Era of Dissonance

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Era of Dissonance

  1. 1. Era of Dissonance, 3 november 2011 Market nsightsEra of DissonanceIntroductionFinancial markets have entered an Era of Dissonance that will stand in sharp contrast to the relative harmony andeconomic expansion of the last half of the 20th century. The Era of Dissonance will not easily resolve itself into amore comfortable and predictable environment and may last as long as a decade or more. During this transitionperiod to a new world order there will be a continual conflict between perceptions of reality, widely variant possibleoutcomes, and confused future expectations. Financial markets will remain challenged, with bouts of uncertaintyconcerning strikingly different potential outcomes. The dissonance will profoundly disturb the dynamic evolutionof market returns, volatilities, correlations, and risk-taking preferences. Our understanding of financial riskmanagement is likely to undergo critical changes, because simplified approaches and traditional “rules of thumb”will not work during this period.Foreign exchange markets, as a natural focal point of economic imbalances among countries, will play a criticalrole in transferring sources of volatility into other asset classes, although not necessarily in a direct manner. Therisk-on, risk-off nature of markets is not going away any time soon. One can no longer assume that over time marketoutcomes are drawn from distributions of possibilities with similar volatility and correlation structures. Correlationstructures will not be stable and may even swing quite wildly. The ability to manage financial risks effectivelyover any time frame will be much more difficult. Market participants will need to re-assess many of the basicassumptions that guide their understanding of financial risks and form the basis for their decision making.Our hope and challenge in this report is to provide an intellectual framework for understanding how to construct aneffective risk management strategy in this Era of Dissonance as well as to highlight some practical guidelines fornavigating through these difficult times.Disclaimer. All examples in this report are hypothetical interpretations of situations and are usedfor explanation purposes only. This report and the information herein should not be consideredinvestment advice or the results of actual market experience.1 market insights
  2. 2. Era of Dissonance, 3 november 2011Our first step will be to identify the key sources of dissonance and gain an appreciation of their long-term economicimplications. We will examine the role of population dynamics, property rights, and policy constraints. For the mostpart, these sources are well known, yet their impact on markets when taken together as a package is not necessarilywell-understood or fully-appreciated.Population dynamics accentuate the economic growth divide between the slower-growing mature industrialcountries and faster-growing emerging market countries. Moreover, the faster-growing countries are lessefficient users of energy and commodities. As emerging market countries grow, they will add to global energy andcommodity demand at an even faster pace. And, as these countries build a larger middle class, their diets willchange and demand for agricultural products and clean water will soar.Property rights represent a second critical source of dissonance. We define property rights broadly to representthe legal, regulatory, and political environment that determines the context for consumer and business planningfor the future. This definition includes how businesses are regulated, what powers the state has to seize or limit theuse of private property, how people and companies are taxed, as well as the overall stability and predictability of thepolitical environment. What we see is the gradual erosion of property rights in the mature industrial countries addingfurther friction to their economies and making unemployment reduction more difficult. The steady improvement ofcontract law and political stability in the emerging markets is increasing their ability to attract global capital to theircountries, allowing stronger productivity growth that eventually encourages wage growth.Policy constraints are our third source of dissonance. Constraints on the effectiveness of fiscal and monetarypolicy in the mature countries will severely limit their ability to reduce the mountain of debt they have accumulatedover the years. The relative flexibility that emerging market countries have in both fiscal and monetary policy givesthem some tools to cushion, if only partly, the impact on their economies from the growth recession in the matureindustrial economies.We might dub these dynamics – population, property rights, and policy – the Three P’s of Market Dissonance. Andwhile we start our analysis with these sources of dissonance, what is equally important is to gain an appreciationthat the long-term economic growth implications coming from the sources of dissonance naturally point toconflicting expectations of how financial markets will resolve different perspectives. Moreover, the sources ofdissonance and their long-term economic implications dramatically increase the tensions within political systems.This heightened tension is reflected in markets, making