Monthly Archives: December 2013

The British and French have a remarkable ability to irritate each other. That skill was demonstrated again recently when Jean-Marc Ayrault, the French prime minister, was asked on television why he was not prepared to take a leaf out of the British book and adopt the UK coalition government’s policies on cutting public sector pay and jobs. His response was firm, not to say aggressive. The Cameron government’s policies have, he asserted, created “mass poverty” and social inequality on a huge scale, of a kind which the French would never find acceptable. And he reminded the viewers that unlike France the UK had still not yet recovered output lost in the great recession.

This latest outburst is in a long line of criticisms elaborated by President François Hollande, and indeed Nicolas Sarkozy before him, both of whom believe that “Anglo-Saxon” governments, economists and credit rating agencies exaggerate French economic weakness. David Cameron’s promise to roll out the red carpet to welcome French entrepreneurs escaping punitive tax rates added fuel to the flames. And it is true that certain elements of the British press are assiduous in peddling a negative view of France as a latter-day Soviet Union, clinging to an outdated economic model.

If we look below the rhetoric, which side has the better of the argument?

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Beijing is using tactics drawn from Josef Stalin’s 1930s playbook in order to crush any form of dissent by the Uighurs, the country’s biggest Muslim ethnic minority, who live in the far western Chinese region of Xinjiang.

On December 16 in a clash in a village near Kashgar, Xinjiang’s southern city and ancient capital, 14 attackers and two policemen were killed in a gun battle in which the Uighurs were said to be only armed with knives and axes. The Chinese government blamed extremist Islamist terrorists linked to al-Qaeda. The World Uighur Congress, a Munich-based advocacy group, said it was the police who opened fire on protesters, stating that, “the abusive use of force by authorities in the area has deprived the Uighurs of their right to live”.

Like so much else in an opaque central Asia there are always two unverifiable and completely different stories to any political event.

This attack follows numerous others on Chinese security forces in Xinjiang and the first-ever suicide attack in Tiananmen Square in Beijing on October 28 when a car loaded with petrol cans and driven by three Uighurs exploded after driving into an entrance into the Forbidden City. Five people were killed including the perpetrators and more than 40 injured. Following this incident there were large-scale arrests of Uighurs in Beijing and other cities.

The largest death toll to date was in July 2009, when at least 200 and possibly up to 400 people were killed in days of rioting and street battles between Uighurs and Han Chinese in the Xinjiang capital Urumqui.

Beijing accuses the fringe East Turkestan Islamic Movement of being behind the attacks. The Chinese say this Islamist group, that has bases in neighbouring Afghanistan and Pakistan and also has close links to al-Qaeda, is involved in global jihad and wants to separate Xinjiang from China. However, historically the largely secular Uighurs, who practice a moderate form of Islam, have had nationalist movements for greater autonomy and even independence, rather than movements in support of Islamic extremism.

But there is little doubt that Pakistani extremist groups have encouraged Uighurs to train and fight with the Afghan and Pakistani Taliban, while other Uighurs have been closely involved in the drugs trade – smuggling heroin out of Afghanistan for the Chinese market. Privately China has come down hard on both Pakistan and Afghanistan to root out Uighur militants on their soil.

The Uighurs, a Turkic-speaking group who once ruled a vast empire in central Asia, are particularly bitter that ever since the 1950s Beijing has been moving millions of Han Chinese into Xinjiang turning the Uighurs into a minority in their own homeland. The Han take the best jobs, housing and education facilities.

There has been widespread repression of Uighur and Islamic sentiments. The latest Chinese measure according to the Reuters news agency is a November announcement that Uighur college students will not graduate unless their political view are approved by the authorities, who admit that they are in “a life-and-death struggle” for people’s minds.

This is all incredibly similar to the brutal tactics that Stalin used in the 1930s in central Asia to try to crush people’s belief in Islam and prevent them performing traditional Muslim rites. Stalin clamped down hard on all religious practices and rites such as public prayers and fasting. Mosques were few and far between and the state-trained Ullema were considered by the public to be government stooges. Islam and its rituals went underground where they continued to flourish.

When I travelled in Soviet central Asia in the 1970s and 1980s, Muslims celebrated Islamic weddings, funerals and circumcision ceremonies at midnight to avoid being harassed by the police. Senior Communist officials, who were born Muslims and were supposed to crack down on such ceremonies, often secretly took part in them for fear of losing contact with their family or clan.
So when perestroika or the openness policy of Mikhail Gorbachev was initiated, Islam quickly surfaced as a deeply popular religion despite 70 years of suppression. However, past resentments also welled up and led to the creation of central Asian Islamist extremist groups.

