making the rich world’s recovery stronger and safer

• Economists expected 2014 to be the year in which the global expansion stepped up a gear. Instead, nearly five years into its recovery from a deep recession, the rich world’s economy still looks disappointingly weak. America’s GDP grew at an annualised rate of only 0.1% in the first quarter. Euro-area growth, at 0.8%, was only half the expected pace. Some of the weakness is temporary (bad weather did not help in America), and it is not ubiquitous: in Britain and Germany, for example, growth has accelerated, and Japan has put on a brief spurt. Most forecasters still expect the recovery to gain momentum during the year.
• But there are reasons to worry. The stagnation in several big European countries, notably Italy and France, is becoming more entrenched. Thanks to a rise in its consumption tax in April, Japan’s growth rate is set to tumble, at least temporarily. America’s housing rebound has stalled. And across the rich world yields on long-term government bonds, a barometer of investors’ expectations for growth and interest rates, have fallen sharply. The yield on ten-year Treasuries, at 2.5%, is half a percentage point lower than it was at the end of 2013. Given that American expansions tend to be about five years long, the United States could find itself going into the next downturn without having had a decent upturn at all.
• What should be done to forestall that outcome? The standard answer is that central banks need to loosen monetary conditions further and keep them loose for longer. In some places that is plainly true. The euro area’s weakness has a lot to do with the conservatism of the European Central Bank, which has long resisted the adoption of unconventional measures to loosen monetary policy, even as the region has slipped ever closer to deflation. Thankfully, it has signaled that it will take action at its next meeting in June.
• But if loose monetary conditions are a prerequisite for a more vigorous recovery, it is increasingly clear that on their own they are not enough. Indeed, over-reliance on central banks may be a big reason behind the present sluggishness. In recent years monetary policy has been the rich world’s main, and often only, tool to support growth. Fiscal policy has worked in the opposite direction: virtually all rich-world governments have been cutting their deficits, often at a rapid clip. Few have shown much appetite for the ambitious supply-side reforms that might raise productivity and induce firms to invest. Free-trade deals languish. The much-promised deepening of Europe’s single market, whether in digital commerce or services, remains a hollow pledge.
• Against this unhelpful background, central banks have been remarkably successful. Growth has been so stable that economists are beginning to talk, somewhat eerily, of the return of the “Great Moderation”, the era of macroeconomic stability that preceded the global financial crisis (see article). Sadly, with such stability at a subpar pace of growth, low interest rates and low volatility have a bigger impact on asset prices than on real investment, and risk creating financial bubbles long before economies reach full employment.
• One way to address this risk is for central bankers to use regulatory tools to counter the build-up of asset-price excesses. This is particularly urgent in Britain, where the housing market is showing clear signs of froth. What is really needed, though, is a more balanced growth strategy that relies less exclusively on central banks.
• Such a strategy would have two elements. One is to boost public investment in infrastructure. From American airports to German broadband coverage, much of the rich world’s infrastructure is inadequate. Borrowing at rock-bottom interest rates to improve it will support today’s growth, boost tomorrow’s and leave the recovery less dependent on private debt. A second element ought to be a blitz of supply-side reforms. In addition to the obvious benefits of freer trade, every rich country has plenty of opportunities for reforms at home, from overhauling the regulations that inhibit house-building in Britain to revamping America’s ineffective system of worker training.
• Progress on these fronts would lead to stronger, stabler growth and would reduce the odds that the next recession begins with interest rates close to zero (making it particularly hard to fight). But it demands politicians who can distinguish between budget profligacy and prudent borrowing, and who have the courage to push through unpopular reforms. The rich world needs such politicians to step up.

