U.S. Will Be the World’s Third Largest Economy

NBC

Image: CNBC.com

The world is going to become richer and richer as developing economies play catch up over the coming years, according to Willem Buiter, chief economist at Citigroup.

“We expect strong growth in the world economy until 2050, with average real GDP growth rates of 4.6 percent per annum until 2030 and 3.8 percent per annum between 2030 and 2050,” Buiter wrote in a market research.

“As a result, world GDP should rise in real PPP-adjusted terms from $72 trillion in 2010 to $380 trillion dollars in 2050,” he wrote.

As the world watches oil prices rise sharply amid unrest in the Middle East, Buiter’s analysis of the world’s long-term prospects offer some hope that better times are ahead but if he is right power will shift from the West to the East very quickly.

“China should overtake the US to become the largest economy in the world by 2020, then be overtaken by India by 2050,” he predicted.

One Way Bet on Emerging Markets?

Growth will not be smooth, according to Buiter. “Expect booms and busts. Occasionally, there will be growth disasters, driven by poor policy, conflicts, or natural disasters. When it comes to that, don’t believe that ‘this time it’s different’.”

“Developing Asia and Africa will be the fastest growing regions, in our view, driven by population and income per capita growth, followed in terms of growth by the Middle East, Latin America, Central and Eastern Europe, the CIS, and finally the advanced nations of today,” he wrote.

“For poor countries with large young populations, growing fast should be easy: open up, create some form of market economy, invest in human and physical capital, don’t be unlucky and don’t blow it. Catch-up and convergence should do the rest,” Buiter added.

Buiter has constructed a “3G index” to measure economic progress; 3G stands for “Global Growth Generators”  and is a weighted average of six growth drivers that the Citigroup economists consider important:

  1. A measure of domestic saving/ investment
  2. A measure of demographic prospects
  3. A measure of health
  4. A measure of education
  5. A measure of the quality of institutions and policies
  6. A measure of trade openness

Using that index the nations to watch over the coming years are Bangladesh, China, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, the Philippines, Sri Lanka and Vietnam.

“They are our 3G countries,” Buiter said.

$1.2 Quadrillion Derivatives Market Dwarfs World GDP

AOL Finance

One of the biggest risks to the world’s financial health is the $1.2 quadrillion derivatives market. It’s complex, it’s unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost — and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so.

A quadrillion is a big number: 1,000 times a trillion. Yet according to one of the world’s leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon’s), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world’s annual gross domestic product is between $50 trillion and $60 trillion.

To understand the concept of “notional value,” it’s useful to have an example. Let’s say you borrow $1 million to buy an apartment and the interest rate on that loan gets reset every six months. Meanwhile, you turn around and rent that apartment out at a monthly fixed rate. If all your expenses including interest are less than the rent, you make money. But if the interest and expenses get bigger than the rent, you lose.

You might be able to hedge this risk of a spike in interest rates by swapping that variable rate of interest for a fixed one. To do that you’d need to find a counter party who has an asset with a fixed rate of return who believed that interest rates were going to fall and was willing to swap his fixed rate for your variable one.

The actual cash amount of the interest rates swaps might be 1% of the $1 million debt, while that $1 million is the “notional” amount. Applying that same 1% to the $1.2 quadrillion derivatives market would leave a cash amount of the derivatives market of $12 trillion — far smaller, but still 20% of the world economy.

Getting a Handle on Derivatives Risk

How big is the risk to the world economy from these derivatives? According to Wilmott, it’s impossible to know unless you understand the details of the derivatives contracts. But since they’re unregulated and likely to remain so, it is hard to gauge the risk.

But Wilmott gives an example of an over-the-counter “customized” derivative that could be very risky indeed, and could also put its practitioners in a position of what he called “moral hazard.” Suppose Bank 1 (B1) and Bank 2 (B2) decide to hedge against the risk that Bank 3 (B3) and Bank 4 (B4) might fail to repay their debt to B1 and B2. To guard against that, B1 and B2 might hedge the risk through derivatives.

