My comments: Prepare for the end of QE2 in the US. This may trigger the a correction in US stocks to the tune of 10 - 25%. Money may flow back to Asia x Japan and Emerging Market stocks as Japan is holding their own QE.
April 5, 2011, 2:00 p.m. EDT
Fed's post-QE2 debate underway:
By Greg Robb WASHINGTON (MarketWatch) - The Federal Reserve began at its March 15 meeting to debate the possible course of monetary policy after the $600 billion bond-buying program ends in June, according to the minutes of the meeting released Tuesday. A few Fed members said that economic conditions might unfold in a way that would warrant the launch of an exit plan this year. At the same time, a few others noted that the Fed's ultra-low monetary policy may be appropriate "beyond 2011." There was a lengthy discussion of the prospects of inflation in the wake of the sharp increase in oil and food prices. In the end, several Fed officials said that their forecasts of inflation had "shifted somewhat to the upside." Economic growth appeared to be on "firmer footing," the Fed officials said.
Published April 5, 2011
Emerging out of the growth ditch
A shift in global growth to emerging markets requires several changes in the financial infrastructure
By RAGHURAM G RAJAN
DEVELOPED countries, hobbled by high levels of household and government debt, are hoping that emerging markets will shoulder the burden of expanding global consumption and investment.
No shoe-in: China will not reform overnight and begin demanding huge amounts of consumer goods. But this could happen over time - indeed, China's 2011 economic plan emphasises the expansion of domestic demand
Clearly, consumption in poorer countries, such as Brazil, China, and India, as well as in Africa and the Middle East, is far lower than average consumption levels in richer ones, and so is their average physical capital - houses, roads, sewerages, and so on. There is clearly room for growth here.
Shifting future growth in spending from industrial countries to emerging markets also has a corresponding environmental benefit: since the production of physical goods, such as housing and cars, takes a toll on the environment, it is better for spending to go to moving the slum dweller in Cambodia into a brick house - a process that will happen sooner or later - than to moving the suburban American couple into a house with even bigger bedrooms that they will likely never use. Such an outcome may be the environmentally sustainable solution to both global trade imbalances and the incipient currency wars. So how to best bring about this necessary shift in global demand?
Growing domestic demand
Some change is already happening. The lesson China seems to have learned from the Great Recession is that it needs to reduce its dependence on foreign demand. The Chinese know that they cannot continue growing at double-digit rates without encountering protectionist barriers. While much of the world has fixated on China's manipulation of the yuan's value to expand domestic demand, Beijing knows that it is as important to reduce the pro-producer bias in its domestic policy, so as to boost household incomes and consumption.
In practice, this means increasing wages, raising interest rates for household bank deposits, and improving the delivery of health and educational services; at the same time, the government is raising corporate taxes and lowering corporate subsidies on inputs such as energy and land. The Chinese government is also encouraging investment in infrastructure to link the poorer, interior western provinces with the richer, coastal ones.
Exchange rate moves
Of course, various economic sectors in China are opposed to change, from China's cash-rich state-owned corporations and banks to foreign firms with production facilities in China that benefit from the low exchange rate. They will fight any loss of their privilege. China will not reform overnight and begin demanding huge amounts of consumer goods. But this could happen over time - indeed, China's 12th five-year plan, to be implemented beginning in early 2011, emphasises the expansion of domestic demand.
Other emerging markets, such as Brazil and India, which have historically not repressed consumption as severely as China, are already on a buying binge, buoyed by growing inflows of foreign capital. Trade among emerging-market countries is increasing rapidly. To facilitate this growth in demand, emerging countries will have to allow their real exchange rates to appreciate - either voluntarily, by accepting revaluations of their currencies, or involuntarily, by having higher inflation.
All this, however, raises an important question: Can emerging markets manage to increase their domestic spending in a more stable way than in the past, or will they experience yet another credit boom followed by a bust?
Assertive regulation
To keep the past from repeating, regulators in both emerging markets and developed economies will have to be more assertive. To ensure that foreign capital inflows do not once again support nonviable investments and irresponsible lending, foreign investors need to be exposed to the full risk of losses. At the same time, domestic financial firms should not have the incentive to expand their balance sheets rapidly when money is cheap.