Peer-to-peer banking, a challenge to conventional banking

• Savers have never had a worse deal but for most borrowers, credit is scarce and costly. That seeming paradox attracts new businesses free of the bad balance sheets, high costs and dreadful reputations which burden most conventional banks.
• Foremost among the newcomers are peer-to-peer (P2P) lending platforms, which match borrowers and lenders directly, usually via online auctions. The loans issued often comprise many tiny slivers from different lenders. Some P2P platforms slice, dice and package the loans; others allow lenders to pick them. Either way, the result is a strikingly better deal for both sides. Zopa, a British P2P platform, offers 4.9% to lenders (most bank accounts pay nothing) and typically charges 5.6% on a personal loan (which is competitive with the rates most banks charge).
• Elsewhere, returns (and risks) are higher. IsePankur, which lends to more than 60,000 people in four euro-zone countries, pays its lenders (who include your correspondent) a stonking 21.45% average net return (after a 3% default rate). Its typical borrowers do not flinch at rates of up to 28%: they are refinancing far costlier credit-card debt and doorstep loans.
• Peer-to-peer lending is growing fast in many countries. In Britain, loan volumes are doubling every six months. They have just passed the £1 billion mark ($1.7 billion), though this is tiny against the country’s £1.2 trillion in retail deposits. In America, the two largest P2P lenders, Lending Club and Prosper, have 98% of the market. They issued $2.4 billion in loans in 2013, up from $871m in 2012. The minnows are doing even better, though they are growing from a much lower base.
• Neil Bindoff of PwC, a professional-services firm, speaks of a “perfect storm” supporting P2P’s growth. Interest rates are close to zero, the public is fed up with banks, costs are low (one third of a typical bank’s, according to Renaud Laplanche of Lending Club), and e-commerce is becoming part of daily life. People use the internet for peer-to-peer telephony (Skype) and shopping (eBay), so why not loans?
• Awareness is still low—a survey by pwc found only 15% of Britons claimed to have heard of the big P2P firms such as Zopa, Funding Circle and RateSetter; 98% had heard of the main banks. Another hurdle in Britain is that P2P is not fully regulated; that will change on April 1st. The Financial Conduct Authority will issue the new rules imminently. In America, people saving for retirement can apply tax breaks to their loans, and offset their losses against profits. Britain’s P2P industry is awaiting a decision to extend tax-free savings schemes to its lenders.
• Regulation should help forestall a big worry: that an ill-run platform might collapse, taking investors’ money with it. At a conference organised by the P2P Finance Association, a trade body, this week, executives were worried about the risks of a “Bitcoin-style bust” that could rattle confidence in the nascent industry. New rules are likely to insist that P2P businesses ringfence unlent funds gathered from savers and arrange for third parties to manage outstanding loans if they cease trading.
• Other big questions abound. One is insurance. Funds placed with P2P lenders are not covered by the state-backed guarantees that protect retail deposits in banks. Some platforms offer something of a substitute. Zopa and most other British companies have started “provision funds”, which aim (but do not promise) to make good on loans that sour. These smooth the risk for lenders, but blunt the original P2P concept. So too does insurance: Ron Suber of Prosper, America’s second-biggest lender, says “deep actuarial conversations” are going on with outsiders who would like to help lenders provide for the risk that their borrower defaults, dies, or loses his job. Purists fear such arrangements could recreate the moral hazard that has plagued conventional banking.
• The boom in cross-border P2P raises tricky legal questions. The European Commission has yet to get to grips with the industry. National rules often determine how credit is issued and debts are collected. But they offer little help when the money comes from hundreds of lenders in dozens of countries. Yield-chasing foreigners, private and institutional, are investing heavily in the American market.
• Only a third of the money coming to Lending Club is now from retail investors: the rest (the fastest-growing slice) comes from rich people and institutions. Should such big investors get a better deal—such as getting their pick of the best loans on offer? In Britain, Giles Andrews of Zopa regards the idea as anathema: all savers should be treated equally. Some others think big lenders will eventually dominate P2P.
• P2P also ends the dangerous mismatch between short-term deposits and long-term loans inherent in conventional banking—but generally by locking lenders in for the loan’s duration. A secondary market in P2P loans is developing fast. This allows investors to get their money back if they need it, usually by selling the loans at a discount. But rules vary: some platforms will buy back the loans; others just hold an auction.
• P2P is not complicated: success largely depends on marketing oomph, the quality of the algorithms used to screen borrowers and ease of use (P2P platforms are scrambling to develop apps for smartphones and tablets). P2P may attract big outsiders, such as banks, or internet companies which already have lots of data about their customers and (like Facebook) are good at connecting them. Google last year led a $125m investment in Lending Club, valuing it at $1.55 billion. It might well want more.

Can bitcoins be relied?