In so doing, B1 and B2 might buy a credit default swap (CDS) on B3 and B4 debt. The CDS would pay B1 and B2 if B3 and B4 failed to repay their loan. B1 and B2 might also bet on the decline in shares of B3 and B4 through a short sale.

At that point, any action that B1 and B2 might take to boost the odds that B3 and B4 might default would increase the value of their derivatives. That possibility might tempt B1 and B2 to take actions that would boost the odds of failure for B3 and B4. As I wrote back in September 2008 on DailyFinance’s sister site, BloggingStocks, this kind of behavior — in which hedge funds pulled their money out of banks whose stock they were shorting — may have contributed to the failures of Bear Stearns and Lehman Brothers.

It’s also the sort of conduct that makes it extremely difficult to estimate the risk of the derivatives market.

How Positive Feedback Loops Crash Markets

Another kind of market conduct that makes markets volatile is what Wilmott calls positive and negative feedback loops. These relatively bland-sounding terms mask some really scary behavior for investors who are not clued into it. Wilmott argues that a positive feedback loop contributed to the 22.6% crash in the Dow back in October 1987.

In the 1980s, a firm run by some former academics came up with the idea of portfolio insurance.

Their idea was that if investors are worried about their assets losing value, they can buy puts — the option to sell their investments at pre-determined prices. They can sell everything — which would be embarrassing if the market then started to rise — or they could sell a fixed proportion of their portfolio depending on the percentage decline in a particular stock market index.

This latter idea is portfolio insurance. If the Dow, for example, fell 3%; it might suggest that investors should sell 20% of their portfolio. And if the Dow fell 20%, it would indicate that investors should sell 100% of their portfolio.

That positive feedback loop — in which a stock price decline leads to more selling — boosts market volatility. Portfolio insurance causes more investors to sell as the market declines by, say 3%, which causes an even deeper plunge in the value of investors’ holdings. And that deeper decline leads to more selling. Before you know it, many investors are selling everything.

The portfolio insurance firm started off with $5 billion, but as its reputation spread, it ended up managing $50 billion. In 1987, that was a lot of money. So when that positive feedback loop got going, it took the Dow down 22.6% in a day.

The big problem back then was the absence of a sufficient number of traders using a negative feedback loop strategy. With a negative feedback loop, a trader would sell stocks as they rose and buy them as they declined. With a negative feedback loop strategy, volatility would be far lower.

Unfortunately, data on how much money has been going into negative and positive feedback loop strategies is not available. Therefore, it’s hard to know how the positive feedback loops have gained such a hold on the market.

But it is not hard to imagine that if a particular investor made huge amounts of money following a positive feedback loop strategy, other investors would hear about it and copy it. Moreover, the way traders get compensated suggests that it’s better for them to take more and more risk to replicate what their peers are doing.

Traders Make More Money By Following the Pack

There is a clear economic incentive for traders to follow what their peers are doing. According to Wilmott, to understand why, it helps to imagine a simplified example of a trading floor. Picture yourself as a new college graduate joining a bank’s trading floor with 100 traders. Those 100 traders each trade $10 million: They “win” if a coin toss lands on heads and “lose” if it lands on tails. But now imagine you’ve come up with a magic coin that has a 75% chance of landing on heads — you can make a better bet than the other 100 traders with their 50-50 coin.

You might think that the best strategy for you would be to bet your $10 million on that magic coin. But you’d be wrong. According to Wilmott, if the magic coin lands on a head but the other 100 traders flip tails, the bank loses $1 billion while you get a relatively paltry $10 million.

The best possible outcome for you is a 37.5% chance that everyone makes money (the 75% chance of you tossing heads multiplied by the 50% chance of the other traders getting a head). If instead, you use the same coin as everyone else on the floor, the probability of everyone getting a bonus rises to 50%.

When Traders Say ‘Jump,’ Risk Managers Ask ‘How High?’

Traders are a huge source of profit on Wall Street these days and they have an incentive to bet together and to bet big. According to Wilmott, traders get a bonus based on the one-year profits of those on their trading floor. If the trading floor makes big money, all the traders get a big bonus. And if it loses money, they get no bonus — but at least they don’t have to repay their capital providers for the losses.

