View: Fed Can’t Save U.S., So Politicians Must

Ben Bernanke is running out of bullets. That should be a sobering fact for politicians still bent on playing games with the debt limit.

On national television today, the Federal Reserve chairman painted a picture of a recovery that, two years after it began, remains “frustratingly slow” and too weak to make a meaningful dent in joblessness anytime soon. Even if the current slowdown proves temporary, as the Fed expects, its forecast pace of growth won’t bring unemployment back down below 7 percent until after 2013.

Much more troubling is the country’s lack of a backup plan if things get worse. The economy’s weakness leaves it vulnerable to shocks of the kind that Europe’s festering sovereign-debt crisis could easily deliver. But neither the Federal Reserve nor the U.S. government is in a good position to provide more life support should it become necessary.

Having already spent some$2.3 trillion on two bond-buying program s aimed at lowering interest rates and boosting growth, Bernanke recognizes that the costs of a third round of so-called quantitative easing may outweigh the benefits.

For one, the recent acceleration in inflation presents a genuine risk, and also provides ammunition for political scare- mongering that could negate any positive effect on confidence and stock prices.

Record Cash Levels

What’s more, businesses and consumers don’t stand to gain much from slightly lower interest rates. Companies are already sitting on record levels of cash, and most homeowners who can refinance their mortgages have already done so. Further easing could give U.S. exporters an edge by pushing down the dollar’s exchange rate against other currencies, but that can only go so far before central bankers in other parts of the world retaliate.

Indeed, even the most recent $600 billion round of quantitative easing has had mixed results. It appears to have helped fend off deflation, but its effect on growth has been muted at best. The Fed currently expects the economy to grow at an inflation-adjusted rate of between 2.7 percent and 2.9 percent this year, down from an estimate of 3.4 percent to 3.9 percent in January.

The country’s only other emergency backup would be increased government spending. Already, economists at Goldman Sachs Group Inc. estimate that as the federal stimulus tapers off, the slowdown in spending will shave about half a percentage point from annualized economic growth in the second half of this year, and more next year.

Fiscal Stimulus

Done right, another $1 trillion or more in fiscal stimulus wouldn’t necessarily worsen the government’s debt burden. If, for example, massive, visible public-works spending managed to create jobs and improve confidence, stronger growth could ease the debt-to-GDP ratio automatically. This is unlikely to happen; the political currents are flowing in the opposite direction.

Fortunately, other approaches could have a similar effect: For maximum impact on jobs, the government might offer a tax credit commensurate to the number of new workers that firms add to their payrolls, as proposed by Alan Blinder, a Princeton University professor of economics.

Here, too, officials’ hands are tied. Unless politicians put the government’s long-term finances on a sustainable track by agreeing on how to rein in or pay for obligations such as Medicare and Medicaid, any extra spending now will look irresponsible. As countries from Russia to Greecehave learned, markets may react by driving up the interest rate the government must pay on its borrowings, making the debt much harder to bear. As Bernanke put it today: “I do think in my role as somebody who is extremely interested in financial stability, that addressing the medium-to-long-term deficit problem is very urgent.”

Realism and Clarity

Realism and clarity are what taxpayers, businesses and markets need from the political system. An agreement in principle on what part of society -- retirees, workers, employers, homeowners, consumers -- ultimately will pay to fix the government’s finances, either through cuts in services or higher taxes, would go a long way toward restoring confidence. It should include mechanisms that guarantee the fix will happen, yet allow some leeway if the economy worsens.

Instead, politicians are engaging in high-stakes haggling over immediate budget cuts as they approach an August deadline for raising the federal-debt limit. If they don’t reach a deal, they risk triggering immediate, sharp spending cuts and a downgrade of the U.S. government’s AAA credit rating. Such a shock could quickly erase the meager gains the U.S. economy has made in the course of the recovery.

Brinkmanship makes for good political theater, and can do wonders for individual politicians’ careers. Unfortunately, as Bernanke made clear on a sweltering day in Washington, it’s a luxury the U.S. can’t afford right now.

Papandreou Budget Hole Threatens to Swallow Europe, Defies Debt-Crisis Fix

George Papandreou was staring into a 20 billion-euro ($29 billion) hole.

