The global locomotive loses steam
 

Apr 29th 2005
From The Economist Global Agenda

For several years, America—and particularly the American consumer—has been powering global economic growth. Now, however, the locomotive seems to be losing momentum. Estimated GDP growth for the first quarter was a disappointing 3.1%, and other indicators look decidedly soft

IN CERTAIN quarters in America, a dreadful word is once again being whispered. “Stagflation”, that puzzling combination of high inflation and economic stagnation, was once thought impossible. The 1970s disproved that painfully, but most thought the phenomenon had been banished when the government got a firmer grip on fiscal and monetary policy. Now, however, all the economic data indicate that America has hit another economic soft patch, even as resurgent inflation begins to nibble at purchasing power and push the Federal Reserve to raise interest rates. Higher oil prices, gaping foreign-exchange imbalances and disappointing jobs data—could the dark days of the 1970s be returning?

Hardly. Economic growth, 3.1% for the first quarter, according to an estimate released on Thursday April 28th, may not be quite as fast as the nation has got used to (see chart). But it doesn’t compare to the economic era between the first oil shock in 1973 and the successful assault on inflation by Paul Volcker, the then Fed chairman, in the early 1980s. That period saw three recessions, double-digit inflation and unemployment mostly in the 6-10% range. Now, America is seeing moderate GDP growth, moderate core inflation (3.3% for the three months to March) and a 5.2% unemployment rate. Even oil prices are less painful than in the bad old days: in real terms, they were nearly twice as high in the 1970s.

But if the hour of doom is not quite at hand, there are still good reasons to worry. Though a 3.1% growth rate would be envied in most European countries, it is probably still below the natural rate at which America’s economy can grow without touching off inflation; that rate is estimated to be 3.5-4%. The rapid pace of America’s economic recovery, and its voracious appetite for imports, have been among the strongest pillars underpinning global growth in recent years. Of the other big economies, only Britain is in relatively good health; France, Germany and Japan are ailing. But should America falter, Britain’s economy is neither big enough nor sufficiently import-hungry to take up the slack.

So far, America’s consumers have saved the day, spending big even through recession, high oil prices and a costly war in Iraq. But to do so, they have taken on a lot of debt, drawing down home equity and piling into credit cards. Low interest rates have kept their monthly payments modest, even as their debt has shot up. But as interest rates rise, this well of consumer demand seems to be running dry. Moreover, payments on credit-card debt and adjustable-rate mortgages will squeeze consumers when interest rates increase further, as most economists reckon they will.

By this stage in the economic cycle, the job market should have been taking the slack, boosting consumer confidence—and incomes. But though the slowdown of 2000-01 did not feature the heavy job losses common in earlier slowdowns, employment figures have not yet picked up as they should. Though the unemployment rate has remained surprisingly low throughout, this is deceptive. It stayed low partly because of a big rise in people who had given up looking for work. The number of people claiming disability benefits has also increased; these are no longer counted in the labour force. A better measure of the employment picture is payrolls, which only surpassed their February 2001 peak in January of this year. Since the working-age population has grown over those four years, this means the jobs picture is still decidedly troubling.

The most likely explanation for sluggish recovery in payrolls comes from Erica Groshen and Simon Potter of the Federal Reserve. They argue that while most unemployment in earlier slowdowns was cyclical—firms laying off employees who would then get their jobs back (or ones very like them) when the economy picked up—in the last two it has increasingly been structural, meaning that people need to switch sectors, locations or skills in order to find a job. Since it takes much longer to do the latter, payrolls are not rebounding as they used to.

No longer shopping till they drop

Already, the numbers show that consumer spending is weakening, with growth falling to 3.5% in the first quarter from 4.2% in the previous one; the latest figures show consumer confidence down sharply. Further moderation is expected, as high oil prices and rising debt payments curtail disposable incomes. There had been hope that businesses would step in to help, but the latest figures make that unlikely. Inventories rose sharply in the first quarter; if goods that were stockpiled rather than sold are left out, GDP grew by only 1.9%. And durable goods orders fell in March for the third month in a row, with a particularly sharp fall of 4.7% in non-defence capital goods, an indicator of business-investment levels. Shipments of those goods also fell. With less capital equipment, and inventories piling up in their warehouses, companies seem set for lower production in the months ahead. That, in turn, will make the jobs outlook less sunny.

There are other clouds on the horizon. Though the impact of higher oil prices has probably already made itself felt, this could change if oil prices rise. Though inflation remains moderate, it is still high enough that the Fed will need to control it by raising interest rates, even if growth is slowing down. And there are also worries about America’s increasingly frothy housing market and surging current-account deficit.

Still, if the future looks darker than the recent past, this may be because in many ways the recent past has been unusually bright. While Alan Greenspan, the Fed chairman, did not quite engineer the “soft landing” that many had hoped for at the height of the boom, he has presided over a slowdown that could barely be called a recession, and a quick recovery. Cheap Chinese imports have helped America avoid the high inflation that would otherwise have been the natural result of the extremely low interest rates enjoyed since 2001. Those low rates have also enabled Americans to increase their spending without increasing their incomes. Tax cuts, financed by foreign investors who buy American bonds at bargain rates, have even put a little extra money in their pockets. After such halcyon days, it is undoubtedly hard to return to modest growth and consumer spending. But barring an oil shock or some other external crisis, Americans can keep their bellbottoms in the wardrobe.

SURVEY: OIL

Oil in troubled waters
 

Apr 28th 2005
From The Economist print edition

Prices are sky-high, with profits to match. But looking further ahead, the industry faces wrenching change, says Vijay Vaitheeswaran

“THE time when we could count on cheap oil and even cheaper natural gas is clearly ending.” That was the gloomy forecast delivered in February by Dave O'Reilly, the chairman of Chevron Texaco, to hundreds of oilmen gathered for a conference in Houston. The following month, Venezuela's President Hugo Chavez gleefully echoed the sentiment: “The world should forget about cheap oil.”

The surge in oil prices, from $10 a barrel in 1998 to above $50 in early 2005, has prompted talk of a new era of sustained higher prices. But whenever a “new era” in oil is hailed, scepticism is in order. After all, this is essentially a cyclical business in which prices habitually yo-yo. Even so, an unusually loud chorus is now joining Messrs O'Reilly and Chavez, pointing to intriguing evidence of a new “price floor” of $30 or perhaps even $40. Confusingly, though, there are also signs that high oil prices may be caused by a speculative bubble that could burst quite suddenly. To see which camp is right, two questions need answering: why did the oil price soar? And what could keep it high?

To make matters more complicated, there is in fact no such thing as a single “oil price”: rather, there are dozens of varieties of crude trading at different prices. When newspapers write about oil prices, they usually mean one of two reference crudes: Brent from the North Sea, or West Texas Intermediate (WTI). But when ministers from the Organisation of the Petroleum Exporting Countries (OPEC) discuss prices, they usually refer to a basket of heavier cartel crudes, which trade at a discount to WTI and Brent. All oil prices mentioned in this survey are per barrel of WTI.

The recent volatility in prices is only one of several challenges facing the oil industry. Although at first sight Big Oil seems to be in rude health, posting record profits, this survey will argue that the western oil majors will have their work cut out to cope with the rise of resource nationalism, which threatens to choke off access to new oil reserves. This is essential to replace their existing reserves, which are rapidly declining. They will also have to respond to efforts by governments to deal with oil's serious environmental and geopolitical side-effects. Together, these challenges could yet wipe out the oil majors.

The ghost of Jakarta

But back to the question of why prices shot up in the first place. The short explanation is that oil markets have seen an unprecedented combination of tight supply, surging demand and financial speculation. One supply-side factor is OPEC's clever manipulation of output quotas. Back in 1997, at a ministerial meeting in Jakarta, the cartel decided to raise output just as the South-East Asian economies were hit by crisis, sending prices plunging to $10. Desperate to engineer a price rebound, Saudi Arabia targeted inventory levels: whenever oil stocks in the rich countries of the OECD started rising, OPEC would reduce oil quotas to stop prices softening. It worked like a charm.

Another supply-related factor has been the shortage of petrol in the American market. Over the past year or two, prices have spiked as refineries have been unable to meet local demand surges.

Supply concerns have also played a part in the so-called fear premium. The nerve-wracking uncertainty before the invasion of Iraq, and the terrible terrorist attacks in Iraq and Saudi Arabia afterwards, have pushed up prices to a higher level than the fundamentals would seem to justify. Other supply worries arose from the crackdown by the Russian president, Vladimir Putin, on the oil company Yukos, and from civil strife in Venezuela and Nigeria. Some pundits think the fear premium may have added $7 to $15 to the cost of oil on futures markets in New York and London.

Adding to the froth has been the sudden influx of new kinds of financial investors into the oil market. Some are merely chasing the huge returns recently offered by oil. Big equity funds, fearful of what $100 oil could do to their holdings, might invest in oil futures at $40 or $50 as a cheap insurance policy. OPEC ministers love to blame hedge funds for high oil prices, but they are only partly correct. The “net long” positions (that is, their speculative bets on higher prices) held by such funds peaked in March last year and dropped through 2004, but oil prices kept rising regardless.

Phil Verleger, an energy economist associated with the Institute for International Economics in Washington, DC, reckons that the cartel itself may be to blame for the speculation: by declaring its intention to prop up prices, first at $30 and now at $40, “OPEC has given Wall Street a free put option” (because investors believe the cartel will cut output to stop prices falling).

Supply constraints coincided with a huge boom in oil demand. Global oil consumption last year increased by 3.4% instead of the usual 1-2%. Nearly a third of that growth came from China, where oil consumption rocketed by perhaps 16%. One senior European oil executive claims that, in contrast with the embargoes and supply-driven price rises of the past, “This is the first demand-led oil shock.”

And it was not just China that used a lot more oil. India's oil consumption too leapt last year, and America's was quite robust. In fact, despite $50 oil, global oil demand in 2004 grew at the fastest rate in over 25 years. The global economy also grew at a scorching pace. That appeared to defy the conventional wisdom that high oil prices drag down demand, and prompted the question whether oil prices even matter any more.

No safety net

So was it supply or demand that pushed prices above $50? Both matter, of course, but neither provides a complete explanation. What is new, and what has set the market alight, is the lack of spare production capacity.

In a normal commodity market, no producer in his right mind would keep lots of idle capacity. But that is precisely what several OPEC countries have been doing with their oil wells for years. Saudi Arabia, in particular, has maintained a generous buffer that it has used to prevent the market from overheating during unexpected supply interruptions. For example, during the Iran-Iraq war, the first and second Gulf wars and Venezuela's political crisis of 2003, oil exports from the countries concerned were disrupted, but the Saudis immediately started pumping more oil from their idle fields and single-handedly prevented a price surge and possibly an oil shock. This vital buffer, argues Robin West of PFC Energy, a consultancy, helps Saudi Arabia to act as the “central bank of oil”.

Alas, the buffer has been in decline for some years, because OPEC has not been investing sufficiently to keep pace with growing demand. As a result, global spare capacity last year dropped to around 1m barrels per day (bpd), close to a 20-year low. Almost all of this was in Saudi Arabia. In short, the market for the world's most essential commodity now has no safety net to speak of.

In such a tight market, argues Edward Morse of HETCO, an energy-trading company, even relatively minor changes in supply and demand can get magnified into unnerving price spikes. In the past, there has often been an inverse relationship between spare capacity and oil prices (see chart 1). The IMF has recently told OPEC that it must increase global spare capacity to 3m-5m bpd in order to ensure “the stability of the world economy.”

More worryingly, Mr Morse believes the problem extends well beyond just spare production capacity. He points to the tightness in markets for oil rigs, tankers, petroleum engineers, refinery capacity and various other bits of the oil value chain, and concludes that the problem is systemic: “The illusion that oil is in perennial oversupply has led to two decades of underinvestment in the oil industry. The world has been living off the legacy spare capacity built up many years ago.”

Given today's high prices, surely the market will soon enough provide the necessary new infrastructure? Probably not, for two reasons. The first is that the world seems to be coping rather well with today's shockingly high prices, so perhaps they have to persist for longer or rise higher still before investors are stirred into action. The second reason is the bitter memory of oil at $10 a barrel.

OPEC countries are unlikely to rush to build lots of spare capacity because they are worried that another price collapse may follow. PFC Energy observes that when the oil price hit $55 late last year, spare capacity was less than 15% of the 8.7m bpd peak reached in 1985, and notes: “OPEC national interests do not lie in creating large capacity surpluses that have existed for most of the history of oil.”

The western oil majors are even more terrified of another price collapse, and are keeping a tight rein on their capital expenditure. Projects are typically “stress-tested” for profitability at $20 a barrel or below. Some argue that Big Oil is being too cautious. But nobody thinks that spare capacity will ever return to the gold-plated levels of the mid-1980s.

Still, the crunch may ease if the Saudis rebuild their buffer. It may be in their interest to do so. For most of the OPEC countries, it makes sense to try to maximise prices in the short term because their reserves of oil are relatively small. The Saudis, by contrast, are sitting atop at least 260 billion barrels of proven oil reserves, far more than Libya, Venezuela, Indonesia and Nigeria combined. Even at current production levels of around 10m bpd, which make them the world's top exporters, they have enough oil to pump for most of this century. They will not want prices to stay too high for too long, or else investors will put money into non-OPEC oil or alternative fuels.

The desert kingdom's rulers also remember the lessons of the 1970s oil shocks, when the biggest losers were not consuming economies (which eventually adapted to higher prices) but the petro-economies of OPEC. Ali Naimi, the Saudi oil minister, rejects the idea that his country wants prices to rise ever higher: “We are misunderstood: we thrive on the economic growth of others, which is concomitant with energy demand.” That is why the Saudis have long acted as the voice of moderation within OPEC, resisting calls from price hawks such as Libya, Iran and, since the rise of Mr Chavez, Venezuela to squeeze consumers.

Indeed, at the most recent formal OPEC meeting, held in Iran on March 16th, the Saudis in effect bullied reluctant cartel members into trying to calm prices down. They won agreement for a rise in oil production quotas to boost global oil inventories that looked like a reversal of the cartel's established policy of keeping OECD inventories tight and prices high.

Developments within Saudi Arabia seem to confirm that the buffer is being rebuilt. Saudi Aramco, the state-run oil giant (and the world's largest oil company), has recently launched its biggest expansion programme in many years. Outside contractors report a surge in rig counts and drilling activity as the country increases spare capacity to its stated goal of 1.5m-2m bpd. But even if Saudi Arabia is willing to re-establish an adequate buffer, this could take years. Will prices stay high until then?

