Tam: Year-end Review

As the year winds down, and most have departed for their winter holidays, I decided to review some of the themes I have explored to see how events have unfolded since.  In general, I have been more optimistic than the apparent consensus on the likelihood of a recovery in the US economy, the prospects of a resolution of the strains of the Eurozone, particularly so on the possibility of Italy making it through the debt-mire to the other side. While I initially argued that global equities were ensconced in a bear market, I later revised this view and embraced a slightly more constructive outlook towards equities as an asset class.  Although I did not hold out much hope for a major breakthrough at the Durban Climate summit, I continued to envisage substantial promise for renewable energy technologies.  But I also view the prospects of a hard-landing in China as potentially problematic for the global economy.   And, obliquely, I have referred on a few occasions to the downside of quantitative easing (QE) which is the Central Banks’ weapon of choice in combating sub-par economic performance in a number of countries.  There were also a few references to libertarian paternalism, which is becoming an increasingly important dimension in policy making, in which policy makers seek to “nudge” individual actors to make choices desired by authority figures.  As one of my holiday indulgences, I’m reading Daniel Kahneman’s Thinking, fast and slow, which I’m hoping will give me further ideas on this.     

Quantitative Easing and the Misallocation of Capital

The policy creates losers as well as winners, and the losers from QE are often overlooked in the clamour for more QE – largely from the winners from QE, i.e.  those who derive their daily crust from the financial markets and allied activities – but also from some slightly surprising sources, particularly from some leading lights of the self-styled moderate left commentariat. 

As an exception, Bill Gross of Pimco recently penned a piece in which he echoed some of the misgivings I articulated about QE:  That persistently low interest rates may eventually inflict harm on the economy in ways that render sustained economic recovery less rather than more likely.  He also referred to the misallocation of capital that may arise from a regime of extremely low interest rates. Since writing my note I have since wondered if, in leading to a misallocation of capital, ultra-low interest rates actually create economic dependence on low interest rates. That the economy becomes distorted in such a way that it subsequently becomes well-nigh impossible to ratchet interest rates back up to normal levels without prompting a slump back into recession, unless the global economy is experiencing a boom and the economy can be lifted by exports.

Paul Krugman, a proponent of QE, sought to rebut Bill Gross’ piece. Krugman grounded his objections the argument on two premises, namely that the economy is caught in a liquidity trap, and that the natural rate of interest, i.e. that rate of interest that would equilibrate saving and investment at full employment is negative.

 I have always understood the natural rate of interest to be essentially unobservable, and, moreover, that the existence of a liquidity trap is very difficult to establish empirically. It seems risky to run economic policy flat out on these two propositions. Moreover, based on these two notions, Krugman also maintains that the huge expansion in the monetary base we have witnessed in a number of countries, notably the US and UK, should have no long-run inflationary consequences.  I fervently hope he is right, but I harbour doubts.   But, drawing on the same Wicksellian notion of the natural rate of interest that I drew upon in my piece, Krugman maintains that it is imperative to retain ultra-low if possible negative real interest rates as a policy correction to the tepid economy.

As regular readers will gather, I remain unconvinced by this, and was heartened when Bill Gross’ piece appeared in the WSJ. I hope policy makers take note. What has remained true this year is that the financial market tail has continued to wag the economic dog, and contributed to a misallocation of capital, which has led to an erosion of realised and potential economic growth.

What is lacking in the QE debate is a sense of scale or gradation. As a parallel, many medications doctors prescribe are highly beneficial if taken in the right, small quantities, but if the patient takes them in too great a quantity he would be better off not taking them at all. For example beta blockers which stabilise heart rhythms can provoke heart block or heart failure if taken to excess.      

US Economic Recovery

Meanwhile, far from diving into a double-dip, economic recovery in the US has been buoyed by a surge in retail sales and blockbuster gains in car sales.  However, many analysts, caught off-guard by the resilience of the economy, have carped that the turn for the better is unsustainable, as it has been driven by a decline in the personal savings rate, and not underpinned by growth in personal income.  But this is how QE and other unconventional measures are supposed to take effect; they encourage spending and discourage saving.  Firms, experiencing a rise in sales, first respond by lowering inventories, but then when inventories become too lean, expand production to match the increased level of sales.  Higher production levels induce them to increase their staff complement. As employment rises, personal income rises, further encouraging consumption spending and so on. Entirely in keeping with this story, the equity market was buoyed when the government statisticians contributed to the air of seasonal cheer with the news on 22 December that initial claims for unemployment benefits dropped to 364000 in the most recent week, the lowest level since March 2008.