them much more sensitive to political agendas, not justthe economic trajectory. In short, the Era of Dissonance will be defined by a very large number of perceivedpolitical and economic conflicts that will generate a seemingly never-ending series of widely divergentexpectations.Our second step, then, is to work through a framework for analyzing how markets resolve dissonance. We will do thisby describing how markets deal with expectations of multiple scenarios of low probability but high impact events.While the statistical and probability theories underlying our analysis are complex, the analytical intuition isstraightforward. Financial markets are designed to be forward-looking discounting mechanisms that resolvediffering perspectives on future scenarios. Markets do not function as smoothly when those competing futurescenarios become more distant from each other. The result is not only more volatility, but times in which volatilityand correlations may shift dramatically only to change again abruptly at some future time.2 market insights
  3. 3. Era of Dissonance, 3 november 2011The final step combines our analysis of the sources of dissonance with our appreciation of how markets resolvedissonance to categorize in a practical manner the challenges all sectors face in managing financial risks in thisenvironment. We focus first on currency markets as a way to illustrate how shocks flow through the asset classes,changing expected returns, volatilities, correlations, and the risk preferences of market participants in their wake.We then examine the “risk-on, risk-off” nature of markets over the past several years. Finally, we draw some practicalconclusions for managing risk in the Era of Dissonance.I. Sources of Dissonance and Long-Term Economic ImplicationsThe last half of the 20th century will go down in history as a very exceptional period of global economic expansion.Following two horrendous World Wars with a Great Depression in between, the formerly protagonist industrialcountries shared common objectives of peaceful nation-building through economic growth and trade. Moreover,despite large cultural differences, the various industrial nations had similar demographics with young and growingpopulations needing to be put to work. A coordinated global monetary system, known as Bretton Woods, wasestablished to provide a framework for the maintenance of a stable, non-inflationary world financial system. Theindustrial countries took broadly similar approaches to the use of fiscal policy to encourage economic growth andcushion economic cycles, while accommodating well their different preferences for social programs.Led by the G5 countries – US, UK, Germany, France, and Japan – economic growth among the industrial countriesof the world was impressive. Certainly, there were some big bumps along the way. The fixed exchange rate systembroke down in 1971. Energy prices surged in 1974-1975 and again in 1979. These economic challenges positionedthe decade of the inflationary 1970s as a potential turning point toward a world of policy conflict. Yet the industrialnations came together again with the shared objective of taming inflation. They coordinated central bank policies,created conditions for disinflation, and ushered in another two decades of solid economic growth and expansion ofworld trade.The first decade of the 21st century, however, served as a wake-up call. For those managing financial risks, it isnot news that we have already been sailing in uncharted waters for several years. From the time the US subprimemortgage debacle burst into the public’s consciousness in 2007, to the Financial Panic of 2008, the EuropeanSovereign Debt Crisis of 2010-2011, and disarray in US budget policy in the summer of 2011, among other events,financial market participants have been hammered with a sequence of exceptional challenges. Yet, in the first fewyears after the Financial Panic of 2008, there was a general perception that somehow, sooner or later, marketswould settle down into a new order that would be relatively predictable and manageable, even if quite different fromthe relative comfort of the latter half of the 20th century.This resolution to a new order has not happened. Our first step in understanding why is to review the key sourcesof dissonance that markets are facing. It matters not that these trends have been widely recognized for a long time.What matters is that they are now on center stage, and they are working as a package, not independently.First, population dynamics are splitting the world into younger and more mature countries. The youngercountries have brighter futures, higher expectations for future economic growth, more of a focus on job creation,and more emphasis on the development of their economic infrastructure. By comparison, the more maturecountries are coming to grips with the reality of slower economic growth, a decaying infrastructure, massive over-indebtedness, and huge challenges in the health care and social safety net arena due to an explosion in the numberof people of retirement age.3 market insights
