Europe’s Vicious Spirals

Barry Eichengreen


BERKELEY – The euro crisis shows no signs of letting up. While 2011 was supposed to be the year when European leaders finally got a grip on events, the eurozone’s problems went from bad to worse.

What had been a Greek crisis became a southern European crisis and then a pan-European crisis. Indeed, by the end of the year, banks and governments had begun making contingency plans for the collapse of the monetary union.

None of this was inevitable. Rather, it reflected European leaders’ failure to stop a pair of vicious spirals.

The first spiral ran from public debt to the banks and back to public debt. Doubts about whether governments would be able to service their debts caused borrowing costs to soar and bond prices to plummet. But, critically, these debt crises undermined confidence in Europe’s banks, which held many of the bonds in question. Unable to borrow, the banks became unable to lend. As economies then weakened, the prospects for fiscal consolidation grew dimmer. Bond prices then fell further, damaging European banks even more.

The European Central Bank has now halted this vicious spiral by providing the banks with guaranteed liquidity for three years against a wide range of collateral. Reassured that they will have access to funding, the banks again have the confidence to lend.

Cynical observers suggest that the ECB’s real agenda is to encourage the banks to buy the crisis countries’ bonds. But that would only further weaken the banks’ credit portfolios at a time when European regulators are desperate to strengthen them. The ECB’s decision to provide the banks with unlimited liquidity does not solve governments’ debt problems, nor is that its intent. But it at least prevents the debt problem from creating banking problems, which, in turn, worsen the debt problem without end.

Europe’s second vicious spiral runs from fiscal consolidation to slow growth and back to fiscal consolidation. Tax increases and cuts in public spending are still needed; there is no avoiding this reality. But these demand-reducing measures also reduce economic growth, causing deficit-reduction targets to be missed. Getting fiscal consolidation back on track then requires more spending cuts, which depress growth still further, causing budget performance to worsen even more.

At some point, recession and unemployment will provoke a political reaction. Angry electorates will boot out austerity-minded governments. And uncertainty about what kind of governments come next will not reassure investors or positively influence growth.

Interrupting this second vicious spiral will require jump-starting growth, which, under current circumstances, is easier said than done. The external environment is not favorable. Economic growth in the United States is still weak, and growth in emerging markets seems poised to slow.

So what are Europe’s policymakers to do? Restarting growth requires a two-handed approach that addresses both supply and demand.

Consider first the supply side. Research on the European economy has shown that small and medium-size enterprises (SMEs) are engines of employment creation.
But SMEs need credit in order to grow and hire, which underscores the importance of the ECB’s recent steps to restore liquidity to the banking system.

The other supply-side measures will have to be taken by governments. The Italian parliament, for example, has agreed to remove limits on store-opening hours as a first step toward liberalizing the retail sector. But taxi drivers and pharmacists have successfully resisted efforts to open their professions and make provision of their services more flexible and efficient. The need to placate such interest groups is a serious obstacle to jump-starting economic growth, because comprehensive reform is more effective than piecemeal reform.

Getting all of the stakeholders to go along will require compensating losers. And here Europe’s social model can be an asset rather than a liability. The losers from reform can be provided generous but temporary unemployment benefits. They can enroll in government-funded, industry-organized training schemes. European governments that promise to aid the losers are more likely to retain political support. They will be better able to stay the reformist course.

Likewise, taxi drivers will be more agreeable to the award of additional medallions if demand for their services is buoyant. Hence the continuing need for demand-side measures, which puts the ball back in the ECB’s court.

Cutting interest rates will not be enough. Pushing up asset prices and pushing down the euro’s exchange rate will require the ECB to buy bonds on the secondary marketnot the crisis countries’ bonds per se, but those of all eurozone members. In other words, it will require quantitative easing.

Nothing is guaranteed. But Europe can still escape its vicious spirals if everyone does their part.

Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.

