Can Europe Be Saved?

Alfred Gusenbauer


VIENNA – In 2011, Europe’s financial and banking crisis escalated into a sovereign-debt crisis. A problem that began in Greece ended up raising doubts about the very viability of the euro – and even of the European Union itself. A year later, those fundamental doubts remain undiminished.

But, if one compares the EU with the United States or Japan (where public debt equals 200% of GDP), the Union’s current poor image is unjustified. Indeed, employment in the EU as a whole remains high, as do private savings rates. Moreover, the Union’s trade is in balance with the rest of the world.

One reason for doubt about the euro and the EU is that, since the spring of 2010, Europe’s leaders have rushed from one crisis summit to the next, each time devising supposed solutions that provided too little and arrived too late. Europe’s leaders have never fully deployed their economic and political firepower. On the contrary, rather than taming the financial markets, as they once intended, Europe’s leaders continue to be besieged by them.

It should come as no surprise that, with national governments’ parochialism impeding joint EU action, financial markets are using what the communists used to callsalami tactics” to slice away at the Union by attacking its member countries one by one. Indeed, the European Parliament and the European Commission have been sidelined, while a new management model for Europe has emerged: Germany makes the decisions, France gives the press conferences, and the rest nod in agreement (except the British, who have chosen isolationism once again).

This management structure is neither democratically legitimate nor justified by its performance (which appears to consist of mere reactions to pressure from financial markets). Indeed, some estimate that, by 2050, Europe will produce only 10% of the world’s GDP, and will comprise just 7% of its population. By then, not even Germany’s economy will be significant in global terms, to say nothing of the other European economies.

As early as 2012, when the world economy is expected to grow by only 2.5%, the battle for shares of the global pie will become fiercer. Europe is fighting for its economic survival, but it does not seem to know it.

So, do we Europeans intend to remain relevant in the twenty-first century, which means strengthening our position? Or are we prepared to undergo a painful decline brought on by nationalist infighting and complacency?

I advocate a strong Europe that embraces the challenges of a relentlessly changing world. We need a new contract among European nations, generations, and social classes, which implies difficult choices. We must bid farewell to national egoisms, vested interests, dirty tricks, and assumed certainties. If Europe wants things to remain as they are, things will have to change dramatically.

First, the EU must become a true democracy – with a directly elected president and a stronger parliament – if pan-European decisions are going to have full legitimacy. The fiscal pact to which EU members (except the United Kingdom and the Czech Republic) agreed in December 2011 cannot be left to bureaucrats and courts alone. The European people, the true sovereigns, must ultimately gain the right to make Europe’s policy choices via elections.

Second, we must close the income gap. The growing divide between rich and poor, stagnating real wages, and deep regional disparities in unemployment are both morally unacceptable and economically counterproductive. The EU’s increasing income inequality misallocates the purchasing power that its economy desperately needs for growth and employment.

Finally, the welfare state needs a serious overhaul. Today, the EU allocates a large part of its public spending to pensions and health care for the elderly, while education suffers from underfunding. A welfare state that focuses mainly on the elderly, and does not provide sufficient opportunities for younger generations, is not sustainable. Moreover, the inequities created by privilege, such as public-sector pension schemes and discretionary advantages for vested-interest groups, must be addressed.

In order to make these changes, higher taxation of wealth and capital income is inevitable. But, while these additional tax revenues would improve Europe’s public finances, they would not obviate the need to reform the welfare state. Indeed, at best, they could facilitate a socially responsible transition to more efficient forms of social protection.

It is also a mistake to believe that austerity measures – the prime focus of Europe’s leaders up to now – will consolidate public finances. Europe is on the brink of recession. Governments should therefore restrict spending cuts to those that will not cause the economy to contract. Likewise, they should increase only those taxes that, when raised, do not reduce consumption, investment, or job creation.

In addition, a “European Marshall Plan” that provides investment in infrastructure, renewable energy, and energy efficiency is needed. Such an initiative would not only foster growth, but would also lower current-account deficits (because expensive fossil-energy imports could be reduced). Public finances would be consolidated only by growth, not by austerity.

The European Central Bank must adapt to the fiscal pact’s new rules. National governments’ vulnerability to the financial markets and their exaggerated interest rates must be reduced. Only the ECB, by taking on the role of lender of last resort, can stop the eurozone’s capital outflow and restore confidence in Europe’s capacity to solve its own problems.

Europe is running out of time. The EU’s institutions must exercise their creativity to the fullestconventional thinking will not be enough to save the Union. Only when the EU has its head above water again can we embark on the difficult but necessary path of framing and adopting a new treaty for a new Europe.