  4. 4. Era of Dissonance, 3 november 2011Second, emerging countries are improving rapidly in terms of political stability, the enforcement ofcontracts, and all the legal manifestations of the protection of property rights that enhance the ability ofconsumers and corporations to plan effectively for future investment and growth. By contrast, mature countries areseeing a steady erosion of the flexibility of their economic models due to tax and regulatory uncertainty, limitationson property rights, and the increasing inability of the political system to reach a consensus and chart a steadyand reasonably predictable course, allowing for the kind of long-run planning by consumers and corporations thatmeasurably enhances economic growth.Third, monetary and fiscal policies are highly constrained tools of economic management in matureindustrial countries. In many cases, these policy tools have hit their limits of effectiveness in the mature countries,yet some degree of flexibility remains in the policy arena for younger and faster growing countries.A. Population DynamicsThere are strikingly different demographic patterns among the major countries of the world. What we haveobserved is that while population trends are broadly recognized, the powerful political-economic implications ofdemographic patterns are consistently under-estimated by financial market participants, possibly due to the slow-moving nature of these trends. Our objective is to emphasize the long-term economic growth implications and thepolitical choices countries have to make that are heavily influenced by the context of their demographic situation.1. Different Aging PatternsHere we want to take a brief look at the population pyramids of six major countries. In all of these charts, theage cohorts represent five-year brackets, starting with the youth at the base of the pyramid, moving through theworking age population, and capping the chart with the elderly.1 When studying these charts, the issues we arecontemplating are the different political forces that are at work through the dynamics of the demographic patterns.For example, is the political support for jobs versus health care programs, or for low inflation versus export growth,the same across countries given the different demographic profiles shown below?India and Brazil are striking examples of youthful nations. Brazil - 2011 India - 2011 Male Female Male Female 100+ 100+ 95 – 99 95 – 99 90 – 94 90 – 94 85 – 89 85 – 89 80 – 84 80 – 84 75 – 79 75 – 79 70 – 74 70 – 74 65 – 69 65 – 69 60 – 64 60 – 64 55 – 59 55 – 59 50 – 54 50 – 54 45 – 49 45 – 49 40 – 44 40 – 44 35 – 39 35 – 39 30 – 34 30 – 34 25 – 29 25 – 29 20 – 24 20 – 24 15 – 19 15 – 19 10 – 14 10 – 14 5–9 5–9 0–4 0–4 10 8 6 4 2 0 0 2 4 6 8 10 65 52 39 26 13 0 0 13 26 39 52 65 Population (In Millions) Population (In Millions)1 All of the population pyramids were sourced directly from the website of the US Census Bureau, the International Data Base Section. Availableonline at www.census.gov/population/international/data/idb/informationGateway.phpPopulations are estimated for 2011, and all brackets are in millions of people with males on the left and females on the right side of the chart.4 market insights
  5. 5. Era of Dissonance, 3 november 2011In stark contrast, Japan and Germany have the profile of much older populations. Japan - 2011 Germany - 2011 Male Female Male Female 100+ 100+ 95 – 99 95 – 99 90 – 94 90 – 94 85 – 89 85 – 89 80 – 84 80 – 84 75 – 79 75 – 79 70 – 74 70 – 74 65 – 69 65 – 69 60 – 64 60 – 64 55 – 59 55 – 59 50 – 54 50 – 54 45 – 49 45 – 49 40 – 44 40 – 44 35 – 39 35 – 39 30 – 34 30 – 34 25 – 29 25 – 29 20 – 24 20 – 24 15 – 19 15 – 19 10 – 14 10 – 14 5–9 5–9 0–4 0–46 4.8 3.6 2.4 1.2 0 0 1.2 2.4 3.6 4.8 6 4 3.2 2.4 1.6 0.8 0 0 0.8 1.6 2.4 3.2 4 Population (In Millions) Population ( Millions) p (In )And then, there are countries such as the United States and China which are aging rapidly, but are not yet facingshrinking populations. United States - 2011 China - 2011 Male Female Male Female 100+ 100+ 95 – 99 95 – 99 90 – 94 90 – 94 85 – 89 85 – 89 80 – 84 80 – 84 75 – 79 75 – 79 70 – 74 70 – 74 65 – 69 65 – 69 60 – 64 60 – 64 55 – 59 55 – 59 50 – 54 50 – 54 45 – 49 45 – 49 40 – 44 40 – 44 35 – 39 35 – 39 30 – 34 30 – 34 25 – 29 25 – 29 20 – 24 20 – 24 15 – 19 15 – 19 10 – 14 10 – 14 5–9 5–9 0–4 0–415 12 9 6 3 0 0 3 6 9 12 15 70 56 42 28 14 0 0 14 28 42 56 70 Population ( Millions) p (In ) Population (In Millions)The mature industrial countries, represented by the US, Japan, the UK and Western Europe, are entering a periodwhen labor force growth is slowing or even shrinking. Their most challenging policy issues, such as health care,surround the demographic cohort of the rapidly expanding retired population.By contrast, emerging economies are challenged to put millions of young people to work or to find urban jobs forworkers migrating from rural areas. In some eerily similar ways, the emerging economies are entering a potentiallydynamic phase of economic growth much like the demographic context that helped propel the industrial countriesinto a half century of growth starting back in 1950.There are some anomalies. For example, China does not fit the pattern. While China has been one of the fastestgrowing countries over the last 30 years, the country’s population dynamics are that of an older nation. What hashelped to sustain China’s rapid economic growth is a massive migration from rural areas to urban centers, which5 market insights