January 10, 2012 7:13 pm

A high-flyer now flags

Dilma Rousseff
In pursuit of progress: Brazil’s President Dilma Rousseff, a tough economist known as a tropical Margaret Thatcher. Voters warm to her no-nonsense approach

In her year-end address, Dilma Rousseff struck the sort of optimistic note that Brazilians have become used to after nearly a decade of economic growth. Nothing is better for a mother or a father of a family than to be able to say on Christmas Eve that in spite of its challenges, this year was good and the next will be even better,” the president told the 200m citizens of Latin America’s most populous nation. “The majority of Brazilians can say that of this new year.”

Ms Rousseff and other Brazilians certainly have much to celebrate. Once an economic problem child, Brazil is today more of an onlooker in the world’s financial crises than a participant. It is believed to have overtaken the UK last year as the world’s sixth-largest economy. On a personal level, Ms Rousseff is one of the country’s most popular presidents ever at this stage of her term.


Yet the upbeat televised address masks serious difficulties that Ms Rousseff and her Workers’ party-led ruling coalition must overcome this year. Brazil’s Asia-like growth rate of 7.5 per cent in 2010 slowed to less than half that level last year – even stalling on a quarterly basis in the three months to September – as the country’s historic enemy, inflation, staged a stubborn revival. Even Mexico, whose fortunes are dictated by the struggling US economy, is expected to have achieved faster gross domestic product growth than Brazil in 2011. On the political front, Ms Rousseff has endured a string of corruption scandals that have threatened to destabilise her unwieldy coalition.

This year, she will have to revive the economy and show that Brazil deserves its reputation as a high-growth member of the “Bricsclub of large emerging markets that also includes Russia, India and China – or risk losing the confidence of investors. “The outlook is still quite constructive and the opportunities are there but I think slowly they are realising they have to work to make it happen,” Alberto Ramos, an economist with Goldman Sachs, says of the Brasília authorities. “Potential GDP growth is way too low.”

In tackling that task, Ms Rousseff has an array of the necessary attributes. A development economist and voracious reader with a bureaucrat’s eye for detail, she is known to be a tough taskmistress, unafraid publicly to humiliate officials or even ministers who turn up at meetings poorly prepared. It is an attitude that has earned her a reputation as a tropical Margaret Thatcher.

Although the first female president of Latin America’s emerging global power may lack the charisma of Luiz Inácio Lula da Silva, her wildly popular predecessor, voters seem to have warmed to her no-nonsense approach. People identify in her a seriousness of purpose and a reserved style that is kind of a relief after the often very narcissistic and loud years of Lula,” says Paulo Sotero at the Woodrow Wilson International Center for Scholars in Washington.

These qualities helped her weather a string of corruption cases last year that would have destroyed other presidents. Her most senior minister, chief of staff Antonio Palocci, was the first to fall in an ethics scandal. He was followed by her agriculture, transport, tourism, sport and labour ministers who were accused of corruption. All vigorously denied the allegations. But in each case Ms Rousseff eventually dismissed the office holder, delighting a public used to seeing its politicians ride out such charges.

. . .

Perhaps for this reason, the scandals seems to have helped rather than hindered her presidency. Her personal approval rating as president was 72 per cent at the end of last year and that of her government 56 per cent. “She is the right president at the right time,” says Christopher Garman, analyst at Eurasia Group, a political risk consultancy. He points to her appeal to a new middle class that wants politicians who focus more on public service delivery rather than infighting.

Sceptics warn, however, that Ms Rousseff will need to put an end to the corruption scandals this year, amid concerns that they are disruptive to a government whose legislative agenda is already crowded with slow-moving and contentious bills. These include the forestry code – an environmental law whose passage is crucial for the country’s agricultural industry, as well as significant pension, mining and oil royalty bills.

“Beyond cleaning up corruption, it is difficult to ascertain what the Rousseff government’s long-term strategy really is,” says João Augusto de Castro Neves, writing in The Brazilian Economy, a publication of the Getulio Vargas Foundation, a local academic institute. “The administration seems to have abandoned any impetus for major reforms and legislation overhaul.”

