The Great Moderation and Recession Future Developments

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					                      The Great Moderation and Recession: Future Developments

                                                   Alexander Suetin

                                    Dr. Alexander Suetin, Ph.D.
                                  Associate Professor – Economics
                             SolBridge International School of Business
                  151-13 Samsung 1-dong, Dong-gu Daejeon 300-814, South Korea
                        Phone: +82 42 630 8540 Mobile: +82 10 5519 2300
                    E-mail: Website:

General Fallout
For the advanced economies as a whole, the slump that followed the global financial crisis
was by far the deepest since the 1930s. It has left an unprecedented degree of
unemployed workers and underused factories in its wake. Although output stopped
shrinking in most countries a year ago, the recovery is proving too weak to put that idle
capacity back to work quickly.

In July 2009 the International Monetary Fund estimated that the median advanced
economy had announced guarantee programmes worth 16.4% of GDP. The figure was
200% in Ireland, which guaranteed all its banks’ liabilities, 50% in Britain and 34% in the
Netherlands. The median bank recapitalisation was only 2.4% of GDP. The Federal
Deposit Insurance Corporation (FDIC) now guarantees $302 billion of bank debt, although
it is unlikely to have to honour much, if any, of that since the lion’s share was issued by big
banks that the government is loath to let default. The bigger risk lies with a string of smaller
bank failures, mostly caused by tumbling property values.1

After the FDIC repays depositors it tries to recoup the cost by selling the seized bank’s
assets. It now holds about $30 billion of assets from failed banks, and has agreed to share
losses on a further $84 billion held by acquirers of the failed banks. Since 2008 the federal
government has in effect backed the debt and guarantees of Fannie Mae and Freddie Mac,
two huge housing-finance agencies. The Federal Housing Administration (FHA), another
agency that will lend up to 97% of a property’s value, has meanwhile been filling the
vacuum left by subprime lenders. Total loans guaranteed by the three have grown by $277
billion 2010, to $6.1 trillion.

But the political and social consequences of the worst economic crisis since the Great
Depression have been milder than predicted. In developing countries, at least,
governments have not fallen in a heap, as they did after the Asian crisis of 1997-98. They
have not battled their own people on the streets, as happened in Europe during the 1930s.
Social-protection programmes have survived relatively unscathed. There have been

    Fiscal iceberg. The Economist print edition, Sep 24th 2009

economic-policy shifts, naturally, but no panicky retreat into isolation, populism or foreign
The last downturn brought the biggest fiscal expansion in history. Across the globe
countries have countered the recession by cutting taxes and by boosting government
spending. The G20 group of economies has introduced stimulus packages worth an
average of 2% of GDP 2009 and 1.6% of GDP in 2010.

The economists are discussing the scale of the fiscal multiplier. This measure, first
formalised in 1931 by Richard Kahn, a student of John Maynard Keynes, captures how
effectively tax cuts or increases in government spending stimulate output. A multiplier of
one means that a $1 billion increase in government spending will increase a country’s GDP
by $1 billion.

The size of the multiplier is bound to vary according to economic conditions. For an
economy operating at full capacity, the fiscal multiplier should be zero. Since there are no
spare resources, any increase in government demand would just replace spending
elsewhere. But in a recession, when workers and factories lie idle, a fiscal boost can
increase overall demand.

And if the initial stimulus triggers a cascade of expenditure among consumers and
businesses, the multiplier can be well above one. A tax cut targeted at poorer people may
have a bigger impact on spending than one for the affluent, since poorer folk tend to spend
a higher share of their income.

Emerging markets seemed likely to suffer disproportionately because of their trade and
financial links with the West. Exports in that dreadful last quarter of 2008 fell by half in the
Asian tigers at an annualised rate

Overall, the loss of output in emerging markets during 2007 was somewhat greater than it
had been in the Asian crisis of 1997-98, but less than had been expected and much less
than the fall in world GDP.

Compared with people in the West, those in big emerging markets seem in almost sunny
mood. In China, India and Indonesia, according to the Pew Global Attitudes Project in
Washington, DC, more than 40% of respondents say they are satisfied with their lives (in
China the figure is 87%). In France, Japan and Britain, the share is below 30%. This is
unusual: measures of ―life satisfaction‖ tend to rise with income, so you would expect levels
to be lower in emerging markets, as they were in 2002-03.2

 Frederique Covington. 2010 Change Snapshot. A view from the streets of Asia. Foreword, p. 5.

