THE MAIN ISSUES IN THE GLOBAL

ECONOMY

INTRODUCTION

Abouhana ASA

International Macroeconomic Policy: Theory and

Evidence from Recent Financial Crises

• We study macroeconomic developments: growth,

unemployment, consumption, investment, inflation, trade

balances, exchange rates, etc.

• Macroeconomics is an international discipline as most

economies are not closed but open to trade in goods,

services, labor, capital, technology, information

(globalization).

• Most countries are small open economies; some (U.S.)

are large open economies. The world economy is

interdependent and interconnected thanks to globalization

Abouhana ASA

International Macroeconomic Policy

• Macroeconomic developments depend on macro policies:

• Conventional (the policy rate tool, the money supply)

and unconventional monetary policy such as, ZIRP

(Zero Interest Rate Policy), QE (Quantitative Easing),

CE (credit easing), FG (Forward Guidance), Negative

Interest Rates, Liquidity Support of Banks and Non-

Banks

• Conventional (tax and government spending) and

unconventional fiscal policy (bailouts of banks,

households, corporations and other state guarantees for

economic agents

Abouhana ASA

International Macroeconomic Policy

• Macroeconomic developments depend on macro policies:

• Exchange rate policies: choice of the exchange rate

regime (fixed, flexible, etc.), forex intervention, capital

controls

• Supervision and regulation of the banks and other

financial sector intermediaries (capital regulation,

liquidity regulation, macro-prudential supervision,

counter-cyclical credit policy)

• International economic policies such as coordinated

macro policies as well as international bailouts (by the

IMF or the “Troika”) of countries or bail-in of countries

(coercive restructuring of public and/or external debt)

Abouhana ASA

The nexus between macro news, policy reactions

and markets/asset prices

• Macro Triangle: macro developments/news, policy

reaction, markets and asset prices

• Macro developments/news lead to policy reactions

• Those policy reactions affect the evolution of the macro

variables

• Macro news and macro policies affect markets and asset

prices (stocks, bonds, currencies, commodities, credit)

• Asset prices react to macro news and policy news, not to

expected changes.

• Asset price changes lead to policy reactions and affect

macro variables (through wealth effects and price effects)

Abouhana ASA

Theory and Evidence from Recent Financial Crises

• Financial crises have become more frequent and severe

in both developed markets (DM) and emerging markets

(EM)

• Recent developed markets crises

• US housing and sub-prime crisis in 2006-2008

• Global Financial Crisis (GFC) of 2008-2009

• Sovereign debt crises and economic crisis in the Eurozone (2010-

2013): Greece, Ireland, Portugal, Spain, Italy, Cyprus, Slovenia

• Recent emerging market crises:

• Mexico (1994), East Asia (1997-98), Russia (1998), Brazil (1999),

Turkey and Argentina (2001)

• EM mini-crisis in 2013

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Nature of Financial Crises

• There are many types of financial crises:

• Currency crisis when a fixed exchange rate regime collapses or a

currency goes into a free fall

• Balance of Payments (BoP) or external debt crisis

• Sovereign debt crisis

• Banking crisis

• Corporate debt crisis

• Household debt crisis

• Broad financial crisis that combines many elements of the above

crises

Abouhana ASA

Types of financial crises: liquidity versus solvency

crises

• Financial Crises can be distinguished into two broad

types:

• Solvency crises

• Liquidity crises

• Insolvency: An agent is insolvent when its debt relative to

its income is so high that in most states of the world it will

not be able to pay back its debt and the interest on it

(unsustainable debt)

• Illiquidity: An agent is solvent but illiquid when its debt is

not unsustainable but it has large amounts of this debt

coming to maturity (short term debt) and it is not able to

roll it over (liquidity crisis, rollover/run crisis)

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Liquidity versus Solvency Crises

• Many combinations of liquidity/illiquidity and

solvency/insolvency

• Illiquidity can lead to insolvency as illiquidity can trigger

default

• Illiquidity can be resolved via:

• Domestic or international lender of last resort support

(bailouts) to stop rollover/run crises

• Orderly but coercive restructuring (maturity extension)

of debts (bail-in of creditors policies)

• Insolvency is resolved via:

• Orderly debt restructuring before default

• Disorderly debt restructuring (default)

Abouhana ASA

Current Global Economic Outlook and Uncertainties

(Known Unknowns)

• Former U.S. Defense Secretary spoke during the

Iraq War of “known knowns, known unknowns

and unknown unknowns”.

• Known unknowns are known risk/uncertainty

factors that will materialize in the future in one

way or another

• The world economic is characterized today by

many “known unknowns”, for example who will be

the next Fed Chairman?

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Known Unknowns: Fed Chair Example

• Known Known: Larry Summers will not be the next Fed

Chairman

• Known Unknown: We will get a new Fed Chairman in

2014. Who will he/she be? Yellen, Geithner, Kohn,

Ferguson, Fischer or even Bernanke again?

• Unknown unknown: One of you or even “Roubini” could

become Fed Chair. Almost impossible.

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Known Unknown: Fed Tapering and exit from QE?

• When will the Fed start tapering QE?

• October FOMC meeting

• December FOMC meeting

• In 2014

• When will the Fed finish tapering and exit QE?

• by June 2014

• in the second half of 2014

• in 2015

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Known Unknown: Fed Forward Guidance & Exit from

Zero Policy Rate

• When will the Fed start exiting from Zero Policy Rate (Fed

Funds rate)?

• In 2014

• In first half of 2015

• In second half of 2015 or late

• When will the Fed finish normalizing the policy rate to a

neutral level?