Perhaps the greatest challenge, though, will be to return the economy to higher levels of growth. During the third quarter, GDP contracted 0.04 per cent from the previous three months and grew only 2.1 per cent compared with a year earlier. For all of 2011, economists estimate growth at less than 3 per cent. The performance of important industries such as the automotive sector, which in 2010 overtook Germany as the world’s fourth biggest by unit sales, plunged in the third quarter. Others such as textiles and shoe manufacturing have been squeezed by soaring Chinese imports and the strength of the Brazilian real against the US dollar.

“When I go to trade shows in Paris, Milan or New York, people always ask me where I’m from,” says Geane Silva, manager of Cavage, a luxury shoe manufacturer in Novo Hamburgo in Rio Grande do Sul, the traditional heartland of Brazil’s shoe industry. “When I reply Brazil, they always saywow, the market must be great over there’, but I tell them they have completely the wrong idea about Brazil. I don’t know where this idea came from that everything is wonderful here. It’s not.”

Economists argue that the rapid deceleration has exposed the structural limitations of Brazil’s economy. The fast growth of 2010 was mostly the result of fiscal stimulation to counter the effects of the 2008 financial crisis but that was carried over into 2010, an election year.

Ms Rousseff withdrew the stimulus last year and the central bank began raising interest rates to tackle rising prices. But inflation still ended 2011 at 6.5 per cent and the economy lost steam. “The sudden reversal ... raises doubts about Brazil’s underlying sources of growth and its ability to sustain an expansion such as the one in 2010,” Alfredo Coutiño at Moody’s Analytics writes in a recent report.

. . .

The public has yet to feel the slowdown. Unemployment, at 5.2 per cent as of November, remains at record lows. The government is helping, with a 14 per cent rise in the minimum wage.

Most economists believe the slowdown is no more than cyclical, with the economy expected to grow about 3 per cent this year and slightly more in 2013. The question is whether the country can achieve higher growth rates than the 4 per cent or so it has averaged over the past decade, let alone regain the 2010 peak.

To do this, economists say Brazil has to make the “hard fixesneeded to improve its long-term competitiveness. Its tax system is notoriously burdensome and more spending is needed on education, training, research and development, and infrastructure. Investment, at about 19 per cent of gross domestic product, is well short of the country’s needs and of levels in China and India.

However, Marcos Troyjo, director of BricLab at Columbia University, argues that instead of focusing on international competitiveness, the Lula-Dilma administrations are quietly pursuing an updated version of the import substitution policies that former governments implemented between the 1950s and 1970s. The government is using a variety of measures to protect and encourage local production, including currency controls, higher taxes on imported goods (such as a 30 per cent tax increase on foreign-made cars last year) and stringent local content requirements, notably in the oil industry.

But this time the policy, which Mr Troyjo callsimport substitution industrialisation 2.0”, does not only benefit Brazilian companiesforeign ones that establish plants in Brazil are also eligible for the benefits. The project is being underwritten by the boom in the energy and agricultural sectors, particularly the promise of the country’s discovery of immense deepwater oil reserves that will come on stream in the next decade. Proponents of such policies point to the high volume of foreign direct investment pouring into Brazil last year – a record $60bn as of November, up 82 per cent on a year earlier – as evidence that external investors are buying into the policy.

“It is as if the promise of Brazil is going to be so huge, everything’s going to be so marvellous and wonderful, that all of the [investment] coming in will allow the government to not take the steps it has to in the short run,” says Mr Troyjo.

Ms Rousseff may not be a reformer but she has shown herself to be a pragmatist. Faced with difficulties overhauling state-run airports in time to host the soccer World Cup in 2014 and the Olympics two years later, she tendered the projects to the private sector. She is a long-time advocate of infrastructure investment and recognises the importance of controlling government spending.

But in a world in which the traditional US or European economic models are broken while Brazil is looking resilient, it will be hard for her government to push through painful reforms. Easier is to engage in hubris.

