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An imaginary retrospective of 2009

Niall Ferguson imagine what the world economy will look like in 2009.

It was the year when people finally gave up trying to predict the year ahead. It was the year when every forecast had to be revised – usually downwards – at least three times. It was the year when the paradox of globalisation was laid bare for all to see, if their eyes weren't tightly shut.

On the one hand, the increasing integration of markets for commodities, manufactures, labour and capital had led to great gains. As Adam Smith had foreseen in The Wealth of Nations, economic liberalisation had allowed the division of labour and comparative advantage to operate on a global scale. From the 1980s until 2007, the world economy had enjoyed higher, more widespread growth and fewer, less severe crises – hence Federal Reserve chairman Ben Bernanke's hubristic celebration of a "great moderation" in 2004.

On the other hand, the more the world came to resemble an intricate, multi-nodal network operating at maximum efficiency – with minimal inventories and just-in-time delivery – the more vulnerable it became to a massive systemic crash.

That was the true significance of the Great Repression which began in August 2007 and reached its nadir in 2009. It was clearly not a Great Depression on the scale of the 1930s, when output in the US declined by as much as a third and unemployment reached 25 per cent. Nor was it merely a Big Recession. As output in the developed world continued to decline throughout 2009 – despite the best efforts of central banks and finance ministries – the tag "Great Repression" seemed more and more apt: although this was the worst economic crisis in 70 years, many people remained in deep denial about it.

"We assumed that we economists had learned how to combat this kind of crisis," admitted one of President Barack Obama's "dream team" of economic advisers, shortly after his return to academic life in September 2009. "We thought that if the Fed injected enough liquidity into the financial system, we could avoid deflation. We thought if the government ran a big enough deficit, we could end a recession. It turned out we were wrong. So much for [John Maynard] Keynes. So much for [Milton] Friedman."

The root of the problem remained the US's property bubble, which continued to deflate throughout the year. Many people had assumed that by the end of 2008 the worst must be over. It was not. Economist Robert Shiller's real home price index in 2006 had stood at just under 206, nearly double its level just six years earlier. To return to its pre-bubble level, it therefore had to fall by 50 per cent. Barely half that decline had taken place by the end of 2008. So house prices continued to slide in the US. As they did, more and more families found themselves in negative equity, with debts exceeding the value of their homes. In turn, rising foreclosures translated into bigger losses on mortgage-backed securities and yet more red ink on banks' balance sheets.

With total debt above 350 per cent of US gross domestic product, the excesses of the age of leverage proved difficult to purge. Households reined in their consumption. Banks sought to restrict new lending. The recession deepened. Unemployment rose towards 10 per cent, and then higher. The economic downward spiral seemed unstoppable. No matter how hard they saved, Americans simply could not stabilise the ratio of their debts to their disposable incomes. The paradox of thrift meant that rising savings translated into falling consumer demand, which led to rising unemployment, falling incomes and so on, ever downwards.

"Necessity will be the mother of invention," Obama declared in his inaugural address on January 20. "By investing in innovation, we can restore our faith in American creativity. We need to build new schools, not new shopping malls. We need to produce clean energy, not dirty derivatives." Commentators agreed that the speech was on a par with Franklin Roosevelt's on his inauguration in 1933. Yet Roosevelt had spoken after the worst of the Depression was over, Obama in mid-tailspin. The rhetoric flew high. But the markets sank lower. The contagion spread inexorably from subprime to prime mortgages, to commercial real estate, to corporate bonds and back to the financial sector. By the end of June, Standard & Poor's 500 Index had sunk to 624, its lowest monthly close since January 1996, and about 60 per cent below its October 2007 peak.

The crux of the problem was the fundamental insolvency of the major banks, another reality that policymakers sought to repress. In 2008, the Bank of England had estimated total losses on toxic assets at about $2.8 trillion. Yet total bank writedowns by the end of 2008 were little more than $583bn, while total capital raised was just $435bn. Losses, in other words, were either being massively understated, or they had been incurred outside the banking system. Either way, the system of credit creation had broken down. The banks could not contract their balance sheets because of a host of pre-arranged credit lines, which their clients were now desperately drawing on, while their only source of new capital was the US Treasury, which had to contend with an increasingly sceptical Congress. The other credit-creating institutions – especially the markets for asset-backed securities – were all but paralysed.

There was uproar when Timothy Geithner, US Treasury secretary, requested an additional $300bn to provide further equity injections for Citigroup, Bank of America and the seven other big banks, just a week after imposing an agonising "mega-merger" on the automobile industry. In Detroit, the Big Three had become just a Big One, on the formation of CGF (Chrysler-General Motors-Ford; inevitably, the press soon re-christened it "Can't Get Funding"). The banks, by contrast, seemed to enjoy an infinite claim on public funds. Yet no amount of money seemed enough to persuade them to make new loans at lower rates. As one indignant Michigan law-maker put it: "Nobody wants to face the fact that these institutions [the banks] are bust. Not only have they lost all of their capital. If we genuinely marked their assets to market, they would have lost it twice over. The Big Three were never so badly managed as these bankrupt banks."

In the first quarter, the Fed continued to do everything in its power to avert the slide into deflation. The effective federal funds rate had already hit zero by the end of 2008. In all but name, quantitative easing had begun in November 2008, with large-scale purchases of the debt and mortgage-backed securities of government-sponsored agencies (the renationalised mortgage giants Fannie Mae and Freddie Mac) and the promise of future purchases of government bonds. Yet the expansion of the monetary base was negated by the contraction of broader monetary measures such as M2 (the measurement of money and its "close substitutes", such as savings deposits, that is a key indicator of inflation). The ailing banks were eating liquidity almost as fast as the Fed could create it. The Fed increasingly resembled a government-owned hedge fund, leveraged at more than 75 to 1, its balance sheet composed of assets everyone else wanted to be rid of.

. . .

The position of the US federal government was scarcely better. By the end of 2008, the total value of loans, investments and guarantees given by the Fed and the Treasury since the beginning of the financial crisis had already reached $7.8 trillion. In the year to November 30 2008, the total federal debt had increased by more than $1.5 trillion. Morgan Stanley estimated that the total federal deficit for the fiscal year 2009 could equal 12.5 per cent of GDP. The figure would have been even higher had President Obama not been persuaded by his chief economic adviser, Lawrence Summers, to postpone his planned healthcare reform and promised spending increases in education, research and foreign aid.

Obama had set out to construct an administration in which his rivals and allies were equally represented. But his rivals were a good deal more experienced than his allies. The result was an administration that talked like Barack Obama but thought like Bill Clinton. The Clinton-era veterans, not least Secretary of State Hillary Clinton, had vivid memories of the bond-market volatility that had plagued them in 1993 (prompting campaign manager James Carville to say that, if there was such a thing as reincarnation, he wanted to come back as the bond market). Terrified at the swelling size of the deficit, they urged Obama to defer any expenditure that was not specifically targeted on ending the financial crisis.

Yet the world had changed since the early 1990s. Despite the fears of the still-influential former Treasury secretary Robert Rubin, investors around the world were more than happy to buy new issues of US Treasuries, no matter how voluminous. Contrary to conventional wisdom, the quadrupling of the deficit did not lead to falling bond prices and rising yields. Instead, the flight to quality and the deflationary pressures unleashed by the crisis around the world drove long-term yields downwards. They remained at close to 3 per cent all year.

Nor was there a dollar rout, as many had feared. The foreign appetite for the US currency withstood the Fed's money-printing antics, and the trade weighted exchange rate actually appreciated during 2009.

Here was the irony at the heart of the crisis. In all kinds of ways, the Great Repression had "Made in America" stamped all over it. Yet its effects were more severe in the rest of the world than in the US. And, as a consequence, the US managed to retain its "safe haven" status. The worse things got in Europe, in Japan and in emerging markets, the more readily investors bought Treasuries and held dollars.

. . .

