Otaviano Canuto, World Bank Group: Macroeconomics and Stagnation - Keynesian-Schumpeterian Wars

Policy makers in the advanced economies at the core of the global financial crisis can make the claim that they prevented a new “Great Depression”. However, recovery since the outbreak of the crisis more than five years ago has been sluggish and feeble. Since these macroeconomic outcomes have to some extent been shaped by policy mixes adopted in those economies in response to the crisis, the appropriateness of those policy choices is a question worth revisiting. This is particularly the case as one considers the hypothesis that a long-run trend toward stagnation may have already been at play during the pre-crisis period, even if temporarily countervailed by pervasive asset price booms.

On the other hand, there is a core divergence among those “Keynesian” and “Schumpeterian” economists who have proposed such stagnation hypotheses. While both groups agree that asset bubbles momentarily offset underlying stagnation trends before the crisis and that the recovery has been subpar, they point to different underlying factors for continued anemic levels of growth. “Keynesians” argue from the “demand side” and believe that fiscal policies have been far too restrictive, with too much emphasis on monetary policies recently, whereas “Schumpeterians” believe that the necessary force of creative destruction has not been allowed to fully take place for a long time now.

Actual GDP has lagged behind its potential along the recovery

Chart 1– from Davies (2013) – depicts several key features of the ongoing recovery in advanced economies. First, the aggregate growth trend exhibited prior to the crisis is no longer there, either because it was not really sustainable in the long run and/or as a legacy of the crisis. Second, a new “Great Depression” has been avoided but actual GDP has remained subpar relative to the latest IMF/OECD estimates for potential output. Finally, despite the possibility of catching-up with potential GDP in two years, as outlined in the central GDP projection, such an outcome remains subject to policymakers properly calibrating their responses to a wide range of idiosyncratic challenges ahead (Canuto, 2014).

[caption id="attachment_7121" align="aligncenter" width="600"] Chart 1: Aggregate G4 (US, Euro Area, Japan, UK) GDP, Potential and Trend.
Note: Potential Output is Average of IMF and OECD estimates. PPP weighted average. Source: Fulcrum Asset Management.[/caption]

As shown by Kose et al (2013), the ongoing recovery in advanced economies has been sluggish and fragile when compared to the three previous ones. While real GDP per capita returned to positive trajectories soon after previous temporary downturns, this time it not only started decelerating well prior to the global recession year (2009), but has not yet fully recovered its peak levels.

“While both groups agree that asset bubbles momentarily offset underlying stagnation trends before the crisis and that the recovery has been subpar, they point to different underlying factors for continued anaemic levels of growth.”

At first glance, this is not surprising, given the nature of the factors underlying the crisis: the pervasiveness and magnitude of asset booms and busts; design flaws of the Eurozone fully revealed as the crisis unfolded; the degree of synchronization of recessions; policy uncertainty associated with a loss of confidence on the sufficiency of established policy blueprints; and so on. Moreover, any such transition from a previously booming economy to a “new normal” would necessarily entail a significant reallocation of resources, with creation/destruction of jobs and productive assets. As remarked by Rajan (2013):

 “(…) the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand. Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.”

On the other hand, gauging by the size and persistence of the gap between actual and potential GDPs exhibited in Chart 1, one may question whether such a transition might have been made faster with appropriate macroeconomic policies. After all, while economists often assume that, no matter where potential GDP might be, actual GDP will eventually move to it, convergence can occur in the reverse direction. Losses associated with prolonged periods of significant output gaps – e.g., labor de-skilling, foregone R&D efforts, and resource idleness – then become permanent.

The crisis response has been single-handedly based on monetary policy

Kose et al (2013) point out how the recovery in advanced economies may have reflected peculiarities of the policy mix adopted as responses to the recent economic downturn, as compared to previous experiences. While both fiscal and monetary policies have been implemented in a countercyclical direction in the past, that has not been the case this time.

Monetary policy has been extremely accommodative. As policy interest rates approached the bottom – the lower zero bound – central banks went so far as to expand their balance sheets, in conjunction with other unconventional monetary policies (Canuto, 2013a). Chart 2 illustrates that by matching short-term interest rates during previous and current (the “Great Recession”) experiences.

[caption id="attachment_7124" align="aligncenter" width="600"]<img class="size-full wp-image-7124" src="https://cfi.co/wp-content/uploads/2014/05/2.jpg" alt="Chart 2: [Left - Advanced Countries. Right - Emerging Market Countries. Blue line - Average of previous recessions. Red line - Recovery from Great Recession.] Short-term interest rate during global recessions and recoveries (percent). Note: Zero is the time of the global recession year. Each line shows the PPP-weighted average of the countries in the respective group. Source: Kose et al (2013)" width="600" height="257" /> Chart 2: [Left - Advanced Countries. Right - Emerging Market Countries. Blue line - Average of previous recessions. Red line - Recovery from Great Recession.] Short-term interest rate during global recessions and recoveries (percent). Note: Zero is the time of the global recession year. Each line shows the PPP-weighted average of the countries in the respective group. Source: Kose et al (2013)[/caption]

Conversely, while previous recovery experiences were supported by the expansion of public spending, fiscal policy has this time moved in the opposite direction (Chart 3). The fiscal stimulus implemented in the US at the outset of the downturn was reversed not long after, followed by fiscal contraction. In the Eurozone, in turn, fiscal austerity policies were implemented as financial havoc morphed into fiscal unsustainability of its crisis-ridden members. Austerity has also been favored in the UK.

[caption id="attachment_7125" align="aligncenter" width="600"]<img class="size-full wp-image-7125" src="https://cfi.co/wp-content/uploads/2014/05/3.jpg" alt="Chart 3: [Left - Advanced Countries. Right - Emerging Markets. Blue line - Average of previous recoveries. Red line - Recovery from Great Recession.] Real primary expenditure (index, PPP weighted). Notes: Dashed lines denote WEO forecasts. Figures are indexed to 100 in the year before global recession. Zero is the time of the global recession year. Each line shows the PPP-weighted average of the countries in the respective group. Source: Kose et al (2013) " width="600" height="252" /> Chart 3: [Left - Advanced Countries. Right - Emerging Markets. Blue line - Average of previous recoveries. Red line - Recovery from Great Recession.] Real primary expenditure (index, PPP weighted). Notes: Dashed lines denote WEO forecasts. Figures are indexed to 100 in the year before global recession. Zero is the time of the global recession year. Each line shows the PPP-weighted average of the countries in the respective group. Source: Kose et al (2013)[/caption]

Why has the fiscal and monetary policy mix been so different? On the fiscal policy side, as shown by Kose et al (2013), public debt levels in advanced economies were much higher than in the past when the macroeconomic downturn took place. Public deficit levels had soared in the run-up to the recession, given the scale of financial support measures and substantial revenue losses. However, one may also say that a policy option for austerity was exercised. In the cases of the US and UK, financial markets were not imposing any substantial short-term fiscal retrenchment - especially if medium-to-long-term structural adjustment plans were to be announced. In the Eurozone, in turn, the intensity of fiscal adjustment in crisis-ridden members could have conceivably been lower provided that a correspondingly higher financial support from outside had been made available.

Unconventional monetary policies, in turn, came out of the urgency of halting potentially catastrophic processes of debt deflation and bank-credit freezes that threatened to transform solvent-but-illiquid balance sheets into insolvent ones. In the case of the Eurozone, such risks of financial meltdown were compounded by negative feedback loops between banks’ portfolios and rising risk premiums associated with crisis-ridden national public debts.

Very loose monetary policies smoothed the process of private-sector balance-sheet deleveraging by keeping yields at low levels and propping up asset values. In the Eurozone, risk premiums abated after the European Central Bank pledge to do “what it takes” to keep currency convertibility.

The phasing out of unconventional policies has been protracted as a reflection of the sluggishness and feebleness of the macroeconomic recovery and the absence of fiscal stimulus as an alternative. In the Eurozone, the debt overhang is still salient and balance-sheet deleveraging still has some way to go, but certainly in the case of the US, where debt deleveraging has already been substantial, fears regarding consequences of the unwinding of quantitative easing have made it a measured and paced process.

Can one point out the single-handed reliance on monetary policy to counter downturn as a factor underlying actual GDP tracking behind potential levels? After all, most analysts attribute an asymmetric capacity to monetary policy in economic downturns: the ability to countervail risks of asset-debt deflation is not accompanied by an equivalently strong capacity to induce agents to invest in new productive assets. As the saying goes, “one can pull a string, not push it!” Furthermore, after a certain point, ultra-loose monetary policy would only lead to a repeat of the bubble-blowing process seen before the crisis.

In this sense, countercyclical moves by policy makers might have reduced the length and size of the observed output gap had fiscal policy operated as a countercyclical tool complementary to monetary policy. However, as we approach in the following, this issue is far from being settled.

What if a “secular stagnation” trend has been at play? Which one?