“We can overtake the large economies in the coming years, principally because Brazil continues to grow at an accelerated rate,” said Guido Mantega, finance minister, after a study last month estimated that the economy had surpassed the UK’s in size. He predicts an expansion of 5 per cent this year, well beyond most forecasts.

Márcio Gomes Pinto Garcia, associate professor of economics at the Pontifical Catholic University in Rio de Janeiro, offers a blunter prognosis: “I think we are still going to do well, although we will do much worse than we could be doing, unless we do the things we know we have to do.”

Amid pragmatic diplomacy, a steelier side emerges

An unusual map hangs on Antônio Patriota’s office in Brasília. On it, the southern hemisphere sits atop the subordinate northern nations – an illustration, says the foreign minister, of the country’s pragmaticco-operative multipolarity”, which gives equal weight to all nations, writes John Paul Rathbone.

Sceptics may scoff. Yet Brazil took this world view long before the era of President Dilma Rousseff, who came to office a year ago, or Luiz Inácio Lula da Silva, her predecessor. Henry Kissinger, US secretary of state, wrote in the late 1970s: “The interest of Brazil in world affairs – [strategic arms limitation talks], the opening to China, detente, the Middle East – is the interest of serious men ... for they think they have a world role to play.”

How serious a role is hotly debated. Certainly, Brazil’srainbow strategy has delivered dividends since developing economies began to outstrip the north following the 2008-09 financial crisis. It now has more embassies in Africa than does the UK. Commercial interests, led by domestic companies such as miner Vale, have rarely been far behind. At the same time, leadership of the UN peacekeeping force in Haiti has earned praise for a “peace and loveapproach that has, more controversially, also embraced Cuba and Iran.

While there is little sign these policies will change much under Ms Rousseff, there might be subtle variations. Brasília now feels less need to thumb its nose at the US. “We don’t want to waste time in futile engagement over issues of minor relevance. The value of the US relationship is clearer under President Rousseff,” says a senior diplomat. An early love affair with China has cooled following industry’s complaints about cheap imports. Significantly, Iranian president Mahmoud Ahmadi-Nejad will not visit Brazil on his regional tour this week, as he did in 2009.

Meanwhile, at home, a steelier side is emerging. Brasília has led the creation of regional alliancesnotably the union of South American nations, excluding the other regional power: Mexico.

Combined with pan-continental infrastructure projects, which will draw the rest of South America tighter into the country’s economic orbit, this has lead to calls, by some, of “yellow and green imperialism. Mr Kissinger also foresaw this 40 years ago, when he observed, that among its neighbours, Brazil’s size and sense of greatness could make it more feared than loved.

Additional reporting by Samantha Pearson

Copyright The Financial Times Limited 2012.

January 10, 2012

The Failure of Governance in a Hyperconnected World


Most of us are taught to think about the long-term consequences of our actions, but it is a life lesson that is easily forgotten — both on an individual and an organizational level. This is why, each year, the World Economic Forum poses the question, “What risks should the world’s leaders be addressing over the next 10 years?”

In response, the Global Risks 2012 report presents threerisk cases” that explore facets of a common theme: governance failure in a hyperconnected world.

The first risk case, “seeds of dystopia,” starts from concern that globalization is not delivering on its promises. Gallup polling shows that people everywhere perceive their living standards to be falling, and express decreasing levels of confidence that their governments know what to do about it.

Meanwhile, both the Internet and urbanization make disparities in wealth more transparent. Disparities can spur achievement when social mobility is perceived to be possible. However, when ambitious young people feel that however hard they work their prospects are constrained, feelings of disengagement and discontent take root.

Social contracts are breaking down in advanced economies, as shrinking workforces have to support growing populations of elderly while their own entitlements are being cut. In emerging economies, sluggish global growth risks disappointing the expectation that a rising tide will lift all boats; in the poorest countries, bulging youth populations lack the skills to succeed or the rights to migrate.