It’s common for freshly minted leaders to discover that there’s not enough money to pay for their campaign promises. So when Papandreou’s new Greek government woke up to a looming budget disaster within days of taking office in October 2009, the alarm bells were slow to ring in European capitals.

Don’t “overrate” the problem, said German Chancellor Angela Merkel, later to play a pivotal role in the debt saga that continues to rock the 17-nation euro area. “There are deficits in other parts of the world as well.”

That initial reaction foreshadowed European leaders’ failure to tame a crisis that is entering its 21st month and has world leaders growing anxious over the prospect of a new financial tsunami as they shake off the effects of the last one. On June 7, President Barack Obama told Merkel it was her job to stop an “uncontrolled spiral of default.” China’s central bank warned on June 14 of a “major risk” incubating in Europe.

“This has unravelled badly,” said Paul de Grauwe, an economics professor at the Catholic University of Leuven in Belgium and a two-time candidate for a European Central Bank post. “The most favorable scenario is that we can bridge the next six months. The less favorable scenario is this gets out of control.”

The 256 billion euros in aid committed to Greece, Ireland and Portugal have done little more than buy time against a looming default, saysAndrew Balls, Pacific Investment Management Co.’s head of European portfolio management. The cost to insure senior debt of 25 banks and insurers has climbed to 162 basis points from 120 on April 8, according to JPMorgan Chase & Co. prices. Insurance against a sovereign default, the most expensive in the world, indicates a chance of more than three in four that Greece will be forced to restructure its debt.

‘Pretty Hopeless’

“If you just look at the economics, it looks pretty hopeless for Greece. It would make you think that a default would already have happened,” Balls told Bloomberg Television June 21. “If you can quarantine Greece, Ireland and Portugal, take these countries out of the market, have them do their adjustments, then you can buy time for Spain, buy time for banks to recapitalize.”

At a Brussels summit tonight and tomorrow, the stewards of the world’s second-largest economy will have another go at the Greek dilemma, debating the size of new loans to the Athens government and how to get holders of Greek bonds to chip in.

Already, European Union leaders are playing down the prospects of a lasting fix at the summit -- and this, three months after proclaiming a “comprehensive” solution to a crisis that, for all the angst, has been limited to countries with a combined 6 percent of the euro area’s gross domestic product.

‘Reform Fatigue’

“Times are difficult,” EU Economic and Monetary Commissioner Olli Rehn said on June 20. “Reform fatigue is visible in the streets of Athens, Madrid and elsewhere, and so is the support fatigue in some of our member states.”

Police in Athens used tear gas to break up protests against austerity measures last week. Demonstrators who have camped in front of the Greek parliament for four weeks have labelled a poster of Papandreou as the International Monetary Fund’s “employee of the year.”

Europe’s debt chain reaction exposed what Romano Prodi, who as Italian prime minister shepherded Italy into the euro, called a “half-baked” setup. The monetary half run by the European Central Bank has delivered low inflation. The fiscal and economic management half has been all over the map.

North-South Split

Another split is emerging, between the wealthier, more export-driven and fiscally restrained north and the poorer south, now facing years of subpar growth, according to the Centre for Economics and Business Research.

“Euro to break up -- not this week but probably by 2013,” the London-based CEBR headlined on June 20, adding a voice to those who have been wrong so far. Greece will be the first to go, opting for growth and jobs over euro-mandated austerity, the research firm predicted.

The accident that Merkel didn’t see coming -- and the EU still sees as a cash squeeze, not an existential matter of solvency -- intruded on the EU leaders’ agenda for the first time on Feb. 11, 2010, in the century-old Solvay Library in Brussels at what was billed as a brainstorming session on a 10- year economic strategy, focused on productivity and innovation.

At the time, Greek 10-year bonds yielded 6.03 percent. The extra yield over German bonds, a measure of the risk of investing in Greece, was 283 basis points.

Emergency Lender

Three months later, with the risk spread nearing 1,000 basis points, jousting among Merkel, French President Nicolas Sarkozy and ECB President Jean-Claude Trichet yielded a decision to establish an emergency lender to prop up debt-wracked states. In so doing, the leaders set aside a core euro principle that each country was the master of its own finances.

At 2 a.m. on May 10, as markets opened in Asia, the details were set. Europe created two funds, of 60 billion euros and 440 billion euros, and the IMF put up 250 billion euros. The ECB went into the bond-buying business.