The role of asset bubbles pulling up the pre-crisis growth trajectory depicted in Chart 1 is now widely acknowledged. In the case of the US:

“(…) the liquidity-generating machine inflated US asset values and fed the exuberant growth of US household spending. US consumers have accounted for more than one-third of the growth in global private consumption since 1990. Increasingly, their spending was made possible by the wealth effect generated by the rising prices of housing and household financial assets and stocks, whose values were in turn expected to more than outstrip those of household debt. It was this upswing in consumption by US households, and others as debt-based consumers-of-last-resort in the global economy that essentially made possible the extraordinary structural transformation and productivity increases experienced by some manufacturing exporters and commodity producers among developing economies.” (Canuto, 2009)

A similar bubble-led growth process could be found inside the Eurozone, starting with the downward convergence of perceived risks and interest rates throughout the zone after the introduction of the new common currency. Today’s countries under stress were able to sustain domestic absorption much above domestic production capacities for a long period, easily financing the difference because of fallen-from-heaven domestic asset value appreciation. The underestimation of fiscal risks can also be seen as a manifestation of such euphoria.

Asset-price dynamics has now been mainstreamed as an important subject to be addressed by policy makers. Macroprudential policies are now a component of the macroeconomic stabilization toolkit (Canuto, 2013b).

However, enhancing the policy framework by revamping financial regulation and supervision and combining monetary and prudential policies in order to ensure both financial and macroeconomic stability may not be enough if some underlying secular trend of stagnation is at play. If the pre-crisis growth trend depicted in Chart 1 was inextricably dependent on the overspending induced by the financial frenzy – credit and house bubbles - then running its course, avoiding future asset price booms and busts might simply lead to stability around low growth rates.

Such a view underlies the possibility of a “secular stagnation” trend as discussed by economists like Krugman (2013) and Summers (2013):

“Manifestly unsustainable bubbles and loosening of credit standards during the middle of the past decade, along with very easy money, were sufficient to drive only moderate economic growth. (…) short-term interest rates are severely constrained by the zero lower bound: real rates may not be able to fall far enough to spur enough investment to lead to full employment.” Summers (2013)

They and other – say, “Keynesian” - economists have suggested an array of possible causes for the US economy and others to display a propensity of aggregate demand shortfalls, in the sense that, as a result of structural conditions, aggregate spending would be enough to ensure full employment and use of potential output capacity only in the presence of negative real interest rates. Such an “investment drought” – or, as a flipside, a “savings glut” as measured by levels of non-consumption expenditures required to sustain income at full employment – could be seen as underlying the evolution depicted in Chart 4, obtained from Fatas (2013).

[caption id="attachment_7126" align="aligncenter" width="600"] Chart 4: [Dark Blue - Private Nonresidential Investments (% of GDP). Light Blue - Real Interest Rate.] US - Private Nonresidential Investment and Real Interest Rates. Source: Fatas (2013).[/caption]

Beyond the legacies of the crisis – higher risk aversion, increased savings by states and consumers, increased costs of financial intermediation and major debt overhangs – several long-standing factors could be pointed out as dampening investment. Among them, I would single out two as most significant:

First, rising income concentration - rising shares of income accruing to capital and the very wealthy - would be leading to overall under-consumption, only occasionally countervailed with unsustainable over-indebtedness by the poor. Second, features of technology evolution might also be contributing to an investment drought. Steep declines in the costs of durable goods – especially those associated with information and communication technology and/or outsourcing – would mean less spending levels associated with investment plans out of corporate savings. Furthermore, the trajectories of technological evolution currently unfolding would not carry an array of high-return investment opportunities comparable to past ones.

Summers (2014) argues that:

“(…) our economy is held back by lack of demand rather than lack of supply. Increasing capacity to produce will not translate into increased output unless there is more demand for goods and services.” He strongly recommends establishing “a commitment to raising the level of demand at any given level of interest rates through policies that restore a situation where reasonable growth and reasonable interest rates can coincide.”

It follows from this view that the policy mix that has prevailed since the aftermath of the crisis has been inappropriate. Instead of relying single-handedly on ultra-loose monetary policy, public spending – on infrastructure, energy and others – should be rescued from the retrenchment to which it has been submitted. By the same token, pro-active public policies to ignite private investment spending should also be implemented.

On the other side of the debate, there are those – say, “Schumpeterian” – economists who have offered supply-side based hypotheses of a long-run stagnation trend already in course for some time. Like Joseph A. Schumpeter, they lay emphasis on growth as a process of “creative destruction” in which obsolete forms of resource allocation and wealth – jobs, fixed-capital assets, technologies, and balance sheets – are replaced by higher-value ones. Although accepting an eventual role of monetary policies in avoiding systemic financial meltdowns, they tend – also like Schumpeter - to be more skeptical of fiscal or other types of countercyclical stimulus if these are designed in ways that retard the process of creative destruction. As for the post-crisis policy mix, even if it is acknowledged that fiscal policy may have moved precociously to the contractionary side, ultimately public policy action to prop up aggregate demand is not considered to be a key component of the fight against stagnation: “If you are postulating a stagnation across the longer run, ultimately it will have to boil down to supply side deficiencies.”(Cowen, 2013). The evolution of declining investments in tandem with lower interest rates shown in Chart 4 would be seen as stemming from disadvantageous rates of return not related to the pace of aggregate demand expansion.

Technological evolution leading to stagnation trends has been for some time now put forth as a hypothesis by Gordon (2014). Nevertheless, his arguments are about low productivity-raising features of current technological trajectories rather than on their supposedly dampening implications regarding aggregate demand.

Cowen (2011) has in turn approached stagnation as an outcome of the exhaustion of a significant set of “low-hanging fruits” reaped in recent history, namely one-off supply-side opportunities associated with post-war reconstruction; trade opening; diffusion of new technologies in power, transport, and communications; educational attainments and others. Other supply-side possibilities of stagnation recently suggested are associated with features of resource allocation – e.g. over-sizing of financial activities, as discussed by Canuto (2013c).

As outlined by Rajan (2012), such line of proposition about stagnation trends suggests that:

“(…) the advanced countries’ pre-crisis GDP was unsustainable, bolstered by borrowing and unproductive make-work jobs. More borrowed growth – the Keynesian formula – may create the illusion of normalcy, and may be useful in the immediate aftermath of a deep crisis to calm a panic, but it is no solution to a fundamental growth problem. If this diagnosis is correct, advanced countries need to focus on reviving innovation and productivity growth over the medium term, and on realigning welfare promises with revenue capacity, while alleviating the pain of the truly destitute in the short run.”

For the sake of conclusion

Keynesian and Schumpeterian hypotheses of stagnation trends are based on non-directly observable factors. Therefore, the struggle for hearts and minds of public opinion and policy makers will likely remain unsettled. Nevertheless, let us conclude by offering two broad takeaways:

First, regardless of the size of public outlays, public action and spending should be both designed in ways that “maximize the bang for the buck” in terms of overcoming obstacles to the process of creative destruction. Take the case of Japan: the third arrow of Abenomics – on structural reforms of the services sectors and others – will be a condition for successful results from its fiscal and monetary arrows. In the Eurozone, quicker action to restructure/consolidate “zombie” balance sheets and companies, in line with a more pro-active stance taken by monetary and financial authorities, should also hasten the path out of the current stagnation.

Second, regardless of whether advanced economies are indeed facing either demand- or supply-side stagnation trends, a major bet for the global economy to escape remains on the developing world’s economic transformation as a source of growth (Canuto, 2011). However, for that to happen, developing countries themselves will also need to pursue their own country-specific agendas of structural reform (Canuto, 2013d).

About the Author

Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank, a new position established by President Kim to bring a fresh research focus to this increasingly critical area. He previously served as the Bank’s Vice President and Head of the Poverty Reduction Network (PREM), a division of more than 700 economists and other professionals working on economic policy, poverty reduction, gender equality and analytic work for client countries. He also served as an Executive Director of the Board of the World Bank from 2004-2007. Outside of the Bank he has held leadership positions at the Inter-American Development Bank where he was Vice President for Countries, and for the Government of Brazil where he was Secretary for International Affairs at the Ministry of Finance. He also has an extensive academic background, serving as Professor of Economics at the University of São Paulo and University of Campinas (UNICAMP) in Brazil.

References

Canuto, O., 2009. The developing world in a post-bubble economy, Economonitor, April 9.

Canuto, O., 2011.  Risky growth engines, Project Syndicate, January 21.

Canuto, O., 2013a. Emerging markets and the unwinding of quantitative easing, Capital Finance International, October 16.

Canuto, O., 2013b. Walking on the wild side – monetary policy and prudential regulation, Capital Finance International, December 16.

Canuto, O., 2013c.  Finance as an economic cholesterol, Huffington Post, September 3.

Canuto, O., 2013d.  Lost in transition, Project Syndicate, December 2.

Canuto, O. 2014.  Calibrating 2014, Huffington Post, January 2.

Cowen, T., 2011. The great stagnation: how America ate all the low-hanging fruit of modern history, got sick, and will (eventually) feel better, New York: Dutton Publishing, Penguin.

Cowen, T., 2013.  Are real rates of return negative? Is the 'natural' rate of return negative?, Marginal Revolution, November 18.

Davies, G., 2013. The implications of secular stagnation, Financial Times, November 17.

Fatás, A., 2013.  Bubbles, interest rates and full employment, Antonio Fatás on the Global Economy, November 19.

Gordon, R.J., 2014. The demise of U.S. economic growth: restatement, rebuttal, and reflections, NBER Working Paper No. 19895, February.

Kose, M.A., Loungani, P., and Terrones, M.E., 2013. Why is this global recovery different?, VoxEU, April 18.

Krugman, P. 2013.  Bubbles, regulation, and secular stagnation, The Conscience of a Liberal, New York Times, September 25.