• Less than a year ago Mt Gox was the pinnacle of bitcoin trading, accounting for an estimated 70% of the cryptocurrency’s global transactions. Today Mt Gox is apparently gone—early Wednesday Tokyo time, its website, which had been blank all Tuesday, displayed a short message saying the exchange was closed “for the time being”. The firm’s Tokyo offices appear to be abandoned, and its chief executive and sort-of founder, Mark Karpeles, has dropped out of sight. (The only thing that has been heard from him since Sunday is an e-mail sent to Reuters, saying “We should have an official announcement ready soon-ish. We are currently at a turning point for the business. I can’t tell much more for now as this also involves other parties.”)
• Worse, according to a document entitled “Crisis Strategy Draft” that is circulating on the web and appears to come from Mt Gox, 744,400 Bitcoins are also missing, the result of “malleability-related theft” that may have been going on since the exchange began operating. When Bitcoins are traded, each transaction is recorded in a log known as the “blockchain”. But a software bug—which Bitcoin’s developers have known about since 2011, but done little to fix—creates a brief time period in which the unique ID (or TXID) of each transaction can be changed.
• The bug seems to have enabled cyberthieves to steal Bitcoins by making it appear that transactions didn’t occur—a problem exacerbated by Mt Gox’s custom software (many other Bitcoin exchanges use standard, “core” Bitcoin software), which made the bug even easier to exploit because it used an automated system to approve withdrawals. The result is a heist that, even at today’s tumbling Bitcoin values, could be in excess of $390 million, or about 6% of all Bitcoins in circulation. That would make it the largest-ever currency-related cybertheft in history.
• Mt Gox has always been an accident waiting to happen. Originally an exchange for trading cards used in the game “Magic: The Gathering” (its name is taken from Magic: The Gathering Online eXchange), the site was converted into a Bitcoin exchange by its founder, Jed McCaleb, who then sold it to Mr Karpeles in 2011. Since then, Mt Gox has been plagued with problems. It has been hacked on a regular basis, has frequently suspended trading and withdrawals, was sued by Bitcoin business-incubator CoinLab, and had some $5 million in assets seized when federal authorities shut down two of its American bank accounts, leaving Mt Gox unable to transfer Bitcoins to America. On February 7th Mt Gox halted all Bitcoin withdrawals, “to obtain a clear technical view of the currency processes”. On Sunday, Mr. Karpeles resigned from the Bitcoin Foundation, the virtual currency’s trade group. Two days later both he and Mt Gox were gone.
• Bitcoin enthusiasts, who often seem to operate within a Steve-Jobs-like reality-distortion field, were quick to distance themselves from Mt Gox—forgetting, perhaps, that until recently they had often lauded it as the most “trusted brand” in Bitcoinland. Other exchanges have rushed to assure customers that all is well, conveniently disregarding the fact that many of them, too, have been the target of a massive and clearly well-coordinated distributed denial-of-service (DDoS) cyber-attack in recent weeks—an attack also aimed at the malleability bug.
• In a recent blog post, Gavin Andresen, chief scientist of the Bitcoin Foundation and a prominent Bitcoin luminary, wrote that “it’s important to note that [D]DoS attacks do not affect people’s bitcoin wallets or funds.” Like so much else in Bitcoinland, this sounds like magical thinking. Blockchain.info, which says it is Bitcoin’s most popular online “wallet”, is less sanguine. Speaking with Coindesk.com, a virtual-currency news service, Andreas Antonopoulos, Blockchain.info’s chief security officer, said that as a result of the DDoS attacks, “malformed/parallel transactions are also being created so as to create a fog of confusion over the entire network, which then affects almost every single implementation out there.” He also assured Bitcoin enthusiasts that no funds had been lost from the system—but in the wake of the massive Mt Gox theft, that seems optimistic.
• So: Mt Gox and hundreds of millions of dollars of Bitcoins have disappeared; large parts of the Bitcoin trading system may have been compromised; the value of a Bitcoin is less than half last year’s peak and fluctuating wildly; and hordes of Bitcoin users seem either to have lost their cryptocash for good, or are unable to withdraw or trade their funds. Many are screaming for help from financial regulators, but none are likely to come to the rescue of a currency that has constantly bragged it is outside the system. Japan’s Financial Services Authority says it isn’t going to help. The only response from America has been the launch of an investigation into Bitcoin by a panel of regulators and the Conference of State Bank Supervisors. And the cryptocurrency’s Stateside woes increased today when the Alabama Securities Commission warned people to steer clear of Bitcoin—a move likely to be followed by other states.
• But as ever, much of the Bitcoin community continues to act as if nothing has happened. Six Bitcoin businesses issued a statement saying that recent events don’t “reflect the resilience or value of bitcoin.” And today’s entry on the Bitcoin Foundation’s blog is an invitation to “Bitcoin 2014” in Amsterdam (“Bitcoin is a game changer on a global scale — don’t miss out!”). It’s hard not to think that the real problem in Bitcoinland isn’t denial-of-service attacks. It’s denial.

world economy will have a bumpy 2014

• For much of 2013 the world’s big stock markets had a magical quality about them. They soared upwards—America’s S&P 500 index rose by 30% last year, and Japan’s Nikkei by 57%—buoyed by monetary stimulus and growing optimism about global growth. Over the past month, the magic has abruptly worn off. More than $3 trillion has been wiped off global share prices since the start of January. The S&P 500 is down by almost 5%, the Nikkei by 14% and the MSCI emerging-market index by almost 9%.
• That investors should lock in some profits after such a remarkable surge is hardly surprising. American share prices, in particular, were beginning to look too high: the S&P finished 2013 at a multiple of 25 times ten-year earnings, well above the historical average of 16. A few bits of poor economic news of late are scarcely grounds for panic. It is hard to see a compelling economic reason why one unexpectedly weak report on American manufacturing, for instance, should push Japan’s Nikkei down by more than 4% in a day. Far easier to explain the market gyrations as a necessary correction.
• Prices always jump around, but in the end they are determined by the underlying economy. Here it would be a mistake to be too sanguine. Economists are notoriously bad at predicting sudden turning-points in global growth. Even if it goes no further, the dip in asset prices has hurt this year’s growth prospects, particularly in emerging markets, where credit conditions are tighter and foreign capital less abundant. Tellingly, commodity prices are slipping too. The price of iron ore fell by more than 8% in January.
• On balance, however, this newspaper’s assessment of the evidence to date is that investors’ gloom is overdone. A handful of disappointing numbers does not mean that America’s underlying recovery is stalling. China’s economy is slowing, but the odds of a sudden slump remain low. Although other emerging markets will indeed grow more slowly in 2014, they are not heading for a broad collapse. And the odds are rising that monetary policy in both Europe and Japan is about to be eased further. Global growth will still probably exceed last year’s pace of 3% (on a purchasing-power parity basis). For now, this looks more like a wobble than a tumble.
• The outlook for America’s economy is by far the most important reason for this view. Since the United States is driving the global recovery, sustained weakness there would mean that prospects for the world economy were grim. But that does not seem likely. January’s spate of feeble statistics—from weak manufacturing orders to low car sales—can be explained, in part, by the weather. America has had an unusually bitter winter, with punishing snowfall and frigid temperatures. This has disrupted economic activity. It suggests that all the figures for January, including the all-important employment figures, which were due to be released on February 7th after The Economist went to press, should be taken with a truckload of salt.
• All the more so because there is no reason to expect a sudden spending slump. The balance-sheets of American households are strong. The stockmarket slide has dented consumer confidence, but investors’ flight from risk has pushed down yields on Treasury bonds, which in turn should lower mortgage rates. Fiscal policy is far less of a drag than it was in 2013. All this still points to solid, above-trend growth of around 3% in 2014. One reason this may not excite investors is that it no longer implies an acceleration. America’s economy was roaring along at a 3.2% pace at the end of 2013. The first few months of 2014 will be weaker than that, even though average growth for 2014 still looks likely to outpace last year’s rate of 1.9%.
• China’s economy, for its part, is clearly slowing. The latest purchasing managers’ index suggests factory activity is at a six-month low. The question is how far and how fast that slowdown goes. Many investors fear a “hard landing”. Their logic is that China has reached the limits of a debt-fuelled and investment-led growth model; and that this kind of growth does not just slow but ends in a financial bust. Hence the jitters on news that a shadow-bank product had to be bailed out. Yet it remains more likely that China’s growth is slowing rather than slumping. The government has the capacity to prevent a rout; and the recent bail-out suggests it is willing to use it.
• If fears about a hard landing in China are exaggerated, then so are worries about a broad emerging-market collapse. That is because the pace of Chinese growth has a big direct impact on emerging economies as a whole. Expectations for Chinese growth will also be a big influence on the desire of foreigners to flee other emerging markets, and hence on how much financial conditions in these countries tighten. After more than doubling interest rates, Turkey’s economy will be lucky to grow by 2% in 2014, compared with almost 4% in 2013. But in most places less draconian rate hikes will merely dampen a hoped-for acceleration in growth rather than prompt a rout.
• The final, paradoxical, reason for guarded optimism is that the market jitters make bolder monetary action more likely in Europe and Japan. With inflation in the euro area running at a worryingly low 0.8%, the European Central Bank (which met on February 6th after we went to press) needs to do more to loosen monetary conditions. Really bold action, such as buying bundles of bank loans, is more likely when financial markets are in a funk. That logic is even stronger in Japan, whose stockmarket has fallen furthest and where the economy will be hit by a sharp rise in the consumption tax on April 1st. So more easing is on the cards.
• If this analysis is correct, the current market pessimism could prove temporary. Investors should recover their nerve as they realise that the bottom is not falling out of the world economy. Our prognosis is a lot better than the outcome markets now fear. But it would not be much to get excited about. The global recovery will be far from healthy: too reliant on America, still at risk from China, and still dependent on the prop of easy monetary policy. In other words, still awfully wobbly.

