June 5, 2012 10:39 pm
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Panic has become all too rational
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By Martin Wolf
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David Humphries illustration


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Suppose that in June 2007 you had been told that the UK 10-year bond would be yielding 1.54 per cent, the US Treasury 10-year 1.47 per cent and the German 10-year 1.17 per cent on June 1, 2012.



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Suppose, too, you had been told that official short rates varied from zero in the US and Japan to 1 per cent in the eurozone. What would you think? You would think the world economy was in a depression. You would have been wrong if you had meant something like the 1930s. But you would have been right about the forces at work: the west is in a contained depression; worse, forces for another downswing are building, above all in the eurozone. Meanwhile, policy makers are making huge errors.




The most powerful indicator – and proximate cause – of economic weakness is the shift in the private sector financial balance (the difference between income and spending by households and businesses) towards surplus. Retrenchment by indebted and frightened people has caused the weakness of western economies. Even countries that are not directly affected, such as Germany, are indirectly affected by the massive retrenchment in their partners.
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According to the International Monetary Fund, between 2007 and 2012 the financial balance of the US private sector will shift towards surplus by 7.1 per cent of gross domestic product. The shift will be 6.0 per cent in the UK, 5.2 per cent in Japan and just 2.9 per cent in the eurozone. But the latter contains countries with persistent private surpluses, notably Germany, ones with private sectors in rough balance (such as France and Italy) and ones that had huge swings towards surplus: in Spain, the forecast shift is 15.8 per cent of GDP. Meanwhile, emerging countries will also have a surplus of $450bn this year, according to the IMF.



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One would expect feeble demand in such a world. The willingness to implement expansionary monetary policies and tolerate huge fiscal deficits has contained depression and even induced weak recoveries.


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Yet the fact that unprecedented monetary policies and huge fiscal deficits have not induced strong recoveries shows how powerful the forces depressing economies have been. This is the legacy of a huge financial crisis preceded by large asset price bubbles and huge expansions in debt.




.Finance plays a central role in crises, generating euphoria, over-spending and excessive leverage on the way up and panic, retrenchment and deleveraging on the way down. Doubts about the stability of finance depend on the perceived solvency of debtors. Such doubts reached a peak in late 2008, when loans secured against housing were the focus of concern. What is happening inside the eurozone is now the big worry, with the twist that sovereigns, the actors upon whom investors depend for rescue during systemic crises, are among the troubled debtors. Such doubts are generating a flight to safety towards Germany and, outside the eurozone, towards countries that retain monetary sovereignty, such as the US and even the UK (see chart).




It is often forgotten that the failure of Austria’s Creditanstalt in 1931 led to a wave of bank failures across the continent. That turned out to be the beginning of the end of the gold standard and caused a second downward leg of the Great Depression itself. The fear must now be that a wave of banking and sovereign failures might cause a similar meltdown inside the eurozone, the closest thing the world now has to the old gold standard. The failure of the eurozone would, in turn, generate further massive disruption in the European and even global financial systems, possibly even knocking over the walls now containing the depression.



How realistic is this fear? Quite realistic. One reason for this is that so many fear it. In a panic, fear has its own power. To assuage it one needs a lender of last resort willing and able to act on an unlimited scale. It is unclear whether the eurozone has such a lender. The agreed funds that might support countries in difficulty are limited in a number of ways. The European Central Bank, though able to act on an unlimited scale in theory, might be unable to do so in practice, if the runs it had to deal with were large enough. What, people must wonder, is the limit on the credit that the Bundesbank would be willing (or allowed) to offer other central banks in a massive run? In a severe crisis, could even the ECB, let alone the governments, act effectively?



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Furthermore, people know that both banks and sovereigns are under severe stress in important countries that seem to lack any prospect of an early return to growth and so suffer the costs of high and rising unemployment. No better indication of this can be imagined than Spain’s final cry for help with its banks. Political systems are under stress: in Greece, a fragile democracy has imploded. Meanwhile, the German government seems to have reiterated opposition to more support.




How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the eurozone? Nobody knows. Might even Germany consider exit? Nobody knows. What is the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile.




Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events. Perhaps the panic will vanish. But investors who are buying bonds at current rates are indicating a deep aversion to the downside risks. Policy makers must eliminate this panic, not stoke it.



In the eurozone, they are failing to do so. If those with good credit refuse to support those under pressure, when the latter cannot save themselves, the system will surely perish. Nobody knows what damage this would do to the world economy. But who wants to find out?




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Copyright The Financial Times Limited 2012.