Rajan, R., 2012. A crisis in two narratives, Project Syndicate, January 27.

Rajan, R., 2013. Why stimulus has failed, Project Syndicate, January 22.

Summers, L., 2013.  Economic stagnation is not our fate — unless we let it be, Washington Post, December 18.

Summers, L., 2014. Strategies for sustainable growth, Washington Post, January 5.

Policy makers in the advanced economies at the core of the global financial crisis can make the claim that they prevented a new “Great Depression”. However, recovery since the outbreak of the crisis more than five years ago has been sluggish and feeble. Since these macroeconomic outcomes have to some extent been shaped by policy mixes adopted in those economies in response to the crisis, the appropriateness of those policy choices is a question worth revisiting. This is particularly the case as one considers the hypothesis that a long-run trend toward stagnation may have already been at play during the pre-crisis period, even if temporarily countervailed by pervasive asset price booms.

On the other hand, there is a core divergence among those “Keynesian” and “Schumpeterian” economists who have proposed such stagnation hypotheses. While both groups agree that asset bubbles momentarily offset underlying stagnation trends before the crisis and that the recovery has been subpar, they point to different underlying factors for continued anemic levels of growth. “Keynesians” argue from the “demand side” and believe that fiscal policies have been far too restrictive, with too much emphasis on monetary policies recently, whereas “Schumpeterians” believe that the necessary force of creative destruction has not been allowed to fully take place for a long time now.

Actual GDP has lagged behind its potential along the recovery

Chart 1– from Davies (2013) – depicts several key features of the ongoing recovery in advanced economies. First, the aggregate growth trend exhibited prior to the crisis is no longer there, either because it was not really sustainable in the long run and/or as a legacy of the crisis. Second, a new “Great Depression” has been avoided but actual GDP has remained subpar relative to the latest IMF/OECD estimates for potential output. Finally, despite the possibility of catching-up with potential GDP in two years, as outlined in the central GDP projection, such an outcome remains subject to policymakers properly calibrating their responses to a wide range of idiosyncratic challenges ahead (Canuto, 2014).

[caption id="attachment_7121" align="aligncenter" width="600"] Chart 1: Aggregate G4 (US, Euro Area, Japan, UK) GDP, Potential and Trend.
Note: Potential Output is Average of IMF and OECD estimates. PPP weighted average. Source: Fulcrum Asset Management.[/caption]
As shown by Kose et al (2013), the ongoing recovery in advanced economies has been sluggish and fragile when compared to the three previous ones. While real GDP per capita returned to positive trajectories soon after previous temporary downturns, this time it not only started decelerating well prior to the global recession year (2009), but has not yet fully recovered its peak levels.

“While both groups agree that asset bubbles momentarily offset underlying stagnation trends before the crisis and that the recovery has been subpar, they point to different underlying factors for continued anaemic levels of growth.”

At first glance, this is not surprising, given the nature of the factors underlying the crisis: the pervasiveness and magnitude of asset booms and busts; design flaws of the Eurozone fully revealed as the crisis unfolded; the degree of synchronization of recessions; policy uncertainty associated with a loss of confidence on the sufficiency of established policy blueprints; and so on. Moreover, any such transition from a previously booming economy to a “new normal” would necessarily entail a significant reallocation of resources, with creation/destruction of jobs and productive assets. As remarked by Rajan (2013):

“(…) the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand. Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.”

On the other hand, gauging by the size and persistence of the gap between actual and potential GDPs exhibited in Chart 1, one may question whether such a transition might have been made faster with appropriate macroeconomic policies. After all, while economists often assume that, no matter where potential GDP might be, actual GDP will eventually move to it, convergence can occur in the reverse direction. Losses associated with prolonged periods of significant output gaps – e.g., labor de-skilling, foregone R&D efforts, and resource idleness – then become permanent.

The crisis response has been single-handedly based on monetary policy

Kose et al (2013) point out how the recovery in advanced economies may have reflected peculiarities of the policy mix adopted as responses to the recent economic downturn, as compared to previous experiences. While both fiscal and monetary policies have been implemented in a countercyclical direction in the past, that has not been the case this time.

Monetary policy has been extremely accommodative. As policy interest rates approached the bottom – the lower zero bound – central banks went so far as to expand their balance sheets, in conjunction with other unconventional monetary policies (Canuto, 2013a). Chart 2 illustrates that by matching short-term interest rates during previous and current (the “Great Recession”) experiences.

[caption id="attachment_7124" align="aligncenter" width="600"] Chart 2: [Left - Advanced Countries. Right - Emerging Market Countries. Blue line - Average of previous recessions. Red line - Recovery from Great Recession.] Short-term interest rate during global recessions and recoveries (percent). Note: Zero is the time of the global recession year. Each line shows the PPP-weighted average of the countries in the respective group. Source: Kose et al (2013)[/caption]
Conversely, while previous recovery experiences were supported by the expansion of public spending, fiscal policy has this time moved in the opposite direction (Chart 3). The fiscal stimulus implemented in the US at the outset of the downturn was reversed not long after, followed by fiscal contraction. In the Eurozone, in turn, fiscal austerity policies were implemented as financial havoc morphed into fiscal unsustainability of its crisis-ridden members. Austerity has also been favored in the UK.

[caption id="attachment_7125" align="aligncenter" width="600"] Chart 3: [Left - Advanced Countries. Right - Emerging Markets. Blue line - Average of previous recoveries. Red line - Recovery from Great Recession.] Real primary expenditure (index, PPP weighted). Notes: Dashed lines denote WEO forecasts. Figures are indexed to 100 in the year before global recession. Zero is the time of the global recession year. Each line shows the PPP-weighted average of the countries in the respective group. Source: Kose et al (2013)[/caption]
Why has the fiscal and monetary policy mix been so different? On the fiscal policy side, as shown by Kose et al (2013), public debt levels in advanced economies were much higher than in the past when the macroeconomic downturn took place. Public deficit levels had soared in the run-up to the recession, given the scale of financial support measures and substantial revenue losses. However, one may also say that a policy option for austerity was exercised. In the cases of the US and UK, financial markets were not imposing any substantial short-term fiscal retrenchment - especially if medium-to-long-term structural adjustment plans were to be announced. In the Eurozone, in turn, the intensity of fiscal adjustment in crisis-ridden members could have conceivably been lower provided that a correspondingly higher financial support from outside had been made available.

Unconventional monetary policies, in turn, came out of the urgency of halting potentially catastrophic processes of debt deflation and bank-credit freezes that threatened to transform solvent-but-illiquid balance sheets into insolvent ones. In the case of the Eurozone, such risks of financial meltdown were compounded by negative feedback loops between banks’ portfolios and rising risk premiums associated with crisis-ridden national public debts.

Very loose monetary policies smoothed the process of private-sector balance-sheet deleveraging by keeping yields at low levels and propping up asset values. In the Eurozone, risk premiums abated after the European Central Bank pledge to do “what it takes” to keep currency convertibility.

The phasing out of unconventional policies has been protracted as a reflection of the sluggishness and feebleness of the macroeconomic recovery and the absence of fiscal stimulus as an alternative. In the Eurozone, the debt overhang is still salient and balance-sheet deleveraging still has some way to go, but certainly in the case of the US, where debt deleveraging has already been substantial, fears regarding consequences of the unwinding of quantitative easing have made it a measured and paced process.

Can one point out the single-handed reliance on monetary policy to counter downturn as a factor underlying actual GDP tracking behind potential levels? After all, most analysts attribute an asymmetric capacity to monetary policy in economic downturns: the ability to countervail risks of asset-debt deflation is not accompanied by an equivalently strong capacity to induce agents to invest in new productive assets. As the saying goes, “one can pull a string, not push it!” Furthermore, after a certain point, ultra-loose monetary policy would only lead to a repeat of the bubble-blowing process seen before the crisis.

In this sense, countercyclical moves by policy makers might have reduced the length and size of the observed output gap had fiscal policy operated as a countercyclical tool complementary to monetary policy. However, as we approach in the following, this issue is far from being settled.

What if a “secular stagnation” trend has been at play? Which one?

The role of asset bubbles pulling up the pre-crisis growth trajectory depicted in Chart 1 is now widely acknowledged. In the case of the US:

“(…) the liquidity-generating machine inflated US asset values and fed the exuberant growth of US household spending. US consumers have accounted for more than one-third of the growth in global private consumption since 1990. Increasingly, their spending was made possible by the wealth effect generated by the rising prices of housing and household financial assets and stocks, whose values were in turn expected to more than outstrip those of household debt. It was this upswing in consumption by US households, and others as debt-based consumers-of-last-resort in the global economy that essentially made possible the extraordinary structural transformation and productivity increases experienced by some manufacturing exporters and commodity producers among developing economies.” (Canuto, 2009)

A similar bubble-led growth process could be found inside the Eurozone, starting with the downward convergence of perceived risks and interest rates throughout the zone after the introduction of the new common currency. Today’s countries under stress were able to sustain domestic absorption much above domestic production capacities for a long period, easily financing the difference because of fallen-from-heaven domestic asset value appreciation. The underestimation of fiscal risks can also be seen as a manifestation of such euphoria.

Asset-price dynamics has now been mainstreamed as an important subject to be addressed by policy makers. Macroprudential policies are now a component of the macroeconomic stabilization toolkit (Canuto, 2013b).

