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Please find attached our latest monthly report, “A Crisis of Confidence.” Key conclusions to the report include:
• Many industrial economies remain in a perilous economic position as political factors are creating great uncertainty about their growth prospects
• The US labor market remains quite subdued, but there are multiple reasons why a new recession will not begin in 2011
• The European economy continued to slow down as summer turned to fall, and the resignation of Germany’s ECB representative has reignited fears about the euro area’s viability
• Yoshihiko Noda, Japan’s new prime minister, assumes the position at a time of slowing growth and faces questions about how Japan will finance its reconstruction efforts
• Restrictive monetary policy actions in China are taking effect as property prices have begun to cool across the country and many other metrics have shown signs of deceleration

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A Crisis of Confidence
September 2011 • Volume 08.14
By David Hale

KEY CONCLUSIONS
• Many industrial economies remain in a perilous economic position as political factors are creating great uncertainty about their growth prospects
• The US labor market remains quite subdued, but there are multiple reasons why a new recession will not begin in 2011
• Confronting the possibility that fiscal drag could hinder economic growth next year, the Obama administration has unveiled a new jobs proposal that could substantially improve 2012 growth
• The European economy continued to slow down as summer turned to fall, and the resignation of Germany’s ECB representative has reignited fears about the euro area’s viability
• Yoshihiko Noda, Japan’s new prime minister, assumes the position at a time of slowing growth and faces questions about how Japan will finance its reconstruction efforts
• Restrictive monetary policy actions in China are taking effect as property prices have begun to cool across the country and many other metrics have shown signs of deceleration
• The region’s strong dependence upon export-led growth has created concerns about Asia’s economic prospects in the face of uncertain growth prospects in the Western economies
• Further monetary tightening has been put on hold in Canada, Australia, and many countries in Latin America because of fears about the global growth outlook
• The global commodity boom is producing remarkable growth results in Africa

WILL FEAR DRIVE US INTO A RECESSION?

The global economic outlook now depends upon the elusive issue of confidence. Recent turmoil in the financial markets has demonstrated that investors have become highly apprehensive. They are concerned about the risk of a double dip in the US and the festering debt crisis in Southern Europe. They fear that there is not adequate political leadership to address either concern, and that passive policies could lead to a new financial crisis and recession. These fears have depressed equity markets all over the world, and thus threaten to make the fears self-fulfilling.

The Obama administration has proposed new fiscal measures which could reverse the drag built into its original budget, but the Congress is unlikely to pass judgment on them until November. European parliaments are expected to approve new powers for the European Financial Stability Facility (EFSF) during the next few months, but the next stage of the aid program for Greece is at risk because the government has been unable to achieve its deficit reduction targets in the midst of a severe recession. The markets believe that Greece is in a situation comparable to Argentina in 2001, but eurozone finance ministers remain determined to avoid a default. The European Central Bank (ECB) is also intervening in the Italian and Spanish bond markets in order to prevent contagion fears from driving up their bond yields. There is discussion about structural solutions to the debt crisis, such as the creation of eurobonds, but Germany remains opposed. Jürgen Stark, Germany’s top representative on the ECB’s executive board, has reportedly resigned from the ECB because of his opposition to the purchases of Italian and Spanish debt. As he was the second German to leave the ECB for this reason, his departure triggered an immediate decline in the euro and European equity markets.

The G-7 finance ministers discussed these issues in early September, but they were unable to offer any solutions. The Federal Reserve will continue to provide the ECB with access to dollar liquidity if it is needed, but the Obama administration will not offer any financial assistance to troubled countries on the European periphery. Italy has been holding discussions with China’s sovereign wealth fund about it purchasing more Italian bonds, but the fund already owns a large share of Italy’s national debt and would need permission to buy more.

A SHARP DROP IN US CONFIDENCE

The sharp gyrations in the US equity market have depressed both household and business confidence, provoking new concerns that the economy could experience a double dip. There is not a direct correlation, however, between the equity market and the economy. The stock market fell as much as 36% during 1987, and real GDP grew by 4.1% during 1988. But the recent equity market turmoil came after a period in which economic data was clearly disappointing, so investors are very apprehensive.

The Labor Department stunned the markets by reporting there was no job growth during August. The private sector created 63,000 jobs, but the gains were offset by the loss of 17,000 government jobs and a strike at Verizon which cost 46,000 jobs. The August private employment gains contrast to the 156,000 new private sector jobs that were created in July and 75,000 in June. The household survey showed a job gain of 331,000, but this came after large losses during the three previous months, so household employment in August was still below its level in May. The workweek also declined. In the past, a decline in the growth rate of private sector employment to less than 0.5% has been a recession signal. In August, the six-month growth rate slipped to 0.7%. If private employment growth during the next two months is only 45,000 jobs per month, the growth rate will dip below 0.5% and increase concerns about the risk of a new recession.

Other August data in the US was less distressing. The ISM Manufacturing Index held at 50.6 compared to many forecasts that it might dip to 48-49. The ISM service index rose 0.6 points to 53.3 as a result of gains in new orders and supplier deliveries. Auto sales also held up at 12.1 million while there were good gains in department stores sales because of the back-to-school season. As these gains followed a 0.8% increase in consumption during July, the economy has clearly not yet entered a recession.

THE 2008-09 GREAT RECESSION: MUCH WORSE THAN WE THOUGHT

In late July the Commerce Department published revised estimates of GDP growth during the previous three years. The new data showed that real GDP fell by 5.1% during the 2008-09 recession rather than the 4.1% drop that was previously reported. During the eight quarters of recovery starting in mid-2009, real GDP grew by average annualized rate of 2.4% compared to gains as large as 6-7% after previous severe recessions. The annualized growth rate of real GDP during the first half of 2011 was only 0.7%. Real GDP is still below its previous peak in 2007. The recovery’s weakness has been broad-based. Exports have been the strongest sector. According to analysis by Credit Suisse, they are now 9.5% above the economy's previous peak while imports are still slightly below the old peak. Consumer spending has increased by only 0.7% from the previous peak compared to an average gain of 13.6% during the recoveries from past severe recessions. Real residential investment is still 38.1% below the previous peak compared to a gain of 25.5% after past severe downturns. Real business fixed investment is also 12.1% below its former peak compared to a gain of 9.7% during previous recoveries from severe downturns. Equipment spending has rebounded, but construction spending remains deeply depressed. State and local government spending is 5.2% below the previous peak, but the Obama stimulus program has pushed federal spending 14.8% above the old peak.

