January 31, 2012 6:42 pm

Europe is stuck on life support

Economic decision-makers are more optimistic than two months ago. The main reason is the belief that the European Central Bank, under the shrewd leadership of Mario Draghi, has eliminated the risk of a financial implosion in the eurozone. As Mark Carney, the respected governor of the Bank of Canada and Mr Draghi’s successor at the Financial Stability Board, remarked at the World Economic Forum in Davos: “There is not going to be a Lehman-style event in Europe. That matters.”

Spreads on credit default swaps on Italian and Spanish banks have fallen since the introduction of the ECB’s three-year long-term refinancing operations in December. Spreads between yields on debt of some vulnerable sovereigns and German Bunds have also eased.


Does this mean the eurozone crisis is over? Absolutely not. The ECB has saved the eurozone from a heart attack. But its members face a long convalescence, made worse by the insistence that fiscal starvation is the right remedy for feeble patients.

Last week’s downgrading of its forecasts by the International Monetary Fund shows the dangers. The IMF now forecasts a recession in the eurozone this year, with a decline of 0.5 per cent in overall gross domestic product. GDP is forecast to fall sharply in Italy and Spain, and stagnate in France and Germany. This is a terrible environment for countries seeking to cut fiscal deficits. Forecasts are far from satisfactory for other high-income countries. But the eurozone is the most dangerous part of the world economy: only there do we see important governmentsItaly and Spainmenaced by a loss of creditworthiness.

Elsewhere, governments of high-income countries can continue to support their economies, largely because they possess a central bank and an adjustable exchange rate. This combination has given them the ability to run large fiscal deficits. In post-crisis conditions, such deficits are both the natural counterpart and the principal facilitator of necessary private sector deleveraging.

The eurozone has no such internal mechanisms. When private external financing dried up, as happened to a number of countries, affected members needed both financing – in the short run – and a mechanism for adjusting their external accounts – in the longer run – other than via deep slumps. The eurozone lacks both capacities. It has turned out, as a result, to have limited ability to cope with the global financial disease. As Donald Tsang, chief executive of Hong Kong, remarked in Davos: “I have never been as scared as I am now.” Astute observers have a sense that little stands between them and a wave of sovereign and banking defaults inside the eurozone, with ghastly global repercussions.

The ECB has reduced the risk of an immediate collapse of the banking sector. But the demand of informed outsiders is for stronger firewalls against the possibility that a collapse of, say, Greece, perhaps including its exit from the eurozone, would lead to a panic over prospects for far more important countries. Christine Lagarde, managing director of the International Monetary Fund, made that one of her three imperatives, along with stronger growth and deeper integration, in a courageous speech in Berlin last week.

What these outsiders want to see is a commitment that vulnerable eurozone countries will be given the time and the treatment they need to recover. Naturally, they also want to see a commitment of resources by the eurozone that makes clear the determination of its members to secure this outcome.

Only then would it make sense for an enhanced IMF to add its own contribution. Why indeed should a relatively poor country, such as China, be expected to contribute to rescuing a eurozone that has shown little will or ability to heal itself?

Alas, the problem is not just one of will. It is one of a lack of a correct diagnosis. This is a problem the ECB cannot correct. Germany, as creditor country, opposes a “transfer union” and insists that fiscal discipline is everything. It is right on the first point and wrong on the second.

A long-term transfer of resources to uncompetitive members would be a disaster, enfeebling recipients and bankrupting providers. But fiscal indiscipline is not all. Just as it was not the dominant cause of the collapse, but rather sloppy lending and improvident private borrowing, so fiscal discipline is not the cure. This attempt to vindicate the catastrophic austerity of Heinrich Brüning, German chancellor in 1930-1932, is horrifying.

The perspective embodied in the fiscal compact itself an attempt to revive the failed stability and growth pactlacks the necessary understanding of the dependence of output in one member country on demand in others, of the role of payments imbalances and of the fact that competitiveness is always relative. If Italy and Spain are to become more competitive within the eurozone then Germany or the Netherlands must become less so.