Is risk aversion a good option?

• Risk has always had a bit of an image problem. It is associated in the popular mind with gamblers, skydivers and, more recently, the overpaid bankers who crippled the global economy. Yet long-term economic growth would be impossible without people willing to wager all they have by starting a business, expanding an existing one or trying to invent a better mousetrap. Such risk-taking has been disturbingly scarce in America of late: the number of self-employed workers, job-creation at start-ups and the sums invested in businesses have been low.
• Though changing appetites for risk are central to booms and busts, economists have found it hard to explain their determinants. Instead, they tend to cite John Maynard Keynes’s catchy but uncrunchy talk of “animal spirits”. Recent advances in behavioural economics, however, are changing that.
• Economists have long known that people are risk-averse: Daniel Bernoulli, a Swiss mathematician, observed as much in the 18th century. Consider this simple test: given the choice, would you prefer a gift of $50, or to play a game with a 50% chance of winning $120? It might seem logical to pick the second, since the average pay-off—$60—is bigger. In practice, most people choose the first, preferring a small but certain payment to a larger but uncertain one.
• Yet the willingness to run risks varies enormously among individuals and over time. At least some of this variation is inherited. One study of twins in Sweden found that identical ones had a closer propensity to invest in shares than fraternal ones, implying that genetics explains a third of the difference in risk-taking.
• Upbringing, environment and experience also play a part. Research consistently finds, for example, that the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons. Alison Booth of Australian National University and Patrick Nolen of the University of Essex found that teenage girls at single-sex schools were less risk-averse than those at co-ed schools, which they think may be due to the absence of “culturally driven norms and beliefs about the appropriate mode of female behaviour”.
• People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.
• But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.
• This seems consistent with a growing body of research that links a low tolerance of risk to past emotional trauma. Studies have found, for example, that natural disasters such as the tsunami that hit South-East Asia in 2004 and military conflicts such as the Korean war can render their victims more cautious for years.
• The authors’ conclusions were reinforced by a separate test administered to a few hundred university students. About half were asked to watch a five-minute excerpt of a gruesome torture scene from a horror film. Then, the entire group answered the same questions about risk as the Italian bank’s clients. Watching the horror movie increased the students’ aversion to risk by roughly as much as the financial crisis had chastened the bank’s clients, although not among those who claimed to like horror movies.
• These studies suggest that the sweep and severity of the recent slumps in America and Europe will scar a wide range of people, not just those who lost money in the markets. The financial crisis is likely to inhibit them from taking the sort of risks that help propel the economy for decades to to come. Regulators and policymakers may soon be worrying about the lack of risk-takers, not fretting about their excesses.