• One year after starting (as in the 1994-1005 cycle)

• Two years after starting (as in the 2004-2006 cycle)

• Three years after starting

• More than three years after starting

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Known Unknown: U.S. Fall Fiscal Fistfights

• Three fiscal known unknowns in the fall in the U.S.:

• Government shutdown if no agreement on a continued resolution

(CR) by October 1st ?

• Technical debt default if now agreement on the debt ceiling

(October 15- November 15)?

• Continuation of the spending sequester or agreement to replace it

with something else?

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Macro and market implications of these known

unknowns

• The resolution of these 4 known unknowns (Fed

tapering, Fed chair choice, Fed exit from zero

rates, U.S. fiscal fights) will affect: • The real economy through demand and confidence (consumer,

business) effects

• The financial markets and asset prices in the U.S. and globally:

bond yields, stock market, credit spreads, U.S. credit rating, U.S.

dollar value, commodities, emerging markets.

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Current Known Unknowns in the Global Economy

• U.S. monetary and fiscal uncertainties

• Prospect for growth in developed markets (DM)

and emerging markets (EM)

• Will DM return to strong growth or will the

recovery remain anemic?

• Is the recent slowdown in EM cyclical or

structural?

• Will some EM experience a full crisis and which

ones are at risk?

Abouhana ASA

Current Known Unknowns in the Global Economy:

Europe

• Will the recovery of growth in the Eurozone be

robust or weak?

• Which government coalition will emerge in

Germany and what its policies will be?

• Will the Italian government survive beyond 2013?

• Political risks in Greece, Spain, Portugal?

• German constitutional court decision on the OMT

• Will the ECB ease monetary policy this year or

stay put? Rate cut or another LTRO?

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Current Known Unknowns

in the Global Economy: Japan

• Will Abenomics work in Japan?

• Strong growth and end of deflation or relapse?

• Will structural reforms and trade liberalization be implemented?

• Effects of the increase in the VAT tax in 2014?

• Risk of a public debt crisis in the next few years?

• Will the Yen weaken further?

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Current Known Unknowns in the Global Economy:

China

• Will China experience a soft landing or hard

landing?

• Will China successfully rebalance growth away

from too much savings, investment and exports

towards private consumption?

• Which reforms will be decided at the November

Third Plenum of the Central Committee of the

CCP?

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Current Known Unknowns in the Global Economy:

EM

• Is the recent slowdown of EM cyclical or

structural? What are its causes?

• Will financial pressures intensify to the point of a

crisis in some EM or will they diminish?

• Which EM are most at risk and why?

• What policy options are available for these EM at

risk?

• What are the medium term prospects for the

BRICS and other EM?

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Current Known Unknowns In the World: Geopolitical

Risks

• Syria: attack or compromise?

• Israel/U.S. versus Iran on nuclear proliferation

• Middle East as an arc of instability

• Asian territorial issues (as in the case of Japan-

China dispute on some islands)

• Geo-political implications of the rise of China:

“peaceful rise”?

• Are we in a G-20 or G-0 world?

• Which other unknown unknowns (like 9/11)?

Abouhana ASA

The global economy after the global financial crisis

(GFC)

• The economic recovery after the GFC was two-speed:

• Anemic, sub-par, below trend in DM (US, EZ, UK, Japan): U-shaped

• Strong with return to potential or above trend in most EM: V-shaped

• Why V-shaped in EM? • Less balance sheet problems of too much private and

public debts. Cleanup after EM crises of the 1990s

• Higher potential growth (5% in EM vs 1-2% in DM)

• More room for policy response

Abouhana ASA

Why U-shaped Recovery in DM?

• The 2008-09 crisis was not a plain vanilla recession

• It was a recession caused by a financial crisis. And a

financial crisis caused initially by too much debt and

leverage in the private sector (households, banks and

some corporates); and then during the crisis by a surge in

public debt and deficits

• History and theory suggests that recovery from balance

sheet crises is anemic for up to a decade: you need to

spend less and save more (dissave less) to reduce debt

and leverage over time. Thus, an anemic recovery.

• Actually, a double dip recession in some DM (EZ, UK,

Japan)

Abouhana ASA

How did we avoid a Great Depression 2.0?

• During the GFC (btw the collapse of Lehman and mid-2009) global economic activity was falling at a speed similar to the beginning of the Great Depression

• The Great Recession of 2008-09 could have ended up into Great Depression 2.0.

• What avoided that? Learning the lessons of the Great Depression and avoiding policy mistakes • Large conventional/unconventional monetary easing

• Massive fiscal stimulus for a while

• Backstop and bailout of the private sector (financial system, households, corporations)

Abouhana ASA

Side effects of the massive policy response during

the GFC

• The massive monetary/fiscal/bailout response during the

GFC was necessary to avoid another depression

• But it has led to lingering problems:

• How to exit from ZIRP, QE, CE, FG?

• How and how fast to reduce fiscal deficits and debts that may be

unsustainable?

• How to deal with the moral hazard that bailouts have induced?

Abouhana ASA

Do you want to be Keynesian or Austrian following a

financial crisis?

• Keynesian approach: provide monetary & fiscal stimulus and bailout the private sector as otherwise the recession can lead to a depression as self-fulfilling panics and runs occur while private demand is collapsing

• Austrian approach (“Austerian”): front-load the adjustment/reform and restructure balance sheets and P&Ls. Don’t bailout as you postpone financial and operational restructuring and you cause moral hazard: zombie banks, households, governments

• Austrian approach was tried in the 1930s (no monetary/fiscal stimulus and allow banks to collapse) and led to Great Depression. “Liquidate liquidate !”