For the rest of the world, 2009 proved to be an annus horribilis. Japan was plunged back into the deflationary nightmare of the 1990s by yen appreciation and a collapse of consumer confidence. Things were little better in Europe. There had been much anti-American finger-pointing by European leaders in 2008. The French president Nicolas Sarkozy had talked at the G-20 summit in Washington as if he alone could save the world economy. The British prime minister Gordon Brown had sought to give a similar impression, claiming authorship of the policy of bank recapitalisation. The German chancellor Angela Merkel, meanwhile, voiced stern disapproval of the excessively large American deficit.

By the first quarter of 2009, however, the mood in Europe had darkened. It became apparent that the problems of the European banks were just as serious as those of their American counterparts. Indeed, the short-term liabilities of the Belgian, Swiss, British and Italian banks were far larger in relation to those countries' economies, while the German, French and Danish banks were much more dangerously leveraged. Moreover, in the absence of a European-wide finance ministry, all talk of a European stimulus package was just that – mere talk. In practice, fiscal policy became a matter of sauve qui peut, with each European country improvising its own bailout and its own stimulus package. The result was a mess. Currencies outside the Euro area were afflicted by severe volatility. Inside the Euro area, the volatility was in the bond market, with spreads on Greek and Italian bonds exploding relative to German bunds.

The picture was even worse in most emerging markets. Especially hard hit in eastern Europe were Bulgaria, Romania, Ukraine and Hungary. Of the Brics (Brazil, Russia, India and China), Brazil had the best year, Russia the worst. It was a terrible year for oil and gas exporters, as prices plunged, taking currencies such as the rouble down with them. The Indian stock market, meanwhile, was battered by escalating tensions between New Delhi and Islamabad in the wake of the Mumbai terrorist attacks.

Political instability also struck China, where riots by newly redundant workers in Shenzhen and other export centres provoked a heavy-handed clampdown by the government, but also a renewed effort by the People's Bank of China to prevent the appreciation of the yuan by buying up yet more hundreds of billions of dollars of US Treasuries. "Chimerica" – the symbiotic relationship between China and America – not only survived the crisis, but gained from it. Although Obama's decision to attend the first G-2 summit in Beijing in April dismayed some liberals, most recognised that trade trumped Tibet at such a time of economic crisis.

This asymmetric character of the global crisis – the fact that the shocks were even bigger on the periphery than at the epicentre – had its disadvantages for the US, to be sure. Any hope that America could depreciate its way out from under its external debt burden faded as 10-year yields and the dollar held firm. Nor did American manufacturers get a second wind from reviving exports, as they would have done had the dollar sagged. The Fed's achievement was to keep inflation in positive territory – just. Those who had feared galloping inflation and the end of the dollar as a reserve currency were confounded.

On the other hand, the troubles of the rest of the world meant that in relative terms the US gained, politically as well as economically. Many commentators had warned in 2008 that the financial crisis would be the final nail in the coffin of American credibility around the world. First, neo-conservatism had been discredited in Iraq. Now the "Washington consensus" on free markets had collapsed. Yet this was to overlook two things. The first was that most other economic systems fared even worse than America's when the crisis struck: the country's fiercest critics – Russia, Venezuela – fell flattest. The second was the enormous boost to America's international reputation that followed Obama's inauguration.

. . .

If proof were needed that the US constitution still worked, here it was. If proof were needed that America had expunged its original sin of racial discrimination, here it was. And if proof were needed that Americans were pragmatists, not ideologues, here it was. It was not that Obama's New New Deal – announced after the Labor Day purge of the Clintonites – produced an economic miracle. Nobody had expected it to do so. It was more that the federal takeover of the big banks and the conversion of all private mortgage debt into new 50-year Obamabonds signalled an impressive boldness on the part of the new president.

The same was true of Obama's decision to fly to Tehran in June – a decision that did more than anything else to sour relations with Hillary Clinton, whose supporters never quite recovered from the sight of the former presidential candidate shrouded in a veil. Not that the so-called "opening to Iran" produced a dramatic improvement in the Middle East region. Nobody had expected that either. It was more that, like Richard Nixon's visit to China in 1972, it symbolised a readiness on Obama's part to rethink the very fundamentals of American grand strategy. And the downfall of the Iranian president Mahmoud Ahmedinejad – followed soon after by the abandonment of the country's nuclear weapons programme – was a significant prize in its own right. With their economy prostrate, the pragmatists in Tehran were finally ready to make their peace with "the Great Satan", in return for desperately needed investment.

Meanwhile, al-Qaeda's bungled attempt to assassinate Obama – on the eve of Thanksgiving – only served to discredit radical Islamism and to reinforce Obama's public image as "The One". Another of the many ironies of 2009 was that the mood of religious reawakening triggered by the economic crisis benefited the Democrats rather than the deeply divided Republicans.

By year end, it was possible for the first time to detect – rather than just to hope for – the beginning of the end of the Great Repression. The downward spiral in America's real estate market and the banking system had finally been halted by radical steps that the administration had initially hesitated to take. At the same time, the far larger economic problems in the rest of the world had given Obama a unique opportunity to reassert American leadership, particularly in Asia and the Middle East.

The "unipolar moment" was over, no question. But power is a relative concept, as the president pointed out in his last press conference of the year: "They warned us that America was doomed to decline. And we certainly all got poorer this year. But they forgot that if everyone else declined even further, then America would still be out in front. After all, in the land of the blind, the one-eyed man is king."

And, with a wink, President Barack Obama wished the world a happy new year.

Niall Ferguson is a contributing editor of the FT and the author of 'The Ascent of Money: A Financial History of the World' (Penguin)

12 Lessons for Investors From a Terrible 2008

(source: wsj)

It's been a terrible year, but those who learn some valuable lessons won't walk away empty handed. What lessons have you learned, or had reinforced? I'd love to hear. Here are 12 that struck me.

• 1. You have to take charge of your own finances. And that means understanding where your money is invested and why. There's only so far you can rely on advisers, portfolio managers and company plans. After all, you will own the results, not them.
• 2. Never put all your trust in one financial whiz, no matter how highly recommended. Few turn out to be Bernie Madoffs, thank heavens. But most of Wall Street's best and brightest still lost 40% or more this year.
• 3. Never invest in something you don't understand. For years, I refused to recommend Fannie Mae and Freddie Mac stock for this reason, despite the urgings of various market sources. Imagine my relief when it emerged that nobody else really understood them either -- including their own CEOs. Simple stocks, like Amazon, or Anheuser-Busch, rarely embarrass you in this way.
• 4. Invest more, not less. Is that a guffaw from the peanut gallery? I don't blame you. Your savings just fell 40% or more. But higher risk and lower returns means you need to invest more to reach your goals.
• 5. Never assume there is investment safety in numbers. The most "popular" investments often turn out worst -- from technology stocks (1999) to real estate (2004) to emerging markets (2006-7).
• 6. Your grandma was right after all. A penny saved really is a penny earned. Debt really is dangerous. And an economy where it's easier to borrow $10,000 on a credit card than find a working electrician is heading for trouble.
• 7. Psmith was right, too. Who? This fictional character, created by the great English comic novelist P.G. Wodehouse, frequently warned against the perils of confusing "the unusual with the impossible." Certainly the events of the last year were unusual. Alas, too many thought they were impossible.
• 8. Own plenty of bonds. Yes, they're less exciting than stocks. Turns out, that's the point. There's little use keeping everything in stocks "for the long run" if they kill before you get there.
• 9. When someone offers you obviously good value -- like inflation-protected Treasurys with a 4% real yield -- take it. When they offer you bad value -- like those same bonds with a real yield of 0%, as they had last winter -- don't.
• 10. Avoid needless risks. Those who speculated on Citigroup or WaMu or General Motors stocks suffered more than most this year. The biggest investment mistakes will generally be those you bought, not ones you missed.
• 11. Take all expert predictions with a pinch of salt. That goes double when the experts all agree. Remember, most economists successfully predicted 12 of the last four recessions, but somehow missed this one. After long experience, when I read a headline like "Pound Poised to Gain in 2009 as Top Strategists See Slower Cuts in Rates" (Bloomberg, Dec. 30) it makes me fear for the poor old pound sterling.
• 12. Still trying to predict the next short-term move, or call the market bottom? Sure, maybe November (Dow 7550) will turn out to be the market low. But that's what some people said in January (Dow 11971), March (11740), July (10963), September (10365), and October (8176). One day, doubtless, they will be right.