However, enhancing the policy framework by revamping financial regulation and supervision and combining monetary and prudential policies in order to ensure both financial and macroeconomic stability may not be enough if some underlying secular trend of stagnation is at play. If the pre-crisis growth trend depicted in Chart 1 was inextricably dependent on the overspending induced by the financial frenzy – credit and house bubbles - then running its course, avoiding future asset price booms and busts might simply lead to stability around low growth rates.

Such a view underlies the possibility of a “secular stagnation” trend as discussed by economists like Krugman (2013) and Summers (2013):

“Manifestly unsustainable bubbles and loosening of credit standards during the middle of the past decade, along with very easy money, were sufficient to drive only moderate economic growth. (…) short-term interest rates are severely constrained by the zero lower bound: real rates may not be able to fall far enough to spur enough investment to lead to full employment.” Summers (2013)

They and other – say, “Keynesian” - economists have suggested an array of possible causes for the US economy and others to display a propensity of aggregate demand shortfalls, in the sense that, as a result of structural conditions, aggregate spending would be enough to ensure full employment and use of potential output capacity only in the presence of negative real interest rates. Such an “investment drought” – or, as a flipside, a “savings glut” as measured by levels of non-consumption expenditures required to sustain income at full employment – could be seen as underlying the evolution depicted in Chart 4, obtained from Fatas (2013).

[caption id="attachment_7126" align="aligncenter" width="600"] Chart 4: [Dark Blue - Private Nonresidential Investments (% of GDP). Light Blue - Real Interest Rate.] US - Private Nonresidential Investment and Real Interest Rates. Source: Fatas (2013).[/caption]
Beyond the legacies of the crisis – higher risk aversion, increased savings by states and consumers, increased costs of financial intermediation and major debt overhangs – several long-standing factors could be pointed out as dampening investment. Among them, I would single out two as most significant:

First, rising income concentration - rising shares of income accruing to capital and the very wealthy - would be leading to overall under-consumption, only occasionally countervailed with unsustainable over-indebtedness by the poor. Second, features of technology evolution might also be contributing to an investment drought. Steep declines in the costs of durable goods – especially those associated with information and communication technology and/or outsourcing – would mean less spending levels associated with investment plans out of corporate savings. Furthermore, the trajectories of technological evolution currently unfolding would not carry an array of high-return investment opportunities comparable to past ones.

Summers (2014) argues that:

“(…) our economy is held back by lack of demand rather than lack of supply. Increasing capacity to produce will not translate into increased output unless there is more demand for goods and services.” He strongly recommends establishing “a commitment to raising the level of demand at any given level of interest rates through policies that restore a situation where reasonable growth and reasonable interest rates can coincide.”

It follows from this view that the policy mix that has prevailed since the aftermath of the crisis has been inappropriate. Instead of relying single-handedly on ultra-loose monetary policy, public spending – on infrastructure, energy and others – should be rescued from the retrenchment to which it has been submitted. By the same token, pro-active public policies to ignite private investment spending should also be implemented.

On the other side of the debate, there are those – say, “Schumpeterian” – economists who have offered supply-side based hypotheses of a long-run stagnation trend already in course for some time. Like Joseph A. Schumpeter, they lay emphasis on growth as a process of “creative destruction” in which obsolete forms of resource allocation and wealth – jobs, fixed-capital assets, technologies, and balance sheets – are replaced by higher-value ones. Although accepting an eventual role of monetary policies in avoiding systemic financial meltdowns, they tend – also like Schumpeter - to be more skeptical of fiscal or other types of countercyclical stimulus if these are designed in ways that retard the process of creative destruction. As for the post-crisis policy mix, even if it is acknowledged that fiscal policy may have moved precociously to the contractionary side, ultimately public policy action to prop up aggregate demand is not considered to be a key component of the fight against stagnation: “If you are postulating a stagnation across the longer run, ultimately it will have to boil down to supply side deficiencies.”(Cowen, 2013). The evolution of declining investments in tandem with lower interest rates shown in Chart 4 would be seen as stemming from disadvantageous rates of return not related to the pace of aggregate demand expansion.

Technological evolution leading to stagnation trends has been for some time now put forth as a hypothesis by Gordon (2014). Nevertheless, his arguments are about low productivity-raising features of current technological trajectories rather than on their supposedly dampening implications regarding aggregate demand.

Cowen (2011) has in turn approached stagnation as an outcome of the exhaustion of a significant set of “low-hanging fruits” reaped in recent history, namely one-off supply-side opportunities associated with post-war reconstruction; trade opening; diffusion of new technologies in power, transport, and communications; educational attainments and others. Other supply-side possibilities of stagnation recently suggested are associated with features of resource allocation – e.g. over-sizing of financial activities, as discussed by Canuto (2013c).

As outlined by Rajan (2012), such line of proposition about stagnation trends suggests that:

“(…) the advanced countries’ pre-crisis GDP was unsustainable, bolstered by borrowing and unproductive make-work jobs. More borrowed growth – the Keynesian formula – may create the illusion of normalcy, and may be useful in the immediate aftermath of a deep crisis to calm a panic, but it is no solution to a fundamental growth problem. If this diagnosis is correct, advanced countries need to focus on reviving innovation and productivity growth over the medium term, and on realigning welfare promises with revenue capacity, while alleviating the pain of the truly destitute in the short run.”

For the sake of conclusion

Keynesian and Schumpeterian hypotheses of stagnation trends are based on non-directly observable factors. Therefore, the struggle for hearts and minds of public opinion and policy makers will likely remain unsettled. Nevertheless, let us conclude by offering two broad takeaways:

First, regardless of the size of public outlays, public action and spending should be both designed in ways that “maximize the bang for the buck” in terms of overcoming obstacles to the process of creative destruction. Take the case of Japan: the third arrow of Abenomics – on structural reforms of the services sectors and others – will be a condition for successful results from its fiscal and monetary arrows. In the Eurozone, quicker action to restructure/consolidate “zombie” balance sheets and companies, in line with a more pro-active stance taken by monetary and financial authorities, should also hasten the path out of the current stagnation.

Second, regardless of whether advanced economies are indeed facing either demand- or supply-side stagnation trends, a major bet for the global economy to escape remains on the developing world’s economic transformation as a source of growth (Canuto, 2011). However, for that to happen, developing countries themselves will also need to pursue their own country-specific agendas of structural reform (Canuto, 2013d).

About the Author

Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank, a new position established by President Kim to bring a fresh research focus to this increasingly critical area. He previously served as the Bank’s Vice President and Head of the Poverty Reduction Network (PREM), a division of more than 700 economists and other professionals working on economic policy, poverty reduction, gender equality and analytic work for client countries. He also served as an Executive Director of the Board of the World Bank from 2004-2007. Outside of the Bank he has held leadership positions at the Inter-American Development Bank where he was Vice President for Countries, and for the Government of Brazil where he was Secretary for International Affairs at the Ministry of Finance. He also has an extensive academic background, serving as Professor of Economics at the University of São Paulo and University of Campinas (UNICAMP) in Brazil.

References

Canuto, O., 2009. The developing world in a post-bubble economy, Economonitor, April 9.

Canuto, O., 2011. Risky growth engines, Project Syndicate, January 21.

Canuto, O., 2013a. Emerging markets and the unwinding of quantitative easing, Capital Finance International, October 16.

Canuto, O., 2013b. Walking on the wild side – monetary policy and prudential regulation, Capital Finance International, December 16.

Canuto, O., 2013c. Finance as an economic cholesterol, Huffington Post, September 3.

Canuto, O., 2013d. Lost in transition, Project Syndicate, December 2.

Canuto, O. 2014. Calibrating 2014, Huffington Post, January 2.

Cowen, T., 2011. The great stagnation: how America ate all the low-hanging fruit of modern history, got sick, and will (eventually) feel better, New York: Dutton Publishing, Penguin.

Cowen, T., 2013. Are real rates of return negative? Is the 'natural' rate of return negative?, Marginal Revolution, November 18.

Davies, G., 2013. The implications of secular stagnation, Financial Times, November 17.

Fatás, A., 2013. Bubbles, interest rates and full employment, Antonio Fatás on the Global Economy, November 19.

Gordon, R.J., 2014. The demise of U.S. economic growth: restatement, rebuttal, and reflections, NBER Working Paper No. 19895, February.

Kose, M.A., Loungani, P., and Terrones, M.E., 2013. Why is this global recovery different?, VoxEU, April 18.

Krugman, P. 2013. Bubbles, regulation, and secular stagnation, The Conscience of a Liberal, New York Times, September 25.

Rajan, R., 2012. A crisis in two narratives, Project Syndicate, January 27.

Rajan, R., 2013. Why stimulus has failed, Project Syndicate, January 22.

Summers, L., 2013. Economic stagnation is not our fate — unless we let it be, Washington Post, December 18.

Summers, L., 2014. Strategies for sustainable growth, Washington Post, January 5.


Europe's First Transnational List has been Presented by the European Federalist Party

[caption id="attachment_7139" align="alignright" width="224"] EU Parliament, Brussels[/caption]

Europe's first transnational list has been presented by the European Federalist Party and covers 6 countries (Austria, Belgium, France, Greece, Italy, Portugal)

Brussels – May, 2014. European Federalist Party (EFP) candidates from Austria, Belgium, France, Greece, Italy and Portugal presented their vision for Europe at a joint Press Conference yesterday in Brussels. EFP is the first-ever transnational party, with sections in 16 countries and with candidates for the upcoming European Parliament elections across the continent (a list of candidates is available here: www.votefederalist.eu).