For much of the late 1980s and 1990s, the world enjoyed low and stable oil prices between $20 and $30. Now oil prices have shifted to double that level, apparently without causing much pain. OPEC ministers and Wall Street analysts talk of a new “price paradigm”. At first sight, there seems to be something in that. In the past, contracts for delivery of crude months or years ahead (what Alan Greenspan, the chairman of the Federal Reserve, has poetically called “distant futures”) usually stayed low and stable even if the spot price shot up because of some short-term disruption. But for the past couple of years the distant futures have tended to shoot up too. The markets clearly expect that higher prices are here to stay.

Political scientists point to the bloated welfare states in most OPEC countries which will require higher oil prices to balance budgets and avoid social unrest. Some industry analysts see a new “floor” price of $30-40, if only to persuade oil firms to splash out on necessary investments upstream. Matt Simmons, a prominent energy investment banker, thinks that in view of rising input costs (for such things as oil rigs, steel pipes, tankers and so on) the oil price “needs to go way, way up”.

But some of this may be wishful thinking. In reality, oil companies have little control over prices. OPEC ministers are better placed, but even they cannot reliably control the oil market, as the industry's history of booms and busts clearly shows. Saudi Arabia's Mr Naimi seems to be arguing for moderation when he says that working out a fair price for oil is “a moving target: it needs to be comfortable for both consumers and producers, and at a level where investors will put money in to grow this industry.” But it is quite possible that prices could drop lower even than Mr Naimi would wish.

One factor is potential weakness in demand. There is much talk about Chinese demand changing all the rules, but that is just plain wrong. China's share of world oil consumption is still under 8%, far smaller than America's at 25%. Goldman Sachs, an investment bank, estimates that even assuming robust growth, China will remain a smaller oil consumer than America for decades to come.

And the growth in China's oil demand of nearly 16% last year is unsustainable. For one thing, there are simply not enough cars in all of China to guzzle that much oil. Much of the 2004 rise was related to the country's overheating economy and is unlikely to be repeated. For example, shortages of cheap coal led to the use of pricey fuel oil or dirty diesel for electricity generation; as bottlenecks in the coal system ease, that oil use will disappear. Over the past two years, as the country has developed its oil infrastructure, it has needed to fill pipelines, storage tanks and the like, but these were one-off purchases. The International Energy Agency (IEA) says that in January and February 2005, Chinese oil demand rose by only 5.4% on the same period in 2004, less than a quarter of the rate a year earlier. And if China's banking sector or its overall economy takes a knock, oil consumption is bound to be hit too.

On the supply side, too, things may ease up. Julian West of CERA, an energy consultancy, has compiled a list of all of the oil projects, led by both government companies and by private firms, that are due to come on stream over the next few years, “all found, all commercial, and all economic at half today's price.” He calculates that this “river of supply” could lead to a dramatic net increase in global oil production, with 2007 perhaps seeing the largest rise in production capacity in history. By 2010, this might add 13m bpd to the 2004 total of 83m bpd. Not everyone agrees with his assessment, and Mr West himself cautions that geopolitics could choke off this pending supply, but otherwise “the supply problem in two to four years will be too much oil.”

The financial markets offer another possible route to a sharp fall in oil prices. Pension funds have usually shunned commodities in the past, but in the past year or two they have poured tens of billions of dollars into securitised investments in oil, hoping for returns above those they can get on the anaemic stockmarkets. Mr Verleger worries that they have now developed a herd mentality reminiscent of the internet boom. As returns inevitably decline over time, the herd may turn tail and prompt a price collapse. In short, despite China's undeniable thirst and the shortage of global spare capacity, the oil-price boom may yet prove a bubble.

Volatile substance

Aramco's boss, Abdallah Jumah, sums it up: “Where the oil price goes, nobody knows.” He wishes it were otherwise. “The key is stability so we can plan. Oil investments take a long time to come to fruition.” His boss, Mr Naimi, argues that “oil is simply too vital a commodity to be left to the vagaries of the marketplace.” But even Saudi Arabia cannot guarantee oil-market stability, especially with its buffer so depleted. Indeed, the only sensible thing anyone can say about oil prices today is that they are unlikely to remain stable. A terrorist attack on Saudi oil infrastructure could send them past $100; a financial-market crash could push them below $10.

That uncertainty creates enormous problems for the western oil majors. Big Oil has never been much loved, but since OPEC's rise in the 1970s the majors have actually been the consumer's best friend, because their success at developing non-OPEC oil has restrained the cartel's market power. So it is worrying that their economic health is not as robust as it appears

Putting up the barricades
 

Apr 25th 2005
From The Economist Global Agenda

America's Congress is taking a harsher line on trade, particularly with China. The Bush administration is also getting into the act, with the treasury secretary and even the newly nominated trade representative talking tough. Is America turning protectionist?

THESE are not happy times for the dwindling band of free-traders in Washington, DC. Trade sceptics are on the move on two fronts: raising the barricades against the Chinese and refusing to lower them for the Central Americans.

Politicians blame China and its fixed exchange-rate regime for America's trade deficit. But Congress is also sceptical about the Central American Free Trade Agreement. Although CAFTA is small beans in economic terms, failure to get it through would spell ill for any global trade deal at the World Trade Organisation (WTO).

China-bashing has captured the headlines. On April 6th, 67 senators voted against dumping a bill proposed by Charles Schumer, a Democrat from New York, that would impose a 27.5% tariff on all goods from China unless Beijing adjusted its currency—which is fixed to the dollar at an artificially low exchange rate—within six months. Not only is the legislation utterly against WTO rules, it would cause havoc for the American economy. But Mr Schumer has been promised a vote by July, and his bill may well pass the Senate.

The Schumer bill's success, which has surprised even its sponsor, is accelerating other measures. Two more senators, Susan Collins and Evan Bayh, are touting the Stopping Overseas Subsidies Act, which would allow American firms to get countervailing duties to make up for Chinese subsidies, including a subsidised exchange rate. China is not currently subject to America's anti-subsidy law as it is deemed a “non-market economy” (which makes it easier for American firms to file anti-dumping cases against it). But declaring China a market economy for the purposes of subsidies, and a non-market economy for the purposes of anti-dumping, is against WTO rules.

Nobody in Congress, alas, seems to care about breaking WTO rules. The aim is to be seen to be bashing China loudly. Mr Bayh is holding up the confirmation of Rob Portman, the Ohio congressman whom George Bush has nominated for US trade representative, until his bill is voted on. Meanwhile, in the House of Representatives, Duncan Hunter, a conservative Republican, and Tim Ryan, a Democrat, have cooked up a law that allows American companies to use “exchange-rate manipulation” as a reason for demanding protection under America's trade laws. And the Congressional China Currency Action Coalition has filed a Section 301 petition asking the Bush administration to file a formal case to the WTO complaining about the yuan.

In the 1980s, a rising trade deficit—at that time with Japan—fuelled protectionist pressure in Congress. Ronald Reagan introduced the notorious “voluntary export restraints” on Japanese steel and cars. The Reagan team also abandoned its laisser-faire attitude to currency markets and, through the Plaza Agreement, engineered a sharp drop in the dollar.

The current bout of China-bashing is not a replay of the 1980s. Back then, large American firms, particularly the Detroit car giants, led the clamour for protection. Now big business, which relies heavily on Chinese inputs, is quieter. The shouting comes from smaller American suppliers. And even the noisier business groups, such as the National Association of Manufacturers, are relatively nuanced. Though the NAM wants Beijing to revalue the yuan, it does not support the Schumer bill.

Less encouragingly, the political and economic risks are bigger this time round. In the 1980s Japan, for all its faults, was always viewed as a democratic ally in Asia. By contrast, China is now seen as a nasty communist regime and a dangerous rival. In the mid-1980s, America's current-account deficit was smaller, 3.5% of GDP in 1985 compared with 6.3% today, and its debt stock lower. Today, America is the world's biggest debtor, with China as an important creditor. A sharp reversal in China's appetite for American Treasury bonds could send interest rates soaring.

This might come sooner rather than later, according to Alan Greenspan, the chairman of the Federal Reserve. In testimony before the Senate budget committee last week, he stated that the Chinese government’s massive exchange-rate interventions were causing growing imbalances in the domestic economy that will force China to abandon its currency peg. Over the weekend, the head of China's central bank also gave a speech indicating that the yuan could be revalued in the near future (though he blamed international pressure, rather than internal imbalances). Once this happens, the People's Bank of China can stop stockpiling dollar reserves—meaning its demand for American government securities will also dry up. Critics wonder if Congress, which has made little effort to curb America’s soaring budget deficits, has quite thought things through.

For now, the Bush administration seems to be trying to muddle along. It has increased its rhetoric about the need for China to fix its exchange rate. It said this at the G7 meeting of finance ministers on April 16th, and, when the Treasury issues its twice-yearly report on currencies later this month, it is likely to come close to calling China a “currency manipulator”—a term last applied to Beijing in 1994. Even Mr Portman, an ardent free-trader, sounded a harsh note on China during an appearance before the Senate finance committee on April 21st. Saying that the Chinese “do not always play by the rules”, he promised to take a firmer stance than his predecessor, Robert Zoellick. This seems to have garnered approval on both sides of the aisle—though not from Mr Bayh, who said that words were no substitute for action.

The Bush team hopes to keep this sort of grandstanding to a minimum. But the China-bashing in Congress presents a danger. At worst, this frenzy could result in a series of illegal (in WTO terms at least) protectionist bills becoming law. Even if things do not get that far, the China effect will complicate an already tough struggle to get CAFTA through.

Aside from a handful of passionate free-traders, Democrats are solidly opposed to the Central American trade deal, thanks largely to a massive lobbying campaign by the unions. The unions believe (correctly) that if CAFTA is defeated, Mr Bush's trade agenda will lie in tatters. In the face of determined union opposition, Mr Bush is already having trouble persuading many Democrats. Alarmist news about imports from China makes this task much harder.

Another set of CAFTA sceptics—the textile lobby—ought to be brought on board by fears of China. The Central American agreement is in part a way of staving off Chinese textile imports, which have surged since the quota regime ended this January. Without CAFTA, Central America's textile industry is likely to be decimated by Chinese competition. With the special duty-free access that CAFTA grants, Central American textile firms—and the American companies that supply them with material—may survive.

The Bush team is busy making this argument to textile groups. But the opposition against free trade of any sort in hard-hit textile states like the Carolinas is considerable. The White House is thus getting more overt with its bribes, such as its decision to consider safeguard quotas against Chinese imports for several textile products. (The European Union said on April 22nd that it is mulling similar restrictions.)

Another powerful southern lobby, the sugar industry, is proving even harder to placate. Outrageous import quotas keep the domestic price of sugar at double that of the world price. CAFTA would allow more imports in from Central American countries, but still less than 2% of US sugar production. For the sugar lobby—and the 15 or so Republican politicians who follow its bidding—that is still too much.

The betting is that, with enough presidential involvement and vote-buying, Mr Bush may get CAFTA through in the next couple of months. Until he does, there will be little appetite in the White House to give the China-bashing in Congress the cold shoulder that it deserves.

George Bush and the world

Cultivating new friends helps old ones flourish, too
 

Apr 7th 2005 | WASHINGTON, DC
From The Economist print edition

A new approach in foreign policy is gradually winning even the Europeans over

ANYONE determined to make the pursuit of freedom and democracy in other people's countries the organising principle of their foreign policy has to feel comfortable leading from the front. Far from being chastened by the difficulties of winning the peace in Iraq, his first term's biggest overseas adventure, George Bush has started his second term bent on tackling tyranny worldwide. After a certain amount of scoffing and some alarm (whose country would the neo-cons be trampling across next?), the idea is catching on in surprising places.

As it does so, from Ukraine to Kirgizstan, and from Afghanistan and Iraq to Lebanon, other problems too—especially the rift with parts of Europe over Iraq—are coming to seem more tractable. The hope is that this, in turn, may make it easier to manage the security challenges that America and its friends face in Iran and North Korea. Given a newly co-operative spirit, optimists argue, even the row between America and the European Union over whether the Europeans should lift their embargo on weapons sales to China may be turned to advantage, if the two sides can sit down and sort out their differences.

Administration officials are more cautious. Just as building democracy in new places is a work of a generation or more, so the tensions in transatlantic relations will not disappear overnight. But the recent run of good news is helping.

The watershed in relations with Europe, but also with parts of the Arab world, came on January 30th, with the impressive turnout in Iraq's election. Since then, says one senior administration official, the questions from even the prickliest European governments are no longer about why America fought the war, but how Europe can help rebuild Iraq. America and the EU will jointly sponsor a donors' conference in May or June. Mr Bush and his team have been pleased too with the support from Poland and Germany for Ukraine's orange revolution, and with France's help in winkling Syrian troops out of Lebanon.

Administration officials are careful to take no credit for these outbreaks of people power: all were home-grown. But Iraq's election and the protests against Syria's armed presence in Lebanon were not unconnected, they feel: the Arab television channels that Americans love to hate broadcast both events, including chants of “Syria out!” from Lebanon, all over the Middle East. Other governments have taken note: Saudi Arabia has tried limited local elections, Egypt is contemplating a mildly contested presidential election and others have been telling Mr Bush of their reform plans. Although the aim is not just to please America—a UN-sponsored Arab human-development report published this week predicts “chaotic upheavals” if Arab governments fail to address reform demands—the development is noted with satisfaction.

The administration has also been changing tack. A fresh team, with new energy and ideas, helps. Condoleezza Rice, unlike Colin Powell, her predecessor as secretary of state, has the president's ear. Between them, she and her deputy, Robert Zoellick, well connected around the world from a former cabinet post and as America's trade representative, are making a point of visiting between them all 25 NATO allies in their first few months. Ms Rice, recently in Europe and Asia, will soon add Latin America, the Middle East (again) and Africa to her itinerary. Mr Bush is due back in Europe in May, to mark the 60th anniversary of VE day, the end of the second world war in Europe, and will come again in July for the G8 summit of wealthier nations at Gleneagles, in Scotland. The diplomatic pace has noticeably quickened, but will Mr Bush give ground on any of the controversial issues?

Agenda-building

Last week, America agreed at the UN Security Council to let some of the top people implicated in the killings in Sudan appear eventually before the International Criminal Court (ICC), which America does not support. The administration is hoping to defuse a theological row with Europe over the court that has threatened to undermine efforts to halt the violence. Although the deal applies only to Sudan, it recognises that any American nationals caught up in these events under the auspices of the UN or the African Union would be subject to the exclusive jurisdiction of American courts (with other non-parties given similar rights). While America cannot live comfortably with the ICC, says a senior State Department official, this sort of solution may be a way of moving on.