Fiscal sustainability

• Fiscal sustainability has become a hot topic as a result of the European sovereign debt crisis, but it matters in normal times, too. This column argues that financial sector reforms are essential to ensure fiscal sustainability in the future. Although emerging market reforms undertaken in the aftermath of the financial crises of the 1990s were beneficial, complacency is not warranted. In the US, political gridlock must be overcome to reform entitlements and the tax system. In the Eurozone, creating a sovereign debt restructuring mechanism should be a priority.
• Does fiscal sustainability matter only when there is a fiscal house on fire, as was the case with the Greek sovereign insolvency in 2011–12?
•  Overcoming challenges that hinder inclusive and sustainable growth can only become possible through actionable policies and programmes if there is sufficient public funding in place, with support from the private sector. Public infrastructure, both physical and legal, for example, provides a foundation for progress in society. Further commitments of public resources are needed to ensure that this new world will be secure and stable.
• Financial support for public spending (on healthcare, pensions, infrastructure, etc.) must be funded through taxes that are clear, fair, and transparent – which is essential to their political acceptability – and that do not cause avoidable damage to the incentives to save, invest, work, and create wealth. Fairness and efficiency have intertemporal and intergenerational dimensions too, so public debt, which redistributes the burden of funding public spending over time – across generations and between different stakeholders within a generation – plays a critical role in meeting many of today’s financial challenges.
• Fiscal crises are just the tip of the public finance/sovereign funding iceberg. Even in normal times, the political and economic choices involved in determining the size and composition of public spending and the structure of the tax system are complex and often deeply divisive.
• The most remarkable feature of the fiscal sustainability crises that followed the North Atlantic financial crisis late in 2007 was that they were all advanced-economy crises, including the heartland of modern capitalism – the US, the UK, and the Eurozone. To varying degrees, advanced economies have socialised financial-sector losses caused by the crisis.
• Together with revenue losses (and automatic fiscal stabiliser-driven increases in social spending) caused by the North Atlantic financial crisis and the balance-sheet recession that followed it, this has tipped already precarious fiscal positions in many advanced economies into outright dangerous territory. For fiscal sustainability, fairness, and moral hazard reasons – that is, future crisis prevention – it is essential that financial-sector reforms be implemented to avoid a recurrence of the socialisation of financial-sector losses.
• Emerging markets and developing countries – historically the usual suspects when it comes to fiscal sustainability crises, sovereign solvency crises, and even public debt restructurings or defaults – were not on the fiscal delinquents list following the most recent financial crisis.
• The reason emerging market nations did not find themselves in the fiscal doghouse after 2007 was that the benefits of the reforms and improved macroeconomic management following the Tequila crisis of 1994, the Asian crisis of 1997, and the Russian crisis of 1998 had not been dissipated by 2008. After the painful and humiliating experiences of the Asian and Russian crises, most emerging markets cleaned up their balance sheets in the banking sector and non-financial corporate sector. Government deficits were brought down and the external current account deficits were reduced or turned into surpluses. Structural reforms to enhance the efficiency of their economies were undertaken – especially in the tradable goods sectors. Almost 15 years of export-led growth followed.
• When the North Atlantic financial crisis hit in 2007, most emerging markets were, for the first time in their histories, able to counter a recession imported from the US and Europe through effective countercyclical policy. Monetary and fiscal stimuli were applied, and most emerging markets recovered swiftly from the crisis. As advanced economies cut official policy rates to historically unprecedented levels during the period 2008–10 and engaged in rapid and large-scale balance-sheet expansions by their central banks, a ‘wall of money’ driven by a relentless hunger for yield came towards those emerging markets that were open to global capital flows; by now most of them except for China and, to a lesser extent, India.
• Attempting to counter the appreciation of their currencies that was warranted by these inflows, emerging markets accumulated foreign-exchange reserves on a huge scale. Attempts to introduce capital controls in a hurry, both administrative and fiscal, to limit inflows were unsuccessful in Brazil and elsewhere. The combination of high emerging market yields and appreciating emerging market currencies was irresistible. Macroprudential tools to stem capital inflows were embryonic, and the accumulation of forex reserves could not be effectively sterilised in most emerging markets, so domestic credit expansion imported from advanced economies resulted.
• Many emerging markets objected vociferously to these ‘currency wars’. When ‘currency peace’ broke out in May 2013, however, they did not like it any better. This was in part because after the successful counter cyclical policies of 2008 and 2009, emerging markets, instead of ceasing to stoke the fires of domestic demand, continued to fan them. India, Brazil, Turkey, Indonesia, South Africa, and many other emerging market nations permitted purely domestically generated credit booms to reinforce the imported credit booms.
• In China, the counterpart to the explosion of the banking sector’s balance-sheet size was mainly local government special purpose vehicles and corporate credit expansion. India’s credit boom also mainly involved corporates. Unlike China, however, quite a few corporates in India borrowed abroad in hard currencies, mainly US dollars. The same was true in Brazil, Indonesia, and Turkey. Corporate and banking-sector balance sheets expanded rapidly. In Brazil, for example, credit to the household sector was the main driver of balance-sheet expansion. Private-sector balance sheets became vulnerable, while external current account surpluses declined or turned into deficits. Stocks of gross external foreign currency debt, mainly issued by the private sector, also rose rapidly. The vulnerabilities were there. All that was needed for a financial ‘kerfuffle’ was a trigger. US Federal Reserve Chairman Ben Bernanke provided it through the tapering announcement of 22 May 2013.
• But even now, the balance sheet positions (or stock positions) and the budget deficit positions of most emerging market sovereigns are less vulnerable than those of the US, the EU, and Japan. There is a risk, of course, that impaired private assets from banks, corporates, or households that are either too big to fail, or too politically sensitive or politically well-connected to fail, will migrate to the public sector balance sheet, turning a private sector balance sheet crisis into a fiscal insolvency crisis.
• As noted earlier, the socialisation of financial sector balance sheet losses has indeed been the norm in the banking crises that were at the core of the North Atlantic financial crisis. The impaired assets of banks and other systemically important or politically well-connected entities were de facto implicit contingent sovereign liabilities. These implicit liabilities have since 2008 become explicit liabilities, most spectacularly in Ireland and to a lesser degree in Spain, Greece, the Netherlands, and Belgium. Slovenia’s government appears to be about to socialise at least part of the losses of its state-owned banks. Such intersectoral asset and liability migrations are not always in the same direction – i.e. they do not always involve the socialisation of private losses. In some emerging markets, notably in Argentina, there have been raids by the state on good private sector assets – the socialisation of private profits – in an attempt to restore public finances to sustainability.
• There is no doubt that emerging markets are more fiscally vulnerable today than they have been since the legacy of the 1997–98 crises. Complacency about the state of public finances in India, Brazil, Indonesia, South Africa, and even China – where there are likely to be large contingent sovereign liabilities hidden in the balance sheets of the banking and shadow banking sectors – is therefore not warranted.