Is Global Financial Reform Possible?
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Paul Volcker
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04 June 2012

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HONG KONGNowadays there is ample evidence that financial systems, whether in Asia in the 1990’s or a decade later in the United States and Europe, are vulnerable to breakdowns. The cost in interrupted growth and unemployment has been intolerably large.


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But, in the absence of international consensus on some key points, reform will be greatly weakened, if not aborted. The freedom of money, financial markets, and people to move – and thus to escape regulation and taxationmight be an acceptable, even constructive, brake on excessive official intervention, but not if a deregulatory race to the bottom prevents adoption of needed ethical and prudential standards.


.Perhaps most important is a coherent, consistent approach to dealing with the imminent failure of “systemically importantinstitutions. Taxpayers and governments alike are tired of bailing out creditors for fear of the destructive contagious effects of failure – even as bailouts encourage excessive risk taking.


.By law in the US, new approaches superseding established bankruptcy procedures dictate the demise rather than the rescue of failing firms, whether by sale, merger, or liquidation. But such efforts’ success will depend on complementary approaches elsewhere, most importantly in the United Kingdom and other key financial centers.


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Strict uniformity of regulatory practices may not be necessary. For example, the UK and the US may be adopting approaches that differ with respect to protecting commercial banks from more speculative, proprietary trading, but the policy concerns are broadly similar – and may not be so pressing elsewhere, where banking traditions are different and trading is more restrained. But other jurisdictions should not act to undercut the restrictions imposed by home authorities.


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Closely related to these reforms is reform of the international monetary system. Indeed, one might legitimately question whether we have a “systemat all, at least compared to the Bretton Woods arrangements and, before that, the seeming simplicity of the gold standard. No one today has been able to exert authority systematically and consistently, and there is no officially sanctified and controlled international currency.


.Arguably, the ideal of a well-defined and effective international monetary regime has become more difficult to realize as markets and capital flows have become vastly larger and more capricious. Indeed, the global economy, it is said, has grown – and emerging countries have flourished without a more organized system.



But what is too often overlooked is that international monetary disorder lay at the root of the successive financial crises of the 1990’s, and played an even more striking role in the crisis that erupted in 2008. The sustained and, in a sense, complementary imbalances in the US and Asia stand out.


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From 2000 to 2007, the US ran a cumulative current-account deficit of roughly $5.5 trillion, with nearly symmetrical offsetting increases in reserves in China and Japan. China found it useful to run a large trade surplus, using a very high rate of internal savings and inward foreign investment to support its industrialization and rapid growth.


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By contrast, the US, in the face of slow growth, was content to sustain exceptionally high levels of consumption at the expense of personal savings, inflating a massive housing bubble that burst with a very large and deeply disturbing bang.


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The practical and inescapable lesson is that when any country is left to its own policy devices, its preferences may lead to prolonged and ultimately unsustainable imbalances. Sooner or later, adjustment will be necessaryif not by considered domestic policy or a well-functioning international monetary system, then by financial crisis.


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Not so long ago, we were comforted by theorizing that floating exchange rates would mediate international adjustments in a timely and orderly way. But, in the real world, many countries, particularly but not limited to small, open economies, simply find it impractical or undesirable to permit their currency to float.


.We are left with the certainty, however awkward, that active participation in an open world economy requires some surrender of economic sovereignty. Or, to put the point more positively, it requires a willingness to coordinate policies more effectively. The possibilities include:


· Stronger surveillance by the International Monetary Fund and a firmer commitment by countries to abide by “best practices” and agreed norms.


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· Direct and public recommendations by the IMF, the G-20, or others, following mandatory consultation.


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· Qualification or disqualification with respect to the use of IMF or other credit facilities (for example, central banks’ swap lines).


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· Interest or other financial penalties or incentives along the lines under consideration in Europe.


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But, if approaches that build on past failure do not seem sufficiently effective, perhaps a new approach toward currency fluctuations would be more promising. That would require some agreement about appropriateequilibriumexchange rates, with a fairly wide band that would allow for uncertainty and permit the market to exert its own discipline. But individual countries would orient intervention and economic policies toward defending the equilibrium rate, or, more radically, an international authority might authorize aggressive intervention by trading partners to promote consistency.


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An appropriate reserve currency and adequate international liquidity represent another central concern. For years, the pragmatic answer has been the dollar, and to some extent other national currencies, giving rise to complaints of an “inordinate privilege” for the US. But it is not in America’s interest to accentuate and extend its payment deficits at the expense of an internationally competitive economy with strong industry and restrained consumption. And the rest of the world wants the flexibility afforded by the currency of the largest, strongest, and most stable economy.