  6. 6. Era of Dissonance, 3 november 2011has fed the growth of China’s industrial sector. This rural-to-urban migration was also a feature of Japan in the1950s and 1960s when the nation regularly posted 10% increases in real GDP per year. The former Soviet Union alsoeffectively utilized the migration of workers from the farm to the city to power its industrial growth in the 1950s and1960s, only to slow down dramatically when the supply of labor from the rural sector ran dry.2. Long-Run Economic Growth DriversDemographic patterns are important economic drivers because they determine the growth of the industrial andservice sector labor force. When coupled with observations about the potential growth in the productivity of thelabor force, one has a framework for considering the impact on long-term growth prospects related to powerfulpopulation dynamics.The industrial and service sector labor force can grow for essentially three reasons. (a) There are more youngpeople entering the working age labor market than there are retirees leaving the market. (b) Working age people aremigrating from rural agricultural pursuits to urban industrial and service sector jobs. And, (c) working age people aremigrating from external locations into the domestic labor force.Productivity growth also tends to come from three sources. (a) New capital investment can raise the productivityof labor. (b) Urban industrial and service sector jobs tend to have much higher productivity than rural agriculturalemployment in developing countries, so a switch from rural to urban employment can raise an emerging nation’slabor productivity. And, (c) technological progress can raise labor productivity.Most of these drivers are present in relatively young, emerging economies, while more mature countries are muchmore dependent on technological progress to power economic growth, given the high quality of their existing capitalstock and their lack of labor force growth. Taken together, it is hard to expect annual real GDP growth in themature industrial countries to exceed more than 2.5% per year, and even that may be an over-estimate whenother factors are considered. By contrast, annual real GDP can reasonably average 5% or more per year in theemerging countries. Cumulative Real GDP Growth from 2001 through 2010 Japan Euro-Zone UK US Brazil India China 0% 50% 100% 150% 200% Source: World Bank Annual GDP Data from Bloomberg Professional6 market insights
  7. 7. Era of Dissonance, 3 november 20113. Old versus Young PoliticsGrowth differentials have powerful implications for wage differentials. Labor productivity is very high in themature industrial countries, but now grows slowly only as technology progresses. In the emerging countries, laborproductivity is quite low and the potential for productivity growth is huge from investments in infrastructure andnew plant and capital equipment. The interesting challenge in the emerging countries is how the benefits fromrapidly growing labor productivity get divided between the wealthy class of owners and the middle class of workers.Put another way, the middle class will certainly expand, but the income divide between the super rich and the poormay also expand, leading to internal political tensions if wage growth falls too far behind productivity growth. This isan important issue today, for example, in China, India, Brazil, and Russia, among other countries.Energy demand will also be a focal point. The mature industrial countries are relatively efficient users of energy,such that a 1% gain in real GDP results in something less than a 1% increase in energy demand. For emergingmarket countries, it is a different story. They are not very efficient users of energy, and they are in the midst ofinfrastructure building which can be energy intensive. For emerging market countries, energy demand is actuallyan increasing function of economic growth. As emerging market countries establish a robust middle class, energyconsumption as a percent of real GDP rises.2 Consequently, if global growth is coming more from the emergingcountries, energy demand will rise considerably faster than otherwise. Oil Import Bills in Net Importing Less Developed Countries 120 Billion dollars (2010) 100 80 60 40 20 0 2000 2005 2010 2011 Notes: 2011 estimated. Source: ”Energy for All”, page 9, special early excerpt of the ”World Energy Outlook: 2011” published by the International Energy Agency, 2011.Other indirect implications will affect both agriculture and water. Agriculture uses a lot of water, but so doesindustry, not to mention the public’s consumption needs. Rapid growth in the emerging countries is going tochallenge simultaneously food production and clean water supplies around the world, creating political and markettensions we can only imagine at this stage.2 See “Fueling Growth: What Drives Energy Demand in Developing Countries?” by Arthur van Benthem and Mattia Romani, The Energy Journal, ,published by the International Association for Energy Economics, Volume 30, 2009.7 market insights