Ms Rice is credited with the new thinking on this issue, and also with encouraging Mr Bush to shift his stance over Iran by recognising that a rejectionist position was making America, not Iran, seem the problem. Reassured on his trip to Europe in February that Britain, France and Germany, who are negotiating with Iran to end its dangerous nuclear dabbling, would keep a promise to take the matter to the Security Council if Iran resumes work to enrich uranium, the president agreed to two European requests: that America would not block talks for Iran to join the WTO, and that licences could be granted for Iran to import spares for its ageing civilian aircraft.

That still leaves the Europeans with the task of trying to talk Iran out of making nuclear fuel. Iran's latest gambit, demanding to keep just a few enrichment machines to do just a modest amount of enriching, is clearly designed to try to reopen the breach between Europe and America. But a more helpful Mr Bush makes it less likely that the Europeans will buckle.

Other issues have also come into play, however. Iran's support for violent groups in the Middle East undermines a cherished European goal: to see peace talks start between the new Palestinian leadership and Israel. The Europeans, for their part, are hoping Mr Bush will press Israel's prime minister, Ariel Sharon, next week over an issue they care deeply about: Israel's settlements in the West Bank.

But as Europeans and Americans start to assemble a more positive agenda, China and the arms embargo could still cause a bust-up. Mr Powell first started raising the issue with his European counterparts early last year. That made little impact in France, which has led the campaign to lift the arms ban in the hope of scooping up contracts (including for weapons, said the French defence minister in a moment of candour earlier this year, though officially neither the quantity nor the quality of the weapons flow is supposed to increase). Germany's chancellor, Gerhard Schröder, also favours ending the embargo, partly in hopes of winning China's support for a German seat on the UN Security Council.

Happily for more reluctant Europeans, and for transatlantic relations, China overplayed its hand. Its new law threatening violence if Taiwan moves towards independence was passed unanimously on the day an EU envoy was attempting to convince the administration and Congress that lifting the ban was purely a routine matter, since the EU's strengthened (but non-binding) code of conduct on arms transfers would suffice.

With a breathing space found, there is now talk on both sides of the Atlantic of the need for a “strategic dialogue” on Asia, in which the embargo issue could be included. No amount of explaining of the technicalities of Europe's arms code, say administration officials, will substitute for the reassurance that the EU understands a fundamental point: that it is American, not European, lives that are at risk in ensuring stability in Asia, and that any technological benefit that China may draw from European weapons or weapons-usable technologies will harm the transatlantic relationship. Meanwhile, credible threats of retaliatory legislation have come from all factions of Congress, from left-wing Democrats to right-wing Republicans.

Should America and Europe manage to start their strategic dialogue (more frequent and expanded contacts are being planned among senior American and EU officials, and America is also keen to beef up discussion at NATO), they will find plenty else to talk about too, from the Middle East to environmental issues and an increasingly autocratic Russia. But how to get a confidential discussion going, with 25 countries on the European side? One idea is to revive the “Quad” of America, Britain, France and Germany, perhaps with the addition of Poland and Italy.

The other problem is that the sort of world-shaping dialogue America is keen to have with Europe over China, and much else, is one that EU leaders have never yet had among themselves. By taking the EU seriously as a partner, Mr Bush may force its leaders to start thinking strategically about the world beyond their back yard. That would be an achievement.

You need us and we need you
 

Apr 6th 2005
From The Economist Global Agenda

America and foreign central banks are locked in a codependent relationship: America is addicted to spending, and the banks can’t stop throwing money at it in order to keep their currencies down. This is unhealthy for both parties, say the IMF and the World Bank. But is there any political will to change it?

AMERICA has been warned many times in recent years that its profligate spending is dangerous, for itself and for the world economy. So far, however, Americans have ignored such doom-mongering, gleefully driving their current-account and budget deficits to record levels. Now the World Bank and the International Monetary Fund (IMF) seem to be trying to stage an intervention. This week, both have come out with reports on the global financial situation—and both reports give warning that America’s fiscal irresponsibility poses serious risks to the world economy.

Neither organisation issues the kind of scathing indictment that might offend its most powerful constituent. Nonetheless, both make it pointedly clear that America’s copious spending is a real, and growing, problem for the rest of the world. America’s 12-month current-account deficit now stands at $665.9 billion, or 5.7% of GDP. Since a negative balance in the current account must be complemented by a positive balance in the capital account, this means that foreign funds are streaming in. America is mortgaging its future to pay for current spending.

Part of the reason this spending is so hard to get a grip on is that it is happening on multiple levels. With interest rates low, consumers have been tapping into their home equity and taking on credit-card debt—the latest figures from America’s Bureau of Economic Analysis show individuals’ savings were just 0.6% of their income in February. Meanwhile, even after massive tax cuts, the Bush administration has forged ahead with ambitious spending programmes. Thus, in 2004 the federal government’s budget deficit hit $412 billion, a worrying 3.6% of GDP. It is projected to fall only to $365 billion, or 3% of GDP, in 2005.

The gap between income and spending has been financed by foreigners, especially central banks; more than half of all publicly available Treasury bonds are now held abroad (see chart). But the central banks that are buying up all this paper, particularly Asian ones, are trapped in something of a vicious circle.

The natural adjustment mechanism for America’s rapidly growing foreign liabilities would be a declining dollar, which would lower demand for imports and make America’s exports more attractive on foreign markets. But the Asian central banks are stalling this process because they want to keep their currencies from appreciating against the dollar and thus becoming less competitive—and buying sackloads of dollars and then dumping them into US Treasuries achieves just that. This simply enables America to borrow more, making the inevitable adjustment sharper when it comes. That risk, of course, makes dollar-denominated assets less attractive, meaning that the Asian central banks have to go to ever-greater lengths to keep their currencies from appreciating.

We can’t go on like this

The World Bank estimates that roughly 70% of global foreign reserves are now in dollars. That growing portfolio of dollar assets is vulnerable to currency correction. This is not such a problem if the dollar declines gently, but an abrupt change in its value could spell trouble, as central banks find themselves with gaping holes in their portfolios.

Central banks have another problem: many are reaching the limits of their ability to “sterilise” their currency transactions. In order to keep their exchange-rate operations from causing inflation at home (the natural result of keeping one’s currency undervalued), central banks sell bonds on the domestic market in order to mop up excess money supply. However, this is expensive, since in many cases the interest rates on domestic bonds are significantly higher than on the Treasuries the central banks are buying. The World Bank estimates that this differential costs emerging-market central banks $250m a year for every $10 billion they hold in reserves.

There are further, institutional, limitations. The Reserve Bank of India, which is forbidden to issue debt or sell rupee assets on international markets, is running down its inventory of securities to sell. Last autumn, South Korea’s central bank bumped up against the annual limits on the sale of government debt. And China, a huge consumer of American debt, has been stuffing securities into its state-owned banks at below-market rates. This has made its already-fragile financial sector even weaker, and cannot go on indefinitely.

But as the IMF notes (and the World Bank agrees), dollar depreciation cannot be the only mechanism of adjustment for current global imbalances. They want developing countries with artificially cheap currencies to make their exchange rates more flexible. Europe and Japan are urged to stimulate domestic demand, taking the pressure off America to be the world’s customer—though this seems a little unfair to Japan, which has been energetic, if ineffective, in pursuit of consumer stimulus. And America, the Bank and Fund make clear, must get its fiscal house in order, cutting its budget deficit and encouraging consumers to save.

I can quit any time

Unfortunately, like much good advice, these recommendations seem to have little hope of being implemented any time soon. The political pressure in Asia to subsidise exports with low exchange rates is intense. Interest rates in Japan have been near zero for four years, giving the central bank little room for additional action; meanwhile, the European Central Bank seems to be preparing for a rise in interest rates this autumn, to keep inflation near its target of just below 2%, which will hardly do much for demand. And in America, the political will to reduce deficits seems to be all but extinct.

Given all these reasons to worry, it might seem surprising that both the IMF and the World Bank are broadly optimistic about the world economy. But as they point out, growth in 2004 was robust, and the world is currently enjoying high levels of macroeconomic stability. Alan Greenspan is expected to deliver steady increases in interest rates, slowing American demand, and forcing its consumers to rebuild shaky savings; it is hoped that this will help bring about an orderly adjustment in the dollar’s value. This will not be pain-free for the rest of the world—developing countries that have got sweet debt deals from investors fleeing low American interest rates will find their borrowing less easy to finance. But the resulting decline in imports should allow central banks to cut back on the breakneck pace of growth in reserves. And who knows? Perhaps once ordinary Americans are forced to live within their means, they will start demanding the same from their government.

The central bank takes stock
 

Mar 17th 2005
From The Economist Global Agenda

OPEC, the oil producers’ cartel, has lifted its quota ceiling by 500,000 barrels per day in an effort to cool oil prices. That prices continued rising to new highs after the move suggests that someone is betting big against oil’s kingpins

BEFORE this week’s meeting of the Organisation of Petroleum Exporting Countries (OPEC) in the old Persian capital of Isfahan, Saudi Arabia’s oil minister, Ali Naimi, had soothing words. “We care about consumers,” he said, “especially in the developing countries, and we don’t want to hurt them.”

To anyone suffering as oil prices have climbed, Mr Naimi’s remarks will come as a surprise. After all, it was Saudi Arabia that masterminded the revival from $10 a barrel in 1999. The Saudis worked out that watching OECD countries’ stocks, and slashing OPEC output if they rose, was a superb way of propping up the oil price. The Saudis long maintained that they wanted to keep prices in the $20s or low $30s. Prices have risen nonetheless: West Texas Intermediate topped $56 for the first time on Wednesday March 16th, the day the cartel met. On Thursday the record-breaking continued, with crude touching $57.

It now seems, though, that Saudi Arabia does want prices to fall a bit. The Isfahan meeting was expected to be a routine affair, at which the cartel merely rolled over its production quotas. Because global oil consumption always falls in the second quarter, as demand recedes from its peak in the northern hemisphere’s winter, raising quotas now seemed an odd idea.

And yet, at Saudi Arabia’s insistence, that is precisely what OPEC has done. The cartel has agreed to lift its quota ceiling by 500,000 barrels per day (bpd) immediately, to 27.5m bpd, the highest ever, and to raise it by the same amount soon if market conditions warrant. Most cartel members are already cranking out all they can, however. That is why, argues Vera de Ladoucette of CERA, an energy consultancy, ministers essentially blessed efforts by Saudi Arabia, Kuwait and the United Arab Emirates (the only cartel countries with any spare capacity) to raise output.

The deal would not have happened without Saudi bullying. Most members, including Iran, this week’s hosts, opposed expanding output; some, like Venezuela, have expressed a desire for still higher prices. But the Saudis said that they would raise output with or without the approval of other members.

Ms de Ladoucette is convinced that the Saudis “want to put a lid on prices”. They have historically been a voice of moderation within OPEC. Lately, they have said that they would like to see prices stay between $40 and $50; but they fear prices could shoot up to $60 or higher. In the past, they maintained a large buffer of spare capacity that allowed them to boost output quickly to cool prices. That earned them the nickname of the “central bank of oil”.

Because years of under-investment nearly wiped out that buffer, the Saudis have been powerless to cool prices recently. This has worried the International Monetary Fund into giving warning that OPEC must expand spare capacity to 3m-5m bpd to ensure the health of the global economy. The Saudis now seem serious about reining in prices. They have embarked on the largest expansion programme in many years, and aim for a buffer of 1.5m-2m bpd. They have unilaterally raised output in recent weeks. Mr Naimi now says he actually wants to see oil stocks grow in coming weeks, so that the world could weather a sharp surge in demand next winter.

Vincent Lauerman of the Canadian Energy Research Institute, a think-tank, says this is “absolutely a U-turn”. A global build-up of stocks, he reckons, “is the quickest way for OPEC to increase supply flexibility in the market”. He notes that it will take time to rebuild spare production capacity, especially when world oil demand is growing by 2m bpd or more a year.

Whether the Saudis will succeed in moderating prices remains to be seen. This week’s new record suggests that someone is betting against oil’s central bank.

Economics focus

Putting things in order
 

Mar 17th 2005
From The Economist print edition

China ought to allow more flexibility in its exchange rate, sooner rather than later

THE Chinese government says that it intends, eventually, to make its exchange rate more flexible and to liberalise capital controls. In the past year or so, it has already eased some controls on capital outflows and officials have said recently that they will open the capital account further this year. On the exchange rate, much less has been done. The yuan has been pegged to the dollar for a decade, and the government is loth to change much until the country's banking system is in healthier shape: this week the prime minister, Wen Jiabao, said that a shift would be risky. But is China putting the cart before the horse? Other countries' experience suggests that it is, and that it is better to loosen the exchange rate before, not after, freeing capital flows.

Most commentary on the Chinese yuan tends to focus on the extent to which it is undervalued. It has been pegged to the dollar for a decade, and there is a widespread belief that it is unfairly cheap. In fact, this is not clear-cut. For instance, the increase in China's official reserves is often held up as evidence that the yuan is undervalued. Yet this largely reflects speculative capital inflows lured by the expectation of a currency revaluation. Such inflows could easily be reversed. Given the huge uncertainty about the yuan's correct level, it makes more sense for China to make its currency more flexible than to repeg it at a higher rate. Greater flexibility would be in China's interest: it would afford the country more independence in monetary policy and a buffer against external shocks. By fixing the yuan to the dollar, China has been forced to hold interest rates lower than is prudent, leading to inefficient investment and excessive bank lending.

The problem is that Chinese officials, along with many foreign commentators, tend to confuse exchange-rate flexibility and capital-account liberalisation. A commonly heard argument is that China cannot let its exchange rate move more freely before it has fixed its dodgy banking system, because that could encourage a large outflow of capital. A recent paper* by Eswar Prasad, Thomas Rumbaugh and Qing Wang, all of the International Monetary Fund, argues that, on the contrary, greater exchange-rate flexibility is a prerequisite for capital-account liberalisation.

Flexibility does not necessarily mean a free float. Initially, China could allow the yuan to move within a wider band, or peg it to a basket of currencies rather than the dollar alone. The authors first knock on the head the notion that the banking system must be cleaned up before allowing the exchange rate to move. Although financial reform is certainly essential before scrapping capital controls, the authors argue that with existing controls in place the banking system is unlikely to come under much pressure simply as a result of exchange-rate flexibility. Banks' exposure to currency risks is currently low and flexibility alone is unlikely to cause Chinese residents to withdraw their deposits or provide channels for them to send their money abroad.