Asked ―Are you better off under free markets?‖ people in emerging markets are more likely
to say yes than those in rich ones. The share of respondents who think they are better off
fell in 2009 by between four points (Germany) and ten points (Spain). In most emerging
markets, the share either rose (in India and China) or stayed flat (in Brazil and Turkey). No
sign of an anti-capitalist backlash there.

Some produced big stimulus programmes. China’s is the best known, but Russia, Hong
Kong, Kazakhstan, Malaysia, Vietnam, Thailand, Singapore, Brazil and Chile also unveiled
large anti-crisis budgets or counter-cyclical spending programmes. As a share of GDP,
stimulus spending by the emerging-market members of the G20 was larger than spending
by the rich members. In that sense, emerging markets did more than their Western
counterparts to combat global recession.

Even countries that could not afford emergency programmes like China’s let their fiscal
balances deteriorate as counter-cyclical spending got under way. In Africa, oil importers let
their budget deficits rise from 2.2% of GDP in 2008 to 6% in 2009.

Since 2007, according to Goldman Sachs, the biggest emerging markets—Brazil, Russia,
India and China—have accounted for 45% of global growth, almost twice as much as in
2000-06 and three times as much as in the 1990s.3 It used to be said that although
emerging markets were contributing an expanding share of world growth, they could not
claim to be the real engine for the global economy because final demand for their exports
lay in America.

But that argument is weaker now that China has overtaken America as the main market for
the goods of the smaller Asian exporters. The recession showed that economic power is
leaching away from the West faster than was thought.

The debt-to-GDP ratio of the 20 largest emerging markets is only half that of the top 20 rich
nations. Over the next few years rich countries’ debt will rise further, so emerging markets’
indebtedness will be only one-third of theirs by 2014. Already there are signs that financial
markets are rewarding them for good behaviour. Sovereign-risk spreads have been lower
in the biggest emerging markets than in some euro-zone countries; in 2009, Hong Kong did
more initial-public offerings than New York or London.

Still the recession was worse than previously believed.

The evidence is clear that the clean-up costs after debt-financed bubbles are too high.
Central banks and governments do have to intervene when credit growth and asset prices
(particularly in property) start dancing their toxic two-step. Asset markets do not work as
well as those for consumer goods.

Census data have corroborated the devastating impact on households. Median income fell
0.7% after inflation, in 2009, finishing the decade down a shocking 5%; the poverty rate

    India 2010: Economic Forecast for Utah. On January 27, 2010, in Trade Talk. World Trade Center Utah

rose to 14.3%, the highest since 1994, from 13.2% and the proportion of the population
lacking health insurance also rose, to 16.7%.

Generally consumers are shopping less and with more purpose. Some people deliberately
pick up a basket rather than collect a trolley in supermarkets, to prevent themselves from
buying too much. Some buy smaller packets, which are cheaper, or huge ones, which are
better value. Many make do without air fresheners, hair conditioner and other fripperies
once deemed essential. Many scour the internet for special deals. According to a report by
PwC, a consultancy, 93% of shoppers say they have changed their behaviour as a result of
the economic downturn.

Consumers are also trading down from one name-brand to another: for example, from
Lindt chocolates to Cadbury’s. Some 18% of packaged-goods buyers switched from a
premium brand to a cheaper one during the recession, according to McKinsey, another
consultancy. Most said they found that the pricier brand ―was not worth the money‖.

Financial markets
Financial markets do not operate in the same way as those for other goods and services.
When the price of a television set or software package goes up, demand for it generally
falls. When the price of a financial asset rises, demand generally increases.

The reason is surely that goods and services are bought with a specific use in mind. Our
desire for them may be driven by fashion or a desire to enhance our status. But those
potential qualities are inherent in the goods themselves—the sports car, the designer
sunglasses, the fitted kitchen. Such goods may be means to an end but the nature of the
means is still important.