  8. 8. Era of Dissonance, 3 november 2011The point here is that it is hard to underestimate the dissonance that will continually hammer markets from the ebband flow of these growth differentials as their direct and indirect implications work their way through the world’sfinancial system. We can make, however, some broad generalizations about the political biases that population andgrowth dynamics create.a. Jobs. Youthful countries have a policy imperative to create jobs and to grow wages. With so many youngpeople entering the labor force, a country needs to creates jobs or political unrest is nearly a given. Consequently,youthful countries have a clear bias to promote export-led job creation, and these countries fear any substantial risein the relative value of their currency that could hurt the job creation process necessary for political stability.b. Wealth and Health. By contrast, the political issue for an older country is wealth preservation (thatis, keep what you have earned), health care, pensions, and social safety nets. The bias toward wealthpreservation shows up as a preference for a stable to strong currency to maintain or increase the internationalpurchasing power of the wealth that has already been created. Creating new jobs is not as important over the longhaul, since the labor force has stopped growing, although putting people back to work after a recession will remain acyclical focus.c. Inflation Tolerance. Similarly, the politics of aging changes the tolerance for inflation. A youthful countryis much more willing to tolerate some inflation as a small price to pay for job creation and the pressures thataccompany the establishment of a viable middle class. An older country does not need secular job creation andwants no part of inflation, which depreciates the wealth already accumulated.B. Swinging Pendulum of Property Rights and Regulatory TrendsOur inclusion of property rights as a source of dissonance is focused directly on the challenges consumers andcorporations face in planning for the future. As noted in the introduction our definition of property rights is broad,intended to represent the ability of individuals and corporations to conduct their business on a level playing field(i.e., laws, rules, regulations, taxes) with an expectation that the rules and goalposts will shift in an orderly manner(i.e., political stability, consistency of court rulings and enforcement of contracts, etc.). That is, we are evaluatingthe various elements that allow for effective planning, which we regard as an important determinant of long-termeconomic growth.What is often underappreciated are the different directions in which the pendulum of property rights isswinging for certain countries or groups of countries. This has powerful implications for relative political confidenceand risk among countries in the 21st century as compared to the last half of the 20th century. It is extremelydifficult, if not impossible, to measure quantitatively the comparative degree of property rights among countries,or the degree to which regulations enhance or degrade economic activity, or even the relative political risks thatemanate from these sources. Our inability to measure something in a credible manner should not, however, becomean excuse to ignore the challenges to the global economy from divergent trends in property rights and economicregulations, as well as their implications for market confidence in political governance systems.In many of the emerging economies, political stability has been dramatically improved since the 1970s, 1980s, and1990s. Contracts are more likely to be enforced. The regulatory structure, while sometimes complex and arcane, isimproving in its clarity and predictability. So, if we could measure it in a credible way, we would probably find that whilethe absolute degree of property rights, regulations, and political stability may still favor the mature industrial countries,the pendulum is swinging backward. Yet in the emerging economy world, the pendulum is swinging forward.8 market insights
  9. 9. Era of Dissonance, 3 november 2011Property rights trends are likely to lead to an environment in which regulatory competition among countriesbecomes more the norm than international coordination. This represents an enormous challenge to multi-nationalcompanies with global growth aspirations, and it also serves as a potentially huge source of market volatility.Property rights and regulatory changes can come swiftly from both mature and emerging countries, and often thechanges come with very uncertain long-term implications.For example, the Russian ban on wheat exports in the summer of 2010 was a trade regulation issue that impactedglobal markets: first directly in terms of wheat prices, and then indirectly in terms of related commodities,currencies of commodity producing countries, and even equities. Wheat Prices Surge Due to Russian Wheat Export Ban 9 USDA#2 Soft Red Winter Wheat @ Chicago Russian Export Spot Wheat Prices, US$ per barrel, Ban Commences 6 3 0 Dec-08 – Feb-08 – Apr-09 – Jun-09 – Aug-09 – Oct-09 – Dec-09 – Feb-09 – Apr-10 – Jun-10 – Aug-10 – Oct-10 – Dec-10 – Feb-11 – Apr-11 – Jun-11 – Aug-11 – Source: Spot Wheat Prices (WEATCHEL) provided by the Bloomberg Professional9 market insights