“In stark contrast with the increasingly vocal anti-Europeans and nationalist parties that are rising in many European Countries, the EFP is convinced that the only way to tackle today's and tomorrow's challenges is by building a better Europe. A Europe that is more democratic, more efficient and closer to the people” noted by Pietro De Matteis, co-President of the European Federalist Party and MEP candidate in Belgium.

The candidates stressed the cross-border character of the EFP campaign: “We are the only party that does not stop at national frontiers” pointed out Bengt Beier, MEP Candidate in Austria. In addition “the existence of the EFP has been instrumental for the creation of a federalist coalition in Italy” noted Marco Marazzi, Secretary General of the Italian section of the EFP, and our presence in the political debate has forced other political parties to openly take a position on European federalism stressed Catherine Guibourg, MEP candidate in France.

“After building the Europe of the single market it is now time to build the Europe of citizens.”

- Benoit Barbier

The European Federalist Party advocates for a) the development of a “social Europe” based on a European minimum income and a European safety net-complementary to national welfare systems- protecting mobile workers/students and job-seekers; b) the establishment of a European industrial policy facilitating the life of Small and Medium Enterprises, the development of European champions and focusing in particular on strategic areas such as youth employment, research, energy and transport; c) the creation of an effective European foreign policy supported by a European diplomacy and army; and for d) institutional reforms leading to the election of the European Commission President, the creation of a Senate representing the federated entities and the reinforcement of the European Parliament which should have the right of legislative initiative.

“After building the Europe of the single market it is now time to build the Europe of citizens” noted Benoit Barbier, MEP Candidate in Portugal. This is even more important if we want to rebuild trust between the European citizens and EU institutions, especially in those countries severely hit by the crisis argued Alfredo Saltiel, MEP Candidate in Greece.

We cannot wait any further, concluded Pietro De Matteis: “Future generations will not excuse our inaction. The choice is between Europe or the decline”.

About the European Federalist Party

The European Federalist Party (EFP) is the only, truly, pan-European political party campaigning for a more democratic and federal Europe. The EFP was founded in 2011 by citizens from all over Europe and has since developed into a cross-border movement with sections in 16 countries. The EFP will have candidates running for the European Parliament elections in 6 countries and they will all be defending the same pan-European programme voted by its members at the 2013 EFP Federal Convention. The EFP contributed to the introduction of several pieces of European legislations including the European Citizens’ Initiative and the EU roaming regulation.

For more information on this specific Press Release please contact Mariarosaria Marziali, European Election press officer: mariarosaria.marziali@gmail.com, Telephone: +32 484077897


José Mujica: At Long Last - A Politician to Admire

 The South American country of Uruguay does not often make for headline news. It’s a relatively well-developed and prosperous place that quietly goes about its business without making any fuss. Uruguay enjoys a moderate, but sustainable, rate of economic growth.

In early 2013, Uruguay became one of only eleven countries worldwide to legalise same-sex marriage. Last December it became the first country in the world to fully legalise the sale, cultivation, and trade of cannabis.

José “Pepe” Mujica, the country’s president, did make the headlines as the first Latin American leader to openly speak out against the US-led war on drugs. Taking cannabis out of the legal equation was Mr Mujica’s way of promoting societal peace.

Having won the election of 2009 as candidate for the Broad Front, a coalition of left-wing political parties, Mr Mujica has led Uruguay according to the principals of social democracy. He has also brought a rather unique and endearing style to his country’s highest office.

“While many governments around the world speak of austerity, the Mujica Administration is one of the few that actually lives according to the austerity gospel.”

Mr Mujica has chosen the path-less-travelled to power and has the bullet wounds to prove it. In the early 1960s he joined the Tupamaros urban guerrilla movement which drew its inspiration from the Cuban Revolution. The Tupamaros were famous for their “Robin Hood” tactics, staging bank robberies as well as targeting businesses only to distribute the loot among the poor of Montevideo.

In 1970, Mr Mujica was arrested and sent to Punta Carretas Prison from where he escaped a year later with 110 other inmates, most of whom fellow Tupamaros members. In 1972, Mr Mujica was again detained after a shootout with the police. He was shot no less than six times, but survived to tell the tale.

After twelve year of brutal military rule, democracy was restored in 1985. Mr Mujica was released from prison under an amnesty law. In all, he spent 14 years of his life behind bars – two of which in solitary confinement.

In 1989, Mujica entered the political fray as the Tupamaros joined other progressive groups in the Movement of Popular Participation, a party which subsequently participated in the Broad Front coalition. Mr Mujica was elected senator in 1999 and became Minister of Agriculture in 2005. Four years after that, he received his party’s nomination as its presidential candidate. He went on to win the election.

While many governments around the world speak of austerity, the Mujica Administration is one of the few that actually lives according to the austerity gospel. Indeed, President Mujica truly leads by example: He donates 90% of his $12,000 monthly salary to charity.

The remainder pays for the presidential residence: A somewhat dilapidated chrysanthemum farmstead just outside Montevideo. Mr Mujica is now trying to convince his staff that the downtown presidential palace may be better employed as a shelter for the homeless.

Mr Mujica’s primary mode of transportation is a beat-up Volkswagen Beetle. Decorum precludes this vehicle to be escorted by a motorcade. Though dubbed the world’s poorest president, Mr Mujica begs, politely, to disagree.

President Mujica is an odd combination of the idealistic old revolutionary and the pragmatic contemporary leader. He is quite content with his austere lifestyle. Posturing does not enter the equation: He is genuinely not concerned with material wealth.

As a politician, Mr Mujica is weary of market economics and the power of global capital. Although he doesn’t impose his lifestyle on the rest of the country, Mr Mujica still finds much wrong with the world’s fixation on over consumption and materialism. Global politics should offer alternatives to this predatory lifestyle.

Yet this conviction is absent from his government’s policies. Mr Mujica is also a pragmatist and presides, progressively minded, over a liberal economy geared for steady growth.

Though Mr Mujica probably wouldn’t read this publication cover-to-cover, he still deserves full credit as a CFI hero. Considering the often disappointing calibre of leaders his country and the wider region have produced as of late, this slightly cantankerous, idealistic, incorruptible old Marxist with his live-and-let-live approach isn’t all that bad. In fact, it is pure genius. Pity then that Mr Mujica has said that he won’t be seeking re-election later this year. He would rather open a school on his farm.


Saudi Arabia’s Capital Market: Foreign Investors Told “Not Just Yet”

The regulator of the Saudi Arabia stock market – by far the largest of the Gulf Region – isn’t making any promises to foreign investors yet. Former World Bank executive director Mohammed al-Sheikh, now chairman of the Capital Market Authority (CMA), recently said that the kingdom remains “interested” in foreign investors. However, no timetable has been set for the opening up of the market.

Mr al-Sheikh indicated that his agency is still hard at work on a series of regulatory changes that aim to make the Saudi Arabia stock market less volatile and more transparent. Reporting requirements are being tightened and caps are being put in place that limit price fluctuations of newly listed stock on their first day of trade.

“There are still a few logistical difficulties to overcome and we are not entirely satisfied yet. These imperfection will, however, be ironed out and the result should be a market that is attractive to foreign and domestic investors alike,” said Mr al-Sheikh.

Since 2008, foreign investors enjoy indirect access to the Saudi Arabia capital market through swaps. Though the discussion has been ongoing for years, no firm decision has been reached on allowing more direct forms of foreign participation. The kingdom is feeling a tiny bit of heat from Bahrain and the United Arab Emirates where markets have been liberalised and trade is booming.

“Economic activity, though, is picking up with sustained growth rates of close to four percent annually forecasted up to 2020.”

Analysts and assorted pundits are quite unanimous in their belief that the foot-dragging has its origin in the fears of King Abdullah bin Abdulaziz al Saud and his ministers about the possibly destabilising effects an opening of the market may bring. It is thought that big swings in stock prices could hurt the Saudi economy. The kingdom’s policymakers are also reluctant to change because of the market crash of 2006 that wiped out some $500bn in value, destroying the savings of countless families. Market volatility has been foremost on the minds of regulators ever since.

Still, the timing would seem just about right for a gradual opening of the Tadawul, the only stock market in Saudi Arabia listing 156 publically traded companies. After again taking a nosedive in 2008, the market has shown resilience of late with prices stabilising and gaining ground. Over 2013, the Tadawul benchmark index rose 25.5% but now seems to have hit a plateau.

Economic activity, though, is picking up with sustained growth rates of close to four percent annually forecasted up to 2020.

While in the Bahraini capital Manama for a finance conference, Saudi Fransi Capital Chief Executive Yasir Al-Rumayyan could barely hide his excitement: “2014 is going to be a big year,” he said, “it’s three things: It’s the regulators and their requirements; it’s the issuers and their willingness to come; and it’s the ability of the adviser to execute. I think this year, the regulator is very excited to get more companies in; issuers are coming in; and financial advisers want to close deals in every quarter and not just once a year.”

Mr Al-Rumayyan also expressed confidence in that in 2014, IPOs (Initial Public Offerings) should exceed in volume those issued in 2012 when seven companies went public and raised a combined total of $1.4bn. Saudi Fransi Capital is currently putting the finishing touches on the IPO of an as of yet undisclosed company that Mr Al Rumayyad expects will raise in excess of $210m.