Financial assets appeal for one reason only: their ability to enhance, or conserve, the
buyer’s wealth. There is nothing that so induces a change in attitude as seeing a friend get
rich. People learn through anecdote and example—the friend who sold his house for a
million, the colleague who made a fortune buying dotcom stocks.

When goods prices are rising, manufacturers make more of them. The same is true of
financial assets and it does not take long or cost much to create new shares. But if the
underlying value of the businesses has not changed, then the creation of new shares
simply dilutes the wealth of existing investors. The dotcom boom transferred the wealth of
pension funds to 20-somethings in Silicon Valley.

If rising prices create euphoria, falling prices induce paralysis. Trading volume in the
market tends to dry up as investors wish neither to realise losses nor to hunt for bargains.
In other words the attitude of investors towards the stock market is the complete opposite
of their attitude towards a department store. They will not rush to take advantage of a sale.

THE financial world seems to be obsessed with the short term. Fund managers are usually
judged on their performance over a three-month period. The television news highlights
daily moves in stock markets. Lots of hedge funds think in terms of milliseconds.

But history is subject to ―long waves‖ that cause economies and markets to change
direction at regular intervals. Roger Babson, an investment adviser who predicted the 1929
crash, claimed the markets were driven by Newton’s third law of motion: every action has
an equal and opposite reaction. Mind you, he also wrote a pamphlet entitled ―Gravity—Our
Number One Enemy‖.

Various academics have argued that industrial economies also have a regular cycle,
fuelled by stocks, capital investment or technological change, and lasting anywhere from
three to 60 years. As with commodities, the driving force seems to be the shift from feast to
famine as firms overinvest and overproduce, driving down profits and prices until a crisis

Impressive was the beginning of the great equity bull market of 1982-2000, one of several
huge stock market cycles in the 20th century. Demography played its part. The baby
boomers created a huge bulge in the workforce and in the pension system. The ―cult of the
equity‖ emerged in the late 1950s as corporate-pension-fund managers realised, first, that
shares had outperformed government bonds over the long run and, second, that the long-
term nature of their liabilities meant they could ride out the short-term volatility of stock

As investors bought equities, valuations (and thus prices) rose, enticing them to put more
money in the stock market. Between 1952 and 2006, American pension funds increased
their equity weighting from 17% to 69%.

THE internet allowed people to pay lower prices for books but also encouraged them to
pay stratospheric prices for shares in loss making dotcom companies. During the subprime
boom Americans believed the illusion that they could get rich by buying each other’s

The lacklustre performance of equity markets in 2010 is symptomatic of the previous
decade. A long-term asset-return study by Deutsche Bank found that American equities
had delivered slightly negative returns over the ten years up to the end of July.

The factor pulling stock markets in different directions 2010 has been low interest rates. On
the one hand, low rates entice investors out of cash and into riskier assets. For example,
issuance of American high-yield (or junk) bonds has already reached $168 billion this year,
more than was raised in the whole of 2009.

Many institutional investors are drifting up the yield curve, buying investment-grade bonds
as an alternative to low-yielding Treasury bonds. Equities have benefited from the same

Over the period from 1900 to 2005, the real return from global equities averaged 5%. The
mean dividend yield over that period was 4.5%.4

Despite this, stock markets devote a lot more time to forecasting and analysing profits than
they do to thinking about payouts. Profits can be easily manipulated and come in a
bewildering variety of forms (operating, reported, post-tax, pre-exceptional, etc). Dividends
are (mostly) paid in cash and so are hard to fake.

In America dividends seemed to go out of fashion in the 1990s. A yield of 2% or so
appeared trivial when the market was rising by 20% a year. The disrespect for dividends
also reflected the belief that, for tax reasons, share repurchases were a better way of
returning cash to investors.

But share repurchases are much more volatile than dividend payouts and were briefly
negative in 2008 (firms issued more shares than they bought back). Dropping a buy-back
programme can be done on the quiet. A dividend cut is a very public statement of
corporate weakness.

The global yield, as measured by the FTSE Global AllCap index, is only 2.5%. That
suggests a very low level of future real returns from equities. Those returns have three
components: the current level of dividend yield, real dividend growth and changes in
valuation (moves in dividend-price ratios).