Given that bonus structure, a trader is always better off risking $1 billion than $1 million. So if the trader, who is the king of the hill at the bank, asks a lowly risk manager to analyze how much risk the trader is taking, that risk manager is on the spot. If the risk manager comes back with a risk level that limits how big a bet the trader can take, the trader will demand that the risk manager recalculate the risk level lower so the trader can take the bigger bet.

Traders also manipulate their bonuses by assuming the existence of trading profits before they are actually realized. This happens when traders get involved with derivatives that will not unwind for 20 years.

Although the profits or losses on that trade have not been realized at the end of the first year, the bank will make an assumption about whether that trade made or lost money each year. Given the power traders wield, they can make the number come out positive so they can receive a hefty bonus — even though it is too early to tell what the real outcome of the trade will be.

How Trader Incentives Caused the CDO Bubble

Wilmott imagines that this greater incentive to follow the pack is what happened when many traders were piling into collateralized debt obligations. In Wilmott’s view, CDO risk managers who had analyzed a future scenario in which housing prices fell and interest rates rose would have concluded that the CDOs would become worthless under that scenario. He imagines that when notified of that possible outcome, CDO traders would have demanded that the risk managers shred that nasty scenario so they could keep trading more CDOs.

Incidentally, the traders who profited by going against the CDO crowd were lone wolves whose compensation did not depend on following the trading floor pack. This reinforces the idea that big bank compensation policies drive dangerous behavior that boosts market volatility.

What You Don’t Understand, You Can’t Properly Regulate

Wilmott believes that derivatives represent a risk of unknown proportions. But unless there is a change to trader compensation policies — one which would force traders to put their compensation at risk for the life of the derivative — then this risk could remain difficult to manage.

Unfortunately, he thinks that regulators aren’t in a good position to assess the risks of derivatives because they don’t understand them. Wilmott offers training in risk management. While traders and risk managers at banks and hedge funds have taken his course, regulators so far have not.

And if regulators don’t understand the risks in derivatives, chances are great that Congress does not understand them either.

Brazil is getting hot. Too hot, too fast

If there is one thing proven beyond doubt during this crisis is that government interventionism in the free market is nefarious.  Developing countries are again and again the victims of globalist inspired management.  Argentina was one notorious case, Iceland and Greece have followed; and now Brazil, a fairly prosperous country in the last decade, is on the way to becoming another victim of artificial implosion.

Financial Times

Brazil’s central bank raised its policy interest rate by three quarters of a percentage point on Wednesday evening in another sign thatBrazil getting too hot the country’s breakneck pace of growth is causing concern over rising prices.

Brazil’s economy expanded by 2.7 per cent in the first quarter over the previous quarter and by 9 per cent over the first quarter of 2009, the national statistics office said on Tuesday. That is much faster than what many economists consider to be the potential, or non-inflationary, rate of about 4.5 to 5 per cent.

“This shows there has been no change in the bank’s position since its previous increase in April,” said Silvio Campos Neto of Banco Schahin in São Paulo. “It is clear from all the indicators that the economy is heating up and inflation is still above target. This is worrying and demands further increases in rates.”

The bank raised its target overnight Selic rate to 10.25 per cent a year, the second three-quarter-point increase at the last two six-weekly meetings of its monetary policy committee.

Consumer price inflation ballooned from a low of 4.17 per cent a year last October to 5.22 per cent in the 12 months to May. Many economists expect inflation to reach 6 per cent by the end of this year, well above the government’s target of 4.5 per cent. Economic growth is expected to be about 6.6 per cent this year.

Mr Campos said he expected the bank to raise the Selic rate to 11.75 per cent by the end of this year.

He said successive interest rate increases would help bring growth back to sustainable levels and predicted the economy would grow by about 4.3 per cent in 2011.

Brazil’s domestic market has recovered quickly from a brief recession during the global crisis, spurred on by a rising consumer class that has benefited from more than a decade of economic stability and low inflation, and from low-cost but effective income transfer programmes.