The China Growth Fantasy

Yasheng Huang of MIT writes on WSJ: China's economic growth has largely been driven by government-heavy-handed investments. Chinese economy lacks a real consumption base. So in hindsight, the "decoupling" theme now sounds almost ludicrous.

I see the key to solve the problem is to shift investment/consumption decision-making from government to individuals. But in order to nurture a good investment/consumption environment for individual investors, it requires establishing a social security system and an affordable healthcare system. Without them, individuals will still resort to precautionary savings and deposit their their money into the banks. And of course, since all large banks are controlled by the state, government thus replaces individuals in their decision making. So in this sense, privatization of state banks and simultaneous introducing foreign competition into the financial system will also help.

Remember the hype about "decoupling"? Not so long ago, Western analysts -- in particular investment-bank economists -- were peddling the idea that China had become a powerful economic center of its own, able not only to drive its own growth independent of the United States but also to power the global economy forward.

To the extent that these Wall Street economists are still employed, few would make that argument now. The economic numbers emerging out of China are sobering. Exports, still the backbone of the economy, are contracting for the first time in seven years, according to the latest data. They're being driven down by slackening demand overseas. Even worse is the sharp decline of imports, a sure sign of falling domestic demand. These two developments taken together signal monumental economic challenges ahead. Clearly China is not bucking global trends.

So how did all the decoupling theorists get it so wrong? This isn't an idle question. The decoupling theory itself was the product of faulty economic analyses that persist today, even as the decoupling theory falls out of favor. Debunking these claims carries important policy implications.

The fundamental problem, and a mortal bias of economists, is a fixation with simple measurements -- especially GDP data. Ask a professional economist how many provinces China has and you are likely to draw a blank stare. But ask him what the GDP growth of China has been and he'll quickly be able to tell you that China has grown at a double-digit rate for 30 years and that at this rate China will overtake the U.S. by 2035 (or some other date). GDP-centrism is endemic, and often comes at the expense of deeper analysis. Just look at the enthusiasm with which economists and analysts greeted Goldman Sachs's famed "BRIC" report forecasting dramatic booms in Brazil, Russia, India and China -- a report based on little more than fifth-grade mathematics.

This obsession with China's impressive GDP growth often ignores discussion of what's causing that growth and whether it's self-sustained. This is where the decoupling enthusiasts stumbled, and where policy makers can still go seriously wrong. Consider, for example, data about the very slow growth of household incomes in China. This is particularly apparent in rural households. For the past 20 years or so, rural household income has grown at a rate half that of GDP growth. The slow household income growth, combined with rapid GDP growth, means that China has created a huge production capacity but it has done so at the expense of its own consumption base. This fact alone should have disproved the decoupling hypothesis. All the new "excess" production had to go somewhere, i.e., to the U.S. What's more, the persistence of this gap suggests that over time, China's growth has become more, not less, a derivative of America's consumption appetite.

This raises the important policy question of why and how Chinese growth systematically undermined its own consumption potential. To answer this, one has get a grip on how China's rapid GDP growth happened in the first place. Part of that growth is a result of economic liberalization, but the market-driven part is small and has been diminishing. Fixed asset investment, heavily controlled by the government, has risen to nearly 45% today, from a level of 30-35% during the 1980s. Much of the GDP growth since the mid-1990s has been a result of government-organized massive investment drives -- in infrastructure, urban construction and urbanization. This government-heavy growth has done the most damage to China's consumption potential, pushing the country further to a dependency on the markets of the rich nations.

Let me illustrate this point by an example. The following proposition will sound familiar to many foreign investors who have done business with Chinese local officials eager to get their investment capital: "Do you want 10 acres of densely populated land for your new factory? No problem. We will clear the land for you in three weeks." Many foreign investors marvel at the "business friendly" attitude of local governments in China, especially in sharp contrast to the seeming incompetence of the Indian government to get things done.

But this "business friendliness" is the heart of the problem: The Chinese households often reap almost no financial benefits from the conversion of their residential land into industrial or commercial development. The Chinese government, thanks to its formal ownership of all land assets, can relocate households on a scale unthinkable in a market economy, often with compensation far below the fair market value of the land. This is why factory owners incur far lower costs in setting up operations in China as compared with other countries, and also is why thousands of skyscrapers can mushroom seemingly out of nowhere overnight in Chinese cities.

But China is not exempt from a basic economic principle: A cost to one person is an income to another. The fact that factory owners and developers in China incur lower costs means that the income to some other economic participant is low. Those who derive low income in China happen to be the majority of the population, especially the rural Chinese who have little political power to protect themselves. Thus one sure mechanism of private wealth creation -- urbanization achieved when small landholders sell out to developers at market prices -- is almost completely missing in China despite the fact that the country is urbanizing at a dizzying rate on the surface.

All this is significant beyond the esoteric confines of the decoupling debate. To truly rebalance the Chinese economy requires the Chinese government to focus on income growth of the Chinese people rather than being fixated with GDP growth. One straightforward way to do this is to adopt market pricing of land by permitting and encouraging competition when acquiring land from Chinese peasants as a part of its current stimulus package. In the past two years, the Chinese leadership has done a good job reducing the expenditures -- such as taxes, education and health fees -- of the Chinese peasants. It is time now to raise their income.

China is one of the few countries in the world endowed with the land mass, the energetic and talented population, and the entrepreneurship to become a true global economic powerhouse. But that potential has been squandered by a misguided development strategy that privileges production at the expense of consumption and uses political power to suppress costs rather than relying on market mechanisms to boost income. In the midst of a global recession, China, along with its 1.3 billion people, is paying a dear price for that mistake now.

Mr. Huang is a professor of international management at the MIT Sloan School of Management and the author of "Capitalism with Chinese Characteristics" (Cambridge University Press, 2008).

Use exchange rate to get out of deflation?

The Journal has a report on how to use exchange rate (by depreciating) to get out of deflation. Barry Eichengreen and Ben Bernanke both hold such view. But as pointed out in this article on Economist Magazine: not all countries have the luxury to implement such policy, especially those who borrowed heavily and in foreign currency. So currency depreciation is not the panacea and it can't be blindly appled everywhere.

The dollar's sharp turn weaker into the end of the year is threatening to reshuffle winners and losers in global trade amid the toughest economic conditions in decades.

For countries like Japan and Germany, it is a source of anxiety, since a stronger currency makes exports less competitive as global demand shrinks. For the U.S., it is a more welcome development and might also help counteract declining prices. In some emerging markets, a weaker dollar is a relief for companies that must pay debts denominated in dollars.

Still, in today's environment, few countries want to be the last one standing with a strong currency. Some economists worry that countries could actively seek to weaken their currencies in an effort to gain an advantage over their trading partners, setting off a round of devaluations that ultimately damage world trade.

Until recently, the dollar was one of the most robust currencies around, surging against everything except the Japanese yen. But in recent weeks -- and particularly after the Federal Reserve slashed a key interest-rate target to near zero -- the dollar has abruptly changed course.

On Friday, the dollar slipped against the euro, with one euro buying $1.406 late in New York. The dollar has weakened about 10% versus the euro and 8% against the yen since the start of November.

That is good news for U.S. exporters, but it is raising concerns in places like Japan and Germany, which are both gripped by recession.

In Japan, officials are so concerned by the strengthening yen that they have sent signals they might intervene to stop it. Earlier this month, Honda Motor Co.'s president warned that the pumped-up yen could cause the "hollowing out of Japanese industry."

"Both countries are very dependent on exports, with very little domestic growth," says Adam Posen, an economist at the Peterson Institute for International Economics. "Bad news is coming, and the dollar going down is additional bad news for them."

