Monthly Archives: March 2014

The Ukraine crisis has been widely described as the most dangerous confrontation between Russia and the west since the end of the Cold War. Today’s talks between US Secretary of State John Kerry and Russian Foreign Minister Sergei Lavrov offer hope that the crisis might be defused, with the US suggesting what seems like a joint US/Russian demilitarised “protectorate” in the Ukraine, in exchange for Russian withdrawal from the Crimea.

We shall see whether that satisfies President Putin, whose recent rhetoric about Russia being “cornered for centuries” suggests that he might have much wider plans.

So far, the global financial markets, outside Russia, have been almost completely unaffected by events in the Ukraine. Initially, there was some decline in the stock markets of European economies with significant trading and banking links with Russia, including Germany, but recently these losses have been reversed.

The low probability of direct military confrontation between Russia and the west in the Ukraine is obviously key to this. Perhaps the markets also believe that the crisis will blow over without a major outbreak of tit-for-tat sanctions, beyond the limited restrictions on individuals which have been announced so far. Or perhaps they have concluded that, while the west can greatly damage the Russian economy, the same cannot happen in reverse.

What has become obvious is that the Russian economy itself is very vulnerable indeed to a worsening in the crisis. The burgeoning capital outflow since the start of 2014 has, in effect, imposed a form of economic “sanctions” on the Russian economy, without the need for western governments to take much action of their own. Western leaders clearly believe that this could turn out to be President Putin’s Achilles heel, though this reckons without the possibility that he will opt for riskier foreign adventures in an attempt to distract attention from economic weakness at home. 

When Janet Yellen was nominated to be Fed Chair in October 2013, the markets viewed her as the most dovish candidate the President could possibly have selected. Based on her decades of published economic research, that judgment seemed amply justified. At around the same time, the FOMC appeared to duck an obvious opportunity to taper its asset purchases in September. The Fed’s extreme dovishness appeared to be baked in.

However, in retrospect, last autumn turned out to be the high point for the dovish camp. Asset purchases were tapered in December; Ms Yellen quickly adopted language very close to the mid point of the FOMC, not the dovish end; and the statement after her first FOMC meeting last Wednesday led to an immediate jump of almost 15 basis points in the 5 year treasury yield.

Many commentators, including the normally well-informed Robin Harding and Jon Hilsenrath, argued that Ms Yellen had not intended to give such a hawkish signal. Viewed narrowly, that is probably right: Ms Yellen herself claimed there had been no change in policy last week.

But in a wider sense there has been an unmistakable shift in the FOMC’s centre of gravity in the past few months. The key to this shift is that the mainstream doves who have dominated policy decisions in the past few years have now essentially stopped arguing against either the tapering of the balance sheet or the start of rate hikes within about a year from now. Only the isolated Narayana Kocherlakota remains in the aggressive dovish corner.

The markets still seem entirely untroubled by this impending headwind for asset prices, but it is the new reality, unless the economy slows sharply. 

Financial turbulence continues to surround the emerging markets, raising the question whether this now morphing into a genuine EM crisis, of the type seen in previous eras of Fed tightening, including the early 1980s, and 1994-98. If so, how will it progress?

I have asked three distinguished international economists to debate this with me. They are Maurice Obstfeld (University of California, Berkeley), Alan M. Taylor (UC, Davis) and Dominic Wilson (Co-Head of Global Economics, Goldman Sachs). Each has produced leading edge research on this topic in recent years.

The entire debate is attached here, and I would encourage everyone interested in the subject to read it in full. However, since the text turned out to be fairly lengthy, I would like to offer here a summary of the main points which emerged.

Please contribute to any aspect of the debate in the comments section below. 

A few weeks ago, this blog advanced the theory that the behaviour of the major central banks, which had dominated market attention for so long, would not be the decisive element for asset prices in 2014. With the Fed, the Bank of England and the ECB all increasingly doubtful about the effectiveness of further growth in their balance sheets, the central banks had become much more circumspect about how much more monetary policy could achieve. Supply side pessimism was gaining ground.

So far, so good for this theory. The Fed has embarked upon “tapering by auto pilot”, and seems increasingly satisfied with its handiwork. A moderate recovery in GDP growth, along with much diminished risks of financial market disruption, is sufficient. They are in no hurry whatsoever to reduce the size of their balance sheet, and that could yet cause trouble; but nor do they show much urgency to return the US economy to its long term output trend.

Emergency policy interventions like QE3 in 2012 have been replaced by an atmosphere of calm. Following the example of the medical profession, they seem to have decided: “first, do no harm”. 

American optimism is irrepressible and an enormous comparative advantage for the nation. Yet the actual economic experience of the median American has been rather disappointing in the past four decades, and there is pronounced pessimism among some economists about the medium term future.

For example, Robert Gordon of Northwestern University, a very distinguished academic, specialising in long term economic growth, predicts that the real living standards of all but the top 1 per cent in the income distribution will barely grow at all in the decades ahead. In other words, the economic performance of America may not be reflected in the experience of most Americans.

Such a gloomy forecast may seem startlingly improbable to most people, but the historic experience of the vast bulk of the population has been no better than that since 1973. Over the whole of that period, median real household income has actually risen by only 0.1 per cent per annum.

There are three main reasons for this – the profits share in the economy has risen at the expense of labour income; the distribution of labour income has become much more skewed in favour of the top 1 per cent, so the median (mid point) of the income scale has grown far more slowly than the average; and the rate of growth of productivity has fallen sharply for most of the period, despite the growth of information technology.

These factors are now well known and have been much debated. But Robert Gordon’s latest work goes even further, predicting almost no improvement into the indefinite future for the vast bulk of the population.