However, while I maintain my expectation that the US economy will do better than the consensus expects, it is too soon to claim victory on this one:  the personal income report for November provided ample sustenance for those whose outlook is gloomier than mine.  Personal consumption expenditure rose by a scant 0.1 percent, and personal disposable income actually fell slightly on the month.  The year-over-year pace of advance in both indicators is more encouraging though, as are wage growth (up 4.1 percent on the year) and durable goods orders, up 12 percent on the level of a year ago).  What may be especially important is that the construction sector is at long last displaying signs of stabilising; it was of course the plunge in construction activity consequent on the tumble in house prices that precipitated the onset of 2007 crisis. But the latest housing data also shows that house prices remain soft, with the Case-Shiller 20 City Composite registering a decline of 1.2 percent between October and September and an annual rate of decline of 3.4 percent, which remains problematic for those who would move to a different location where prospects of securing employment are better.        

Debt distress in the Eurozone, and Italy    

The Bank of England weighed-in with a perspective that was diametrically opposed to the stance I have taken on the Eurozone, contending that some Eurozone countries might actually be insolvent, meaning the fundamental problem goes beyond one of illiquidity. However, the BoE viewpoint was not well received in other quarters.  According to the Wall Street Journal, December 19 page 4, “And, last month, Bank of England Governor Mervyn King asserted some euro-zone countries might be insolvent, thereby pitting his judgement against that of the International Monetary Fund, European Central Bank, European Commission, ratings firms and most independent economists, not to mention investors still buying euro-zone government bonds.”      

I must belong to the category “independent economists” since while I have acknowledging that Greece is probably insolvent, but not so large that it is beyond the means of the EU to mount a rescue operation, I contended that should an event trigger a return of confidence to the Eurozone, the other distressed economies can escape their current crisis of funding and the euro can survive.  Italy is clearly the kingpin.  Should Italy prove unable to refinance its maturing debt in 2012, then the Eurozone is likely to fracture under the resultant stresses.  There is an historical precedent for a more optimistic stance though – during the 90s Italy ran double digit interest rates for several years but managed to dig itself out of the hole it was in.  Can it do so again? 

Japan’s central bank highlighted the dangers of an adverse feedback loop in which evaporating confidence in European governments has increased concerns about the stability of the financial system and which in turn has started to affect economic activity as far afield as Asia.  Precisely.  What is desperately needed is some shock to confidence that triggers a virtuous feedback loop instead. 

Stephen Nagourney, in a characteristically thought-provoking post, outlined measures that might prove effective. For starters, high yielding Italian bonds should be viewed as more of an opportunity than an obstacle and as far as possible sold principally to Italians themselves.  That way, high yields don’t translate into a burden on the economy itself, but generate an income transfer from borrowers to lenders within the system (in this instance from taxpayers to savers).  Expanding on his idea, elevated yields would serve as a kind of lottery win for Italian savers, rather than enriching foreign investors.  Indeed, this could be rendered true in a literal sense as the government’s funding needs could be partly financed through a kind of NS&I scheme for Italy, similar to the UK scheme, with the level of winnings paid out linked to the level of bond yields.  The heightened odds of winning would be likely to attract a large influx of savings flows.  But if saving were diverted towards the funding of domestic debt, then a means of financing the current account deficit of 3 percent of GDP would have to be found. However, the ECB has already broadened the range of collateral it is prepared to accept in order to provide funding to Italian banks.  Any performing loan, including loans to business for trade finance, would be eligible.  The key is that the ECB will need to stand ready to ensure that Italian banks don’t go to the wall.  But the sums of money involved, around €50 billion, would be considerably less than the hundreds of billions otherwise likely to be spent on the indiscriminate purchase by the ECB of Italian bonds.

A further insightful perspective emanated from Becker and Posner on their blog. Becker writes in the spirit of one who was not in favour of the creation of the common currency in the first place, but is now seeking solutions to the difficulties now. His initial opposition to the common currency stems from the fact that it would evidently not provide “weaker members enough levers to adjust to various idiosyncratic shocks they would inevitably face”. Nevertheless, he goes on to observe, that while”(t)his view has turned out to be correct, a return to separate currencies in the middle of the crisis is likely to be highly disruptive”.   What to do then?  Posner further goes on to observe that “at present the European Central Bank and the wealthy northern European EU members are in a game of chicken with the GIIPS. The former want reform and the latter want handouts.  Games of chicken can end badly. This one would not, were it not for the fact that all the countries involved share one currency.”

Becker favours a suggestion made by Germany’s Council of Economic Experts, namely that the EU could assume joint responsibility for any sovereign debts that exceed 60 percent of a country’s GDP, with that portion below 60 percent to remain the responsibility of the individual nation states. Even weaker countries should be able to manage this he suggests, especially if bond yields fall upon adoption of the measure, which is likely. If the EU were to underwrite countries’ debts under such a scheme, it would also acquire greater say over the fiscal positions of individual member states – steps towards a fiscal union in other words. Becker believes that such a plan would prove ameliorative in the near-term, but fears that longer-term the Eurozone may not survive because weaker countries do need the option of currency adjustment as a response to idiosyncratic shocks.        