The corporate sector slashed employment and boosted productivity during the downturn and early stages of recovery. As a result, profits have increased 28.5% from the previous peak according to Credit Suisse. Labor compensation, by contrast, has increased only 3.1% compared to 33.1% during recoveries from past severe downturns. The weak income growth has constrained consumer spending.

WILL HIGH-END CONSUMERS STOP SPENDING?

The retail sector has had to rely heavily on spending gains from upper income people who have benefited from the large gains in the equity market since March 2009. The new risk to consumer spending is that $2.5 trillion of wealth losses in the equity market since April could cause high income households to curtail spending at the same time that slower employment growth is depressing personal income. Households do not respond immediately to wealth losses. They instead smooth the adjustment, and wait to see how far the price correction will go. There was a $4 trillion wealth gain in the equity market between the fourth quarter of 2010 and the second quarter of 2011, which had the potential to boost consumer spending by 1.0-1.5%. The recent equity market decline could cut these potential gains in half or produce even larger losses if there is a sustained decline in confidence. Falling gasoline prices are the only new positive factor for consumer spending this autumn.

FIVE ARGUMENTS AGAINST A NEW US RECESSION

First, the economy's most cyclical sectors—housing, auto sales, and business investment—are still far below their previous cyclical peaks. They cannot decline sharply when they have failed to fully recover.

Secondly, interest rates remain at record lows. When the economy experienced a double dip in 1981, Federal Reserve policy was highly restrictive and real interest rates were nearly 8%. At the current time real interest rates are minus 1.5% compared to an average of plus 3.4% before the onset of previous recessions. The Fed has promised to restrain interest rates for another two years, and they may take other actions to ease policy at its next meeting. The yield curve is also positively sloped, whereas it is normally inverted before recessions.

Thirdly, the corporate sector is in a very healthy condition. Both profit margins and profits per worker are at record highs. The corporate sector has $2 trillion of cash on its balance sheet. As a result there is no pressure to lay off workers or slash investment. On the contrary, there will be 100% first-year depreciation allowances available for new equipment purchases before year end.

Fourthly, the household sector has begun to correct the balance sheet excesses which led to the slump three years ago. It has reduced debt by over $1 trillion. There has been a sharp decline in household debt servicing payments. According to revised data from the Bureau of Economic Analysis, household mortgage payments totaled $548 billion at annualized rates during the second quarter, which is $134 billion below the record high reached during the fourth quarter of 2007. Mortgage payments as a share of disposable personal income (DPI) are now 4.7% compared to 6.5% at the peak. In June non-mortgage interest payments totaled $152 billion at annualized rates, which is $123 billion below the former high in mid-2007. The ratio of non-mortgage interest payments to DPI has fallen from 2.6% to a new record low of 1.3%. The Federal Reserve publishes a household financial obligation ratio, which is the broadest measure of debt service as it includes all principal and interest payments, rental payments, and automotive lease payments, as well as homeowner’s insurance and property tax payments. This ratio has fallen from just under 19.0% four years ago to 16.4%, or the lowest level since 1994. The ratio of household liabilities to DPI is now 116% compared to 130% at the peak four years ago, but this is still above its thirty-year average of 92%, so there is still potential for the household sector to deleverage further. But the decline in the debt servicing ratio has the potential to boost consumer spending by at least 1-2% unless falling confidence causes households to raise their savings rate. The savings rate fell to 5.0% in July from 5.5% in June as consumers increased their real spending at a 5.6% annualized rate.

Finally, US banks have made a strong recovery from the large losses which occurred during 2008 and 2009. They have pushed their equity-to-assets ratio above 11.0% from 9.3% in late 2009, and have increased their return on assets to 0.86% from negative 0.07% in 2009. Banks are now relaxing lending standards for both business and household borrowers.

FISCAL DRAG REMAINS THE BIGGEST RISK IN THE US OUTLOOK

The great risk in the outlook has been fiscal drag. The OMB budget published in late August projected that there would be drag in the new fiscal year equal to 2.7% of GDP. The budget projected the tax share of GDP would rise to 17.1% from 15.5% as tax cuts enacted in December expired. The spending share of GDP was projected to decline from 24.3% of GDP to 23.4% as the Obama stimulus program unwound. Some of the largest cuts will be in aid to state and local governments. The aid in the current fiscal year is projected to drop from $59 billion in the most recent fiscal year to $6 billion despite the fact that states will run a cumulative fiscal deficit of over $100 billion. State and local governments have laid off 345,000 employees during the past year. The decline in federal aid could lead to further large job losses.

WILL OBAMA’S JOBS PROGRAM WORK?

The Obama administration recognized the dangers posed by restrictive fiscal policy and announced new proposals in early September to reverse this fiscal drag. It proposed new tax cuts and spending programs worth $447 billion. The administration wants to extend the Social Security payroll tax cut and increase it to 3.1% from 2.0% at a cost of $175 billion. The administration is also proposing to reduce employer Social Security payroll taxes by half for the first $5 million of a firm's wages at a cost of $65 billion. It wants to extend the 100% first-year depreciation allowances at a cost of $5 billion. The proposals also include a measure to give state governments $35 billion of new aid in order to lessen the risk of additional teacher layoffs, and another measure that would extend unemployment benefits for another year at a cost of $49 billion. It wants to spend $80 billion on infrastructure, and create an infrastructure bank with $10 billion of capital at its disposal. The president describes his proposals as a jobs program that is designed to lessen the risk of a new recession. The Republicans are very skeptical about fiscal stimulus philosophically, and they claim the Obama administration’s original program failed to revive the economy. But the public is clearly worried about the risk of a new recession, and the stock market has fallen sharply, so they cannot completely dismiss the president's proposals. Republicans will probably agree to extend the payroll tax cut and reduce payroll taxes for small businesses, but it is doubtful they will accept higher infrastructure spending or extended unemployment insurance. What remains to be seen is whether the special congressional committee assigned to offer new proposals for deficit reduction will attempt to pursue any serious tax reform. They could give a boost to the economy by reducing corporate and personal tax rates in return for a scaling back of tax allowances. They could also increase tax receipts next year by $30-40 billion by lowering the tax rate on repatriated foreign profits from 35% to 5%, as the Bush administration did in 2004.