• Bernanke learned the lessons of the Great Depression

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Do you want to be Keynesian or Austrian following a

financial crisis?

• In the short run you want to be Keynesian as you want to avoid panic, animal spirits, runs and illiquidity to lead to a collapse of the private sector. Public demand has to substitute for collapsing private demand. Rescue illiquid but solvent agents.

• In the medium-long term you want to be more Austrian and do true economic and financial restructuring as, otherwise, you can zombify the economy and reduce long term growth

• Are problems of illiquidity or insolvency?

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These debates – Keynesian vs Austrian- are still

ongoing today

• Growth versus austerity debate

• Front load fiscal austerity (as in EZ and UK) or back load

it (US, Japan)?

• Be very aggressive in monetary easing (US and Japan) or

less aggressive (UK, EZ)?

• Bailout banks and recapitalize them fast (US) or go slow

(EZ, UK)?

Abouhana ASA

Empirical evidence on appropriate policy response

• US avoided a double dip recession and is growing at a 2% rate (output above pre-crisis level). Now even Japan is growing robustly

• EZ and UK had a double dip recession and are now barely growing (output still below pre-crisis level)

• What explains this relative performance? • Relative monetary easing stronger in US/Japan

• Front load or back load of fiscal consolidation

• Backstopping the financial system and recapitalizing the banks early on to avoid a sever credit crunch

Abouhana ASA

Recent Reversal of

DM vs EM Growth Fortunes

• In 2010-2012 slow, anemic growth in DM (U-shaped),

strong growth in EM (V-shaped)

• In 2013:

• Signs of stronger growth in DM (US, EZ, UK, Japan)

• Sharp slowdown of growth in EM and financial pressures on EM

markets

Abouhana ASA

Why growth is recovering in DM?

• Deleveraging of private and public sector balance sheets has been ongoing for five years. Closer to a clean-up

• New rounds of unconventional monetary policies in the U.S., Japan (QE and FG) and even in the EZ and UK (FG)

• Bailouts of banks and sovereigns in the EZ avoided a worse crisis and EZ break-up

• The massive monetary stimulus has led to asset reflation (equity, housing, lower bond yields) that boosts confidence and increases demand

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Why slowdown of Growth in EM and Financial

Pressures?

• Strong growth in EM in the last decade (2003-2013) was

due to structural factors and cyclical/luck ones

• Structural:

• 1st generation structural reforms (trade liberalization,

openness to FDI, privatizations, opening of the

economy)

• Sounder monetary and fiscal policy and stronger

balance sheets after the EM crises of the 1990s

• Cyclical:

• China boom (10-11% growth)

• Commodity super-cycle (partly because of China)

• Super-easy monetary policies in DM after 2009. Search for yield

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Why slowdown of Growth in EM

and Financial Pressures?

• Why slowdown now then?

• 2nd generation reforms did not occur (micro ones that increase competition and productivity)

• Move away from market oriented policies towards state capitalism

• Some laxity in monetary and fiscal policy as liquidity was abundant, interest rates too low and credit excesses

• End of luck as:

• China is slowing and becoming less resource oriented

• The commodity super-cycle is over

• However slowly the Fed will taper and exit 0% rates. US bond yields up from 1.6% to 2.9% since May

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Which EM will suffer the most?

• Some EM have stronger macro, financial and

policy fundamentals and some have weaker ones

• Weaker ones include countries with large current

account deficits, large fiscal deficits, falling

growth, rising inflation, socio-political protest and

upcoming elections

• Weaker group includes: India, Indonesia, Brazil,

Turkey, South Africa, Ukraine

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Will some EM experience a severe financial crisis?

• Compared to the past even the weaker EM have some

positives:

• Flexible exchange rates rather than fixed ones that

could collapse

• A war chest of forex reserves to avoid liquidity runs on

banks, currencies and governments

• Less currency mismatches and liability dollarization

• Lower private/public/external deficits and debts: less

solvency risk

• Better regulated banks and financial systems

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Will some EM experience a severe financial crisis?

• But the weaker EM have some negative risks

• Ugly policy dilemma: • If you tighten monetary policy to avoid currency free fall

and inflation, you kill growth and damage banks/corporations. So tight money is not credible.

• If you loosen monetary policy to boost growth, there is the risk of an inflationary free fall of the currency and risk that foreigners will not finance your external deficit. If you thus loosen monetary policy you may lose the nominal anchor of the economy and thus cause a free fall

• So damned if you do and damned if you don’t!

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Medium term optimism for EM in spite of short run

pressures

• Medium term positive trends in EM:

• Urbanization

• Industrialization

• Population growth

• Per capita income growth

• Rise of middle classes and consumer society

• A larger share of global GDP and growth in EM

• High potential growth given by: • Demographic dividend (high population growth)

• 2nd generation reforms will boost competition and productivity

• Ability to absorb existing and new technologies developed in DM

• Technological innovation in some EM (Korea, China, India, etc)

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Will the DM recovery soon lift

the growth in EM?

