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April 24, 2012 4:33 pm

Banks are on a eurozone knife-edge

By Martin Wolf

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We want to get away from them. But “developments in the euro area remain the key risk to global financial stability. Recent important policy steps have brought some much-needed relief to financial markets, as sovereign spreads have eased, bank funding markets have reopened, and equity prices have rebounded. However, new setbacks could still occur. The path ahead has significant ... risks, and policies need to be further strengthened to secure and entrench financial stability.”


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Thus did the International Monetary Fund’s Global Financial Stability Report assess progress towards what it calls, optimistically, a “quest for lasting stability”. Many would settle for something far less ambitious: a few years of stability would be an unexpected delight.



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The latest World Economic Outlook, also released last week, offers sensible recommendations: “it is ... critical to break the adverse feedback loops between subpar growth, deteriorating fiscal positions, increasing recapitalisation needs, and deleveraging ... The European Central Bank should implement additional monetary easing to ensure that inflation develops in line with its target over the medium term and guard against deflation risks, thereby also facilitating much-needed adjustments in competitiveness. Moreover, ... banking authorities should work together ... to monitor and limit deleveraging of their banks at home and abroad.”
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Let us summarise. First, it is still easy to identify risks, not least the state of the banks, particularly given their close relationship with fragile sovereigns. Second, growth is too slow and ECB monetary policy too tight. Finally, inflation needs to rise in the more competitive countries, to facilitate adjustment among member countries.


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If the IMF is called to offer assistance to member countries out of the additional resources it has acquired, its conditionality for the eurozone needs to match these arguments. It is not enough to beat up weak countries. The policy regime itself needs to change.



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Yet, perhaps the most important point to have emerged is that the crisis is subject to growing political risks. The fall of the Dutch government and the victory of François Hollande in the first round of the French presidential election demonstrate this point.


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The street might overwhelm the establishment. The fear of just this might cause yet another self-fulfilling prophecy of crisis. Even France might be dragged in. Then the game might be up.



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Encouragingly, confronted with the risk of a financial meltdown in late 2011, the eurozone did act. The ECB’s long-term refinancing operation reduced funding strains and contained the risk of bank failures. New governments in countries under pressure are implementing substantial reforms.


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Ireland and Portugal have made progress in their adjustment programmes. Greece has negotiated debt restructuring. Progress has been made towards surveillance of internal imbalances, not limited to fiscal imbalances. The eurozone’s firewall” against contagion has been strengthened.


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In short, the GSFR notes, downside economic risks have indeed been reduced. Unfortunately, it states, financial stability risks remain. A particularly important aspect of those risks is of further deleveraging by the banks. This is necessary, given their bloated balance sheets. But it is economically dangerous.



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In what the GSFR calls its “current policies scenario”, 58 large banks based in the European Union could shrink their balance sheet by as much as €2tn ($2.6tn) by the end of 2013, or almost 7 per cent of total assets. The effect on eurozone credit supply is only 1.7 per cent of credit outstanding, but this decline will be concentrated in what the report callshigh-spreadcountries, making their return to private-sector led growth even harder to achieve. Other likely victims are emerging economies of central and eastern Europe. Even under what it calls a “complete policies scenario”, which would include strengthened crisis management, dynamic bank restructuring and a “road map for a more financially and fiscally integrated monetary union” the fall in banks assets might be $2.2tn.



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To contain the dangers of disorderly deleveraging, capital will have to be inserted into banks, including by the new support funds. But even this would not break the pernicious link between banks and fragile sovereigns. As much as 12.4 per cent of the consolidated assets of Italy’s depository institutions” – an amount equal to 32 per cent of forecast 2012 gross domestic productconsists of claims on the Italian government. In Spain, corresponding numbers are 7.7 per cent of assets and 26.5 per cent of GDP. The combination of vulnerable sovereigns with exposed banks remains dangerous.


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Indeed, the ECB’s generous funding has strengthened that link. This medicine has perilous side effects. But it had to be used, given the desire of so many foreigners to reduce their exposure. Almost half of Italy’s public debt is held abroad. If that is dumped, it is bound to end up in Italian hands.