Of course, there are upsides to a having a stronger currency in some corners of the globe. The dollar's turn lower has brought a modicum of relief in emerging markets, where currencies have been battered in recent months. That is easing the burden on companies with debts to pay in foreign currencies.

For the U.S. in particular, a weaker currency could be a welcome help on another front -- avoiding a cycle of declining prices.

"There is a pretty compelling argument both in theory and in history that if your problem is deflation, then pushing down the exchange rate is an effective way of addressing that problem," says Barry Eichengreen, an economist at the University of California, Berkeley.

Mr. Eichengreen notes that, during the Great Depression, it was difficult to use a weaker currency to export more because of protectionist policies in place around the globe. However, it was a useful way to change people's expectations about prices, since imports become more expensive. When the U.S. devalued the dollar in 1933, he said, the prices of some commodities, which had been spiraling lower, suddenly began to go up.

One fan of this line of thinking: Federal Reserve Chairman Ben Bernanke. In a 2002 speech, Mr. Bernanke noted that the devaluation of the dollar and the rapid increase in the money supply in 1933 and 1934 "ended the U.S. deflation remarkably quickly." He described the episode as an illustration of what can be achieved "even when the nominal interest rate is at or near zero."

That, of course, describes where the Fed's key interest-rate target sits today. The fact that the Fed has been willing to embrace unconventional and aggressive lending measures carries an implicit message, says David Gilmore of Foreign Exchange Analytics, a Connecticut research firm, namely that "a weaker dollar in an orderly way is certainly a desired outcome." He adds that the Treasury Department has avoided its usual mantra in recent months in which it reiterates its support for a strong dollar. The current problem, he says, is that "every country on the planet needs a weak currency right now, and not everybody can have one."

In late November, China briefly pushed its currency, the yuan, sharply lower against the dollar, raising fears that it could be seeking a competitive leg-up. Since then, the yuan has recovered those losses. In Vietnam, where the local currency, the dong, is pegged to the dollar, the central bank devalued the currency on Wednesday for the second time this year. The move will help facilitate exports and control the trade deficit, the central bank said in a statement.

In the late 1990s, a number of emerging markets from Asia to Russia faced financial crises and were forced to devalue their currencies. Eventually, that helped spur economic recoveries by touching off export booms at a time of buoyant demand elsewhere. Today, though, the whole world is reeling, making it difficult for a country to export its way out of trouble.

"The world can't depreciate [its currency] against Mars and export to the rest of the solar system," says Simon Johnson, a former IMF chief economist.

Economics of Used Books

It explains why new books (especially textbooks) these days are sold at exorbitant expensive prices and how the Internet has changed book selling. (source: NYT)

Japan: TWO lost decades

For over 20 years, Japanese stock market went nowhere but down.

Wall Street Job Outlook in 2009

Minsky Moment in a nutshell

PIMCO's Paul McCulley gives us a nice graph on Minsky moment:

China: Reverse Brain Drain

Following my last post on China's hunting for the Wall Street talents, NY Times had another report: "Chinese financial institutions, in a reverse brain drain, are looking to recruit from the ranks of recently laid-off finance sector employees".

How Iceland Collapsed

Icelanders borrowed over 200% of their income, and in foreign currencies. Many countries in Eastern Europe have the similar problem.

Commodities outlook

Interview of Don Coxe of BMO:

Get ready: for a lost decade

Sometimes it's a complete takeover; sometimes it's a bailout in the form of capital injections.  Government has been in a steep learning curve in this crisis and thus far it lacked a coherent strategy.  As argued in this article below, an one-time experience of Great Depression does not at all guarantee we will do absolutely better this time; Politics works in its own twisted mechanism, especially in a democracy.  So don't be surprised if we have a Japan-like lost decade or even another Great Depression.

Get Ready for a Lost Decade  --- Bad times don't produce good policy

How many times have you heard that we've learned the lessons of the Great Depression and won't repeat the same mistakes?

 

That statement is a bit of a false promise, since there was only one Great Depression, and many, many steps were taken and not taken, with no chance to rerun the experiment over and over to figure out what worked, or would have worked, and what didn't.

Letting hundreds of banks collapse, destroying savings and confidence, is one mistake we won't make again. But many want to insist, without evidence, that more government spending would have ended the depression. That's the direction the Obama administration is taking. Others say government did not do enough to restore business confidence, or did too much to damage it, piling on taxes, regulation and labor unions. This at least is firmer ground. Plenty of evidence from history shows that actions hostile to business tend to be related to an absence of prosperity.

But more important than these talismanic assurances about what we've learned from the Great Depression is the mistake in assuming that, even if we had a coherent view of what should be done, coherent polices would therefore be implemented.

This has little relation to how policy is made in a democracy.

Policy is always bad to a degree, but long periods of prosperity tend to be self-reinforcing since powerful interests are born with the means and motive to preserve the status quo. That status quo may really be a contributor to prosperity, such as regulatory restraint and moderate tax rates. That status quo may in some respects be ill-advised, such as excessive subsidy to housing debt.

But once prosperity blows up, the quasi-virtuous policy circle becomes an unvirtuous one as new interest groups come to the fore to exploit an appetite, previously weak, to impose their costly or vindictive wish lists. And even well-meaning policy gets twisted and rendered incoherent.

It's already happening to our banking bailout. If injecting government capital to improve confidence in banks was a good idea, it did nothing to improve the banks' own confidence in their borrowers. Yet now that banks have government capital, they're being pressed to lend to politically favored constituents regardless of their own judgment about whether the borrower is good for the money.

Or take the gathering auto bailout: Taxpayer dollars are being thrown at Detroit auto makers to make them "viable," even as Congress imposes new fuel-mileage mandates requiring them to incur tens of billions in costs unlikely to be recouped from their customers -- the definition of "nonviable."

Mr. Obama's troops palpitate with excitement at the prospect of $1 trillion in "stimulus," though any net benefit to the economy likely will be incidental. Al Gore has thrown out the window any unpopular carbon taxes in favor of direct subsidies to his green energy investments. He sees the moment for what it is -- alarm about global warming has degenerated into a pretext. Billions will be diverted from useful purposes to create "green jobs" that deliver no meaningful impact on climate or the accumulation of atmospheric carbon.

Large "confidence" costs were always destined to flow from the extreme steps being taken, even if advisable, to prop up the economy. The federal government's alternating takeovers and bailouts of companies are inherently destabilizing and create massive uncertainty in investors and businesses. The Fed's shocking steps to print money and acquire every kind of private asset and, soon perhaps, washing machines and Chevy Tahoes, may in retrospect be seen as just the right medicine. At the moment, no rational investor or business manager looks upon such doings with confidence in our economic future.

On top of it all, the Madoff scandal is peculiarly demoralizing in ways that may make its impact greater than the sum of its parts.

Our point here is that the bad policy vicious circle probably has a long way to run. While it's still possible to entertain wild hopes about an Obama administration, such hopes are partly self-liquidating on closer inspection -- they exist in the first place only because Mr. Obama has given us so little to go on, except campaign boilerplate.

Bottom line: Politics is in charge -- in a way that makes a lost decade of subpar prosperity more likely than not.

Happy Holidays.

China's data massage in 2009?

Just like in Asian financial crisis, Chinese officials may have to massage their data again to make the growth figure look better, so that there would be no challenge to their ruling power. 

In 2009, China watchers may double check GDP number with industrial production, and electricity usage, to find the potential discrepancies. 

Read report from WSJ:

China's economy is slowing. By just how much is a bit of a guess.

The uncertainties around Chinese economic data-gathering make it hard to tell. Yet with China likely to be one of the few major economies to show growth next year, the question is pretty crucial. Already there are concerns Beijing could massage its GDP data next year.

Keeping the annual growth rate above 8% has for long been the sine qua non of Chinese economic policy. That rate was 9% in the third quarter, and all the economic news since then points to a lower rate in the past three months of this year.

Any dip below 8%, however temporary, would be a blow to the government's standing. Having announced a $586 billion fiscal-stimulus package this autumn, the government needs to show that it has worked by next year.