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A useful reserve currency must be limited in supply, but have sufficient elasticity to satisfy the large, unpredictable needs that may arise in a turbulent financial world. Above all, confidence in its stability and availability must be maintained, which highlights the practicality of a national currency, or perhaps a variety of national currencies.


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Paul Volcker is a former chairman of the US Federal Reserve Board.


Austerity and Debt Realism
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Kenneth Rogoff
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01 June 2012

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CAMBRIDGE Many, if not all, of the world’s most pressing macroeconomic problems relate to the massive overhang of all forms of debt. In Europe, a toxic combination of public, bank, and external debt in the periphery threatens to unhinge the eurozone.


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Across the Atlantic, a standoff between the Democrats, the Tea Party, and old-school Republicans has produced extraordinary uncertainty about how the United States will close its 8%-of-GDP government deficit over the long term. Japan, meanwhile is running a 10%-of-GDP budget deficit, even as growing cohorts of new retirees turn from buying Japanese bonds to selling them.


.Aside from wringing their hands, what should governments be doing? One extreme is the simplistic Keynesian remedy that assumes that government deficits don’t matter when the economy is in deep recession; indeed, the bigger the better. At the opposite extreme are the debt-ceiling absolutists who want governments to start balancing their budgets tomorrow (if not yesterday). Both are dangerously facile.



The debt-ceiling absolutists grossly underestimate the massive adjustment costs of a self-imposedsudden stop” in debt finance. Such costs are precisely why impecunious countries such as Greece face massive social and economic displacement when financial markets lose confidence and capital flows suddenly dry up.


.Of course, there is an appealing logic to saying that governments should have to balance their budgets just like the rest of us; unfortunately, it is not so simple. Governments typically have myriad ongoing expenditure commitments related to basic services such as national defense, infrastructure projects, education, and health care, not to mention to retirees. No government can just walk away from these responsibilities overnight.


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When US President Ronald Reagan took office on January 20, 1981, he retroactively rescinded all civil-service job offers extended by the government during the two and a half months between his election and the inauguration. The signal that he intended to slow down government spending was a powerful one, but the immediate effect on the budget was negligible. Of course, a government can also close a budget gap by raising taxes, but any sudden shift can significantly magnify the distortions that taxes cause.


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If the debt-ceiling absolutists are naïve, so, too, are simplistic Keynesians. They see lingering post-financial-crisis unemployment as a compelling justification for much more aggressive fiscal expansion, even in countries already running massive deficits, such as the US and the United Kingdom. People who disagree with them are said to favorausterityat a time when hyper-low interest rates mean that governments can borrow for almost nothing.


.But who is being naïve? It is quite right to argue that governments should aim only to balance their budgets over the business cycle, running surpluses during booms and deficits when economic activity is weak. But it is wrong to think that massive accumulation of debt is a free lunch.


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In a series of academic papers with Carmen Reinhart – including, most recently, joint work with Vincent Reinhart (“Debt Overhangs: Past and Present) – we find that very high debt levels of 90% of GDP are a long-term secular drag on economic growth that often lasts for two decades or more. The cumulative costs can be stunning. The average high-debt episodes since 1800 last 23 years and are associated with a growth rate more than one percentage point below the rate typical for periods of lower debt levels. That is, after a quarter-century of high debt, income can be 25% lower than it would have been at normal growth rates.


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Of course, there is two-way feedback between debt and growth, but normal recessions last only a year and cannot explain a two-decade period of malaise. The drag on growth is more likely to come from the eventual need for the government to raise taxes, as well as from lower investment spending. So, yes, government spending provides a short-term boost, but there is a trade-off with long-run secular decline.


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It is sobering to note that almost half of high-debt episodes since 1800 are associated with low or normal real (inflation-adjusted) interest rates. Japan’s slow growth and low interest rates over the past two decades are emblematic. Moreover, carrying a huge debt burden runs the risk that global interest rates will rise in the future, even absent a Greek-style meltdown. This is particularly the case today, when, after sustained massivequantitative easing” by major central banks, many governments have exceptionally short maturity structures for their debt. Thus, they run the risk that a spike in interest rates would feed back relatively quickly into higher borrowing costs.



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With many of today’s advanced economies near or approaching the 90%-of-GDP level that loosely marks high-debt periods, expanding today’s already large deficits is a risky proposition, not the cost-free strategy that simplistic Keynesians advocate. I will focus in the coming months on the related problems of high private debt and external debts, and I will also return to the theme of why this is a time when elevated inflation is not so naïve. Above all, voters and politicians must beware of seductively simple approaches to today’s debt problems.