Many of these Stalinist measures, which so obviously failed in the Soviet Union, already exist in Xinjiang. Students are forbidden to fast during term time, prayer time is limited and public prayers are not encouraged. The old medieval Muslim parts of Kashgar are being bulldozed and replaced with concrete tower blocks. The old bazaar has virtually vanished. Therefore it is not surprising that religious-minded youth are finding their way in ever-increasing numbers to the Taliban camps to the south.

The lesson Stalinisation taught about trying to suppress religion is that it does not work. Today’s watered down version of Chinese Communism, with its heavy consumer bias, can certainly co-exist with religion. Islam only becomes a threat when Muslims are repressed and treated as third class citizens.

September 11 2001 awakened the world about the threat from religious extremism but also alerted us to the need for tolerance and understanding of all religions. Unfortunately in the land that possesses one of the world’s oldest civilisations, the mistreatment of religious belief grows.

The writer is the author of ‘The Resurgence of Central Asia’ and ‘Jihad, the rise of militant Islam in Central Asia’

With equity markets reacting enthusiastically to the Fed’s historic policy change announced last week, many have rushed to declare victory. Whether in asserting investor comfort with the policy regime shift or in declaring the definitive end of dependence on quantitative easing (“QE”), they believe that the markets’ short-term reaction can indeed be extrapolated into the longer-term.

Compare this with what we have been hearing from central banks. Reactions there have been quite muted. Humility may well be a factor, especially given that three prior attempts to “exit” earlier versions of QE regimes had to be abandoned. But there may well be more at play. Central bankers have good reason to be more cautious about declaring victory at this stage. And the rest of us would be well advised to ask why.

As widely reported last week, Fed policy makers decided to reduce – or “taper” – the purchases of securities. The first step, to be implemented in January, lowers the monthly market intervention from $85bn to $75bn by cutting equally both mortgage and Treasury purchases. Moreover, Ben Bernanke, outgoing Fed Chairman, signalled that – assuming there are no major economic surprises – we should expect the Fed to consistently reduce its purchases throughout 2014. So much so that, if all develops according to plan, the Fed could well terminate QE3 by the end of the coming year.

Unlike between May and June when the mere mention of the word “taper” severely disrupted markets, the Fed’s announcement this time did not stop just at taking away a measure that is widely believed to have significantly bolstered asset prices and, to a lesser extent, helped the real economy too. Our central bankers adopted compensating measures by providing greater assurances that policy interest rates would remain floored for quite a while. They have also hinted at additional measures should interest rates behave erratically – such as cutting the interest that the Fed pays banks on excess reserves.

Equities and other risk assets have soared in reaction to the news. After all, investors now have a clear road map for Fed policies, thus reducing a component of the uncertainty premium. Moreover, it is highly reassuring that the Fed remains committed to supporting the economy through the “asset channel.” And all this is taking place in the context of an improving economy as evidenced by the strong employment report and the upward revision in GDP growth.

While most Fed officials will welcome the markets’ favourable reaction – and especially so after the May-June shock – I suspect that they are much more cautious. Indeed, there are four reasons why such caution is understandable.

First, the impact of Fed policy remains overly dependent on using artificially-high asset prices to alter household and company economic behaviour. Other transmission mechanisms, including the credit channel and the deployment of cash in real economic investments, remain muted. Accordingly, concerns about financial soundness will persist until the Fed witnesses improving economic fundamentals that validate artificially-elevated asset prices.

Second, the Fed is entering a more uncertain policy phase due to its ongoing instrument pivot – namely, less reliance on a direct measure (monthly purchases) and greater reliance on an indirect one (impacting behaviour through forward policy signals). Issues regarding the degree of effectiveness and control could well come to the fore. Just witness the recent sharp upward moves in the 5-year US Treasury yields, along with other intermediate maturities.

Third, those at the Fed who follow closely market positioning will probably recognise that equity markets are currently in the grips of very favourable technicals; and, judging from history, such technicals can lead to price overshoots whose reversal can be quite disruptive.

Finally, the Fed is not the only central bank that has been active in maintaining economic and financial tranquility and, to this end, continuously bolstering asset prices; and it is not the only institution that has been forced to rely on imperfect instruments to fulfil this task.