The authors argue that it is also not necessary to open the capital account to create a proper foreign-exchange market. Because China exports and imports a lot, with few restrictions on currency convertibility for such transactions, it can still develop a deep, well-functioning market without a fully open capital account. A more flexible currency would itself assist the development of such a market. For example, firms would have more incentive to hedge foreign-exchange risks, encouraging the development of suitable instruments. The experience of greater exchange-rate flexibility would also help the economy to prepare for a full opening of the capital account. While capital controls shielded the economy from volatile flows, China would have time for reforms to strengthen the banking system.

China instead seems intent on relaxing capital controls before setting its exchange rate free. This ignores the history of the past decade or so: the combination of fixed exchange rates and open capital accounts has caused financial crises in many emerging economies, especially when financial systems are fragile. China would therefore be wise to move cautiously in liberalising its capital account, but should move more rapidly towards greater exchange-rate flexibility.

Yuan at a time

The Chinese have tried to offset the recent upward pressure on the yuan by easing controls on capital outflows, for instance by allowing firms to invest abroad. While this is in line with the eventual objective of full capital-account liberalisation, it runs the risk of getting reforms in the wrong order. An easing of controls on outflows may even be counterproductive if it stimulates larger inflows. By making it easier to take money out of the country, investors may be enticed to bring more in.

Capital controls are not watertight. So although China will continue to be protected from international flows, its controls can be evaded through the under- or over-invoicing of trade. Multinationals can also use transfer prices (the prices at which internal transactions are accounted for) to dodge the rules. Despite extensive controls, a lot of capital left China during the Asian crisis in the late 1990s; recently, lots of short-term money has flowed in. Controls are likely to become even more porous as China becomes more integrated into the global economy. Thus, waiting for speculative and other inflows to ease before changing the exchange-rate regime might not be a fruitful strategy.

China ought to move to a flexible exchange rate soon, while its capital controls still work. Experience also suggests that it is best to loosen the reins on a currency when growth is strong and the external account is in surplus. China should take advantage of today's opportunity rather than being forced into change at a much less convenient time.

Buttonwood

Starkers
 

Mar 16th 2005
From The Economist Global Agenda

The dollar may get another short-lived respite but it is heading inexorably down. The question is how much it takes with it

ALL you need to get into Harvard Law School these days, it seems, is a pair of fuchsia-pink high-heeled shoes. Or so say Buttonwood’s daughters, reliably informed by an early-teen cult film, “Legally Blonde”. On the basis that they can probably manage the shoes, if not the grades, Buttonwood is paying close attention these days to exchange rates. Her hope is that in seven years’ time, if the dollar continues to slide against other currencies (and British universities continue to raise their fees), it might cost little more to send the thuglets to study in Cambridge, Massachusetts than it would to pay their way in Cambridge, England.

What gives with the greenback? In two of the past three weeks, the dollar took a pasting on reports that various Asian central banks, whose purchases of America’s debt help it to go on borrowing and consuming, were planning to diversify their foreign-exchange reserves away from dollars. Bond yields spiked up (ie, prices fell) and shares looked glum too.

Then, on Tuesday March 15th, keenly-awaited figures from America’s Treasury showed a big increase in net purchases by foreigners of American long-term securities. The net flow in January ($91.5 billion) was 50% up on December’s figure ($60.7 billion), way over January’s trade deficit of $58.3 billion. Hidden in the figures were some interesting trends: purchases of American shares picked up, for example—which suggests a genuine fondness for the dollar unlikely to be unwound soon. But so too did purchases from the Caribbean—home to even more hedge funds than The Economist’s own St James’s Street—which could be liquidated tomorrow. Mark Austin, chief of foreign-exchange research at HSBC, a British bank, points out that central banks bought about the same amount as before, while private-sector purchases increased sharply. Is that positive for the dollar or negative? The currency rallied, though questions persisted.

The Treasury data tend to be volatile and in any event show only a portion of real flows. And one month does not a summer make. But taken together with other figures from the Federal Reserve showing an increase in February and early March in the securities it holds in custody for foreign owners, they do suggest two things. The first is that the full shock-horror scenario, in which Asian central banks dump the dollar and America promptly collapses, is way overdone. The second is that although Bretton Woods II is still in business, it is likely to change fundamentally.

The fact is that the markets are hyper-sensitive to these figures, and analysts pore over them like Kremlinologists. The fear that central banks are contemplating industrial action against the dollar—and the collective sigh of relief when it seems they are not—is part of a broader unease about the nature and solidity of America’s economic growth. Based, as it is, on mammoth consumption by both the private and public sectors—ie, on big trade and fiscal deficits—it needs foreigners willing to suspend disbelief and buy shiploads of securities denominated in a currency that has steadily lost value for about 40 years.

So far, the foreigners—mainly Asians plus a few outliers, including Russia and Brazil—have obliged, permitting America to scoop up 75% of the world's surplus savings. Together, Asian central banks have accumulated about $2.5 trillion in foreign-exchange reserves, up almost a quarter in little more than a year, most of it in dollars; Japan and China alone have reserves of nearly $1.5 trillion between them.

Central banks have more reason to purchase dollar assets than to dump them. Buying American securities keeps their own currencies low, their exports competitive and their workers free to move from fields to factories. America’s economy is still growing strongly, despite higher oil prices: this week’s retail-sales figures confirmed that. There is money to be made there: like investors everywhere, foreign buyers are chasing yield by moving up the risk-reward curve these days into bigger purchases of agency debt (the stuff put out by Fannie Mae and other government-sponsored agencies) and corporate bonds. And the biggest dollar holders—especially China and Japan—cannot really afford to start talking down the currency for they would see the value of their own holdings diminished at a stroke.

But the Faustian deal into which Bretton Woods II has turned—whereby America gets to spend beyond its means and Asia gets to invest in export-led growth, at the cost of recycling much of its earnings in America’s securities markets—turns out to have a shorter horizon than most people reckoned. It could turn sour at any time now. And confirmation of that came from another set of economic data, released on Wednesday: America’s fourth-quarter current-account deficit widened to $187.9 billion, a record.

The dollar’s role as the reserve currency of discriminating central bankers everywhere has already lost ground. On figures from the Bank for International Settlements (BIS), the world held 76% of its reserves in dollars in 2000; by 2003, the proportion had slipped to 68%. Part of that reflects the dollar’s slide in value. But part reflects growing diversification, which is as it should be. Asian countries are trading more with each other these days, as well as with Europe. The euro now offers a liquid alternative to the dollar, and Europe shows no signs of wanting to flood the world with its paper.

Russia, Indonesia, South Korea, India and Japan have all murmured significantly, if guardedly, about diversifying of late. Though figures are elusive, the best guess is that most are doing so already. At the end of February, officials and academics from all around Asia met in Bangkok to discuss the sliding dollar and concluded that they should move more definitively to their own advantage. There are repeated suggestions that regional payments systems should be set up, such as the gold dinar standard proposed for the Islamic world in 2002 by Malaysia’s prime minister.

It is possible that, this time around, OPEC and other oil exporters will channel their windfall profits through the Treasury’s books. But what will happen if a significant portion of countries decided not to add to their dollar holdings? More than the dollar would weaken. Big foreign buyers of bonds have been keeping interest rates down, perhaps by one percentage point, as Alan Greenspan suggests. That would change, for a start. Without this support, the yield on the ten-year benchmark Treasury bond could rise to more than 5%, pushing up interest rates on mortgages. That, in turn, could prick America’s house-price bubble and prompt a general deleveraging, with implications for economic growth both in America and elsewhere. Standard & Poor’s, a rating agency, warned on Monday that a weak dollar would substantially increase concerns about credit quality.

This is perhaps not the week to air such apocalyptic concerns, though they are much on Buttonwood’s mind. In the end, what foreign central bankers have it in their power to do is to reveal before all the world that the mighty American economic empire has no clothes—not even a pair of little fuchsia-coloured shoes.

The neo-conservatives

Back in their pomp
 

Mar 10th 2005 | WASHINGTON, DC
From The Economist print edition

Times are very good for America's least-loved foreign-policy makers. But their apotheosis may not last

BILL KRISTOL tells a nice story about a chance encounter in a shopping mall. Mr Kristol is a neo-conservative prince, the son of one of the movement's founders, and a ubiquitous talking head on Fox News. But even neo-conservative princes have to go shopping. One weekend found him wandering the glitzy corridors of Tyson's Corner, in northern Virginia. A young man accosted him and confessed that he, too, was a neo-conservative. He then paused for a moment before adding that he wasn't quite sure what neo-conservatism was.

This is not an isolated example of enthusiasm for the creed. The neo-conservatives are back in their pomp after a dismal year. The essence of neo-conservative foreign policy (to clear up the young man's confusion) is a mixture of hawkishness and idealism: hawkishness on projecting American power abroad, but idealism when it comes to using that power to spread good things like freedom and democracy. The neo-cons have no doubt that their vision has been vindicated by recent events in the Middle East. Would democracy be stirring in the region if Mr Bush hadn't chosen to topple the Taliban and Saddam Hussein? “Three cheers for the Bush doctrine”, says Charles Krauthammer, a leading neo-con journalist, in Time magazine; “Neo-cons may get the last laugh”, says Max Boot in the Los Angeles Times; “Let us now praise Paul Wolfowitz”, adds David Brooks in the New York Times.

Many of the fiercest critics of “neo-conservative foreign policy” are being forced to back-pedal. Mr Krauthammer quotes Jon Stewart, the presenter of Comedy Central's wildly popular mock news programme: “What if Bush has been right about this all along? I feel that my world view will not sustain itself and I may...implode.” There has been a good deal of imploding already among anti-war Democrats, with even Ted Kennedy proclaiming that George Bush deserves credit for the stirrings in the Middle East (see article).

The neo-conservatives are also taking heart from two other developments. The first is Mr Bush's decision this week to nominate John Bolton as America's ambassador to the United Nations. Mr Bolton is more “con” than “neo-con”. (Cons, for example, were against keeping troops in Iraq after the end of the war.) But at the least he is one of the neo-conservatives' favourite conservatives. He shares their distrust of multilateral institutions, with their airy-fairy waffle and their predilection for impinging on American sovereignty. He described his signing of a document formally notifying Kofi Annan of America's intention, in effect, to withdraw from the International Criminal Court as “the happiest moment of my government service”. Two of the neo-cons' great heroes, Daniel Patrick Moynihan and Jeanne Kirkpatrick, were both at their finest as UN-bashing ambassadors to the UN; Mr Bolton is well placed to follow in their footsteps.

The second development is the administration's growing worries about China. In the early days of the administration the neo-cons were as preoccupied with that country as anything else. They then felt that they had lost the battle over China when America produced such a feeble response to the collision of an American surveillance plane with a Chinese fighter-jet over China in April 2001. But Europe's decision to lift its embargo on selling arms to China has left them feeling doubly vindicated, both in their worries about Beijing's military ambitions and in their impatience with Europe's claims to moral superiority.

It would be a stretch, however, to conclude from all this that neo-conservative voices will be the loudest in future foreign-policy debates. That influence is contingent on events in the Middle East, which are certain to be messy and confused. It is worth remembering how low the neo-conservatives sank in the run up to the November election. Not only did anti-war Democrats attack them, but Republican realists denounced them for their naivety. Bill Buckley, the patron saint of the conservative movement, agreed that “their ambitions in Iraq seem to be leading to their self-destruction”.

Look at the staffing of the second Bush administration, and it hardly seems as if the neo-conservatives will exercise unqualified influence. They are no doubt pleased to see the back of two of their leading critics, Colin Powell, the former secretary of state, and Richard Armitage, his deputy. But they are also losing two of their fiercest champions in Washington: Douglas Feith, the under-secretary of defence for policy, and John Bolton. However much they may crow about Mr Bolton's ability to foul the UN nest in Manhattan, they would much rather have had him in the heart of Washington, at the State Department or the Pentagon.

Neo-conservatives are also ambivalent about Condoleezza Rice, the new secretary of state. Her neo-con defenders point out that she is much closer to Mr Bush than Colin Powell ever was, and much keener on using American power abroad. They argue that neo-conservative ends can be achieved by “realist” means such as diplomacy. But others are not so sure. They note that Ms Rice is a protégé of Brent Scowcroft, one of the leading Republican critics of the war. And they see her filling the State Department with fellow realists, led by Robert Zoellick, her new deputy.

The limits of neo-conservative influence may well be shown by Iran. It is axiomatic in neo-con circles that Iran cannot be prevented from acquiring nuclear weapons by a combination of diplomacy and bribery. But Mr Bush is at pains to point out that the White House is not preparing for war in Iran. And the Pentagon has made it clear that it is already overstretched by Iraq. The days when Richard Perle could sum up American foreign policy with the resonant phrase, “Who's next?” are long gone.

The neo-conservatives have every reason to be feeling good about themselves at the moment. But if they think that their current good fortune will translate into a permanent lock on Mr Bush's foreign policy making, they are much mistaken.

Hedge funds

The new money men
 

Feb 17th 2005 | NEW YORK
From The Economist print edition

Investors have made a trillion-dollar bet that hedge funds will bring them rich returns. But will they?

IT SEEMS an unlikely trend. In recent years the fund-management industry has been mauled for its excessive and opaque fees, deceptive marketing and rampant conflicts of interest. At the same time, however, not only has the industry flourished, but it has done so in its costliest, highest-leveraged and least transparent segment: hedge funds. Instead of shunning such unregulated funds, investors have been falling over themselves to grab a piece of the action.

Whereas the size of the mutual-fund industry in terms of assets and offerings has merely returned to its level of 2000, hedge funds have doubled in size and number, according to Hedge Fund Research, a consultancy (see chart 1). In 2004 alone around 400 new hedge funds were created, bringing the known total (many others escape scrutiny) of 7,000 into rough parity with the number of mutual funds.

The start-up fever is especially acute in the many hedge-villes dotting Greenwich, Darien, Rowayton and other lovely, affluent towns in southern Connecticut. New funds begin daily, some in spare rooms in someone's home, others in waterfront offices with parking for yachts. In Manhattan, midtown office towers serve as hedge-fund warehouses. Tiny windowless offices house unknown operators trying to build a track record. Full-floor suites filled with lavish artwork, gyms and kitchens that bubble over with superb (and healthy) food are the domain of successful funds. The same is true in Boston, San Francisco and London.