reconstructing eurozone banks

• The worst of the crisis may appear to be over, but the Eurozone still contains undercapitalised banks with massive losses still on their books. This must be resolved, fast. A new restructuring agency for Europe’s banks is the best solution.
• The EU has made progress on the construction of a banking union, by agreeing on common rules for dealing with failed banks. The downside is that these rules won’t kick in until 2015: the Eurozone faces another year with weak banks, short of the funds they need to go about their business
• There are further problems. Funding for these new rules on “banking resolution” will be built up over the next decade, a long time in a sector where collapses can happen overnight. And it seems that the issue will still be handled on the national level, so that the deadly embrace of bank and sovereign fragility across the Eurozone periphery won’t be addressed.
• Resolution tomorrow; funding even later? Many banks are still crippled by massive losses incurred over the past five years, and still have problems raising capital. This is today’s reality and it awaits urgent resolution.
• Weak and fragile banking systems across Europe are holding back economic recovery. The current discussion continues to mix guarantees for future losses with resolution of legacy losses. A separate and more short-term solution to address Europe’s five-year-old banking crisis is urgently called for.
• We could resolve the crisis through the establishment of a new agency that we would term the Eurozone Restructuring Agency(ERA). This agency would focus solely on legacy issues – it is not intended to address any future failures within the banking union.
• Once weaker banks are identified, the ERA would coordinate efforts throughout the Eurozone to rescue the viable banks and liquidate the non-viable ones. The agency should be a temporary vehicle, with a clear sunset clause, so that it ends its duty after banking union is completed.
• The ERA would be created in two phases. The EU is currently investigating its banks to separate the weaker ones into the institutions it deems viable and those that are unviable. This process, involving an “asset quality review” and “stress tests” (where bank performance is modelled in a variety of unfavourable scenarios), is due to finish in mid-2014.
• Unviable banks would be liquidated while banks that are weak but viable would be restructured, preferably by separating them into good and bad banks. This phase should also involve a “bail-in”, where unviable banks’ creditors are asked to contribute either part or all of the money necessary. Therefore the public funding necessary should be minimal.
• In the second phase, the ERA becomes responsible for both the good and the bad banks that emerged from phase one. After the bail-ins, the ERA would inject capital in the good banks. In return, it would become a part owner of these banks by taking equity stakes.
• The ERA would be jointly owned by the 17 Eurozone members, in the same proportion as their shares in the current safety-net for nation-states, the European Stability Mechanism. All liabilities, but also assets and equity stakes in the good banks, would thus indirectly be owned by European taxpayers.
• For years now, a fix to Europe’s banking crisis has been held up by political deadlock between policymakers favouring a centralised solution, mostly in crisis countries such as Spain or Greece, and those favouring a country by country approach, most prominently Germany.
• While European loans to states only involve down-side risk, our proposal has the advantage that positive returns will be redistributed back to the ERA shareholders in proportion to the capital they put in. Creditor countries will receive larger pay-offs if things turn out favourably, even if these revenues come from debtor countries such as Spain.
• However, downside risks stemming from the bank resolution should be borne in proportion to country risks, at least in the long-run.
• For years now, a fix to Europe’s banking crisis has been held up by political deadlock between policymakers favouring a centralised solution, mostly in crisis countries such as Spain or Greece, and those favouring a country by country approach, most prominently Germany.
• While European loans to states only involve down-side risk, our proposal has the advantage that positive returns will be redistributed back to the ERA shareholders in proportion to the capital they put in. Creditor countries will receive larger pay-offs if things turn out favourably, even if these revenues come from debtor countries such as Spain.
• However, downside risks stemming from the bank resolution should be borne in proportion to country risks, at least in the long-run.
• One option is that the European Central Bank’s revenue from issuing Euros (known as seigniorage) could be redistributed from debtor to creditor countries, in line with losses incurred on banks headquartered in the respective countries.
• Another option is that countries whose banks receive assistance post collateral with the ERA, such as gold reserves or shares in state-owned companies. If the losses are greater than expected, these assets can be sold and the proceeds distributed among ERA’s creditors (and indirectly, Europe’s taxpayers).
• To avoid a seizure of their collateral, debtor countries will have incentives to support the ERA and to assure that good banks and bad assets are sold at the highest price possible.
• To implement its mandate, the ERA would be legally independent –- akin to the European Central Bank –- so as to insulate it against political pressures from European or national actors. The agency will have centralised decision power over the banks both good and bad. However, bank management and the liquidation of the non-performing assets are best done at the local level.
• This proposal for a Eurozone Restructuring Agency has a number of advantages. It would mean distressed banks could be resolved quickly, speeding up the liquidation of bad assets and maximising returns for European taxpayers.
• It would create a “clean slate” for a forward-looking Eurozone banking union. Certainty about the resources needed to resolve the crisis would re-establish confidence in the soundness of European banks.
• The EU’s announcement is better than nothing, and progress has certainly been made. But the problem remains that the Eurozone still contains under capitalised banks with massive losses still on their books. This must be resolved, fast. A new restructuring agency for Europe’s banks is the best solution.

