The next scapegoat

14 Oct 2014

Fund managers may not realise it but they are already being set up as scapegoats for the next financial crisis. Banks got most of the blame for the 2008-9 crisis, and were severely criticised for their role in the eurozone’s troubles, but it looks like asset managers could be next.

Just look at the latest edition of the twice-yearly Global Financial Stability Report from the International Monetary Fund (IMF). Although the discussion is under the heading of shadow banking, with a whole chapter devoted to the topic, it makes it clear that this includes asset managers. It leaves no doubt that fund management is seen as a potential source of future financial instability.

For those unfamiliar with the jargon the term shadow banking is defined as credit intermediation outside the conventional banking system. Sources of such credit can include investment funds – particularly bond funds and money market funds – and insurance companies.

Shadow banking has become more important recently at least partly because of the tightening of bank regulation. If banks are less able or willing to lend it is not surprising that corporates turn to other sources. For example, firms can circumvent traditional borrowing by issuing bonds that are in turn purchased by investment funds.

By some measures this trend is particularly pronounced in Britain. The IMF estimates that shadow banking assets account for more than twice the share of GDP than in any other area.

From a regulator’s perspective the rise of shadow banking is a problem as it is less tightly regulated than conventional banking and lacks a formal safety net. New forms of credit intermediation therefore increase systemic risks. As the report argues: “Continued financial risk taking and structural changes in credit markets have shifted the locus of financial concerns from the banking system to the shadow banking system—particularly to asset managers— thereby increasing market and liquidity risks.”

The inevitable conclusion drawn from this discussion is that shadow banking needs to be more tightly regulated. Collecting additional data is posed as the first stage of this process but there is no doubt it will go further.

Much of this may sound like common sense but it would be wise to be more wary. Bankers were in many ways set up as scapegoats for the last financial crisis. Politicians in particular were keen to one-sidedly focus on the role of banks in the inflation of the preceding financial bubble.

This is not to argue that bankers were entirely innocent. Clearly they played a role. But what has become the conventional narrative focuses far too much on them and far too little on the role of government and central bankers. For instance, easy credit also played a role in the creation of the bubble. More fundamental structural weaknesses of the economy also tend to be downplayed.

Recent history should put the current discussion of the dangers of shadow banking in a different light. Technocrats and politicians are keen to get their retaliation in first rather than accept any blame for future economic difficulties.

Fund managers have been warned.

This blog post was first published today on Fundweb.

 

This is my column for the October issue of Fund Strategy.

Few seem to have noticed how the role of mainstream economics has changed in recent years. In many cases it could reasonably be called the art of making excuses for poor economic performance.

Until a few years ago, many policymakers were congratulating themselves on how the world economy was doing. There were claims that technocrats trained in economics could guarantee economic stability. It was widely argued that by pursuing prudent policies and targeting inflation, the world’s central bankers could make crises a thing of the past.

Reality begged to differ. With the emergence of the economic crisis in 2008, growth numbers plummeted and the excuses for the poor performance of the developed economies multiplied. Some talked about a “new normal” of slow growth while others claimed the low-hanging fruit of technological innovation had all been picked. The most recent and probably most influential explanation is secular stagnation hypothesis.

Larry Summers, a former US Treasury secretary, coined the term at an International Monetary Fund (IMF) forum in November 2013. Many other influential figures have taken it up, including Paul Krugman (Nobel laureate in economics) and Martin Wolf (chief economics commentator of the Financial Times). It also had the IMF’s implicit support in its April 2014 World Economic Outlook. The 19 July edition of the Economist illustrated the idea with a cover image of a frustrated jockey trying to giddy up a giant tortoise draped in the American flag.

Now VoxEU.org, a policy portal set up by the Centre for Economic Policy Research in London, has published a free e-book on the topic ( Secular Stagnation: Facts, causes and cures Edited by Coen Teulings and Richard Baldwin (VoxEU.org 2014). It pulls together many of the main proponents of the hypothesis, including Summers, Krugman and Olivier Blanchard, the IMF’s chief economist.