While there have been numerous pronouncements that the tide will soon turn, nothing suggests this is imminent. Quite the opposite. Initially sold only to wealthy individuals, then the family offices of wealthy individuals, increasingly hedge funds are now being sought out by large institutions. Foundations and endowments, the least regulated component of the institutional world, came first; company and public pensions are now piling in. The State of New York announced in January that it might put some of its $88 billion pension fund into hedge funds, joining those managing the pension funds of teachers in Texas and Ohio as well as public employees in Chicago and California. If institutions merely meet the amount they currently intend to invest in hedge funds, another $250 billion will be flowing into the industry, according to Greenwich Associates, a consultancy.

What might hold them back is not desire, but capacity. Such is the popularity of hedge funds that many of the largest are closed or, as they say in the trade, “soft-closed”, meaning that entry requires special pleading—and many plead. Caxton Associates, Moore Capital, Renaissance Technologies, SAC Capital Advisors, Maverick Capital, and Highbridge Capital Management, all carrying excellent records and managing billions of dollars, are considered too inaccessible to be included in a Standard & Poor's index of investible funds. Unable to get into established winners, investors are pouring money into managers with no track record but good pedigrees. Last November, Eric Mindich, formerly of Goldman Sachs, raised $3 billion for a new fund. His old partner, Dinakar Singh, will open an equally big fund this month. It is widely believed that either one could have raised two or three times as much money.

Given the enthusiasm, at the very least it should be clear what all these customers are buying. In fact, that is a surprisingly hard question. Unlike mutual funds, which are strictly defined under America's 1940 Investment Act, hedge funds operate under exemptions to the law. Theoretically that limits their audience to sophisticated and affluent investors. In reality, clever lawyers, lots of money and astute marketing have expanded the exemption so that they can be sold to anyone, do almost anything and keep whatever they do, and who they do it for, a secret.

Some hedge funds actually hedge, meaning they attempt to invest in a manner that offsets adverse market movements. But since they also want to capture returns, the hedge is never complete and many funds do not even bother (see chart 2). Responding to institutional demand, notes Greenwich Associates, some new hedge funds restrict themselves to holding long positions in common stocks, just like ordinary mutual funds or, for that matter, traditional accounts managed by brokers on behalf of clients.

Hedge funds have some common characteristics. They are usually pooled investments (like mutual funds) structured as private partnerships (unlike mutual funds). Many carry substantial leverage and are quite rigid about the flow of money from clients. Initial “lock-ups” for as long as four or five years are not uncommon; rarely is money allowed to come in or go out more than monthly. This restriction allows hedge funds to take positions in the most illiquid corners of the market including options, futures, derivatives, and unusually structured securities.

Where's the money?

Increasingly, the large funds that have succeeded flit from one area to another. Last year and the year before, when lots of companies were coming out of bankruptcy and the economy was improving, successful funds dominated the market for distressed debt. Since hedge funds can account for more than half the daily volume on the New York Stock Exchange and can have an equally large presence in every other financial market, where they might be today is anyone's guess.

Investors value this ability to embrace opportunities, magnify returns through leverage, and take difficult positions because of a stable base of assets. But they have not always been so keen. Mutual funds, if structured correctly, can have the same characteristics (though there are some liquidity restrictions). A big reason why mutual funds approach investing differently is that when they tried to take a flexible approach in the mid-1990s they were torn apart by consultants and customers for so-called “style drift”. Complaints reached a crescendo in 1996 when Jeffrey Vinik was hounded out of running what was then the single largest fund, Fidelity's Magellan, for moving from stock to bonds just a bit before the investment cycle turned.

Under pressure from the press and pension consultants, most (but not all) mutual funds began to follow narrow pre-designated benchmarks that were tightly limited to a class of investing, such as shares of companies included in the S&P 500 index, or an even narrower subset, for example a mid-cap benchmark. That helped performance in the soaring equity markets at the end of the last decade, but also contributed to their wretched results during the bear market of 2000 to 2002. It also undermined mutual-fund fee structures. Customers realised that much of the funds' performance simply mimicked the relevant index. Many chose to invest in index funds instead, because these charge far smaller management fees. (Perhaps appropriately, Mr Vinik, who has been something of a genius in identifying trends, reincarnated himself as an outstanding hedge-fund manager.)

The bear market prompted many investors to think it might be good to have money with an investment manager who knows when to invest and, ideally, where to invest, and works within a format that allows him to do so. Relatively good returns, meaning better performance than the market, has become a bit less important than absolute returns (ie, not losing money, especially when the market falls). Mr Vinik's move into bonds would now be considered within the context of astute risk control. Institutions aspire to hire managers who can provide high “alpha”, meaning risk-adjusted returns. But it may amount to much the same thing—making money and not losing it.

A clever mutual-fund manager could, of course, pursue this approach in the new environment. But it has become much more sensible to start a hedge fund. Why? Because, to cite a phrase of the moment, a hedge fund is “a compensation scheme masquerading as an asset class”. Whereas the average mutual fund charges 1% or 2% of assets, and smart buyers can pay a fraction of that, hedge funds charge 1% or 2% plus a big slug of profits, typically 20%, but often more. One well-known, but secretive, fund based on Long Island is reputed to charge 5% of assets plus 44% of profits. Another leading fund charges no maintenance fee but 50% of profits. An industry consultant says he has seen a new fund that will receive 80% of any excess above a guaranteed return linked to a well-known index. Even these huge costs do not really reflect what investors pay, since most hedge funds agree to conduct business through a prime broker, which extracts fees through stock- and bond-lending charges, as well as trading costs based on the fund's net asset value.

The benefits of this kind of relationship for a manager and for the Wall Street firms are obvious. In a report published in 2003, Bernstein Research reckoned that the size of the hedge-fund industry was one-sixth that of the mutual-fund industry, but already provided more revenues. If true, the situation is now even more dramatic. People attracted to the idea of working in the investment world for the money (a sizeable percentage) cannot shift into hedge funds fast enough. Nor can the investment banks, which are losing good employees but enjoy the solace that many become exceedingly good customers.

To bank or to hedge?

Institutional Investor's obsessively read list of most-highly-paid hedge-fund managers starts with familiar names (George Soros: $750m), but 16 others made at least $100m in 2003. As impressive as the earnings are at the top, they are even more striking viewed from the bottom. Business-school graduates note that a job at investment banks often lasts only until the first bump in the market. Salaries are high, but pressure from those above you is higher still and there is constant carping about costs. A bad year at a hedge fund may result in unemployment, but a good year means good compensation amid excellent resources: costly data terminals and abundant creature comforts, such as fresh fruit, flowers and parties.

Banks might gripe about these comparisons were they not battling so hard for hedge-fund business. At a time when mutual and pension funds have become ever more reluctant to pay the traditional five cents a share for trades, hedge funds pay up to four times that amount if in the process they can receive good ideas or particularly effective execution. This makes sense because the hedge fund's compensation is tied to outperformance, not efficiency.

And trading is just the beginning for banks. Hedge funds want hot issues, structured derivatives, margin, stock-lending for short sales and the equivalent for fixed-income, clearing and settlement, customer support and marketing. The money coming from all these transactions and fees is enormous. Svilen Ivanov of the Boston Consulting Group reckons hedge funds received $45 billion in revenues last year, of which one-third to half was profits. Although there is some overlap in the numbers, investment banks collected $15 billion either directly from hedge funds or because of them, producing $6 billion in profits. For individual firms, hedge funds were critical to last year's performance. They produced one-quarter of Goldman Sachs's profits, estimates Guy Moszkowski of Merrill Lynch, and only a slightly smaller slug of Morgan Stanley's returns.

Performing for whom?

Oddly, given the spectacular wealth that hedge funds produce for their own managers and for investment firms, they do not, overall, seem to produce much wealth for clients. Certainly the highest-performing funds have produced breathtaking returns. Renaissance has earned almost 40% annually for more than a decade, SAC in excess of 30%. There are many others with excellent records. But there are good reasons to believe that these are rare exceptions. Whatever the merits of high fees—the ability to attract talent, a performance-oriented incentive structure that discourages bloat—they are almost certainly exceeded by the problems.

The most evident is the drag which high fees put on performance. Historically, an investor able to outperform the broad market by two percentage points annually has been considered something of a genius. But that barely covers the maintenance of the average hedge fund. High fees tied to performance also encourage hedge funds to take big risks. Winners might just be lucky and their luck may be offset by the losses of others. A third problem caused by high fees is attrition. Successful managers become rich, possibly too rich to care about work, in just a few years. Managers that disappoint are quickly put out of business by angry clients, or they may shut down voluntarily because earning a performance bonus will require catching up to a prior “high-water mark” first. Last year around 270 funds closed. The available information on hedge funds suggests they typically last only a few years.

That adds complexity to the task of selecting a fund that will do well in the future. It also plays havoc with any indices used to track hedge-fund performance. A paper* published last November by Burton Malkiel, a professor at Princeton, and Atanu Saha, of the Analysis Group, a consultancy, presents a frightening picture of what is left out of the most commonly cited benchmarks. Hedge funds report their performance only when they want to, and consequently stop reporting in the months that they are collapsing. Unsuccessful hedge funds may never report. Clever hedge-fund organisers may seed many funds, operate them for a few years, then announce in public only the most successful ones, “backfilling” the performance data from prior periods—ie, projecting what the fund might have earned before it existed if it had pursued the same strategy. Worst of all, bad funds tend to disappear along with their records. Only one-quarter of the 600 funds that reported data in 1996 still exist. Recalculating results, Mr Malkiel concludes that for all their vaunted talent, hedge funds perform less well than cheaper mutual funds.

A second paper, in the Journal of Investment Management**, concludes that, because of their double fee structure, hedge funds of funds (ie, funds that buy into dozens of other hedge funds, following the “fund of funds” approach that has become common in the private-equity market) perform worse than individual hedge funds. Yet such funds have become popular, especially with investment consultants, because they are seen as diversifying risk.

And even this somewhat patchy record may overstate the potential for hedge-fund success. Hedge-fund returns, relative to market returns, have been fading. This may be true for a number of reasons, including low interest rates (hedge funds often hold big cash balances while they wait for bright ideas); the result of so many hedge funds getting into the business and, often, pursuing the same strategies; the possibility that the supply of hedge funds has outstripped the talent to run them; or simple chance. “Why should the appeal of rich fees be limited to smart managers?” asks Howard Marks of Oaktree Management, a hedge-fund adviser in Los Angeles.

Nor do hedge funds represent a fresh start for their scandal-tainted industry. A small fund named Canary Capital was at the heart of the late-trading, market-timing scandal. Other funds have been prosecuted for allocating fees to brokers who never executed trades; violating fiduciary obligations by shifting good investments to personal accounts; and using funds for personal expenses. All of these are hard for outsiders to detect.

Dog for sale, $10m

The largest area of transgression, and one that is almost certain to arise more in the future, is the incorrect valuation of securities held in funds. All securities are, to some degree, hard to price. The less liquid they are, the harder this becomes and hedge funds specialise in illiquid securities. Even if a hedge fund wants to value its portfolio correctly, it could make mistakes. If it had other motives—and because compensation is a multiple of returns this cannot be ruled out—disaster could follow.

The SEC has brought 51 cases (11% of all its enforcement actions) against hedge funds, claiming damages in excess of $1 billion. Known prosecutions, as well as others that have yet to be disclosed, encompass around 400 funds. In only three of these cases were investors made whole, a result the SEC blames in part on the fact that it is able to investigate a fund only in response to receipt of a complaint.

That is due to change next year. Last December, William Donaldson, chairman of the SEC, pushed through new regulations for hedge funds. Funds will have to register, meaning they will have to acknowledge their existence and submit to inspection by the SEC of their books and records. It would be no surprise if a series of announcements were to follow about hedge funds repricing their assets downwards and also, perhaps, reviewing how much they charge for compensation (the details of performance bonuses are complex and there is an assumption that they are mostly resolved in favour of managers).

Whether the new rules will act as a deterrent to abuses by managers or, more importantly, whether they will do anything to slow the industry's momentum remains to be seen. The bigger it grows, the more the boundaries between hedge funds and traditional asset management are blurring. But on current trends, hedge funds' second trillion dollars of assets will arrive even faster than the first.

Buttonwood

Cinderella markets
 

Feb 15th 2005
From The Economist Global Agenda

If ever there was a time to shun glamour and look for inner beauty, this is it

WHEN Buttonwood went through outstandingly plain phases as a youthette, her mother—now, alas, of sainted memory—used to raise the quotient of references to Inner Beauty and its superiority to the flashy outward stuff. How those memories come back these days, with fund managers touting as never before the fragrant charms of fast-growing foreign markets. As April nears and those last bits of tax-favoured retirement income look for a home, investors are listening. Last week’s net inflows into emerging-market equity funds were the largest one-week numbers in over a decade. So far this year, investors have put $4.64 billion into non-American equity funds and pulled $1.58 billion out of American equity funds. The figures come from Emerging Portfolio Fund Research, a firm in Cambridge, Massachusetts.

The attractions are obvious. Though there are certainly lemons among them, developing economies as a group are likely to grow twice as fast as developed ones this year, the IMF reckons. Their shares are far cheaper, trading on trailing price/earnings ratios about a third lower than in developed countries and at a larger-still discount if predicted future earnings are factored in instead. So emerging-market shares, which were hot in the 1990s but cooled off later in the decade, have been making a comeback.

Investors think they are betting that these countries will continue to outpace the developed world in economic growth. But they are also—unconsciously—making a lot of other bets: among them, that corporate profits will grow in line with the countries’ economies; and that shareholders in existing companies will have a corresponding share of these profits.

But does past economic growth in fact imply greater future stockmarket returns? Not on your nellie, say Elroy Dimson, Paul Marsh and Mike Staunton from London Business School (LBS), in an annual study of global investment returns sponsored by ABN AMRO, a Dutch bank, that was published last week. Though this finding is not entirely new, the LBS team brings to the analysis an unrivalled set of data going back 105 years for 17 developed countries and substantial periods for another 36 countries.

They identified three elements in the total return on shares—dividend yield (price divided by previous dividend), dividend growth and changes to the price/dividend multiple. They found that, over the long haul, economies with slower GDP per capita growth produced better real returns on shares than faster-growing ones, and vice versa. The star performer over more than a century, by the way, was Australia, followed by Sweden, South Africa, America, Canada and Britain.

Messrs Dimson, Marsh and Staunton then tested this finding in a different way, using a share-trading rule based explicitly on economic growth. They classified all their countries into quintiles according to how quickly GDP had grown in each over the previous five years. Equal sums were invested in each quintile, and dividends were reinvested. The countries were re-ranked each year, the quintiles were re-based and fresh investments were made. At the end of 2004, the total return from buying shares in slowest growing countries was 12% a year, compared with a 6% return on shares in the fastest-growing countries.