Carving Global banking

• Some wounds go on hurting for years after they were inflicted. For bank regulators, the trauma of the collapse little more than five years ago of Lehman Brothers is as raw as if it had just happened.
• Lehman had spanned the world, and was run as a single entity largely overseen in America. Its disintegration caused rancour almost everywhere. Britain complained that it had been allowed to snatch $5 billion in cash from its London operation just days before the bankruptcy. Germany fumed that the Bundesbank had been saddled with defaults on about €8 billion-worth ($11 billion) of loans the central bank had made to Lehman’s German subsidiary.
• Since then regulators around the world have done much to avoid a repeat. Many of their actions, such as making banks hold more capital, have been sensible. But the rule makers have also been quietly carving up the global financial system.
• Britain is forcing the local operations of foreign banks to hold more capital. In Germany regulators have told the subsidiaries of Dutch and Italian banks not to send cash out of the country. But the biggest move could come in America, where the Federal Reserve will soon publish rules governing the operations of big foreign banks that will, in effect, throw up a wall around America’s financial markets.
• This rush to reduce the risks posed by the collapse of big foreign banks is understandable. Regulators are accountable to taxpayers at home. And, given Europe’s tardiness in cleaning up its own banking system, who can blame the Americans for wanting to insulate themselves from its troubles? European banks are still undercapitalised compared with their American peers. In an ideal scenario, forcing Barclays or Deutsche Bank (let alone shakier local German lenders) to put up more capital would make the whole system safer everywhere.
• But reality is not that simple. To begin with the Europeans may well retaliate. France’s big banks are already lobbying the European Commission to impose retaliatory restrictions that will keep JPMorgan and Goldman Sachs out of French bond markets (even though the American banks are better capitalised). That will fragment global finance.
• Walling off banking systems will increase the costs of borrowing, especially in small or fast-growing economies that need to import capital. It will cut returns to savers in countries with excess saving. McKinsey, a consultancy, reckons that fragmented banking systems could trim global growth by almost 0.5 percentage points a year. And a more fragmented system, even with better-capitalised local banks, is not necessarily safer. Risk will be more concentrated if banks cannot spread it around the world, and failures more common if they cannot move capital to bail out ailing units.
• The Fed’s impatience with Europe is understandable. America has cleaned up its banks and Europe has not. European regulators need to use the European Central Bank’s forthcoming asset-quality review to show they are serious about doing so.
• But even the Americans admit that the best system, for big banks, is a global one—and there are ways of making a global system safer. Banks could be forced into structures that would push losses from their subsidiaries up to the parent and send capital down to struggling subsidiaries. Big cushions of equity and “bail-in” debt held centrally could reassure regulators.
• For that to happen, there need to be formal deals between the main financial centres. The Financial Stability Board (FSB), a club of supervisors and central banks, is championing these ideas, but neither the Americans nor the Europeans have done enough to push them. If the Europeans get serious about cleaning up their banks, the Americans should make one final, genuine attempt to get the FSB’s global rules to work.