In one discussion I read, a commentator posed the very reasonable question:  why do investors seemingly prefer to incur a certain loss in real terms on German Bunds, and at the same time eschew Italian bonds? It is conceivable that they will make a loss on Italian bonds, but then again they might not.  It’s possible that this perspective is in the throes of dawning; the latest Italian bond auction on 28 December has gone off without a hitch. 

The nub of the European problem is now viewed not so much as a debt problem as a productivity/competitiveness problem.   See for instance former Fed Vice Chairman Alan Blinder’s piece The Euro Zone’s German Crisis, Wall Street Journal, December 14, pg 17. According to Blinder, since 2000, German unit labour costs have risen about 20 to 30 percent less than unit labour costs in the other euro countries. Consequently, Germany has a large and rising intra-EU trade surplus.  The euro exchange rate that is appropriate for other Eurozone economies is wildly stimulatory for Germany.  According to Blinder, one route out of the problem would be for Germany to “volunteer for higher inflation than its euro partners by, for example, implementing a large fiscal stimulus or ending its wage restraint. How do you say “ain’t gonna happen in German?”       

Of the outlying positions I have taken, the one that the Eurozone could survive in its current form is the one to which the greatest attendant degree of risk attaches; Italy has to finance 23.5 percent of GDP in 2012, and Spain 20.6 percent of GDP, in the shape of maturing debt and new funding.  Against this backdrop the euro is weaking on global currency markets, to below 1.30 to the dollar.  This could prove to be a highly significant development, especially if euro weakness develops into a rout.  Most of the attention up until now has been on the economies of the GIIPS.  But, possibly, the most interesting consequence of euro weakness would be the fillip it would deliver to the already strong German economy, which would in turn imbue that economy with additional muscle in dealing with the strains of the Eurozone.         

The Durban Summit and Renewable Energy    

Along with most others, I did not hold out much hope for a comprehensive globally binding deal to reduce carbon emissions at the Durban summit, but remain simultaneously hopeful about prospects for renewable energy.  I think that progress will continue to be made, but more through a succession of bottom-up advances rather than an overarching top down deal that addresses the issues once and for all. The Kyoto accord was extended to 2015, but so narrowly based in reach that it has been described as the Europeans “doing a deal with themselves”.  What is more promising is that major emitters such as the US and China have agreed to participate in the roadmap to the architecture of a global agreement, with emissions cuts to begin in 2020. However, the scientific consensus suggests that this will come too late to avert an increase in global temperatures beyond 2 deg C. Other measures may have to be deployed – they do exist.  Adaptation to climate change seems set to become an increasingly important part of the landscape in many countries around the world. 

Meanwhile, the renewable energy frontier continues to expand apace. The New Scientist in an editorial (17 December 2011, pg 3) argued that “(h)ere is cause for hope amid the gloom.  Even as climate diplomacy has become ossified, green technology has blossomed. In the exhibition halls and meeting rooms of Durban, large numbers of technologists were promoting an extraordinary array of schemes to cut emissions. They included everything from smart buildings to using the soils of Africa as carbon sinks, from curbing the soot of billions of African and Indian stoves to the intricacies of carbon trading. We may in truth have to forget about the world’s governments and the folly of their short-sighted and parochial ways, and instead seek technological fixes.  If going green can be made profitable it will become a no-brainer. Self-interest may serve the greater good where national interest does not.” 

Such developments are arguably most evident in the solar industry.  The prices of solar panels are plummeting as the locus of global production shifts.  Prices of solar panels have tumbled as supply has outstripped demand, and demand has yet to catch-up to the new reality.  Economists often refer to sticky prices; the solar industry may be an illustration of what happens when prices aren’t sticky and it is demand that is slow to respond.  It is estimated that prices of solar panels have fallen 70 percent during the last 30 months.  But it’s good news for consumers – at the same time as prices are falling, new technological breakthroughs are increasing the productivity of solar panels, such as three dimensional panels to capture maximum sunlight at greater latitudes.  This means that the competitiveness of solar relative to fossil fuels is improving apace. As is so often the case, China is in the vanguard of the price reductions, if not necessarily the technological innovation, and now produces 60 percent of the world’s panels. 

The increased economic rationale for solar comes at a time when the Tōhoku earthquake in Japan and the devastating tsunami that followed, which gave rise to the meltdown at the Fukushima power plant, had an enduring effect in increasing the level of distrust of nuclear technology,  and governments such as those of Japan and Germany are seeking alternatives.           

With prices of solar decreasing at this rate, reasonable projections are that the supply of electricity in the US attributable to solar could rise tenfold over a short period of time from the around one percent that it presently contributes. But solar companies are in turmoil in this environment, and a major shake out is occurring.  The industry will doubtless survive and even thrive – computer manufactures have dealt with declining chip prices for years – but the eventual shape it takes as a mature industry will look very different from today’s.