May 22, 2012 7:41 pm
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A fragile Europe must change fast
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By Martin Wolf




I sympathise with the Germans. This is not because I agree with their prevailing view of how the crisis occurred or what to do about it. I sympathise because the German elite were the ones who understood what creating the euro implied. They realised that a currency union could not work without a political union. But the French elite wanted, instead, to end their humiliating dependence on the monetary policy set by Germany’s Bundesbank. Now, two decades later, Germany’s partners, including France, have learnt a painful lesson. Far from being liberated from German control, they are now far more firmly under it. In a big crisis, creditors rule.


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Consider how much better off Europe would have been if the exchange rate mechanism had continued, instead, with wide bands. Interest rates in the crisis-hit countries would probably have been higher and asset price bubbles and current account deficits smaller. When the turnround in financial flows occurred, currency crises would indeed have erupted. The Greek drachma, the Irish punt, the Portuguese escudo, the Spanish peseta, the Italian lira and, maybe, the French franc would have devalued against the Deutschmark.



Price levels of these countries would have shown a temporary jump. But the blame for any fallout would have fallen overwhelmingly at home. I feared that the euro would weaken the sense of mutual trust, in a crisis, not reinforce it. So it has proved already, even though the eurozone has barely started the adjustment.




Why, then, do creditors rule in a crisis? The answer is simple: they can borrow cheaply. As lenders have fled from weaker credits, the interest rate on German Bunds has fallen to 1.3 per cent, against 5.8 per cent in Italy and 6.2 per cent in Spain. With flat nominal gross domestic products, countries with high interest rates are at risk of falling into a debt trap. They need help in controlling their costs of borrowing that only creditors can supply. (See charts.)



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As Harold James of Princeton university, Ronald McKinnon of Stanford and many others have noted, Alexander Hamilton, the first US Treasury secretary, confronted a not dissimilar challenge with the debts incurred by the states in the American war of independence. Hamilton used the powers of the (second and centralising) constitution to assume these debts, issuing new federal debt, instead. In the long run, the modern US federal system emerged, with limits on state borrowing, a central bank (at the third time of asking) and a federal budget able to stabilise the economy.



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Since dismantling the eurozone would be very costly, as I argued last week, could such a union deal with the current difficulties? The answer, in theory, is yes. The eurozone already has a central bank. The fiscal compact beloved of Angela Merkel, Germany’s chancellor, could be the equivalent of the balanced budget rule of US states. So what is missing for a lifehappy ever after”? The answer seems to be a robust fiscal arrangement, to cushion the impact of crises, help members manage their debts and cut the link between weak sovereigns and banks.




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Yet assumption of debts by a central treasury or replacement of national by federal fiscal mechanisms support is out of the question. The budget of the EU is 1 per cent of gross domestic product. There is no will to make it bigger.


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In place of such central action, stronger solidarity among members would need to emerge. But I find it hard to believe such measures would endure. The European Stability Mechanism, designed in this crisis to help countries in difficulty, is too small, at just 5 per cent of eurozone GDP. The answer would have to be some kind of eurozone bonds, with joint and several backing. Support will be quite limited. Creditworthy members tend to dislike supporting the “irresponsible”. Voters dislike sharing with non-voters. Crucially, the federal constitution preceded Hamilton’s solution, though the big debts were a reason for ratification.



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If dismantling the euro is out of the question, true federal finance is unavailable and mutual solidarity will remain limited, what is left? The answer is faster adjustment, to bring economies back to health. Indeed, that would be essential even if stronger solidarity were available. The eurozone must not turn the weaker economies of today into depressed regions, permanently supported by transfers, a policy that has blighted the south of Italy.




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So how is faster adjustment to be achieved? The answer is through a buoyant eurozone economy and higher wage growth and inflation in core economies than in the enfeebled periphery. Moreover, the required growth strategy is definitely not just a matter of policies for supply. According to forecasts from the International Monetary Fund, eurozone nominal gross domestic product will rise by a mere 20 per cent between 2008 and 2017. In the latter year, it will be 16 per cent lower than if it had continued to grow at the rate of 4 per cent achieved between 1999 and 2008 (consistent with 2 per cent real growth and 2 per cent inflation). For the economies under stress, such feeble growth in the eurozone is a disaster: it means that the eurozone as a whole tends to reinforce, rather than offset, their credit contractions and fiscal stringency. They can blame the universal adoption of fiscal stringency and the policies of the European Central Bank, which let the money supply stagnate.



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What has this to do with the risk of a Greek exit and the need to manage the fallout, should this occur? Nothing and everything. Nothing, because it will still be necessary to manage panics, almost certainly by unlimited ECB support, as Jacek Rostowski, Poland’s finance minister, has argued in the FT.



