November 8, 2011 8:33 pm

Thinking through the unthinkable

Pinn illustration

Will the eurozone survive? The leaders of France and Germany have now raised this question, for the case of Greece. If policymakers had understood two decades ago what they know now, they would never have launched the single currency. Only fear of the consequences of a break-up is now keeping it together. The question is whether that will be enough. I suspect the answer is, no.

Efforts to bring the crisis under control have failed, so far. True, the eurozone’s leadership has disposed of George Papandreou’s disruptive desire for democratic legitimacy. But financial stress is entrenched in Italy and Spain (see chart).

With a real interest rate of about 4.5 per cent and economic growth of 1.5 per cent (its average from 2000 to 2007, inclusive), Italy’s primary fiscal surplus (before interest rates) needs to be close to 4 per cent of gross domestic product, indefinitely. But the debt ratio is too high. So the primary surplus has to be far bigger, the growth rate far higher, or the interest rate lower. Under Silvio Berlusconi, none of the necessary changes is going to happen. Would another leader fix things? I wonder.

The fundamental difficulty throughout has been the failure to understand the nature of the crisis. Nouriel Roubini of New York University’s Stern School of Business makes the relevant points in a recent paper.* He distinguishes, as I did in a column on October 4, between the stocks and the flows.

The latter matter more. It is essential to restore external competitiveness and economic growth. As Thomas Mayer of Deutsche Bank notes, “below the surface of the euro area’s public debt and banking crisis lies a balance-of-payments crisis caused by a misalignment of internal real exchange rates”. The crisis will be over if and only if weaker countries regain competitiveness. At present, their structural external deficits are too large to be financed voluntarily.

Mr Roubini discusses four options for addressing these stock and flow challenges simultaneously: first, restoration of growth and competitiveness through aggressive monetary easing, a weaker euro and stimulatory policies in the core, while the periphery undertakes austerity and reform; second, a deflationary adjustment in the periphery alone, together with structural reforms, to force down nominal wages; third, permanent financing by the core of an uncompetitive periphery; and, fourth, widespread debt restructuring and partial break-up of the eurozone. The first could achieve adjustment, without much default. The second would fail to achieve flow adjustment in time and so is likely to morph into the fourth. The third would avoid both stock and flow adjustment in the periphery, but threaten insolvency in the core. The fourth would simply be the end.

Alas, huge obstacles exist to all of these options. The first is the most likely to work economically, but is unacceptable to Germany. The second is politically acceptable to Germany (despite the bad effects on its economy), but would ultimately be unacceptable in the periphery. The third is politically unacceptable to Germany and is even likely to prove unacceptable in the periphery, too. The fourth is unacceptable to everybody, if only for now.

What is now happening is an unhappy mixture of the second and third options: one-sided austerity with grudging finance. Mr Mayer argues that it could morph into the first.

His argument is that the lender-of-last-resort activity of the European System of Central Banks, in favour of banks unable to fund themselves in the market, is financing payments deficits. Central banks of the surplus countries are, as a result, accumulating large credit positions vis a vis the European Central Bank, while those of the deficit countries are accumulating counterpart liabilities (see chart). This is a transfer union. In the long run, suggests Mr Mayer, monetary financing of balance of payments deficits is going to prove inflationary and so turn into the first of Mr Roubini’s options. I am not sure that the danger of inflation is real. But Germans certainly fear it is.

In the long term, the first and last of Mr Roubini’s options seem most likely: either the entire eurozone adjusts, or it breaks up. Germany should accept the risks of the former path. I know that its nightmare is the hyperinflation of 1923. Yet the brutal austerity of 1930-32 finally brought Adolf Hitler to power.

The question is whether exit would be feasible without blowing up the world. Start with a decision that, for a severely uncompetitive country, such as Greece, exit would be co-operative. Greece would introduce a currency – the “new drachma”. New contracts executed under Greek law and taxes and spending in Greece would be in this currency.

Existing contracts would stay in euros. Banks would have legacy euro accounts and new drachma accounts. The exchange rate of the new currency against the euro would be set in the market. It would depreciate rapidly. But that is desperately needed.

