Daily Archives: September 18, 2013

The Federal Reserve refrained on Wednesday from reducing its experimental bond purchase program, thus maintaining its unconventional support for markets and the economy. In doing so it is probably signalling more than continuing worries about America’s tepid recovery, high unemployment rate and the risk of another round of self-manufacturing problems courtesy of Congress. It may also be signalling its concern about triggering renewed financial volatility that would undermine growth, job creation and global financial stability – worries that are unlikely to dissipate easily given the different reaction functions of the economy and markets.

Starting in the last few months of 2008, the Fed successfully normalised markets whose functioning was severely stressed by the global financial crisis. It pivoted in 2010 to the more ambitious goal of using unconventional monetary policies to deliver better economic outcomes; and did so with little policy support from other government agencies with better tools, but constrained by political polarisation.

With economic outcomes repeatedly falling short of their expectations, central bankers got dragged ever deeper into policy experimentation, including an $85 billion monthly bond-buying programme (known as “QE3”). Despite all the bold and innovative policy measures, however, they are still not in a position to declare a comprehensive victory.

Undoubtedly, the Fed has provided crucial time for endogenous healing while turbocharging risk assets. However, the resulting balance sheet repair has proved insufficient to decisively pull the economy out of a low-level growth equilibrium that creates too few jobs and contributes to income inequality. Indeed, Fed officials again had to lower their projections for the economy.

In the meantime, they will worry even more about the risk of collateral damage from such highly-experimental policies (eg, the risk of fuelling excessive financial risk taking, contributing to resource misallocations, and undermining the functioning of markets).

In balancing the “balance, costs and risks,” the Fed is not yet comfortable to do what many, includingme, had expected – namely embark on a “Taper Lite” involving an initial $10bn-$15bn cut in monthly purchases. I suspect that the decision may well have been heavily influenced by how the mere mention of a taper back in May contributed to significant financial market instability, both in the US and abroad.

Essentially, the Fed is dealing with a reality that is well known to students of economics: financial markets can react a lot quicker than the real economy. So, while the Fed is focused on calibrating its gradual transition out of QE with economic conditions (the “journey”), market participants are much more inclined to rush to what they deem to be the “terminal values” (the “destination”).

This basic difference is highlighted by how, notwithstanding a broadly unchanged outlook for the economy, the 10-year Treasury bond rose by around 100 basis points after the taper talk. The interest-rate sensitive segments – which had been bright spots – are already feeling the negative impact. Witness, for example, the 14 per cent decline in home purchase applications, 66 per cent drop in the refinancing index, and 18 per cent fall in home affordability.

Given these realities the Fed is not quite ready to embark on what will be a multi-stage journey out of unconventional policy – one that will sequentially involve the taper, less accommodative forward policy guidance and then normalising the fed funds rate. This is a journey that will take a few years. It is also fraught with risk and uncertainty.

In postponing the taper, the Fed only delayed what many market participants will continue to expect. This will not alter the prospects for the economy in any fundamental manner though it impacts financial markets. Indeed, the Dow hit an all-time high just after the Fed’s policy announcement. The Fed will thus need to monitor even more carefully domestic and international reactions, particularly those with large network effects and quick feedback loops.

The Fed’s greatest challenge is not in deciding on the optimal month to start the taper, as hard as this may be. It is in balancing its focus on a carefully-crafted journey (namely a gradual, measured and conditional normalisation of monetary policy) with the markets’ natural inclination to jump quickly to the destination (thereby risking to pre-emptively impose market-determined terminal values on a still-fragile economy). Unfortunately, there is no easy way to reconcile the two, regardless of how long the first taper step is delayed.

As we mark the fifth anniversary of Lehman Brothers’ demise and the onset of the global financial crisis, we must ask: what have we learnt? How well have we done? To what extent are the persistent weaknesses in the US and Europe a result of the misdeeds of the financial sector before the crisis, the crisis itself, and the way in which the crisis was managed?

The best – and it’s a great deal – that can be said is that we avoided the worst: another Great Depression. Whether this was a result of the forceful action of governments and central bankers is an exercise in counterfactual history – what would have happened without the massive bailouts we’ll never know for sure.

What we do know is a half decade after the crisis, gross domestic product in many European countries is lower than it was before the crisis, a worse performance than in the Great Depression; that some countries – like Spain and Greece – are in depression; that labour force participation in the US is at a 35 year low; that the income and wealth of most Americans is still markedly lower than it was before the Great Recession; that the banking industry is more concentrated, the financial sector less competitive, that new abuses get uncovered almost every day, that not a single senior banking official has been held accountable, and that the financial sector has succeeded in fighting off many of the reforms that would make it more competitive, more transparent, less risky, and less prone to take advantage of ordinary citizens. We know too that the increase in debts and deficits that resulted from the downturns is now constraining actions in both Europe and the US that would enhance growth and employment.

Defenders of the massive bank bailouts suggest that now that most of the money has been repaid, there is nothing to complain about. I disagree. The state lent the banks tens of billions of dollars at close to zero interest rate, which they then lent out at higher interest rates, giving them the money to repay the government. It was an easy-to-see through shell game. Had the government demanded more of the banks, our fiscal position would have been better; had we demanded as a condition for getting our money that the banks lendmore – rather than paying out bonuses – maybe we would have had a more robust recovery. Even Hank Paulson, former US treasury security, was surprised, and offended, at the banks’ behaviour.

Though the damage done to the economy by the financial sector totals in the trillions, the financial sector should not be blamed for all the woes of Europe and America today. In part, the bubble that deregulation and low interest rates helped create masked deeper problems; but unfortunately, the crisis has made it difficult to address these.

On both sides of the Atlantic there is a need to restructure the economy, to move away from manufacturing to a service sector economy. With productivity increases in manufacturing exceeding the pace of demand, global employment inevitably decreases; and shifting comparative advantage means Europe and America will receive a smaller share of this declining global employment. Markets do not make such transitions easily – as we saw as we moved from agriculture to manufacturing; there is a need for government – just at a time when government spending is being cut back.

Both Europe and America face growing inequality – worsened by the Great Recession. Just released data from Thomas Piketty and Emmanuel Saez show that 95 per cent of the gains in the US economy from 2009 to 2012 went to the top 1 per cent. Both Europe and America face weak aggregate demand, and this growing inequality is a prime cause.

But the financial crisis has constrained the ability and willingness of governments on both sides of the Atlantic to deal with this growing inequality – an inequality for which we pay a high price, an economic price in growth, an even greater price in an increasingly divided society.

But we should be clear that the euro crisis was not fundamentally caused by the financial crisis. The flaws in the structure of the eurozone would have eventually come to the fore. The crisis simply brought them out sooner than would otherwise have been the case.

Misguided ideas shaped the economic agenda in the years before the crisis. Ideas about limited government led, ironically, to the largest government interventions in the history of mankind. But the same ideology and ideas that prevailed before the crisis have held enormous sway in the years after the crisis: not surprising, since large inequalities of economic power lead to large inequalities in political power. The result is a world which is in some ways safer, in other ways riskier – but a world in which we have postponed doing anything about the fundamental problems we confront.

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