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Fed Policy and Inflation Risk.

31 March 2012
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Martin Feldstein
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CAMBRIDGE – During the past four years, the United States Federal Reserve has added enormous liquidity to the US commercial banking system, and thus to the American economy. Many observers worry that this liquidity will lead in the future to a rapid increase in the volume of bank credit, causing a brisk rise in the money supply – and of the subsequent rate of inflation.


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That risk is real, but it is not inevitable, because the relationship between the reserves held at the Fed and the subsequent stock of money and credit is no longer what it used to be. The explosion of reserves has not fueled inflation yet, and the large volume of reserves could in principle be reversed later. But reversing that liquidity may be politically difficult, as well as technically challenging. Anyone concerned about inflation has to focus on the volume of reserves being created by the Fed.


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Traditionally, the volume of bank deposits that constitute the broad money supply has increased in proportion to the amount of reserves that the commercial banks had available. Increases in the stock of money have generally led, over multiyear periods, to increases in the price level.


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Therefore, faster growth of reserves led to faster growth of the money supply – and on to a higher rate of inflation. The Fed in effect controlled – or sometimes failed to controlinflation by limiting the rate of growth of reserves.



The Fed began an aggressive policy of quantitative easing in the summer of 2008 at the height of the economic and financial crisis. The total volume of reserves had remained virtually unchanged during the previous decade, varying between $40 billion and $50 billion. It then doubled between August and September of 2008, and exploded to more than $800 billion a year later. By June of 2011, the volume of reserves stood at $1.6 trillion, and has since remained at that level.


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But this rise in reserves did not translate into rapid growth of deposits at commercial banks, because the Fed began in October 2008 to pay interest on those reserves. Commercial banks could place their excess funds in riskless deposits at the Fed, rather than lending them to private borrowers. As a result, the money supply has grown by only 25% since 2008, despite the 40-fold increase in reserves since that time.


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During the past year, the Fed has further increased the liquidity of the banking system – and of the American economy – by a strategy called Operation Twist, buying $400 billion of long-term securities in exchange for short-term Treasury bills. The banks that hold these Treasury bills can sell them at any time, using the proceeds to fund commercial lending.



The massive substitution of reserves for longer-term securities during the period of “quantitative easing,” and of Treasury bills for long-term securities in Operation Twist, has succeeded in reducing long-term interest rates. The combination of low interest rates at every maturity and the substitution of short-term securities for longer-term assets has also succeeded in raising share prices.


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But it is not clear that the lower interest rates and higher share prices have had any significant effect on real economic activity. Corporations have a great deal of liquidity, and do not depend on borrowing to invest more in plant and equipment. Housing construction has not revived, because house prices are falling. Consumers temporarily increased their spending in response to the increase in the stock market at the end of 2010, but that spending has recently been much more sluggish.


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The risk is that the commercial banks could always decide to start using those excess reserves, forgoing the low rate of interest paid on deposits by the Fed (only 0.25%) and lending those funds to firms and households. Those loans would add to deposits and cause the money supply to grow. They would also increase spending by the borrowers, adding directly to inflationary pressures.


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When the economy begins to recover and companies have the ability to raise prices, the commercial banks will want to increase their lending. This will be welcome, as long as it is not too much or too fast. The Fed will appropriately want to limit the expansion of bank lending. This is what the Fed used to talk about as its “exit strategy.” Essentially, it would mean raising interest rates on the deposits at the Fed and allowing interest rates more generally to rise. If this is done in a timely way and on an adequate scale, the Fed will succeed in preventing the current vast liquidity from generating higher inflation.



Here is what worries me: the structure of US unemployment is very different in the current downturn than it was in the past. Nearly half of the unemployed have been out of work for six months or longer. In the past, the corresponding unemployment duration was only 10 weeks. So there is a danger that the long-term unemployed will be re-employed much more slowly than in previous recoveries.


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If the unemployment rate is still very high when product markets begin to tighten, the US Congress will want the Fed to allow more rapid growth in order to bring it down, despite the resulting risk to inflation. The Fed is technically accountable to Congress, which could apply pressure on the Fed by threatening to reduce its independence.

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So inflation is a risk, even if it is not inevitable. The large volume of reserves, together with the liquidity created by quantitative easing and Operation Twist, makes that risk greater. It will take skill – as well as political courage – for the Fed to avoid the rise in inflation that the existing liquidity has created.