For economists, the key frustration in China's GDP figures is the lack of a quarterly expenditure breakdown to balance the output figures that the statistics bureau provides. Mark Williams, of consultancy Capital Economics, says proxies for consumption, investment and net trade actually suggest the Chinese economy grew more quickly in the third quarter than 9%.

So what can China-watchers turn to as a check on official GDP data, and a means to divine the future?

Stephen Green, Standard Chartered's head of research, tracks a mixture of industrial goods production, freight activity, bank-credit growth and commodities imports to derive a measure of real activity in China. That is currently showing "very weak" growth momentum going into the first part of 2009. China's own industry minister has said industrial output needs to expand by 12% next year if the economy is to retain its 8% expansion rate. In November, industrial production grew by just 5.4% on an annual basis.

Looking further forward is more frustrating. Standard Chartered found that neither money-supply measures nor purchasing managers' indices, consumer expectations or even the stock market are reliable leading indicators.

Still, the totemic 8% growth mark will be at risk early next year. Exports, which have contributed about 20% to GDP over the last couple of years, fell year-on-year for the first time since 2001 in November, and an imminent recovery in China's main markets looks unlikely. The property sector is still in a slump, and domestic consumer spending isn't making up for the slowing of both these areas.

Set against this is the $586 billion stimulus package spread over 2009 and 2010, but its effects mightn't be felt until the second half of 2009 at the earliest. By that time, the speed and magnitude of the slowdown should already have made annual growth of 8% impossible to achieve.

The first and second quarters of 2009 will provide a stern test of China's 8% growth commitment, then -- and the probity with which those figures are produced.

Jim Rogers

His investment outlook for 2009. Rogers' views tend to mirror the Austrian economics, where everything that governments are trying to do is treated with deep distrust and suspicion.

But I agree with his outlook on agricultural commodities; Inflation is a big worry down the road; and watch when treasuries bubble bursts.

Euro's dilemma

source: wsj

All governments would like a weaker currency to ease the pain of the financial crisis -- and nowhere more than the euro zone, where the soaring common currency is inflicting economic pain and exposing political tensions. The euro zone is likely to get its wish granted in 2009.

As political tensions mount, investor confidence in the euro will suffer, bringing about the devaluation needed to stop it falling apart.

Investors are aware of the tension, judging by the higher premiums they want for buying the debt of weaker euro-zone economies. Italian, Portuguese and Greek government debt trades at spreads of at least one percentage point above equivalent German 10-year bonds, the highest since the euro was created in 1999. That only makes sense if investors believe there is a possibility a euro-zone member might default or even quit the single currency.

That may seem a distant prospect today, but there already is a wide disparity in the public finances of individual member states. The German government has total debt of 65% of GDP and a projected budget deficit for 2009 of around 0.5%. In contrast, Italy has total debt of 104% of GDP and a projected deficit for 2009 of more than 3%. That makes a mockery of EU rules for debt to be no greater than 60% of GDP and for annual deficits to be kept below 3%.

Weaker member states may be tempted to borrow even more to avoid a catastrophic slump, caused partly by the strength of the euro. In terms of purchasing power, the single currency is at least 20% overvalued against the dollar. With a U.K.-style devaluation out of the question, that is a particular problem for countries like Ireland and Spain, trying to restore their competitiveness and recover from burst property and construction bubbles. Credit Suisse reckons Irish and Spanish wages need to fall 20% to 30%, something no government could countenance.

In any other single currency area, this would be resolved via massive borrowing by a centralized agency, much like the U.S. Treasury, and fiscal transfers between regions. The euro zone has no mechanism for this to happen. Reluctantly resigned to spend more than it wanted to stimulate its own economy, Germany is still unwilling to fund a massive fiscal-stimulus package to revive the euro-zone economy. Hence the risk of disorderly borrowing by other countries, taking advantage of investor appetite for government bonds.

That won't please the Germans. After decades of hard work to build up their inflation-fighting credentials, they also fear they will be forced to pick up the tab if a member state defaults. On the other hand, it may stop the euro falling apart, and trigger the devaluation the eurozone economy so urgently needs.

All Keynsian Now???

Economist Robert Skidelsky, the great biographer and master of Keynes, talks with Tom Ashbrook on On Point at WBUR. Listen to the show here (about 45 mins). A good review of history, and of some core intellectual ideas of the 20th century. Highly recommend.

shoplifting of Japanese elders

When you have no economic growth for almost two decades, and population is rapidly aging, you know you will have a big social problem. Who would expect Japanese over 65 years old would steal, and so frequently? (source: Money)

link to the video

Chicago School of Economics in battle

Challenge Milton Friedman and his ideas? (source: Bloomberg)

Will this crisis bring more government regulation? Yes.
Will this crisis challenge the core ideas of Chicago school of economics? I don't think so.

"There are no atheists in foxholes and no ideologues in financial crises". Get us out of this mess first, then worry about writing economic theories.

Lucas: Bernanke is the best stimulus

Bob Lucas, Nobel laureate at University of Chicago, approves what Bernanke has done and he thinks monetary policy is most effective to fight the current crisis.  What the Fed has done is to bypass banks to lend directly to the broader economy. 

Bernanke Is the Best Stimulus Right Now

A zero interest rate isn't the last weapon in the Fed arsenal

The Federal Reserve's lowering of interest rates last Tuesday was welcome, but it was also received with skepticism. Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused. Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending.

There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount -- lend against -- a wide variety of securities held by a variety of financial institutions. (The addition is to be weighed against September 2007's total outstanding level of reserves of about $50 billion.)

This action has been the boldest exercise of the Fed's lender-of-last-resort function in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue or expand this discounting activity as long as the situation dictates.

Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality" that is very much analogous to the "flight to currency" that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety. Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets. The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession. Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending.

When the Fed wants to stimulate spending in normal times, it uses reserves to buy Treasury bills in the federal-funds market, reducing the funds' rate. But as the rate nears zero, Treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of "quality" assets.

A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves -- or "printing money" -- to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector.

This expansion of Fed lending has not violated the constraint that "the" interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months. The yield on short-term governments is now about the same as the yield on cash: zero. But the spreads between governments and privately-issued bonds are large at all maturities. The flight to quality means exactly that many are eager to trade private paper for non-interest bearing (or low-interest bearing) reserves and with the Fed's help they are doing so every day.

Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this. We care about the quantity of its liabilities.

There are many ways to stimulate spending, and many of these methods are now under serious consideration. How could it be otherwise? But monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans. It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues.

Mr. Lucas, a professor of economics at the University of Chicago, received the Nobel Prize in Economic Sciences in 1995.

Quantitative Easing: A Primer

Quantitative easing from Marketplace on Vimeo.

Why gold isn't falling in deflationary environment?

Summer inflation worry was all gone.  Now everybody is worried about deflation, including Bernanke.  So why the gold, the hedge of inflation, isn't falling? (Source: WSJ)

Many corners of the market are fearing deflation. So why is it that gold isn't selling off sharply?

As the quintessential hard asset, one that traditionally hedges against rising consumer prices, gold's trajectory these days should be downward. After all, prices for just about every other commodity, from oil to nickel to cotton, have plunged as inflation risks have seemingly abated and as investors increasingly fear deflation.

Yet, gold has largely traded between $750 and $850 an ounce for the last few months, and is up about 8% since the Fed cut interest rates to between 0% and 0.25% last week.

It hasn't been an entirely smooth ride. Gold sank amid panic this fall as investors crowded into the U.S. dollar. And it remains well under its $1,002 close back in March. But the metal hasn't stumbled nearly to the degree many other commodities have. Clearly, deflation worries aren't tugging at gold.

Instead, other factors -- historically low U.S. interest rates, U.S. dollar weakness and the longer-term inflationary pressures of the Federal Reserve throwing trillions of dollars at the American economy -- "mean the environment is favorable for gold," says Tobias Merath, head of commodity research at Credit Suisse in Singapore.

The Fed's recent actions and words -- that it will pursue unconventional stimulus such as buying agency debt, mortgage-backed securities and, potentially, longer-term Treasurys -- have pushed Treasurys to unusually low yields.