  10. 10. Era of Dissonance, 3 november 2011The point can be further illustrated by comparing how the corporate planning process in the United States andChina is affected by government decision-making. China’s modern leaders have an obsession with five-year plans.The country is currently in its 12th Five Year Plan. Plans change, and there are course alterations, but China wantseveryone to know the intended path. By contrast, the US Congress over the years has increased its use of stop-gaplegislation. Debt ceilings need to be raised every year or two. Tax legislation has expiration dates requiring newlegislation or a reversion to an old set of taxes. New regulations are enacted into law, but the agencies in charge areunder-manned and cannot meet mandated deadlines to interpret the new law, as with recent financial and healthcare legislation. What is interesting is not that US corporations still have much more control over their own destiniesand freedom to conduct business than Chinese companies at an absolute level. What matters in economics is therelative direction of trends, and the US system is becoming less friendly to long-run business planning, while theChinese system is becoming relatively friendlier.To extend this illustration with a focus just on the US, observe the time it takes for labor markets to recover aftera recession. Over the last two decades there has been a steady increase in regulations and rules regarding therelationship between corporations and their employees. The result of this regulation-creep has been a steadyincrease in the explicit and hidden costs of labor. One of the manifestations of this shift in the relative cost of capitaland labor is that in a recession corporations have been quicker than ever to reduce costs through cutting back theirworkforce. Then, during the recovery period, corporations have been much slower to rehire workers than they oncewere given the increase in labor costs, especially related to health care and other benefits.The current recovery period in the US is further challenged by the deleveraging that occurs after a recession causedby a financial crisis, by the persistent problems in the housing market, and by the drag from fiscal policy. Eventaking these factors into account, though, the impressive recovery in corporate profits in 2010 and 2011 has not ledto much hiring by the private sector. The time it takes to regain the previous peak in employment is likely to set amodern record, and by a very wide margin compared with the four years it took to recover from the 2000 recession,and the two year recovery time averaged during the recessions occurring between 1948 and 1983. US Employment Has Been Taking Longer to Recover after each Recession since 1990 Dec 2000 Mar 1990 Peak of Employment Aug 1981 June 1974 Mar 1970 April 1960 April 1957 July 1953 Sept 1948 0 10 20 30 40 50 60 Number of Months from Peak to Recovery Note: the mini-recession of March 1980 caused by the short-lived restrictions on credit cards is omitted due to its special circumstances. Source: Federal Reserve Bank of St. Louis ”FRED” Database10 market insights
  11. 11. Era of Dissonance, 3 november 2011C. Policy Context and Relative Constraints and/or FlexibilityThe constraints presented by the economic policy context in which countries find themselves are our third majorsource of dissonance for markets. Economic policies can be broadly categorized as (1) fiscal policy, (2) monetarypolicy, and (3) government asset/liability management. What is important to recognize is how much flexibility somecountries have in the policy area compared to how constrained others are. This relative matrix of constrained versusflexible policy alternatives will be a large source of potential market dissonance between mature and emergingmarket nations and also among the mature nations themselves as they go their own ways in this challengingdecade.1. Fiscal PolicyThe expansion of government debt as a percentage of GDP in the mature industrial countries over the last twodecades and particularly over the last few years in response to the Financial Panic of 2008 has created a large classof countries with little or no choice but to restrain fiscal policy and to focus on getting their debt under control.To the extent that long-term growth rates of real GDP have decelerated for these over-indebted countries due topopulation dynamics and property rights erosion, the problem is even worse.What really matters is not just the size of the economy relative to the debt load, but the income growth availableto support the interest payments on the debt. Slower economic growth means less income to service a given sizedebt load. By contrast, the emerging market world has much lower government debt to GDP ratios, as well asmuch higher long-term potential GDP growth rates to service their smaller debt loads. Thus, fiscal policy is highlyconstrained in the mature industrial world, while considerably more flexible in the emerging economyworld. Moreover, in the mature industrial countries fiscal restraint is likely to be a major drag on economic growthfor most of the decade to come.2. Monetary PolicyFollowing the policy efforts to recover from the Financial Panic of 2008, the central banks of many mature industrialcountries found themselves relatively ineffective. Immediately after the crisis, they had pushed short-term rates tonear zero and expanded their balance sheets aggressively. They had reached the limits of their abilities to influenceeconomic activity. By contrast, central banks of the emerging economies, with high interest rates and conservativebalance sheets, have some policy flexibility to deal with the challenges they face.A comparison of the US and Brazil is a