• Optimistic viewpoint: the strong recovery of DM growth will soon lift – via trade channels – the growth rate of EM (recoupling)

• Three reasons to be skeptic: • The recovery of most DM will be anemic. Soft data

(PMIs) are strong but hard data (GDP, employment, demand) are weaker

• If the DM recovery will be stronger the Fed will exit QE faster and that will hurt the weaker EM while benefitting the stronger ones via trade

• If some weak EM were to experience a crisis, global risk will be off & contagion from EM to DM is possible

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U.S. growth is still anemic if improving tentatively

• U.S. economy still in an anemic recovery and only tentative improvement

• Q2 growth 2.5% (1.9% ex inv.); Q3 expected to be 1.5%. 2013: 1.7% below a 2.5-2.75% trend

• Latest data on GDP, labor market, consumption, investment, net exports are soft

• Unemployment rate falling because of fall in labor force participation rate (discouraged workers)

• Still a fiscal drag and fiscal uncertainties

• The rise in long rates given taper talk is already crimping growth of interest sensitive sectors (housing, capex)

• This is why Fed decided not to taper QE in September

• 2014 growth: Consensus: 2.7%. More likely: 2.4%

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Eurozone outlook: less tail risks but fundamental

problems unresolved

• The recovery of the EZ after the GFC was weaker than in

the US given weaker policy stimulus

• The EZ relapsed in a double dip recession in 2011-2013

• The periphery of the EZ entered a severe financial crisis

with serious sovereign risks. Seven countries in trouble

and five bailed out (Greece, Ireland, Portugal, Spain,

Cyprus)

• Problems were initially in the private sector in Spain and

Ireland; in the public sector in Greece, Portugal and Italy

• Doom loop between the EZ banks and the sovereigns

• At the peak of the crisis in summer of 2012 risk of Grexit,

EZ break-up, loss of market access by Italy and Spain

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EZ tail risks are lower today

• EZ tail risks are lower today thanks to:

• Draghi’s “whatever it takes”

• OMT program

• ESM program on top of EFSF and EFSM

• Beginning of a banking and fiscal union

• Germany realizing that EZ is also a political project

• Austerity and reforms supported by bailout funds, both fiscal and

monetary (ECB)

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Some Positives in the EZ Today

• The EZ recession is over (even if 5 members of the periphery still in recession)

• A lot of fiscal adjustment is done and less fiscal drag ahead

• Troika agreed to back load some austerity

• Beginning of structural reforms

• Internal devaluation (fall in Unit Labor Costs to increase competitiveness) in some periphery

• Fiscal adjustment and reform in exchange of liquidity and bailout funds holding politically. Grand bargain between core and periphery

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The Negatives in the EZ

• Low potential growth given slow reforms

• Recovery after recession will be very weak

• Public and private debts are still high and rising.

Debt sustainability issue

• Loss of competitiveness has not been fully

reversed. Improvement in trade balances is

cyclical (recession)

• Strong euro doesn’t help

• Still credit crunch in banks

• Still fiscal drag if diminished

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The Negatives in the EZ

• A monetary union requires a banking, fiscal,

economic and political union to be viable in the

long run

• Some limited progress on the banking union

• Austerity fatigue in the periphery and bailout

fatigue in the core

• Political risks in the periphery are high

• The ECB is moving but too little too late; as usual

behind the curve. Its forward guidance isn’t strong

enough

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Abenomics is working so far in Japan but risks

remain

• Abenomics is working so far:

• Deflation ending

• Growth picking up

• Yen weaker and stock market stronger

• Open issues:

• Will structural reforms and trade liberalization that

increase potential growth be implemented robustly?

• What will be the effect of the rise of the consumption tax

in 2014-15?

• Is the public debt of Japan sustainable in the long run?

• How and when to exit QE?

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China: Hard landing or soft landing?

• Will China experience a soft landing or hard landing?

• China’s growth is unbalanced and unsustainable: too

much savings, investment and exports; too little private

consumption

• Will the reforms to be decided at the November Third

Plenum of the Central Committee of the CCP strong

enough to rebalance growth?

• Reforms will be slower than optimal and desirable as

leadership is divided

• Risk of a harder landing than the consensus expects

(7.5% t0 8% growth). Growth may slow down to 7% in

2014 and below 6% by 2015

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Economy (global) during the Global Financial Crisis

(GFC)

• The US and the global economy experienced in 2008-

2009 their worst recession in decades • The housing and mortgage bust led to an economy wide

recession in the US as there were spillovers of the housing recession to other sectors of the economy (autos, manufacturing, consumer durables)

• The liquidity and credit crunch that started in the sub-prime mortgage market spread to all credit and financial markets as this was not just a sub-prime problem: sub-prime, near prime and prime mortgages, commercial real estate mortgages, credit cards, auto loans, student loans, leveraged loans

• Also the US consumers (consumption is 70% of aggregate demand) were shopped-out, saving-less and debt-burdened

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Economy (in the GFC)

• This was both a liquidity crunch and a credit crunch the driven by serious solvency problems given over-leverage of households, financial institutions and parts of the corporate sector

• The myth that the rest of the world could decouple from the US recession was shattered in 2008: there was massive re-coupling first in financial markets and then in the real economy. Recession in most advanced economies (US, Eurozone, Japan); recession or massive growth slowdown in emerging market economies)

• The Great Recession of 2008-09 bottomed out in late 2009 when most economies started to recover. But the recovery in DM since then has been anemic, sub-par, below trend, a U-shaped recovery. Stronger in 2014?

