Edward Hadas

By Edward Hadas
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Financial markets are tiring of the Federal Reserve’s love offerings. The U.S. central bank has long been able to soothe nervous investors with rate cuts or newly-printed money. But markets spurned Wednesday’s announcement of the Twist, an operation to lengthen the maturity of $400 billion of the Fed’s $1.7 trillion U.S. Treasury.

Stock markets fell sharply and the price of bonds from governments still considered safe rose. Investors were right not to be impressed. The Twist is aimed primarily at the U.S. housing market. But even if the Fed’s rearrangement lowers mortgages costs, house prices will be held back by a weak economy and the massive oversupply left over from the bubble years.

Tight monetary policy has long ceased to stand in the way of economic growth. Official real interest rates are solidly negative almost everywhere. The Twist could even impede lending –- and growth –- by narrowing the gap between short and long term rates. Banks, after all, gain from a steep yield curve.

Central banks could try to regain investors’ favour with yet more monetary love. The Bank of England dropped some not so subtle hints on Sept. 21 about another round of quantitative easing. There are calls in the United States for QE3. But no amount of money –- whether it comes from fiscal transfers, QE3 or QE33 -– can force banks to lend or consumers to borrow and spend.

More money will not push up the prices of financial assets which investors deem too risky. The Asian market rout is caused in part by fund managers trying to get ahead of an expected wave of redemptions from cross-border investors. But while the gains from monetary stimulus are small, the potential harm is significant. The Fed and its peers are creating piles of money which would be put in and taken out of different assets in disruptive quantities and dizzying speeds.

In the current economic environment, the twists and turns of monetary policy will not reduce unemployment or rebalance trade. It would be better for the world if central banks stopped trying.

It’s the beginning of a strong economic recovery. Just ask the folks at Intel. The chip producer is smiling because companies “have some breathing room in the economy and their budgets”, as chief executive Paul Otellini put it on Tuesday. Or maybe it’s the end of a weak recovery. Tom Albanese, the boss of miner Rio Tinto, subsequently noted “fears about a possible double-dip recession in OECD countries and a slight slowdown in Chinese growth”.

Both chiefs are optimistic for the long term. Why not? The enriching of most of the world’s five billion or so relatively poor people will be great news for suppliers, whether of the most basic raw materials or of the most sophisticated electronic components.

But for the next few quarters, investors have a lot to worry about. Tech companies may be doing better — Dutch chip equipment maker ASML increased its 2010 forecasts on Wednesday — but the macroeconomic data from the United States and much of Europe remains largely mediocre. Euro zone industrial production in May, released on Wednesday, grew less than expected.

Investors are torn. They’ve been optimistic for almost two weeks, but that hardly makes a trend. The mood improvement came after a pretty bad second quarter. Indeed, since last September stocks have been up and down, but have generally made little progress while credit spreads have widened.

Financial markets look more fragile than markets for goods, despite near maximal fiscal and monetary support from governments and central banks. Or maybe because that support could end. Modest tightening in China is probably hurting asset prices there and in commodity markets. The fear of similar policy moves elsewhere, especially if they come before economic growth is well established, is restraining investors’ exuberance.

It would not take much to darken the mood in the market — a misstep from a central bank here, a bit too much deflation there or an unexpected bank problem somewhere else. But for now, liquidity is still ample and there are just enough signs of growth to keep up investors’ spirits.

The poor are teaching the rich a lesson. It used to be that the world’s less developed nations were the problem children — giving plutocrats too much power while running irresponsibly large budget deficits and failing to overcome deep internal imbalances. Now, rich countries look like the new poor.

Start with trade. China and middle income commodity exporters have most of the biggest trade surpluses while the world’s richest large economy, the United States, still runs the biggest deficit. With surpluses come financial clout and funds for investment. Deficits lead to dependency and, eventually, industrial weakness.

Fiscal deficits are too high everywhere, but after the financial crisis of 2008 the rich are in far worse shape than the poor. Deficits in developed economies like America and Britain have jumped by 7.7 percent of GDP, close to twice the 4.2 percent rise in middle-income countries, according to the International Monetary Fund.

And rich-country governments are finding it hard to summon the political will to reduce those outsized deficits. Leaders know they have a problem but can’t bring their people — and sometimes their political allies — along with them. Barack Obama and Nicolas Sarkozy are among them. That’s a big contrast to the strong and popular governments in countries such as Brazil.

Finally, rich countries seem unable to agree what they stand for. America’s culture wars define its politics. There are sharp disputes about the future of the European Union and the euro. Japan is forever searching for its role in the world. Poor countries have their fights, but much less doubt in their overarching goal of getting richer.

Sure, there are exceptions. Many poor countries, such as Thailand, are struggling. And some rich ones, including Germany, are doing relatively well despite the economic turmoil surrounding them. But the global balance does seem to have shifted.

