Davos in a Nutshell (Part 2)

Here are key takeaways from additional sessions I attended in Davos. The last blog mainly covered sessions that were statements of fact (e.g. current economic indicators); here I cover sessions on which there was an exchange of opinions – in particular, different viewpoints around the world on what economic policies to adopt.

Economic Policy Around The World
  • Mark Carney became governor of the Bank of England and adopted forward guidance – indicated that he would not raise rates until unemployment fell below 7%. He expected this to take 3 years, but it’s likely to take 6 months – unemployment is currently at 7.1%.
    • Thus, just before Davos he issued a statement saying he wouldn’t automatically raise once unemployment fell below 7%
    • Since then he’s said that he will use the output gap (the difference between actual GDP and potential GDP), rather than unemployment to guide policy
  • Geoff Cutmore (CNBC anchor, moderator of this session): is this back-tracking a sign that monetary policy has failed?
    • George Osborne: no. We’re only discussing this because unemployment has fallen rapidly to 7.1% – because the exceptionally supportive monetary policy has worked
    • 7% was never going to be a trigger for action, merely a threshold – one of many things that the Bank of England would consider when deciding whether to raise rates
    • Moreover, the interest rate isn’t the Bank of England’s only tool. It has tightened the mortgage approval process and used the Funding For Lending scheme. The Bank of England is second to none in having all the relevant tools at its disposal – the interest rate and a variety of macroprudential tools
  • Larry Summers: I’m worried about macroprudential complacency, due to human error
    • Governments missed the 1987 stock market crash, the 2007 financial crisis.
    • Spain’s countercyclical capital requirements didn’t protect it against the real estate bubble
  • Thomas Jordan (governor of Swiss National Bank): we don’t do forward guidance, but this doesn’t mean it’s bad. Different policies are good for different countries.
    • Switzerland targets the exchange rate
    • Also has tried to rein in the property bubble through bank capital regulations, rather than interest rates
  • Cutmore: the UK has seen a fall in the savings rate, and a housing market recovery, but no increase in exports nor productivity: rapid fall in unemployment despite modest rise in GDP suggests productivity hasn’t risen. Growth has been bubbly, not balanced.
    • Osborne: the job is indeed only half-done. But, the progress has been good. The recovery has indeed been generated by the consumer, but income-generated, not debt-generated. Now we must hand over to business investment and exports
  • Haruhiko Kuroda (Governor of the Bank of Japan): Abenomics contains three arrows:
    • Flexible fiscal policy: short-term fiscal stimulus, but the government aims to eliminate the deficit by 2020
    • Supportive monetary policy: Quantitative and Qualitative Easing (QQE)
    • Structural reforms
  • Kuroda: Abenomics has worked so far. It aimed to achieve a 2% inflation target in 2 years. We’re 9 months in, and consumer price inflation is at 1.2% (excluding fresh food)
    • There’s still a way to go; it’s premature to discuss tapering. But, we’re watching how other banks (e.g. Fed) are managing the tapering process
  • The Fed only started tapering the second time around. The first time around, it blinked: in September 2013, Bernanke decided not to taper. In December, it reduced QE by $10bn/month to $75bn, and said it would wind down QE by end of 2014
  • Monetary policy shouldn’t be conducted in isolation. As we taper monetary policy, we can’t do too much fiscal contraction
  • Larry Summers:
    • We are way better off than in 1929 due to good policy, but growth has only kept pace with population growth
    • We have significant structural issues: structural unemployment leads to hysteresis, meaning that US output is way less than potential.
    • We don’t know how to have sustainable growth. The growth in 2003-6 was said to be good because unemployment fell without inflation rising, but this was due to credit expansion and a fall in lending standards.
  • Summers: the good news of the past year allows us to shift focus from the public deficit to other deficits in the economy, such as the public investment deficit
    • Construction unemployment is in double-digits. The US can borrow for 30 years at 3% in a currency that we print ourselves. Why not fix JFK airport?
    • We spend 25% less on life sciences than 5 years ago. That’s a deficit too
    • Deficit isn’t just financial debt, but other debts we bequeath to future generations
  • Jordan: businesses will only invest when the feel confident; the near-death of the Euro made this much harder. Policymakers can’t force a company in a free market to invest, but they can do everything to create conditions that support investment.
  • Cutmore (to Osborne): Why are businesses not investing? What do they fear?
    • That your government won’t be around to follow through on its policies?