Moreover, if the private sector is running a structural financial surplus to lower its debt, policymakers can eliminate structural fiscal deficits if and only if the country runs a structural current account surplus. Germany should understand this because that is precisely what it is doing. Countries hit by financial crises almost always have large structural private sector financial surpluses. If these countries are indeed to eliminate structural fiscal deficits, they, too, must run structural current account surpluses, just like Germany. Yet every country cannot run such surpluses, unless the eurozone as a whole is to do so.

It is impossible for individual countries to heal without offsetting changes elsewhere. As Ms Lagarde said in Berlin: “Resorting to across-the-board, across-the-continent, budgetary cuts will only add to recessionary pressures.” Fiscal tightening must be selective. More important, the indication that the adjustment process is workingso making unnecessary the long-term fiscal transfers Germany rightly detests – would be buoyant demand in the core of the eurozone, with inflation well above the eurozone average – a mirror image of what happened before the crisis.

The strongest note of optimism on the eurozone I heard in Davos rested on the dire results of a break-up. Yet desperate people do desperate deeds. Members now need the time and the opportunity to adjust. Strong firewalls should give the time, but only shifts in competitiveness will give the opportunity. Without both, the crisis will surely return.

Copyright The Financial Times Limited 2012

The Chancellor Who Played with Fire

Joschka Fischer


BERLIN – German Chancellor Angela Merkel should be happy nowadays: her party’s approval ratings aren’t bad, and her own are very good. She no longer has serious rivals within the center-right Christian Democratic Union (CDU), while the left opposition is fragmented into four parties. Her response to the European crisis has prevailed – or at least that is the impression that she conveys, and that most Germans believe. So everything is fine and dandy, right?

Not so fast. Two issues could complicate Merkel’s re-election bid in the autumn of 2013.

Domestically, her coalition partner, the liberal Free Democrats (FDP), is disintegrating. Even if the FDP survives the next election (which is by no means certain), the current coalition is unlikely to retain its parliamentary majority, leaving Merkel increasingly dependent on the Social Democrats (SPD). While this need not matter to her too much as long as she retains the chancellorship, in Sigmar Gabriel, the SPD’s leader, she faces – for the first timean opponent whom she would underestimate at her peril.

But the real danger to Merkel is external: the European crisis. If she is unlucky, the crisis will come to a head at the start of the German election year, and all previous calculations could be moot, because, despite Germans’ frustration with Europe, the electorate would punish severely those who allowed Europe to fail.

The European Union’s economy is sliding into a severe and, in all likelihood, long-lasting recession, largely self-inflicted. While Germany is still trying to banish the specter of hyperinflation with strict eurozone austerity measures, the EU crisis countries are facing a real threat of deflation, with potentially disastrous consequences. It is only a question of timeno longer very much time before economic destabilization gives rise to political instability.

Hungary, where democratic backsliding appears to be taking hold, provides a foretaste of a Europe in which the eurozone crisis and deflation persist. The mood in the Mediterranean EU members, as well as in Ireland, is heating up, owing not only to the tightening squeeze of austerity, but also – and perhaps more importantly – to the absence of policies that offer people hope for a better future. The explosive nature of current trends, which point to eventual re-nationalization of sovereignty from the bottom up, is greatly underestimated in Berlin.

The crisis has now reached Italy and is threatening to spread to France. With Mario Monti’s premiership, Italy has mobilized its best people, and neither Italy nor Europe will get a better government for the foreseeable future. If Monti’s administration is toppled either in parliament or in the streets – the EU’s fourth-largest economy could come crashing down. Monti is urgently calling for help. Where is it?

Developments in France (the second-largest eurozone economy) should also not be underestimated in this presidential election year. If a majority of the French come to believe that a course of action is being imposed on them from outside – and by Germany, no less! – they will respond with traditional Gallic stubbornness.