The Greek government would abide by the terms of a reformulated external programme. It would continue to strive for fiscal balance, helped by what is likely to be a massive real depreciation. Its central bank would manage the new currency independently. The price level would jump in the new currency, but, given the excess capacity, hyperinflation could be avoided with some external support.

Public and private default on euro liabilities would be sizeable. But if Greece were to experience prolonged domestic deflation, in order to regain external competitiveness, without the new currency, the real value of euro debt would also explode upwards. This would merely accelerate the process. Meanwhile, Greece would lose its vote in the ECB. But the possibility of a return would remain.

Such a co-operative approach to reintroduction of a new currency would be the least costly. But it would surely generate contagion. If the eurozone has decided that it must avoid that threat, then it must go back to the first on the menu of options laid out by Mr Roubini. Potentially solvent countries would be financed and the eurozone would grow its way out of the crisis.

A eurozone built on one-sided deflationary adjustment will fail. That seems certain. If the leaders of the eurozone insist on that policy, they will have to accept the result.
*Four Options to Address the Eurozone’s stock and flow imbalances, unpublished,
Copyright The Financial Times Limited 2011.

 Only the ECB can save Italy now, but it can’t act alone
Mohamed El-Erian

Here we go again. Europe’s debt crisis has entered a new, more dangerous phase with the yield on Italian 10-year bonds crossing the seven per cent level on Wednesday morning. 
This is a eurozone-era record that, if sustained, would severely destabilise the debt situation of the world’s third largest bond issuer and one of the original six founders of the modern European project.

Those who lived through the horrid days of the various emerging market debt crises will quickly recognise the four distinct factors that have come together in the last few days to form a highly destabilising cocktail. And they may well agree on what needs to be done to stop a bad situation getting worse.

Messy domestic politics have undermined the already-complicated relations between those with the potential to solve Europe’s debt crisis – the highly-indebted countries, their official creditors and private holders of their debt.

As in Greece, Italy is now going through an uncertain political transition. While the media has understandably focused on when and how Prime Minister Silvio Berlusconi will resign, what Italy urgently needs is much more complex – namely, a new government that can credibly design, implement and shepherd multiyear efforts to lower debt and deficits, while also increasing economic growth.
Secondly, it has become fashionable not only to sell Italian bonds but also to tell the world about it, as loudly as you can.

In the last few days several banks have rushed to announce that they have been actively reducing their holdings of Italian debt – as a means of reducing market concerns about their own well-being. This phenomenon is similar to the 1980s phase of “macho provisioning” that saw banks trying to outdo each other in telling the world that they were fully protected against their past loans to Latin America.

The result today is to encourage and push other Italian creditors to also sell, adding to the market pressures. In too many cases, the damage to the demand for Italian bonds is much more than transitory.

Third, a series of technical changes are disrupting the Italian bond market, adding to its instability.

They range from Tuesday night’s increase in margin requirements imposed by a major clearing house, to the decrease in availability of hedging instruments in the derivative markets.

Finally, the European Central Bank has appeared more hesitant in recent days to purchase Italian bonds. Whether it is an issue of willingness or ability, the result has been to add to the mounting market instabilities.

Left to their own devices, several of these factors could get even more disruptive. Italy is now in the grips of what economists call a ‘path-dependent multiple equilibria – where one bad outcome raises the probability of another, even worse outcome.

There is only one institution that has an immediately-available balance sheet that could stabilise the situation in the next few days and weeks – the ECB. But before we all join the chorus urging the bank to do more, we should recognise that it, alone, cannot deliver good outcomes.

To act as a durable circuit breaker, the ECB needs others to help on four critical issues: a bold and lasting separation in how we deal with Europe’s insolvent nations and its illiquid ones; a regional programme to enhance growth and employment; immediate actions to counter the fragility of the banking system; and bold political decisions to strengthen the institutional underpinning of the eurozone, either as it is configured today or via a smaller and less imperfect one.

The European summit on October 23 came close to partially addressing some of these factors but slow progress and disruptive national political developments limited its impact. As a result, Europe’s crisis has entered a new and even more worrisome phase.