What might account for this perverse relationship between economic growth and stockmarket performance? The easiest thing to say is that by the time a country comes to be recognised by the global investment community as “fast-growing”, its share prices have probably been bid up too high for newcomers to make much money out of it. Another explanation is that insiders cream off profits before they hit the bottom line. Also, growth may be fuelled by thousands of small entrepreneurial companies that never come to market and thus do not recompense shareholders in existing firms.

More broadly, economies tend to grow when they get bigger inputs of labour, capital and technology. The benefits of growth may be felt by those who supply the labour (local workers), the capital (including local savers and investors) and the technology (eg, Cisco Systems)—or by none of the above, such as consumers. Shareholders will probably get a look-in, but there is nothing to say how big.

Jay Ritter, who teaches finance at the University of Florida, takes the argument further. In a paper that will be published soon in the Pacific-Basin Finance Journal, he maintains that not only is past economic growth no guarantee of future stockmarket returns, but even future economic growth (could we but know it) is no guarantee of contemporaneous stockmarket returns except in the most transitory way. A rough-and-ready empirical example of that truth, looking only at share prices: in 2004, and for the second year running, China was the worst performing stockmarket tracked by The Economist, falling 15% despite the country’s rapid growth. Mr Ritter reckons that current earnings yields are the best guide—but earnings need to be massaged over ten years or so to remove the distorting effects of specific moments of the business cycle.

So is the moral of the story to forget high-flying Thailand? Not quite. Emerging markets may not produce the outsized returns investors expect but they are still a good way to diversity portfolios. As the developed world’s markets become more highly correlated, emerging markets, refreshingly, continue to go their own way. The point is not to expect Thailand to produce greater-than-average returns on its shares—and to keep a sharp eye out for transaction costs, which are often higher in emerging markets.

If this argument about economic growth and stockmarket returns feels faintly familiar, it’s because it is. Here we have, on a bigger scale, a favourite debate of stockmarket strategists over whether growth stocks or value stocks give the bigger return. Are investors better off buying a stock with a high price/earnings ratio because they think its prospects for growth justify a higher multiple? Or do they get better returns from buying a cheaper, higher-yielding share? In the short term, either investment style can produce consistently good returns: growth stocks predominated in the 1990s, value stocks have done better in the past five years and there are those who think the tide is about to turn back now. In the long run, however, according to the LBS team and many others, value stocks—like Cinderella countries with unglamorous growth rates—are more likely to provide higher returns.

There is something so counter-intuitive about this line of reasoning that Buttonwood doubts investors will be able to resist the lure of fast women, fast cars and fast economies—any more than she really believed her mother about the superiority of Inner Beauty. But just in case reason lurks out there somewhere among the irrational exuberance, the accompanying table groups countries, as the LBS team did, according to how quickly they have grown in the past five years. On “value investing” criteria, the countries in the lowest-growth category are no worse a bet—even perhaps a better bet—than the countries under highest growth. Anyone for Denmark?

Buttonwood

Billion Dollar Babies
 

Feb 3rd 2005
From The Economist Global Agenda

A flurry of big acquisitions and better-than-expected corporate profits has heartened a dubious stockmarket recently. Don’t break out the champagne yet

BUTTONWOOD is beginning to feel like a time traveller. When she last shook the dust of London from her feet, Citicorp and Travelers were just merging. It was a dramatic moment, not only because it produced America’s largest financial-services firm but also because it seemed to herald a more general revolution in the sector: cross-selling banking, insurance and securities in a way that regulation, soon to be changed, had largely prevented. She returns, and within weeks Citigroup is selling the last bits of Travelers to MetLife, a life-assurance company. Bancassurance American-style apparently did not flatter banks’ returns.

This is only one of the multi-billion-dollar deals announced in recent days that helped to lift American share prices from their week-on-week doldrums during the first month of the year. On Friday January 28th, Procter & Gamble, a big consumer-products firm, said it was planning to buy Gillette, ditto, for about $57 billion. A string of big buyers, actual and potential, then popped brightly out from the woodwork, mainly in communications, publishing and the media. Most of the firms in the S&P 500 have now announced fourth-quarter earnings and most of these, in turn, were higher than forecast. The granddaddy of them all was ExxonMobil’s massive $8.42 billion after tax.

Thanks to all this, the S&P 500 index climbed out of its week-on-week doldrums and managed to finish the month just 2.5% down on its December close. There are those who set great store by January share-price movements, holding that as goes January, so goes the year. Buttonwood is not a particular fan of “the January effect”: what matters for share prices—or ought to—are the discounted value of a company’s future earnings and the relative attraction of other investments. But given all there is to ponder these days in both stock- and bond markets, the January effect may be as good as anything to go by.

To begin with, what are we to read into this new wave of mergers and acquisitions (M&A)? Some $136.6 billion-worth of deals involving American firms was announced last month, according to Thomson Financial, a research firm—$187.9 billion if foreign deals are included. December was a big month too, with $147.5 billion in American and $307.7 billion in worldwide deals announced. Why this rush of blood to the head? And what does it mean for share prices?

The first question is easier. The slump of 2001-02 is over. The memory of Enron and WorldCom is beginning to fade, and corporate shame with it. America has kept consuming despite the threat of terrorism. Companies have cut costs and put their balance sheets in order, many of them buying back hefty dollops of their own shares. Margins are high: corporate profits in America last year were running at around 10% of GDP, nearly a record. And cash is plentiful: S&P 500 companies alone had almost $600 billion in cash and short-term assets in their coffers last year. That could increase, thanks to a weird one-off tax break for companies with operations abroad.

Dynamic firms are now looking to consolidate their position within their industries and find ways to grow. Refocusing can take different forms, and not everyone is buying. Citigroup, after all, shed its insurance business and is coy about saying what it plans to do with the roughly $2 billion it will be left with in exchange. American Express too, on February 1st, announced that it planned to shed an operation that seemed a poor fit. More firms are likely to divest as well as to acquire.

What the merger wave means for share prices is harder to say. Big acquisitions usually give a fillip to stockmarkets because they indicate confidence in the future and suggest that other companies may be bought at attractive premiums. Investors should keep an eye out for upward drift in the premiums that cash-rich acquirers are willing to pay, as they would be a sign that too much money is chasing too few targets. The deals being done now are at premiums far below the 30-50% seen in the merger wave of the late 1990s. But they are not insignificant. Gillette’s shareholders will get about 18% more than their shares were worth the night before the deal was announced.

Different messages

The conundrum that is exercising Buttonwood’s mind at present is different: are bond markets and stockmarkets living in the same country these days? How can low, flat bond yields be telling us that all is well, with lowish inflation and interest rates here to stay, while share prices that keep failing to break upwards signal that equity buyers are in fact uneasy about the future? Though shares are slightly overvalued compared with historical price/earnings ratios, they remain undervalued compared with bonds.

The broader point, however, may be that investors in both markets have grown complacent during what has been essentially a 20-year bull market in financial assets. Low inflation and low interest rates have been around for a long time, but they will not be with us forever. And here the economic arguments, well rehearsed elsewhere, roll up.

While opinions differ as to degree and timing, America’s economy will grow more slowly this year than last. Evidence from the slower-than-expected fourth-quarter growth of last year was echoed, tentatively, by an Institute of Supply Management survey released on Tuesday. It showed that factory activity slowed in January, and by more than had been predicted. Again, opinions may differ as to whether the Federal Reserve’s key interest rate will hit 3.5% or 5% by year-end, but the fact is that it is heading upward—the Fed, as expected, raised the rate by another quarter of a percentage point, to 2.5%, on Wednesday. The same is probably true of inflation.

None of this is dramatic stuff—nothing like as dramatic as America’s vast fiscal and trade deficits—but it all bears watching. Look for a modest single-digit increase in share prices over the year unless the M&A wave swells sharply. Clint Eastwood’s “Million Dollar Baby” is a great film, but it doesn’t end happily.

A reheated economy
 

Jan 25th 2005
From The Economist Global Agenda

China’s economy re-accelerated in the last quarter of 2004, despite official efforts to curb rampant investment. Is it growing too fast to keep its balance?

ON TUESDAY January 25th, the Chinese authorities sheepishly confessed that the economy beat expectations last year, growing by 9.5%. It finished the year particularly strongly, growing at an annual pace of almost 13% in the last three months, according to J.P. Morgan. Anywhere else, this would be cause for celebration. But in China, the firecrackers remain unlit. Instead, analysts and investors are trying to reassure themselves that this is not bad news.

Economists, who freely mix their metaphors, have spent the past year worrying that China is “overheating” and hoping that it will make a “soft landing”. Their worries reached a peak in the spring, when China’s banks were lending freely, investment was expanding blindly and prices were rising quickly. This anxiety was shared by the Chinese authorities. In April, Wen Jiabao, the prime minister, said China would take “very forceful measures” to cool the economy. The authorities imposed curbs on investment in sectors such as steel, aluminium and cement, refused to release land to developers and threatened to impose price controls if inflation remained out of hand. In October, the central bank raised interest rates (if only by a little) for the first time in nine years.

By the winter, however, hopes of a soft landing were high. Inflation was ebbing, investment was cooling and output was slowing (see chart). Most economists expected Tuesday’s figures to show a further slowdown in growth. Instead, its pace has quickened. The Chinese economy has taken a puzzling detour on its gentle route back down to earth.

The world’s most populous country has vast reserves of labour and no shortage of capital. Why, then, should we worry that it is growing too fast? Since China embraced market economics in 1978, its average rate of growth has been 9.4%. By its own standards, then, last year’s pace of expansion was nothing out of the ordinary.

But economists are anxious about the balance of China’s economy as much as its speed. China may or may not be growing too fast, but it is certainly investing too much. In the year to the first quarter of 2004, spending on fixed assets—plant, property and infrastructure—grew by 43%. Investment accounted for 42% of GDP in 2003, and perhaps a still greater share last year. No economy can sustain such a colossal rate of capital accumulation. At some point, China’s investment must run into rapidly diminishing returns. Are two cement factories twice as good as one?

If investors were betting their own money, these redundant cement factories—not to mention steel mills, luxury flats and car plants—would probably never have been built. But China’s reckless investment owes a lot to the heedless lending of its banks. Chinese households still save about 45% of their income. They deposit about two-thirds of these savings in China’s four big state-owned banks, which lend about two-thirds of these deposits to state-run firms. The banks pay little attention to risk and do not expect much of a return: perhaps 40-50% of loans are non-performing. In fact, their lending is best seen as a form of state subsidy. If these subsidies were added to the government’s books, China’s budget deficit would balloon to 18% of GDP, reckons Diana Choyleva of Lombard Street Research, an economic consultancy.

Suppose, says Ms Choyleva, that China can sustain a rate of investment of about 35% of GDP, rather than its current rate of 40-45%. How does it get there from here? Such a sharp contraction in the investment rate is not, she says, consistent with a soft landing. If investment slows, the economy as a whole will plummet. China, she predicts, cannot escape “the natural violence” visited on all developing countries that go through such boom-and-bust cycles of investment.

Those who still hope for a soft landing agree that China’s rapid rate of investment must slow. But they hope that exports and consumption can take up the slack. They will draw some comfort from Tuesday’s figures. Investment in fixed assets grew by 21.3% in the year to December, its slowest pace in seven months. And yet the economy still quickened. Exports jumped by a third to $63.8 billion in December. Rural incomes, boosted by a bumper harvest, grew by 6.8%. And in the cities, real disposable incomes increased by 7.7% and retail sales by 14.5%.

Since 1978, China’s communists have let thousands of private firms bloom, from small-town enterprises, growing organically, to giant manufacturing concerns, built with foreign money. According to Tuesday’s figures, China’s economy is still sprouting vigorously. But some still fear that too much of this growth will turn out to be dead wood.

Buttonwood

The end of the affair?
 

Jan 25th 2005
From The Economist Global Agenda

Emerging-market debt has been a sweetheart deal over the past three years. It is almost time to move on

BUTTONWOOD having sensibly decided to go off and earn some real money, the search for his successor was long and arduous. The gene pool of those equally familiar with capital markets and Claire’s Accessories is not enormous, but the challenge was met. On detail, Buttonwood II is long dogs rather than cats and prefers four-hooved to four-wheeled transport; but she shares with her predecessor an interest in the high-yield end of the bond market—more specifically, emerging-market debt.

One spectacle that is always guaranteed to push up investors’ blood pressure is an Argentine government road show, and the current one is no exception. With some $81 billion (not counting unpaid interest) of the world’s biggest defaulted debt to swap, the country’s finance team is trotting its unappealing offer around the world, leaving bondholders howling. The proposed “haircut” remains somewhere north of 70%, depending on how you calculate it: US marine-like. So last week the Not The Argentine Road Show swung into action in London. Representing 30,000 investors holding $1.2 billion in debt, the Argentine Bond Restructuring Agency (ABRA)—part of a broader coalition—argues that Argentina could and should double its offer.

It could, but it won’t. The price of Argentina’s debt in the secondary market is around 32 cents (per dollar of debt outstanding), which suggests that this may in fact be what it is worth. Argentina’s public-relations skills are lamentable and its negotiating skills even worse, but its case is not without merit. Though the country’s economy grew by 8% last year and may see another 5% this year, output remains lower than in 1998. If the swap goes through, Argentina will still be left servicing a public debt equal to 80-90% of GDP, far more than Brazil, say.

Argentina says it will consider the swap a success if 50% of bondholders participate; the IMF (which, incidentally, is owed an additional $13.8 billion) wants 75%; the result will probably be between the two. Up to 40% of the debt is held by Argentines, for a start, and institutions there will settle. The professional, mainly foreign, investors who bought the bonds after default at 20 cents or so on the dollar will still make money after the haircut, especially if Argentine bonds move up in price as a result, which is likely. The sort of legal action that some bondholders are threatening is not promising, as recent judgments against Argentina in America have failed to produce a single seizeable asset. And a certain fatigue may be setting in, which the Bad Boy of the Pampas is counting on. The offer expires in mid-February.

The broader emerging-market debt story lies elsewhere, however, and it is very different. Brazil quietly raised a tidy ten-year €500m in euros, tightly priced, while Argentina was fighting with its creditors last week. For at least two years, with returns on Treasuries and other top-grade credits scant, investors have chased yield down every risky path, many of them far-flung. Now, however, investors may have to start going straight. Alan Greenspan warned in the Federal Reserve Open-Market Committee minutes published in January that he would know what to do if they didn’t. Some selling-off of riskier assets resulted. And analysts at securities firms, including Citigroup Smith Barney and Merrill Lynch, are writing that investors indeed feel more risk-averse than they did.