The European Central Bank and the Bank of Japan are in the same boat. And they, too, face tricky policy issues ahead, with success also ultimately dependent on the overall ability of their economies to overcome the trio of inadequate aggregate demand, insufficient supply responsiveness and residual debt overhangs.

After a couple of false starts, Fed officials have impressively won the first big battle in implementing a gradual orderly exit from QE3, a highly-experimental measure whose longer-term consequences are not fully known as yet. They are yet to win the war.

Meeting in Brussels on Friday, European leaders addressed defence cooperation at an EU Summit for the first time since 2008. The timing of the discussion was propitious, coming at a time when European concerns about America’s commitment to transatlantic security and engagement had grown significantly as a result of Washington’s announced pivot to Asia and President Barack Obama’s hesitancy over Syria earlier this summer.

If ever there was a time when European leaders would need to demonstrate their willingness to do more on defence, this was it. And, indeed, the leaders rightly concluded that “defence matters.” They agreed to cooperate more closely on defence, including by increasing the effectiveness of their common security and defense policy, enhancing defense capabilities, and strengthening Europe’s defense industry.

These are important commitments. The EU is uniquely capable of bringing military, diplomatic, financial, trade, and other resources together in addressing security problems, and further developing ways to enhance comprehensive approach makes sense. So, too, does focusing development efforts on critical enabling capabilities, like medium- and high-altitude drones, air-to-air refueling, satellite communications, and cyber defence. As the operation in Libya demonstrated, Europe’s lack of these capabilities hampered independent military action. And strengthening defence industrial cooperation makes sense at a time when national industries cannot be sustained by a declining national demand for defense goods and services alone.

Yet, while all these are useful steps, they will affect Europe’s overall defence capabilities only at the margins. On the real issue – more spending – the silence of Europe’s leaders was deafening. While better cooperation – more pooling and sharing of capabilities, better industrial collaboration, improved planning of operations and missions – can help, the real problem facing European defence is the decline in spending, and nothing that happened in Brussels suggested a change in that dominant trend anytime soon.

It must be noted that the decline in defence spending has been going on for quite a while, now. At the beginning of this century, defence spending by non-US NATO countries still amounted to two per cent of these countries’ gross domestic product. By 2007 – a year before the financial crisis, mind you – that percentage had dropped a quarter, to 1.5 per cent of GDP. In 2012, non-US NATO spending on defence had declined to just 1.3 per cent in GDP.

Not only has the overall level of defence spending been cut by one-third over the past decade, but investments in future capabilities have suffered even more. Over the past decade, European countries have become increasingly involved in military operation – from Iraq to Afghanistan, from counter-piracy operations in the Gulf of Aden to stabilisation missions in western Africa and the bombing campaign over Libya. However, rather than raising defence spending to pay for this increased operational involvement (as the US did, dramatically), European countries decided to pay for these added costs with funds originally allocated to buying and investing in new equipment.

So future European defence capabilities suffered a double whammy this past decade: not only did overall spending decline sharply, but an increasing amount of what remained went to pay for current operations rather than to invest in future capabilities. Not surprisingly, the US spends three times as much as Europe on equipment, four times as much per soldier, and seven times as much on defence research and development. In other words, the gap between European and American capabilities is big, and getting bigger.

Thirty months ago, in his farewell speech in Brussels after serving six years as US secretary of defence, Robert Gates warned Europeans of the “blunt reality … that there will be dwindling appetite and patience in the US Congress, and in the American body politic writ large, to expend increasingly precious funds on behalf of nations that are apparently unwilling to devote the necessary resources … to be serious and capable partners in their own defense.” Nothing in the past two-and-a-half years would suggest that this blunt reality has changed. If anything, American appetite and patience has continued to decline.

That is why, it is so unfortunate, even if not exactly surprising, that European leaders meeting to discuss defence issues for the first time in more than five years failed to address the real issue of spending more on their own security and defence. In choosing to turn a deaf ear to the real issue of defence resources, European leaders seem once again to assume that their security can be bought on the cheap or paid for by someone else. That may well prove to be a costly – and dangerous – assumption.

Flags of the EU member states fly in front of the European Parliament in Brussels

For a few years now, I have felt as if I live intellectually in the Alps. In the European Council, I used to translate the virtues of discipline into Mediterranean languages, while also interpreting for northern countries the difficulties felt by southern Europe.