What is at stake is less the election’s outcome than the margin between President Nicolas Sarkozy and the far-right National Front leader, Marine Le Pen – and whether she overtakes him to qualify for the second-round run-off against the Socialist candidate. While she would be unlikely to win the presidency, she could reshape and realign the French right. For that reason, a Sarkozy debacle would drastically reduce his Socialist successor’s room for maneuver on European policy, fundamentally altering France’s position in Europe.

But, while the French election’s outcome will hinge to a crucial extent on European crisis politics, Germany’s government acts as if this were none of its concern. Instead, the main – almost exclusivetopic in Berlin is the upcoming election. And the central question is not, “What needs to be done now in the interest of Europe?” Rather, it is, “How much can people in Germany be expected to accept – in particular, how much honesty?”

No one will act in a way that jeopardizes their electoral prospects, at least while there are still alternatives. So it is conceivable that Germany is not at all interested in a serious effort to resolve Europe’s crisis, because that would mean taking big risks and investing a lot of money.

The CDU-FDP coalition prefers to sugarcoat the situation by convincing themselves of an Anglo-Saxon conspiracy, abetted by those in the European crisis countries unwilling to perform and reform and whose only purpose is to make the Germans pay. So far, Merkel’s coalition is like someone driving against traffic, dead certain that everyone else is going the wrong way.

Europe’s disintegration has already advanced much further than it might appear. Distrust and national egoism are spreading rapidly, devouring European solidarity and common purpose.

Institutionally, Europe has been on the right track since the last summit, but it threatens to disintegrate from the bottom up. To save the euro – which is essential, because the European project’s fate depends on the success of monetary unionEurope needs action now: in addition to indispensable austerity measures and structural reforms, there is no way to succeed without a viable economic program that will assure growth.

That won’t come cheap. If Merkel’s government believes that paying lip service to growth is enough, it is playing with fire: a euro collapse in which not only Germans would be badly burned.

Joschka Fischer, Germany’s foreign minister and vice-chancellor from 1998 to 2005, was a leader in the German Green Party for almost 20 years.

Getting Technical
Will Gold-Mining Stocks Finally Hit Paydirt?
The price of bullion is rising again after a correction. But can the mining sector glitter like the metal itself?

After five months of choppy declines and arguments by pundits that the so-called gold bubble has burst, the yellow metal just scored a technical breakout to the upside.

Action from gold's peak last September above $1923 per ounce through last months' low under $1524 was a correction in a long-term bull market. And with January's breakout, that bull market is ready to resume. Gold traded Monday at $1734.

The question I'll answer shortly is whether gold-mining stocks will join the metal in a rally.

But for a moment, let's look at the metal itself, who usually needs to perform well if gold miners have a reasonable chance of heading north. Using the SPDR Gold Trust (ticker: GLD) as a proxy, I wrote of a critical support level that needed to hold last month (see Getting Technical, "Gold's Last Stand," December 12, 2011). Twice, this exchange-traded fund dipped below the critical 154 level only to reverse course and start to climb higher (see Chart 1).

Chart 1


In technical analysis, a breakdown followed by immediate reversal is a powerful bullish signal.
Last week, the market confirmed this bullish change when it broke out to the upside from its five-month pattern, soon after Fed Chief Ben Bernanke reported that he would hold short-term interest rates near zero until late 2014. Midday Monday, it traded at 168.24. Chart watchers now expect the gold ETF to top 190. The equivalent in gold itself would be $2000 and that would indeed open a few eyes.

Gold-mining stocks have alas been a different story. Last year, I wrote that mining stocks, despite lagging the metal for several years, were not ready to play catch up to the commodity (see Getting Technical, "The Trend Is Gold Bullion's Friend," May 18, 2011).

Since then, the relationship has not changed much - with one small exception. Starting in December, the Market Vectors Junior Gold Miners ETF (GDXJ) started to move higher both in absolute price and relative to gold itself. In other words, junior miners -- which tend to be smaller, younger companies that are still in the exploration and discovery phase of developing gold mines -- have started to outperform (see Chart 2).