Regulators in a country receiving capital should discourage short-term foreign-currency-denominated loans to their banking system. Instead, they should encourage foreign investors to make long-term direct loans to domestic nonfinancial firms, denominated in the local currency. Government regulators should increase capital requirements, tighten liquidity requirements, and limit leverage for domestic financial firms when credit expands rapidly.
Finally, domestic regulators should also improve their national bankruptcy systems so that investors will take a quick and relatively predictable hit when projects fail.
Biting the bullet
At the same time, regulators in countries with outward capital flows should be careful that their major financial institutions are not overly exposed to any one region, country, or sector. Irish taxpayers should not have to bail out their banks' bondholders simply because these bonds are held by British and German banks. Large cross-border banking firms currently operate with impunity, knowing they are virtually impossible to shut down and will therefore be bailed out when in danger.
Reaching an international accord on how to close these banks when they get into trouble will be difficult but important. Finally, multilateral institutions, such as the IMF, should force investors in a country's debt to take a significant loss if those institutions have to step in to bail the country out - or else taxpayers will end up having to pay both those institutions and the investors.
How best to include clear and transparent triggers for write-downs in debt contracts is not an easy question - but not an impossible one, either.
All these measures will raise the direct costs to emerging markets of borrowing and will make foreign investors more careful about lending. Higher direct costs will be more than offset by the benefits of more productive and sensible investments, not to mention the decreased likelihood of future busts.
A triple mandate?
The slowdown in spending by the industrial world will give emerging markets strong incentives to shift their growth strategies away from exports - stronger, in fact, than might emerge from any agreement produced by international summitry.
But will 'the Great Spender', the United States, cooperate and avoid yet again pumping up demand excessively? US households have certainly increased their savings rates in response to the recession and are trying to pay down their debt. But what is worrying is that many of the efforts of the Federal Reserve and the Obama administration - whether to keep interest rates very low or offer new tax benefits and government-supported credit for home purchases - have been meant to encourage household spending.
In the meantime, reduced government revenues and increased spending - the usual effects of a recession - have been coupled with repeated stimulus packages, which has led to a ballooning of public debt.
As in past recessions, Washington's central concern is job creation. Unfortunately, many of the jobs that were lost at the onset of the latest downturn were tied to construction: not only construction workers themselves but many of the supporting workers, such as home improvement contractors or real estate brokers and lenders, lost their jobs, as did those people who worked in manufacturing construction materials.
Given the extent of overbuilding during the last decade, it is unlikely that government spending or low interest rates will bring these jobs back. Instead, unemployed construction workers will have to gain new skills or relocate to areas that have jobs. In other words, the jobs recovery will require politicians to have new ideas, time, and patience - all of which are in short supply given the political pressure.
More generally, Washington must focus more on tailoring the skills and education of the US work force to the jobs that are being created, rather than hankering after the old jobs eliminated by technology or overseas competition. In this light, the Obama administration's focus on improving educational standards by measuring student performance, evaluating teachers' abilities, and increasing competition between schools is appropriate; indeed, such reform efforts should be pushed with even greater urgency.
The Fed as stabiliser
The United States also needs a better social safety net, not only to reassure workers but also to ensure that slow recoveries do not result in frenetic, and ultimately excessive, stimulus spending.
Finally, a more stable and less aggressive US monetary policy will not only lead to more sustainable US growth; it will also reduce the volatility of capital flows coming into and out of emerging markets. Given the thin safety net, the political pressure on the Federal Reserve to be adventurous with monetary policy when unemployment is high is enormous.
But such pressure can be counterproductive if the Fed's aggressive policies have little direct effect on employment but instead generate asset price bubbles and risky lending, which eventually impose high costs on the economy, including greater unemployment.
It is debatable whether Congress should force the Fed to take seriously its de facto role as the rate setter for the world and unlikely that Congress will ever expand the Fed's mandate to do so.
At the very least, however, the Fed's mandate should be extended to include financial stability explicitly, on par with its current responsibilities to keep inflation low and maximise employment.
The writer is professor of finance at the Booth School of Business at the University of Chicago and the author of 'Fault Lines: How Hidden Fractures Still Threaten the World Economy'. This article is sourced from Foreign Affairs, a publication of the US Council of Foreign Affairs. This is the third in a series drawn from a longer article in the March/April edition
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