Mahindra,the obvious face of India capitalism

•  Anand Mahindra, an Indian tycoon, there is a rebel bursting to get out. He works amid aircraft models and walls of framed posters and has a mildly indiscreet Twitter account with a million followers. A former film student at Harvard, he describes his country’s malaise using the metaphor of “Star Wars”. Graft and cronyism in India are like an evil Empire that has struck back. His hope is that middle-class and young Indians become Jedi knights to battle the Dark Side.
• Most of the time, though, Mr Mahindra, aged 58, is a senior statesman—the acceptable face of Indian capitalism, especially since the retirement in 2012 of the admired Ratan Tata from Tata Sons. Mahindra & Mahindra dominates India’s market for sport-utility vehicles (SUVs) and is the world’s largest tractor firm by volume, selling them in India and abroad—it is sufficiently entrenched in America to sponsor Texan bull-riding tournaments. It is not huge, being the fifth-biggest Indian family group by sales ($16 billion) and the 17th largest Indian firm by market capitalisation ($15 billion). But it is notable in several ways.
• First, it is a rare Indian manufacturing success—and has created its technology at home. Indian conglomerates are often financial quagmires but Mahindra has high returns and little debt, and uses capital efficiently. In a country where power is dynastic it is the business house closest to being controlled by outside investors: the family and its allies own only 25%. Mr Mahindra is the third generation, and probably the last, to be boss—there is no obvious family successor. Lastly, the group is known for avoiding cronyism. Mr Mahindra has kept away from industries that require “a competence for lobbying”, and says he avoids Delhi, India’s capital, like the plague.
• The magic formula has ordinary ingredients: luck and judgment. When India liberalised in 1991 Mahindra was sprawling and flabby like many of its peers—making everything from jeeps to lifts. It slimmed fast, perhaps because the family’s low stake made it vulnerable to a takeover. In 1993 it hired Pawan Goenka, a veteran of Detroit, who now runs the automotive unit. Then came a fall in property prices, in 1997-98, which stretched the firm’s finances and forced it into some hard choices, says Bharat Doshi, a director. Rather than put more cash into a joint venture with Ford, Mahindra backed its own SUV project. By 2002 a model called the Scorpio was born and by 2005 it was a huge hit.
• More good decisions have come since then. New SUV models were launched. In 2007 Mahindra had a sniff at Jaguar Land Rover (JLR), a British carmaker, but backed off. Although JLR has since prospered under Tata’s control, the $1 billion of cash it ate up in the first year of its new ownership would have overwhelmed Mahindra, which then had a market capitalisation of only $4 billion. In 2009 Mahindra bought Satyam, an IT-services firm that had been floored by a huge fraud. It fully merged Satyam with its own IT arm in June, lowering its stake to 26% in the process but helping to boost the value of the combined entity, which has reached $6 billion.
• The big worry is that Mahindra will have a “Nokia moment”, when an apparently unassailable position crumbles. The Indian SUV unit contributes about 55% of operating profits and cashflow. It has a market share of 41% according to Hitesh Goel of Kotak, a broker. Its returns on capital are tremendous, partly reflecting a relatively low level of technology investment. Tractors, also with a 41% market share, contribute one-third of profits—and demand is booming thanks to this year’s heavy monsoon rains.
• Max Warburton of Sanford C. Bernstein, a research firm, notes that the global SUV craze has created other successful specialists—China has Great Wall, a firm now worth $20 billion. But Mahindra’s strong position in its home market is vulnerable to attack from the global carmaking giants, as they seek to diversify away from the unprofitable mass market for conventional cars towards such profitable niches. Renault and Ford have launched new SUVs and now “everyone and his uncle, cat and dog is leaping in,” says Hormazd Sorabjee, editor of Autocar India. In tractors, too, foreign firms are developing the smaller machines that tend to do best in India, says Abhijeet Naik of CLSA, another broker.
• Mahindra is not asleep at the wheel. It has new SUV models in the pipeline and a rural distribution network that will be hard for rivals to replicate. Still, it makes sense for it to invest in new areas. In 2011 it bought SsangYong, an ailing South Korean firm, and is nursing it back to health. Mahindra hopes to use its brand to build a presence in pickup trucks and two-wheelers—efforts which analysts tend to hate, arguing that both product lines are losing money and face formidable competitors.
• Yet taken together these three experimental areas are hardly big bets, consuming only about one-fifth of the group’s underlying cashflow. Mahindra spends only $170m a year on research and development—1.9% of its market value. It has a conservative balance-sheet, with no almost no net debt once you exclude the liabilities in its listed finance arm.
• Sometimes being an admired firm is a trap. Investors get addicted to steady cashflows and become jittery about risky new projects. Mahindra could legitimately invest heavily in developing big tractors for the American market, trying to export more SUVs under its own brand or SsangYong’s, and broadening its rural presence into new areas such as logistics. It could also buy a Western car firm, to acquire better technology—already it is considering a new research centre in Britain. Mr Mahindra says “it is not in our culture” to bet the ranch. But it must not be too conservative either. Capitalism only works when the best firms rebel a bit and take some risks.

Clarity about public spending can make poor countries richer

• Whether you are a farmer in Mexico, a student in Nigeria or an IMF official, openness about government expenditure matters. In the run-up to this week’s summit in London of the Open Government Partnership, a slow-moving international effort to promote transparency, clarity about budgets is a bit of a bright spot.
• Until 2008 the Liberian government provided scant information on its spending. It now puts budget documents online, and in January erected an electronic billboard outside the Ministry of Finance in Monrovia, the capital, to provide fiscal news to passers-by. Meanwhile, Morocco and Kyrgyzstan publish their budgets on downloadable spreadsheets.
• Openness need not be costly. Of the African states surveyed by the International Budget Partnership (IBP), a pressure group, 24 turned out already to produce 58 of the budgetary documents needed. But these were private—either for donors or for internal purposes. Warren Krafchik of the IBP says political will, not technical capacity, is the main brake on openness.
• Once details are published, citizens can lobby for different spending priorities. BudgiT, a Nigerian group, turns the numbers into easily understood infographics. It shows that $144 billion from oil revenues could pay the university costs of 1.5m students, or provide fertiliser for 14m farmers. Fundar, a Mexican think-tank, created a website showing that richer states got the lion’s share of money from the Procampo farm-subsidy programme. (Getting the data took 30 requests and 16 appeals.) After a media uproar the authorities brought in a new maximum payout for subsidies and promised to revise the list of recipients.
• Openness and scrutiny encourage lenders. In a study in 2012 the IMF linked economic crises to undisclosed debts and deficits. Openness in public finances was found to be an important predictor of a country’s credibility in the eyes of the market. Richard Hughes from the IMF’s Fiscal Affairs Department says that clarity also makes shocks to fiscal policy less likely.
• The IMF does not exactly practise what it preaches, however. In an index on aid transparency published last week, it came 28th out of 67 donor organisations for the openness of its aid programmes, with a “poor” score of 32%. (America’s Millennium Challenge Corporation came top, with 89%.) Secrecy is a hard habit to ditch. But at least it is becoming more conspicuous.