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Everything, because with large divergences in competitiveness, weak fiscal solidarity and fragile banks, a plausible prospect of adjustment into growth is vital. If countries face year after weary year of debt deflation and depression, the euro risks becoming a detested symbol of impoverishment. As a strong federal union, the US will bear the strain of such sustained disappointment. The far more fragile eurozone will not.



Copyright The Financial Times Limited 2012.

A Global New Deal

Jomo Kwame Sundaram

22 May 2012



NEW YORK Recent political developments, including the defeat of incumbent governments in France and Greece, suggest that the public’s tolerance for economic policies that do not reduce unemployment has collapsed. Indeed, given the alarming economic and employment situation in many countries today, with no prospect of recovery on the horizon, further political turmoil is likely unless policymakers change course accordingly.



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The economic crisis has wiped out more than 50 million jobs after years of weak, job-poor growth and increasing inequality in the world’s rich countries. Since 2007, employment rates have risen in only six of the 36 advanced economies, while youth unemployment has increased in a large majority of both established and emerging markets.


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In the near term, the global crisis is likely to become worse as many governments, especially in advanced economies, prioritize fiscal austerity and tough labor-market reforms, even as such measures undermine livelihoods, incomes, and the social fabric.


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Meanwhile, despite quantitative easing, many companies have limited access to credit, depressing investment and reducing job creation. Easy credit before the crisis encouraged over-investment in those sectors, such as housing, that were thought to be profitable. It is no surprise that the resulting excess capacity now discourages private investment in the real economy.


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With inequality and unemployment higher, and incomes and domestic markets shrinking, everyone hopes to recover by exporting – an obviously impossible solution. Developing countries, long encouraged or even compelled to export and otherwise embrace globalization, have been abruptly told to switch course: to produce for the domestic market and to import more. The irony is that this advice comes after much of their former productive capacity has disappeared.


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But, having suffered currency and capital-account crises with greater openness, many emerging-market economies still feel compelled to accumulate huge reserves to protect themselves in the face of greater global financial volatility. While financial globalization has not enhanced growth, it has exacerbated volatility and instability. Meanwhile, nationalpolicy space” for economic recovery has shrunk since the crisis.


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Public investment and basic social protection can help to turn this around, by creating millions of jobs. But, despite strong evidence to the contrary, the presumption that public investment crowds out private capital continues to discourage government-led economic-recovery efforts.



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Historically, in fact, most advanced economies have lived with far higher fiscal deficits than they have today, and not only during wartime. Such deficits have financed strong, sustained, and inclusive growth not only in their own economies, but also abroad – as with the United States’ Marshall Plan, so central to European post-war reconstruction and recovery.


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But now, because governments’ deployment of overwhelming financial resources to save selected private institutions deemed too big to fail caused sovereign debt to increase dramatically, officials have imposed fiscal austerity in deference to bond-market demands. Meanwhile, eurozone countries are constrained not only by this fiscal fetish, but also by their lack of exchange-rate flexibility.


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Moreover, multilateral cooperation for global recovery has been disappointing since 2009 – the year of the G-20’s London and Pittsburgh summits, including the Global Jobs Pact, on which there has been little meaningful progress since. As a result, the past three years have witnessed little movement toward developing and implementing a strategy for strong, sustained, and inclusive recovery. Instead, we have seen creeping protectionism, and not only on the trade front.


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So, how can the world escape a cul-de-sac constructed by the short-term perspective of financial markets and electoral politics?
Although inclusive multilateralism has been battered by various challenges, including its seeming messiness and slow progress, it remains the best option for various reasons. The United Nations system must be bolder, but powerful interests must also allow it to play a bigger role.


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In 2009, recognizing that market forces alone will not generate the investments needed for climate change mitigation as well as affordable nutrition for all, UN Secretary-General Ban Ki-moon proposed a Global Green New Deal, including proposed cross-border, public-private partnerships, especially to generate renewable energy and increase sustainable food production.



Under recent French leadership, the International Monetary Fund, after decades of promoting economic – especially financial – liberalization and globalization, has become more careful, if not skeptical, of its own previous policy analyses, prescriptions, and operations. Likewise, recent initiatives by the International Labor Organization – such as Fair Globalization, the Global Jobs Pact, and the Social Protection Floor – are all directly relevant to addressing the current stasis.



Unique among international organizations, the ILO’s inclusion of both workers and employers as social partners in its tripartite governance allows it to help lead the undoubtedly difficult processes needed to ensure strong, sustained, and inclusive recovery and growth. So, perhaps more than ever in recent decades, inclusive multilateral institutions are on the same page. Now their efforts need the support that they deserve.