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Major E’s in the global economy:

The 2010-2013 period

• Economy

• Energy and oil prices

• Exchange rates and external imbalances

• Euro/Eurozone/ECB

• Emerging Markets

• East as Middle East

• East as East Asia

• Earnings/Equity markets

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Causes of the housing/credit bubble and bust/crisis

• Easy monetary policy (the Fed tightened too little too late)

• Lax supervision and regulation of the financial system

• Excessive risk taking and leverage of the financial sector given distorted incentives

• Global current account imbalances and global savings glut

• Irrational exuberance and animal spirits leading to bubbles

• Government subsidization of housing (tax benefits, role of Fannie and Freddie, Community Reinvestment Act)

• Distorted incentives of rating agencies

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Energy

• US/global recessions have been associated with oil price spikes (1973-74, 1979-80, 1990-91, 2000-2001).

• In 2008 oil prices spiked again (to $145 a barrel in the summer). This increase in oil prices was not driven by economic fundamentals but, in part, by speculation

• The high oil prices were one of the factors that triggered the global recession as they represented a negative terms of trade and real disposable income shock for oil importing economies (US, Eurozone, Japan, China, etc.)

• Once the global recession emerged oil and energy (and commodity) prices collapsed (oil down to $30 at the bottom).

• Since then oil prices have recovered and are now hovering around $100 plus as the global recession bottomed out and then recovered

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Exchange rates and External imbalances

• The strength of the U.S. in the 1990s relative to Euro, Yen and other currencies led to a large a growing current account deficit in the US as the US lost competitiveness

• After 2000, the US current account deficit worsened further as the fiscal deficits mushroomed (“twin deficits”) and as the private savings rate sank close to zero

• This led to the debate on whether this current account deficit was sustainable or was going to lead to a crash in the value of the US dollar and/or a spike in US interest rates (dollar hard landing)?

• The dollar started to decline in 2002-2004, especially relative to the Euro, but then it sharply appreciated again in 2005 as interest rates and real growth differentials favored the $ relative to the euro and the yen.

• But the dollar resumed its fall in 2006-07 when the US had a growth slump, a financial crisis, and the Fed cut the Fed Funds rate starting in the fall of 2007

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Exchanges rates and External imbalances

• The global current account imbalances were one of the causes of the global financial crisis

• The dollar started to appreciate during the financial crisis of 2008 as panicked investors were seeking the safety of dollar assets. When risk is off the dollar goes up

• The US trade deficit also started to shrink as the fall in consumption led to a fall in imports. But was this improvement mostly cyclical or structural? Is shale gas a game changer for the U.S. external balance?

• Will the further adjustment of global current account imbalances be orderly or disorderly?

• What is the risk of a dollar crash if foreign investors – who are financing the US twin deficit become concerned about the sustainability of such deficits and about the risk that the US will use high inflation as a way of wiping out the real value of its debts?

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Europe/Euro/ECB (2000-2012)

• Growth was sluggish in Europe in the 1990s relative to the U.S. given structural impediments to growth

• Recovery of European growth after 2005

• The Euro showed significant weakness relative to the US dollar until mid 2002 as the Eurozone growth was weaker than US growth.

• The Euro then sharply appreciated until the end of 2004 (by about 40%), and again in 2006-07 (after a brief dollar rally in 2005)

• During 2008 not only Europe did not decouple from the US crisis but the recession in the Eurozone was more severe than in the US

• This was in part due to the fact that the policy easing in Europe (monetary and fiscal) was not as aggressive as in the US

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Europe/Euro/ECB

• Fiscal stimulus in Eurozone was weaker because many of the member countries start from large fiscal deficits, large stocks of public debt and banks that are too big to fail and too big to be saved

• ECB easing during and after the GFC was weaker than the one of the Fed as the ECB has a single mandate of price stability.

• The recovery of growth in the EZ was even more anemic than the one of the US given less easy monetary policy, early fiscal tightening and unresolved bank problems

• Sovereign debt problems in the EZ and the EZ crisis

• Potential growth for the Eurozone is low – 0% to 1.5% in the periphery - and possibly falling because of structural rigidities

• What are the prospects for structural reforms in Europe?

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Emerging market economies (2000-2013)

• Emerging market (EM) economies experienced many economic and financial crises in the 1994-2002 period

• 2001 was a dismal year for emerging market (EM) economies. The slowdown of growth in US and G7, the tech bust and the reduction of flows of capital to emerging markets led to a sharp slowdown of growth in many emerging markets.

• Outright currency and financial crises emerged in Turkey (February 2001) and Argentina (December 2001). In 2002, severe pressures mounted in Uruguay and Brazil; Uruguay experienced a severe financial crisis in 2002; Brazil barely escaped a financial crisis as elections loomed in late 2002 but then it recovered after Lula followed moderate policies.

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Emerging market economies

• Emerging market (EM) economies’ growth recovered sharply in 2004, especially in Asia but also in Latin America. Important role of macro and financial reforms after the EM crises in this growth recovery

• 2004-2007 were excellent years for EMs as global conditions were ideal: global growth was high, global interest rates were low, commodity prices were high and global investors’ risk aversion low (search for yield).

• The financial crisis to a massive re-coupling – financial and real - of emerging markets with advanced economies: many emerging markets entered a recession and others had a massive growth slowdown.

• Financial and economic crises in Emerging Europe

• The recovery of growth in some emerging markets – China, India, some other parts of Asia, Brazil and parts of Latin America – was earlier and faster than advanced economies as their macro and financial fundamentals are robust. A V-shaped recovery

• But now in 2013 many EM face slowdown and financial pressures

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East as in Middle East

• Further turmoil in the Middle East (the Syria security situation; the Arab Spring; tensions between Israel and its neighbors; the risk of a military confrontation between Israel/US and Iran on the nuclear issue) would affect oil prices that could increase further.