The Obama administration’s proposals could boost the economy's growth rate next year by 1.5-2.0%. There is no guarantee that small firms would increase their hiring because of lower Social Security taxes, but the extension of the payroll tax cuts and unemployment benefits would help to sustain consumer spending. The latest survey of small business confidence by the National Federation of Independent Business indicates that the sector remains very cautious. In August the confidence index fell 1.8 points to 88.1. Small business reported disappointing sales and expects demand to remain weak during the next six months. There was an increase in the number of firms boosting investment and a net 5% of firms plan to increase their hiring in the future. There would be more hiring if firm owners had greater confidence in the outlook for final demand. Firms with fewer than one hundred workers account for approximately one-third of US employment.

The Obama administration is also planning to revive its efforts to help troubled homeowners by having Fannie Mae and Freddie Mac lower the interest payments on the 2.9 million loans they control. The administration launched a program to help distressed borrowers two years ago, but only 838,000 people utilized it. Falling home values and restrictive income requirements discouraged participation. The CBO has estimated that reducing interest payments on the Fannie Mae and Freddie Mac loans could save homeowners $7.4 billion in the first year, and help about 111,000 people to avoid default.

HOUSING SECTOR WEAKNESS PARTIALLY OFFSET BY ROBUST EXPORT GROWTH

There can be little doubt that the housing sector has been one of the major constraints on the economy's performance during the past two years. Home values have fallen over 30% from their previous peak, forcing households to increase their savings rate. The construction sector lost over two million jobs, and has replaced next to none of them. There are still two million homes moving through foreclosure while nearly as many are seriously delinquent. Almost one quarter of homeowners have negative equity in their properties. The home ownership ratio for people aged 25 to 34 years has fallen from 51.6% in 1980 to 42.0% in 2010. The ratio for those aged 35 to 44 years has fallen from 71.2% to 62.3%. The ratio for those aged 45 to 54 years has fallen from 77.0% to 71.5%. The thirty-year mortgage rate has fallen to a near record low of 4.22% compared to 4.35% one year ago, but demand has been constrained by the imposition of tighter credit standards and higher down payment ratios. The multifamily housing sector is the one sector of the housing market which has begun to revive. The Multifamily Production Index compiled by the National Association of Home Builders rose to 44.4 during the second quarter from 41.7 in the first quarter. This is the highest reading since 2006, and continues a steadily improving trend since the index troughed at 16.0 during the third quarter of 2008. Multifamily construction is rising because of a sharp decline in the vacancy rate for apartments. More Americans now plan to rent rather than buy a home.

The economy's strongest sector continues to be exports. The trade deficit fell to a six-month low of $44.8 billion during July because of exports surging 3.6% and imports falling 0.2%. This gain more than offset a 2.5% decline during the two previous months. There was a large increase in exports of capital goods (+5.5%) and industrial materials (+6.9%). The year-on-year growth of exports is 17.2%. The improvement in the trade account could bolster real GDP growth by 0.9% during the third quarter. The gains in trade coupled with the large increase in consumption during July and August should produce a real GDP growth rate in the 2.0-3.0% range during the third quarter.

WHAT TOOLS REMAIN AT THE FEDERAL RESERVE?

Federal Reserve Chairman Ben Bernanke has made two speeches indicating the FOMC will explore new ways to boost the economy at its meeting in late September. He has not yet said what they will do because there is no consensus. There are six district presidents who are opposed to any new policy easing. On the other side of the spectrum, Chicago Fed President Charles Evans gave a speech in early September calling for new easing. The presidents of the Boston and San Francisco Federal Reserve banks have expressed sympathetic views as well. If the chairman wants to pursue new policy moves, he can still get a majority of the voting members of the committee to agree with him. The market is expecting him to propose that the Fed should extend the maturity of its portfolio of government securities. The Fed currently has $516 billion of securities with a maturity of under three years. The FOMC could vote to sell some of these securities and purchase more ten-year bonds. As the current yield on ten-year paper is already at or below 2.0%, it is doubtful that such an action would have much impact on long-term interest rates, but it would be a way for the Fed to show its concern about the economy. It is doubtful that the FOMC will agree at its next meeting to purchase another large volume of government securities. When the Fed pursued such a policy one year ago, the core inflation rate was only 0.6%, and some governors were concerned about the risk of deflation. The core inflation rate is now 1.8% and the total CPI inflation rate is 3.6%. The Fed will return to a policy of quantitative easing only if it perceives the economy is sliding into recession. As it still expects moderately positive growth during the next few quarters, it will not want to expand its balance sheet at the current time. Mr. Bernanke is probably also sensitive to the sharp criticism of him by Republican presidential candidates. He will not let them stop him from taking actions necessary to help the economy, but they have increased the burden of proof needed to justify new policy actions.

FHFA LITIGATION IS A THREAT TO GLOBAL BANKS

The Federal Housing Finance Agency (FHFA) has filed lawsuits against seventeen US and foreign banks. The suit alleges that the banks made misleading claims about $200 billion of mortgage paper sold to the GSEs, Fannie Mae and Freddie Mac. The FHFA failed to specify a damages figure, but in a similar recent lawsuit against UBS, the FHFA sought to recover about 20% of the face value of the bonds at issue. The largest claims are against Bank of America ($57.5 billion), JP Morgan Chase ($33 billion), Royal Bank of Scotland ($30.4 billion), Deutsche Bank ($14.2 billion), Credit Suisse ($14.1 billion), and Goldman Sachs ($11.1 billion). Bank of America is vulnerable to such large claims because of its acquisition of Countrywide, a large subprime lender, in 2008. JP Morgan Chase is also facing large potential claims because of its acquisition of Washington Mutual from the FDIC in 2008. The other danger posed by the FHFA litigation is that it could reveal information which would open the door to more private lawsuits over the quality of loans sold. The litigation has helped to encourage a large decline in bank share prices at a time when investors were already apprehensive because of concerns about potential financial contagion from Europe.