The first phase of the crisis was over and the markets settled down.

In October, they awoke with a clatter. In an Oct. 18 tete- a-tete in Deauville, on France’s English Channel coast, Merkel and Sarkozy decided it was time to shift the costs of saving the euro from taxpayers to bondholders. Merkel won French backing for a permanent rescue fund with the option of putting states into default.

Investor Flight

Investors didn’t like what they heard. While Merkel’s “private investor participation” provisions wouldn’t kick in until mid-2013, the mere floating of the idea made bonds of deficit-plagued states such as Ireland, Portugal and Spain less attractive.

Phase two of the crisis was under way, with a front opening over how creditors would contribute to the rescues.

From the latter half of October into November, investors dumped bonds of countries on Europe’s periphery. Ten-year Irish yields rose from 6 percent on Oct. 18, the date of the Merkel- Sarkozy beachside promenade, to 9.2 percent on Nov. 26, prompting Ireland’s capitulation. The yield is now 11.7 percent.

Ireland’s 67.5 billion-euro bailout package on Nov. 28 came along with what Trichet called a “useful clarification”: chastened by the plunge in Irish, Portuguese, Spanish, Italian and Belgian securities, Germany diluted demands for a future “orderly default” procedure.

Armistice

What at first looked like peace with the bond markets turned out to be a short-lived armistice. In Brussels and European capitals, work proceeded on upgrading the temporary rescue fund, setting up the permanent one and tightening the “stability pact” that had proven toothless in enforcing the euro area’s deficit and debt rules.

Politics in Germany and Finland delayed agreement on the strengthened rescue mechanism until June. Each country now plans to boost its guarantee, enabling the fund to tap the full 440 billion euros promised on the dramatic May weekend, and to buy bonds directly from straitened governments.

“Crises thrive on uncertainty, and the officials are providing that in large doses,” Alessandro Leipold, a former acting director of the IMF’s European department, said on Bloomberg Television. “The decisions are too politicized. It really is time for once for them to surprise us on the upside and actually anticipate the market.”

All the while, there was a slow burn in Portugal, the originator of Europe’s “Lisbon agenda” of 2000 that set the goal of turning the EU into the world’s most competitive economy by 2010.

Portugal’s Miss

Few countries landed wider of that mark. Portugal’s GDP per capita, a measure of wealth and productivity, was 81 percent of the EU average in 2010, the lowest in western Europe and barely ahead of the ex-communist Czech Republic, at 80 percent.

Portugal’s implosion ended the taboo against European authorities intervening in national politics. With the crisis triggering early elections, the euro area and IMF forced both main parties to sign up to budget cuts in the heat of the campaign as a condition for 78 billion euros in loans.

By then, Germany and the bond market were falling out. It began April 14 when Finance MinisterWolfgang Schaeuble hinted at the need for a Greek debt restructuring in a Die Welt newspaper interview. A day later, Deputy Foreign Minister Werner Hoyer told Bloomberg News that a restructuring “would not be a disaster.”

Germany’s thrust came with Greece’s 10-year yield premium at 948 basis points, virtually unchanged since New Year’s Day. It quickly deteriorated. By May 16, the day of Portugal’s bailout, it was 1,250 basis points. It peaked last week at 1,503 basis points.

Germany Yields

German musings about shoving Greece into default met pushback from the ECB and France, the country most exposed to Greek debt. A new confrontation over bond contracts and market psychology played out, ending in a German climbdown.

Merkel blinked on June 17. With Sarkozy at her side, she dropped the idea of a compulsory Greek debt exchange that would lead rating companies to place Greece in default. “Let me make that perfectly clear,” Merkel said. The ECB now had a veto over the method for getting bondholders to roll over Greek debt.

It was the squabble and not the agreement, though, that raised eyebrows.

“It’s very hard for people to invest in Europe, within Europe and outside Europe, to understand what the strategy is when you have so many people talking,” U.S. Treasury Secretary Timothy F. Geithner said June 21. “It would be very helpful to have Europe speak with a clearer, more unified voice.”

Falling Short

In the meantime, Greece was failing to keep up its end of the bargain. While Papandreou delivered 20 billion euros of EU- and IMF-ordained budget cuts in 2010, the resulting 4.5 percent economic slump squeezed tax revenue, leaving the deficit above target and debt on an upward trajectory.