• The Middle East is an arc of instability that goes from the Maghreb all the way to Af-Pak

• Also, such oil market turmoil affects skittish investors’ mood and consumer confidence as it increases uncertainty and reduces real incomes.

• The Middle East and oil prices are a major source of geo-political tension on global markets.

• Previous US and global recessions have been associated with stagflationary oil price shocks

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East as in East Asia

• China experienced rapid economic growth and overheating in the 2003-2008 period

• But the US recession led to a massive growth slowdown in China in the fall of 2008. But the aggressive policy reaction of China led to a robust growth recovery. But China risks now a hard landing unless it changes its growth model

• Dynamism of the IT sector in India contributed to high growth in last decade. But India now faces severe fiscal problems and the need for major structural economic reforms. Growth has slowed down sharply since 2012

• East Asia growth strongly depends on China and the US. A number of Asian EM are now at risk

• Japan’s recession in 2008-09 was very severe and the recovery anemic. Will now Abenomics work?

Abouhana ASA

Earnings/Equity markets (2004-2009)

• Equity markets in the US and globally did well in the 2006-2007 given high global economic growth

• High earnings growth, much improved corporate balance sheets, easy monetary conditions supported equities

• Profits sharply increased as a share of GDP

• But during the recent global financial crisis US and global equities sharply fell (by over 50% btw the fall of 2007 and March 2009) with a bear market that experienced a number of bear market rallies.

• Since March 2009 a massive rally in U.S. and global equity markets (about 50% to 100%). Is it excessive and at risk of a significant correction or bound to rise further?

• Disconnect between slow recovery of the real economies and rapid rise in equity prices.

Abouhana ASA

Earnings/Equity markets

Background on US equity markets in the 2000-2013 period:

• The U.S. and global economic slowdown in 2001 led to a sharp slowdown of earnings and underperformance of equity markets (on top of the dotcom bust and Nasdaq collapse in 2000).

• Equity markets also underperformed in 2002 as the stock market rally after the 9/11 drop was excessive and based on overoptimistic expectations of growth.

• Stock markets slumped again in the first quarter of 2003 as the concerns about a war with Iraq led to renewed risk aversion.

• But they then recovered sharply after the war in 2003 as markets started to expect a sustained economic recovery and a sharp pick-up in profits and earnings.

• But stock indexes remained mostly flat on average in 2004 and even in 2005 and 2006 (with only a modest uptrend since 2004) even if corporate balance sheets have improved sharply (with debt de-leveraging) and earnings growth has been sustained in 2004-2006.

• Equity markets – in the US and abroad – rallied sharply in 2006-2007

• Bear market in equities starting with the financial turmoil in the fall of 2007

• Bottom of the bear market in March 2009 and then rapid recovery through 2013 with some episodes of risk off followed again by risk on.

Abouhana ASA

Linkages between the U.S. and the rest of the world

occur via various channels

• Trade

• Capital flows and FDI (Europe, Japan, Emerging markets)

• Value of the US dollar

• US monetary and fiscal policy

• Global stock markets and financial links

• Developments in oil and commodity markets

• Political shocks and risks

• Global investors and corporate confidence

Abouhana ASA

Fed policy: 2000-2013

• The Fed reduced the Fed Funds rates 11 times in 2001, by 475pbs to a rate of 1.75% as the economy entered a recession.

• Faltering in the US recovery in the fall of 2002 led the Fed to cut the Fed Funds again, down to 1.25% in November 2002 and down to 1% in June 2003 as a jobless recovery emerged during the war with Iraq.

• In 2004, as growth of output and jobs picked up and inflation started to increase, the Fed started to increase the Fed Funds rate in 17 consecutive steps bringing it to 5.25% by June 2006 and then pausing in August 2006.

• The risk of a US hard landing and the market turmoil in the summer of 2007 led the Fed to cut rates starting in the fall of 2007 from 5.25% to effective 0% in 2008

• Massive quantitative easing in 2008-13 during and after the financial crisis: highly unconventional monetary policy. When and fast will the Fed now exit?

Abouhana ASA

US fiscal policy since 2008

• Fiscal stimulus package in 2008 as the economy entered a recession

• As second $900 billion fiscal stimulus package legislated in early 2009

• Deficit for 2009 rose to be $1.4 trillion but is now much lower ($600 bn) or 4% of GDP in 2013

• Fiscal path – deficit and debt - is clearly unsustainable as over the next decade deficits will rise again unless entitlement spending is reformed (Social Security and Medicare)

• Difficult issue of when to exit from the fiscal stimulus. The U.S. postponed till 2012 but now serious fiscal drag given spending cuts/sequester and rise in taxes

Abouhana ASA

Global current account imbalances

• Are the global current account imbalances (large deficit in the US, large surpluses in Europe, Japan, China and most emerging market economies) sustainable over time?

• Is the US current account deficit and external debt accumulation sustainable? It is shrinking but too slowly?

• Will the adjustment of global imbalances be orderly or disorderly?

• What are the implications of this deficit for the value of the US dollar in the future?

• How will the major currencies ($, Yen and Euro) perform? Will the dollar weaken or strenghten?

• Is there a risk of a hard landing of the US dollar especially if the foreign creditors of the US get tired of financing the US twin fiscal and current account deficits?