US CORPORATE PROFITS STRONG, BUT CEOs ARE CAUTIOUS

The GDP measure of corporate profits with inventory valuation and capital consumption adjustments rose to $1.933 trillion during the second quarter from $1.876 trillion during the first quarter and $1.786 trillion one year ago, which was a gain of 8.2%. Domestic profits rose to $1.495 trillion from $1.395 trillion one year ago, or a gain of 7.1%. Foreign receipts rose to $648 billion from $566 billion one year ago, which is a gain of 14.5%. If the economy were to experience a mild recession, profits could decline by 25%, as they did in 1990-91 and 2000-01. If the economy is merely sluggish, the growth rate of profits could slow to 4-5% next year. Equity analysts are still projecting double-digit gains next year, but their forecasts have not yet been adjusted for the change in economic forecasts resulting from the recent turmoil in financial markets. The National Association of Business Economists has just conducted a survey of forecasts among its members. In the new survey economists project real GDP growth of 1.7% this year and 2.3% next year. In the previous survey, they had expected growth of 2.8% in 2011 and 3.2% in 2012. This new consensus is not yet reflected in profit forecasts.

US RECOVERY IN LINE WITH 1990 AND 2001

There can be little doubt that the U.S economy has had a lackluster recovery from the most severe recession since the 1930s. But it appears subdued only when compared to the recoveries from past severe downturns (1958, 1974, 1982). If we instead make comparisons with the recoveries after the two most recent recessions (1990, 2001), it does not appear to be nearly as lackluster. The gains in private payroll employment, real retail sales, and real business spending during the current recovery have exceeded the two previous ones. The great laggards have been housing and state and local governments. The growth rate of credit has also been far more negative because of the deleveraging resulting from the financial crisis. There is no need for a new recession to curtail financial excesses or speculative bubbles in important asset markets such as housing. The economy is constrained because the housing market has not yet recovered while state governments are still running large fiscal deficits. Federal Reserve policy is helping the consumer by lowering debt servicing payments. The corporate sector has enjoyed a spectacular profit recovery because of its success at reducing costs and boosting productivity. These factors should help to sustain demand unless there is a loss of confidence which drives savings rates sharply higher. The events in Washington during late July and early August had a very negative impact on confidence. The challenge now facing the nation's political leadership is to bolster confidence by showing an ability to cooperate on the president's fiscal proposals and pursuing long-term deficit reduction. If they cannot, the year 2011 could go down in the history books as the first time that the American people talked themselves into recession.

A WAVE OF BAD NEWS IN EUROPE

The European economy showed clear signs of a continuing slowdown during July and August. The euro area PMI index fell 1.4 points to 49.0 in August. The German index eased to 50.9 from 52.0. France’s index reading fell to 49.1 from 50.5. The Italian index dropped to 47.0 from 50.1. Spain’s index dipped to 45.3 from 45.6. The Greek index plunged to 43.3 from 45.2.

The European Commission’s Economic Sentiment Indicator slumped 4.7 points to 98.3 during August. The industrial index fell to -2.9 from 0.9. The service index fell to 3.7 from 7.9. Some of the largest declines were in countries which had previously been resilient, including Germany (-5.7 points), Holland (-3.0 points), and Austria (-4.1 points).

The German economy slowed to a growth rate of only 0.1% during the second quarter, or 2.7% year on year. Private consumption fell 0.7%, but gross capital formation rose 3.8% quarter on quarter. There were special factors which magnified the economy's weakness during the second quarter. There was a 7% increase in construction during the first quarter because of benign weather conditions which set the stage for a 0.9% decline during the second quarter. The shutdown of several nuclear power plants after Japan's earthquake also reduced energy output by 8% and subtracted 0.2% from total GDP. German industrial production rose 4% in July as firms cancelled traditional summer holidays, but industrial orders still fell 2.8%. The largest decline was in orders for other vehicles (aircraft, trains, ships, etc.), a sector in which orders had been abnormally high during previous months. If this sector is omitted from analysis, orders fell only 0.2%. The German's economy growth rate should rise to 0.3% during the third quarter, but it will remain vulnerable to weakness in the global economy because of the large size of the export sector. In 2008 exports accounted for nearly 48% of GDP.

ECB President Jean-Claude Trichet has acknowledged that the European economy now faces downside risks, but he has not offered any hints as to whether the ECB will reverse recent interest rate hikes. His term as ECB leader will end on October 31st, so the decision may depend upon his successor, Mario Draghi. The ECB staff has produced a new forecast which suggests that inflation risks are now "broadly balanced" compared to "on the upside" last month. The staff now projects quarterly growth of 0.25-0.5% during the second half and inflation easing to 1.7% during 2012 from 2.5% recently. As the ECB does not attempt to fine tune policy as much as other central banks, the forecast of modest output growth could leave policy unchanged. But since confidence is vulnerable to recent shocks in the financial markets, there is clearly a possibility that the ECB could act before year end. The share prices of European banks have fallen sharply, credit spreads have widened, and some European banks have funding problems.

HAVE WE ENTERED A NEW PHASE IN THE EUROZONE CRISIS?

The political conflict over the ECB's role in helping to rescue troubled debtor countries has intensified with the resignation of Jürgen Stark from the central bank. He oversaw the research department and was the German member of the executive board. He also resigned six months after the departure of Axel Weber from the presidency of the Bundesbank. Mr. Weber had once been the front runner to succeed Mr. Trichet, but he withdrew from the race because of his disagreement with Mr. Trichet's decision to purchase the bonds of troubled countries such as Greece, Ireland, and Portugal. Mr. Stark was reportedly protesting the intervention in the Italian and Spanish debt markets.

The German government moved quickly to appoint a successor to Mr. Stark. He is Mr. Joerg Asmussen, state secretary of the finance ministry and a right-hand man of German Finance Minister Wolfgang Schauble. The problem for Germany is that its influence over ECB policy has been declining since the retirement of Ottmar Issing five years ago. After a long career at the Bundesbank, Mr. Issing became director of research at the ECB and commanded broad respect. Mr. Stark replaced him in 2006 after also serving at the Bundesbank. Mr. Stark had previously worked at the ministry of finance and was a close advisor to Chancellor Helmut Kohl on the negotiations over the creation of the European Monetary Union. He was a member of the Christian Democratic Party as well. Mr. Asmussen has played an important role in shaping Germany's response to the current financial crisis, but he has never served at the Bundesbank and is a member of the Social Democratic Party (SDP). It will take him time to establish credibility in a central banking role at a time when leadership of the ECB will pass to a Southern European. The departure of Mr. Stark will therefore intensify German concerns about the commitment of the ECB to a low inflation policy and the influence of Southern European countries on the conduct of monetary policy. During recent days several German economists have expressed concerns about the ECB deviating from the policies of the Bundesbank and assuming a new political role. A former member of the Bundesbank board, Mr. Edgar Meister, said that Mr. Stark’s resignation is "a wake-up call, perhaps the last warning" to euro area governments. He added, "Politicians cannot misuse the central bank to finance governments, otherwise danger threatens–for the ECB as well as the euro.” The fact that a Southern European is taking over the leadership of the ECB next month makes it even more essential for European parliaments to approve new powers for the EFSF. The ECB wants the EFSF to take over its role of intervening in Southern European debt markets. If an Italian central bank president has to purchase a large volume of Italian debt, German public opinion will become even more hostile to the monetary union.