useful illustration. Over the past decade, the central bank of Brazil has consistentlymaintained a steady premium between short-term market interest rates and year-over-year inflation – a classic centralbank approach to containing inflation pressures. As global economic growth slows and inflation pressures abate, there isample room to cut rates and provide some limited cushion for the economy from global impulses.By contrast, the US Federal Reserve has not found it possible to operate in nearly as a consistent manner as thecentral bank of Brazil (Banco Central do Brasil). As the growth recession in the mature industrial economiescontinues, their central banks, such as the Federal Reserve, are effectively tapped-out in terms of providingadditional economic stimulus, since short-term rates are already at or near zero. This has led to experimentationwith balance sheet expansion, known as quantitative easing or “QE.”11 market insights
  12. 12. Era of DissonancE, 3 novEmbEr 2011 Comparison of Debt/GDP Ratios of Selected Mature Countries Compared to Emerging Market Countries Japan Greece Italy Slower Growers Germany France United Kingdom United States Brazil India Argentina Faster Mexico Growers China Russia 0% 50% 100% 150% 200% Outstanding Government Debt as Percentage of GDP – 2010 Source: Based on US CIA’s World Fact Book and Eurostat Database.The use of the central bank balance sheet in a financial crisis to stabilize the banking system can prevent a recessionfrom turning into a depression. The evidence is still being collected, but it appears that QE programs have little to noimpact on providing economic stimulus. QE is effectively only a defensive tool to be used to prevent financial marketdisruption from contagion related to weak or insolvent banks.In addition, when economies are in the midst of a deleveraging phase or when uncertainty about the future is athighly elevated levels, neither consumers nor corporations are making their decisions based primarily, or evensecondarily, on interest rate considerations. In this environment, lower rates are not possible because they arealready at zero. And, the zero-rate policy has only limited effectiveness until the deleveraging ends or the cloud ofuncertainty is lifted. What is critical to watch is both consumer credit and bank lending to corporations. When theseindicators turn upwards and can extend that new trend for three to six months, this will be an indication that interestrates have again become an important decision factor for consumers and businesses and the zero-rate policy maystart to have a stimulatory impact on the economy.12 markEt insights
  13. 13. Era of DissonancE, 3 novEmbEr 2011 Brazil’s Central Bank Maintains Rates with a Steady Premium over the Inflation Rate: Expectations of Declining Inflation Can Bring Lower Rates 30% Overnight Interest Rate 25% 20% 15% 10% 5% Inflation Rate 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Brazilian CPI and Rates Data from Bloomberg Professional3. asset/Liability management Asset/liability management at the country level involves two very different tasks. On the liability side, the task isdebt management, which is most challenging for the over-indebted mature industrial countries. On the asset side,the task is reserve management, which spans both the emerging countries and the mature countries, but does notinclude the US. As the provider of the dominant reserve currency, the US dollar, the US has not had to worry aboutasset management, but it may well have to cope with the repercussions of the portfolio decisions other nationsmake regarding their international reserves. Tentative Signs that the US Consumer Has Preliminary Indications that Corporations are Stopped Deleveraging (US Consumer Credit Data) Starting to Increase Borrowing From Banks Again US BAnk Commercial & Industrial Loans 1.8 3.0US Consumer Credit Outstanding, 1.6 and Leases, Trillions of Dollars 2.5 1.4 Trillions of Dollars 1.2 2.0 1.0 0.8 1.5 0.6 1.0 0.4 0.2 0.5 0.0 0.0 1 93 4 5 7 9 0 2 3 5 6 8 9 1 -9 y-1 v-9 v-0 y-0 y-9 y-0 y-0 y-9 v-0 v-0 v-9 v-0 n- 1 93 4 5 7 9 0 2 3 5 6 8 9 1 c Ma -9 y-1 v-9 De No v-0 y-0 y-9 y-0 y-0 y-9 v-0 v-0 v-9 v-0 Ma No No Ma Ma Ma No No Ja Ma No n- c Ma De No Ma No No Ma Ma Ma No No Ja Ma No Source: US Consumer Credit Data Provided Through Bloomberg Professional Source: US Bank Commercial & Industrial Loans and Leases Data Provided Through Bloomberg Professional13 markEt insights
  14. 14. Era of Dissonance, 3 november 2011a. Government Debt Management. Within the mature industrial countries there are critical distinctions involvingthe choices available for debt management. The determining criterion is the relationship between the currencyof denomination of the debt and whether the debtor country controls the central bank that issues the currency.Countries that issue debt in the currency which their central bank controls effectively do not have creditrisk – they have inflation risk. That is, at some point when the debt load is perceived as too crushing to managethrough fiscal policy, the central bank can issue liabilities (i.e., print money, depreciate the currency) and inflate thevalue of the debt away. By contrast, when a country issues its debt in a currency it does not control, the inflationalternative is not available, and the debt must be