of the US, the UK, and Japan are worried enough to mull a fresh blast of money, Frankfurt is talking up its exit strategy. It risks repeating the error of July 2008 when it raised rates in the teeth of the crisis.
The ECB is winding down its lending facilities for eurozone banks, regardless of the danger for Spanish, Portuguese, Irish, and Greek banks that have borrowed €362bn, or the danger for their governments. These banks have used the money to buy state bonds, playing the internal "carry trade" for extra yield. In other words, the ECB is chipping at the prop that holds up Southern Europe.
One has to conclude that the ECB is washing its hands of the PIGS, dumping the problem onto the fiscal authorities through the EU's €440bn rescue fund. That is courting fate.
Who believes that the EMU Alpinistas roped together on the North Face of the Eiger are strong enough to hold the rope if one after another loses its freezing grip on the ice?
How Canada is among most indebted nations in the world
Michael Babad Columnist profile E-mail
Globe and Mail Update
Published Thursday, Sep. 23, 2010 10:35AM EDT
Canada has been winning praise throughout the industrialized world for Ottawa's fiscal position, a relatively low level of government debt-to-GDP when compared to its peers. But, Scotia Capital notes today, add in private debt and it doesn't look so good.
"Just as the federal government vacated the debt markets from the mid-1990s onward, Canadian households, businesses and some provinces all too eagerly stepped up to the plate to fill the space," said economists Derek Holt and Grocia Djeric. "Canada's combined household debt and business debt readings relative to GDP give us among the most indebted private sectors anywhere using this World Economic Forum measure of private debt extended by lenders to households and businesses."
As their chart above illustrates, Canada is "pushing toward the outer limit," in company with the likes of the United States, Britain and Spain when you look at both public and private gross debt.
"Connect the dots between the U.S., U.K., Canada, France, Italy and Japan on the chart, and being near the resulting ring isn't terribly appealing to us," the Scotia economists said in a research note. "Canada has a lot of company in this zone, but the view that the country is vastly superior on debt exposures that itself stems from focusing just on the federal government or just net debt of all governments combined is incorrect."
BRICs Oppose U.S. on Currency Controls, Russia Says
Oct. 8 (Bloomberg) -- The BRIC countries are united in opposing U.S. efforts to weaken or eliminate mechanisms to control currency fluctuations, Russia's Finance Ministry said.
Brazil, Russia, India and China will put up "strong resistance" to attempts to make a "harsh appraisal" of currency controls at the annual meeting of the International Monetary Fund and World Bank this week in Washington, Deputy Finance Minister Dmitry Pankin told reporters late yesterday.
The BRIC countries "have agreed on a position that exchange rates aren't themselves a problem," Pankin said. "Rather they are a consequence of deeper processes, such as tendencies to save, to invest, of the investment climate."
U.S. Treasury Secretary Timothy F. Geithner said this week that large economies undervaluing their currencies may accelerate inflation, create asset bubbles and restrict growth. China is the biggest target for criticism after limiting the yuan's rise to about 2 percent against the dollar since a June pledge to make the currency more flexible.
The yuan was little changed today at 6.6712 per dollar at 1:29 p.m. Moscow time. Before relaxing the peg, China held its currency at about 6.83 per dollar for two years to shield its exporters from the global crisis.
Japan last month sold the yen for the first time in six years to spur exports and economic growth, joining countries across Asia and Latin America that have tempered gains in their currencies against the dollar. Brazil's Finance Minister Guido Mantega warned Sept. 27 of a "currency war" and said that his government will buy all "excess dollars" in the market to curb the real's appreciation.
Brazil is among the countries struggling with its currency's appreciation, as investors pump record levels of cash into emerging markets since EPFR Global started tracking the data in 1995. Indian Finance Minister Pranab Mukherjee said yesterday it's the duty of every central bank to watch inflows and intervene "as and when it is necessary."
Capital "fluctuations" may also pose a risk for Russia, Pankin said.
"I don't believe in a weak currency as a good way of having growth," Alexei Ulyukayev, first deputy chairman of Bank Rossii, said in an interview in Moscow on Oct. 5.
The ruble depreciated the most in three weeks versus the dollar as oil declined. The Russian currency weakened 1.1 percent to 30.0100 per dollar at 2:27 p.m. in Moscow.
Russia's central bank has pledged to shift its policy regime to target inflation and make the ruble a free-floating currency. Bank Rossii currently buys and sells currency on the market to steer the ruble's value against a basket of euros and dollars to smooth "excessive volatility" in the exchange rate.
The central bank has "made serious progress in liberalizing the exchange rate," selling $1.3 billion in September compared with interventions earlier this year that exceeded $10 billion a month, Ulyukayev said.