There have been many rumors during early September that Greece would default because its severe recession has made it impossible for the government to achieve its deficit reduction targets. The deficit between January and August was €18.1 billion compared to €14.8 billion last year. Tax receipts faltered because real GDP could contract by 6% this year while the recession has increased transfer payments. The economy lost 300,000 jobs in the past year, and there are one million people seeking work in a country with a population of 11 million. The unemployment rate is 16% for the country and over 40% for people aged 15-24. In the first half of 2011, there were over 42,000 applications to move to other eurozone countries compared to 3,355 in all of 2007. The Greek government continues to rule out default and announced the introduction of a new property tax to raise another €2 billion of revenue. New revenues need to be found by the Greek government because its inability to reach the deficit target was jeopardizing its ability to obtain funds from the next stage of its rescue program.

The two critical factors in resolving the European debt crisis continue to center on German politics and Greek politics. Can the German policy elites maintain public tolerance for the rescue programs? Can Prime Minister George Papandreou continue to impose austerity policies on a country suffering a severe recession? The German elites have supported the monetary union because German exports to Europe are equal to 29% of GDP. They fear that a breakup of the union would lead to a massive devaluation all over Europe while Germany’s currency could follow the recent course of the Swiss franc. There has been an erosion of German support for the monetary union during recent weeks as some prominent businessmen are now suggesting Germany should create a new currency with other Northern European countries. A prominent FDP politician and German economic minister, Philipp Roesler, has written an article saying, "an orderly default for Greece should no longer be ruled and out that the country's deficit reduction measures are insufficient." Chancellor Angela Merkel is still supporting the rescue programs, and the Bundestag is scheduled to vote on the new powers for the EFSF in late September. If Ms. Merkel cannot hold her own coalition together, the SDP will ensure the legislation passes. But a defeat for Ms. Merkel in her own coalition would lessen the odds of any new rescue programs going forward.

The Greek government is sticking to the austerity program because a default would deny it access to the capital markets for many years and undermine the solvency of the Greek banking system. The government would have to rescue the banks at a time when it could not borrow. Greece’s government has ruled out leaving the monetary union because such an action would also trigger a financial crisis. The Greek banking system would disintegrate as Greeks engaged in massive capital flight in order to avoid owning the newly resurrected drachma.

Market concerns about Greek debt have led to a sharp decline in the share prices of European banks during recent weeks. European banks have $162.4 billion of exposure to the Greek economy while non-European banks have $44 billion. France has the largest exposure at $65 billion followed by Germany with $39.9 billion and the UK with $19 billion. Many of these loans are to the Greek private sector. Societe Generale and Credit Agricole own Greek banks outright. Credit Agricole’s bank has assets of €26.4 billion while Societe Generale has assets of €4 billion. Only two banks, one German and one French, have exposure to Greek government debt of more than $7.2 billion. More than half of Greece's public debt is now owned by official institutions such as the IMF and the ECB.

European policymakers have been proposing more radical solutions to managing eurozone economic policies. At a recent conference in Italy, both Mr. Trichet and Mr. Draghi called for much greater policy coordination and stricter budgetary surveillance. Mr. Draghi called for "a quantum leap toward economic integration," going beyond fiscal discipline and focusing on structural reforms to enhance competitiveness. Dutch Prime Minister Mark Rutte produced an article in the Financial Times calling for the creation of a new EU special commissioner to oversee eurozone states that are receiving bailouts. The commissioner would have the authority to impose financial penalties, suspend EU subsidies, adjust tax and spending policies, revoke EU voting rights, and even eject a state from the eurozone if it failed to pursue effective fiscal reforms. The Germans support this idea in principle, but the Dutch want to make the commissioner an institution of the European Union whereas the Germans would prefer to give this role to the new financial stability facility. The Dutch want to enhance the role of the EU in order to lessen the risk of a German-dominated Europe.

The Italian government has finally enacted a new deficit reduction program which promises to achieve a primary balance of 0.9% of GDP this year and the elimination of fiscal deficits by 2013. The program achieves these goals primarily through tax increases, including a hike in the VAT to 21%, increasing the income tax rate on incomes over €300,000 by 3%, and an increase in the capital gains tax to 20% from 12.5%. The primary balance is projected to show a surplus of 5.5% of GDP by 2014, and thus will set the stage for a gradual decline in Italy's public debt to 110% of GDP from 120% this year. Italy needs further structural reforms to enhance the growth rate of its economy. Wage growth has exceeded productivity growth for many years, so the country's competitive position has deteriorated. Italy's economy may grow by only 0.7% both this year and next.

THE SWISS PEG AND INFLATION

The Swiss National Bank has announced that it will now peg the franc to the euro at a rate of 1.20. It took this action because the debt crisis in the eurozone was generating significant capital flight into the franc and driving it steadily higher. The Swiss National Bank (SNB) was concerned about the impact of this revaluation on the economy. In 2008 exports were over 56% of GDP and manufacturing was 8% of GDP. Switzerland pursued a similar policy during the late 1970s, and it led to an increase in the money supply which boosted inflation above 5.0%. The new policy could have a similar effect if it forces the SNB to expand the money supply in order to absorb a large influx of foreign exchange.


UK COULD DELAY NEW CAPITAL REQUIREMENTS

The UK economy continues to suffer from weakness in both consumer spending and output. Forecasters are now projecting output growth of only 1.3% this year and 1.6% next year. There is increasing discussion about whether the Bank of England should return to a policy of quantitative easing. Adam Posen, an external member of the Monetary Policy Committee of the Bank of England, has been advocating such an action for many months, but he has been alone in this view. Chancellor of the Exchequer George Osborne has now voiced his support for a return to quantitative easing, so the odds of some action have increased. The chancellor is anxious to maintain his restrictive fiscal policy, so he naturally wants more help from the central bank.