Alfred Gusenbauer was Federal Chancellor of Austria in 2007-2008.

Copyright: Project Syndicate, 2012.

March 2, 2012 7:23 pm

Our era needs to rediscover economic statesmanship

Thomas Carlyle, the eminent Scottish essayist, wrote that the history of the world was but the biography of great men. This tells half the story: the eurozone crisis shows how financial markets can weigh down on deeply rooted political cultures. But individuals do make a difference.

Contrast our leaders with their 20th-century predecessors. Unlike Eisenhower or Reagan, a cerebral President Obama does not enjoy deep personal bonds with the principal actors in Europe. Helmut Kohl’s vision for a unified Germany within a united continent contrasts with the crablike approach followed by his one-time protégée Angela Merkel. The common denominator today is a lack of economic statesmanship.


The eurozone crisis is now three years upon us. To date, the international response has been faltering and piecemeal. There are imperfect historical parallels between the present economic crisis in Athens and an earlier Greek crisis in the winter of 1947, which similarly threatened to produce a domino effect across Europe. The two eras are of course different. Still, the Marshall plan required a great deal of political courage. Truman, Acheson and Marshall had to pull out every stop to secure congressional approval for the newly expansive foreign policy which – in notable contrast to today – was secured on bipartisan lines.

That earlier European crisis forms the backdrop to Acheson’s memoir, Present at the Creation, which vividly describes the creation of a postwar order in which the US assumed world leadership. Arguably, the stakes in the eurozone crisis are just as high. A break-up of the single currency at this point would be overwhelmingly against US interests. And officials in Brussels do speak of the stuff of history, the greatest phase of institution building since Monnet, Schuman, Spaak and de Gaspari. But the lack of crisis management and statesmanship on either side of the Atlantic prompts a different view for these times: Absent at the Creation.

There are several reasons why the US has today employed a more cautious response to Europe’s debt crisis. The US was the epicentre of the financial crisis, so its initial response involvedcontainment at home”. Indeed, it remains constrained by its own fiscal and political shortcomings. By the time of the second phase, US soft power had eroded. To echo Ms Merkel, those responsible for the crisis should not lecture those caught up in the consequences.

Yet none of the above fully explains why America has failed to exercise the leadership that it applied not just in the winter of 1947 but in 1997-98 during the Asian and Russian financial crises. Part of the answer lies in the Obama administration’s strategic pivot toward Asia. Yet, contrary to the European imagination, US politicians are quite capable of walking and chewing gum at the same time. This is not necessarily a zero-sum game.

More likely, the White House has made a conscious decision to exercise restraint because the eurozone’s problems involve questions that only the Europeans themselves can answer. These questions concern democracy, governance and sovereignty, which go to the heart of national identity and political culture. In Mexico’s tequila crisis, for example, the US was drawn into crisis management because its own currency was at stake. This time it is a euro-denominated crisis rather than a dollar-denominated crisis.

Similarly, resistance in Europe to US overtures or admonishments derives from the belief that the future of the euro is ultimately a matter for Europeans to resolve. But how much confidence should we have that the Europeans will vindicate their own judgment?

Barely a few weeks ago many commentators had written off the euro. Mario Draghi’s bold decision to provide cheap credit to Europe’s banks has bought a breathing space, perhaps more. But excessive pre-Christmas pessimism has given way to excessive post-Christmas optimism.

Politics – rather than markets – will probably dominate in the coming months. The place to watch is not just Ireland, which this week announced a referendum on the German-ordained fiscal compact, but France. The present frontrunner in the presidential election, Socialist François Hollande, who appears to be widening his lead in the polls over President Nicolas Sarkozy, has promised to renegotiate the treaty.

The big question, then, is whether the politics can catch up with the economics. Germany does have a plan for a political Europe to balance a more integrated eurozone. The fiscal compact may be part of a bigger game-plan to launch eurobonds, which some see as the logical answer to the crisis. But as has been remarked, there are three Germanys in Europe: the chancellor, the Bundesbank and the constitutional court. The push-me, pull-you between these three power centres is one reason why Ms Merkel is constrained.

And as the latest spat over the ECB’s easy credit policy amply demonstrates, there is considerable resistance within the Bundesbank for measures that many believe were essential to rescue the euro. There may be concerns about long-term inflationary effects, but, right now, the matter has become existential – just as it was in Greece in 1947.

America has so far refrained from intervention. But if, as I suspect, we are entering a new phase of the euro crisis, where politics becomes paramount, there may be a case for greater American engagement and, yes, economic statesmanship. If not to save the Europeans from themselves, then to save the rest of the world from the consequences of an uncontrolled eurozone break up.