A mutual learning process is now essential. The south, as it adapts to the social market economy, must be more determined in pursuing fiscal discipline and structural reforms. Likewise the north, Germany in particular, must appreciate that such efforts by the south are unlikely to generate sustainable improvements unless Europe’s policy framework becomes more growth-friendly.

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When the EU acknowledged in May that Italy, after two years of tight fiscal policy, no longer needed to be under the EU’s “excessive deficit procedure”, it was seen in the country like a release from prison. Although the exit reduces interest rates, and so has a favourable effect on the budget, this interpretation was mistaken. Some in Italy even saw the decision as an EU admission that it had been too tight-fisted to start with. Others jumped straight into discussions on new ways to spend money, as if freed from budgetary constraints intended to safeguard stability and protect future generations.

In fact, achieving stable and sustainable budgetary conditions will require southern countries to make cultural adjustments. In particular, people must accept that budgetary discipline pays. Policy makers will need to persuade people that fiscal discipline is not a forced tribute paid to gods residing in more northern parts of Europe. It is simply appropriate economic behaviour.

Northern Europe must also give something: a deeper understanding of the role of investment in economic activity. The Maastricht treaty did not distinguish sufficiently between public expenditure for consumption and for investment. Consequently, many European countries have achieved budgetary discipline through disproportionate cuts in public investment, which is usually politically less painful – though more damaging – than cutting public current expenditure.

Of course, it is not easy to distinguish among different sorts of public investment – whether productive investments or pseudo-investments (as when a government transfers funds to state-owned companies to cover their current losses). Definitions and measurement need serious work. Yet this alone does not justify assuming that all public sector investment is essentially like consumption, or lacks any economic merit and productive purpose, which is what is done if the pact is taken at face value.

Now that the south is moving closer to the economic and fiscal concepts of central and northern Europe, it is encouraging to see that the European Commission and the European Council – and perhaps even Germany – are more willing to enforce the pact more meaningfully.

But what about structural reforms? Although they have come to be recognised as a top priority, more nations have succeeded in adjusting their budgets than in reform. There are two reasons for this.

The first concerns the game of pitting government against organised interest groups. The task of government is harder when reforms directly affect the interests of well-organised groups, businesses, professionals or public sector employees. Such steps will usually inject competition into a market, wiping out comfortable rents for specific groups. The effects of budgetary measures such as tax rises are, by comparison, more diffuse.

The second reason is that Europe provides less help on the more important task: structural reforms. The focus of European monetary union has been on obtaining budgetary discipline.

Ultimately, this boils down to a simple rule of thumb: if you meet stronger opposition to structural reforms domestically, and receive less of a push from Europe on this than on budgetary consolidation, the likelihood is that you will make less progress on structural reforms.

That is why I welcome the recent reorientation of EU policy – not away from fiscal discipline but towards emphasis on country-specific recommendations on structural reforms, for example to make labour markets more flexible. When I was a member of the European Council, I favoured the idea of contractual arrangements between the commission and individual countries on specific reforms as the way forward. This strengthens the influence of the EU on governments and strengthens the hand of each government in relation to domestic organised groups, all in the interest of achieving structural reforms.

Coupled with mechanisms to facilitate the financing of the reforms in countries that still face high borrowing costs but are pursuing the policies recommended by the EU, these arrangements may help to push Europe towards further reforms to promote growth and employment. The European Council of December 19-20 will, I hope, endorse this.

The writer is former Italian prime minister and chairman of the Berggruen Institute on Governance’s Council for the Future of Europe

Job done, at least for now. Ben Bernanke and his colleagues at the Federal Reserve will be delighted at the market reaction following their monetary “pincer movement” on Wednesday. The Fed will taper its asset purchases by $10bn a month in January – down from $85bn to $75bn a month – with a strong hint that further tapering will occur as 2014 progresses.

At the same time, however, the Fed has strengthened its “forward guidance” message. Simply put, America’s central bank is promising low interest rates for longer. If the Fed’s forecasts are to be believed, rates will now be 25 basis points lower than previously projected at the end of both 2015 and 2016. Mr Bernanke has even managed to ease some of the tensions that had muddied the Federal Open Market Committee’s message over recent months. Those members who had previously offered a more hawkish view on interest rates appear to have had their talons trimmed.

