Seven faces of "The Peril"

What sounds like an Asian action flick is in fact an important research paper (server down, but here's the exec summary) by James Bullard of the St. Louis Fed which has caught the markets' attention last week. The attention is well deserved as the paper demonstrates how current monetary policy concepts and postures might lead the world's largest economy(US) to join its second largest (Japan, for now) in a steady state equilibrium of very low interest rate / inflation. This second intersection point of the Fisher relation with the non-linear Taylor rule is a most undesirable place to be in, of course, because monetary policy is entirely ineffective there, but Mr. Bullard shows convincingly how we might end up there all the same. His proposed way out is quantitative easing (QE II) rather than the current monetary stance.

This leaves the Fed with uncomfortable short term choices: either stick to the current extended period (of very low interest rates) language with its associated Japan scenario, or start Mr. Bernanke's helicopters once more. Neither will be much appreciated.

It has barely begun

On Thursday, I attended a Goldman Sachs investment conference in Lucerne. Jim O'Neill, the firm's chief strategist, gave the keynote presentation containing an outlook for the world economy, which was surprisingly optimistic (this year's global growth rate is expected at 4.4% vs 3.9% consensus). To my question where deleveraging was in that picture, he answered that it wasn't because there is no reliable information about leverage available, and that we shouldn't trust anyone who claims to have it.

It appears to be more than a little cavalier to ignore a presumably major phenomenon simply because it is hard to measure. It is therefore very timely that MGI has just published a major report on debt and deleveraging. MGI looks at the buildup of debt at a per country and per sector level and distills four archetypal deleveraging scenarios from past episodes: Austerity, Inflation, Default and Growth. Unsurprisingly, they find that deleveraging has only just begun in a quite moderate way, as private sector debt reduction is compensated by increasing public sector debt.

Counterparty risk in credit markets

As pension funds increasingly seek to efficiently manage their balance sheets, they invariably come to rely on OTC derivatives, by way of which they become exposed to counterparty risk. On 20 February, thus shortly before 16 March which saw the US Fed-assisted emergency neutralisation of Bear Stearns counterparty risk, Barclays Capital issued a research note that assessed the transmission vectors and systemic fallout of a major counterparty's default. The knock-on effects due to immediate re-pricing of credit risk would amount to an estimated USD 36 - 47 bio for an imputed outstanding notional of USD 2'000 bio. Bear Stearns' notional was well over six times that number.

Longevity concerns

The Economist brings us up to scratch on Abolishing Ageing, highlighting those areas of medicine which directly address ageing itself. For obvious reasons, this is an area of science that the retirement industry needs to watch closely, even though the current trend towards widespread obesity would not suggest that the most immediately promising approach of caloric restriction could win a popularity contest. But it could, once the side effects of caloric restriction (i.e. near starvation) are removed. Even so, the UK industry prepares for even higher longevity - some mortality tables expecting the average 65-year-old to live to 100 and beyond by 2050. 

It is therefore apprpriate that the finance industry provides tradable longevity indices, such as Goldman Sachs' QxX family, or JPMorgan's Lifemetrics toolkit. Credit Suisse's Longevity Index does not appear to be directly accessible on the web. 

Global Graying Report

Standard & Poor's has an interesting update of its Global Graying Report, which projects the current fiscal policy stance in conjunction with forecast demographic expenditures to arrive at hypothetical future ratings. It is a pity that Switzerland is missing from the simulations - France for instance goes from AAA today to Speculative in 2040.

Global upward trend in profit share

The BIS has an interesting working paper #231 on The global upward trend in the profit share. The paper addresses the rising share of value added going to capital rather than labour, a trend which is in evidence since the mid-1980s. The authors claim that this is not a cyclical development (unless you take Kondratiev-cycles into consideration, which they do not), but a fundamental shift explained by faster technological obsolesence of capital goods. The implications of this assessment are far reaching, not least with regards to the sustainability of equity valuations.

640% of GDP

That would be the steady state equilibrium size of a Finnish model pension fund, assuming an elderly dependency ratio of 44% by 2050, up from currently about 23%. This is one of the interesting numbers that yet another central banker, Mr Erkki Liikanen of the Bank of Finland, has quoted in his recent address to the Conference of Social Security Actuaries and Statisticians.

There is a lot of interesting food for thought in that speech. I have just one question mark concerning the conclusions, where Mr Liikanen claims that "the volumes needed for financing pensions mean [that] the system will always have to be based on a public PAYG scheme". We think that always is an awfully long time. Mr Liikanen does not specify why funded systems should be unable to reach the required level of funding in the course of a generation or so.

Ask the economist

The OECD has published an interesting protocol of an online debate with OECD economists about the pensions challenge. There's plenty of materials and food for thought there, especially in the background readings listed, or the annuity debate; one wonders whether the lack of private annuity products may not to some extent be due to an effective crowding out by mispriced public policy alternatives - but unfortunately that question is not touched upon.