The financial crisis has exposed the weaknesses in any currency union among otherwise sovereign countries, particularly the difficulty of adjustment and the lack of a proper central bank. It has also exposed the weaknesses of the actual design of the eurozone. Last but not least, it has exposed weaknesses in policies and institutions of member states, particularly in financial regulation, in their banks, in management of public finances and in labour markets. Unfortunately, the scale of the crisis has made it necessary to remedy what can be remedied, under huge pressure. At every stage, the eurozone has done more than one might have expected, yet it has not been enough.



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The immediate priorities are clear, however: to give the countries in difficulty the time and the opportunity to adjust their economies and so achieve stability once more. My reading of the IMF analyses is that these countries are making painful progress. But far more must be done. Above all, growth must restart if the burden of public and private debt and the close links between such debts and the banks are to be managed. The challenge remains huge. Try even harder, for everybody’s sake.


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Copyright The Financial Times Limited 2012.

 

Reinventing the Sino-American Relationship

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Michael Spence

23 April 2012
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MILANChina and the United States are in the grip of major structural changes that both dread will end the Halcyon era when China produced low-cost goods and the US bought them. In particular, many fear that if these changes lead to direct competition between the two countries, only one side can win.


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That fear is understandable, but the premise is mistaken. Both sides can and should gain from forging a new relationship that reflects evolving structural realities: China’s growth and size relative to the US; rapid technological change, which automates processes and displaces jobs; and the evolution of global supply chains, driven by developing countries’ rising incomes. But first they must acknowledge that the old pattern of mutually beneficial interdependence really has run its course, and that a new model is needed.


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The old model served both sides well for three decades. China’s growth was driven by labor-intensive exports made more competitive by transfers of technology and knowledge from the US and other Western countries. This, coupled with massive Chinese public and private investment (enabled by high – and recently excessivesavings), underpinned rising incomes for millions of Chinese.


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The US consumer, meanwhile, benefited greatly from declining relative prices of manufactured goods in the tradable side of the economy. Accordingly, US employment shifted to higher-value-added activities, in turn supporting higher incomes in America, too.


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Multinational companies operated increasingly efficient and complex global supply chains, which could be reconfigured as the shifting pattern of comparative advantage dictated. Global supply chains ran largely from east to west, reflecting the composition and location of demand in the tradable part of the global economy.


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But all of this is starting to change. The benefits are shifting from cost to growth. Supply chains are now running in both directions, and are being combined in novel ways. Chinese demand is not only growing, but, as incomes rise, its composition is shifting to more sophisticated goods and services.

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Thus, China’s role is changing: once the West’s low-cost supplier, it is now becoming a major customer for Western products. This represents a major opportunity for advanced economies to rebalance their growth and employment, provided that they are positioned to compete for the appropriate parts of evolving supply chains.



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Rising Chinese incomes also imply structural change for China, as continued growth presupposes a shift to higher-value activities. Technology and knowledge will still be important, but China must begin generating new technologies, in addition to absorbing Western tools and skills.


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In order to meet the challenges of structural change, the goal for US policy should be to expand the scope of its tradable sector, with a focus on employment. Reorienting US policy toward external demand across a broader array of sectors, in turn, requires attention to two critical areas: education and investment.


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High-quality education and more effective skills development are crucial to generating new employment opportunities for the middle class, while investment can rectify America’s disconnection – particularly that of its medium-size businesses – from global supply chains. The trading companies and infrastructure that smaller, more open economies have created in order to connect to global markets are underdeveloped in the US.



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To be sure, success in these areas will not come overnight. But nor is the status quo a permanent condition; it can be improved with investment and supportive policy. Moreover, the US would benefit in the short term from relatively simple measures, such as removing barriers to inward foreign direct investment, particularly from China.



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On the Chinese side, policy prescriptions are not the issue. The importance of evolving a different growth pattern is already understood, and has been enshrined in China’s 12th Five-Year Plan. Its successful implementation will require strengthening incentives to innovate, deepening the technology base, investing more in human capital, developing the financial sector, and applying competition policy equally to domestic, foreign, and state-owned enterprises.



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Given the requirements on both sides, how to ensure a productive and mutually beneficial relationship between the US and China is a relatively straightforward matter. China still needs access to advanced-country markets and technology, but the emphasis is shifting to homegrown knowledge, skills, and innovation. The US, still an innovation powerhouse, can help, but requires access to the growing Chinese market and a level playing field once there. The same is true of financial-sector development.