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Jomo Kwame Sundaram is UN Assistant Secretary-General for Economic Development and G-24 Research Coordinator.


Markets Insight

 
May 22, 2012 9:54 am

Devaluation – last option to save the euro


As debate about a Greek exit from the euro grows, the European crisis is reaching boiling point. There are three sources for the problems of Greece and other peripheral European nations.


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The first and most immediate is the fear that Greek banks will convert euro deposits into a new Greek currency. This has prompted withdrawals from not only Greek, but also Spanish and Portuguese banks and sent money flowing to German banks and German government bonds. The second is the unsustainable budget and current account deficits of many of the peripheral countries.




The third, and ultimately most important and intractable source of the crisis, is that labour costs in the peripheral countries are too high and uncompetitive with the northern European countries, particularly Germany. Historically, overpriced labour markets have been cured, albeit painfully, by currency devaluation – an option which is not open to euro-based economies.



If Greece does exit the euro and establish a new currency, investors fear that Greek deposits and Greek debt will be converted into a new currency which will sell at a steep discount to the euro. If Greece took this action, it would cause bank runs in Portugal, Spain, and even Italy as depositors fear their governments will do the same.




Although Greek and Portuguese banks are relatively small compared with those in the EU, banks in Spain and Italy are not. A run on the banks in those countries would need to be met by massive loans from the European Central Bank to prevent an all-out financial collapse.



That is why if Greece exits the euro and converts euro deposits into its own currency, it would be necessary for the ECB to quickly guarantee all deposits in all eurozone banks, a policy similar to the one that the Federal Reserve followed after the Lehman bankruptcy in 2008.



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The second source of the crisis involves the large and growing debt of the peripheral countries. This has led to ECB and German demands for austerity which have sparked a fierce backlash in Greece and other countries. But excessive government debt is not now the most critical problem facing the peripheral countries.



The US, the UK, and Japan have huge budget deficits yet their banking systems are stable and their interest rates are at or near record lows. Even if the peripheral countries slash spending and raise taxes to reach a sustainable debt path, they will still remain in severe recession because of the uncompetitive state of their labour markets.
 
 
 
The source of their labour market problems is not difficult to find. When, following the adoption of the common currency, risk spreads between Greek and German debt fell, capital quickly flowed into these peripheral countries. This generated a boom that raised labour costs beyond productivity growth, primarily because unions found it easy to compare their wages to workers in Germany and the strong economic conditions encouraged acquiescence to labour demands. When the financial crisis hit, labour costs had risen too high and unemployment skyrocketed.



Austerity does nothing to solve the problems of an uncompetitive labour market. Reforming the tax systems of Greece, Spain and other peripheral countries and reducing their bloated public sectors and unsustainable pension systems are important long-term goals. But raising taxes and cutting spending now will only worsen their recessions.



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Some economists have argued that the peripheral countries implementinternal devaluation”, the reduction in nominal wages to regain labour competitiveness. But history has shown that the substantial reduction in nominal wages necessary to achieve this goal would be extremely difficult to achieve and apt to worsen their current downtrends.



The least disruptive route Europe can take is to sharply lower the value of the euro. This will help improve the trade deficit in the peripheral countries and bring some relief to their downward spiralling economies. Euro depreciation would push the German trade surplus even higher and cause some inflationary pressures in those few European countries that are still near full employment. Given the strong German labour market, a lower euro would be likely to raise German wages and help close the gap between German and other European labour costs. The mild inflationary effect of a euro closer to dollar parity would be far less painful for all concerned than forcing austerity or internal devaluation on the peripheral countries.



The European Monetary Union was a high-minded, but ill-conceived plan to spur economic growth and forge a closer political union among European countries. The current pressures by the German government to force austerity on the peripheral countries will accelerate the disintegration of the monetary union. The ECB’s best hope of saving the union is to back away from austerity and accept a lower euro. It may not work, but it is the last viable option to save the common currency.



Jeremy Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania


Copyright The Financial Times Limited 2012.

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Why China Won’t Rule

Robert Skidelsky

21 May 2012

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LONDONIs China poised to become the world’s next superpower? This question is increasingly asked as China’s economic growth surges ahead at more than 8% a year, while the developed world remains mired in recession or near-recession. China is already the world’s second largest economy, and will be the largest in 2017. And its military spending is racing ahead of its GDP growth.


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The question is reasonable enough if we don’t give it an American twist. To the American mind, there can be only one superpower, so China’s rise will automatically be at the expense of the United States. Indeed, for many in the US, China represents an existential challenge.


