Edward Hadas

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.

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.

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.

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.

Currency buyers are suffering from King Lear’s dilemma. Shakespeare’s monarch could not decide which of his two ungrateful daughters was less awful. What looked like a bad deal from one, permission to stay with 50 knights, suddenly seemed attractive when her sister’s alternative was a mere 25.

Trading floors may not echo with Lear’s desperate words — “when others are more wicked, not being the worst stands in some rank of praise” — but foreign-exchange dealers know the feeling.

Only a few weeks ago, they were mostly worrying that the mix of huge U.S. fiscal deficits, political gridlock and tepid economic recovery would undermine the dollar. The euro, by comparison, looked less awful. The region’s sluggish recovery and expensive currency in terms of relative prices were offset by a positive trade balance and signs of fiscal discipline.

The conventional wisdom is that Japan has never really recovered from the bursting of the stock market and real estate bubbles in 1990. That view is basically wrong.
Sure, prices have never recovered. The stock market is still almost 75 percent below its peak and land prices are down 60 percent. After two decades of nearly stable consumer prices, the Japanese government is once again badgering the central bank to do something to create a bit of inflation.
This appeal, like so many before it, is likely to end inconclusively. Japan will continue with its longstanding pattern of near-stable prices, slow growth and gargantuan government deficits. But the economy is basically in pretty good shape.
Sure, an annual GDP growth rate of 1 percent since 1990 sounds unimpressive. But the number of people below retirement age has been shrinking by 0.4 percent a year. Annual growth in U.S. per capita GDP over the same period was 1.4 percent – not much different from Japan.
Other economic indicators suggest Japan is managing pretty well. Even in mid-recession, car sales are only 20 percent less than at the 1990 peak. Housing starts are down 50 percent, but the population was rising then and is declining now. The 5 percent unemployment rate is modest by Western standards. And the 1.4 percent yield on the 10-year government bond hardly sounds like a vote of no confidence in the government or the country.
The country’s financial burden — gross government debt at 200 percent of GDP — could yet prove too much to bear for a rapidly aging and steadily declining Japanese population. But for now, Japan should be more a sign of hope than gloom for the United States, UK and euro zone countries that have endured a severe financial collapse.
However, Japan had advantages in dealing with a financial collapse. It has a high savings rate, a big trade surplus and a powerful tradition of cultural and political unity. Few Western countries have all of these. Most also face almost Japanese-style demographic challenges. They will be fortunate to do as well as Japan.

The Federal Reserve deserves some sympathy. The U.S. central bank did everything it could to stage-manage its minimal tightening moves, announced late on Feb. 18. But markets reacted as if to serious bad news.

The changes really are small. The main one was to increase the Fed’s discount rate, which is not currently crucial to the financial system, by a token quarter of a percentage point. That widens the spread between the policy interest rate, currently zero, and the discount rate, which is used for emergency lending to banks, to half a percentage point. Before the crisis, the gap was a full percentage point.

The Fed tried to keep markets calm. It had hinted the move was coming and the press release announcing the changes started by explaining that they were a response to the “continued improvement in financial market conditions”. To hammer the point home, the Fed added that the moves “do not signal any change in the outlook for the economy or for monetary policy”.

It isn’t just the Sophocles connection that makes it easy to think of Greek fiscal woes as a tragedy in the making. A chorus of euroskeptics has been chanting a persuasive ode of despair. They wail that a currency union without a fiscal union is always doomed. The no-bailout clause, the cheating Greeks and the mean spirited Germans — woe, woe, woe are the euro zone and the euro.

The skeptics interpret each hesitation as a sign of trouble. So they gloat that the European Union’s statement last Thursday was weaker than hoped and the market was unexpectedly skeptical. But while their assessment is almost instinctive, these are no random ululations. Their case is cogently argued, mostly from the western side of the English Channel. The logic is that workers in the euro zone will not take wage cuts or losses on savings, so overpaid or overleveraged members of the single currency cannot hope to restore normalcy. There is also a dark reading of history.

Look at the failures of the Latin and Scandinavian Monetary Unions in the early 20th century.

By Edward Hadas and Richard Beales

It is easy to imagine a better candidate than Ben Bernanke to run the Federal Reserve. But actually finding one is another matter. The current chairman should get a second term, even though he does not unequivocally deserve it.

Bernanke has worried too much about deflation, and not enough about excessive leverage, trade imbalances, financial deregulation and fiscal irresponsibility. He has probably not paid enough attention to the global role of the dollar. He was arguably too soft on the financial industry when that industry was riding high — and he may now be too eager to consolidate regulatory power at the Fed.

In his defense, though, he did well in the thick of the banking crisis in 2008. Along with the New York Fed and the Treasury, he helped rescue and reshape the industry after the bankruptcy of Lehman Brothers.