Time for a theory of eurozone relativity

Stephen King

February 20, 2012

Ptolemy’s theory of the universe held that the earth was at its centre. All other celestial objectsincluding the sun rotated around it. It was, of course, nonsense. Copernicus later came along with his far-superior heliocentric system. Luckily, he died before anyone could be offended by his theory.

Galileo, a supporter of Copernicanism, was not so fortunate, ending up under house arrest under suspicion of heresy.

The eurozone is in danger of shifting towards a Ptolemaic system with Germany at its centre. But, like Ptolemy’s theory, a German-centric eurozone may wilt under close scrutiny. It requires economic adjustment by others to protect the interests of German taxpayers and voters. That, however, makes the system as a whole increasingly unstable.

Consider, for example, the need for improvements in competitiveness in the so-called peripheral nations. What does this actually mean? Presumably, the likes of Italy and Spain would have to have inflation rates – both of prices and of wagessignificantly lower than the eurozone average. That, in turn, would require countries such as Germany to accept inflation rates well above the average.

In a Ptolemaic system, however, the good men and women of Berlin, Bremen and Bonn might simply dig their heels in, refusing to tolerate what they could regard as an unacceptable loss of price stability in Germany. The competitive adjustment within the eurozone would then either fail, or come about only after further painful austerity measures deliver excessively low inflation rates across the whole eurozone.

The Ptolemaic version of the eurozone also requires lopsided adjustment of so-called imbalances. It is more important, apparently, that the southern European nations reduce their current account deficits than that the northern European nations reduce their surpluses.

Perhaps the idea is that the eurozone as a whole should run a bigger surplus with the rest of the world (in which case, the terms under which the rest of the world runs a bigger deficit with the eurozone have yet to be enunciated). If, however, the adjustment in the eurozone is to take place via shifts in competitiveness, it follows not only that the real exchange rates of southern Europe should decline but, also, that the real exchange rates of northern Europe should rise. We are back to the need for different inflation rates in the north and south.

The Ptolemaic system also requires a skewed view of bond markets. High yields in the periphery and low yields in Germany and other core nations are two sides of the same coin. A flight to “quality” has both punished the periphery and rewarded the core. This is as much a reflection of concerns about the euro’s survival as it is an indication of excess borrowing in individual nations. Yet those who benefit from the euro’s systemic weaknesses Germany, with its remarkably low borrowing costs is surely a prime examplechoose instead to talk only about the potential costs associated with bailing out others.

The Ptolemaic system needs to be replaced. This is not an issue concerning Greece alone, even if investors remain focused on the minutiae of austerity, bail-outs and debt haircuts. It is, instead, about the need for adjustment by those who appear to be in strong financial position.

Germany can play its part, encouraging domestic demand to grow more quickly, allowing its real exchange rate to rise with a more tolerant approach to inflation, ensuring that its current account surplus is invested not in potentially-worthless chunks of peripheral debt but, instead, in factories in southern Europe and welcoming migrants from southern Europe as they try to escape from unemployment.

In other words, we need to drop Ptolemy and come up with a theory of eurozone relativity.

The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. He is a member of the Financial Times Economists’ Forum

February 19, 2012 7:37 pm

Greece must default if it wants democracy

When Wolfgang Schäuble proposed that Greece should postpone its elections as a condition for further help, I knew that the game would soon be up. We are at the point where success is no longer compatible with democracy. The German finance minister wants to prevent a “wrong democratic choice. Similar to this is the suggestion to let the elections go ahead, but to have a grand coalition irrespective of the outcome. The eurozone wants to impose its choice of government on Greece – the eurozone’s first colony.

I understand Mr Schäuble’s dilemma. He has a fiduciary duty to his parliament and is being asked to sign off on a programme that he doubts will work. 

Releasing the funds before an election is risky. What is to stop a new Greek government and a new parliament from unilaterally changing the agreement?


Greece has a poor record of implementing policies it has agreed to. The mistrust is understandable. But to overcome this, the eurozone is seeking assurances that are unbelievably extreme.