    • The U-turn on forward guidance, which creates policy uncertainty?
  • Osborne: we’re building nuclear power stations and investing in fracking, which other governments aren’t. The UK is prepared to take difficult decisions

Rebuilding Banking in Europe

  • A few months ago, probability of Italian default was 40%; the world had stopped funding some European firms. Credit default spreads were high, liquidity and bank capital were low
    • So we’ve come a long way in a short space of time. The ECB took decisive action, and fiscal policy became more credible
  • Tail risks (e.g. fear countries exiting the Euro) have been alleviated. As of January 2014 we now have more members of the Euro (Latvia has joined, so now 18 members) not fewer
  • But, there’s still a long way to go
    • Anshu Jain (Deutsche Bank): 3/4 of credit in Europe comes from banks, not capital markets, so banks are key to the health of the overall economy
  • While the European economy has recovered a little, this hasn’t manifested in greater lending, either to businesses or households. Some people think that one more push (e.g. the Asset Quality Review) will finally get lending going again.
    • But, this is wishful thinking. The problem isn’t insufficient supply of loans (we’ve already had a huge fall in bank funding costs which has increased loan supply), but an insufficient demand for loans.
    • Businesses won’t demand loans for investment while there’s still uncertainty over policy, and uncompetitive labor markets.
  • The European Central Bank will be the single regulator of all banks in the Eurozone from 2014. It will conduct an Asset Quality Review throughout Europe to “stress test” banks’ portfolios, to see if banks are healthy.
    • Are you worried that it will unveil severe problems? Jeroen Dijseelbloem (Dutch Minister of Finance): I hope so! We want to find problems so that we can fix them.
    • Having banks fail will show that the stress tests were done seriously. Europe first did some stress tests in 2010, but they were viewed as not tough enough. National supervisors did them independently, with little coordination. Thus, they had incentives to hide problems. This is why Ireland and Spain didn’t fail more banks
    • However, we must realize that stress tests aren’t a panacea. They can’t tell you definitively the quality of a bank’s loan portfolio – this quality keeps changing. This is why bank capital is necessary, to help prepare for the unpredictable.
    • Interbank lending is low, even with in Europe. The world’s willingness to lend to European banks is also low. A stringent stress test will encourage lending to banks that pass the tests.
  • Lord Adair Turner (former Chairman of the UK Financial Services Authority): the US’s stress tests in 2009 were very successful as they were stringent. Also, it was very clear what would happen if a bank failed: it would be given a certain number of months to raise capital privately; if it failed to do so, there would be a public recapitalization.
    • Dijseelbloem: but EU does have a clear set of next steps if a bank fails the stress test. It will be given time to deal with its problems. If unsuccessful, it must engage in a “bail-in”, where existing bondholders see part of their debt written off (this happened in Cyprus). Only if it’s undertaken a bail-in can it request government funds as a last resort. If the government can’t recapitalize the bank because  it’s too big, it will have to request a loan from the European Stability Mechanism, the eurozone’s government bailout fund.
  • December 2013: EU finance ministers created a Single Resolution Mechanism. It imposes levies on banks to build up national resolution funds, which will be gradually merged over 10 years into one European pot worth €55bn. This will act as a financial backstop
    • When a bank fails, its shareholders and creditors (rather than the taxpayer) should pick up the bill. But, the resolution process may require outside funds, e.g. to recapitalize key parts of a bank before selling it, or provide liquidity. This is what the backstop is for
    • While the resolution funds are being built up, the backstop will be the national government (and thus the ESM if the government has insufficient funds)
  • €55bn pot criticized as being too small. The Spanish bailout cost €40 bn, ant that’s only one country
    • But this fund is only the last line of defense. We have been building up other lines of defense. Bank capital is the first line of defense, and banks have been recapitalizing. We also have national resolution funds
  • Lord Adair Turner : we need to go further than the mutualization of a guarantee scheme
    • We need a single banking union, just like in the US. It’s not the case that New York banks just lend to New York, and New York depositors rely only on New York for deposit insurance
    • We can’t just close down a very large bank that’s failing. We will need to put in public capital. This is why the Resolution Fund (financial backstop) is key. Until the fund is in place, we’re still in danger
    • In the US, there’s a pan-US response if a bank fails. In Europe, it’s a national response
  • Trust is a huge issue in banks at the moment:
    • LIBOR and Forex benchmark manipulation
    • Commission-oriented salespeople sold Payment Protection Insurance that wasn’t needed
    • Banker bonuses despite losses
  • David Rubinstein (Carlyle): not clear that popularity is the relevant criterion. Even in good times, the public never loves banks or PE. Unlike Apple or Starbucks, most people’s relationship with banks involves paying fees
  • Lord Turner: the collapse of the financial system isn’t a problem just for industry, but also for regulators and academic economists
    • Policymakers used to think that more innovation, more efficiency is always better – they overly believed in market efficiency
    • Central bankers thought the financial system unimportant for the real economy
    • Most academic models don’t contain a financial sector
Coperation Between China, Europe, and the US
  • Theme of session: these are the three largest economies. If they can work together, we can guarantee global growth and world peace. But, how can we foster cooperation?