There are different versions of secular stagnation but the editors identify three main points of consensus. The first is worth quoting in full: “A working definition of secular stagnation is that negative real interest rates are needed to equate saving and investment with full employment.”

The second concern is that secular stagnation makes it hard to achieve full employment with low inflation and official interest rates close to zero.

Finally, there is agreement that under the new conditions the old economic toolkit is inadequate. There is no consensus on the solutions needed but there is a widespread implication that mass unemployment may become a permanent scar on society. Summers suggests inflation targets could be raised. Krugman and others imply that fiscal stimulus may need to become a permanent feature of the West’s economic life. Many others favour conventional prescriptions such as increased investment in public infrastructure, improving education and simplifying procedures for establishing businesses.

The first thing to notice about the secular stagnation hypothesis is its limited character. Claiming that negative real interest rates are needed to equate savings and investment with full employment is merely an observation. A rough analogy is the fact that an earth day lasts about 24 hours. Although it is true it does not explain why the earth rotates on its own axis.

The contributors recognise that low real interest rates need to be explained but their arguments are not convincing. Summers points to a variety of structural factors such as slower population growth and possibly slower technological growth. But it is not clear why such variables are necessarily fixed or as influential as he describes.

There is not an adequate explanation of why so little weight is attached to such key economic indicators as profitability or investment levels. Nor is there a discussion of the extent to which the structure of the eurozone is itself contributing to low growth in continental Europe.

The secular stagnation hypothesis is a one-sided reaction to the economic crisis of recent years. Just as there was an overstatement of the world economy’s strength in the years leading up to 2008, so there is an exaggeration of its weaknesses today. A proper explanation of the plight of the global economy would need to probe the subject far more deeply.

 

The world’s economic fortunes depend more than ever on China’s performance. So when an expert claims that the Asian giant is facing formidable challenges his arguments should be considered carefully.

Fraser Howie certainly qualifies as a specialist in Chinese finance. He has written three books on the subject including most recently Red Capitalism:The fragile financial foundations of China’s extraordinary rise. In addition, he was worked in Asian stockmarkets for two decades, is fluent in Chinese and is married to a Chinese woman. I was therefore particularly interested to hear him speak at a recent Lombard Street Research seminar.

The thrust of his argument is that China’s growth model is changing. “China for many years was a miracle growth story has now become a debt story,” he says. ‘We’re just at the beginning of the problem of bad debt in China”.

Despite a laudable reform agenda relatively little has changed over the past 18 months. The Chinese authorities recognise the need for extensive legal and regulatory change but its implementation is painfully slow. One notable exception is the tie-up between the Shanghai and Hong Kong stock exchanges.

Even the liberalisation of the currency is going far more slowly than many breathless headlines suggest. The renminbi is still relatively little used for international transactions considering the size of the Chinese economy.

Howie draws a vivid analogy between Beijing’s Forbidden City and the country’s financial system. The huge grounds of the former imperial palace are divided into numerous distinct palaces and courtyards. In a similar way the financial markets are segmented into multiple isolated areas. For that reason he regards the system as “dysfunctional”.

Charles Dumas, the chairman of Lombard Street Research, also discussed China at the event but from a macroeconomic perspective. He described the economy as “wildly out of balance” with its extremely high levels of investment – accounting for almost half of GDP – and low levels of consumption.

Dumas also pointed to the likely impact of a Chinese slowdown on the global economy. For example, Germany’s bonanza from selling capital goods to China is likely to come to an end.

China’s economic slowdown is a huge subject and it would be unfair to expect too much to be crammed into a single morning’s session (which covered other topics in the global economy as well). However, it was surely right to ask awkward questions on the subject rather than embrace the orthodoxy that China is enjoying an orderly slowdown.

Nor is the common assertion that China is coming to the end its catch-up growth phase as helpful as is often assumed. The same claim could have been made a few years ago and will still probably be plausible in a few years’ time. After all China is still far poorer in terms of income per head than the advanced economies. The challenge is to substantiate the argument if it is indeed true.