evaluated by world markets in terms of its credit risk.In the 1960s and 1970s, it was typical of emerging market countries to issue debt in their own currency. But asthey over-extended themselves, they abused fiscal and then monetary policy, leading to currency depreciation andinflation. One solution was to force debt issuance by certain emerging countries, particularly in Latin America, intoUS dollars, a currency they did not control, making explicit the credit risk challenge. As emerging market countrieshave been able to demonstrate policy credibility over time, they have been able to pay off their US dollar debts andagain issue debt in their own currencies.The countries in the 21st century that find themselves in the credit risk market segment are the countries of theEuro-Zone. While they may issue their debt in euros, the common currency of the region, no one country controlsthe European Central Bank (ECB). As the sovereign debt crisis of Europe demonstrates, this is a crisis of credit risk,which has evolved into a parallel crisis for the banks of Europe that took on excessive credit risk in the form of thesovereign debt of weaker Euro-Zone countries.What emerging market countries already knew from their own experience in previous decades, and what they arelearning again from watching the Euro-Zone struggle with its sovereign debt crisis is that they should avoid issuingdebt in another country’s currency, such as the US dollar, and issue their debt in their own currency. This has verylarge implications for the currency management and currency convertibility policies of emerging countries that havesought to restrict how their currency is used internationally. Currency restrictions and limited currency convertibilityare not compatible with a globally viable market in their currency’s debt.We note that certain Western European countries chose not to join the Euro-Zone. For example, Sweden has hada National Debt Office since the 1700s to manage the country’s liabilities, and for liability management and manyother reasons did not want to adopt the euro. The UK also places a high value on being able to manage its ownindependent currency, which was among a variety of reasons this country also did not adopt the euro.14 market insights
  15. 15. Era of Dissonance, 3 november 2011 Country Country Issues Country Issues Debt in its Own Debt in its Currency With Own Currency Control of Without Control Central Bank of Central Bank US/UK/Japan YES Euro-Zone Countries Before the Euro YES Euro-Zone Countries After the Euro NO EUR Emerging Markets Then NO USD Emerging Markets Then YESb. International Reserve Management. Between the years 1998 through 2011, countries of all stripes – fromemerging countries, such as Brazil, India, and China, to mature countries, such as Japan – accumulatedinternational reserves on the asset side of their central bank balance sheets and in the coffers of their sovereignwealth funds. A majority of the international reserves are denominated in US dollars, which creates a potentiallylarge zone of tension specifically with the United States and a major source of policy dissonance for global markets.Should the owners of these massive stockpiles of US dollar denominated assets choose a policy of currencydiversification, the implications for US interest rates and the US dollar will cause policy challenges not only for theUS, but for the whole world financial system.3If, or perhaps we should say, when the owners of the US dollar denominated international reserves shift fromexchange rate stabilization policy goals to wealth preservation policy objectives, currency diversification will be anobvious step to take. The catalyst for this asset allocation shift may come from the economics of the US, or it maycome from the global political arena. One of the political features of the Era of Dissonance is that it represents atransition period from a world order dominated by one super power, the US, to a world order in which there are atleast two powerful countries at the world level – the US and China – and a number of important regional powerswith global ambitions – Brazil, India, and Russia. And, because of the disruptions of the sovereign debt crisis, it isnot at all clear where Europe fits into this power matrix.3 The study of the role of economic growth, money supply, exchange rates, and the accumulation of international reserves has a long history,pioneered by Professor Harry Johnson, Nobel Prize winner Professor Robert Mundell, and the always-controversial Professor Arthur Lafferwhen they were together at the University of Chicago in the late 1960s and early 1970s. The author of this research report has also contributedto this scholarly literature, starting with “Money, Income, and Causality in the United States and the United Kingdom” co-authored with Profes- ,sor D. Sykes Wilford and published in the American Economic Review, Volume 68, in 1978, and including more recently “Chinese ExchangeRates and Reserves from a Basic Monetary Approach Perspective” co-authored with Professors Stephen Jay Silver and D. Sykes Wilford, ,published in the Journal of Financial Transformation, Volume 31, in 2011, as well as several books and other articles on the subject publishedover the years.15 market insights

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