June 12, 2012 7:26 pm

A new form of European union

By Martin Wolf .
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Pinn illustration




Here is the biggest question about the eurozone: can we envisage a set of reforms that are not only politically feasible and economically workable, but would let it prosper, as it is. If so, what might they be?



We already know that, as designed, the eurozone did not meet this test. Hence all the improvisation of today. The original design created huge imbalances. When the flow of finance dried up, these delivered a wave of financial and fiscal crises and a legacy of unaffordable debt. Furthermore, the forces driving those imbalances generated divergences in competitiveness. These also need to be redressed, as quickly as possible.


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In response, the eurozone has developed a strategy based on fiscal austerity and structural reform. In addition, the European System of Central Banks, as lender of last resort, and the International Monetary Fund and eurozone governments, via the temporary European Financial Stability Fund and, soon, the permanent European Stability Mechanism provide indirect financing for fragile economies and sovereigns. The $100bn proposed rescue of Spanish banks is the latest example of this strategy at work. It is unlikely to be the last.



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Will the strategy work? Probably not. As Mark Cliffe and his team at ING note, in a report entitled Roads to Survival, a good way to think about the challenge is in terms of the external and internal imbalances bequeathed by the incontinent cross-border lending prior to the crisis.




If external deficits are to be reduced, domestic demand must shrink. If done too swiftly, this would raise unemployment, possibly enormously (see chart). In the long run, high unemployment, aided by market-oriented reforms, should drive down nominal wages. But this could take many years. Meanwhile, persistently weak economies mean a growing mountain of bad private debt, high fiscal deficits, rising public debt, high interest rates and extremely fragile financial systems.
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This strategy, then, looks neither politically feasible nor economically workable. Now consider alternatives. A federal union, with a federal government that finances spending throughout the union, is certainly economically workable. We have many examples: the US, Canada, Australia, Switzerland. But we can safely say that, whatever the position may be a century from now, the eurozone is very far from able to share such a government.




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A less ambitious – but still ambitious alternative would be a transfer union, by which I mean a system of permanent transfers from richer to poorer member countries, as is normal within countries. This is surely politically infeasible. Above all, it is neither necessary nor desirable from the economic point of view. It is unnecessary for poorer countries to run sustained current account deficits, provided wages remain in line with productivity (as ceased to be the case for several members during the pre-crisis boom). It is undesirable for countries to receive large and sustained net transfers, because that tends to entrench backwardness.




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If the current policies seem unlikely to work and either a federal or a transfer union is ruled out on grounds of political or economic infeasibility, what is left? I suggest the combination of two ideas: “insurance union” and “adjustment union”. By an insurance union, I mean one that provides temporary and targeted support for countries hit by big shocks. By an adjustment union, I mean one that ensures symmetrical adjustment to changes in circumstances, including, changes in financing.




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Both are necessary and, together, they should be sufficient to ensure a workable union in the long run. These notions would have been unnecessary if original members had been far more similar: the minimal union would then have worked. But that is not what now exists. If the eurozone is to sustain its current membership, it needs a combination of insurance and adjustment.



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Before the birth of the euro, some economists thought that members might use fiscal policy to cushion country-specific shocks. We now know this does not work, even if (as was true for Ireland and Spain), the victim began with a healthy public finances. Really large capital inflows and asset price bubbles overwhelm fiscal policy. For this reason, members cannot self-insure against severe shocks. Insurance must be provided collectively, on the principle that everybody benefits from the survival of the union.



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The insurance must support the financial system and (if possible) fiscal solvency in a crisis. But if it is to be insurance, not an open-ended hand-out, conditions must be imposed. Designing insurance that stabilises financial systems and sovereign finances in a crisis is tricky, but not impossible. Clearly, support needs to be larger and more automatic than now, without being open-ended.