However, the IPO generating most excitement among the kingdom’s investors is one being now prepared by the Saudi Finance Ministry for the National Commercial Bank – the country’s largest lending institution. Mr Al Rumayyan sees signs that the erstwhile very strict Capital Markets Authority is embracing a more hands-off approach, focusing instead on corporate disclosure requirements and due diligence while allowing the market more leeway in setting the price of newly introduced stocks.

Just last year, the regulatory authorities discouraged Astra Food, a Saudi producer and distributor of foodstuffs, from going through with its IPO plans after it was found the company could not satisfactorily substantiate its financial performance projections.

With a series of IPOs now lined up for launch, the Saudi stock market looks for improved liquidity, though this is not necessarily one of the regulator’s priorities. “What is important to the CMA is the development of more stable market conditions. This may be attained by attracting a class of perhaps slightly more sophisticated investors to the market. Against this light, the opening up of the Tadawul to foreign investors would seem to make sense,” says Anas Al Sheikh of Clifford Chance, the first law firm to operate a partnership in the kingdom.

Mr Al Sheikh also expects movement on the Mergers and Acquisitions front, especially in the insurance sector where he anticipates consolidation of various market participants. Meanwhile, foreign investors must make do with swaps. However, nearly all stakeholders in the Saudi stock market agree that their time will come – probably sooner than later.


Walter Owen Bentley: Refinement Delivered at Speed

 Born in 1888 in Hampstead, Walter Owen Bentley was the youngest in a family of nine children. Fascinated to near-obsession by mechanical precision and speed, W.O. – as the Benjamin of the Bentley family was known affectionately – burst forth from school at age 16 to become a Premium Apprentice at the Great Northern Railway works in Doncaster; the first rung of a steep ladder that would lead to the exalted position of engine driver.

Training was conducted with Victorian thoroughness. It took all of 18 months before the apprentice was allowed anywhere near a steam engine. And then it was only to undertake the most menial of jobs. W.O. studied hard and learnt, hands on, each technical procedure; how to design, cast, make and assemble complex machinery. Much later in life, Mr Bentley commented that “the underside of a car after a few thousand miles is as hygienic as an operating theatre, compared to a locomotive engine in for overhaul”.

It took W.O. until the final year of his five-year apprenticeship to realise his lifelong ambition of becoming an engine driver. The happiest time of his life had arrived.

However, Mr Bentley’s passion for speed and endurance did not remain confined to the railways. It was his love of motorcycles that spurred him to make an epic drive from Doncaster to London one fateful Saturday. That journey took him through every town and village along the meandering A1. Attaining a top speed of barely 30 mph, W.O. arrived home at around 9 pm having duly demonstrated the true grit and determination he possessed.

“The underside of a car after a few thousand miles is as hygienic as an operating theatre, compared to a locomotive engine in for overhaul.”

It wasn’t long before W.O. was entering major endurance races against professional riders and teams. He achieved gold medals in both the London – Plymouth – London and London – Land’s End – London trials. Always the engineer, W.O. was not impressed with the performance of his bikes, or himself for that matter. He spent countless hours tuning his machines and perfecting his riding techniques.

Although he cherished great love and affinity for the railways, W.O. soon realised that a career as a locomotive driver would unlikely yield the lifestyle that could meet his growing ambitions. In 1913, W.O. joined his brother Horace Miller Bentley – H.M. – to create “Bentley and Bentley”; a company initially dedicated to selling French DFP (Doriot, Flandrin & Parant) cars.

Drawing on his trials experience, W.O. set about using motorsport competitions as a means to market the French vehicles. It was the chance discovery of an aluminium paperweight in the DFP offices that proved key to the company’s success.

At the time, aluminium was not considered a metal suitable for use in internal combustion engines due to its low melting point. After much tinkering, W.O. was able to come up with an aluminium alloy able to withstand high temperatures. Pistons made from this alloy were much lighter, and also ran cooler, than cast-iron or steel ones. This allows for significantly higher compression ratios which in turn increases engine power. Installing these pistons in a competition car, W.O. was able to beat off even the strongest competitors, claiming the record in the 2-litre class at the Aston Clinton Hill Climb.

The aluminium alloy Mr Bentley discovered took on even greater significance after the outbreak of the Great War when he passed his trade secrets on to the Royal Navy. He was promptly handed a commission in the Royal Naval Air Service and told to give aero engine manufacturers the scoop on his work. Rolls Royce and Sunbeam immediately incorporated aluminium pistons into their designs. However, the French Clerget aero engine plant in Chiswick refused to adapt its designs. Slightly annoyed, the Royal Navy assigned a team of engineers to Mr Bentley who was then instructed to go ahead and design his own engine.

In 1916, W.O. unveiled the Bentley Rotary 1 (BR1), followed two years later by the BR2. The first Bentley aero engine proved a resounding success. It replaced the Clerget engine in the Sopwith Camel fighter plane, boosting power to 150 hp while increasing reliability. The BR1 also cost 30% less than its French-designed competitor. The 24.9-litre, nine-cylinder BR2 upped power output to 245 hp and went on to equip both the Sopwith Snipe and Salamander. To this day, the BR2 stands at the very apex of rotary engine development.

For his invaluable work, Mr Bentley was awarded an MBE (Member of the Most Excellent Order of the British Empire) in 1920. He also received £8,000 from the Royal Commission on Awards to Inventors.

W.O. Bentley and his brother went on to found Bentley Motors Limited. To this day that company closely adheres to the passion that drove its founding father: To deliver speed in ulterior comfort and style.


MIGA (World Bank) - A New Boon for Emerging-Market Financing: Achieving Investment-Grade Bonds with MIGA’s Credit Enhancement

[caption id="attachment_7177" align="alignright" width="183"] Hungary: The Chain Bridge in Budapest[/caption]

Many investors, lenders, and government officials are familiar with the Multilateral Investment Guarantee Agency (MIGA) of the World Bank Group. For 25 years, the agency has insured investments in developing countries against political risk. This insurance facilitates productive foreign direct investment that boosts development, creates infrastructure, and produces jobs.

Increasingly, MIGA is becoming known in banking circles for its ability to reduce the risk profile of a broad range of financing structures. This was made possible through the introduction of new products that protect investors and lenders against non-payment by a sovereign or sub-sovereign entity, or state-owned enterprise.

Until recently, the primary users of this credit enhancement have been commercial lenders that provide loans to public-sector entities for infrastructure and other investments that require large amounts of capital and project financing. The benefits of MIGA’s insurance accrue to the developing countries where these investments are made, in the form of reduced borrowing costs, longer tenors, and compliance with environmental and social standards that represent international best practices.

“The benefits of MIGA’s insurance accrue to the developing countries where these investments are made, in the form of reduced borrowing costs, longer tenors, and compliance with environmental and social standards that represent international best practices.”

But we wanted to go further and have been looking for more creative applications of our credit enhancement tools, in the knowledge that it has tremendous potential to bridge emerging-market financing gaps. This is now more important than ever, as countries need new financing options in the face of constraints faced by commercial lenders and reduced official development assistance from donor countries and entities.

The perfect opportunity presented itself toward the end of 2013. At the end of September, MIGA backed a EUR400-million bond issue by Hungary’s Export-Import Bank (Exim) that made big financial news. The bonds will expire in February 2019 and carry a coupon of 2.125 percent. The novelty was that MIGA’s non-honouring of financial obligations cover – which in this case protects investors should the Hungarian government not stick to its commitment to cover Exim’s debts – raised this bond issue from non-investment grade to investment grade.

The very positive results of this rating improvement were several. First, Exim achieved a savings of approximately $25 million that it will use to directly support Hungarian exporters. Second, the issue was significantly oversubscribed, garnering very strong interest from international investors. Bond buyers included investors from the Benelux countries, Germany, Japan, Norway, and Switzerland who would not usually have bought Hungarian or Exim bonds. Last, the issue introduced a new model for emerging markets to raise capital that harnesses the power of the private sector with the backing of an international development institution: A win-win-win situation indeed.

Why Do Hungarian Exporters Matter?

The answer is simple: They are a bright spot in Hungary’s economy – an important source of commerce and jobs. In fact, according to Exim’s head Roland Nátrán, 85-90 percent of the country’s GDP has its roots in the export sector which is dominated by small- and medium-sized enterprises. Even in the face of the global financial crisis, the country’s export sector stayed buoyant and credit demand remained robust.

But the crisis did exact its toll as lending for the Hungarian corporate sector declined sharply, mainly as a result of tighter credit allocation from the banking sector. In this context, exporters play an even more important role: As domestic consumption and investment fall, outward-looking sources of economic activity are more critical.

As an export credit agency, the mandate of Hungary’s Exim is to provide alternative or supplementary financial tools to fill gaps in trade finance created by commercial banks’ lack of capacity or willingness to absorb risk. Ultimately, this serves Exim’s mission to create and maintain jobs in the country and develop the national economy.

During the credit crunch, the Hungarian government mandated Exim to provide more affordable financing to Hungarian exporters. The agency was hard-pressed to deliver on a tough mandate in difficult market conditions – in short, to look for a creative solution.

And here is where MIGA’s search for new applications of its credit enhancement products and Hungary’s development priorities met. Covering this bond issue represented an important milestone for MIGA, representing the first time the agency used its non-honouring of financial obligations cover for a capital markets transaction.