This shouldn’t be too surprising. People in developing countries want more wealth, and are learning from those who amassed it before them. As for the cultural malaise of the already rich, almost two millennia after the Roman Empire started its decline, the jury is out on what exactly went wrong.

The Gulf of Mexico disaster has wrecked many reputations. BP, President Barack Obama and the whole offshore drilling business are all struggling under the weight of an uncontrolled flow of oil. A key feature of British corporate governance — a separation of the role of chairman and chief executive — is also under threat.

The two-at-the-top approach has some thoughtful defenders. Paul Myners, a high profile British critic of supine institutional shareholders, told students at Yale on Thursday that his board experience, on both sides of the Atlantic, supports the case for separation. He says a single leader can stifle “effective and challenging discussion”.

Myners does not discuss BP. But the oil company is certainly no poster child for the British way. The crisis has shown the current chairman and chief executive, Carl-Henric Svanberg and Tony Hayward respectively, to be a pair of relative weaklings.

Their predecessors, Peter Sutherland and John Browne, were both considered tough and the duo was widely admired. In retrospect, though, it seems clear they presided over the creation of a dangerously weak safety culture.

To get the split model to work, it is necessary to find chairmen who are strong enough to keep the boss in check, but restrained enough not to meddle unnecessarily. Purists also insist that chairmen should come from outside the company — if not the industry — guaranteeing a high level of ignorance about many important matters.

Myners may exaggerate the strengths of the split model. But he is right that the combined model can go badly wrong. It allows bosses with hyper-egos to push companies anywhere they want, with other board members following along like fearful ducklings.

So if split and combined are both imperfect, what is the right formula for boards of directors? There isn’t one. Shareholders need to recognize that companies and countries are too diverse for such a one-size-fits-all approach.

Besides, there is no way to eliminate the greatest weakness of all governance arrangements, which is not structural but moral. Chairmen, chief executives and board members will always be prey to foolishness and greed.

The European Union has rarely looked so united. The disparate members have joined up to mount a strong defence of the region’s single currency. But the EU has also never looked so close to dissolution, divided by tensions between more and less fiscally responsible and economically successful countries. The fate of the union could follow either of two historical precedents with starkly different outcomes.

Exactly 150 years ago, on May 27, 1860, Giuseppe Garibaldi started to besiege Palermo. The city was the capital of the Kingdom of the Two Sicilies, which had lasted in roughly the same form for almost six centuries. Most of the establishment at the time, including the Pope and Emperor Napoleon III of France, dismissed the notion of an Italian nation.

The romantic nationalist Garibaldi proved them wrong. Italy was unified under the Turin-based king of Sardinia. Huge regional differences in history, economy and culture have been diminished by the flow of people from south to north and of government money and bureaucracy in the other direction. The unified Italy has survived and prospered.

The less optimistic precedent is Yugoslavia. An expansion of the Kingdom of Serbia, the country was created after the First World War. Strong Slavic ethnic identity made it only slightly less likely to succeed as a nation than Italy. And Yugoslavia’s disparate peoples seemed on the path to unity for most of the following six decades.

But everything fell apart quickly 30 years ago, after the May 1980 death of Marshall Tito. Without Yugoslavia’s longstanding autocratic leader, the Serbian nationalism that had supposedly been crushed proved a potent divisive and destructive force.

Overall, the last two millennia of European history look more Yugoslav than Italian. But the last half-century has been more Italian, helped by the increasingly free movement of ideas, money and people.

For the future, much depends on the region’s collective memory, a term coined by Maurice Halbwachs, a French — or is that European? — sociologist. Europeans may choose to read their history as an inevitable movement towards unity. If they do that, Athens and Berlin may prove no more distant than Palermo and Turin.

By Martin Hutchinson and Edward Hadas

Investors rarely like wars or rumors of war. But for global markets, the renewed military tension on the Korean peninsula comes at a particularly sensitive time. The threat to this fairly big economy — South Korea’s GDP is four times larger than Greece’s — adds to the impression of a world out of control.

South Korea’s response to confirmation that the North torpedoed a Southern naval vessel in March seems proportionate, merited and economically minor — sanctions will hit an annual trade of only $286 million, about 0.3 percent of South Korea’s GDP. The effect on the already impoverished Northerners may even be mitigated by China, Pyongyang’s traditional ally.

In more settled economic times, markets could probably absorb this increase in Korean tension without too much difficulty. Everyone knows North Korea is dangerously unpredictable. Investors usually respond to provocative actions with only a brief flurry of worry. They sometimes even interpret aggression as desperation, and dream of potential gains from eventual Korean unification.

This time could be different. As of Tuesday, the Korean stock market had dropped 8 percent since the official report on the sinking, and the won had fallen by a similar proportion against the dollar. Investors may be thinking South Korean companies will face higher capital costs or that military expense will hold back the country’s growth. Or they may just be blindly shunning geopolitical risk.