Chart 2


There are several reasons why technical analysts think junior miners look good. From momentum indicators to moving averages, the weight of technical evidence does seem to have tipped towards the bullish side. And with last week's Fed-induced rally in gold, the junior gold miner ETF also enjoyed volume support.

Real money flowed into the sector and that suggests demand is higher, too.

To be sure, the path to higher prices is not an easy one. Resistance from a giant trading range between roughly 30 and 40 is daunting (the ETF traded at 29.20 Monday). But the underlying mood has changed for the better.

The junior gold miners index itself is constructed from more than 80 stocks. Nearly two thirds are stocks traded in Canada, one fifth are traded in Australia and only about 7% are traded in the United States. Therefore, domestic investors might be better sticking to the ETF instead of trying to pick component stocks.

Keep in mind that by definition, these stocks have relatively low market capitalizations and the dollar volume of shares traded each day is much less than more large, liquid gold stocks such as Newmont Mining (NEM). Most component junior-mining stocks account for less than 3% of the weight of the junior miners ETF. Therefore, it would take a good deal of effort to assemble a portfolio representing a cross section of the index.

So, despite the naysayers, gold is starting to shine again. This time, it may be ready to take junior gold-miners with it on a ride higher.

Michael Kahn, mutual fund co-manager, author of three books on technical analysis, former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, also blogs at www.quicktakespro.com/blog.

Neville Chamberlain was Right

J. Bradford DeLong


BERKELEY – Neville Chamberlain is remembered today as the British prime minister who, as an avatar of appeasement of Nazi Germany in the late 1930’s, helped to usher Europe into World War II. But, earlier in that fateful decade, relatively soon after the start of the Great Depression, the British economy was rapidly returning to its previous level of output, thanks to Chancellor of the Exchequer Neville Chamberlain’s reliance on fiscal stimulus to restore the price level to its pre-depression trajectory.

Compare that approach to the expansion-through-austerity policy being pursued nowadays by British Prime Minister David Cameron’s government (with Chancellor of the Exchequer George Osborne leading the cheering squad). The country’s real GDP has flat-lined, and the odds are high that British real GDP is headed down again.

Indeed, in less than a year, if current forecasts are correct, Britain’s Cameron-Osborne Depression will not merely be the worst depression in Britain since the Great Depression, but probably the worst depression in Britain ever.

that is quite an accomplishment. As Phillip Inman of The Guardian recently put it: “The UK’s plan for recovery from the financial crisis was based on a full-throttle recovery in 2012....Consumer confidence, business investment, and general spending would converge to send the economy on a trajectory of above-average growth.”

It did not work: government ministershave done what the right-wing economists told them to do and moved out of the way – the theory being that public-sector spending and investment was ‘crowding out the private sector.” Instead, as Inman says, “Spain is showing the way with its austerity-driven recession. Where the weak tread, we [in Britain] look keen to follow...”

The failure of expansionary austerity in Britain should give all of its advocates around the world reason to reflect on and rethink their policy calculations. Britain is a highly open economy with a flexible exchange rate and some room for further monetary easing. There is no risk or default premium baked into British interest rates to indicate that fear of political-economic chaos down the road is discouraging investment.

There is an argumentnot necessarily true, but an argument nonetheless – that, while in office from 1997 to May 2010, the Labour governments of Tony Blair and Gordon Brown overshot long-term sustainable government spending as a share of GDP. Their actions stand in contrast to countries that reduced their debt-to-GDP levels in the 2000’s, and to the United States, where the problem was not excessive spending but insufficient taxation under the Bush administration.

Yet, if one takes this view seriously, Britain, with a ten-year nominal interest rate of less than 2.1% per year, should already be in a boom. If there was ever a place where expansionary austerity should work well – where private investment and exports should stand up as government purchases stood down, confirming its advocates’ view of the world – it is Britain today.