We have, thus, shifted from one course of monetary drugs to another. The side effects from quantitative easing were becoming troublesome: the Fed’s rapidly-expanding balance sheet was raising eyebrows in Congress; financial assets were becoming ever-more expensive even as the pace of economic recovery remained lacklustre; and hot money flows globally were reigniting imbalances in parts of the emerging world. The Fed recognised much of this earlier in the year but, at that stage, hadn’t quite worked out a strategy to avoid the onset of post-QE cold turkey. With the imposition of forward
guidance, Mr Bernanke has prescribed the economic patient a new set of monetary pills.

But just as QE came with side-effects, might we eventually discover that forward guidance also has its problems? After all, it only really works if members of the public believe the central bank’s view of the future and if those members of the public believe that other members of the public also believe the central bank’s view of the future (in other words, it works on the basis of Keynes’ beauty parade). At the very least, then, forward guidance is a fragile exercise in second-guessing.

Guessing, however, is not a good foundation for monetary policy. Despite the Fed’s best efforts, however, it’s difficult to see how guesswork can be removed altogether. Before the financial crisis, central banks were keen to offer maximum monetary “transparency”. Forward guidance and transparency, however, are not happy bedfellows.

The opaque nature of forward guidance relates in part to time and economic reality. Is forward guidance a promise not to raise interest rates until a certain date or, instead, is it a promise not to raise interest rates until certain economic conditions are met? The Fed’s statement suggests the latter. Defining those conditions, however, is hardly straightforward. We now learn that the 6.5 per cent unemployment rate threshold is only a “soft” target, with the FOMC judging that “it likely will be appropriate that to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 per cent, especially if projected inflation continues to run below the Committee’s 2 per cent longer-run goal”.

That all sounds very dovish. What the Fed has not clarified, however, is the causal relationship between unemployment and inflation, a relationship that depends on the nature of the western world’s post-financial crisis economic funk. Typically, we tend to think that inflation is a lagging indicator relative to unemployment: demand picks up,
the jobless rate falls, wages accelerate and prices eventually rise. On that basis, a big drop in unemployment is an early warning sign of higher inflation in the future, leading markets to anticipate a tightening of monetary policy.

In a post-financial crisis world, however, the causality may be reversed. Weak credit growth – reflecting either a weak banking system or persistent deleveraging – pushes inflation below target which, in turn, raises real interest rates (at the zero rate bound), pushes up real levels of debt and triggers further deleveraging. Under those circumstances, a fall in unemployment might be merely a cyclical accent within a story of underlying structural decline. This, after all, was the Japanese experience in the mid-1990s, when a modest economic recovery did nothing to prevent deflation from taking hold.

Which of these stories is relevant for the US is, at this stage, unclear. And that, ultimately, is the weakness with forward guidance. The Federal Reserve can’t make convincing promises because, like the rest of us, it doesn’t have a perfect crystal ball. But if those promises aren’t convincing, it’s not clear whether the real economy risk aversion which has
limited the pace of recovery in the US will go away any time soon.

The writer is HSBC’s chief global economist and author of When the Money Runs Out

As on past occasions, the agreement reached by eurozone finance ministers on the single resolution mechanism will officially be saluted as a big step towards a fully-fledged banking union. But many will be disappointed because the agreement falls short of expectations.

The mechanism is unsatisfactory from several viewpoints. The decision-making process is cumbersome and involves too many bodies. The funds are insufficient to tackle a big banking problem. The ability of the mechanism to borrow in the markets is still unclear. The period of transition to the final system is too long, at least compared to the frequency of banking crises. Overall, the separation between banking and sovereign risk – which was the main goal of the union – has not been achieved.

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North Korea’s formerly powerful number two, the ill-fated Jang Song Thaek, was very publicly and brutally executed, along with key aides — either as part of leader Kim Jong Un’s plan to consolidate his unrivalled power; as retaliation for fomenting a military coup against the boy leader; or as punishment for simply “not clapping with sufficient enthusiasm” (as mentioned in the litany of charges against him).

The state’s propaganda organs were in rare form when they denounced him: “Despicable human scum Jang, who was worse than a dog, perpetrated thrice-cursed acts of treachery,” pronounced the official news agency. “Every sentence of the decision served as a sledgehammer blow brought down by our angry service personnel and people on the head of Jang, an anti-party, counter-revolutionary, factional element and despicable political careerist and trickster.”