The fear is likely to be exaggerated. An all-out war can probably be avoided, even if North Korea’s announcement of a freeze in relations leads to direct military confrontations. What’s more, while the Korean economy is bigger than Greece’s, it accounts for only 1.5 percent of global GDP. The euro zone contributes 22 percent.

The political forces which threaten the Koreas are completely different from those that are shaking confidence in the euro zone. But there is one unfortunate similarity. Until a few months ago, the governments, which had responded so powerfully to the financial crisis, were a comfort to markets. But weak and wild policies around the globe are undermining that conviction.

Forget about Greece for a moment. Just think about country X, which has lived well beyond its means for years thanks to loans from inattentive or foolishly optimistic lenders. When the crunch comes, the X-people will have to cut back on spending. And the X-lenders will generally suffer from the famous rule of banking: “Can’t pay, won’t pay.”

If Herman Van Rompuy, the president of the European Council, has his way, Greece is not going to be country X despite its weak government, bloated civil service and poor trade position. Van Rompuy said on March 25 that a vague new support agreement should “reassure all the holders of Greek bonds that the euro zone will never let Greece fail”. This default taboo should be reconsidered.

True, the Greeks might manage to tough it out. But it won’t be easy, even if the EU, the IMF and foreign investors are willing to help. A near miraculous economic recovery is required: from sharp recession and falling wages to fast growth. The euro makes the task more difficult, because Greece cannot stimulate growth through devaluation.

A limited default — rescheduling combined with modest write-downs — would make the task more manageable, besides appropriately punishing risk-blind lenders and complacent politicians. But Van Rompuy and many investors fear a sovereign default would start a chain reaction of panic and failures, perhaps breaking up the euro zone.

The worries are certainly not groundless, even if Greece’s 270 billion euros of debt is only 4 percent of all euro zone sovereign obligations. A write-down could reduce Greek banks to insolvency. Other fragile European banks would suffer. Other weak sovereign borrowers might follow, intentionally or not, creating a cascade of traumatic defaults.
But carefully planned debt write-downs could actually be less destabilising for markets than a long wait to see if Greece can struggle through. The uncertainty is distorting the euro zone’s politics and the euro’s value. A solution, even a bitter one, would calm nerves. And the risks of a Lehman Brothers II meltdown could be reduced by a three-pronged preparation.

First, the market needs to be softened up for bad news. For months, politicians such as Van Rompuy have been trying to persuade a doubtful world that Greek default is unthinkable. A change would cause a shock, but on reflection investors might actually welcome a more realistic approach.

Second, banks need to be kept in business. The Greek government does not have enough euros to rescue its own banks, so some tough but fair measures would be needed: converting bank debt into equity, freezing bank deposits and perhaps selling out to healthy foreign institutions.

Foreign banks holding Greek paper might need government help to get through write-downs. That path is well-trodden and it might ultimately prove less costly for other EU governments to help banks directly rather than offering indirect help through guarantees or loans to the Greek government.

Finally, other members of the euro zone with debt problems would need to get ready. Ireland, Italy, Portugal and Spain have already started to argue that they are fundamentally different from Greece. If their cases are persuasive, investors will not abandon these governments. But if one or more cannot avoid a debt restructuring, then delay will not lessen the eventual pain.

The Greek problem is important for the world, because the country has a particularly acute case of a common financial disease: debts that are too large to be serviced by current incomes. The leverage-fuelled global bubble in asset prices has left many individuals, some companies and a scary list of countries at credible risk of default whenever interest rates rise from their current ultra-low levels. The United States and the UK are certainly on the list.

The Van Rompuy solution, a combination of growth and frugality, can solve the problem, but only if creditors are patient and debtors are virtuous. Historically, the more common ways to cut debt loads have been monetary: straight write-downs of loans, inflationary increases in incomes or currency devaluations that reduce the real value of repayments to foreign lenders.
Debt overhangs are unseemly and all the monetary solutions are unpleasant. But default may not be the worst. In Greece and elsewhere, it shouldn’t be dismissed without first getting serious consideration.

Greece has come to the market again. It has successfully sold 5 billion euros ($6.7 billion) of seven-year paper at a yield of 6 percent, about 3.5 percentage points more than comparable German government debt. If politics were all that mattered, the new bonds would be a steal.

Greece clearly has political leverage over the European Union. Even Angela Merkel, the German chancellor who has been taking a hard line on helping Athens, does not want to countenance a default by a euro zone government. The International Monetary Fund is also interested in helping.

But ultimately, Greece has to make good on its existing 270 billion euros of government debt, not to mention the roughly 25 billion euros of new debt it is expected to raise in 2010. For that, the politicians need not merely a financial, but an  economic, work-out.  The constraints are daunting. On one side is the mountain of debt, set to rise to 125 percent of GDP this year. Yields on new paper are 3 percentage points higher than at the 2005 trough.