Equally weighted, the average equity market enjoyed no real dividend growth at all over the
1900-2005 period. America performed better than most, achieving 1.3% annual growth.
Thanks to Wall Street’s heavy weighting in the world index, this dragged up the global
dividend increase to 0.8% a year. But this figure falls well short of GDP growth. If repeated,
it would raise the real equity return to just 3.3%.

As for valuation, this contributed around 0.7% a year to global equity returns between 1900
to 2005. In other words, share prices rose faster than dividends, and the yield fell. With the
yield well below the historic average it seems implausible to assume any further
contribution from valuation. Indeed, changes in valuation may subtract from future returns.

The modern fashion for creating derivatives means that it is possible to gauge investors’
expectations about future dividend growth. Dividend swaps allow investors to separate the
income from the capital return of equities.

A very gloomy view for European payouts, at least, has already been absorbed in the price.
Investors are expecting no growth at all in European nominal dividends between now and
2019. That looks unlikely. Even America managed to generate some dividend growth
during the Depression.

 Michael R King. The cost of equity for global banks: a CAPM perspective from 1990 to 2009. BIS Quarterly Review,
September 2009, p. 66

Some would say that bubbles tend to coincide with periods of great economic change,
such as the development of the railways or the internet. Individual speculators may lose
from the resulting busts but society gains from their overoptimistic investments. However,
this argument is harder to sustain after the recent bubble in which society ―gained‖ some
empty condos in Miami and holiday homes in Spain.

The thinking behind the regulatory push for simplicity and solidity is that over the past few
decades banks have been allowed to build complex capital structures made from inferior
materials. The best sort of capital to ensure a stable banking system is equity, because it
directly absorbs losses and can thus cushion against systemic shocks.

When banks fail, they devastate the economy.

Does it really matter who is in charge of the regulators? The grunt work of supervision
depends on more junior staff, who will always struggle to keep tabs on smarter, better-paid
types in the firms they regulate. There is a natural tendency for regulators to get captured
by their charges.

Some of the new institutions will be less important than others—Europe’s new banking
watchdog will have less to do than the markets supervisor, for instance. Tighter regulation
in one bit of finance may push excessive risk-taking into unregulated areas. And when
crisis hits, decision-making shifts to a tiny handful of people at treasuries and central banks
who can spend or create money.

Putting too much faith in the regulators would indeed be a mistake.

The purpose of the new rules is to ensure that banks have more capital when they face the
next crisis, and are thus better able to cope with bad debts. The core Tier 1 ratio will rise to
7%, slightly less than expected but still a lot better than before the crisis (at the end of
2007, Royal Bank of Scotland had a ratio of just 3.5%).

Government bonds have returned about 8% this year in local-currency terms in these three
countries, according to Barclays Capital, outpacing equity returns.

The rush to bonds reflects both expectations of lower inflation and a longer period of rock-
bottom central-bank lending rates. Of the 120-basis-point drop in the ten-year Treasury
yield since January, about three-fifths can be attributed to a decline in the expected
inflation rate over the next ten years, to 1.6% from 2.3%, as measured by the spread
between nominal and inflation-linked bond yields. French and German yields reflect a
similar drop in expected euro-zone inflation.

Low bond yields should comfort central banks: they are the main channel by which they
hope to stimulate demand. They are also a boon to governments with yawning fiscal
deficits. Whether investors should be similarly comforted is more questionable. In 2003 ten-
year government-bond yields shot from 0.5% to 1.5% in just three months, sparked by
nothing more than fading fears of deflation and casual remarks by the Bank of Japan.

Bonds also look pricey compared with shares. Analysts at JPMorgan calculate that the
―equity-risk premium‖, the expected excess return of shares over government bonds, is at a
record high in America, reflecting an 8% earnings yield on stocks and 1% real yield on
bonds. In Germany, Japan and Britain the story is similar.

Fund managers have been making the case for emerging markets on a regular basis over
the past 20 years. Developing countries offer higher economic-growth rates, have younger,
more dynamic populations and are under-represented in the global stock market. Buying a
stake in emerging markets is like buying a stake in the future.