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In the US, a determined effort to restore fiscal balance and establish a sustainable growth pattern – that is, one not based on excessive domestic consumption – is crucial to long-term economic health. Such rebalancing implies sustained reduction of the current-account deficit by expanding exports, rather than merely curtailing imports. Chinese demand will help, all the more so as its economy grows in size and sophistication. So expanding linkages with China now is an investment in the future with a rising return, rather than a quick fix.


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A lower US current-account deficit will also benefit China, whose $3.2 trillion in foreign-exchange reservesheld mostly in dollar-denominated assets – is becoming a large and risky investment. Progress towards external balance in the US would allow a slow reduction in China’s reserves, alleviating its asset-management headache.




A deeper understanding of each other’s shifting structural challenges would facilitate both sides’ ability to identify areas of mutually beneficial cooperation. But the core of the relationship is simple: China needs US innovation to grow, and the US needs Chinese markets to grow. If both countries are to benefit from such symbiosis, there is no alternative to collaboration, substantial investment, and reforms on both sides of the Pacific.


The 2012 contenders fiddle while Medicare burns

Steven Rattner

April 25, 2012




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Even as Mitt Romney was effectively crowned as the Republican party’s nominee to challenge Barack Obama in the 2012 presidential elections, we received a grim reminder of the deteriorating condition of America’s two bedrock social welfare programmes. It arrived on Monday in the form of non-partisan reports from the trustees of Social Security and Medicare - and what worrisome news it was.



The Social Security programme that supports old age and disability payments is now forecast to exhaust its resources by 2033, three years sooner than estimated just a year ago. Without any action, the trustees calculated that beneficiaries would then experience an immediate 25 per cent reduction in their pensions.



As for the Medicare health insurance plan for the elderly, while its outlook didn’t deteriorate last year, it remains in an even more dismal state than Social Security. Over the next 75 years, using realistic assumptions, Medicare costs are projected to increase from less than 4 per cent gross domestic product to more than 10 per cent of GDP.



Still more depressing than these grisly statistics is the utter lack of progress in addressing so obvious and so cataclysmic a problem. Every day that goes by either brings America’s elderly closer to a huge cut in their benefits or threatens every younger generation with an equally huge bill to pay.



With a presidential election looming in less than seven months time, the two ends of the political spectrum are more polarised than ever over how to address the problem.



Liberals, such as the New York Times columnist Paul Krugman, pooh-pooh all the Chicken Little talk and blithely assume that Medicare will be funded out of general tax revenue. That, of course, would do nothing to solve America’s broader fiscal problems or to halt the country’s march toward claiming an ever larger share of America’s economic resources.



Conservatives, led by Paul Ryan, the chair of the House Budget Committee, want to save Medicare by eviscerating it. Under his original scenario, seniors would be given a voucher with a fixed value; any costs for insurance above that would be their responsibility.



That would raise the share of health care costs borne by seniors from about 25 per cent at present to about 68 per cent. With public opinion polls showing that large majorities even of Tea Party members don’t want Medicare to be cut, I am confident that the American public would angrily reject this proposal if they understood it.



Ironically, for the all the intense emotion, fixing Social Security – the smaller and better funded of the two programmes – should not be too challenging. The Bowles-Simpson deficit reduction commission laid out one of several workable alternatives: to reduce cost-of-living increases, gradually increase the retirement age, extend the payroll tax to higher income levels and reduce benefits to wealthier Americans.





Medicare is tougher, not only financially but morally. With the normal market mechanism of price mostly neutered, little prevents patients from demanding ever increasing amounts of care and doctors from providing it.



In the face of intense public opposition to any form of rationing (recall the reaction to Sarah Palin’s ludicrous accusation that Obamacare provided for “death panels”), policy makers are correctly focused on pulling some of the same tax and benefit levers that the Bowles-Simpson commission recommended for Social Security. That won’t be enough. Equal attention must be paid to the flotilla of ideas emerging from academia and think tanks to address the rapid escalation of health care costs and excessive usage.



In addressing the needs of both programmes, let’s not forget a key principle: just like any pension programme or insurance plan, each cohort of beneficiaries should save as much as possible (via taxation) for its own retirement and medical needs.




Otherwise, America will simply be saddling its children and grandchildren with the responsibility for caring for the rest of us in our old age.