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More important even than such insurance is adjustment. Members need a chance of returning to health within a reasonable time period provided they adopt sensible policies. If membersparticularly large members – are to adjust, they will need complementary adjustments elsewhere. More precisely, the necessary return to external and internal balance in crisis-hit countries cannot be achieved without higher spending and inflation in the core. The European Central Bank is astonishingly complacent in failing to react to yet another recession.


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Unless one imagines that the world economy could now cope with a big shift by the eurozone as a whole towards surplus, the rebalancing must occur largely inside the eurozone. If this adjustment is blocked by weak demand and very low inflation in core countries, the vulnerable countries will be locked into semi-permanent slumps. That way lies close to guaranteed failure.



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Is it possible for the eurozone to make the needed reforms in the near future? I do not know. The time may now be too short and the irritation too great. But, conceptually, it seems clear what is needed: a swift and effective move towards an insurance and adjustment union. That is neither a federal union nor a transfer union. It is a way of making it possible for countries that remain largely sovereign to share a single currency. I do not know whether even this is economically and politically feasible. But if not that, what? And if not now, when?


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Copyright The Financial Times Limited 2012.


06/13/2012 01:34 PM

Euro Crisis Deepens
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Italy Struggles to Break Out of Downward Spiral

.By Hans-Jürgen Schlamp in Rome
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After Spain, the focus of the euro crisis has now shifted to Italy, which is struggling with a shrinking economy and rising bond yields. Prime Minister Mario Monti has denied that his country will ask for an EU bailout, but optimism about Italy's future is in short supply.



Claudio Pesaro actually had big plans for this year. The 35-year-old Italian, who still lives at home, wanted to buy his own place, marry his girlfriend and have children. But even though he has saved more than a third of the purchase price for a property, he can't find a bank that is willing to lend him the rest. His job is also at risk, as his company is making losses. As a result, he will have to put his plans on ice for now.



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Marco Michelli wanted to go into business for himself, starting a microbrewery complete with pub. Beer is popular in Italy, especially among the young. But the municipal authorities hampered him with conditions and fees, and the bank withdrew its commitment to fund his business. That was the end of his project.



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These are just two typical stories from Italy, which is currently in the fourth year of its crisis. The mood in the country is depressed. The number of people committing suicide for economic reasons is increasing. The enthusiasm with which Italy greeted the introduction of the euro has long vanished. Now, around 65 percent of the population are skeptical of the common currency.



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Hence, Italians were relatively tranquil in their reactions to the latest "Black Monday" on the stock markets, when stocks fell sharply following the announcement that the Italian economy had contracted by 0.8 percent in the first quarter of 2012. They have come to expect such plunges. The focus of the euro crisis is, after Spain, shifting again to Italy. Italian share prices have plummeted, and yields on Italian government bonds jumped back over the dangerously high 6 percent mark. Stock markets insiders report that hedge funds are investing large sums of money in bets against the country, on the assumption that yields will continue to rise -- and are thereby fueling the downward spiral.



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Italian Prime Minister Mario Monti has denied that his country will ask for an EU-led bailout. He told the German broadcaster Deutschlandradio Kultur on Wednesday that he realized Italy had a reputation as a "cheerful and undisciplined" country, but that it was "more disciplined" than many other European countries -- adding that it was "also not so cheerful."



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Downward Trend


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On Wednesday, Italy saw yields on its 12-month bonds shoot up again in a €6.5 billion ($8.1 billion) auction. The interest rate rose to almost 4 percent, up from 2.34 percent last month. Demand, however, was strong.




The country also wants to raise €4.5 billion on Thursday and €9.5 billion on Friday. Together, that's a total of over €20 billion in new borrowing. If the interest rate on those bonds increases by just one percentage point, say from 5 to 6 percent, it will cost the state an additional €200 million. That happens to be the same amount of money that Corrado Passera, the Italian minister for economic development, is lacking to finance his growth program, which he announced some time ago. The program is currently paralyzed because of internal government wrangling over its financing.