But the fast pace of growth has exposed bottlenecks such as the poor quality of Brazil’s infrastructure and its heavy tax burden. The rate of investment has risen in recent years but is still short of what is needed to deliver fast, sustainable growth.

Background: Fears of overheating

Brazil’s economy was among the fastest growing in the world during the first quarter, according to figures released on Tuesday that add to fears the economy is overheating and to expectations that the central bank will raise rates again on Wednesday.

The economy grew at a faster-than-expected annual rate of 9 per cent in the three months to March and by 2.7 per cent compared with the previous quarter, according to the IBGE, the national statistics office.

Part of the reason for the growth was an increase in investment, with the rate of investment rising to 18 per cent from 16.3 per cent a year earlier, spurred by gross fixed capital formation, which leapt by 26 per cent year on year, the fastest rate since the IBGE’s current series began in 1995.

“This confirms that the economy is very heated,” said Rafael Bacciotti, economist at Tendências, a consultancy in São Paulo. “The stand-out sectors were industry and services. Employment and wages are also growing strongly and we expect this to continue throughout the year.”

The manufacturing industry grew by 17.2 per cent year on year and the retail sector by 15.2 per cent. Imports also set a record, surging by 39.5 per cent year on year.

The central bank’s most recent weekly survey of market economists showed expectations of overall growth this year rising to 6.6 per cent, the 12th consecutive week of climbing expectations.

But many believe the economy cannot grow at more than 4.5 or 5 per cent a year without provoking an increase in inflation.

The central bank has been forced to act by steadily rising inflation expectations over recent months. Since October, Brazil’s consumer inflation rate has surged from an annual rate of 4.17 per cent to 5.26 per cent in April. However, the central bank’s most recent survey showed a slight drop in forecasts for inflation during 2010, with the average falling to 5.64 per cent from 5.67 per cent a week earlier.

Most economists expect the central bank to announce a second consecutive three-quarter percentage point rise in its policy interest rate, the Selic, at the end of its monetary policy committee’s regular two-day meeting tomorrow.

The committee meets every six weeks to decide whether to change the Selic rate in pursuit of the government’s annual consumer price inflation target, currently 4.5 per cent a year.

If expectations are confirmed, the Selic will rise to 10.25 per cent a year, up from 8.75 per cent when the current tightening cycle began in April.

US media demands Greek-style austerity for American workers

WSNM

In recent days, the US media—led by the standard bearer of American liberalism, the New York Times—has insisted that workers inseek truth the US, like their brethren in Greece, have been living the good life for far too long and must accept a drastic and permanent reduction in their living standards.

In a May 9 piece, Times columnist Thomas Friedman denounces workers in the US and Western Europe for believing in the “tooth fairy” and expecting government services without paying for them. In America, Friedman says, the baby-boom generation, which supposedly had inherited the prosperity of the post-war years, had “eaten through all that abundance like hungry locusts.”

“After 65 years in which politics in the West was, mostly, about giving things away to voters, it’s now going to be, mostly, about taking things away. Goodbye Tooth Fairy politics, hello Root Canal politics.”

Describing what he has in mind, two days later Friedman wrote about his meeting with Greek Prime Minister George Papandreou in a rooftop restaurant in Athens. Praising Papandreou for defying mass protests, theTimes columnist hails the government for carrying out a “revolution,” including raising the retirement age and slashing wages and pensions for public sector workers, imposing regressive consumption taxes and wiping out two-thirds of the country’s publicly owned companies.

Another May 11 article, appearing on the front page of the Times, is entitled, “In Greek Debt Crisis, Some See Parallels to U.S.” Its author, David Leonhardt, led the newspaper’s campaign to promote Obama’s health care overhaul, explicitly supporting limits on medical treatments ordinary people could receive. (“In truth, rationing is an inescapable part of economic life”).

“It’s easy to look at the protesters and the politicians in Greece—and at the other European countries with huge debts—and wonder why they don’t get it,” Leonhardt writes. “They have been enjoying more generous government benefits than they can afford…

“Yet in the back of your mind comes a nagging question: how different, really, is the United States?… Both countries have a bigger government than they’re paying for. And politicians, spendthrift as some may be, are not the main source of the problem.