That development neutralizes a key argument against gold: that gold imposes a holding cost since it generates no interest. Now, the U.S. dollar, measured by short-term T-bill returns, effectively offers no yield either.

And while inflation isn't apparent today, stimulus packages and bailouts mean much more money in the system. That is classically inflationary. Moreover, despite efforts to sop up this liquidity later, the effects of unintended consequences might mean some portion of the trillions added to the Fed's balance sheet are likely to "stick around" to fuel inflation, says Axel Merk, who recently increased gold exposure in his Merk Hard Asset Fund and personal portfolio.

Says Malcolm Southwood, commodities analyst at Goldman Sachs JBWere in Australia, "I'm telling clients that the environment over the next five years is extremely constructive because of the inflationary risks further out."

Near-term gold could still demonstrate some weakness as the last of the panic trade peters out. And if the European Union cuts interest rates, as some expect, that could boost the dollar's value, which could undermine gold. And U.S. and European Central banks could sell gold to raise cash to pay for bailouts, which would be bearish for gold prices. But Mr. Southwood suspects Asian central bankers looking to diversify reserves would grab that supply, seeing the sales as "an alarm signal about the dollar."

And what if deflation does hit? Even that doesn't necessarily spell doom for gold, as some think. During the deflationary Great Depression, "gold preserved its value," says Matt McLennan, a lead manager at First Eagle funds, which runs a gold fund. "It preserved its purchasing power."

Yes, economists still can't predict crises

From Boston Globe:

THE DEEPENING ECONOMIC downturn has been hard on a lot of people, but it has been hard in a particular way for economists. For most of us, pain and apprehension have been mixed with a sense of grim amazement at the complexity of what has unfolded: the dense, invisible lattice connecting house prices to insurance companies to job losses to car sales, the inscrutability of the financial instruments that helped to spread the poison, the sense that the ratings agencies and regulatory bodies were overmatched by events, the wild gyrations of the stock market in the past few months. It's hard enough to understand what's happening, and it seems absurd to think we could have seen it coming beforehand. The vast majority of us, after all, are not experts.

But academic economists are. And with very few exceptions, they did not predict the crisis, either. Some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime. And, now that we're in the middle of it, many frankly admit that they're not sure how to prevent things from getting worse.

As a result, there's a sense among some economists that, as they try to figure out how to fix the economy, they are also trying to fix their own profession. The discussion has played out in blog posts and opinion pieces, in congressional testimony and at conferences and in working papers. A field that has increasingly been defined, at least in the public eye, by quirky studies explaining the economics of our everyday lives - most famously in the best-selling book "Freakonomics" - has turned decisively, in the last couple months, to more traditional economic turf. And at economics powerhouses like Harvard, MIT, and the University of Chicago, faculty lunch discussions that once might have centered on theoretical questions and the finer points of Bayesian analysis are now given over to dissecting bailout plans. Long-held ideas - about the stability of the business cycle, the resilience of markets, and the power of monetary policy - are being challenged.

more here

Great Inflation and its Aftermath

Robert Samuelson, author of "Great Inflation and its Aftermath", talks about how we got hyperinflation in 1970s, and how low low inflation since mid 1980s contributed to our longest economic boom and market boom. It's a very good review of economic history.

Listen to this interview here.


I have two lines of thoughts:

1. Smart people don't necessarily bring about smart economic policies, as mentioned by Bob in the interview. Keynesianism and big government spending dominated policy thinking in 1960s, and this was designed by a group of Nobel-winning economists. Today, we have similar situation. I hope smart people this time got it right.

2. Recently I was often wondering whether the Great Moderation is a good thing or not. It's good because it brings down inflation expectations and gives us much needed price stability; it's not so good because people since then had become so complacent about risk --- everything was levered up: banks, consumer debt and housing market. And now comes the deepest and the longest recession since 1930s. Maybe, policy shouldn't be so successful all at once and frequent small 'fire' is needed to keep people in alert.

The economics of college enrollment

How the current economy affects the enrollment of colleges, especially the private liberal arts colleges. (source: NYT)

Meyer predicts modest recovery by mid 2009

Larry Meyer, former Fed governor, founder of Macroeconomic Advisers, which provides the only monthly US GDP series, talks about the outlook of the economy.

Dr. Doom's 2009 Outlook

Roubini's recent interview on FT:

Less Mobile America

Despite the nation's reputation as a rootless society, only about one in 10 Americans moved in the last year — roughly half the proportion that changed residences as recently as four decades ago, census data show.

The monthly Current Population Survey found that fewer than 12 percent of Americans moved since 2007, a decline of nearly a full percentage point compared with the year before. In the 1950s and '60s, the number of movers hovered near 20 percent.

The number has been declining steadily, and 12 percent is the lowest rate since the Census Bureau began counting people who move in 1940.

Read more here

China 30-year reform series, Part 2

Part 2, The 30-year China and US trade partnership all worked, until it didn't.  The US now will learn to how to save more.  Meanwhile, China should rethink its development strategies.  Thomas Friedman tells an anecdotal story to illustrate this point. (Source: NYT)

I had no idea that many of those oil paintings that hang in hotel rooms and starter homes across America are actually produced by just one Chinese village, Dafen, north of Hong Kong. And I had no idea that Dafen's artist colony — the world's leading center for mass-produced artwork and knockoffs of masterpieces — had been devastated by the bursting of the U.S. housing bubble. I should have, though.

"American property owners and hotels were usually the biggest consumers of Dafen's works," Zhou Xiaohong, deputy head of the Art Industry Association of Dafen, told Hong Kong's Sunday Morning Post. "The more houses built in the United States, the more walls that needed our paintings. Now our business has frozen following the crash of the Western property market."

Dafen is just one of a million Chinese and American enterprises that constitute the most important economic engine in the world today — what historian Niall Ferguson calls "Chimerica," the de facto partnership between Chinese savers and producers and U.S. spenders and borrowers. That 30-year-old partnership is about to undergo a radical restructuring as a result of the current economic crisis, and the global economy will be highly impacted by the outcome.

After all, it was China's willingness to hold the dollars and Treasury bills it had earned from exporting to America that helped keep U.S. interest rates low, giving Americans the money they needed to keep buying shoes, flat-screen TVs and paintings from China, as well as homes in America. Americans then borrowed against those homes to consume even more — one reason we enjoyed rising wealth without rising incomes.

This division of labor not only nourished our respective economies, but also shaped our politics. It enabled China's ruling Communist Party to say to its people: "We will guarantee you ever-higher standards of living and in return you will stay out of politics and let us rule." So China's leaders could enjoy double-digit growth without political reform. And it enabled successive U.S. administrations, particularly the current one, to tell Americans: "You can have guns and butter — subprime mortgages with nothing down and nothing to pay for two years, ever-higher consumption and two wars, without tax increases!"

It all worked — until it didn't.

With unemployment now soaring across the U.S., said Stephen Roach, the chairman of Morgan Stanley Asia, Americans — "the most over-extended consumer in world history" — can no longer buy so many Chinese exports. We need to save more, invest more, consume less and throw out most of our credit cards to bail ourselves out of this crisis.

But as that happens, we need China to take our discarded credit cards and distribute them to its own people so they can buy more of what China produces and more imports from the rest of the world. That's the only way Beijing can sustain the minimum 8 percent growth it needs to maintain the political bargain between China's leaders and led — not to mention pick up some of the slack in the global economy from America's slowdown.

However, if I've learned one thing here, it's just how hard doing that will be. China's whole system and culture nourish saving, not spending, and changing that will require a huge "cultural and structural" shift, said Fred Hu, chairman for Greater China for Goldman Sachs.

In China, for instance, to buy a home you have to put at least 20 percent down, and the average is 40 percent. If you try to walk away from the mortgage, the bank will come after your personal assets. Moreover, China can't just shift production from the U.S. market to its own consumers. Not many Chinese villagers want to buy $400 tennis shoes or Christmas tree ornaments.