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Italy's battered economy desperately needs stimulus, but the downward trend is continuing unabated:


  • Italy's industrial output is falling almost every month. Since early 2008, the country's total production has shrunk by about a quarter.


  • The unemployment rate has increased from 8 to 10 percent over the last 12 months. Among the under-25s, it has risen from 28 to 36 percent. These figures may even be understating the problem: Many of the unemployed no longer bother to register, meaning they are not included in the statistics.


  • Italy's gross domestic product (GDP) will decrease this year amid the deepening recession. The Italian central bank has said it will be satisfied if the decline does not exceed 1.5 percent.

  • A raft of other indicators, including net national income, consumer demand and standard of living, are also falling.


  • The only thing that is growing is Italy's mountain of debt, which is already at 120 percent of GDP and will probably exceed the €2 trillion mark this year. As long as the economy is shrinking, it is very difficult to break through the vicious circle of debt, which almost automatically produces more new debt.



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Putting a Positive Spin on the Situation



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Minister Passera has tried to play down the significance of the figures. The poor economic data had been expected, he said, arguing that exports are actually doing well, the banks are stable and government spending is proceeding as planned. Passera insists that the situation in Italy is much better than in other crisis-hit countries. Unfortunately the markets do not appear to recognize the subtle distinction.



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Meanwhile, the enthusiasm that many Italians felt for Mario Monti's technocratic government in its early days has faded. Many Italians complain that Monti and his cabinet have talked a lot about economizing but have mainly increased taxes and other charges.


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They have done little so far in terms of cutting spending, for example to the wide range of unnecessary subsidies or the generously funded political and administrative system. And the promised reforms of Italy's ossified economy remain stuck in the early stages.



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Passera's attempts to put a positive spin on the situation have earned him criticism, scorn and ridicule from his compatriots, including in forums on newspaper websites. "The day when we have serious politicians will be a great day," wrote one user on the website of the conservative-liberal newspaper Corriere della Sera. The comment is reminiscent of complaints from the Berlusconi era.



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'Ms. Merkel, You Can't Go on Like This'



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Italy's beleaguered politicians are trying to shift the blame for their plight. For example, the recent earthquake in the north of the country has been blamed, which did indeed cause great damage and considerable loss of production. But it is mainly the Germans who are increasingly being identified as the culprit, with the hard-hearted Chancellor Angela Merkel being a particular focus of resentment. In the view of some Italians, all the ideas that the highly indebted countries of the euro zone want or propose -- including euro-bonds, a banking union or investment and growth programs financed with jointly issued debt -- meet with a stubborn "Nein" from Berlin.


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Things must change, wrote the Italian business newspaper Il Sole 24 Ore in a commentary published Tuesday, echoing the current political sentiment. "Ms. Merkel, you can't go on like this," writes the newspaper in the piece, titled, in German, "Schnell, Frau Merkel" ("Quick, Ms Merkel"). "You will not get very far if you continue to be indifferent to the Greeks' anger and distant from the Spaniards' wounded pride, the Italians' fears and the anxieties of the French." The commentator appeals directly to the chancellor to act, arguing that: "A strong and healthy Germany cannot possibly exist amid the ruins of European countries."



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The reason why Merkel is not, however, acting quickly is addressed by the newspaper La Repubblica which quotes Monti as saying that Merkel is taking a hard line because of the upcoming 2013 national election in Germany. But Europe cannot wait that long, the newspaper quotes Monti as saying: "The time for hesitation" is over.