An additional, indirect development effect of bolstering Exim’s lending ability deserves note. As it does not possess its own branch network, Exim closely cooperates with Hungarian commercial banks in order to reach small and medium enterprises through their distribution networks. This cooperation supports the stability of the Hungarian banking sector in general, as Exim provides long-term refinancing facilities, strengthening liquidity.

More MIGA Support to Capital Markets Transactions on the Horizon, but Selectively

In the wake of this successful bond issue, we have received significant interest from banks and issuers. Exim also reports that other institutions in Europe and Central Asia have been requesting information about how the transaction works.

But the path blazed by Exim was not always smooth. The bond investors to whom the offering was marketed were not necessarily familiar with MIGA and we had to spend time and effort explaining both our agency and its products. However, the work paid off and we now have every indication that investors will more easily understand the full implications of our guarantee the next time a MIGA-supported bond goes to the capital markets.

However, this by no means implies that MIGA will begin to insure a flood of bond issues. What this means is that – as with any investment the agency insures – there needs to be a strong development rationale. Why do Hungarian exporters matter? There was a strong answer to that question. Potential clients need to be prepared to convince MIGA that they have similar narratives to tell. Also, MIGA will conduct extensive due diligence on any project it is asked to insure.

The Post-International Financial Crisis World: How Emerging-Market Financing and Capital Markets Have Changed

The global financial crisis and its aftermath put the need for diversified financing options for developing countries in perspective. National governments that were traditional donors around the world reduced official development assistance as they tightened fiscal belts. This happened at a time when the overall aid landscape had shifted significantly.

[caption id="attachment_7184" align="alignleft" width="115"] Author: Olga Sclovscaia[/caption]

While just over ten years ago development assistance was overwhelmingly provided by traditional donors, today other sources of funding continue to expand. These include less-concessional flows, and assistance from philanthropists and global funds. The use of private-sector instruments, blended with support from the public sector and multilateral institutions, is also increasing – and with good reason. Done well, investors can make their profits while public institutions can fulfil their mandates as industries create jobs. Research suggests that developing countries are welcoming this additional choice and the increase in the array of tools they can now use to meet their financing goals.

From the perspective of capital-markets investors and issuers, the financial crisis had an important impact as well. It resulted in a significant dearth of highly-rated capital market issues. This means that there is a market gap that needs to be filled, and instruments like MIGA’s credit enhancement products are very well-placed to help accomplish this.

About the Author

Olga Sclovscaia is MIGA’s Sector Manager for Finance and Telecommunications.


Andy Green: Inspiring a New Generation of Engineers

 This is not your dad’s sports car. It bundles the power of about 180 Formula 1 racing cars and aims to shatter the speed record on land. The Bloodhound SSC (SuperSonic Car) is being designed to attain a speed of no less than 1,000 mph (1,609 km/h).

The vehicle will be equipped with an EJ200 jet engine; a power plant more usually found in the Eurofighter Typhoon plane. Delivering up to 20,250 lbf thrust, this piece of kit is merely fitted to propel the Bloodhound SSC to a speed of about 300 mph (480 km/h). At this point a custom-designed hybrid rocket kicks in, taking the vehicle up to its target speed. A conventional 2.4L V8 Cosworth F1 petrol engine rated at 750 hp provides auxiliary power to the rocket and other on-board systems.

Riding this beast requires a special breed of speed demon. Royal Air Force wing commander Andy Green (1962) not only belongs to that cast; he leads it. On October 15, 1997, Andy Green became the first person to break the sound barrier on land.

Sitting astride Thrust SSC – a British designed jet-propelled car – Commander Green reached a speed of 763 mph (1,228 km/h, Mach 1.016) thundering across Black Rock Desert in Nevada. Thrust SSC was powered by twin Rolls Royce Spey turbofan jet engines delivering a combined power output in excess of 110,000 hp.

“Riding this beast requires a special breed of speed demon. Royal Air Force wing commander Andy Green not only belongs to that cast; he leads it.”

The current Bloodhound SSC project entails more than just a lust for speed. It aims to inspire a new generation of students to pursue a career in science, technology, engineering or mathematics. The initiative was the brainchild of Lord Drayson, then minister of state for science and innovation, who in 2008 proposed innovative ways to encourage students to take a second look at the exact sciences, often wrongly perceived as rather boring and the realm of geeks and nerds.

An avid amateur racing driver, avowed “car nut”, and currently president of the UK Motorsport Industry Association, Lord Drayson approached Andy Green and Richard Noble, a previous land speed record holder, to enlist their support. While Commander Green is slated to drive the Bloodhound, Mr Noble has taken on overall coordination of the project.

Some 5,500 schools in the UK and South Africa receive regular updates on the progress of the Bloodhound SSC project. A vast volume of curriculum material is also made available free of charge allowing students to gain an appreciation for the engineering skills and processes required for a project of this scope.

Commander Green regularly visits schools to share his insights and excitement with students. He also receives students at the Maritime Heritage Centre in Bristol where the Bloodhound is assembled. Fittingly enough, this project’s site sits in the shadow of SS Great Britain – the first iron steamer to cross the Atlantic (1845) and one of the many great feats of engineering of legendary Isambard Kingdom Brunel whose pioneering spirit and bold vision are alive and well in contemporary Britain.

Andy Green is slated to take Bloodhound SSC for a spin later this year on the Hakskeen Pan in the Northern Cape, South Africa, on a specially cleared, 19 km long track. Here, the vehicle is expected to reach a speed of around 200 mph (320 km/h) which will allow all systems to be thoroughly tested. A date for the speed record breaking attempt has not yet been set.


Q&A Bentley Motors’ Stephen Reynolds: Unchanged Core Values Drive  Bentley’s Global Expansion

[caption id="attachment_7196" align="alignright" width="210"] Stephen Reynolds: Bentley’s Regional Director for Middle East & Asia Pacific.[/caption]

How does Bentley secure continuous innovation and technological improvement?
With the launch of new models in the coming years, the levels of technologies available will also increase. Our new Flying Spur for example, incorporates incredible technology with touch-screen infotainment, mobile connectivity including Wi-Fi, a rear seat entertainment suite and a new hand-held touch screen remote which allows rear-cabin occupants to control an extensive range of features from the comfort of their seat. An eight-channel, eight-speaker audio system with balanced mode radiators also provides high quality sound of exceptional clarity.

We also pride ourselves in being the first luxury brand to present a plug-in hybrid and we are leading the way in bringing new powertrain choice to the luxury automotive sector. By the end of the decade, at least 90% of our production will be available as a plug-in hybrid.

What efforts have been made to improve the after-sale service and overall customer satisfaction?
Given the nature and level of the products we provide, an exceptional customer experience is a must and a given. For nearly ninety years, Bentley Mulliner has been personalising Bentleys, and an even longer tradition exists of employing the finest craftsmen and -women who are able to turn their talents to creating extraordinary, personalised features for Bentley owners. Whatever the customer chooses, they can be sure of their cars exclusivity.

“Our aim is to deliver cars with a unique combination of luxury and performance as well as to have continuous improvement through our organisation with expertise, passion and pride.”

In terms of after-sales services, all Bentley customers receive a call from Bentley Motors within ten days of taking delivery of their car and after any service or repair work. This is meant to ensure that they are entirely happy with their experience and allows us to take recommendations for any possible improvements. These responses are then passed to our dealers and shared within the Bentley organisation to ensure a consistently high performance of the service we offer our customers.

What geographical markets seem the most promising for the future?
Our main markets – Americas, China, and Europe – will continue to be strong but increasingly we will grow our presence in areas such as Russia and Brazil.

In 2013, sales were fairly evenly split between our three key regions, the Americas, China, and Europe, including the UK. The Middle East is also becoming an increasingly key region for us and sales already account for 12% of total volume.

We know that in the high-end luxury sector, new models drive sales and this is why we invest heavily and continued to do so throughout challenging economic conditions.

What are your core corporate values?
Our Brand Vision is to be the most successful luxury brand in the world. Our aim is to deliver cars with a unique combination of luxury and performance as well as to have continuous improvement through our organisation with expertise, passion and pride.

We are already the most successful Company in our sector in terms of sales but we aspire to excel in every area of our business.

Our Brand Essence is Luxury Performance in everything we do and the way communicate, be it through our cars or our organisation. We continually measure how our brand is perceived and work to broaden our business appeal beyond cars and through strategic external brand partnerships such as Breitling, Pankhurst, The Bentley Home collection of furniture, the Bentley Fragrance collection and also though our Mulsanne Visionaries.

How does the new Flying Spur differentiate itself?
The original Continental Flying Spur was very much a four-door GT with a very high degree of commonality with its coupe stable mate. The new Flying Spur has a much more distinct identity, standing as a model line in its own right and establishing a new benchmark for luxury performance saloons. This is reinforced by its unique, sleek and elegant design language and the clear emphasis on hand-crafted luxury, comfort and refinement.

What are the business lessons gained from international expansion?
It is important to continually monitor world economies and to be flexible in providing the right volumes of the right cars in the right markets. The upper luxury sector is constantly growing and we are always looking to ensure that we provide our customers with the right distribution network for our cars and services.

Bentley has been working to localise its work force in the Middle East what, kind of skills have you been transferring?
Our dealers must adhere to the labour relations rules of the country in which they operate and employ a mix of local and international employees as appropriate to the requirements of the job.