Martin Feldstein is Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research. He chaired President Ronald Reagan’s Council of Economic Advisers from 1982-1984, and is currently a member of President Barack Obama’s Economic Recovery Advisory Board, as well as a member of the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the National Committee on United States-China Relations





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Copyright Project Syndicate - www.project-syndicate.org


April 2, 2012 7:25 pm

A divorce settlement for the eurozone


The European Central Bank has averted disaster, sparking a powerful relief rally – but nothing fundamental has been resolved. Greece may need another debt restructuring; Portugal and Ireland may need restructuring too. Spain and Italy may yet come under the gun. Banking crises are hardly ever resolved without removing toxic assets or recapitalisation. The eurozone still lacks essential features of monetary unions that have stood the test of time; and planned reforms may exacerbate latent fiscal, banking and external imbalances, leaving it less, rather than more, resilient to regional shocks.



Splitting up may be hard to do, but it can be better than sticking to a bad marriage. The periphery debt crisis threatens to engulf the core in huge bank capital shortfalls and fiscal liabilities, trapping both in protracted stagnation. This reflects possibly intractable eurozone design flaws. So we propose the following amicable divorce settlement.

 

 

Countries leaving the eurozone must rebalance away from growth led by debt, towards export- and income-led growth. Members of a “rumpeurozone should rebalance toward domestic demand. The EU free trade arrangement is critical to this end. Ideally, five distressed peripherals Portugal, Ireland, Italy, Greece and Spain – would exit, negotiating bridge financing.




Currency realignment would aid this adjustment. It is far better to restore competitiveness through devaluation than by changing relative prices with a fixed nominal exchange rate, which implies protracted debt deflation, potentially ending in disorderly defaults and exits in any case, or sustained inflation above target in surplus countries. There would of course be disruption even in a cooperative, partial dismantling of the currency union, but it would be in everyone’s interest to minimise the damage by adhering to the agreed exit strategy.



This strategy would ensure exiting countries’ viability and the euro’s credibility. It would maintain the EU customs union to the benefit of all member states; and set a monetary framework for the rump ECB and exiting national central banks.



A transitional monetary framework would effectively reverse the exchange rate mechanism that led to the euro: FX targeting by exiting national central banks, with ECB support to avert currency collapse, capital flight and a resultant surge in inflation. New FX trading corridors would be widened in steps as inflation and exchange rate risk premia returned to normal.



After the transition, independent national central banks and the ECB would implement congruent inflation targets, averting protectionism in the wider EU by restraining competitive devaluation. Exiting countries would be small, open economies relative to the rump eurozone, where FX movements would quickly pass into inflation, inducing them to avoid maxi-devaluations that could provoke wage price spirals.



Unlike other currency regime changes, FX corridors would not be threatened by the inadequate FX reserves of exiting countries. The ECB would buy the new currencies at the floor of the trading band, to mitigate losses from currency collapses and disorderly defaults. This element of the plan would put the burden of financing adjustment and exit on the ECB and remaining eurozone members. But transitional alimony or one-off settlements are often the key to amicable divorces; transitional official financing would mitigate losses and defaults, as in many currency regime changes, and facilitate EU survival and cohesion helping to avoid the de-globalisation that often follows financial crises.


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A clear, consistent legal framework for exit is crucial. We would redenominate all contracts made under domestic laws into the new currencies at the time of exit. We would retain euro denomination for contracts made under foreign law, subject to the territorial connection of the contract or obligor, in line with consensus legal opinion.



Exiting countries should accelerate the “domestication” of external debts before the transition to minimise balance sheet mismatches. Imbalances in the payments system would be redenominated by negotiation and netted between the ECB and national central banks. The widening of FX trading corridors as risk premia fell would lessen balance sheet effects. An eventual free float of currencies by inflation-targeting, independent central banks would restore macroeconomic shock absorbers and aid policy credibility.

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Banks and financial markets pose the gravest immediate threats to the exit strategy. Pursuing domestication prior to exit would reduce credit losses and currency risk. The ECB’s currency support would allow time for hedging and repayment of euro-denominated obligations. These policies would mitigate damage to the banking system and support economic activity and investment. However, doubts about the strategy might spark capital flight, requiring temporary bank nationalisation, curbs on deposit withdrawals and greater use of non-cash payments, as well as temporary capital controls.



We have divorce laws because amicable divorce is better for all concerned than enduring the chronic depressions that accompany bad marriages. The eurozone should devise plans for orderly exit sooner rather than later, because delaying often makes break-up more costly.



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The writers are managing director and chairman of Roubini Global Economics
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Copyright The Financial Times Limited 2012.