The problem with closed, totalitarian states is that we cannot truly know why things happen. Jang’s sentence was handed down perhaps because of some combination of the above – or it could have been because the “Great Successor” (as Kim Jong Un is occasionally called, to remind all of his lineage) did not like the look in his eye during a sideways glance at a military parade. This macabre exhibition both appals us and draws us to look more closely: how is this Asian hybrid of Hobbes and Orwell even possible in 21st century northeast Asia, the veritable cockpit of the global economy?

Jang was seen in China and in the South Korean security establishment as a kind of human bellwether for North Korea’s trajectory. How he went would tell us how the country goes. He had long been viewed as the most experienced, cosmopolitan member of the elite — and the one best positioned to perhaps help embark the cloistered country on a path towards gradual opening and reform. Married to the aunt of Kim Jong Un and bestowed with military honours and privilege, he was regarded by some as almost family, which did not save him from the executioner. In truth, he was the favoured son of China, the only senior official in Pyongyang in whom Beijing had any confidence or indeed hope. Now that he has been dispatched, the anxiety levels have crept up perceptively along Beijing’s corridors of power.

There are indications that China has grown steadily more concerned by the brutal goings-on in Pyongyang and the provocations staged against its neighbours. Jang’s elimination will only add to the worry. The repeated nuclear tests, the sinking of a South Korean warship, the shelling of disputed island territories, and repeated missile tests and military exercises have dialled up tensions in China’s immediate neighbourhood. They have served as the driving force behind defence modernisation and military deployments for the US and its friends – certainly not in a rising-China’s best interests. There have been many reasons posited for China’s reluctance to entertain regime change in the North. There is, of course, the desire to maintain a kind of buffer state on its periphery, and the fear of instability immediately on the border. There is also the very reasonable fear of North Korean instability triggering the intervention of outside powers, with the potential for profound geopolitical miscalculations and large armies clashing.

But there is also, in all likelihood, a kind of recognition and form of empathy in Beijing for the bizarre machinations and public trials of Pyongyang. Strip away the hereditary power transitions and unique qualities of juche (a North Korean concept of self-reliance verging on deprivation), and North Korea most resembles Stalin’s Russia or Mao’s China going through the horrors of the cultural revolution. Surely it would be painful – even for the current generation of modern, technocratic Chinese leaders – to consider abandoning a fraternal progeny, even one as horribly deformed and so belonging on the ash heap of history as North Korea. No, China will not cast away its ideological cousin and comrades from the Korean war, but instead continue to counsel patience, gradual reform and restraint – and, bluntly put, hope for the best.

Jang obviously did not survive this hoping for the best, and looks remarkably like an Asian version of Arthur Koestler’s protagonist in Darkness at Noon. Jang, like the old Bolshevik Rubashov, probably had an inkling of his destiny. Before he is carefully excised from all the photographic history of North Korea, examine one of the few existing pictures of Jang with Kim Jong Un. There he is at a factory site with the young genius still with his baby fat, standing just in the background, uncomfortable, knowing his ultimate fate, but still hoping for the best.

I can perform only one magic trick, and it is not a really good one. It involves making a small object, like a coin, disappear.

This rather feeble trick usually works only once on people. And, like other magic tricks, the key is to divert attention during a critical transition phase. Accordingly, you will find me making lots of hand movements and speaking loudly to obfuscate the fact that the coin is being “secretly” transferred either to my pocket or to a sleeve.

At times, policy makers find themselves in the role of magicians, especially when they are pivoting from one well-accepted policy stance to another less certain one. In fact, this is what the world’s most powerful central bank, the US Federal Reserve, will be doing in the next few weeks – perhaps as early as next week (a 50/50 chance), more likely in January and most definitely by the end of March.

As signalled already by Fed officials, and as nearly implemented in September, the central bank is on the verge of altering its policy mix in a material fashion – gradually reducing its reliance on monthly asset purchases (which have been held unchanged at $85bn since the announcement a year ago) and relying more on indirect tools. Put another way, the Fed is seeking to maintain its support for the US economy and markets while reducing the use of a highly experimental tool that, many believe, risks longer-term collateral damage and unintended consequences.

As it is already way deep into unchartered waters, the Fed will be taking this new policy step without the benefit of meaningful historical experiences, tested analytical models or a widely-accepted policy game plan. Accordingly, its initial success will depend in large part on the skillful management of expectations in the private sector – namely, maintaining the private sector’s focus on what the Fed is doing to support the economy and markets, and away from the stimulus that is gradually being taken away.