The article is based on this year’s Montague Burton lecture in Edinburgh. The writer is the editor of the Financial Times

Copyright The Financial Times Limited 2012

ECB liquidity is not a free lunch

March 4, 2012 12:20 pm

 by Gavyn Davies

The initials LTRO, barely ever discussed prior to last December, now form the most revered acronym in the financial markets. Before the first of the ECB’s two Longer Term Refinancing Operations in December, global equity markets lived in fear of widespread bankruptcies in the eurozone financial sector. Since LTRO I was completed on December 21, equities have not only become far less volatile, but have also risen by 11 per cent.

With LTRO II completed last week, over €1tn of liquidity has been injected into the eurozone’s financial system. Private banks were permitted to bid for any amount of liquidity they wanted, the collateral required was defined in the most liberal possible way, and the loans will not fall due for three years. Any bank that might need funds before 2015 should have participated to the hilt, thus eliminating bankruptcy risk for a long time  to come.

What can there possibly be not to like about this? A few things. Some observers point to the danger of a zombie banking system, kept alive artificially as a wing of the central bank. And, in a much-publicisedprivate letter to Mario Draghi in February, Jens Weidmann, Bundesbank president, expressed concerns that the latest two LTROs will expose the ECB to potential losses which will undermine its capital base.

Of course, this can only happen in dire circumstances, under which banks borrowing from the ECB or the national central banks go bust, and the collateral held by central banks proves insufficient to cover the associated debts. Even in the case of Greece, this has not yet happened, because the ECB has been fully protected from losses on Greek government bonds up to now. But it is fairly easy to imagine that it could happen, especially if there were a generalised collapse in the euro, involving sovereign defaults in several of the indebted economies at the same time.

It is now widely recognised that a central bank cannot become insolvent in the same way that a private company can. Even if it incurs losses on its assets which more than completely eliminate its equity, it can never find itself in a position where it is unable to settle its debts, at least in its own domestic currency. Most of the liabilities of a central bank come in one of two forms: banknotes, and commercial banks’ deposits at the central bank. It is impossible for the private sector to force the central bank to exchange these assets for any other asset (like gold, for instance), and in any event the central bank can create more of each of them at will. Hence it can never become illiquid.

Admittedly, a central bank can encounter a negative equity (ie insolvent) position by taking write-downs on its assets, and it cannot eliminate this simply by creating central bank money. This is because printing money increases its liabilities as well as its assets, thus leaving net capital unchanged.

But over time it would expect the interest earned on its assets (eg government bonds) to be much higher than that paid on its liabilities (eg banknotes), so an increase in the size of the balance sheet would normally be expected to generate extra profits for the central bank. It could take some time, but these profits, which are called seigniorage, will in the long run compensate for any losses made by the ECB on its LTROs.

So why worry? One reason is that the ECB’s future seigniorage revenue should be seen as an asset of the governments of the member states. Therefore if it is used up in LTRO losses, the long-term income of the member states from the ECB will be reduced, and in effect their net government debt will be increased.

Seigniorage revenue is an asset of the governments, like future tax revenues. A decision to put the future seigniorage revenue at risk is in fact exactly equivalent to putting at risk future tax revenues by making inter-government loans which might incur subsequent defaults. Jens Weidmann is correct to point this out, though Mrs Merkel seems to be much more favourably disposed to these heavily disguised, quasi fiscal transfers than he is.

The second reason to be concerned is the potential risk to inflation. There is a long run safety limit to seigniorage, which is determined by the amount of central bank money which the private sector will be willing to hold if inflation remains at its 2 per cent target. Recent estimates by Willem Buiter at Citigroup and Huw Pill at Goldman Sachs both suggest that the net present value of this asset is over €2tn, many times bigger than the official capital reserves of the ECB of only €80bn.

These calculations have led many economists to conclude that the ECB could lose more than E2tn on its LTRO and other lending operations before it risks creating inflation through excessive creation of central bank money. Since this would imply a much greater loss than anything that appears likely at present, the LTRO operations have been widely deemed to be “non inflationary”.

This conclusion is not axiomatically true. If the central bank brings forward its future seigniorage revenue by creating a lot of money now, it seems clear that it could cause inflation to rise in the short term while still remaining well within its long-term E2tn limit for central bank money creation. This is analogous to a situation in which the government creates inflation by running a large budget deficit in the short term, while remaining solvent in the long term.

I am not saying that the ECB has already done this. It has not. But I am saying that it must be careful not to do this in the future. The LTROs were the right thing to do in the difficult circumstances of the time, but they are not a free lunch.