The provocation of Greece has been escalating for some time. The first was the incendiary proposal, contained in a policy paper, to impose a fiscal Kommissar on Athens, with the power to veto economic policy decisions. After that was rejected, officials proposed using an escrow account, which would ensure that the eurozone can withhold funds to Greece at any time without triggering a default. But clearly the most extreme proposal is to suspend the elections and keep the technical government of Lucas Papademos in place for much longer.

It is one thing for creditors to interfere in the management of a recipient country’s policies. It is another to tell them to suspend elections or to put in policies that insulate the government from the outcome of democratic processes.

These demands fail Immanuel Kant’scategorical imperative” – Germany does not will them to be universally adopted. Nor could they be adopted in Germany – they would be unconstitutional. Only recently the German constitutional court ruled that parliament’s sovereignty was absolute, that parliament must not permanently transfer sovereignty to outside institutions and that one parliament must never constrain the freedoms of its successor. The proposals violate the principles of Germany’s own constitution. In short, they are unethical.

A senior German official has told me that his preference is to force Greece into an immediate default. I can therefore only make sense of Mr Schäuble’s proposal to postpone elections as a targeted provocation intended to ellicit an extreme reaction from Athens. If that was the goal, it seems to be working. Karolos Papoulias, the Greek president, fired back at Mr Schäuble’sinsults. Evangelos Venizelos, finance minister, said certain elements wanted to push Greece out of the eurozone.

Conspiracy theories abound. Hardly a day passes by without a cartoon in the Greek press of Angela Merkel and Mr Schäuble in Nazi uniforms. German MPs expressed outrage at the Greek outrage.

Bild, the German mass-market daily, is calling for Greece to be “kicked out” of the eurozone. I shudder at the thought of an act of violence committed against Germans in Greece or Greeks in Germany. This is the kind of conflict that could easily escalate.

The situation highlights the political vulnerability of the current eurozone rescue strategy. Let us set economic arguments aside for once, and consider the politics. Anybody calling for an increase in the rescue package should remember that solidarity between governments is close to being exhausted.

This has happened even before a single cent has crossed a border. It is also the strongest argument for a fiscal union. If you want to shift hundreds of billions of euros around, you simply cannot do this on an inter-government basis, where Germany, the Netherlands and Finland pay for Greece, Portugal and Ireland. For that, you need a federal system. You need it not for reasons of economic efficiency but to prevent a Germany-versus-Greece type conflict. If a fiscal union turns out to be politically unacceptable then we simply have to admit that a transfer insurance system cannot and will not happen.

The reason the current system is breaking down is the loss of mutual trust. It narrows the political options of crisis resolution. Mistrust is the reason why the Greek rescue package has been delayed until the latest possible moment, and why the latest proposals contain so many poison pills: implementation deadlines, the escrow account, and a permanent representation of creditors and the International Monetary Fund. Soon there will be yet more austerity. At some point, somebody will snap.

The German strategy seems to be to make life so unbearable that the Greeks themselves will want to leave the eurozone. Ms Merkel certainly does not want to be caught with a smoking gun in her hand. It is a strategy of assisted suicide, and one that is extremely dangerous and irresponsible.

Copyright The Financial Times Limited 2012

February 19, 2012 11:28 am

China and Japan unite on IMF resources

In a rare display of unity, China and Japan have expressed conditional support for an expansion of the International Monetary Fund’s resources to help address Europe’s sovereign debt crisis.

In a meeting in Beijing on Sunday, Wang Qishan, Chinese vice-premier, and Jun Azumi, Japanese finance minister, said they were prepared to support the IMF’simportant role” in combating turmoil in the eurozone.


However, they warned that the eurozone would need to lift the €500bn cap for its bail-out funds if it hoped to persuade non-European Group of 20 nations to increase their funding of the IMF.

Christine Lagarde, IMF managing director, has been pushing for an extra $500bn in funding to contain the eurozone crisis and to protect economies around the world from spillover effects. Eurozone countries have so far committed $200bn, while the US has said it will not contribute additional funds.