.This is way over the top. In fact, the existence of a single superpower is highly abnormal, and was brought about only by the unexpected collapse of the Soviet Union in 1991. The normal situation is one of coexistence, sometimes peaceful sometimes warlike, between several great powers.


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For example, Great Britain, whose place the US is often said to have taken, was never a “superpower” in the American sense. Despite its far-flung empire and naval supremacy, nineteenth-century Britain could never have won a war against France, Germany, or Russia without allies. Britain was, rather, a world powerone of many historical empires distinguished from lesser powers by the geographic scope of their influence and interests.


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The sensible question, then, is not whether China will replace the US, but whether it will start to acquire some of the attributes of a world power, particularly a sense of responsibility for global order.


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Even posed in this more modest way, the question does not admit of a clear answer. The first problem is China’s economy, so dynamic on the surface, but so rickety underneath.


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The analyst Chi Lo lucidly presents a picture of macro success alongside micro failure. The huge stimulus of RMB4 trillion ($586 billion) in November 2008, mostly poured into loss-making state-owned enterprises via directed bank lending, sustained China’s growth in the face of global recession.


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But the price was an increasingly serious misallocation of capital, resulting in growing portfolios of bad loans, while excessive Chinese household savings have inflated real-estate bubbles. Moreover, Chi argues that the crisis of 2008 shattered China’s export-led growth model, owing to prolonged impairment of demand in the advanced countries.


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China now urgently needs to rebalance its economy by shifting from public investment and exports towards public and private consumption. In the short run, some of its savings need to be invested in real assets abroad, and not just parked in US Treasuries. But, in the longer term, Chinese households’ excessive propensity to save must be reduced by developing a social safety net and consumer credit instruments.


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Moreover, to be a world economic power, China requires a currency in which foreigners want to invest. That means introducing full convertibility and creating a deep and liquid financial system, a stock market for raising capital, and a market rate of interest for loans. And, while China has talked of “internationalizing” the renminbi, it has done little so far.



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“Meanwhile,” writes Chi, “the dollar is still supported by the strong US political relations with most of the world’s largest foreign-reserve-holding countries.” Japan, South Korea, Saudi Arabia, Kuwait, Qatar, and the United Arab Emirates all shelter under the US military umbrella.

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The second problem is one of political values. China’s furtherascent” will depend on dismantling such classic communist policy icons as public-asset ownership, population control, and financial repression. The question remains how far these reforms will be allowed to go before they challenge the Communist Party’s political monopoly, guaranteed by the 1978 constitution.


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Two important cultural values underpin China’s political system. The first is the hierarchical and familial character of Chinese political thought. Chinese philosophers acknowledge the value of spontaneity, but within a strictly ordered world in which people know their place. As the Analects of Confucius puts it: “Let the ruler be a ruler, the subject a subject, a father a father, and a son a son.”


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There is also very little belief in the sanctity of human life: Buddhism holds that there is no difference between humans and animals and plants. A pledge to protect human rights was written into the Chinese constitution in 2004; but, as the recent case of the blind dissident Chen Guangcheng illustrates, this is mostly a dead letter. Similarly, private property ranks below collective property.

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Then there is the Confucian doctrine of the “mandate of heaven,” by which political rule is legitimized. Today, the mandate of Marxism has taken its place, but neither has any room for a mandate of the people. Ambivalence about the source of legitimate government is not only a major obstacle to democratization, but is also a potential source of political instability.


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These historical legacies limit the extent to which China will be able to share in global leadership, which requires some degree of compatibility between Chinese and Western values. The West claims that its values are universal, and the US and Europe will not cease pressing those values on China. It is hard to see this process going into reverse, with China starting to export its own values.


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China has a choice: it can either accept Western values, or it can try to carve out an East Asian sphere to insulate itself from them. The latter course would provoke conflict not only with the US, but also with other Asian powers, particularly Japan and India. China’s best possible future thus probably lies in accepting Western norms while trying to flavor them with “Chinese characteristics.”


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But neither choice is a scenario for Chinareplacing” the US. Nor, I think, is this what China wants. Its goal is respect, not dominance.



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Robert Skidelsky, Professor Emeritus of Political Economy at Warwick University and a fellow of the British Academy in both history and economics, is a working member of the British House of Lords. The author of a seminal three-volume biography of John Maynard Keynes, he began his political career in the Labour party, before helping to found the short-lived Social Democratic Party and eventually becoming the Conservative Party’s spokesman for Treasury affairs in the House of Lords. He was forced out of the Conservative Party for his opposition to NATO’s intervention in Kosovo in 1999.


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Copyright Project Syndicate - www.project-syndicate.org