OPINION

April 1, 2012, 5:49 p.m. ET

Federal Lending Is as Rotten as Federal Borrowing

Uncle Sam has a loan for everyone, and many of them are likely to go bad.


By GEORGE MELLOAN

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We all know about the dire fiscal outlook arising from manic federal borrowing. The interest cost of financing and refinancing the burgeoning national debt has climbed 55% over the last three years. The Obama budget predicts net interest expenses tripling to over a half trillion dollars by fiscal 2015 from the 2010 level. That is probably conservative, given the likelihood that the administration has lowballed inflation and interest-rate prospects.



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If that isn't bad enough, let's consider the risks not from federal borrowing but from federal lending. Those risks are pretty awful, too.



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The big bump in federalized lending came in August 2008 when the government took over failing Fannie Mae and Freddie Mac. With the addition of these two giants, the federal government now has a $5 trillion mortgage portfolio, much of it of dubious value.



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Since the takeover, Fannie and Freddie have drawn a net $136 billion from the Treasury to cover their losses, and they could cost taxpayers $259 billion through 2013, according to their regulator, the Housing and Home Finance Agency (HHFA). On top of that, the Federal Housing Administration is facing huge losses on the home mortgages it has guaranteed over the years and very likely will also require a taxpayer bailout.



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By comparison, the cost of the $700 billion Troubled Asset Relief Program in 2008 is relatively modest, a mere $28 billion so far, according to the latest government audit. Major banks have paid back their share of the loans.



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As large as these numbers are and as likely that the HHFA is overly optimistic about the future of Fannie and Freddie, these exposures are only a part of the big picture of federal lending disarray.



Government lending, like government borrowing, is a political tool used by Washington to win favor with voters. According to a Congressional Budget Office (CBO) report this month, the government has, in addition to Fannie, Freddie and TARP, a further $2.7 trillion in other loans and loan guarantees outstanding, and some of those loans don't look so good either.
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One of the more worrisome categories is student lending, which the government took over directly in 2010 after having merely guaranteed private loans previously. Student lending has soared along with college tuition, and has even contributed to tuition inflation by flooding colleges and universities with government cash. William Brewer, head of the National Association of Consumer Bankruptcy Attorneys, has been quoted as predicting that student loans will be the next "debt bomb" for the U.S.




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The CBO's new report says that federally issued or guaranteed student loans outstanding have grown to $706 billion from $79 billion a decade ago. (The government's new Consumer Financial Protection Bureau estimates that all student loans outstanding now total over $1 trillion.) They don't seem to be very good risks. A Journal story reporting on the CFPB estimate cites Federal Reserve Bank of New York data showing that as many as "one in four student borrowers who have begun repaying" are behind on their payments.



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The sad state of government loan programs has produced two opposing views. Liberals want further bailouts for debtors. Dick Durbin of Illinois, the No. 2 Democrat in the Senate, has proposed that bankruptcy laws be liberalized so more former students can shed their debt burdens.



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The Obama administration is pushing the idea of forgiving the portions of home mortgage debts that are under water. HHFA acting director Edward DeMarco has opposed forgiveness, telling Congress it would cost taxpayers another $100 billion. But the administration is applying pressure, offering to pay half the cost with unused TARP funds, so look for TARP losses to rise.



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Taking a more responsible but politically risky approach, House Budget Chairman Paul Ryan (R., Wis.) is backing a budget bill provision that would put a more realistic value on the cost to taxpayers of government-subsidized lending. Currently, agencies calculate subsidies by comparing the interest rates on their loans to the rates on Treasury securities. Given rock-bottom Treasury rates, that often makes it look as if the agency is getting a positive return. Under Mr. Ryan's "true value" accounting (backed in the CBO's March report), the return instead would be measured against market interest rates.


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The CBO analysis shows that true-value accounting on direct student loans would convert what the government records as a positive return into a budgetary loss.



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Naturally, none of this pleases the agencies, the higher education lobby, the housing lobby or their friends in Congress. But it would be an important step in putting government lending on sounder footing and reducing the risk of future huge losses piling on top of those that the taxpayer has suffered these last three years.



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Aside from undercounting the cost of politicized loan subsidies, there is another problem. As the Federal Reserve pursues its zero interest-rate policy and the economy draws more on the enormous monetary reserves the Fed has created, inflation prospects are rising. Inflation helps the government get out of its debt swamp by allowing it to pay off loans with devalued dollars. But it does the opposite with debts owed to the government. All those trillions of loans owed American taxpayers will be paid with devalued dollars as well. So the taxpayer loses not only through the ravages of inflation but also from the escape hatch inflation provides for the most irresponsible borrowers from the government.




.Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is the author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).
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Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved



April 1, 2012 6:58 pm

The G20 should say no to the eurozone



For anyone demanding a big bazooka, Friday was a disappointment. The finance ministers of the eurozone settled on one of the lesser proposals for an increase in the firewall. The agreement raises three immediate questions. How big is the firewall really? Will it all be enough? And should the Group of 20 leading economies top up their commitments to the International Monetary Fund?



Ignore the headlines. This is not an increase in the eurozone’s rescue fund to €700bn. The reality is that the eurozone’s new fund, the European Stability Mechanism, will have €500bn available for future crisis programmes. The €700bn is a meaningful metric only for parliaments of member states because it outlines their risk exposure. It is not a forward-looking measure.

 

The best aspect of last week’s agreement was that it confirmed €500bn will be available, more or less, from day one of the next crisis. But behind that simple statement lies a complex construction where the unused funds from the old mechanism are used to balance a shortfall due to the gradual build-up of capital in the new one.




The essence of the new agreement, however, is refreshingly simple. The €500bn will have to pay for everything. The existing programmes continue but once they expire, or are restructured, any new funds will have to come from below this ceiling. You could say that the ESM was not really raised from €500bn to €700bn but from €300bn to €500bn.



How much will €500bn buy? If one assumes that the IMF will increase its share of the total package proportionately, the total available for new programmes will be €750bn. This would have to pay for second programmes for Portugal and Ireland, a third programme for Greece and probably a first and second programme for Spain (the first being a narrow one focused on the recapitalisation of the banking sector).



The enlarged ESM should be able to handle a subset of those, but will have no headroom left. If Spain were to fall into a deep and prolonged recession, as I expect it will, debt levels will rise and with them the eventual probability of a fully fledged programme. Once Spain is in that position, pressure on Italy and Belgium will rise as well.



The EMS enlargementif you want to call it that – is big enough to deal with the immediate and the clearly foreseeable problems. But it is not of sufficient size to cope with more distant and unexpected events, which of course is its whole purpose.



Jens Weidmann, president of the Bundesbank, was right when he said you cannot solve the eurozone crisis through a rescue fund. But an enlarged ESM would have given the rest of the world reassurance that the eurozone is serious in its efforts to solve the problem. That is now not the case.



One reason for this exercise was to persuade the G20 to authorise a proportional increase in IMF support for the eurozone. Should the 20 nations agree, as eurozone leaders were quick to demand on Friday? I think not. The US and other member states have asked the eurozone to double the capacity of the ESM and raise its funds from €500bn to €1tn. This would have paved the way for an IMF contribution of €500bn. The combined size of the umbrella would have been €1.5tn, or roughly $2tn. That will now not happen.



Of course, you could always add up numbers that should not be added up. So if you count the €500bn of the ESM, €200bn from existing European Financial Stability Facility programmes, €49bn from another European Union-level programme and €53bn in bilateral support, you do arrive at €800bn, or “more than $1tn”, as Friday’s official statement helpfully explained. But this number is meaningless.



Last week the leaders of China, India, Russia, Brazil and South Africa expressed their frustration about the eurozone’s policy response. This agreement is not going to put their minds at rest. The double-counting also leaves a bad taste. It reminds me of last year’s disgraceful attempt to raise the lending ceiling through leveragingsomething that surely deserves the title of the daftest idea in the politics of crisis resolution. Friday’s agreement was not daft, simply too small. It should and will be understood as just that.



The truth is that eurozone capitals in general, and Berlin in particular, are politically not ready to commit more funds. Any observer of German politics would have known that. Chancellor Angela Merkel simply does not have a majority for a “big bazooka”. She may even need a two-thirds majority in the Bundestag to get this agreement passed.



The G20 should tell the eurozone that Friday’s deal is unacceptable. The idea of ESM enlargement was to provide a minimally sufficient degree of insurance to preserve the integrity of the eurozone in the most adverse situation. A €500bn ESM cannot do that. It is unreasonable to expect the rest of the world to make up the rest, especially given the negative impact of the eurozone’s austerity programmes on the rest of the world. The G20 should instruct the eurozone to return to the negotiating table.

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Copyright The Financial Times Limited 2012.

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The Hazard of Second Best

02 April 2012

Mohamed A. El-Erian

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NEWPORT BEACH – The international community risks settling for second best on two key issues to be discussed this month at global meetings in Washington, DC: the lingering (if currently somewhat dormant) European debt crisis, and the selection of the World Bank’s next president. It is not too late to change course, but doing so will require the United States and governments in Europe to resist harmful habits, and emerging countries to follow up effectively on recent initiatives.