The importance of the Fed offering something in exchange for the “taper” announcement was vividly highlighted by the experience of the highly dislocated markets in May and June. At that time, investors were alarmed by the mere mention of the word – so much so that, fearing that the Fed would prematurely reduce its exceptional support, they sent virtually all asset prices sharply lower. In the process, they tightened the economy’s “financial conditions”, thus undermining an already-tentative growth and job recovery.

At that time, the Fed had no choice but to react and play massive defence. In July, it clarified its previous communications, including correcting potential misunderstandings on the part of the private sector. It went even further in September when it decided not to taper when most had been conditioned into expecting a modest cut in monthly purchases.

This time around, look for the Fed to be less reactive and much more proactive. Accordingly, in announcing the change to its policy mix, it will likely combine the taper with other (and even more experimental) measures that signal its intention to remain supportive.

Positioned under the impressive and mysterious label of “optimal control”, look for the Fed to strengthen its forward policy guidance, enhance the comprehensiveness of the threshold variables, and reduce the interest it pays banks on excess reserves. In other words, it will seek to minimise any harmful effect from the taper through a firmer anchoring of interest rates on short-dated bonds and by encouraging banks to lend to the real economy.

In purely analytically terms, the Fed will be starting the transition from more to less direct involvement in financial market price formation; and it will do so for both positive reasons (the US economy has been gradually improving) and negative ones (concerns about the potential political, economic and financial risks – real and perceived – of a large and consistently-growing Fed balance sheet). In the process, the overall potency and predictability of its policy stance will likely come down.

While the relative call is clear, the absolute one is not. Specifically, it is debatable whether this new policy mix will be as effective in buying time for the real economy to heal further while, simultaneously, bolstering financial markets as a way of encouraging households to spend (what economists call “the wealth effect”) and companies to invest (triggering “animal spirits”). The related concerns are amplified by the extent to which prolonged Congressional polarisation has paralysed policy making in virtually every other area of importance to the economy.

By following a basic rule of magic, the Fed will look to divert the private sector’s attention from this sad reality for as long as possible.

The writer is the chief executive and co-chief investment officer of Pimco

The let-down that China watchers felt when the much anticipated summary communique came out of the third plenum of the Communist party was soon overridden by the ambitious agenda laid out in the subsequent “decision” document. Despite the vagueness of the communique, the “decision” provided a comprehensive reform programme that, if acted upon, will absorb the energies of this generation of senior leaders and beyond. Ironically, rigorous implementation of these reforms will alter market incentives so that annual gross domestic product growth in the coming years could rise to 8-plus per cent even as the recent Central Economic Work Conference debated whether to lower the official target to 7 per cent to reinforce that quality now matters more than quantity.

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Much is made in the west of the supposed enigmatic qualities of the east and generally that sentiment really tells us more about a lack of knowledge among westerners than about the complexities of things Asian. However, Thailand may be an exception. Even the most astute observers are regularly caught off guard by political developments inside the kingdom.

I remember speaking to one of America’s most respected Thai specialists seven years ago just before the coup against former prime minister Thaksin Shinawatra, and he sagely advised that all was stable in Bangkok and there were no threats to his popularly elected government. Two weeks later, on September 19 2006, the army was in the streets and the military took power, repeating a tragic pattern that has bedevilled Thailand’s politics for decades.

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Both the UK and Japan would like to see sustained economic recoveries but, until recently, the recoveries they craved were fundamentally different in nature. The UK ideally wanted an export-led recovery supported by plenty of productive investment. The financial crisis provided the perfect opportunity to wean the UK off the housing-led, debt-financed consumer booms of old. Japan, meanwhile, hoped to see a shift towards a consumer-led recovery, helped along by an end to the deflationary curse which had persuaded the Japanese to hoard cash and repay debt.

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As economist Robert Triffin explained more than 50 years ago, the development of an international reserve currency requires that the issuing country or area records a current account deficit. This partly explains why the yen and the Deutschmark did not develop an equivalent role to the dollar, in spite of the relative strength of the Japanese and German economies. The eurozone economy is now in the same position.

The eurozone countries have adjusted, during the financial crisis, from running a broad external balance, which prevailed until 2010, to a rising surplus (2.7 per cent of gross domestic product in 2013, up to 3 per cent in 2015). Only Estonia, Greece, France, Cyprus and Finland are still expected to have a slight deficit this year. Spain, Italy, Malta, Austria, Slovenia, Portugal and Slovakia have moved from deficit to a surplus.