Kenneth Rogoff, Professor of Economics at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist at the International Monetary Fund from 2001 to 2003. He is one of the world’s premier international economists, with influential publications spanning the fields of global finance, monetary and fiscal policy, and economic development.

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Copyright Project Syndicate - www.project-syndicate.org


OPINION
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June 5, 2012, 6:52 p.m. ET
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Big Banks Are Not the Future
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As leading financial firms face market and regulatory challenges, the likelihood of their managers responding deftly seems slim at best.
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By HENRY KAUFMAN
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The halcyon days of large financial conglomerates are over.



This assertion may seem surprising in light of the growing power—and profitability—of the leading financial institutions in recent years. The trend toward oligopoly, already in full swing during the 1980s and '90s, only accelerated during the financial crisis of 2008, as faltering firms were absorbed by a handful of burgeoning survivors.



Coming out of the crisis, those at the top seemed unassailable.



Today, a mere 10 highly diversified financial institutions are responsible for 75% of total financial assets under management. Not only are they too big to fail, if the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act works as intended, they are supposed to become more stable going forward.



Many observers therefore assume that these behemoths will dominate into the foreseeable future. Or will they? The same crisis that shrank the number of leading players also exposed many of their frailties.



Giant diversified financial institutions operate on both sides of the market—as portfolio managers and institutional investors on the buy side, as underwriters and dealers on the sell side, and as financial advisers on both sides. These conflicts, which are built into the firms' structures, strategies and decision-making dynamics, often bring them into conflict with the public interest.



The diversified financial giants also suffer from structural weaknesses that undermine the ability of their senior executives to govern them effectively. Increasingly, power resides in middle managers, who are highly motivated by various incentive formulas to take (sometimes irresponsible) risks. Top executives must navigate through a blizzard of arcane formulas and oversee activities in far-flung operating units in order to assess and manage overall risk properly. Because they often lack the time and tools to monitor diligently, they must rely on the veracity of others.


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Dodd-Frank includes various provisions to discourage recklessness among the giants, but regulation is not the solution. While enshrining the leading financial firms as "too big to fail," the new legislation imposes on them a long list of strictures—of "dos" and "don'ts"—for controlling their behavior. But a well-run financial system cannot be micromanaged through elaborate regulatory codes. As the trend continues—as the huge financial conglomerates operate under continuous and rigorous scrutiny—they will become financial public utilities. Meanwhile, the crucial job of competitively allocating credit will be relegated to a shrinking portion of the financial markets.



Imposing higher capital requirements on these big institutions also is not the way to go. Will such higher requirements actually remove or minimize the many conflicts of interest noted earlier? I don't believe so. Indeed, higher capital requirements may well encourage more risk-taking.



The power of leading financial conglomerates is being narrowed in other ways. Their inventiveness in introducing new financial products and marshaling new technology allowed them to outrun regulators for decades. The gap is now narrowing. Even though supervisory authorities initially were slow to perceive the implications of securitization and to respond appropriately to the rapid growth of derivatives, the landscape is much clearer now. In the wake of the 2008 crisis, neither regulators nor investors see these innovations as reliable ways to diversify risk. Large financial institutions will need to work hard to develop new techniques for expanding credit that are acceptable to regulators.



Information technology, once the handmaiden of leading financial conglomerates, now serves regulators. It is not difficult to imagine a day in the near future when credit flow informationdata on trades, loans, investments, changes in liabilities, and so on—will flow instantaneously from financial institutions to official regulators.



In the somewhat more distant future, the entire demand deposit function probably could be taken over by governments through a network of computer facilities in "the cloud." Even more likely, within a generation branch banking will become obsolete as the general population (not just early adopters) conducts all its banking on hand-held devices. McDonald's or Starbucks or some other retailing chain will gobble up the bank branches for remodeling.



As leading financial firms have challenges to their dominance from several directions, the likelihood of their managers responding deftly seems slim at best. Change is seldom attractive for incumbents, especially when they enjoy such a predominant position in a major sector of the economy. Rather, shareholders need to push for action.



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The most critical measure shareholders should insist on is divestiture. The financial conglomerates need to shed some of their activities and become more focused. That strategy would bring several major benefits, for the firms as well as for our financial markets and our economy. It would reduce their operations to manageable proportions. It would declassify them as "too big to fail." It would lessen the role of government in the marketplace. And, in a win-win dynamic, it would enhance stockholder value significantly. All are reasons not to lament the sunset of the giant financial conglomerates.



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Mr. Kaufman is president of Henry Kaufman & Company Inc. and author of "The Road to Financial Reformation: Warnings, Consequences, Reforms" (Wiley, 2009).


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