Abouhana ASA

Global deflation or inflation? and commodity prices

• Until 2007 and early 2008 there was concern about global inflation as global growth was robust, emerging market economies were overheating and experiencing double digit inflation (30 plus countries) and as commodity prices were rising

• But once the US recession became global in the second half of 2008 serious deflationary pressures emerged in the global economy because of slack in goods markets, slack in labor markets and sharply falling commodity prices

• By spring of 2009 economies experiencing actual deflations included US, Eurozone, Japan, China and a number of other advanced economies and emerging markets

• Will inflation return as the global economic recovery may accelerate in 2014 and beyond? Or are disinflationary forces stronger?

• Should we worry more about inflation or about deflation and over which time horizon should we worry more about one or the other?

• Is the commodity super-cycle over?

Abouhana ASA

Some of the cutting edge issues (and jargon terminology

used) in international macro policy debates

• Why did the subprime crisis lead to a wider credit crunch?

• Was the crisis due to a liquidity crunch or a credit crunch/solvency crisis?

• What is the risk of a another systemic crisis and what factors trigger one?

• What causes asset bubbles? What causes housing bubbles and bust?

• How should monetary policy react to asset bubbles and asset bubbles bursting? Should central banks address bubbles with a rise in interest rates or via macro-prudential supervision and regulation?

• Should we worry about deflation or inflation?

• How will central bank exit unconventional monetary policies (ZIRP, QE, CE, FG)?

• What is the risk of sovereign debt crises in developed markets?

Abouhana ASA

Some of the cutting edge issues in

international macro policy debates

• Should we worry about stagflation or stag-deflation?

• Are global external imbalances sustainable or not, and for how long?

• Are twin fiscal and current account deficits sustainable in DM and EM?

• Should we worry about asset protectionism and restrictions to FDI?

• Should we worry about capital controls on inflows and outflows?

• Should we worry about resource protectionism?

• What is the future of offshore outsourcing?

• Is the trade liberalization Doha round as dead as Dodo?

• Is free trade compatible with flexible exchange rates or does greater trade integration require managed or pegged exchange rates?

Abouhana ASA

Some of the cutting edge issues in international macro policy

debate

• What is the BBC (Basket, Band and Crawl) exchange rate regime allegedly chosen by China?

• Are highly-leveraged institutions and hedge funds a source of systemic risk?

• Is offshore outsourcing a threat or a benefit for the global economy?

• Will the BRICs dominate the world economy in the next decades?

• Is the balance sheet approach the appropriate framework for thinking about financial crises in emerging economies?

• Are crises due to fundamentals or self-fulfilling liquidity runs?

• What explains sudden stops and reversals of capital inflows?

• What explains the joint eruption of currency, sovereign debt, systemic banking and systemic corporate crises?

Abouhana ASA

Some of the cutting edge issues in international macro policy

debates

• What is the appropriate form of PSI/bail-in/burden-sharing in crisis resolution?

• Do we need an international lender of last resort (ILOR)?

• What explains international contagion?

• How to deal with liability dollarization and original sin?

• Do we need an international bankruptcy regime for sovereigns?

• What is the most desirable sovereign debt restructuring mechanism?

• Do emerging markets suffer of fear of floating and if so why?

• Is unilateral dollarization the way of the future?

• Are monetary unions feasible without broader banking, fiscal, economic and political unions?

• Is sterilization of excessive capital inflows feasible and desirable?

• What is the desirable reform of the international financial architecture?

• Will the US dollar remain the main global reserve currency?

Abouhana ASA

Sources of International Macroeconomic Interdependence

among Economies

• “Macroeconomics” is “international” given the

increasing economic interdependence among

countries and the increased globalization of

trade and finance.

• Trade links: • Income effects on imports and exports of goods and services

• Direct and indirect trade links

• Exchange rate effects on trade

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Financial channels of interdependence

• Assets/Liabilities traded internationally

• Stocks

• Bonds

• Derivative instruments (in the GFC)

• International financial markets/intermediaries:

• Banks

• Capital markets (stock/bond/money markets)

• Foreign exchange markets

• Commodities markets

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Interdependence channels via

common shocks and FDI/MNCs

• Common sectoral /external shocks • Common oil and commodity shocks

• Tech sector technology shock in the mid 1990s and bust in 2000-2001

• Housing bubbles in the US and other countries; and their bust in 2007-09

• Global credit crunch

• Foreign Direct Investment (FDI)/ Multinational Corporations (MNCs): • Real investment (FDI, M&A)

• Output/production location decisions

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Interdependence via Policy Links

• Domestic effects of macro policies

• International effects of domestic policies if a country is large (US, Europe, Japan) • Global financial contagion of 2008-2009

• International effects of domestic policies even if a country is small (international contagion): • Mexico Tequila effect in 1995

• The Asian fever/flu

• The Russian virus (contagion to emerging markets – Brazil, LatAm - and advanced markets – LTCM & US capital markets)

• The Turkish influenza in 2001

• Greece, Iceland, Cyprus in 2010-12

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Many Financial Crises in Emerging Markets and G7

Economies in the last two decades

• Currency/Financial Crises in Emerging Markets:

• 1980s debt crisis in Latin America

• Mexico, East Asia, Russia, Brazil in the 1990s;

• Turkey and Argentina in 2001; Uruguay in 2002; Brazil

mini-crisis in 2002; Dominican Republic in 2003

• Market turmoil (mini-crisis) in EMs in May-June 2006

• Massive contagion of US financial crisis of 2008-2009 to

emerging markets economies markets and economic

growth. Avoidance of outright financial crises given

stronger fundamentals

• EM mini crisis of 2013? Temporary or persistent?