But Britain today is not that place. And if expansionary austerity is not working in Britain, how well can it possibly work in countries that are less open, that can’t use the exchange-rate channel to boost exports, and that lack the long-term confidence that investors and businesses have in Britain?

Nick Clegg, Britain’s deputy prime minister and the leader of Cameron’s coalition partner, the Liberal Democrats, should end this farce today. He ought to tell Queen Elizabeth II that his party has no confidence in Her Majesty’s government, and humbly suggest that she ask Labour Party leader Ed Miliband to form a new one.

To be sure, if Clegg did this, his political career would probably be finished, and his party’s electoral prospects would be damaged for a long time to come. But Clegg’s political career and his party’s fortunes will be shaky for a long time to come in any case, given the economic hardship that Britain is enduring (and will continue to endure). At least defection from the ill-advised Conservative-Liberal coalition now would benefit his country.

Policymakers elsewhere in the world take note: starving yourself is not the road to health, and pushing unemployment higher is not a formula for market confidence.

J. Bradford DeLong, a former assistant secretary of the US Treasury, is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research.

Copyright: Project Syndicate, 2012.

The Fed’s new transparency efforts risk undermining it

Lorenzo Bini Smaghi

January 31, 2012

Last week’s decision by the Federal Reserve to provide a quantitative definition of price stability and the publication of the 17 Federal Open Market Committee members’ expectations of the Fed funds rate over the next few years aims at improving transparency and accountability of the central bank. It also raises several questions.

The first relates to the time horizon over which the Fed is supposed to achieve price stability, namely the long-run. This differs from most other central banks in advanced economies, where price stability is targeted over a horizon of two to three years. The reason for focusing on the medium term is that inflation forecasts over a longer period are not very reliable. Price movements 10 years from now will depend on factors that cannot be foreseen today and in any case are hardly affected by today’s policy decisions.

Monetary policy produces its effects with lags of one to three years. This is the period over which the central bank should be held accountable. Focusing over this time horizon also helps market participants. For instance, it’s not too difficult to anticipate a monetary policy tightening if a central bank publishes forecasts that show inflation rising above the stated objective for the next two to three years.

But if the objective of price stability is defined over the longer term, communication becomes more complex. In particular, the link between the inflation forecasts and the policy decision is unclear. What should market participants derive from a published inflation forecast above the two per cent target in the long run (but not necessarily over the next two years)? Should they expect a tightening to take place? And when? The long run is not a “policy-relevanttime horizon and thus has little value for those attempting to understand the central bank’s next moves.

The second question relates to the fact that the interest rate expectations formulated by the FOMC members are all conditional on the state of the US economy. If conditions change over time, the members will revise their forecasts at the next meeting. But for the market to understand this process, and to be able to continiously update its views, it needs to have some idea of the forecasting model used by each of the members. Without this, the task of Fed-watchers will become much more complicated. The suspicion may arise that the interest rate forecasts are ultimately dictated by the members’ short- term policy preferences, rather by than their ability to predict prices over the long-term.

Finally, while the concept of a conditional interest rate forecast is understood by market participants, it may not be by the public and politicians. This could lead to misunderstandings and recriminations. How will people react if, after having taken a decision (for example, take up a mortgage for a new house) on the basis of the Fed’s published expectation of unchanged interest rates until 2014, they find out that interest rates might rise earlier because the conditions underlying the central bank’s forecast have changed. Won’t they, and their elected representatives, blame the Fed for having induced them to take decisions that turned out to be more costly than expected? How easy would it be for the Fed to explain that the earlier interest rate forecast was conditional on assumptions that did not materialise and that people should have taken the forecast with more caution?

To be effective, central bank communication needs to be well understood not only by sophisticated market participants but also by the public. As they are currently designed, the new tools might turn out to be too complex, and risk creating confusion, for both groups. This could be exploited by those, in particular in Congress, who are looking for new excuses to undermine the independence of the Fed. This risk should not be underestimated.

The writer is a former member of the executive board of the European Central Bank and currently visiting scholar at Harvard’s Weatherhead Centre for International Affairs