This is a combustible combination, as suggested by the outbreak of social unrest over the last year from Greece, Chile and China to the Arab Spring to the Occupy movement. Without bold and imaginative leadership, growing popular disillusionment could undermine the nascent global cooperation mechanisms that are our best hope of addressing its root causes.

The second risk case focuses on “how safe are our safeguards” — the policies, norms, regulations or institutions through which we manage the complex systems on which global prosperity depends. Experts in many domains, from climate to finance to emerging technologies, worry that governance is lagging behind accelerating complexity.

In relying on 20th-century institutions to respond to 21st-century systems, the danger is that safeguards fail to balance an activity’s risks with its potential benefits.

Safeguards that are too lax may have the same ultimate effect of curtailing an activity’s benefits as safeguards that are too cautious. This dynamic played out in the aftermath of the March 2011 Japan tsunami: lax safeguards at the Fukushima power plant led to a meltdown that ignited global popular concern about nuclear safety; the German government responded by decommissioning its own nuclear plants.

A mindset change is needed in how we define safeguards. We need mechanisms that are nimble and flexible, involve and give incentives to stakeholders, and use insights from complexity theory to anticipate emerging threats to systemic resilience.

The final risk case addresses the global system on which so many others now depend: the Internet. Connectivity has transformed the ways in which we conduct business and personal relationships. Almost a third of the global population is online and the connectedness of “things” — from hospital beds to domestic electricity meters — is growing even more rapidly.

But we understand the benefits more fully than the risks. The “dark side” of connectivity considers the potential of terrorism, crime and war in the virtual world to become as deadly and disruptive as their equivalents in the physical world. Stuxnet, the cyber weapon that targeted Iran’s nuclear program in 2011, suggests what may be possible. The same kind of automated systems it attacked are used to control everything from nuclear reactors and gas pipelines, to chemical treatment of tap water and prison door locks.

There is little reliable empirical evidence about cyber threats. Victims have an incentive to keep it quiet, while vendors of security solutions have an incentive to talk it up. Nonetheless, the Global Risks 2012 report has a 10-year time horizon. Ten years ago, the dotcom bubble had just burst and there was a sense that the hype about the Internet’s transformational benefits had been overblown. With hindsight, we can see that the hype was merely premature.

None of the challenges highlighted in these three risk cases is insurmountable. But difficulties will inevitably arise when traditional solutions are misapplied to novel problems.

Today’s rising economic anxiety, for example, is not merely a cyclical problem demanding the usual cyclical fixes, as some experts make it seem. Our economic problems are structural and require a different sort of solution.

The aim of the Global Risks report, therefore, is not to raise anxiety levels even higher, but to start the necessary conversation about how stakeholders can work together to invent the solutions needed to address these new constellations of risks.

Lee Howell is managing director in charge of Global Risks 2012 at the World Economic Forum.

Everything You Wanted to Know About Gold

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Tuesday, January 10th, 2012


Hyperinflation Comes To Iran

Submitted by Tyler Durden

on 01/10/2012 12:58 -0500

Hyperinflation has struck again, this time at ground zero of the most sensitive geopolitical conflict in ages: Iran. EA WorldView reports:

An EA source reports that a relative in Tehran ordered a washing machine for 400,000 Toman (about $240) this week. When he went to the shop the next day, he was told that --- amidst the currency crisis and rising import costs --- the price was now 800,000 Toman (about $480). Another EA source says that the price of an item of software for a laptop computer has tripled from 50,000 Toman to 150,000 Toman within days.
And so the opportunity cost for the Ahmedinejad regime to preserve its status quo gradually grinds to zero, as the entire economy implodes (courtesy of a few strategic financially isolating decisions) making further escalation virtually inevitable, in a 100% replica of the US-planned Japanese escalation that led to the Pearl Harbor attack, and gave America the green light to enter the war.

Summary of McCollum's 1940 memo.

h/t L0gg0l