The central bank's shift to a free-floating ruble is a "dangerous policy for the economy," because a more flexible exchange rate may undercut Russia's competitiveness, Deputy Economy Minister Andrei Klepach said Oct. 6. "Russia isn't fully ready" for the free-float regime now, he said.
Sharp currency-exchange "fluctuations" act as a hurdle to growth, Pankin said. "From the point of view of any economic process or an investment project, it's impossible to work in a situation when the exchange rate jumps 20 percent in four months," he said.
"A free-floating exchange rate isn't itself a cure for all ills," Pankin said.
Is the Fed playing with fire?
Federal Reserve Chairman Ben Bernanke called the last round of asset purchases an "effective program."
By Chris Isidore, senior writerOctober 5, 2010: 4:05 PM ET
New York (CNNMoney.com) -- The Federal Reserve is about to throw some more fuel on the fire it has been stoking for more than two years.
But the expected move to pump more cash into the system might not do much good at this point, and the economy could get burned in the process.
The central bank has pumped about $2 trillion into the economy since the recession began in September 2008, in a process known as quantitative easing -- massive purchases of financial assets, like mortgages and Treasurys, designed to encourage spending through lower interest rates.
Now, as the Fed prepares for a two day meeting the first week of November, top officials are sending clear signals that more purchases are on the way.
"Further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident," said William Dudley, president of the Federal Reserve Bank of New York said last week.
In remarks Monday, Chairman Ben Bernanke said of the possibility of future purchases, "I do think they have the ability to ease financial conditions."
But further Fed action comes with a number of risks, and not everyone is eager to see another round of quantitative easing. Here are the dangers:
Another bubble. The idea behind asset purchases is to flood the economy with money, which would lower interest rates and spur more lending and spending.
But new asset bubbles could form if the Fed doesn't start backing away from its policy of easy money -- often thought to be the source of the housing bubble which caused the recession in the first place.
Kansas City Fed President Thomas Hoenig has been warning of asset bubbles since early this year, and consistently voting against additional asset purchases and low interest rates.
And there are already troubling signs of possible new bubbles, like increases in the values of various assets from Treasurys to gold to other commodities.
A falling dollar. At the last Fed meeting policymakers said prices were too low, and signaled they were ready to take action if necessary.
That caused a drop in the value of the dollar, as investors fear the currency will lose value in the future. That day, the dollar fell about 1% against the euro, and almost 4% more since then.
If more confidence is lost, a downward spiral for the greenback could raise prices by making the cost of various commodities and imports, such as food and oil, more expensive for Americans.
That could also drive up interest rates, as overseas investors financing U.S. government debt would demand higher rates to compensate for expected declines in the dollar.
Higher rates could lead to a host of problems, like making business and consumer loans more expensive. And it would hurt the value of the Fed's huge asset holdings.
"When the Fed buys long-term government debt from the private market, it shifts interest rate risk from bondholders to taxpayers," Minneapolis Fed President Narayana Kocherlakota warned last week.
It won't work. There are fears that rushing to buy additional assets will do little to spur hiring or spending in an economy already awash in excess cash, one in which nervous consumers are saving more and paying down debt.
"Asset purchases in our current economic environment can do little if anything to speed up the return to full employment," Philadelphia Fed President Charles Plosser said in a speech last week. "Because I see little gain at this point, and some costs, I would prefer not to engage in further asset purchases at this time."
Many economists echo Plosser's doubts about the Fed being able to jumpstart the economy with more money.
"I think the impact [of additional purchase] will be minimal," said Bernard Baumohl, executive director of the Economic Outlook Group.
Even if asset purchases lower interest rates, Baumhohl said, banks are still reluctant to lend and both businesses and consumers are still too nervous to take on more debt.
So lowering rates feeds the risk of inflation down the road without solving the problem today.
"We are following policies that unless changed will eventually lead to lots of inflation down the road," said Warren Buffett at Fortune's Most Powerful Women Summit Tuesday. "We have started down a path you don't want to go down."
The risk of doing nothing. While the economy remains fragile, sitting on the sidelines isn't a safe option either.
There are growing concerns of a double-dip recession or a deflationary spiral that could hurt economic growth for years to come. A recent poll of top economists by CNNMoney found nearly twice as many worried about deflation than a return of inflation.
With inflation currently near zero, many fear that a downward spiral in prices is a serious threat.
"Once deflation gets going, it's very hard to stop," said James Hamilton, economics professor at the University of California at San Diego.
Even having very low inflation can cause problems for the economy, he said. "As long as we have inflation this low, people have an incentive to hoard cash rather than putting it to work constructively."
He argues the weak economy warrants immediate action, despite the risks, and supports another round of asset purchases.
"We have to balance those worries about negative consequences with worries the economy faces right now."
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