The resulting gap is “a very large number”, said a senior Japanese official. Japan and China both believe that it will be exceedingly difficult to fill that gap unless the cap on the European Stability Mechanism is removed.”

The ESM is expected to debut in July as the permanent successor to the temporary, €440bn European Financial Stability Facility.

Eurozone finance ministers meet on Monday to discuss a new debt relief package for Greece.
The bilateral consultation on the issue is part of a broader effort at closer co-ordination of international financial policies between Tokyo and Beijing. “We agreed that Japan and China will co-operate so as to be able to common action in response to an IMF request,” said Mr Azumi on Sunday.

The two sides agreed on regular follow-up consultations through the vice-governors of their central banks and vice-ministers of finance.

Japan co-ordinates closely with the US when it comes to the IMF, so we find it very strange that China and Japan, the two largest holders of foreign exchange reserves, would not do that, especially now that there are so many global crises these days,” said the senior Japanese official.

Mr Azumi said he and Mr Wang agreed that European countries should strengthen their own firewall” against the debt crisis.

China and Japan also agreed to work more closely to promote the use of yen and the renminbi in cross-border trade, and to support a potential doubling of the $120bn funds available to an Asian crisis prevention mechanism known as the Chiang Mai initiative.

Japan and China, including Hong Kong, are the two biggest contributors to the CMI, a pan-Asian network of bilateral currency swap agreements that grew out of the regional crisis of the late 1990s.

In a further show of co-operation, Japan has applied to invest in Chinese government bonds – a market off-limits until now.

Copyright The Financial Times Limited 2012.

Don't Be Fooled By The 'Breakout' In Stocks

by: The Financial Lexicon

February 19, 2012

Over the years, whether in casual conversations or in the media, I've noticed that when someone references "the market," he or she is almost always referring to the Dow Jones Industrial Average (DIA). This index, which represents just 30 stocks (well-established, well-recognized companies), seems to be the representation of the stock market in the minds of many Americans and appears to have an impact on the psyche of many retail investors unlike any other equity index in existence.

In recent days, the Dow broke above its 2011 high of 12,876 on an intraday basis as well as its 2011 closing high of 12,810.54. This received a good deal of attention, especially from business television stations. So how should investors view this breakout above last year's highs?

While it is impressive that the Dow has managed to recover so strongly from last October's lows, what about the other broader indices? Are they following suit into breakout territory? In fact, there are several big ones that are not, at least not yet.

The Dow Jones U.S. Total Stock Market Index (full cap) is a broad market index that has the objective of representing all equities with readily available prices from companies based in the United States. This index reached its 2011 high on May 2 at 14,501.56. It is currently trading at 14,331.21, 1.17% below last year's high. The NYSE Composite Index, designed to track all common stocks listed on the New York Stock Exchange (including ADRs and REITs), reached its 2011 high of 8,718.25 on May 2, 2011.
It is currently trading at 8,114.51, a rather large 6.93% below last year's high. And, of course, we can't forget about the extremely popular S&P 500 (SPY). Although it is not as broad as the two indices just mentioned, it still remains a much broader representation of equities than the Dow Jones Industrial Average.

The S&P 500 also reached its 2011 high of 1,370.58 on May 2. At the moment, it is at 1,361.23, still 0.68% below last year's high.

I recognize that the Dow Jones U.S. Total Stock Market Index and S&P 500 are within a stone's throw of their 2011 highs. However, given the popularity of the Dow Jones Industrial Average among the investing public as a representation of all things stocks, I think it is important to point out that, in fact, it is not the most accurate representation of the underlying strength of publicly traded equities as a whole. The NYSE Composite, S&P 500, and the DJ U.S. Total Stock Market index help to confirm this.
Furthermore, given the incredible popularity in recent years of diversifying into international equities, it is useful to look at broad-based indices holding international equities if we are to achieve a more realistic picture of how a diversified equities portfolio might be performing and whether it too is breaking out above last year's highs.