But there is nothing like a rout—in fact, quite the contrary. If forecasts by the Institute for International Finance (IIF), a Washington-based think-tank, are correct, private capital flows to emerging markets ($279 billion in 2004) will remain strong in 2005. True, much of that is direct investment, as opposed to the portfolio kind, and bound for the two “special cases”, China and Russia. But the IIF reckons that non-bank credit flows (mainly bonds) will fall back only $8 billion from their seven-year high last year of $65 billion. Other figures confirm the trend. Emerging Portfolio Fund Research, a firm based in Cambridge, Massachusetts, says that the emerging-market bond funds it tracks have seen solid net inflows for the past 12 weeks.

If investors are going off risk, why are they still keen on emerging markets? Many believe that these markets are not very risky any more. Most countries on J.P. Morgan’s EMBI+ (Emerging Markets Bond Index) are profiting from economic growth, high commodity prices, cheap money and broadly more sensible fiscal policies. A number are delinking from the dollar and diversifying the range of currencies in which they borrow (viz Brazil). They are also diversifying their sources of financing by raising more money in their domestic markets (Brazil again, and Mexico). The ratings agencies have rewarded many of them with upgrades. Over half of the issuers in the EMBI+ index now have investment-quality ratings.

There are other reasons, too, why emerging-market bonds continue to attract. Cash is sloshing around the system at the moment, and debt issuance has been fairly restrained. In certain markets (eg, China) investors are betting on a currency revaluation. But the basic reason is that investing in places like Ecuador, Thailand or Kazakhstan is no longer seen as taking a walk on the wild side. Accordingly, the spreads on emerging-market debt over Treasuries have come right down, as the chart shows.

But these tight spreads may not really be compensating investors for the extra risk, even if that risk looks reduced in the current economic conditions. Few expect big shocks from within the emerging markets themselves, though there are pockets of poor quality such as the Philippines, which wants to raise $1 billion this week. But there are many risks out there threatening not just high-yield markets but the whole investment climate: for a start, America’s twin deficits, the prospect of slowing world growth and the possibility of more corporate scandals shaking investors’ confidence.

The big question for high-yield debt is how soon and how sharply American interest rates move up, pulling investment into Treasuries and other low-risk securities and driving up yields generally. The consensus, reflected in current spreads, is that rates will rise gradually and emerging markets hold firm at least through the end of 2005.

But investors ignore the possibility of other kinds of bad news at their peril. Buttonwood II has lived in various exotic locations in recent years, and if there is one thing she knows, it is that most investors in New York and London haven’t a clue what companies and governments are up to in two-thirds of the globe. Transparency is not second nature east of Suez, or indeed south of the Rio Grande. The end of this particular affair should be anticipated.

Thrift is a foreign concept
 

Jan 14th 2005
From The Economist Global Agenda

The falling dollar has failed to narrow America’s trade deficit, which set another record in November. The world’s largest economy is looking increasingly like the mirror image of its third largest, Germany

TRADE deficits are as American as apple pie. But the deficit announced on Wednesday January 12th still caught many by surprise. Despite falling oil prices and a falling dollar, America’s exports of goods and services fell short of its imports by $60.3 billion in November. It was a record, the second in a row, and marked a widening of almost $10 billion in the trade gap since September.

On the import side of the ledger, America’s petrol bill increased. Though the price of oil had eased, America imported more of it. In the other column, the country’s exports slipped by 2.3%, with sales of capital goods, such as machinery and equipment, falling particularly hard. Economists thus lowered their sights for fourth-quarter growth. J.P. Morgan, which had expected the American economy to maintain an annual pace of growth of 4% in the fourth quarter, now envisages growth of 3.5%.

In theory, the falling dollar should be narrowing the trade deficit. Other things being equal, a cheaper dollar should make America’s exports more competitive and its imports dearer. Since May 2004, the dollar has fallen by 8.2% in trade-weighted terms. But the deficit has only widened in that time.

Of course, some $16.6 billion of America’s November deficit was in trade with China alone, and a dollar depreciation provides little help for American exporters against Chinese rivals because China—like several other Asian countries—pegs its currency to the dollar. But falls in the dollar also do surprisingly little to deter imports. By one estimate, if the dollar depreciates by 10%, the prices of American imports rise by just 2%.

So, the dollar does not drive the trade figures; instead, the trade numbers seem to drive the dollar. Deficits must be financed. And as America’s deficit sets new records, foreign investors ask themselves anew whether it is sustainable, and, more to the point, whether they want to be the ones left sustaining it. On Wednesday, some decided not. The dollar lost much of the ground it had gained in the past three weeks.

A European pastime

Living within your means by importing no more than you export has, it seems, become an un-American activity. It is the sort of thing they do in “old” Europe. Over the past 12 months, Germany’s exports surged by 8.2%, the federal statistics office said on Thursday. Europe’s largest economy is running a sizeable trade surplus, which accounted for about 70% of its economic growth last year. (Yes, there was some.)

Foreigners are keen to buy German goods, but Germans themselves are more hesitant. Domestic demand fell in 2004 for the second year in three. The reasons are not hard to discern. In Germany, unlike America, unemployment has risen: the ranks of the jobless reached 4.48m in December. The country’s shops are open at the retailers’, not the shoppers’, convenience. And the Germans are, by American standards, a financially repressed people. They are not free to overborrow against overvalued homes.

Some at America’s central bank, the Federal Reserve, think a little repression is now needed in the United States. In the minutes of its December meeting, concerns were voiced about “potentially excessive risk-taking in financial markets” and “speculative demands…in the markets for single-family homes and condominiums”. Americans are tempted to live beyond their means because they blithely assume that gains in the value of the assets they hold—those houses and flats—will make up the difference.

At that meeting, the Fed raised interest rates to 2.25%, taking them above those in the euro area for the first time since 2001. On Thursday, the president of the Federal Reserve Bank of St Louis, William Poole, said that the Fed’s measured pace of rate hikes may accelerate in the coming months. The markets have priced in a federal funds rate of 3.5% by the end of this year. The European Central Bank, by contrast, again kept interest rates steady at 2% on Thursday. It may keep things on hold for the whole of this year and next, reckons Capital Economics, a London-based consultancy.

This transatlantic gap in interest rates, and the prospect that it will grow, will tempt some to keep faith with dollar assets, attracted by the better yields they offer. Indeed, the dollar strengthened a little on Thursday after Mr Poole’s comments. But returns on these investments are only worth as much as the dollars in which they are denominated. As Capital Economics points out, a single day of panic in the currency markets can easily wipe out months of accumulated yields. Until thrift becomes an all-American virtue once again, the prudent will stay away.

George Bush's second term

The revolution comes home
 

Jan 13th 2005 | WASHINGTON, DC
From The Economist print edition

From the pensions system to the tax code, George Bush wants to overhaul America's economic institutions. Does his radicalism stand a chance?

MOST two-term American presidents lose steam in their second four years. If scandal doesn't get them (Watergate, Iran-contra, Monica Lewinsky), weariness does. Sitting presidents rarely campaign on a revolutionary agenda, just feel-good blather: Ronald Reagan's “Morning in America”, or Bill Clinton's “Bridge to the 21st century”. And a re-elected president is a lame-duck long before his second term ends, leaving little time to get much done.

George Bush seems determined to be different. He has laid out a second-term domestic agenda more ambitious than anything seen in the first term, and that was hardly a lull. It brought the biggest tax cuts since 1981, the broadest education reform in a generation and the costliest expansion of Medicare, the state health system for the elderly, since it was set up in 1965.

If the first-term legacy is largely a deficit, the second term promises to shake some of the country's economic pillars. At the Republican convention last September, Mr. Bush spoke of transforming America's fundamental economic institutions for the 21st century, and offered two broad organizing themes. The first was to make the United States the best place in the world to do business. That covered changes from tort reform (fewer burdensome lawsuits) to a simpler tax code, spurring more economic growth. The second theme was to foster an “ownership society”, by giving individuals greater control over, and responsibility for, their own health care and pensions. In particular, it meant restructuring Social Security, America's public pension system, by basing it partly on private accounts.

Empty campaign promises? Not so. At his post-election press conference, the president left no doubt that he regarded his victory as a mandate for reform. “I earned capital in the campaign, political capital”, he said, “and now I intend to spend it.”

In recent weeks, priorities have been set. Tort reform is top of the list of first-term left-over. In early January Mr. Bush gave three speeches pushing laws to curb frivolous lawsuits. Top of the new list of second-term priorities is Social Security reform. Tax reform has been put off until a bipartisan presidential commission under two ex-senators, John Breaux and Connie Mack, has studied the issue; they have been asked to report by the end of July. No one expects much action on tax until 2006. In contrast, the White House has hinted that it wants to move on pension reform within the next few months.

There is more, though the other topics may be even more contentious. Judicial appointments are a top priority for Mr. Bush's conservative base, but are certain to create a poisonous battle in the Senate. Immigration reform, particularly the creation of a guest-worker programme, will cause painful divisions within Republican ranks. Mr Bush may attempt them, all the same.

The president's ambition, coupled with increased Republican majorities in both the House of Representatives and the Senate, makes for heady expectations. Right-wing activists talk of a “conservative New Deal”, with Mr Bush changing America as profoundly as Franklin Roosevelt did in the 1930s. Democrats, equally exercised, accuse Mr Bush of fabricating a crisis in the pensions system, in particular, in order to destroy the fabric of modern America.

But just as the scale of the project has emerged, so the political landscape has become more difficult. According to Gallup polls, Mr Bush has the weakest job-approval rating of any newly re-elected president since 1948. High casualties in Iraq are the main reason, but the public also seems uninspired by much of this reform agenda. The Democrats are also surprisingly united in their opposition, particularly to Social Security reform. In the case of tax cuts, in the first term, several Democrats switched sides early on; but virtually none has defected in favour of private retirement accounts. Even centrist Democratic groups have come out against them. At the same time, congressional Republicans are both nervous about supporting pension reform and divided on how to go about it.

As a result, Washington's punditocracy has been whispering about over-reach even before the inauguration. Nasty comparisons are being made between Mr Bush's Social Security plan and Bill Clinton's disastrous efforts to overhaul America's health-care system in 1993. And Cassandras are crowing that Mr Bush's second term will be a spectacular failure.

The hyberbole on both sides is misplaced. Mr Bush's agenda combines the incremental and the radical, the sensible and the reckless, the politically doable and the impossible. Even under the most favourable circumstances, not everything will get done: Mr Bush has simply put too much on the table. But unless the White House loses its political touch entirely, some reforms will be pushed through.

Of torts and taxes

A few early signs are good. Of the various unfinished jobs from the first term, tort reform is the right one to focus on. The tort system—designed to compensate accident victims and deter negligence—is expensive, economically distorting and hideously inefficient. America spends over $230 billion a year, or around 2% of GDP, on these kinds of legal actions, far more than any other advanced economy. But victims of negligence get a remarkably bad deal. Over half the compensation is eaten up by administrative costs.

Trial lawyers apart, few deny that America's tort system needs reform. And Mr Bush's basic ideas, though clearly a boon for his corporate cronies, are sensible. He wants to cap non-economic damages at $250,000; shift national class-action lawsuits from state to federal courts to stop plaintiffs shopping among the states for the highest pay-outs; and reform the rules for asbestos compensation. (Asbestos claims, by themselves, explain much of the recent rise in tort costs.)

Shaking up the tort system will not revolutionise America's economy. But it would save billions of wasted dollars and might boost productivity growth. The House has already passed Mr Bush's proposals; the sticking point has long been the Senate. That remains the case, but, with a bigger Republican majority and some judicious compromises, tort reform might actually happen.

That is more than can be said for other left-overs from the first term, particularly Mr Bush's first-term tax cuts. These officially expire by the end of 2010. Passing new legislation to make them permanent (or at least permanent until the size of the deficit forces a rethink) is high on the president's second-term agenda.

This obsession goes down well with conservative activists, who want all taxes cut at all times. From an economic and strategic perspective, it is misplaced. First-term tax cuts have already helped to reduce America's tax revenue, as a percentage of GDP, to its lowest level since the 1950s. If Mr Bush's new-found fiscal prudence is genuine (he promises to halve the budget deficit), he has no business making America's fiscal problems worse. More important, setting his first-term tax cuts in stone makes his bigger second-term goal of broad tax reform considerably harder to achieve. And although tax reform is likely to be much less ambitious than many conservatives now imagine, it will still be tough to do.

Mr Bush is right that America's tax code is a mess. The tax laws and their attendant regulations run to 60,000 pages, 10,000 of which were created during Mr Bush's first term. The annual cost of tax compliance is estimated at $115 billion. Simplifying the system by slashing its myriad deductions would be a big step forward.

And that is a large part of what Mr Bush intends to do. Although conservative ideologues dream of killing off the income tax and replacing it with a flat tax or national sales tax, the White House has little truck with such radicalism. Mr Bush wants to improve today's system, not junk it. He approves of tax breaks for mortgage interest, as well as the need to keep incentives for charitable giving. His commission, tellingly, includes no prominent advocates of fundamental tax reform.

Incrementalism does not rule out ambition. If a simpler tax code is one Bush goal, the other is a code friendlier to savings and investment. The president's first-term tax cuts have already pushed in that direction, by slashing tax rates on dividends and capital gains. He would like to protect yet more investment income from taxation and allow firms to deduct investment spending up-front, rather than charging the depreciation of capital over time.

Paying for such changes (assuming Mr Bush has given up his first-term recklessness) means eliminating deductions. Two targets that the White House is said to be considering are the state-income-tax deduction and the tax-break firms receive for providing health benefits to their employees. Eliminating either would involve a huge political battle. Most Washington budget veterans scoff at the very idea, particularly since Mr Bush has already put off any action until 2006.

Some reform looks likely, however, thanks largely to the Alternative Minimum Tax. The AMT, which was originally designed to prevent rich Americans avoiding taxation, will hit 24m taxpayers by 2008, up from fewer than 3m in 2003. With luck, Mr Bush will marshal the political pressure from angry AMT-payers to push for some base-broadening reform. A clear political bargain could be arranged: elimination of the AMT in return for scrapping favoured deductions. The tax code will not be rewritten, but even modest improvements would be well worth having.

The Big Enchilada

On Social Security, in contrast, Team Bush has no truck with incremental change. A recent (leaked) White House memo described the reform project as one whose “scope and scale...are hard to overestimate”. Success in revamping Social Security, it went on, would “rank as one of the most significant conservative governing achievements ever”.

Social Security, created in 1935 by Franklin Roosevelt, is America's biggest and most popular government programme, providing pensions to the elderly and disabled. Thanks to Social Security, poverty among the elderly has been virtually eliminated. Most Americans rely on the programme for much of their retirement income.