Abouhana ASA

Crises and financial stresses in Advanced/G7 Economies

• S&L crisis in US in early 1990s

• Corporate/Banking crisis in Japan in 1990s after bursting of the 1980s asset price bubble

• European Monetary System (EMS) currency crisis in Europe in 1992-93 (Italy, UK, France, Sweden)

• Banking crisis in Finland and Sweden in early 1990s

• Bond market crash in the US in 1994 as the Fed unexpectedly tightened monetary policy.

• Sharp fall of the value of the US dollar in 1994-1995

• LTCM crisis in 1998 and seizure of U.S. capital markets

Abouhana ASA

Crises and financial stresses in Advanced / G7 Economies

• Bursting of the US asset price bubble in equity markets in 2000-2002; IT and dot.com crash.

• US corporate and accounting scandals in 2002-2003 (Enron, Sarbox legislation, etc.)

• GM-Ford downgrade in 2005 and turmoil in credit derivatives markets

• Equity market turmoil in the spring of 2006 during the “inflation scare”

• Housing bust and sub-prime crisis in the US (2006-2008)

• US and global financial markets turmoil and volatility starting in the summer of 2007

• Global financial crisis and recession of 2008-2009

• Eurozone crisis of 2010-2013

Abouhana ASA

Major macro and financial events of the last 20 years:

Advanced Economies

• 1987: Greenspan becomes chairman of the Fed. Stock market crash in the US in 1987.

• S&L (Saving and Loans) financial crisis in the late 1980s; evidence of a “credit crunch” in the US.

• US and global recession in 1990-91 during the Gulf War.

• Persistent stagnation of Japanese economy in the 1990s (4 recessions in the 1990s decade) after the bursting of the 1980s asset bubble

• Currency crisis in the European Monetary System in1992-93

• European Monetary Union (1999 introduction of Euro) and mediocre economic/growth performance of Europe in the 1990s

• Large swings in the value of G3 currencies ($, Yen, Euro)

• Global financial crisis in 1998 following Russian crisis and LTCM collapse

• “New Economy”, internet and technology boom: the U.S. boom years (1995-2000): high growth, low inflation, high productivity growth, low unemployment rate, boom in equity markets, budget surpluses, strong dollar, large current account deficits.

• Bust of the IT bubble in 2000-2001; sharp fall of investment leading to economic slowdown in the US.

Abouhana ASA

Major macro and financial events of the last 20 years:

Advanced Economies

• The oil shock in 2000 contributing to the global slowdown

• Fed tightening of monetary policy between mid 1999 and mid 2000 as the economy was “overheating”.

• US slowdown and recession and global slowdown in 2001; it started before 9/11 but was exacerbated by it.

• Third and final stage of EMU (“Euro” introduction) started in 2002.

• A de facto “Bretton Woods II” regime since 2001 as China and Asia effectively pegged their exchange rates to the U.S. dollar through aggressive foreign exchange intervention.

• Tentative U.S. and global economic recovery in early 2002 that slowed down in the spring and in the fall. Slow growth in H1-2003 (given Iraq war uncertainty); U.S. and global recovery in second half of 2003 and Q1:2004 but with poor job growth (“jobless recovery”). Higher US and global growth in 2005-2006

• Bursting of the US housing bubble and a housing bust since mid 2006. Sub-prime mortgage crisis in the US (2007)

• US and global economic and financial crisis of 2008-2009

• Anemic, sub-par, below trend U-shaped recovery in DM in 2010-2013

• Double dip recession in Eurozone, UK and Japan in 2011-2012

• Stronger recovery in advanced economies in 2014 and beyond?

Abouhana ASA

Major macro and financial events of the last 20 years:

Emerging markets

• Latin American debt crisis (in the 1980s) and its solution (Brady Bonds) in the late 1980s and early 1990s

• Large capital flows to emerging markets in the 1990-95 period.

• Transition to a market economy in Central and East European countries.

• Mexican currency crisis in 1994-95

• Asian currency and financial crisis (Thailand, Indonesia, Korea, Malaysia) in 1997-98

• Russian financial and currency crisis (8/98) and its contagion to emerging markets and advanced economies financial markets (LTCM)

• Currency crisis in Brazil in 1/99

• Financial turmoil and IMF rescue packages in Argentina and Turkey in November-December 2000

• Sovereign debt restructurings after partial/full default in Ecuador, Russia, Ukraine and Pakistan in 2000-2001

• Turkish currency and financial crisis in February 2001

Abouhana ASA

Major macro and financial events of the last 20 years:

Emerging markets • Argentina currency and financial crisis and default of 2001-2002

• Financial/currency crisis in Uruguay in 2002

• Risk of a financial crisis in Brazil as October 2002 elections were looming. Financial recovery after the election. Weak economic performance of Latin America in 2003 with growth recovery in 2004-2005.

• Accession of 10 emerging markets (mostly transition economies) to the European Union in 2004.

• Rapid growth of emerging market economies in 2004-2006 on the back of macro/financial reforms and benign global conditions (high global growth, high commodity prices, low G7 interest rates). International investors rediscover emerging markets.

• Boom in commodity prices exported by EMs.

• 2006-2007: Africa as the new EMs growth story and asset class?

• Turmoil in EM financial markets in May-June 2006, especially for countries with external vulnerabilities

• Bubbly equity markets in EM especially in China, India and Gulf states

• Contagion of the US financial crisis to emerging market economies in 2008-2009.

• Strong V-shaped recovery of EM in 2010-2012 given stronger fundamentals

• Slowdown and financial pressures in EM starting in 2012: slowdown of China, end of commodity super-cycle, Fed talk about tapering, policies reducing potential growth

Abouhana ASA