The fact that the eurozone records a surplus in the trade of goods and services with the rest of the world may be considered appropriate for an ageing society. The accumulation of net assets with the rest of the world is a way to smooth consumption over time.

However, this situation is inconsistent with the desire of the rest of the world to invest part of its savings in the eurozone, given the reserve status of the euro and international investors’ diversification of their portfolios away from the dollar. This strong demand is not being met by a sufficient supply of assets by the eurozone, which is a net exporter of capital.

In the current global financial environment, the status of reserve currency cannot be imposed by the monetary authorities. It is largely determined by the decisions of international investors. The international role of the euro gradually increased after the start of monetary union but stalled in the midst of the euro crisis. More recently, however, as international investors have regained confidence in the ability of the eurozone authorities to muddle through and ultimately avoid a collapse of the single currency, the demand for euro assets has recovered, putting upward pressure on the exchange rate.

The rising eurozone external surplus is magnifying this effect, by reducing the net supply of euro-denominated assets. The combination of rising capital inflows from the rest of the world and higher eurozone current account surplus is creating a new tension in global financial markets, which may distort the valuation of the European single currency. This represents a threat for the economic recovery in the euro area.

There are no easy solutions. A reduction of the financial market fragmentation within the eurozone would certainly help, but only at the margin because the countries that in the past experienced external deficits cannot afford to increase their external debt again. The surplus countries would have some margins to reduce their net savings, but their current policy preferences do not signal any change in that direction. The eurozone could discourage the inflow of capital, but it is difficult to see how this could be achieved without imposing capital controls, as some emerging markets have done.

Short-term capital inflows in the euro area could be discouraged by imposing a negative interest rate on deposits at the central bank. This measure would also encourage eurozone financial institutions with excess liquidity to look for international investment opportunities.

Another possibility could be for the European Central Bank to stop its policy of reabsorbing back the liquidity issued against the purchase of Italian, Spanish, Irish and Portuguese bonds under the Securities Market Program which was conducted in 2010-11. These operations are currently conducted through weekly tender operations. Their termination would release about €180bn of liquidity in the money market. It would create a further incentive for eurozone institutions to lend to each other and to invest in external assets, thus alleviating the pressure on the euro.

If the sterilisation operations were still considered necessary, for window-dressing purposes, they could nevertheless be implemented in a more flexible way – allowing, for instance, counterparties to use foreign currency. This would contribute to absorbing the increasing foreign demand for euro-denominated assets. The maturity of these operations could also be extended, to meet international investors’ preference.

If these instruments prove not to be sufficient to curb international investors’ excess demand for eurozone assets, more drastic measures might be needed, following what other central banks have done. The recent sharp reduction in the size of the ECB’s balance sheet, while that of all other central banks is increasing, is not consistent with the fragile state of the eurozone economy nor with an inflation rate that is increasingly deviating from price stability.

Overall, the eurozone is in a unique situation. It is the issuer of the second-most important currency, whose demand by the rest of the world is on the rise. At the same time its trade surplus with the rest of the world increases. This requires innovative solutions.

The writer is a former member of the executive board of the European Central Bank, and currently visiting scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome

Beijing’s declaration last week of a special air defence identification zone above disputed islands in the East China Sea and the surrounding waters claimed by Japan and China is a clear escalation of an already dangerous situation. It might be tempting for commentators at this stage to digress into describing the torturous history of the disputed Chinese or Japanese sovereignty over these uninhabited rocks, to provide context for how the two great nations of Asia have virtually drawn daggers over barren island territories in a distant corner of the Pacific Ocean. Yet, the deeply unwise and provocative new Chinese decree of unspecified military measures in the event of unauthorised entry into this airspace has served to dramatically broaden the regional context of this bilateral stand-off. Continue reading »

One system believes in limiting how much power money can buy and imposes redistribution mechanisms to counter inequalities of opportunities and outcomes. The other throws the weak out of the premier stratum of society, and uses large income distribution to perpetuate dominance and power structures.

No, I am not referring to the socioeconomic systems pursued by different countries. Nor am I referring to some grand academic experiment to test whether high growth with redistribution is indeed feasible. Instead, I am talking about the contrast between professional sports on the two sides of the Atlantic Ocean.

Continue reading »

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