Already at a European record of 142.8 percent of GDP, Greek debt is set to rise to 157.7 percent this year and 166.1 percent next year, the EU predicts. It prodded Greece to get serious about selling 50 billion euros of state assets to pay off creditors, pushing the government to the breaking point.

Unable to lure the opposition into a unity coalition, Papandreou, 59, the Minnesota-born scion of a political dynasty, replaced his finance minister last week, stiff-armed an inner- party rebellion and staked his future on a confidence vote.

Papandreou Hangs On

The interim climax came early yesterday. As 10,000 protesters besieged the parliament in Athens, hurling bottles and fruit at riot police, the Socialist convert to spartan economics warned the assembled lawmakers that Greece had run out of alternatives.

The government survived, by a margin of 155 to 143. Votes next week will determine the fate of 78 billion euros in budget cuts, the price demanded by the EU and IMF in exchange for a 12 billion-euro loan installment to banish the specter of default, at least through August.

Risks are rising of “a Lehman-esque event rippling out from Europe,” said Carl Weinberg, chief economist at High Frequency Economics Ltd. in Valhalla, New York. “Things are out of control. We’ve been reduced to a game of chicken between Greece and the governments of Europe to see who blinks first.”

Asian Hedge Funds Struggle to Raise Cash Even Amid Boom

Asian hedge-fund managers are missing out on the cash flooding into the world’s fastest- growing region, leading some to close funds or defer new offerings.

Singapore-based Amoeba Capital Partners Pte, run by the former head of Asian investments at Morgan Stanley’s asset- management unit, is returning money to investors in its stock hedge fund, citing “tough” industry conditions. Michael Coleman, co-manager of the $1.3 billion Merchant Commodity Fund, in June shelved plans to raise money for an equity hedge fund.

“The Asian hedge-fund industry, overall, has yet to definitively prove to the global investor community that it has matured past the ability to deliver beta,” or investments whose returns tend to track the market, said Kirby Daley, a Hong Kong- based senior strategist with Newedge Group’s prime brokerage business. “This is seemingly constraining asset flows into the region past a certain point.”

Hedge-fund managers in the region are failing to cash in on the world’s fastest economic growth even as their stock-fund rivals are. Asia’s hedge funds saw $1.2 billion of outflows in the first seven months of the year, Eurekahedge Pte said in its September report. In contrast, the region attracted about $19.8 billion in net inflows into equity funds this year, Cambridge, Massachusetts-based EPFR Global said in an e-mail Oct. 12.

Assets of Asia’s hedge funds have shrunk 8 percent to $117 billion since the financial crisis, according to Singapore-based Eurekahedge. That’s even as the region grows at the world’s quickest rate, with Asia’s developing economies set to expand 9.2 percent in 2010, outpacing growth of 2.6 percent in advanced nations, the International Monetary Fund forecast in July.

‘Rough it Out’

One problem is the relatively small size and youth of many Asian hedge funds. Most of the larger institutional investors require managers to oversee at least $100 million and have three years of track record, said Albert Ee, founder of Singapore- based Pilgrim Partners Asia Pte, which started a macro hedge fund in May. Others want to see a track record of at least nine months before committing capital, he said.

“I probably will still need to rough it out for the next six months or so before I start doing serious marketing,” said Ee, a former managing director of Millennium Management LLC’s Asian business. His firm oversees about $28 million, of which half are assets in the macro hedge fund and the remainder are managed accounts for institutions.

The proportion of Asian hedge-fund managers overseeing $50 million or less has grown to 66 percent of the industry, from 57 percent two years ago, according to Eurekahedge.

Underperformers

Asia-focused hedge funds returned 26 percent last year, less than the MSCI Asia Pacific Index’s34 percent advance, and lost almost 21 percent in 2008 as the stock benchmark plunged 43 percent, according to Eurekahedge. North American funds gained 23 percent in 2009, matching the jump in the Standard & Poor’s 500 Index, after declining 9.2 percent in 2008, less than a quarter of the losses in the benchmark index, data from the research firm show.