Perhaps the most difficult task is to divine what exactly is happening on the productive side of China’s economy. Unfortunately conventional economic measures are of even less use here than in the developed world.

Understanding these trends is perhaps the single most urgent task confronting those who want to understand the global economy.

This blog post was first published today on Fundweb.

The Worldbytes citizens’ TV channel recently interviewed me on contemporary anti-semitism. You can watch the video here.

 

Dished

26 Sep 2014

My recent FT book review was cited on Andrew Sullivan’s Daily Dish today.

This is the text of my book review from last Friday’s Financial Times.

Any serious attempt to understand the US’s current impasse by moving outside the conventional framework should be welcome. The stale pairings of liberal and conservative, right and left, no longer cut it.

Joel Kotkin, an American academic and author, has come up with the unlikely proposal of understanding the country’s predicament in terms of class conflict. But his conception is a world away from the old socialist notion of a combative proletariat battling against an intransigent ruling class. Instead, his is an innovative attempt to rethink the main contours of US society.

For a start, he sees the American elite as split between two mutually antagonistic oligarchies. On one side is a new elite based largely on information technology, although with substantial support from Wall Street. On the other is the old plutocracy centred on sectors such as agribusiness, construction, energy and manufacturing.

The new oligarchy differs from the old in important ways. Its technology wing is concentrated in and around San Francisco, with a secondary cluster in Seattle, and it employs far fewer people than traditional industries. Kotkin estimates that in 2013 the leading social media companies together directly employed fewer than 60,000 people in the US. By contrast, GM employed 200,000, Ford 164,000 and Exxon more than 100,000. The different nature of technology firms, with far less dependence on cheap energy, helps explain why they are predisposed to green thinking. They also tend to be both geographically and emotionally distant from middle America.

Meanwhile, the financial sector, which has traditionally favoured the Republicans, has benefited from enormous government largesse. This includes federal bailouts, cheap money and low interest rates. As a result, it has become more amenable to the progressive causes usually associated with the Democrats.

These new oligarchs are in alliance with what Kotkin calls the clerisy. This is the burgeoning class of technical specialists ensconced in government, law firms, the media and foundations. The technical class has swollen in line with the increased role of the state. Almost instinctively, the clerisy advocates increased regulation as the solution to any problem it encounters.

Together, the tech oligarchs and the clerisy tend to favour what Kotkin calls gentry liberalism. This outlook has an almost aristocratic disdain for the mass prosperity that long characterised the US. It typically favours sustainability over economic growth. It dismisses the suburbs in which most Americans choose to live as ugly “sprawl”.

The yeomanry – the class of small business owners – is the big loser in this new arrangement. Not only are its members being squeezed by offshoring, globalisation and technology, but excessive government regulations are undermining their livelihoods. The restrictions so beloved by the clerisy are breaking the traditional backbone of US prosperity.

Kotkin believes the new oligarchy and the clerisy together provide Barack Obama’s support base. Although the president often rails against excessive inequality, he has widespread backing from the ultra-wealthy of Silicon Valley and Wall Street. His predilection for government regulation also sits well with the interests and outlook of the clerisy.

Kotkin does not advocate supporting the Republicans as an alternative. Their ties to the old plutocracy are transparent. Meanwhile, self-proclaimed progressives rail against the excesses of the “1 per cent” while disenfranchising the middle and working class from popular prosperity.

His solution is for a renewed emphasis on broad-based economic growth. This means shifting government priorities away from lavish pensions and benefits towards investment in physical infrastructure. It involves greater emphasis on education and training, with particular attention to adult learning. Kotkin also advocates a resurgence of blue collar industry and the creation of new homes and businesses on the periphery of metropolitan regions.

Although his framework is superior to the platitudes of liberals versus conservatives, it has weaknesses. It does not sufficiently explain why an elitist technocratic outlook has such a grip on American life. The ever-increasing role of government is only part of the story. Nor does he acknowledge how many leaders in traditional industries, not just the tech oligarchs, have embraced notions such as sustainability.