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THE FED BUYS TREASURY AUCTION
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June 13, 2012
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Just how does this little game of Finance 2012 work anyway? To quote our friends at Zero Hedge: “A month after the U.S. Treasury sold $24 billion in 10 Year bonds at what was then a record low yield of 1.86%, the U.S. government once again approaches that mysterious primary dealer-repo nexus with the latest offer U.S. banks can't refuse: a $21 billion reopening. What is notable about today's auction is that in about 40 minutes, the auction will price at a record low yield of just about 1.63%, or 23 bps lower to the last record yield. Where things get patently surreal, however, is when one takes a look at today's POMO operation conducted by the Fed (remember those). Because as can be seen on the table below from the NY Fed, at 11 AM today, so precisely 2 hours before when the Treasury will complete its own sale, bought $4.8 billion of... wait for it... 10 Year bonds.” (And, you thought QE and POMO were over probably.)




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Two hours later the Treasury auctioned $21 billion in 10 year bonds at a yield of 1.622%. You can put 2 and 2 together, but this is the type of stuff which for the most part is done behind the curtain and away from the MSM and financial media more absorbed with Jaime Dimon. Call it what you willthree card Monte, Ponzi or just plain manipulation.




Meanwhile the volatility in markets continues at a high level. What’s the deal? Clearly we await Jobless Claims (Thursday), Empire State Mfg Survey, Industrial Production, Consumer Sentiment and, of course, Quadwitching (Friday). Then Sunday is another Greek election (ugh) and Wednesday’s FOMC Meeting Announcement. So how do you like uncertainty in spades?



This leaves any commentator at a loss to describe the two-way action—down, up and then down again. One day I feel good about being liquid and/or hedged while the next my animal spirits stir. Well, you don’t care about that but I’m keeping this commentary short given what lies ahead.



There wasn’t much in the way leadership since everything that led the way higher Tuesday reversed. The dollar (UUP) was weaker since the euro (FXE) is so damn attractive. Gold (GLD) rallied some and bonds (IEF), as noted, set new record lows in yield.



Volume was average by recent levels and breadth per the WSJ was quite negative.
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OPINION

Updated June 12, 2012, 2:43 p.m. ET

Obama's Real Spending Record
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.There's no way around the facts. Under Presidents Bush and Obama, government exploded as a share of the economy.
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.By ARTHUR B. LAFFER AND STEPHEN MOORE




President Obama shocked us the other day when he said, "Since I've been president, federal spending has risen at the lowest pace in nearly 60 years." Having heard him champion the "multiplier effects" of deficit-financed stimulus spending, we saw him as an enthusiastic supporter of throwing other people's money at just about any problem.



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Thus began our quest to see where we had strayed from the straight and narrow. Here's the picture. In the chart nearby we've plotted federal government spending on a National Income and Product Accounts (NIPA) basis as a share of total U.S. GDP from 1990 to the present. The NIPA numbers are used here as opposed to appropriations or outlays to capture the actual periods when production occurs. The stories the chart tells are amazing.


The first is how much government spending fell during President Bill Clinton's eight years in office and how low it was when he left office. When he became president in 1992, government spending was 23.5% of GDP, and when he left in 2001 it was 19.5% of GDP. President Clinton, in conjunction with a solid Republican Congress, cut government spending by more than any other president in modern times, and oversaw one of the greatest periods of economic growth and prosperity in U.S. history.


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Sadly for fiscal conservatives, the biggest surge in government spending came during the last two years of President George W. Bush's eight years in office (2007-2008). A weakened Republican president dealing with a strident Democratic Congress, led by then-House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid, resulted in an orgy of spending.




.Mr. Bush and Republicans in Congress capitulated to and even promoted each and every government bailout and populist redistribution canard put before them. It's a long list, starting with the 2003 trillion-dollar Medicare prescription drug benefit and culminating with the actions taken to stem the 2008 financial meltdown—the $700 billion Troubled Asset Relief Program, the bailout of insurance giant AIG and government-sponsored lenders Fannie Mae and Freddie Mac, the ill-advised 2008 $600-per-person tax rebate, the stimulus add-ons to 2007's housing and farm bills, etc. The script had it that greedy right-wingers were the cause of our collapse, and deficit spending and easy money the answer.