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In the last few days, European leaders, including French President Nicolas Sarkozy and European Central Bank President Mario Draghi, have declared that the worst of the eurozone crisis is over. Others, like French Finance Minister Francois Baroin, have gone even further, claiming that Europe “has done its part,” and that it is now up to other countries to do theirs.



These announcements should come as no surprise. Having experienced prolonged turmoil, the eurozone is currently in a period of relative tranquility. The courageous reform measures implemented by Mario Monti, Italy’s technocratic prime minister, have eased immediate concerns that Greek dislocations might tip other European countriesmuch bigger and harder to rescue – into insolvency. Europe’s decision last week to bolster its internal financial firewalls has reinforced the resulting positive impact on market sentiment.



But, as important as these steps are, the recent tranquility has been more borrowed than earned. Since December, the ECB has twice deployed long-term refinancing operations, which provide unlimited three-year financing to banks at 1% interest. This has given the banking system more time to increase capital and improve asset quality. It has also reduced several governments’ financing costs. What it does not do, and is not meant to do, is resolve Europe’s twin problems of too little growth and too much debt.



If it is not careful, Europe risks falling into the trap of trying to shift responsibility for its problems onto others, rather than building on recent progress. That temptation is partly reflected in efforts to press officials from around the world to agree this month to a major increase in the International Monetary Fund’s resources, with emerging economies footing a significant part of the bill.



In pivoting from internal to externally-financed firewalls, Europe is pushing a political agenda that is not yet warranted by economic and financial realities. Europeans are about to embark on another round of elections, in both core and peripheral EU countries, as well as a referendum in Ireland. Recent history suggests that these votes are unlikely to favor ruling parties unless they can signal some progress in resolving the crisis.



The rest of the world should counter the risk of European complacency, and the US should take the lead. But US officials no longer seem interested because they need to secure Europe’s support for another second best this month: the anointment of the American candidate, Jim Yong Kim, as the World Bank’s new president.



For the first time in its nearly 70-year history, the Bank’s executive board is also considering two non-Americans for the job: the Colombian Jose Antonio Ocampo and the Nigerian Ngozi Okonjo-Iweala.


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The nomination of these two unambiguously qualified and experienced individuals to compete with Kim is an important first step in changing the feudalistic practice whereby nationality has been the overriding criterion for selecting the World Bank’s president (as well as the choice of the IMF’s managing director, which Europe controls).



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All three candidates meet US President Barack Obama’s justified insistence that “a development professional head the world’s largest development agency.” But this does not make them equal. They are not.



A consensus has emerged that, when judged by the Bank’s own criteria for the job, the highly respected Okonjo-Iweala dominates the other two candidates. On that basis, she has already gained the endorsement of influential observers and opinion-forming media outlets.


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Moreover, her appointment would speak to other important initiatives with which Obama has aligned himself, including efforts to fight corruption, strengthen meritocracy, and support gender equality.



I suspect that, in their hearts, US officials know that Kim, while an inspired nominee, is not the best candidate. Yet their historical attachment to a harmful nationality-based entitlement stops them from opting for the best. Meanwhile, Europeans are happy to hold their tongue as a reward to the US for having supported their nationality-based appointment last year of Christine Lagarde to head the IMF.



The responsibility of resisting two second bests now falls to emerging countries. It is up to them to do the right thing this month. And, for the first time in my career observing the international monetary system, they are in a position to take three important steps.



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First, since they are expected to contribute significant financial resources, emerging economies can postpone bolstering the IMF until the eurozone does more to improve the policy mix in member countries and further strengthens its financial firewalls and fiscal harmonization.



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Second, by asking Ocampo to step aside in favor of Okonjo-Iweala, they can unite their votes behind a highly credible merit-based appointment for the World Bank.


Finally, they can put pressure on their Western counterparts by maintaining momentum on the alternative of a “development bank for the South,” an initiative that received support at last week’s BRICs meeting in India.


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The considerations of Realpolitik that influence global meetings often lead to second-best compromises as a means of avoiding more costly inaction. By contrast, this month’s discussions in Washington can and should opt for the first best. But this will happen only if emerging countries play their cards well, and if Europe and the US do what is in their own best longer-term interests, as well as those of the global economy.


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Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment compamy PIMCO, with approximately $1.4 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, and 2011. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by the Economist