  • Nick Clegg: GATT reflected the old world order. Now, the balance of power has shifted from the west to the east. Thus, trade agreements are bilateral, not global
    • Must ensure regionalism and bilateralism don’t undermine multinatinoal agreements
  • Lloyd Blankfein: trade is always a win-win. Everyone has a stake in everyone else. If oil is discovered anywhere in the world, it’s best for the country that discovered it, but it’s good for other countries too. The same goes for growth: any growth in the world is good for the rest of the world.
    • China will grow, but we have to manage our expectations. This is quite natural – if China would definitely grow and there are no risks involved, the market would be inefficient
  • Angel Gurria (Secretary-General of OECD): it’s OK to build brick-by-brick, as long as bricks fit into a coherent bubble
    • Agreements should be not just on trade, but intellectual property rights and procurement
    • State-owned companies must be on a level playing field with private companies. Common labor and disclosure rules. Need to pay dividends to the Ministry of Finance
  • Joseph Nye: we must include Japan in these discussions, and not let tension between China and Japan get in the way
  • Clegg: any open economy requires China; the UK is one of the most open economies. Chinese investment in the UK in the last 18 months has exceeded the investment in the prior 30 years
    • Thus, UK must stay in the EU to be able to negotiate with clout with countries like China. UK is 60m people, Europe is 500m.
  • Clegg on trade: there’s no future in protectionism, but we need to be true to our values. We can’t ignore human rights.
    • It’s insufficient to sign up to new agreements; we must adhere to them, and have teeth in case countries don’t adhere
    • We’ve gone beyond haggling tariffs; we’re now discussing norms and standards
  • Should China see its future with the BRICs rather than the west, because the west isn’t growing so fast?
    • No, that would be very short-sighted. The US will still be huge. Even though China GDP will soon overtake the US’s, China GDP/capita won’t for a while, and this is a measure of economic effectiveness.
  • Clegg: China should recognize that it’s own future depends on sustainability. It can’t ignore the environment
    • Gurria: China is a big user of coal, which is very bad for the environment.
    • China is so large that any actions that it take have global implications.
Challenges Facing US Competitiveness
  • The World Economic Forum ranks the US #5 in global competitiveness, up from #7
  • There are concerns that the government should stay arm’s length with the private sector
  • Michael Porter:
    • The US faces structural competitiveness challenges. The few jobs they are generating are in areas insulated from international competition, suggesting that the US is losing international competitiveness
    • The problem isn’t that the US doesn’t have strengths (it has science, technology, entrepreneurship, innovation) but that it has allowed weaknesses to crop up: regulatory complexity, poor infrastructure, public education, tax complexity. Complying with regulations costs $17tr, $10k per employee. The tax system is so complex that companies would rather invest overseas
  • Glenn Hutchins (Silver Lake):
    • There will be a global equalization of wage rates as China, former Soviet Union come into competitive markets. This will push US wages down, so wages may not be there to support consumption
    • Employment has to be reformed. Unemployment benefit is not means-tested
  • There’s great opportunities to do trade agreements – no President since FDR has had such ability to negotiate trade, but little has been done.
  • Healthcare costs are out of whack; Obamacare didn’t get at the cost structure.
  • The US will gain 35m workers, of which 43m (> 100%) will come from immigration. China will lose workers due to its 1 child policy
  • Eric Cantor (House Majority Leader): we believe in a global economy as it reduces costs for consumers, but access to the US market requires reciprocity in turn
  • Porter: the US is complacent. We think we’re rich and will be rich foerever, while other countries are fixing regulation, investing more
    • Unfunded Medicare liabilities seriously worsen the deficit
    • Need to transfer from Defined Benefit to Defined Contribution pension plans, but the president won’t go there
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