With neither the region nor the global economy in a position to afford many more slippages, let us hope that this latest development will serve as a loud, urgent and effective call for proper diagnosis and comprehensive action.

The writer is the chief executive and co-chief investment officer of Pimco

Europe’s Darkness at Noon.

Barry Eichengreen


BERKELEY – It may be hard to imagine that Europe’s crisis could worsen, but it just has. European Union leaders failed at their summit two weeks ago to produce anything of substance. China and Brazil are clearly reluctant to come to the rescue by providing a large injection of foreign cash. And the recent G-20 summit in Cannes produced no agreement on steps that might have helped to resolve the crisis.

Now there is the collapse of the Greek government. The trigger may have been outgoing Prime Minister George Papandreou’s ill-advised decision to call for a referendum on the EU’s rescue package (which implies further severe austerity measures); but the fundamental problem is that a brutal recession made the government’s demise all but inevitable.

The formation of a new national unity government does not mean that the Greek problem is behind Europe or the world. On the contrary, the new government’s position will be no more tenable than that of its predecessor. Until there is hope, however remote, that Greece can begin to grow again, the problem will not go away.

Even worse for financial stability, Papandreou’s announcement of a referendum provoked German Chancellor Angela Merkel and French President Nicolas Sarkozy to break an important taboo.

Previously, European leaders had averred that the euro was forever, repeating at every turn that they would do whatever it took to hold the monetary union together. Last week, in a dangerous departure, Merkel and Sarkozy bluntly told the Greeks that it was up to them to decide whether they wanted to keep the euro.

Their statements were designed to beat Greek politicians into submission, and may have succeeded, at least for now. But they also opened the door to destabilizing speculation. The temptation to bet against continued Greek participation in the euro is now greater than ever. As investors place their bets, the balance sheets of Greek banks and the Greek government will deteriorate further, which could cause bearish expectations to become self-fulfilling.

The greater danger is that where Greece leads, Portugal and Italy will be forced to follow. Anyone who doubts this need only think back to 1992, when the European Monetary System fell apart.

In September of that year, Bundesbank President Helmut Schlesinger made some reckless comments about how devaluations within Europe’s system of supposed stable exchange ratescannot be ruled out.” Schlesinger’s unguarded remarks signaled that the Bundesbank was not willing to do whatever it took to preserve the system – a signal that encouraged investors to place massive bets against the British pound and Italian lira. The result was the collapse of Europe’s exchange-rate mechanism.

If Merkel and Sarkozy are serious about preserving the euro, they will have to repair the damage caused by their reckless remarks. They should acknowledge that the only entity with the capacity to stabilize the situation is the European Central Bank. And they must give the ECB the political cover that it needs to do what is required to preserve the system.

Specifically, the ECB must do much more to support economic growth. Its decision to cut rates by 25 basis points at the first policy meeting under its new president, Mario Draghi, is the one ray of light in an otherwise darkening sky. But 25 basis points are a drop in the bucket. With Europe headed for recession, the danger of rising inflation is nil. Still, given German sensitivities, Merkel should use her bully pulpit to reassure her public.

More controversially, the ECB needs to increase its purchases of Italian bonds. Unless yields on those bonds fall to German levels, there is no way that Italy’s debt arithmetic can be made to add up. But Draghi has indicated that he is reluctant to see the ECB become a lender to governments. Reassuring the markets by adopting structural reforms, he has observed, is properly the responsibility of those governments, not of the central bank.

But structural reforms cannot be accomplished overnight. Italy needs time to put its pro-growth reforms in place. Not providing that time would sound the death knell for the euro.

Here’s where the political cover comes into play. Merkel and Sarkozy need to make the case that if the euro is to become a normal currency, Europe needs a normal central bankone that does not merely target inflation like an automaton, but that also understands its responsibilities as a lender of last resort.

Meanwhile, Italy, now under the watchful eye of the International Monetary Fund, needs to move ahead with those pro-growth reforms in order to reassure the ECB’s shareholders that the central bank’s bond purchases are not money losers.

If it does, maybe just maybe – there will be reason to hope that the European project’s darkest hour is just before the dawn.
Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar.