What’s more, about 70 percent of interest payments leave the country — so it’s not even as though Greece can tax the  recipients. On the other side is the precipice of falling GDP.  The government’s austerity plan involves cuts in spending and wages. The result is likely to be a steep recession, which would normally reduce tax revenue.

The most direct ways to get the debt level down — default and inflation — are all currently closed to Greece. That leaves  putting up taxes, further swingeing spending cuts and rapid growth as the main options.  The snag is that an even hairier fiscal shirt would militate against growth. And the easiest way of getting growth — a devaluation — isn’t an option.

For a country to stabilise its debt/GDP ratio, broadly speaking two things are needed. First, it has to stop running a so-called “primary deficit” — that is, the deficit before interest payments. Second, its average interest rate needs to be less than its nominal growth in GDP.

Both of these will be a challenge for Greece. Its primary deficit, 7.7 percent last year, is forecast to be not much under 5 percent despite the belt-tightening. Meanwhile, the average interest rate, currently 4.4 percent, will rise in the immediate future as the country issues bonds with 6 percent coupons.

What that means is that the economy really needs a period of  sustained nominal growth of 5 percent. Greece has enjoyed rapid growth in the past. Between 2000  and 2008 nominal GDP grew at a 7.3 percent compound rate. Butthe current yield reflects justified scepticism that it can get  back on the growth track.

The financial industry isn’t the only one that needs reform. The Federal Reserve, which if Senator Christopher Dodd has his way will get even more authority over the banking system, needs a transformation of its own. After all, the most senior U.S. financial watchdog missed one of the biggest credit bubbles since its founding.
But while action is called for, it’s not obvious what sort. After all, mindset, not the rulebook, was the Fed’s main weakness during the credit bubble. It had enough legal authority and political independence to fight against financial excess, but chose not to.
The politicians who are trying to redesign the national financial landscape can’t legislate a new intellectual paradigm, but they can try to avoid three pitfalls.
First, beware of the monolithic mindset. The 12 regional Federal Reserve Banks, each with its own traditions and expertise, provide a healthy check on groupthink in Washington and New York.
Second, don’t let politicians micro-meddle. The Fed needs political guidance on how to balance its objectives, but it’s healthy to have tension between a strong central bank favoring financial stability and elected office-holders primarily wanting happy voters.
Finally, beware of regulatory capture. As it stands, the two best-informed members of the board of the New York Fed are chief executives of giant financial companies: Jamie Dimon of JPMorgan and Jeffrey Immelt of General Electric. That creates unacceptable potential for conflicts of interest.
Mr. Dodd’s plan, unveiled on Monday, gets it mostly right. The regional Feds will stay, which is a plus. Bankers will be kicked off their boards. That’s good, but the plan goes too far by also banning all former bankers, whose expertise could be useful.
The plan goes wrong by making the New York Fed president a political appointment, just like the members of the Fed’s central board of governors. Politicians aren’t ideal judges of who has the technical expertise needed to sit at the center of the financial markets.
Still, one more political appointment might not be too high a price to pay for a generally sensible reworking.

Birthdays are a good time to look back. The first anniversary of the global stock market rally — the lows were hit on March 9, 2009 — certainly brings back memories. It’s easy to see why the MSCI World Index  is 71 percent higher now than then.

Then there was a steep recession, now there is GDP growth. Then it was realistic to worry about such horrors as rapid deflation, serial banking crises and a competitive protectionism. All of those menaces have now receded. And stock market investors can be cheered to see companies sufficiently in control of their short-term destiny for most of them to meet or beat analyst expectations of reported profits.

But this birthday celebration is no better than bittersweet. The stock market rally has spluttered somewhat. While the UK’s commodity-heavy FTSE 100 index is hitting new highs, most others have made almost no progress for five months. That stalling reflects both an unexpectedly tepid economic recovery and serious worries about whether there will be much to celebrate on future birthdays of the 2009 stock market trough.

Too many of the wounds of the financial crisis remain unhealed. Central banks are still extraordinarily generous and unemployment rates remains unacceptably high. The world remains too leveraged for its own good. And while the financial system is no longer in crisis, its newfound ebullience is itself a cause for worry.

The new talk of inflation is a sign of how far from health markets are. Stock markets are ultimately good hedges against rising prices, but investors feel queasy when economists at serious institutions such as the International Monetary Fund, Morgan Stanley and Societe Generale see high inflation as either the most likely or the least bad way to erode excessive leverage.

Historically, a great 12 months in the stock market has usually been followed by a mediocre period — an average 3 percent decline since 1940 in the United States, according to Deutsche Bank. Stock markets are still well below their peak levels, but there may not be much to celebrate this time next year.