We, the people, are.”

It is rich to hear demands for sacrifices and lectures about “the people” living beyond their means, particularly from the likes of Leonhardt and Friedman. The latter, who is paid $50,000 per speaking engagement, is married to the heir of a multi-billion dollar real estate fortune. According to theWashingtonian magazine, the couple owns “a palatial 11,400-square-foot house” in suburban Washington, DC, valued in 2006 at $9.3 million.

In these circles it is taken for granted that massive cuts must be imposed on the living standards of the working class, but not a word is said about the hundreds of billions that are funneled into the personal fortunes of the financial aristocracy and the subordination of the entire economy to increasing their piles of wealth.

The events of the last several years have revealed to the world that the greatest burden on society is not ordinary working people but the anti-social activities of an unproductive and parasitic financial elite. The grotesque consumption and appropriation of social wealth by this oligarchy is not a minor factor in the crisis of the global capitalist system itself.

The bankrupting of whole countries—chiefly through the transferring of the bad debts of the financial speculators onto the books of various governments—is being used to demand austerity from workers and ever-greater riches for the elite.

The four biggest US financial firms—Bank of America, Citigroup, Goldman Sachs and JPMorgan Chase—made money from trading every single day during the first quarter of the year, according to their financial filings. The banks, which all benefited from the Wall Street bailout, reaped hundreds of millions in profits from betting on the movement of currency, commodity and sovereign debt markets, including in relation to Greece.

At the same time, the value of corporate shares has risen, chiefly through a campaign of job cutting, wage and benefit concessions and a staggering 3.8 percent increase in worker productivity in 2009. As a result, corporate CEOs, who took stock options in lieu of pay increases when profits were down, are now cashing in, according to an Associated Press report, entitled, “America’s top CEOs are set for a once-in-a-lifetime pay bonanza.” Yahoo’s Carol Bartz, for example, received a $47.2 million package during her first year on the job, 90 percent of which came from stock awards and options.

While these vast personal fortunes have been made, there has been no recovery in the wages and benefits workers have lost during the recession. The Organization for Economic Co-operation and Development (OECD) reported that real wages fell last year by 2.7 percent in Japan and Ireland, 1.1 per cent in Germany and 0.8 percent in the US.

The unbridled greed of America’s ruling elite—and the complete subservience of the political establishment, from Obama on down, to its needs—can only be compared to the ancien régime in France. The parasitism and extravagance of the aristocracy became a major factor in the country’s breakdown, and ultimately the eruption of the French Revolution in 1789.

Workers must reject the demand for austerity. The working class did not create this crisis and must not pay for it. Instead, the ill-gotten gains of the ruling elite must be confiscated and used to meet the interests of society as a whole, instead of gutting social programs and destroying jobs.

This must include a multi-trillion dollar program of public works to put the unemployed to work—at decent wages and full medical care—to rebuild the cities and suburbs, repair the nation’s infrastructure and provide high quality housing, medical care and education for all.

In the midst of the Great Depression, the founder of the Fourth International, Leon Trotsky, argued in the Transitional Program that it is “impossible to take a single serious step in the struggle against monopolistic despotism and capitalistic anarchy—which supplement one another in their work of destruction—if the commanding posts of the banks are left in the hands of predatory capitalists. In order to create a unified system of investment and credits, along a rational plan corresponding to the interests of the entire people, it is necessary to merge all the banks into a single national institution. Only the expropriation of the private banks and the concentration of the entire credit system in the hands of the state will provide the latter with the necessary actual, i.e., material, resources—and not merely paper and bureaucratic resources—for economic planning.”

The nationalization of the banks, however, will produce positive results, Trotsky explained, “only if the state power itself passes completely from the hands of the exploiters into the hands of the toilers.”

For this to be realized the working class must build its own mass political party, independent of and irreconcilably opposed to the two parties of big business, and dedicated to the fight for a workers’ government to replace capitalism with socialism.