Updated March 4, 2012, 8:49 p.m. ET

Lenders Stress Over Test Results


Some very large banks are clashing with the Federal Reserve over how much detail the central bank will reveal about them when it releases the results of its latest stress test.

The 19 biggest U.S. banks in January submitted reams of data in response to regulators' questions, outlining how they would perform in a severe downturn. Now, citing competitive concerns, bankers are pressing the Fed to limit its release of information—expected as early as next week—to what was published after the first test of big banks in 2009.
Bloomberg News
Fed's Daniel Tarullo says stress-test disclosures are critical for investors.

Three years ago, as the financial crisis was abating, the Fed published potential loan losses and how much capital each institution would need to raise to absorb them. This time around, the Fed has pledged to release a wider array of information, including annual revenue and net income under a so-called stress scenario in which the economy would contract and unemployment would rise sharply.

The Clearing House Association, a lobbying group owned by units of companies such as J.P. Morgan Chase & Co., Bank of America Corp. and Wells Fargo & Co., warned in a letter this month to the Fed that making the additional information public "could have unanticipated and potentially unwarranted and negative consequences to covered companies and U.S. financial markets."

Government officials aren't backing down from their plan to publish detailed projections of how the biggest lenders would fare in a steep economic downturn lasting two years. Regulators view full disclosure as critical to assuaging investor concerns about banks' capacity to withstand a market shock or economic setback.

"The disclosure of stress-test results allows investors and other counterparties to better understand the profiles of each institution," Fed Governor Daniel Tarullo, the central bank's lead official on supervisory matters, said in a speech last November.

The dispute is the latest flashpoint between big banks and their overseers. In the financial crisis, U.S. regulators forced banks to slash their dividends and curtail stock buybacks in exchange for billions of dollars in government aid. More recently, the sides have butted heads over the rollout of new rules tied to the Dodd-Frank financial-overhaul law, such as the so-called Volcker Rule that aims to limit bank risk taking.

Fed officials are assuring banks they won't release data that rivals could mine for clues to future acquisitions or other moves. In one concession, the Fed told banks it doesn't intend to break out projected losses on a quarterly basis.

The haggling between the government and the banks could escalate in the coming days. Before releasing the final results, the Fed is likely to provide banks with preliminary figures and an opportunity to raise concerns with the central bank. When the Fed gave banks a sneak peek at results in 2009, some institutions were able to persuade regulators to scale back by billions of dollars the sums they were ordered to raise.

The biggest U.S. lenders have been raising capital over the past year, and most institutions are expected to receive approval for dividend increases or share buybacks. Bankers believe those moves will boost their appeal with investors at a time when many financial stocks are trading below book value, a measure of net worth.

Even so, regulators are walking a fine line with the latest test. If banks look ill-equipped, markets could be spooked, adding to the stress on firms already struggling with the low interest rates, soft growth and new rules that led banking-industry revenue to fall last year for just the second time in 74 years. Shares of the biggest banks fell as much as 58% in 2011 amid questions about the industry's profit outlook and the impact of the European debt crisis.

If regulators are viewed as too pliant, the tests will fall short of their basic confidence-building purpose, possibly undermining a market recovery that pushed the Dow Jones Industrial Average above 13000 for the first time in four years and pushed the KBW index of commercial bank stocks up 16%. Similar tests administered by regulators in the European Union were denounced for giving passing grades to some lenders that later required taxpayer bailouts.

Soon after the Fed said last November that the results would be made public, the debate began about how much the Fed should disclose.

More than a dozen bank holding companies subject to the stress testsall with at least $50 billion in assetsmet with Federal Reserve staff in late December to discuss what the Fed might say, according to disclosures on the Fed's website. The meetings were at the Fed's invitation, and Fed staff said they were still considering the timing, scope and level of detail of the data they will publish, according to a summary of the meetings posted by the Fed.

Officials from Metlife Inc., Bank of America, J.P. Morgan Chase, Goldman Sachs Group Inc. and other financial institutions also discussed with Fed staff the implications, including competitive issues, of making the results public.

Bankers say it is unfair for the Fed to release more information than it did during the initial 2009 stress tests.

The reason: The Fed is still in the middle of writing a rule establishing what information it will make public in future stress tests, as required by the Dodd-Frank financial law passed in 2010.

Last year the Fed didn't make any aspect of its stress test public, leaving disclosure to institutions, many of which then released some results. Some bankers warn they may put out their own figures if they disagree with the Fed's calculations.

"They could just publish something that has nothing to do with reality," said one top executive at a major bank.

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