As in most of the rest of the world, the combination of longer life expectancy and lower birth-rates will put increased financial pressure on this pay-as-you-go social insurance system. Over the coming decades, Social Security's payments will rise much faster than its revenues, which come from payroll taxes. The net present value of this financial imbalance over the next 75 years is $3.7 trillion, less than 1% of cumulative GDP. Over an even longer horizon, the present value of the permanent imbalance is estimated at around $10 trillion, a number Mr Bush loves to repeat.

These numbers can be hard to interpret, but the larger point is that Social Security is on an unsustainable trajectory, one that goes well beyond the retirement of the baby-boomers. It is not an immediate “crisis”. In fact, payroll-tax revenues will exceed pension payments until 2018, masking America's overall fiscal imbalance. Nor is it America's biggest long-term fiscal problem. The financial burden from Medicare will be much bigger. Mr Bush's first-term decision to introduce a prescription-drug benefit for retirees worsened Medicare's long-term financial imbalance by more than twice as much as the entire Social Security problem. Nonetheless, Social Security needs fixing. And that means either boosting revenues (for instance, by raising payroll taxes) or reducing promised benefits.

But cutting the pension fund's deficit is not what makes conservatives excited. Their most treasured objective is to restructure the system into one based partly on private accounts. Individuals would be allowed to divert a share of their payroll taxes into such accounts, gradually building up a pre-funded retirement nest-egg in return for a lower guaranteed benefit from the government.

Diverting payroll taxes would shrink America's biggest government programme and change the nature and scope of social insurance. According to its proponents, it would create a nation of investors (and hence, fear Democrats, of Republican voters), foster a savings culture and boost work incentives. On this logic, Americans would work harder, regarding the diversion of money into their own accounts as equivalent to a tax cut.

The scale of the change would depend on how big a share of payroll taxes was diverted. According to proponents, large accounts would not only have more emphatic effects on work and saving incentives, but, by capturing higher returns in equity markets, would do more (though at higher risk) to address Social Security's financial imbalance. On no plausible assumption, however, could private accounts eliminate it.

A small but vocal “free lunch” group of conservative Republicans disagrees. Large private accounts, they claim, can fix Social Security's finances with no need for benefit cuts or tax increases. Legislation proposed by John Sununu, a Republican senator, and Paul Ryan, a Republican congressman, proposes diverting half of payroll tax revenue with no reductions in promised Social Security benefits. The plan relies on permanent subsidies from the rest of the budget and wholly implausible cuts in spending outside Social Security to make its numbers add up.

Fortunately, Mr Bush has not been tempted by the free-lunch route, at least not yet. Though he has ruled out raising payroll taxes, the White House memo made clear it was a “bad idea” to push individual accounts alone. Instead, the White House is keen on a plan first proposed by the Bush-appointed Commission to Strengthen Social Security in 2001. This would allow individuals to divert an average of one-sixth of their payroll taxes into individual accounts. It would cut Social Security's future liabilities by indexing the calculation of initial retirement benefits to prices rather than wages. Although future retirees' pensions would stay constant in real terms, they would no longer rise in line with average wage growth. Over time, Social Security would replace an ever smaller share of workers' pre-retirement income, from 42% today for a typical worker to 20% in 2075 and ever less thereafter. This plan would involve substantial transitional borrowing (around $2 trillion over the next decade alone), although this would be offset by a reduction in the government's obligations to future retirees.

Judging the risks

Until the details become clearer, it is hard to judge the merits of any White House plan. Economically, the benefits of private accounts—at least in the early years—are likely to be modest. A debt-financed transition will not boost national savings; though the accounts will imply higher private savings, government borrowing will rise by the same amount. The gain from private accounts might be eroded by high management fees or poor risk-management by account-holders. But, in principle, Mr Bush could craft a package that shores up Social Security's financial health and reaps the benefits of individual accounts, without sacrificing the basic nature of social insurance.

Less obvious is whether that is politically possible. Americans are increasingly concerned that Social Security is in trouble (in a recent Washington Post poll, more than seven out of ten said the system faced “major problems”). But while younger people like the sound of private accounts, polls suggest that Americans overall are almost evenly divided over whether people should be allowed to invest their payroll taxes in financial markets.

Mr Bush's success will depend on how well he explains his ideas. Interest groups are massing on both sides of the debate. The AARP, America's huge pensioners' lobby, is leading the opposition against the “risky” privatisation scheme. But money is also piling up on the other side, particularly from well-financed conservative lobby groups.

At present, the congressional maths does not look good. Congressmen who face re-election next year are terrified of talking about benefit cuts. Other Republicans are nervous about the upfront borrowing involved. To protect their political flank, party leaders have told Mr Bush that this scale of social change must be done with bipartisan support. But embattled Democrats are loth to give Mr Bush an inch, and the compromises that might appeal to them—such as raising payroll taxes—will appal conservative ideologues.

For all these reasons, Social Security reform will be a long, tough battle. Failure need not sink Mr Bush's whole agenda, but it will overshadow any progress elsewhere. Without pension reform, Mr Bush's second term will be as disappointing as most others. Success, in contrast, could place him beside Ronald Reagan as a true conservative revolutionary.

Plumbing the depths
 

Dec 29th 2004
From The Economist Global Agenda

The dollar has hit another record low against the euro. It is set for further falls against major currencies in the coming year, even though American interest rates will rise

FORECASTING exchange rates, warns Alan Greenspan, the chairman of the Federal Reserve, has a success rate no better than calling the toss of a coin. But the dollar keeps coming up tails. At the start of 2004, holders of America’s currency had to part with $1.25 to buy a euro. At year’s end, they must fork out another dime or more. On Wednesday December 29th, it cost over $1.36 to buy a single euro, a fresh record.

The cause of the dollar’s decline is hardly a mystery: private investors have become less eager to finance America’s huge current-account deficit. The deficit widened slightly in the third quarter of 2004, to a record $165 billion, or 5.6% of GDP in that period.

These record deficits are adding to America’s foreign debts at an alarming rate. But as yet, America still earns more from its foreign assets than it pays on its foreign liabilities. That is about to change. As interest rates rise, refinancing America’s debt will become more costly. Goldman Sachs forecasts that net foreign-investment income is likely to shift to a sizeable deficit during 2005, growing thereafter. The investment bank estimates that, if America’s current-account deficit remains steady as a share of GDP and interest rates average 5% in future, net foreign debt-service payments will reach 4% of GDP by 2020—a significant drag on American living standards.

To avoid shelling out such large sums to foreigners, America will, ultimately, have to rely more on its own savings and less on savings imported from abroad. The country as a whole saved just 1.7% of national income in the first nine months of 2004. Households saved just 0.7%.

The dollar’s decline may force America to embrace thrift, argues Goldman Sachs. As the dollar falls, foreigners will demand more American goods. This will put pressure on America’s manufacturers, which are already operating at 78% of capacity. As supply is stretched, inflationary pressures will build. The Federal Reserve will raise interest rates, curbing domestic demand, and thus creating room for an export boom. The higher interest rates will thus promote the saving America has so sorely lacked.

This process has barely begun. Over the past two years, the dollar has lost almost 23% against the euro. But it has shed less than 13% against a broader basket of currencies (see chart), and it has not lost a cent against China’s yuan. As a matter of official policy, the Chinese currency has remained within a tight range around 8.28 to the dollar for the past decade. Forecasting the intentions of China’s policymakers may actually be harder than calling a toin coss. But many are trying. Offshore markets, for example, allow speculators to make a bet on the value of the yuan in 12 months time. At the moment, punters reckon you will get just 7.8 of them for your dollar this time next year.

Against the yen, the dollar is actually slightly stronger than it was in late November. The Bank of Japan has not intervened in the foreign-exchange markets since March, but the threat to do so remains. Japan’s finance minister, Sadakazu Tanigaki, gave warning this week that his country’s authorities would monitor foreign-exchange markets over the New Year holiday, a time when trading is thin and official buying can make a big difference.

If Japan’s finger is on the trigger, the European Central Bank (ECB) seems prepared to sit on its hands. Jean-Claude Trichet, president of the ECB, has lived with strong currencies before. As president of France’s central bank in the years before euro entry, he was dubbed “the ayatollah of the franc fort” for his unflinching support of a strong national currency. Indeed, for much of 1995, a weighted basket of the franc and the 11 other currencies that formed the euro was worth almost as much against the dollar as it is now.

In his press conferences, Mr Trichet has made it clear that recent rises in the single currency are unwelcome. But he has dwelt at greater length on the danger of rises in energy prices. His chief duty, as he sees it, is to convince firms and workers that inflation will remain well contained, despite the oil price spike of the autumn. It is a confidence game: if he can convince them an inflation spiral won’t happen, then it won’t. The strong euro will actually add to his credibility, by curbing the price of imports.

Besides, the hard men of hard money believe that weak currencies make life too easy for firms and politicians. Devaluing the currency provides an unsatisfying alternative to deregulating and restructuring the economy. An overvalued currency, on the other hand, leaves uncompetitive firms and tentative politicians with “no place to hide”, as Eric Chaney of Morgan Stanley puts it. They must reform or perish.

“You cannot devalue your way to prosperity,” says John Snow, America’s treasury secretary, somewhat hypocritically. The year to come may reveal whether Europe can revalue its way to the same end.

Investing money

In search of a golden egg
 

Dec 29th 2004
From The Economist print edition

For most of the past two decades, investors have enjoyed double-digit annual returns. The next ten years look less easy

DURING the past 20 years even a blindfolded monkey with a pin should have found it easy to make money. Annual total returns (including reinvested income) on American shares and bonds averaged 13% and 10% respectively, well ahead of inflation. Dollar investors in British equities and property did even better, scooping 14-15% (see chart 1). Today, although inflation is low and interest rates are correspondingly miserly, investors continue to hope for double-digit returns. They are likely to be disappointed: the past two decades were exceptional.

In 2004 (up to December 28th) the best performing stockmarkets in dollar terms (among those tracked by The Economist) were Colombia's and Egypt's, which both rose by more than 100%. America's S&P 500 index returned a more modest 11%. All too often, though, one year's star is the next year's dog. It is more informative to look at longer periods. As chart 2 shows, over the past 100 years American shares have outperformed bonds, property, art and gold, with an annual average total return of 9.7%, or 6.3% after inflation. Government bonds returned less than 5%.

This performance underlies the common view that as long-term investments shares are hard to beat. History has no doubt helped investors to live with their losses since the equity bubble burst in 2000. But a lot depends on how long the long term is. In a book in 2002, “Triumph of the Optimists”, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School found that in 13 of the 16 countries studied, shares did worse than cash in the bank in at least one 20-year period in the 20th century. Over ten-year periods, negative real returns on equities were not that uncommon. An investor buying American shares in 1964 and selling in 1974 would have made a real loss of 35%.

Another reason for caution is that periods of exceptionally high returns—such as the 1980s and 1990s—are usually followed by phases of exceptionally poor performance. The 20-year bull markets in shares (which lasted until 2000) and in bonds (which continued into 2004) were fuelled by an almost continuous fall in inflation and hence interest rates. But now that inflation is low, neither shares nor bonds are likely to deliver double-digit returns.

An environment of low and stable inflation is good for economic growth, says Martin Barnes, an economist at the Bank Credit Analyst, a Canadian investment-research firm, but it is not so great for financial markets. Interest rates have now adjusted to low inflation, and bond yields are near historic lows, so potential capital gains are limited unless deflation emerges. That implies bond returns in most countries will be broadly in line with their current yield of less than 5%.

What about equities? Despite the slump in prices in the three years to 2002, price-earnings (p/e) ratios still look a bit high, notably on American shares, and share valuations are unlikely to benefit from falling interest rates in future. Meanwhile, lower inflation means that the pace of profits growth will slow. Assume that America's nominal GDP grows by 5% a year (3% in real terms, plus 2% for inflation). If the share of profits in GDP is constant, profits will grow at the same rate. However, profits could do much less well, because in America, Japan and the euro area their share of GDP is close to a record high. They might well be expected to fall.

Suppose, though, that profits do rise in line with GDP and that p/e ratios stay the same. Then, Mr Barnes estimates, the total nominal return on American shares over the next decade will average 6.8% (5% profits growth, plus dividends), half the figure for the past 20 years. If profit margins fall modestly and the p/e ratio reverts to its long-term average, returns will average 4.9%—well below investors' expectations. Surveys suggest that individuals expect returns of more than 10%.

Could property instead lay the golden egg of the next decade? According to The Economist's global house-price indices, housing has yielded double-digit returns (including rental income) in most countries over the past 20 years. But the peak may be close. In several countries house prices are at record levels relative to incomes and rents. At best, they are likely to flatten off over the coming years. Add in the sharp fall in rental yields, and the prospective total return on property over the next five years or so is poor.

The retirement of the baby-boom generation will also start to weigh on both house and share prices within a decade or so. During middle age, people tend to acquire assets, such as shares and second homes, as a future nest-egg. When they retire they sell those assets to the next generation of investors. With more sellers than buyers, that could push prices lower. And if older people care more about receiving a steady income than about maximising gains, they are likely to prefer bonds to equities, which could dent the relative value of shares.

Average returns of 5% on equities and bonds sound meagre. That said, as long as central banks keep pumping out liquidity at their current rate, asset booms and bubbles are always likely somewhere. Commodity prices, which have surged over the past three years, could keep rising strongly, thanks to rapidly growing demand from emerging economies, such as China and India, and to supply constraints.

Investing in emerging stockmarkets could also pay off handsomely over the next decade. The average p/e ratio in emerging markets, based on future expected profits, is around ten, not much more than half of Wall Street's. To be sure, they are a risky bet: although in 18 of the past 20 years one of these markets has topped the global investment league, the same market has often collapsed the next year. Over the past 20 years, emerging markets as a group have underperformed Wall Street, with an average total return of 10.9%. But if governments can maintain their current, sounder economic policies, growth should be more stable in the years to come—and returns should be higher and less volatile.

European shares could also outperform Wall Street. The old continent's economies are widely derided for their rigid markets, high taxes and lack of entrepreneurial vim. But financial markets have discounted all this, and European shares look cheap next to American ones. Such is the gloom about Europe that there is plenty of room for pleasant surprises.

The canny investor who seeks out such opportunities is likely to fare better than a blindfolded monkey over the next decade. But the most important lesson for investors is that when nominal GDP is growing by only 5%, asset prices cannot on average be expected to rise much faster than this. Anybody wanting a bigger nest-egg will have little choice but to save more.