Also, China has no real Social Security, health insurance or unemployment insurance. Without that social safety net, it's hard to see how Chinese don't end up saving most of their stimulus. "You open up the newspaper every day and you hear about this factory shutting down or that supplier going belly up," said Willie Fung, whose company, Top Form International, is the world's leading bra maker. "You can never be too careful in this financial climate."

As such, "the world should not have a false hope that China can cushion the global downturn," by stimulating its domestic demand in a big way, said Frank Gong, head of China research for JPMorgan Chase. "The best thing China can do is keep its own economy stable."

It's good advice. China is not going to rescue us or the world economy. We're going to have to get out of this crisis the old-fashioned way: by digging inside ourselves and getting back to basics — improving U.S. productivity, saving more, studying harder and inventing more stuff to export. The days of phony prosperity — I borrow cheap money from China to build a house and then borrow on that house to buy cheap paintings from China to decorate my walls and everybody is a winner — are over.

Quantitative easing: Lessons from Japan

Quantitative Easing is not panacea.  Japan's QE popped up a bond bubble and killed money market.  These are hard lessons the Fed should keep in mind (source: FT).

By John Richards

As the recession deepens, policy rates around the world are rapidly approaching zero and they cannot go any lower. Does that mean that central bankers have run out of ammunition? Not necessarily.

With policy rates approaching zero, central banks can still impact the economy by buying government securities across the yield curve, bringing down longer term interest rates, thereby boosting the economy.

The US Federal Reserve adopted this strategy at Tuesday's federal open market committee meeting. Now, the asset (securities) and the liability sides (deposits) of the Fed's balance sheets will expand rapidly.

Support will be provided indirectly to leading sectors of the economy, such as housing, as the Fed purchases mortgage-backed securities and the debt of government sponsored enterprises such as Fannie Mae and Freddie Mac.

Because the Fed's balance sheet is set to expand almost without limit and without regard to the level of the policy rate, this policy is called quantitative easing.

But does quantitative easing work? Does it have unforeseen consequences? Japan is the only economy in recent times to have tried a full-scale version of quantitative easing for a significant period.

The Bank of Japan lowered the policy rate to zero in February 2001 and then went to quantitative easing the next month. It ended both quantitative easing and its zero interest rate policy only in 2006.

In Japan's case, the mechanics were simple. The BoJ added reserves to the banking system through open market operations and by directly purchasing government securities from the secondary market.

The size of the bond-buying operation (Rinban) became the policy tool to target the level of reserves rather than the policy rate, which was fixed at virtually zero.

The BoJ's monetary policy committee voted on the desirable level of reserves and the size of the Rinban, much as it had previously voted on the level of the policy rate.

And, when the economy deteriorated further, the BoJ increased the Rinban, pumping up reserves. At its peak, reserves reached around Y35,000bn of which only around Y8,000bn were required.

It is a matter of debate whether or not quantitative easing had much impact on the Japanese economy, even though it coincided with the longest expansion in Japan's post world war two history (2002-2007). But, I think not.

Quantitative easing was nearly irrelevant to the expansion of real economic activity that began in 2002. The expansion was largely self-financed by corporations' free cash flow and therefore not constrained by an absence of banks' lending.

Neither were there big liquidity problems in Japan to be solved by quantitative easing. Capital injections and guarantees to the banks had largely cured them well before the process began.

Money market rates were already low and their spreads were tight to the policy rate. High oil and other input prices ended headline consumer price index deflation, but the CPI less food and energy continue to be nearly flat even now.

This makes it hard to argue that quantitative easing ended deflation; high oil prices did that. Meanwhile, the economy cured on its own most of the structural problems such as excess capacity and too much debt associated with the deflationary environment.

However, the bond market during quantitative easing was anything but smooth. The process ignited a bond bubble, whose eventual collapse destabilised financial markets, even threatening Japan's hard-earned economic recovery. Long- term interest rates began to plummet in the spring 2002, with 10s reaching 0.48 per cent in June 2003, down 120 basis points over the year.

The yield curve experienced a rolling flattening in which successively longer maturities tightened down on the zero policy rate.

When the bond-bubble burst in June 2003, rates soared and the curve steepened sharply. This created what in Japan is still known as the Var-shock because of the sudden rise in yields and the accompanying jump in volatility triggered when banks, which were using similar risk management models, tried to dump Japanese government bonds at the same time.

The effects on banks' earnings were so severe that it raised concerns that the economy would be plunged back into another 1990s-style period of economic stagnation.

About all quantitative easing did on the positive side for Japan was to help the BoJ keep its independence from the politicians by giving the appearance of action.

The costs were the shutting down of the money market, although it revived fairly quickly when QE ended, and a dangerous bond-bubble, whose popping threatened the recovery and destabilised the financial system.

One of the lessons of this episode for policymakers is that while quantitative easing may help to solve the short-run liquidity problems that arise in times of extreme financial duress, it is not a substitute for some of the harder choices governments must make.

These include underwriting of systemic financial risks, e.g. by guaranteeing bank deposits, the re-capitalisation (forced or voluntary) of the banks, regulatory pressure on banks to disclose and write down the bad assets, or the pressures on businesses directly via their banks to restructure and deleverage or shut down.

A worst-case current scenario is that policymakers rushing to quantitative easing fail to understand this, giving us a bond-bubble but no permanent fixes of the underlying structural problems.

In that case, when the bond-bubble bursts, paradoxically, quantitative easing will have increased systemic financial risks instead of decreasing them.

John Richards is head of Research, Royal Bank of Scotland, Asia Pacific

Bill Miller: victim of value trap

How Bill Miller at Legg Mason consistently beat the market for over 15 years and then lost all his reputation in this crisis. (source: WSJ)

Taylor on the best stimulus to the economy

John Taylor, the author of the famous Taylor rule, discusses how to design fiscal policy to stimulate the economy.  He uses Friedman's permanent-income hypotheis to argue short-term tax rebates won't work because unless tax rebates (cuts) are permanent, consumers won't spend the received money.  The first tax rebate in early 2008 now looked like a failure (see the graph below):

 

 

Read the full text:

 

Why Permanent Tax Cuts Are the Best Stimulus

Short-term fiscal policies fail to promote long-term growth

The incoming Obama administration and congressional Democrats are now considering a second fiscal stimulus package, estimated at more than $500 billion, to follow the Economic Stimulus Act of 2008. As they do, much can be learned by examining the first.

The major part of the first stimulus package was the $115 billion, temporary rebate payment program targeted to individuals and families that phased out as incomes rose. Most of the rebate checks were mailed or directly deposited during May, June and July.

The argument in favor of these temporary rebate payments was that they would increase consumption, stimulate aggregate demand, and thereby get the economy growing again. What were the results? The chart nearby reveals the answer.

The upper line shows disposable personal income through September. Disposable personal income is what households have left after paying taxes and receiving transfers from the government. The big blip is due to the rebate payments in May through July.

The lower line shows personal consumption expenditures by households. Observe that consumption shows no noticeable increase at the time of the rebate. Hence, by this simple measure, the rebate did little or nothing to stimulate consumption, overall aggregate demand, or the economy.

These results may seem surprising, but they are not. They correspond very closely to what basic economic theory tells us. According to the permanent-income theory of Milton Friedman, or the life-cycle theory of Franco Modigliani, temporary increases in income will not lead to significant increases in consumption. However, if increases are longer-term, as in the case of permanent tax cut, then consumption is increased, and by a significant amount.

After years of study and debate, theories based on the permanent-income model led many economists to conclude that discretionary fiscal policy actions, such as temporary rebates, are not a good policy tool. Rather, fiscal policy should focus on the "automatic stabilizers" (the tendency for tax revenues to decline in a recession and transfer payments such as unemployment compensation to increase in a recession), which are built into the tax-and-transfer system, and on more permanent fiscal changes that will positively affect the long-term growth of the economy.

Why did that consensus seem to break down during the public debates about the fiscal stimulus early this year? One reason may have been the apparent success of the rebate payments in 2001. However, those rebate payments were the first installment of more permanent, multiyear tax cuts passed that same year. Hence, they were not temporary.