“The source of capital that has supported the Asian hedge- fund industry has been money from the U.S. and Europe and they have been after short-term returns rather than long-term capital growth,” said Shuhei Abe, president and chief executive officer of Sparx Group Co., Asia’s second-biggest hedge-fund firm. “Money dried up after the Lehman Brothers Holdings Inc.’s bankruptcy and the global credit crisis that followed.”

Investors in the U.S. and Europe are less willing to seek Asia-based managers as “travel expense becomes a big part of the budget” when times are hard, said Stephane Pizzo, founder of Singapore-based hedge-fund investing firm Lotus Peak Capital.

Local Opportunities

“If you’re sitting in Europe or the U.S. and you have the opportunity to invest with a manager based locally, it is a pretty compelling proposition,” said Pizzo, former managing director of Geneva-based Unigestion Holding SA.

Investors also still see “significant opportunities” in U.S. markets and “have not felt the need to look harder” at overseas managers, said Judith Posnikoff, managing director at Irvine, California-based Pacific Alternative Asset Management Co., which invests clients’ money in hedge funds.

Shares on the S&P 500 index are valued at an average 12.3 times estimated earnings, versus 14.2 times for the MSCI Asia Pacific Index.

North American hedge funds continued to attract the most capital, gaining $4.7 billion in August, the seventh consecutive month of net inflows, Eurekahedge said in its report.

Big Versus Small

Smaller managers are also struggling to raise assets as investors are allocating money to larger funds. The money that is flowing into the region is going into the “Asian end of the big global firms” and a small number of boutique firms that have successfully tapped U.S. investors, saidPeter Douglas, principal of Singapore-based GFIA Pte, which advises investors seeking to allocate money to hedge funds and runs a wealth- management business.

“Investors are generally focusing on fewer stronger relationships,” said Daniel Mudd, chief executive officer of New York-based Fortress Investment Group LLC, which managed $41.7 billion as of June 30. “Some advantage has accrued to a firm like Fortress that is big enough to have the full level of products and global expertise and client support.”

Fortress is considering launching an Asia-focused macro fund, which seeks to profit from broad economic trends, as it opens an office in Singapore.

Increased Scrutiny

Asian hedge funds in the past relied on European investors including private banks and family offices for assets, both of which are now allocating fewer funds, said GFIA’s Douglas.

Meanwhile U.S. investors, which are becoming more substantial allocators to hedge funds globally, are reticent to put money with Asian managers which they find harder to scrutinize due to the distances involved, Douglas said. Investors in funds have increased scrutiny of managers after Bernard Madoff’s $65 billion fraud was uncovered.

There have been 73 Asian hedge fund closures this year, according to Eurekahedge, after 107 in 2009. DragonBack Capital Ltd., a Hong Kong-based manager co-founded by a former Lehman executive, closed its two hedge funds after redemptions, AsianInvestor reported on Oct. 8. DragonBack is now seeking to provide risk-management services to fledgling funds, according to AsianInvestor.

Minerva Macro Fund, set up by Stanley Ku, Fortress Investment’s former Hong Kong head, returned investors’ money 10 months after starting with backing from Man Group Plc, a person with knowledge of the matter said in June.

Amoeba Capital plans to give clients their money by Dec. 31, Managing Partner Ashutosh Sinhasaid. The Amoeba Capital Asia Fund, which bets on rising and falling stocks in Asia outside Japan, returned 67 percent from its inception on July 10, 2006, through Aug. 31, Sinha said, compared with a 22 percent gain in the MSCI Asia Pacific ex-Japan Index over the same period.

‘Tough’

“The hedge fund industry has been tough in the last few years,” said Sinha, who worked at Morgan Stanley Investment Management for 11 years before founding Amoeba Capital in 2006.

The fund has shrunk to $135 million following client withdrawals during the global financial crisis, from a peak of $750 million, he said.

Singapore-based Aisling Analytics Pte had earlier this year sought to raise $300 million for an equity long-short fund investing in commodities and natural resource companies. Long- short funds bet on rising and falling stocks.

“It became a distraction when it was clear that raising money for new funds was much, much harder than pre-2008,” said Coleman, who manages the firm with partner Doug King. “We’ve seen very high levels of due diligence over the last 12 months, but conversion rates appear to be quite low.”

Some still see hope for Asian hedge funds. “There’s huge interest in Asian hedge funds because the world genuinely believes the Asian story,” said GFIA’s Douglas. “What you don’t have is capital flowing.”