But in having the courage to junk the old nostrums, he has taken an important step forward. The challenge is for others to go even further.

Latest FT book review

19 Sep 2014

My latest book review for the Financial Times is on Joel Kotkin’s The New Class Conflict (free registration may be necessary to read). I will post the full text at a later date.

 

This blog post from Portugal was first published yesterday on Fundweb. Although I do not draw out the point in the piece it seems to me that the European Union, as an elitist technocratic project, has played a considerable role in inculcating the fatalist mood I describe.

 It was not originally planned that way but I was hoping that a visit to Portugal would give me some insight into the country’s economic plight. In the event it did but not quite in the way that I expected.

For the large football-loving section of the population there was a sense of national disaster but not over economics or politics. The Portuguese national team suffered a shock home defeat to Albania in its first Euro 2016 qualifying match. I cannot speak Portuguese, nor am I an expert in body language, but Paulo Bento, the team manager, looked embattled in the numerous television interviews he gave after the game. A few days later he announced his resignation.

 Beyond that I am more wary than most writers about drawing sweeping conclusions about a country on the basis of a short visit. I certainly do not believe that the standard journalistic technique of interviewing a local taxi driver is a reliable gauge of public opinion.

It would be easy to draw the misleading conclusion that the relatively large number of unoccupied shops and other buildings (although no more than in many British high streets) are a symptom of economic retrenchment. There probably is some truth in this but it is also the case that from as far back as the 1970s many shops and business have migrated to the outskirts of Portuguese cities. Although tourists tend to stick to seaside resorts and historic city centres many Portuguese prefer to spend spare time in American-style malls.

Young volunteers are a ubiquitous sight in many towns and on the transport system. Typically they travel in groups of three or more and they are set tasks such as aiding commuters or helping to keep beaches clean. No doubt this phenomenon is a reflection of the high levels of youth (16-24) unemployment. The rate of about 35 per cent is grim but down from a peak of over 40 per cent in February 2013. Presumably the young volunteers, who are evidently paid a small stipend, are not classified officially as unemployed.

High migration, particularly by the well educated, is another effect of unemployment. Some go to Portugal’s former colonies, such as Brazil and Angola, while others migrate to European destinations such as Germany. German classes at the local Goethe Institutes are reportedly full of young graduates learning the language in preparation for a working life in central Europe.

Talk to older adults and a different although parallel picture emerges. Incomes for public sector workers have been slashed while many aged 50 or over have come under pressure to retire early with a reduced pension entitlement. Whole sectors, such as construction, appear to be largely idle.

There is also much talk of privatisation of such entities as the airport operator and the insurance arm of the state-owned bank. Such initiatives appear to be a result of EU pressure to raise revenue rather than by what is sometimes derided as an ideological commitment neoliberalism.

However, the most striking feature of Portugal’s plight is the widespread fatalism of the population rather than the economic challenges themselves. People talk about “the crisis” as if it is a natural disaster. There seems to be little sense that the eurozone’s recent woes are at least partly the product of the monetary bloc’s structural flaws as well as bad economic policy.

Resigned acceptance is a poor starting point for working out how to generate a new round of prosperity.

I will be speaking at two sessions at this year’s Battle of Ideas weekend festival in London’s Barbican Centre on the weekend of 18-19 October.

On Saturday I will be debating the plight of the “Pigs” – Portugal, Italy, Greece and Spain – in the eurozone crisis. Philippe Legrain and Vicky Price will also be on the panel while Nikos Sotirakopoulos is the chair.

On Sunday I will take part in a discussion on the idea of “growth is good”. Ricardo Fuentes-Nieva and Kitty Usher are also on the panel. Angus Kennedy is chairing.

The entire weekend is well worth attending.

A reminder that Daniel will be introducing a discussion of America’s new technocratic elite at the Institute of Ideas Economy Forum in London tomorrow evening.