November 8, 2011
Two Peas in a Pod


The world’s two biggest democracies, India and the United States, are going through remarkably similar bouts of introspection.
But the similarities do not stop there. What has brought millions of Indians into the streets to support the India Against Corruption movement and what seems to have triggered not only the Occupy Wall Street movement but also initiatives like — a centrist group planning to use the Internet to nominate an independent presidential candidate — is a sense that both countries have democratically elected governments that are so beholden to special interests that they can no longer deliver reform. Therefore, they both need shock therapy from outside.

The big difference is that, in America, the Occupy Wall Street movement has no leader and no consensus demand. And while it enjoys a lot of passive support, its activist base is small. India Against Corruption has millions of followers and a charismatic leader, the social activist Anna Hazare, who went on a hunger strike until the Indian Parliament agreed to create an independent ombudsman with the staff and powers to investigate and prosecute corruption at every level of Indian governance and to do so in this next session of Parliament. A furious debate is now raging here over how to ensure that such an ombudsman doesn’t turn into an Indian Big Brother,” but some new ombudsman position appears likely to be created.

Arvind Kejriwal, Hazare’s top deputy, told me, “Gandhi said that whenever you do any protests, your demands should be very clear, and it should be very clear who is the authority who can fulfill that demand, so your protests should be directed at that authority.” If your movement lacks leadership at first, that is not necessarily a problem, he added, “because often leaders evolve. But the demands have to be very clear.” A sense of injustice and widening income gaps brought Occupy Wall Street into the street, “but exactly what needs to be done, which law needs to be changed and who are they demanding that from?” asked Kejriwal. “These things have to be answered quickly.”

That said, there are still many parallels between the Indian and American movements. Both seem to have been spurred to action by a sense that corruption or financial excess had crossed some redlines. In the United States, despite the fact that elements of the financial-services industry nearly sank the economy in 2008, that same industry is still managing to blunt sensible reform efforts because it has so much money to sway Congress. It seems to have learned nothing. People are angry.

Meanwhile, in India, the commodities and telecommunications booms, coupled with urbanization that is driving up land prices, have set loose billions of rupees, and officials who control zoning and mining permits have just been pigging out. Some 50 top officials have been jailed lately for everything from the crony allocation of wireless spectrum, leading to potential losses to the state of up to $38 billion, to illicitly selling Indian iron ore, needed for development here, to China for a higher price. People are fed up.

Yet, commented the Indian writer Chetan Bhagat in The Times of India on Monday, “our government attacks almost every anti-corruption crusader” and “sadly, even our opposition parties have lots of corrupt people.” Sound familiar? Democracy not only needs a decent ruling party, but an intelligent opposition, and neither India nor America has both today.

Yes, Indians are mad at a system that makes them pay a bribe to get their birth certificate. Americans are mad at a system that has made it legal for unions to bribe the officials who will decide their pay and for bankers to bribe the lawmakers who will decide how much risk they can take. But both are essentially threatened by the same disease, best captured in the title of Robert Kaiser’s book about lobbying — “So Damn Much Money” — and it’s being thrown around now by so many special interests that these democracies are not only being warped by it but can’t fix themselves either.

Hazare has called this moment India’ssecond struggle for independence.” I think he is on to something for both India and America. I think that repairing our respective dysfunctional democracies — so they are truly enablers for the 21st century and not inhibitors in India’s case or “the sum of all lobbies” in America’s case — is for our generation what the independence movement in India and the civil rights movement in America were for our parents’ generation.

Here’s hoping we’re as successful.

November 8, 2011 8:44 pm

The free market secret of the Arab revolutions

A few weeks ago I met Salem, the younger brother of the brave Tunisian fruit vendor whose self-immolation triggered the Arab uprising. When I asked him what his brother in heaven would say if we asked what he hoped his sacrifice would bring to the Arab World, Salem did not hesitate: “That the poor also have the right to buy and sell.”

It is worth remembering these words as experts busily debate the challenges for the future of the Arab revolution as countries balance the quest for democracy, fidelity to Islam, with secularism and tribal power.