Goldman Sachs, for example, reckons that the total capitalisation of emerging markets will
rise from $14 trillion today to $80 trillion by 2030, increasing from 31% of the global total to
55% in the process.5 Even allowing for new equity issuance that will still translate into an
annualised return of 9.3% compared with just 4% for developed markets. It seems like a

But experience should teach investors to be suspicious of no-brainer decisions. The same
arguments were advanced in the early 1990s, after all. But between 1991 and 2000
emerging markets delivered a total return of just 38% and developed markets returned
171%. Outperformance came only in the decade just gone, with emerging markets almost
quadrupling investors’ capital since the end of 2000.

A caveat also needs to be applied to the growth case. There is no correlation between an
individual country’s GDP growth rate per head and the returns to investors.

What is the explanation for this rather counter-intuitive result? One answer is that a stock
market is not a perfect facsimile of an economy. Many companies are unquoted. Those
businesses that have floated on the market may be mature, or slower-growing, or simply
overweight in one sector. In 1900 Wall Street was dominated by railroad stocks, for

A second answer is that growth countries may behave like growth stocks. A period of
strong performance leads to overvaluation, from which subsequent returns are inevitably

The old rule of thumb was that emerging markets were pricey when they traded at a higher
multiple of profits than their developed counterparts, as they did in 1999 and 2007 just
before sharp falls in prices.
At the moment they trade at a modest discount.

But emerging markets are prone to boom-and-bust cycles. They have suffered three 25%-
plus losses in the past 20 calendar years, and five years in which annual returns have
exceeded 50%. International investors have probably been behind much of the volatility,

    Projecting market capitalization. Equitymaster Agora Research Private Limited, October 8, 2010

pushing the markets this way and that as they switch between enthusiasm and risk

It is quite possible that another boom is on its way. Bubbles, as described by Charles
Kindleberger, a financial historian, usually involve an initial displacement, followed by rapid
credit creation and then a phase of euphoria.

The displacement may have been the financial crisis of 2007-08 which undermined the
solvency of the developed world. As governments propped up their banks, their debts
soared. On average emerging-market governments now have much lower debt-to-GDP
ratios than their developed peers. Economic power seems to have made a decisive shift.

The crisis was followed by the slashing of interest rates in the developed world. These
have had a limited effect in reviving lending in Western economies. But they have
encouraged Western investors to buy higher-yielding assets, like emerging-market

Emerging-market equity funds have already received inflows of $45 billion this year,
according to EPFR Global, a research group. And low rates will also boost credit creation
in those developing countries that import American monetary policy via managed exchange

Euphoria will follow as cheap money drives up asset prices—this may have already
happened in parts of the Asian property market. Investors probably have no option but to
ride the wave, if only because the outlook for developed markets looks so flat. There is, at
least, more solidity to emerging markets than there was to dotcom stocks.

In the emerging world the macroeconomic errors come from politicians behaving as if
growth there were more fragile than it is. The pace has slowed a bit, but from breakneck
speed to merely very fast. Most vital signs, from productivity to government debt, are
healthy. Yet many policymakers are buying boatloads of dollars to stop their currencies
rising as foreign capital pours in from Western investors seeking better returns.

And emerging economies, as a group, still save more than they invest, which explains why
global imbalances—notably the controversial surplus in China and deficit in America—
remain so big. That makes little sense. Poor countries, especially young ones, ought in
theory to invest more than they save, and so be a net source of demand for richer, older
ones, all the more so when the latter are in bad shape.

Yet neither the European Commission nor the markets can fix the euro’s deeper problem,
which does not lie in fiscal profligacy. Ireland and Spain did not flout the fiscal rules in the
boom years, yet both are in trouble now. The bigger failing is that several (mostly
Mediterranean) members have suffered a huge loss of competitiveness against Germany
and other northern countries. This shows up in yawning imbalances inside the zone. Too
many governments believed that, once in the euro, they could worry less about

competitiveness. Actually, they should have worried more, because they have lost forever
the let-out of devaluation.

The one thing certain about the next crisis is that it will feature the same crushing panic,
pleas from banks and huge political pressure to stabilise the system, whatever the cost.
The hope is that regulators might have a means to impose losses on the private sector in a
controlled way, and not just face a binary choice between bail-out or oblivion.