We understand that many companies have faced an uphill battle to localise their work forces is there anything you feel other companies could learn from your experiences in the Middle East?
While localising the work force is an important part of our commitment to this region, it is also important that all job requirements are met. While like other brands we have faced some challenges, it is an area we see great potential in. It is important that companies think about what they can offer their employees and as much as what the local work force can offer them.

Do you foresee a time when almost all your work force in the Middle East is made up of local employees?
Our dealers will always recruit according to the labour policy in place at the time. However, with the mix of both local and international employees, it is important to ensure that we service our international customers, many of whom have homes and businesses in other countries, and expect us to be able to service their requirements world-wide as well as locally.

As a producer of large cars, what steps is Bentley taking to lessen environmental impact?
Bentley is envisioning a powerful and even more efficient future. Our commitment to this is highlighted with the Bentley Hybrid Concept – a technology showcase that previews Bentley’s first plug-in hybrid model, which is set to be a dedicated version of the all-new SUV available in 2017. As I mentioned earlier, Bentley will be leading the way as the first luxury brand to present a plug-in hybrid to the luxury automotive sector.

How do you incorporate feedback from customers into future design?
Bentley continues to listen carefully to our customers across the globe. Their opinions are important to us and their reaction to concept vehicles are taken in to account so that we can then refine the concept further.

With the exciting news of a new Bentley SUV in 2016 do you have plans to further broaden your product range?
The response from customers shows us that the demand for Bentley to offer this type of model remains very strong and continues to grow. A Bentley SUV will leverage the success of the global SUV market and is a key element of our strategy to sell 15,000 cars per year. This will balance profit and investment in the years ahead and deliver sustainable business growth. This car will appeal to all our existing markets – and has the potential to increase Bentley’s presence in new markets too. It offers a further interpretation of the all-wheel drive Grand Touring luxury Bentley – and is a natural progression for the brand.

There is always the possibility we may develop other types of vehicles or derivatives but they would have to be true to the Bentley brand values of luxury and performance. It’s in that spirit that we are entering the SUV market.


Luxury Goods Market: Crisis? What Crisis?

In the luxury goods market, nothing quite drives sales as brand recognition does. Slap a Louis Vuitton label on a handbag, and shoppers will think nothing of plopping down a thousand euros or more to carry it off.

As Europe sank into its post Panic of 2008 phase of doom and gloom, the luxury goods market did not just take the downturn in stride, the sector positively bloomed and prospered. At this rarefied end of the market, there is simply no such thing as a recession.

While traditional manufacturers of mass market consumer goods struggled to survive, the likes of Hermès, Salvatore Ferragamo, Ferrari, and a host of other premier brands made a killing. The merged French luxury goods provider of Louis Vuitton and Moët Hennessy (LVMH) saw its combined sales jump from EUR17.2bn in 2008 to over EUR30bn last year.

LVMH’s performance is by no means exceptional. Each year an estimated ten million consumers make their first forays into the high-end luxury goods market, now estimated to include no less than 330 million people worldwide – triple the number of discerning buyers counted merely twenty years ago.

“While the luxury goods sector gains new clients in new markets, it also loses quite a few customers in more mature markets such as those in Europe, North America and Japan.”

The luxury goods market currently moves around EUR220bn annually with growth coming mainly from China which is set to shortly replace Japan as the most important market for luxury products and services. However, luxury goods makers are fast discovering that China is not quite as easy a market as it is often mistaken for. A recent in-depth analysis by global management consulting firm Bain, concludes that Chinese customers are exceptionally fickle in their buying habits, displaying nothing like the brand loyalty that is taken for granted elsewhere.

Savvy Buyers

Bain researchers found that Chinese consumers are surprisingly savvy. “We discovered a lot of indiscriminate binge buying of status symbols in megacities like Beijing and Shanghai. However, the fad soon passes and consumers become highly conscious of both price and quality,” says Claudia D’Aprizio who drafted the Bain report.

While the luxury goods sector gains new clients in new markets, it also loses quite a few customers in more mature markets such as those in Europe, North America and Japan. It is not just the economic crisis that caused dampened sales; a sort of disenchantment seems to have set in.

A combination of factors is driving this downward trend: Consumers in traditional markets have become more socially aware than they used to be, shunning brands that are perceived as portraying a lifestyle out of tune with both contemporary values and reality. Steady price hikes, above and beyond inflation levels, have also caused disillusion. Most luxury goods brands have upped prices by as much as 70% over the past two to three years in an attempt to bridge the price gap between China and the rest of the world.

As the Chinese increasingly travel overseas, they couldn’t help but notice the comparatively low prices that luxury goods command outside their country. Instead of driving prices down in China, most manufacturers opted to increase price levels everywhere else, instilling a sense of betrayal in their more traditional customers.

Troublesome Hedonists

Another problem faced by the purveyors of luxury goods is that the market has shifted in a somewhat curious, and rather unexpected, direction. According to the Bain market study, the biggest group of luxury goods consumers are the hedonists – people who like to flash their mostly newfound wealth.

As it happens, these in-your-face consumers are highly unlikely to recommend luxury brands to their friends. In fact, 47% of consumers deemed hedonist by market researchers said they would most definitely not recommend any of the products they buy to friends or family.

However, Bain does propose a solution that may yet stem the trickle exodus of western consumers: Go the Apple route. “Brands should be much more active in creating an experience rather than merely a product, and may also strive for a much improved after-sales service. Opening other sales channels besides high-end shops and branded stores is another of the suggestions made.

However, the advice, though sensible, goes against the grain of one of the peculiarities that mark the luxury goods segment. To a fault, successful companies at this end of the market have managed to overcome the difficulties of perceived value – how much can a handbag, or a scarf, really be worth? – by implying that whomever uses their exclusive products becomes, in turn, more desirable and admirable as a human being.

This is the stuff money can’t buy and only expert and sustained marketing efforts can deliver. A Jaeger-LeCoultre watch still only tells its wearer the time, give or take a few seconds, but may cost the equivalent to the annual remuneration of a Swiss civil servant on a moderately respectable pay grade. Such a timepiece, however masterfully crafted, is not really good value for money. Still, the company is doing just fine and has no trouble selling its exquisite merchandise.

Curious Market Forces

Economists dub these high-end products Veblen goods, named after the American economist Thorstein Veblen (1857-1929) who conducted extensive research on conspicuous consumption and is perhaps best known for his book The Theory of the Leisure Class (Oxford World Classics, ISBN 978-0-1995-5258-0). Mr Veblen found that some products generate a demand proportional to their price in an apparent contradiction to the Law of Demand. Thus, the more expensive a given product is, the more demand it generates.

The Veblen effect is well-known to the luxury goods industry. It is but one of a family of much-studied micro-economic effects that propel the sector to ever greater heights such as the snob-effect, the bandwagon-effect, and – most importantly – the common law of business balance, otherwise known as: You get what you pay for – the more you pay, the more you get.

Notwithstanding Bain’s expert counselling, a slick website, fancy app or excellence in after-sales service cannot make up for, or even add to, the human vanity factor that lays at the foundation of a still flourishing industry. In fact, there is little to worry about, for vanity is not a trait likely to disappear anytime soon.


Jacques Delors: Despite Design Flaws Euro Success Assured

Hindsight may offer some comfort and solace from contemporary reality. It is thus that Jacques Delors – aka Mr Euro – concludes that Europe’s much-maligned common currency suffers from a few design flaws. Those imperfections may even have doomed the euro from its inception and lie certainly at the root of the debt crisis that erupted in 2008.

Even so, Mr Delors – three-time president of the European Commission – has no regrets other than not giving enough pushback to overly excited politicians who at the time choose to ignore red flags and other warning signs. The euro – Delors’ masterwork in unifying the continent – will ultimately survive. For all the bridges burnt, he sees no way back.

When Jacques Delors assumed the presidency of the European Commission in 1985, the then European Community found itself relegated to the doldrums, suffering from what came to be known as eurosclerosis – an affliction not unlike the one presently haunting the continent’s economies whereby lacklustre growth results in high levels of unemployment.

In 1985, Mr Delors promptly set out to reinvent European integration and provide the process some new momentum. Within a year he had cajoled or otherwise convinced member states into accepting the Single European Act (1986) which served as the basis for the scaffolding of the much broader Treaty of Maastricht (1992) that foretold the creation of a common currency and changed the community’s name to European Union – a name much better suited to cover the bundling of not just economic forces but of entire nations.

Jacques Delors also laid the groundwork for the EU’s rapid expansion. Austria, Sweden and Finland joined in 1995 while in 2004 ten Eastern European countries were welcomed into the fold. At times controversial and perhaps a tiny bit authoritarian, Mr Delors did succeed in putting Europe back on the agenda.

The euro is – if nothing else – a project of a most ambitious nature. As such it is also most admirable. Notwithstanding its flaws, the common currency did help forge a common identity and create bonds, albeit discomforting ones.

Mr Delors was one of only a handful of politicians who recognized the fact that Europe’s many and varied headstrong nations are condemned to live with each other in a rather cramped geographical space. Not just that, Mr Delors was found willing and able to pursue policies based on that fact as opposed to the many who engaged in navel-gazing or worse.

Should the euro indeed succeed and prosper – as Mr Delors predicts it will – this French politician will have pulled off a unique feat in the economic history of mankind – attempts at introducing and maintaining common currencies have never before met with lasting success.