In the wake of the overthrow of three autocrats, not enough credit has been given to the mighty consensus that triggered the uprising – the desire of a vast, underclass of people to work in a legal market economy. In the culturally diverse Middle East and north Africa, the one common thread is its informal economy. This is the key to future growth and indeed stability.

This huge shift began after all when the 26-year-old Tarek Mohamed Bouazizi, immolated himself in front of the governor’s offices in the town of SidiBouzid last December, after his merchandise was confiscated.

One day after he set himself alight, thousands of people in his town and neighbouring villages took to the streets. Before a few weeks passed, many of the 180 million Arabs who work in and around the informal markets in the Middle East and north Africa were identifying with his disempowerment and sending their shouts to heaven.

Millions marched under banners for reform. According to research by colleagues of mine, at least 35 businessmen followed his desperate example and set themselves on fire (13 more in Tunisia, 17 in Algeria, four in Egypt, three in Morocco and so on).

People identified with his dire situation: like 50 per cent of all working Arabs, he was an entrepreneur, albeit on the margins of the law, who died trying to gain the right to hold property and do business without being hassled by corrupt authorities.

If the region’s new leaders want to make a difference, they have to appreciate the underclass of such aspirant capitalists, a supranational movement that spans Arab cleavages, different languages, political environments and cultures. That will be the driving force in the months ahead.

If Marx taught us anything, it is that the powerless can crystallise into a revolutionary class when they become conscious that they share a common suffering –and especially when a martyr embodies that suffering. There is no doubt that millions of Arabs see Bouazizi as their icon. “We are all Mohamed Bouazizi,” Mehdi Belli, a university IT graduate working as a merchant in L’Ariana market in Tunis, told me.

To understand this you have to appreciate the details: Bouazizi flicked his lighter on at 11.30am, one hour after a policewoman, backed by two municipal officers, had expropriated his two crates of pears ($15), a crate of bananas ($9), three crates of apples ($22) and an electronic weight scale ($179, second hand). While a total of $225 might not appear to justify suicide, the fact is that, as a businessman, Bouazizi had been summarily wiped out.

Without those goods, Bouazizi would not be able to feed his family for more than the next month. Since his merchandise had been bought on credit and he couldn’t sell it to pay his creditors back, he was now bankrupt. Because his working tools were confiscated, he had lost his capital. Because the customary arrangement to pay authorities three dinars daily for the property right to park his vendor’s cart on two square yards of public space had been terminated, he lost his informal access to the market. Without property and trade, his reputation as a reliable administrator of goods was now undermined in the only market he knew.

He was not on a salary. He was a budding entrepreneur. According to his mother and his sister, his goal was to accumulate capital to grow his business. But this was impossible as we discovered when we investigated the records and the laws he had to comply with.

To get credit to buy the truck he so needed, he needed to demonstrate he had some kind of legally recognised collateral. The only legal collateral he had access to was the family house in SidiBouzid. However, he had never been able to record a deed in the property registry, an indispensable requirement for using the house as a guarantee. Compliance requires 499 days of red tape at a cost of $2,976.

To create a legal enterprise he would have had to establish a small sole proprietorship. This would require taking 55 administrative steps during 142 days and spending some $3,233 (12 times Bouazizi’s monthly net income, not including maintenance and exit costs). Even if he had found the money and the time to create a sole proprietorship firm the law did not enable him to pool resources by bringing in new partners, limit liability to protect his family’s assets, and eventually, issue shares and stocks to capture new investment.

The forces of the market have come to the Arab world – even if governments didn’t invite them in. Political leaders must realise that, since Bouazizi went up in flames and his peers rose in protest, poor Arabs are no longer outside but inside, in the market, right next to them.

The Arab consensus ahead is undoubtedly about more than just emancipating the entrepreneurial poor. But Middle Eastern and African leaders cannot afford to forget what the industrial revolution was about: if their agenda does not include tackling the nitty-gritty institutional deficiencies that make most Arabs poor, they will eventually open the doors to the anti-democrats and enemies of modernity who fight democracy and modernity in their name.

The writer is author of ‘The Mystery of Capital’ and ‘The Other Path’
Copyright The Financial Times Limited 2011.