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   Investment Thoughts - Macro Observations

Financing the Global Transition
Interesting remarks on the current financial situation by the Governor of the Bank of Canada



"I would like to start by putting the recent darkening of the global economic outlook in perspective. Europe has built a single market of 500 million people and 27 countries, with free movement of goods, services, capital and people. In the process, it has transformed the economies of southern and eastern Europe. It has also played a consistently positive role in rising above national interests to address global problems.


On a global scale, never in history has economic integration involved so many people, such a variety of goods and so much capital.


This process lifted hundreds of millions of people out of poverty and created the potential for hundreds of millions more to follow in their path. The gap between rich and poor countries has narrowed dramatically and soon the global middle class will outnumber the poor."



"In many respects, the problems we face today are the product of two flawed monetary unions: one formal - the European monetary union; the other informal - Bretton Woods II. In both cases, financial reforms will be integral to the solution."


European Monetary Union


"Further, price stability across the euro area has been composed of large differences in national inflation rates. In the eight-year run-up to the crisis, inflation in the crisis economies was about twice that of the core countries.


Most importantly, unit labour costs in peripheral countries shot up relative to those in the core economies, particularly Germany. The resulting deterioration in competitiveness has made the continuation of past trends unsustainable.

Europe is now stagnating. Its GDP is still more than 2 per cent below its pre-crisis peak, and private domestic demand sits a stunning 6 per cent below."




"The contraction is driving banking losses and fiscal shortfalls. These are understandably receiving much attention, but it should be remembered that these challenges are symptoms of an underlying sickness: a balance-of-payments crisis."


What Should the Europeans Do?


"A sustained process of relative wage adjustment will be necessary, implying large declines in living standards in one-third of the euro area."


"A comprehensive adjustment is necessary. The burden cannot only be on increasing unemployment and falling wages in countries like Spain. Deflation in the peripheral countries will not likely prove any more tolerable than it did in the United Kingdom under the gold standard of the 1920s. An increase in German wages and private demand (and inflation) would ease the transition. It is striking that German real wages barely grew in the two decades before the crisis. Moreover, it is essential that the structural reforms now under way across the deficit countries boost productivity."



"Bold steps are required to restore the single financial market. And bold steps are now under consideration. One example is the current European proposal to create a banking union. By centralising bank restructuring, re-capitalising banks with European rather than national resources, moving towards centralised (or federalised) supervisory oversight and harmonising (or better still mutualising) deposit insurance, Europe can break the increasingly toxic links between banks and sovereigns.


The recent agreement to recapitalise the Spanish banking system marks progress towards a greater financial and fiscal union that will reinforce the monetary union. It is further evidence of Europe’s resolve to address its problems.

If such measures are combined with swift implementation of the Financial Stability Board’s (FSB) financial reform agenda, which I will outline in a moment, there is a prospect of relaunching a deeper, more robust pan-European financial system."

Bretton Woods II

"The second flawed monetary union is at the heart of the current international monetary system: the so-called Bretton Woods II arrangement, which is centred on China and the United States.


The current international monetary system is a hybrid of, on the one hand, mainly major advanced economies with floating exchange rates and liberalised capital flows and, on the other, a group of countries that actively manage their exchange rates. The result is a system that does not facilitate timely and symmetric adjustment to shocks or structural change. For example, despite its economic miracle, China’s real exchange rate did not appreciate in the two decades before the global financial crisis.


In the decade before the crisis erupted, China’s relentless accumulation of reserves contributed to low real interest rates and, for a time, subdued macroeconomic volatility.


Market participants increasingly assumed this stable macroeconomic environment would persist - prompting a search for yield, rising leverage and a dramatic underpricing of risks."




"With 20 per cent of global output, the United States imported 60 per cent of global capital (on a net basis) on the eve of the crisis. This would not have been a problem if this capital had been invested in expanding productive capacity. Unfortunately, not enough of it was."

How To Pay Down Debt

"Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really only three options to reduce debt: restructuring, inflation and growth.


Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly, and on a sufficient scale to restore sustainability. Policy-makers need to be careful about delaying the inevitable and merely funding the private exit.


Some have suggested that higher inflation may be a way out from the burden of excessive debt. To be effective, this would need to be coupled with various forms of financial repression, including capital controls and forced holdings of government debt.


This is a counsel of despair.


An inflation surprise needs to be very large or very sudden to work. Moving opportunistically to a higher inflation target would risk unmooring inflation expectations, destroying the hard-won gains that have come from the entrenchment of price stability, and increasing real rates that would exacerbate unfavourable debt dynamics.


Financial repression would have to be both massive and sustained. It would undermine the system that has helped bring us the prosperity of the past three decades.


The most palatable strategy to reduce debt is to increase growth.

Private growth will not flourish in an environment of macro instability. Fiscal sustainability and price stability are essentials, not luxuries.


Private growth needs an enabling environment, including tax competitiveness and a framework for infrastructure investment. It needs a sound financial sector that is diverse, resilient and open.




Ending Too-Big-To-Fail


"Since failures will still happen, there remains the need to reduce their impact, which is one of the reasons to focus on ending too-big-to-fail. More fundamentally, we must address, once and for all, the unfairness of a system that privatises gains and socialises losses. By restoring capitalism to the capitalists, discipline in the system will increase and, with time, systemic risks will be reduced. Most importantly, the knowledge that major firms in markets far away can fail, without meaningful consequences at home, will restore confidence in an open global system.


To achieve this objective, bondholders, shareholders and management - rather than taxpayers - must bear the brunt of losses. To this end, all FSB member countries have committed to have in place a bail-in authority. In addition, each global systemically important bank must have in place a Resolution and Recovery Plan within the next six months, to be supplemented by cross-border co-operation agreements.


The framework for systemic institutions is now being extended to domestic banks, global insurers, and key shadow banks. When implemented, greater supervisory intensity and higher loss absorbency will ensure that the system is never again beholden to the fate of a single firm or group of firms."


Creating Continuously Open Markets


"An important element of ending too-big-to-fail is ensuring that key markets can withstand the failure of systemic firms. It is unacceptable that core markets seized up during crisis, and that relatively small firms had to be saved because of concerns that they would take markets with them if they failed. Creating continuously open core markets requires changes to the plumbing of derivative and repo markets, along with better data and tracking of exposures."





Mark Carney, Governor of the Bank of Canada-21 June 2012







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