The British government's Independent Commission on Banking has issued a report calling for banks to have capital and "bail in bonds" worth 17-20% of their risk-adjusted assets. This is substantially higher than the capital requirements proposed under the Basel rules. The risk is that forcing banks to hold a fifth of their assets in low yielding investments will force them to raise interest rates on other borrowers and could increase bank spreads by as much as 0.7%. The chancellor recognizes this danger and has therefore already announced that the report's recommendations will be delayed until at least 2015. He clearly does not want to produce tighter lending conditions at a time when the economy is already very weak.

JAPANESE GROWTH DECELERATES AS NODA TAKES OVER

The Japanese economy is continuing its recovery from the March earthquake, but the pace of improvement is slowing. Real GDP is growing by approximately 7.0% during the third quarter as firms have resolved the supply problems resulting from the earthquake and have increased exports at a 32.0% annualized rate. Consumers also increased real spending by 3.5% after a small decline during the second quarter. Real export growth will slow to 8% as the global economy weakens while consumers are turning more cautious. As a result, real GDP growth could slow to 3.5% during the fourth quarter despite a 15% gain in public investment.

Yoshihiko Noda was elected Japan's sixth prime minister in five years in early September. Although he had only a 2.9% preference rating in the opinion polls, he was able to forge a coalition with former DPJ leader Ichiro Ozawa which gave him a majority in the leadership election. Mr. Noda is ten years younger than his predecessor and has a very different personality. He has talked about cooperating with the opposition parties and is far more open to working with the bureaucracy. Mr. Noda has revived weekly meetings of the administrative vice ministers, meetings that were abolished or ignored by his predecessors Mr. Hatoyama and Mr. Kan. He is also less populist and more business friendly.

Mr. Noda's immediate challenge will be managing reconstruction efforts from the earthquake. The total size of the reconstruction program is ¥19 trillion. The Diet has already approved the first ¥6 trillion and will now have to approve the next ¥13 trillion. The government expects to spend ¥16 trillion during the first three years and ¥8.5 trillion next year. There is no consensus about how to finance the reconstruction effort. Mr. Noda endorsed tax increases when he was minister of finance, but he backed away from such proposals during the leadership campaign because they are unpopular with the DPJ. There is also concern about raising taxes at a time when the global economy is slowing. It may therefore be impossible to enact any meaningful tax hikes until after the elections currently scheduled for 2013.

KEY METRICS SLOW IN CHINA

The Chinese economy showed new signs of resilience in August. Exports grew by 24.5% year on year while imports rose by 30.2%, led by demand for commodities and capital goods. The demand for imports appears to reflect strength in the property sector. Housing starts grew by 32% year on year in August because of investment in social housing. The demand for private housing rose by only 13.5%. Fixed asset investment rose by approximately 23% in August compared to 24.7% in July. The slowdown resulted from a halting of high speed railway construction and nuclear power projects as well as tighter lending conditions for local government. The purchasing manager index for August rallied 0.2 points to 50.9 as a result of an uptick in the output index. The index was stronger than expected, and suggests that Chinese growth is slowing gradually rather than rapidly.

Monetary policy remains restrictive because the inflation rate peaked at 6.5% in July and eased to only 6.2% in August. Food prices are now declining, so the inflation rate should drop towards 5% later this year, but the inflation rate for manufactured goods has risen to 2% while the inflation rate for services prices has risen to 3% because of rising wages, so the central bank is inclined to remain apprehensive. The growth rate of M2 fell sharply to 13.5% year on year in August from 14.7% in July. The central bank added to its tightening policies in late August by announcing new reserve requirements on "margin deposits." The margin deposits include commercial bill acceptances, letters of credit, and business guarantees. These items had a value of 4.4 trillion renminbi (rmb) in July, or 5.6% of total rmb deposits. The new rule will remove 887 billion rmb of liquidity from the banking system, and thus be equivalent to a 130 basis point increase in reserve requirements (which are now 21.5% for large banks). The central bank is concerned about the credit growth occurring outside of formal bank lending, so it will continue to search for ways to regulate alternative forms of intermediation. Small firms have found it difficult to obtain loans from the large banks, so they have had to turn to the informal lending market. The government has promised to improve their credit access, but such changes will take time. Chinese bank lending to small- and medium-sized enterprises grew by only 7.1% during the year through April. These loans accounted for 28.8% of all corporate loans.

There are more signs that the property market in China is cooling. The China Index Academy released data in late August showing that property prices in China's first-tier cities eased 0.41% in August. Meanwhile, about sixty of the cities surveyed showed declining property prices. Land purchases also declined 2% year on year in August while prices fell by 12% month on month.

Real retail sales rose by 10.4% in August. The retail sector is benefiting from wage inflation and recent reductions in the level of income tax. Consumers are also borrowing more to finance their purchases. The Boston Consulting Group has just published a report which estimates that household borrowing could triple by 2015 to 21 trillion rmb ($3.3 trillion). Consumer lending accounted for just 18% of GDP in 2009, and could now grow at an average annual rate of 24%. BCG projects that credit card debt could grow from 450 billion rmb in 2010 to 2.5 trillion rmb by 2015. There were 230 million credit cards at the end of 2010. BCG estimates there could be over 800 million by 2020, making China the largest credit card market in the world.

SDR

The French finance minister, Francois Baroin, has announced that the G-20 will discuss proposals to include the renminbi in the IMF’s SDR basket. France will host the G-20 meeting in November with a theme of revamping the global monetary system. China and France have established a working group to prepare a proposal for the Chinese currency unit to be included in the SDR basket. The SDR is now composed of the US dollar, the euro, the British pound, and the Japanese yen. In order to qualify for the SDR, a currency must (a) be a part of large international trading activities and (b) be fully used in global affairs. The Chinese currency satisfies the first condition, but not the second because it is not yet fully convertible. In mid-2010, China launched a campaign to make the renminbi an international currency. It is now encouraging Chinese companies to conduct their trade in the currency, and is providing renminbi credit lines to foreign central banks. China is also gradually liberalizing its capital account and could permit full convertibility by 2015. Some countries are also starting to hold the renminbi in their forex reserves. Malaysia announced such a move several months ago. Nigeria announced in early September that it will now hold 5-10% of its reserves in the renminbi.