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How to Compete in Europe


.Philippe Maystadt
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24 April 2012
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LONDONInterest in the European Union’s competitiveness did not begin with the euro crisis. Safeguarding Europe’s advanced position in the world economy was, after all, a key motivation behind the creation of the single market.
Since then, interest in EU competitiveness has risen further, spurred in particular by the challenge posed by countries like China.



In order to ensure sustainable and inclusive economic growth in Europe, policymakers and the public must, above all, regard international trade as a mutually beneficial exchange of goods and services. Productivity growth and innovation are critical to reaping the benefits of this exchange, and, to ensure both, policies that cost European taxpayers nothing are at least as important as policies requiring public funds.



The first step is to stop viewing international trade as a zero-sum game that costs some countries as much as it benefits others. Obviously, companies within the same industry are in direct competition with each other, and gains in market share by one tend to come at the expense of competitors. So it follows that the payroll and earnings of a company will rise if it outperforms its competitors.



Unfortunately, many people believe that their country’s prosperity requires that it outperform other countries in the same way. This understanding of international competitiveness continues to motivate a wide range of policy initiatives, including industrial policies to create and defend national champions” and support a variety of so-called strategic industries.



There are two problems with this approach. First, there is little evidence to support the view that industrial policies enlarge a country’s share in world trade. All too often, government interventions based on strategic-trade considerations simply provide cover for protecting domestic industries, which harms other countries – and ultimately the protectionist’s own economy.



Second, and more important, analogizing companies to countries is deeply flawed. When a company becomes more competitive, it crowds out its rivals; they get nothing in return. But when a country becomes more productive and increases its exports, it acquires the means to import more, so other countries’ exports rise. Indeed, increasing imports is the ultimate reason for a country to boost its exports, whereas a company is motivated to outperform its competitors so that it never needs to buy anything from them.



Thus, external competitiveness is what the Nobel laureate economist Paul Krugman calls a “dangerous obsession” – at least to the extent that it is based on the company-country analogy. But if competitiveness refers to productivity, it remains a meaningful concept. Productivity growth and innovation benefit countries not by helping them to compete with other countries, but by enabling them to produce and consume more, or to produce and consume the same amount with fewer resources.



Understanding competitiveness in this sense is a prerequisite for successfully designing and implementing a growth agenda for Europe. Indeed, a considerable body of researchpioneered by Harvard economist Philippe Aghion and his colleaguessuggests that innovation is the key driver of economic growth in advanced countries.



This implies, first and foremost, the need to expose companies to strong domestic and foreign competition. Faced with strong competition and the threat of extinction, companies typically try to innovate to survive. The EU would thus do well to combine budgetary support for R&D policies with competition rules that keep companies on their toes, while granting successful innovators appropriate patent protection.



In recent decades, Europe has not moved vigorously enough on these fronts, but it is not too late to pick up the pace. Here, the services sector holds the greatest promise.



Our everyday experience inclines us to regard innovation in terms of more sophisticated and/or higher-quality goods and production processes. And, indeed, manufacturing is arguably an important source of innovation and economic growth. But any agenda aimed at stimulating economic growth in Europe must include the services sector.



Indeed, services account for about two-thirds of total value added in the EU economy. In employment terms, the services sector is larger still. Moreover, since the 1990’s, output growth in the EU has been primarily driven by expansion of services.



At the same time, productivity growth in the EU’s services sector has been lagging behind developments in the United States (even given the possibility that pre-crisis productivity growth in US financial services was partly notional). This suggests that there remains untapped potential to boost innovation and productivity in Europe.



Of course, the best type of productivity growth in services results from innovation that improves quality rather than increases quantity with the same or fewer resources, notably labor. Think of healthcare, education, and care for the elderly. Productivity growth should not result in fewer employees taking care of more patients, students, and old people.



In raising productivity in services, what economists callintangible capital” becomes ever more important. Intangible capital results from investment in R&D, but it is also the result of investing in workers’ skills, organizational improvements, better processes, new designs, and so on.



Countries whose services sectors have made a large contribution to productivity growth have invested significantly in intangible capital, pointing the way to success in boosting innovation. This is the route that the EU should follow.



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Philippe Maystadt is a former Minister for Economic Affairs, Minister of Finance, and Deputy Prime Minister of Belgium. He was President of the European Investment Bank from 2000-2011.




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Copyright Project Syndicate - www.project-syndicate.org