Japan’s economy has long been sickly. It now also has to contend with a stronger yen,
thanks in part to loose monetary policy elsewhere in the rich world. That alone gave the
Bank of Japan (BoJ) reason to act on October 5th 2010. So too did criticism that it has not
done enough to spur the economy, which has inspired Japanese politicians to suggest
legislation to weaken the central bank’s independence. Whatever its motivation, the BoJ
this week took three modest but symbolic steps. First, it lowered its policy rate from 0.1% to
a range between zero and 0.1%. That signals to the market, and to disenchanted
politicians, that the BoJ cares. Second, the BoJ stated that it would maintain its virtual zero-
rate policy until there was ―medium- to long-term price stability‖. Until deflationary Japan
sees consumer prices rise by between 0% and 2% a year (with an unofficial aim of 1%),
the long-standing near-zero policy rate will remain.

Deflation is even greater than the official estimate of 1.5%, which means that, even at 1%,
Japanese bonds are offering a very nice real yield. The yen is much more attractive than
gold, which is being bought for irrational motives, given the lack of inflationary pressure.
One reason for the yen's long-term strength is that its trading partners have not been
accumulating unwanted yen; as a result, its government debt is owed mostly to its own

China is therefore seeking to diversify its reserves. It has increased its holdings of South
Korean bonds from less than 1.9 trillion won ($1.5 billion) at the end of last year to 5.2
trillion won at the end of September. Its euro holdings represent about 26% of its portfolio;
it promised this month to buy new Greek debt when the country resumes issuing bonds.

Tracking the government’s purchases is not easy, however. It often buys securities
indirectly, through proxies in London or Hong Kong. (The extra cost of doing so is one
measure of its concern to disguise its dollar exposure.) Around the same time that China
was selling yen bonds in August, for instance, there was an increase in purchases of
Japanese debt made from Britain It is not impossible that China was behind some of these

Japan feared that China’s purchases, amounting to as much as ¥2.3 trillion ($25.5 billion)
in the first seven months of this year, were driving up the value of the yen, which has
climbed by 15% against the dollar since April 2010. China holds by far the world’s biggest
stockpile of foreign-exchange reserves, worth $2.6 trillion at the end of the third quarter.
About 65% of these holdings are in dollars, according to the China Securities Journal, an
official newspaper.6
    Patrick Oliver-Kelley. January 2011 Economic Overview. 20 December 2010
China’s dollar dependency is a consequence of its currency policy. If it sells dollars to buy
yen or won, it risks depressing the value of the greenback. And as long as it remains tied to
a dollar standard, it must follow the greenback down, buying as many dollars as its firms
wish to sell to it at the prevailing rate. Only if it is serious about pegging to a broader basket
of currencies will it gain more leeway over where to cast its line.

Currency wars
Countries blame each other for distorting global demand, with weapons that range from
quantitative easing (printing money to buy bonds) to currency intervention and capital

Behind all the smoke and fury, there are in fact three battles.

The biggest one is over China’s unwillingness to allow the Yuan to rise more quickly.
A second flashpoint is the rich world’s monetary policy, particularly the prospect that central
banks may soon restart printing money to buy government bonds.

A third area of contention comes from how the developing countries respond to these
capital flows. Rather than let their exchange rates soar, many governments have
intervened to buy foreign currency, or imposed taxes on foreign capital inflows. Brazil
recently doubled a tax on foreign purchases of its domestic debt.
Thailand announced a new 15% withholding tax for foreign investors in its bonds.

What needs to happen is fairly clear.

Global demand needs rebalancing, away from indebted rich economies and towards more
spending in the emerging world. The furore about currency wars has confounded several
separate policy issues.

One is the scale of rebalancing that the world economy requires, and the role of exchange
rates in that process. A second issue concerns the spillovers from policy choices, both
within the rich world and between rich and emerging economies. A third set of questions
asks how emerging economies, especially small open ones, should best distinguish
between a permanent rise in capital inflows and a temporary surge—and how they should
deal with such a surge.

The prospect of further QE helps to explain why gold, equities and government bonds are
all performing well at the same time. Gold bugs are buying bullion for the understandable
reason that central banks appear committed to printing more money: they fear that
eventually this will lead to inflation.