For those investors wanting to look at broad indices with large international exposure, the MSCI EAFE Index, often traded through the popular exchange-traded fund EFA, is significantly below its May 2, 2011 high. The EFA touched $64.35 on that day and is currently trading at $54.52, a massive 15.28% below last year's high. This index represents so-called developed markets outside of North America. EAFE stands for Europe, Australasia and the Far East. As of February 16, 2012, EFA had 929 holdings, including ones from the United Kingdom, Japan, France, Germany, and Australia.

Another international index, the MSCI Emerging Markets Index, often traded through the popular exchange-traded fund EEM, is also well below its 2011 high. On May 2 of last year, EEM reached $50.43.
Today, it stands at $43.93, a significant 12.89% below last year's high. The popular ETF representing this index has 840 holdings as of February 14, and includes exposure to China, Brazil, India, South Korea, and Taiwan.

If the Dow Jones Industrial Average is to be taken as a solid gauge for an equity market breakout and/or as a gauge of strength for the U.S. economy as a whole, many investors would expect to see some confirmation from small cap stocks, the transports, and semiconductor stocks. In fact, the Russell 2000 (IWM) is trading 4.59% below its 2011 high. The Dow Jones Transportation Average is 7.35% below its high of last year, and the Philadelphia Semiconductor Index is 8.94% below its February 18, 2011 high.

In the interest of fairness, the NASDAQ Composite Index has also broken out above last year's high. At the moment, the NASDAQ Composite is at 2,951.78, 2.22% above last year's high of 2,887.75. When trying to discover why such a broad-based index has been able to break out when other broad-based indices have not, we can look at the NASDAQ 100 (QQQ), which represents 100 of the largest non-financial securities, based on market cap, listed on the NASDAQ Stock Market. The NASDAQ 100 has broken out far higher above its 2011 high than the NASDAQ Composite Index has (5.98% versus 2.22%). A large reason for this is due to the massive weighting and importance of Apple (AAPL).

Apple, which has a 16.41% weighting in the NASDAQ 100, is trading 17.68% above last year's high. While Apple is not the only reason the NASDAQ is performing so strongly, it has a major influence in determining both the direction and magnitude of moves in the index. I don't want to dismiss the importance of the NASDAQ Composite Index joining the Dow Jones Industrial Average in breaking out above their 2011 highs. However, I do want to highlight that when investors dig down into the holdings of the NASDAQ Composite in order to determine the breadth of the breakout among individual holdings and compare this to the total number of publicly traded companies across various market indices, they might not be as impressed as they imagined they would be.

In closing, don't be fooled by an index that represents just 30 stocks. For now, things are going well in the equity market, but not as well as the Dow would imply. When trying to determine the importance of a breakout in the Dow Jones Industrial Average or the NASDAQ Composite as it pertains to equities as a whole, don't forget to look at other broad-based indices as well.

February 18, 2012

China Cuts Bank Reserve Ratio to Spur Growth


BEIJING (AP) — China's central bank will lower the ratio of funds that banks must hold as reserves in a move that frees tens of billions of dollars for lending and aims to help spur slowing economic growth.

The reserve requirement ratio for major commercial banks will be decreased Friday to 20.5 percent from 21 percent, the People's Bank of China said Saturday in a one-sentence notice on its website.

The cut frees money for lending at a time when the growth rate is expected to drop from last quarter's 8.9 percent to closer to 8 percent.

The cut is the second in two months. The bank had pushed the rate to a record 21.5 percent in June after consumer prices rose by a three-year high of 5.5 percent the previous month.

Consumer prices rose by an unexpectedly strong 4.5 percent over a year earlier, up from December's 4.1 percent. Food prices shot up 10.5 percent, accelerating from the previous month's 9.1 percent.

The spike in inflation could complicate efforts by Chinese leaders to gradually ease controls to boost growth and create jobs. Regulators are moving cautiously, however, avoiding interest rate cuts and retaining lending controls imposed to cool an overheated housing market.

China rebounded quickly from the 2008 global crisis with a flood of stimulus spending and bank lending that ignited a speculative boom pushing up stock and housing prices. New policies are being put in place to help the working poor and exporters hit by a fall in global demand.