EXPORT DEPENDENCE RAISES CONCERNS IN ASIA

Forecasters are now shaving their estimates of Asian growth to reflect new concerns about the U.S and European economies. They are most concerned about Malaysia, Singapore, Thailand, Taiwan, Thailand, the Philippines, and Korea because of their heavy dependence upon foreign trade. The ratio of exports to GDP was 110% in Malaysia during 2010, 233% in Singapore, 69% in Thailand, 49% in Korea, 74% in Taiwan, and 51% in the Philippines.

Thailand recently raised interest rates because of concern about the new government's regulatory and spending policies, but other countries are now putting monetary policy on hold. Korea's central bank declined to tighten at its most recent meeting despite headline inflation rising to 5.3% in August. Indonesia raised interest rates six months ago, and has made it clear there will be no further tightening. The same is true of Malaysia and the Philippines. The only country which has a high likelihood of further monetary tightening is India. The Reserve Bank of India has already raised interest rates eleven times by 325 basis points during the past eighteen months, but as inflation is still over 8.0% it could go for an additional 25 basis points increase. India is less vulnerable to the global economy than the other countries in the region because its exports are only 21% of GDP. India's software sector is very vulnerable to the cost cutting now occurring in American and European banks, but as revenue grew by 20-30% last year the major companies are in good financial shape. Malaysia and the Philippines have recently undershot their budget targets, so they have the potential to bolster government spending during the next few quarters.

The World Economic Forum (WEF) has published its new rankings of global competitiveness. The Philippines and Malaysia experienced the largest improvements in their ratings while India had the largest decline. The WEF focuses heavily on factors which determine the level of a country's productivity. India has suffered from its failure to make an adequate investment in infrastructure. The national rankings are Singapore (2), Hong Kong (11), Taiwan (13), Malaysia (21), Korea (24), China (26), Thailand (39). Indonesia (46). India (56), and the Philippines (75).

CANADA FRETS ABOUT THE US

The Canadian economy contracted by 0.4% during the second quarter because of disruptions to auto output resulting from the earthquake in Japan. The GDP was very bifurcated. Final domestic demand rose by 3.0% at annualized rates, but exports slumped 8.3%. As imports rose at a 10% annualized rate, net exports subtracted 5.0% from overall growth. The surge of imports reflected the strength of capital spending. Business spending on machinery and equipment jumped by 31% after a 15% rise in the first quarter. The Bank of Canada has responded to the recent evidence of weakness in the US economy and financial market turmoil by putting monetary policy on hold. In its May statement, it said, “some of the considerable monetary stimulus in place will be eventually withdrawn.” In last week’s announcement it said, “In light of slowing global economic momentum and heightened financial uncertainty, the need to withdraw monetary policy stimulus has diminished.”

There has been some speculation that the central bank might even ease policy, but it is unlikely to do so unless the US economy actually slides into recession. The unemployment rate is 7.3%, and the bank’s measure of potential GDP yields an output gap of just 0.7%. Unit labor costs have also increased by 2.6% during the past year through the second quarter. Canada is very vulnerable to any US downturn because its exports to the US are 20% of GDP, but its domestic economy is more resilient than the US. There was no banking crisis during 2008 and 2009. The country’s fiscal deficit is small and shrinking. Canada regained all the jobs lost during the recession last year. Canada is also benefitting from the boom in global resource investment. The Mining Association of Canada recently predicted there will be $130 billion of new investment from the mining sector during the next five years. Canada is a major producer of nickel, uranium, potash, coal, and gold. Prices for these commodities have been boosted by strong demand from China and other developing countries.

AUSTRALIAN MINING SECTOR DRIVES GROWTH

Australia's real GDP grew by 1.2% during the second quarter while the decline in the first quarter was revised down to -0.9% from -1.2%. Consumption grew by 1.0% as the household sector reduced its saving rate to 10.5% from 11.7%. This number surprised forecasters because retail sales had been sluggish. The terms of trade rose 5.4% during the quarter to a 140-year high. As a result of the higher price for exports, income grew by 2.6% during the quarter, or more than twice as much as GDP. The commodity price boom is producing large gains in capital spending, but it is also creating a two-tier economy. The mining economy grew by 5.7% during the past year while the non-mining economy grew by just 1.1%. Forecasters expect the mining sector to grow at a 16% rate during the next two years with the rest of the economy growing at only a 1.5% rate. The commodity boom has also encouraged a significant appreciation of the Australian dollar which is magnifying these divergences. The strong Australian dollar is squeezing foreign demand for the manufacturing sector, tourism, and educational services. The Reserve Bank has left interest rates unchanged at its last nine meetings, and is unlikely to act again in the near future because of new uncertainties about the global economy. The Reserve Bank is still optimistic about Australia's medium-term prospects because of Chinese demand for commodities, but the turmoil in financial markets could dampen both household and business confidence, and thus weaken the non-mining economy. There is some speculation that the Reserve Bank could reduce interest rates, but with unemployment close to 5.0% and upward pressure on wages the Reserve Bank is unlikely to ease unless there is a major financial shock in the northern hemisphere that sets the stage for a new recession.

MONETARY POLICY IN LATIN AMERICA EASES

Brazil's central bank surprised the financial markets by reducing its overnight lending rate from 12.5% to 12.0% at the end of August. The markets had not expected such an action because the inflation rate reached 7.2% in August, and is thus well above the bank's target. The communiqué explaining the move was quite long and cited three major reasons for the action. First, it is concerned about a slowdown in the global economy which could be disinflationary. Secondly, the domestic economy has been slowing from a growth rate above 7.0% last year to 3.3% at annualized rates in the second quarter. Thirdly, the government has been increasing its primary fiscal surplus. The communiqué provided little forward guidance, but there is an emerging consensus there could be further interest rate cuts during the fourth quarter, possibly as large as 100 basis points.

Brazil still enjoys robust domestic demand because labor markets are tight and wages are increasing. Investment also rose at a 7.1% annualized rate during the second quarter. The economy's weak sector is foreign trade. Imports are growing at a double-digit rate while export growth has slowed to 6.0%. Brazil has been relying on price increases to boost its export income rather than volume gains. Price increases accounted for 87% of export growth during the first quarter and 86% during the second quarter. The manufacturing sector has also been suffering from the large appreciation of the real during the past year. Industrial production contracted by 0.7% during the second quarter.