What are the implications for a second stimulus early next year? The mantra often heard during debates about the first stimulus was that it should be temporary, targeted and timely. Clearly, that mantra must be replaced. In testimony before the Senate Budget Committee on Nov. 19, I recommended alternative principles: permanent, pervasive and predictable.

- Permanent. The most obvious lesson learned from the first stimulus is that temporary is not a principle to follow if you want to get the economy moving again. Rather than one- or two-year packages, we should be looking for permanent fiscal changes that turn the economy around in a lasting way.

- Pervasive. One argument in favor of "targeting" the first stimulus package was that, by focusing on people who might consume more, the impact would be larger. But the stimulus was ineffective with such targeting. Moreover, targeting implied that increased tax rates, as currently scheduled, will not be a drag on the economy as long as increased payments to the targeted groups are larger than the higher taxes paid by others. But increasing tax rates on businesses or on investments in the current weak economy would increase unemployment and further weaken the economy. Better to seek an across-the-board approach where both employers and employees benefit.

- Predictable. While timeliness is an admirable attribute, it is only one property of good fiscal policy. More important is that policy should be clear and understandable -- that is, predictable -- so that individuals and firms know what to expect.

Many complain that government interventions in the current crisis have been too erratic. Economic policy -- from monetary policy to regulatory policy, international policy and fiscal policy -- works best if it is as predictable as possible.

Many good fiscal packages are consistent with these principles. But what can Congress and the incoming Obama administration do to give the economy a real boost on Jan. 20? Here are a few fairly bipartisan measures worth considering:

First, make a commitment, passed into law, to keep all income-tax rates were they are now, effectively making current tax rates permanent. This would be a significant stimulus to the economy, because tax-rate increases are now expected on a majority of small business income, capital gains income, and dividend income.

Second, enact a worker's tax credit equal to 6.2% of wages up to $8,000 as Mr. Obama proposed during the campaign -- but make it permanent rather than a one-time check.

Third, recognize explicitly that the "automatic stabilizers" are likely to be as large as 2.5% of GDP this fiscal year, that they will help stabilize the economy, and that they should be viewed as part of the overall fiscal package even if they do not require legislation.

Fourth, construct a government spending plan that meets long-term objectives, puts the economy on a path to budget balance, and is expedited to the degree possible without causing waste and inefficiency.

Some who promoted the first stimulus package have reacted to its failure by saying that we must now switch to large increases in government spending to stimulate demand. But government spending does not address the causes of the weak economy, which has been pulled down by a housing slump, a financial crisis and a bout of high energy prices, and where expectations of future income and employment growth are low.

The theory that a short-run government spending stimulus will jump-start the economy is based on old-fashioned, largely static Keynesian theories. These approaches do not adequately account for the complex dynamics of a modern international economy, or for expectations of the future that are now built into decisions in virtually every market.

Mr. Taylor, undersecretary of Treasury for international affairs 2001-2005, is a senior fellow at the Hoover Institution and a professor of economics at Stanford University.

 

 

China 30-year reform series, Part 1

In celebrating 30 years of economic reform in China, I plan to post a series of articles and commentaries on the topic.  Today, David Pilling writes on FT:

China's 'warp-speed' industrial revolution

By David Pilling

Mao Zedong was right all along. Deng Xiaoping was a "capitalist roader". Thirty years ago this week, at the catchily named third plenum of the 11th party congress central committee, Deng wrested power from the old guard loyal to Mao and launched China on the path of market reform.

Of course, history is never so clear-cut. Struggle and counter-struggle had been raging within the Communist party since Mao had died two years earlier. Deng, forced to work at a tractor factory during the Cultural Revolution because of his "rightist" tendencies, had long believed rigid communist ideology and overweening state interference were leading the economy down a dead end.

Yet today is as good a time as any to take stock. Deng's China, to this day a pragmatic blend of capitalism and communist state control, has lasted 30 years. That is one year more than Mao's China, born in 1949 with the victory of the Red Army and subsequently dragged through the madness of the Great Leap Forward and the Cultural Revolution. What have those 30 years brought to China and to the world?

A degree of economic prosperity, undoubtedly. By 1978, China had begun to recover from the brutal distractions of the later Mao years. By dint of its sheer scale, it was already the world's 10th largest economy. But annual income per capita was still pitifully low at $190, making it, according to the National Bureau of Statistics, 175th in the global pecking order. Three decades of compounding nearly 10 per cent annual growth has brought income per head to about $2,500, and much higher than that on the prosperous eastern seaboard. Although that still ranks only 132nd – other countries have not stood still either – China has become the world's fourth biggest economy, second on a purchasing power parity basis.

As a trading nation, China has gone from 27th to third. It runs trade surpluses with the US far larger than those Japan mustered in the late 1980s when one US congressman made a show of smashing a Toshiba radio cassette recorder in protest at the rising economic threat from Tokyo.

China's warp-speed industrial revolution – "a compression of developmental time" in the phrase of James Kynge, whose book China Shakes the World captures the historical significance of its rise – has transformed the global economy. Its foreign reserves, at nearly $2,000bn, are easily the largest in the world, providing the liquidity that helped inflate the global bubble. Its export of cheap goods has allowed the world to consume far more than it once did. On the demand side, China's ravenous appetite for steel, iron ore, coal, petroleum, grains, oilseeds and so on pushed prices to vertiginous heights until its abrupt economic slowdown this year helped bring them crashing down again.

Yet the process by which these astonishing changes have occurred owes as much to accident and experiment as to grand design. Deng likened his non-ideological, gradualist approach to "crossing the river by feeling for the stones". Many of the so-called market reforms were little more than giving space – often by turning a blind eye – to what China's entrepreneurial citizens were already doing. The month before Deng seized control, 21 farmers in Xiaogang village in eastern Anhui province concluded a secret pact to divide their communal land into individual farms. So daring was their act that they made provision to look after each other's children should they be arrested. A few years later an estimated 300m rural households were parcelling out land, often regaining control over plots to which their ancestors had held title for generations.

The same happened in industry, where so-called "red hat" capitalists set up private businesses in the guise of state enterprises. Many raised capital from family or underground banks. As long as such freedom created wealth and did not challenge party authority, Deng was prepared to let a hundred flowers bloom.

He and the leaders who followed him did take some top-down decisions that helped unleash China's economic potential. In 1980 he set up the special economic zones, such as Shenzen, which became magnets for foreign capital and expertise from Taiwan, Hong Kong and other free-market economies China was seeking to emulate. But other reforms went wrong. When Deng freed prices in 1988, it triggered the high inflation that was at least a proximate cause of the Tiananmen Square protests.

The Communist party appears to have brought 30 years of spectacularly smooth growth, even allowing for the statistical manipulation that sometimes occurs. But that obscures often desperate flailing as the party cranks this lever and that to produce the economic progress on which its survival ultimately depends. Beneath these shifting policies lies one inalienable understanding: "We'll give you growing prosperity, if you don't question our right to absolute power." Yet there is an inherent contradiction between exerting unyielding political control and trying to unshackle entrepreneurial creativity.

That does not mean the arrangement is under imminent – or even mid-term – threat. Both Singapore and Japan offer evidence that one party can maintain power, even without the benefit of force. But for all China's impressive economic progress, the past 30 years have owed much to cobbling together policy and struggling to reconcile contradictions. The problem with fumbling from slippery rock to rock is that there is always the danger of falling in.

Country diversification

If history and the current crisis teach us anything, one of the most important lessons is: country's development should not focus on one or two narrow strategies; just like investment portfolio, diversification in development strategies can significantly reduce country risk, putting the country on a smooth growth path.

For this reason, China should move out of its current export-led manufacturing intensive development strategy and allocate more resources to human capital development and improving the quality of its domestic institutions;  Russia should not rely too much on its natural resources; India should avoid over-specialization in services.

Because of its heavy reliance on energy export, with crude oil falling over 75% from its peak, Russia is apparently in big trouble now.

Adam Smith told us specialization is good;  but over-specialization reverses the benefits of specialization.