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The numbers are mind boggling. From the second quarter of 2007, i.e., the first full quarter of a Pelosi-Reid dominated Congress and a politically weakened President Bush, to the second quarter of 2009 when President Obama assumed office, government spending skyrocketed to 27.3% of GDP from 21.4%. It was the largest peacetime expansion of government spending in U.S. history.
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After taking office in 2009, with spending and debt already at record high levels and the deficit headed to $1 trillion, President Obama proceeded to pass his own $830 billion stimulus, auto bailouts, mortgage relief plans, the Dodd-Frank financial reforms and the $1.7 trillion ObamaCare entitlement (which isn't even accounted for in the chart). While spending did come down in 2010, it wasn't the result of spending cuts but rather because TARP loans began to be repaid, and that cash was counted against spending.



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In 2011 and 2012, the pace of spending was slowed when a new emboldened breed of Republicans took back the House promising to end the binge. The House Budget Committee, headed by Wisconsin Rep. Paul Ryan, has identified about $150 billion of new spending Mr. Obama wanted in 2011 and 2012 that Republicans would not approve. As the chart shows, government spending as a share of GDP fell, and taxes were not raised. But to attribute this drop in government spending to the president or congressional Democrats would be dishonest.



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Slowing spending and the decision not to raise taxes may have prevented the Great Recession from becoming the next Great Depression. In 1930, the Smoot-Hawley tariff was signed into law by another weak Republican president, Herbert Hoover. Smoot-Hawley was the largest single tax increase on traded products in U.S. history. Not surprisingly, the markets collapsed.






Like President Obama, President Hoover proposed massive tax increases. Unlike Mr. Obama, Hoover was successful. The highest marginal income tax rate jumped to 63% from 24% on Jan. 1, 1932. That November, Hoover lost the election to Franklin D. Roosevelt in a landslide.



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As if Hoover's tax increases weren't enough, on Jan. 1, 1936, FDR raised the highest marginal income tax rate to 79% with further rate increases up to 83% coming later. Estate and gift taxes, taxes on retained earnings, state and local taxes were also raised. This is why the Great Depression was the Great Depressionmassive deficit spending and tax rate increases.


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Today's economy is again decelerating in no small part because on Jan. 1, 2013 we face Taxmageddon—the largest automatic tax increase on investment and businesses in generations, including the end of the Bush tax cuts and the more recent payroll tax cut. According to the Congressional Budget Office, this would drain $607 billion out of the economy next year, pushing us back into recession.



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Keynesians, of course, are advising more deficit spending and easy money. But the most amazing feature of the nearby chart, which is rarely ever noted, is that when spending declined sharply the economy boomed under President Clinton, and when spending soared under Presidents Bush and Obama, the economy tanked.



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Maybe Keynes was wrong and Milton Friedman was right when he warned that government spending is taxation and that government can't tax an economy into prosperity. Friedman made it clear time and again that restraining government spending stimulates the economy by liberating private resources.



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The good news is that the tea party Republicans who took office after the 2010 elections have completely altered the face of the opposition. Legislation to repeal ObamaCare and Dodd-Frank soared through the House, as did Rep. Ryan's proposed plan to curb federal spending and lower tax rates for individuals and businesses.



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Next, look for an insurrection of closet Clinton New Democrats against their party's big-government leadership, as may have begun last week when Mr. Clinton and other leading Democrats pronounced that all the Bush tax rates should remain in place for another year.


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The right point of focus is not at what pace spending has grown under President Obama but instead how much more he needs to cut spending from its bloated levels to bring the economy back to health. The huge increase in spending as a percentage of GDP under Presidents Bush and Obama is the reason we are experiencing the slowest recovery since the Great Depression. As Milton Friedman understood, an economy cannot spend or tax itself into prosperity.



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Mr. Laffer is president of Laffer Associates. Mr. Moore is a member of the Journal's editorial board.
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