Brazil’s central bank has made it clear that its priority has switched from restraining inflation to sustaining growth. It is the only emerging market central bank other than Turkey to have made such a decision. This policy could call into question the credibility of the new central bank governor, Mr. Alexandre Tombini. As Brazil has $352 billion of foreign exchange reserves, there is no danger of a sudden currency collapse, but the real is now likely to reverse some of the large appreciation which has occurred since 2009. If it falls sharply, it may also be difficult to bring inflation significantly below 6.0% during 2012.

Other Latin American countries have put their monetary policies on hold. Chile and Colombia recently decided to forego expected interest rate hikes. Chile's inflation rate eased to 2.9% in July despite a strong job market. Forecasters expect output growth to slow to 3.5% during the third quarter from over 6.0% during the first half. Colombia, by contrast, is experiencing explosive credit growth because of the deepening of its financial system. As property prices are also rising rapidly, the central bank will have to remain cautious. Peru's central bank is concerned about the fact inflation is 3.4% compared to a target of 3.0%, but its latest communiqué acknowledges that there are more risks to growth. It could ease later this year if these risk perceptions increase.

The Mexican central bank announced that interest rates would remain unchanged at its meeting on August 26th. But it also hinted that policy could be eased in the future if it perceives that changes in the domestic economy or international economy make it unnecessarily tight. The bank has several concerns. Real GDP growth has slowed to 3.3% from 7.6% one year ago. The US economy is showing clear signs of slowing. Oil prices have fallen and could lower Mexico's inflation rate. The government has a fiscal deficit equal to 2.0% of GDP, and will be reluctant to pursue a more expansionary fiscal policy. These factors suggest that the Mexican central bank could join Brazil by reducing interest rates later this year.

AFRICAN GROWTH OUTLOOK STILL STRONG

South Africa's economy slowed to a growth rate of only 1.3% during the second quarter, which is the lowest rate since the third quarter of 2009. Manufacturing and mining contracted 7.0% and 4.2%, respectively, as a result of strike activity. Manufacturing output also fell 6% during July because of strikes while mining output fell 4.3% for similar reasons. The weakness of output has had a very depressing effect on business confidence. The RMB/BER Business Confidence Index slumped to 39 during the third quarter from 48 in the second quarter. Manufacturing confidence fell sharply because of the recent strike activity and new concerns about the global economy. Consumer confidence also fell to its lowest level since 2009 during the third quarter. Households were generally pessimistic about the outlook for the economy. The weak tone of these surveys suggests that real GDP growth may have fallen below 1.0% during the third quarter. The Reserve Bank will probably adopt a more dovish tone in its next statement, but it will not rush to cut interest rates. The economy's weakness will make it difficult for the government to achieve its target of reducing the fiscal deficit from 4.9% last year. It is likely that the deficit will increase to 5.5% of GDP this year and 5.2% during 2012-13. The IMF had been projecting 4.0% output growth in South Africa this year.

Rio Tinto has announced that it will sell its 58% shareholding in the Palbora Mining, its only direct South African holding. The withdrawal of Rio Tinto from South Africa is discouraging because it ranks among the top three mining companies in the world and has ambitious capital spending plans in many other regions, including West Africa. South Africa has failed to benefit from the recent global commodity boom because of political factors. The government has done a very poor job of processing mining rights applications. There has recently been a debate about nationalizing the mining sector led by the leader of the ANC youth league, Julius Malema. The government has rejected any discussion about nationalization, but the debate has still unnerved many potential investors. The ANC may try to remove Mr. Malema from his position because of his recent call for revolution in Botswana, but he will remain vocal even if he loses control of the youth league. The situation is further complicated by the fact that Jacob Zuma is seeking another term as president, and he relied very heavily on the party's left wing elements to win three years ago. He could attempt to build a different coalition this time, but he will find it difficult to abandon his original supporters. One of his pillar supporters, COSATU, recently demonstrated its power by vetoing proposals from the finance minister, Pravin Gordham, to liberalize the labor market. With an unemployment rate exceeding 25%, South Africa desperately needs to promote job creation by creating a more flexible labor market, but the trade unions have long ruled out any such policy changes.

As a result of the commodity boom, there are ten African countries which will have growth rates close to 7.0% or higher this year. Ghana's growth rate could exceed 12% because of its new role as an oil producer. The mining and oil developments are having spillover effects on urbanization and infrastructure. The global law firm DLA Piper has produced a report estimating that Africa will need $93 billion per annum of infrastructure spending to improve its transportation and power generating capacity. There are only 10,000 kilometers of roads connecting African countries. If this could be increased to 60,000-100,000 kilometers, it would boost regional trade by $250 billion over the next fifteen years.

There will be several elections in Africa during the next several months. The copper boom should allow Zambian President Rupiah Banda to win re-election this month. The DRC is scheduled to hold an election which should see President Joseph Kabila re-elected, but there are many logistical problems. Cameroon’s President Paul Biya has held power since 1982, and is likely to win again in October. As he is seventy-eight years old, this is likely to be his final term. President Ellen Johnson Sirleaf is likely to win re-election in Liberia as the country continues its recovery from a savage civil war. Senegalese President Abdoulaye Wade is trying to change the constitution so that he can seek a third term. Zimbabwe will probably hold elections in 2012. President Robert Mugabe is now 87 and suffering health problems, but he is expected to seek re-election.

KAZAKHSTAN’S CENTRAL BANK JOINS THE GOLD RUSH

The central bank of Kazakhstan has announced that it will buy all of the country's gold output until at least 2015 in order to reduce its exposure to the sagging US dollar. The gold assets of the central bank have grown by 29.5% since the end of last year to stand at $4.0 billion. They now account for 11% of total gold and foreign currency reserves. Kazakhstan plans to boost its gold output to 33 tonnes this year from 20 tonnes in 2010. Kazakhstan joins several other developing countries, including Korea, Thailand, India, and Russia, in boosting its gold reserves.

WHY THE DOLLAR WILL HOLD STEADY IN THE NEAR TERM

The financial crisis in Southern Europe has boosted the U.S dollar by 6% against the euro during the past two weeks. The euro could rally if the markets become convinced that the seventeen members of the eurozone will approve new powers for the EFSF and that Greece will not default, but it may be several weeks before the situation is fully clarified. The decision of Switzerland to peg its currency to the euro provoked some speculation that Japan would also intervene more aggressively, but so far the Ministry of Finance has done nothing despite the election of a new prime minister who favored intervention in the past. As Japanese export growth will soon slow, there could be new