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The Fed’s second best solution
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Mohamed El-Erian
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June 20, 2012


Pity Ben Bernanke and his colleagues on the Federal Reserve’s main policymaking committee. Once again they felt compelled to do something to be seen as countering a renewed slowing of the domestic economy that is compounded by a deepening European crisis and less buoyant emerging economies. But in continuing to act on its own, all the Fed will do is buy some time that will again be wasted by the country’s politicians. Meanwhile, collateral damage will mount, making the next policy steps even more excruciating.


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It is not so long that the Fed was discussing how to exit the unconventional policy phase initiated in the midst of the 2008 global financial crisis. Instead, and having already ballooned the balance sheet to 20 per cent of US gross domestic product, it will now exchange even more of its short-term Treasury holdings (up to 3 year maturities) for longer-dated (6-30 year) bonds. This extension of “operation twist” has, as an intermediate objective, repressing market interest rates to push investors to assume more risk, trigger the wealth effect and reignite animal spirits. The ultimate objective is, of course, to promote non-inflationary growth.





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While the Fed has been able to normalise market functioning and boost valuations, it has repeatedly failed to deliver on its desired economic outcomes. Unfortunately, there is little to suggest that things will be any different this time around.



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Whether you are worried about insufficient demand or the economy’s sluggish supply response, it is hard to argue that what ails the US is in the domain of Fed tools. The most it can do is buy time while trying to inform and — at the margininfluence steps that can only be taken elsewhere.




.The Fed can again try to slow the inevitable deleveraging of over-indebted parts of the private sector. But, given the liquidity trap, it won’t meaningfully counter lower government spending, consumers’ debt overhang and less dynamic export markets. It cannot get congress to agree on fiscal reform, nor will it remove the housing inventory, revamp housing finance, boost infrastructure, and enhance labour retraining and retooling.



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What this continued Fed activism will do is to continue altering the functioning of markets, contaminate price discovery and distort capital allocation. Already, the viability of several segments – from money markets to insurance and from pension provision to suppliers of daily market liquidity, all of whom provide financial services to companies and individuals – has been undermined. The Fed has also conditioned many market participants to believe in a policy put for both equities and bonds. And other government agencies are relieved to have the policy spotlight remain away from their damaging inactivity.



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Yet, judging from Wednesday’s decision, the Fed remains undeterred. This is not due to a lack of recognition of the increasingly unattractive balance between what Chairman Bernanke called in August 2010 the “benefits, costs and risks” of unconventional policies. Instead, I suspect that Fed officials feel a moral obligation to act when others won’t; they worry that their flexibility will erode as they get closer to the November elections; and the last thing they want is to inadvertently contribute to a sluggish US economy that would accentuate the synchronized slowing now taking holding of the global economy.



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The Fed also remembers last summer when political brinkmanship over the debt ceiling took the country to the edge of a technical default and contributed to the loss of a triple-A sovereign rating.



.Now, due to the serial postponement of key congressional decisions, the US faces the menace of an end-year fiscal cliff – a disorderly contraction of some 4 per cent of GDP through arbitrary spending cuts and across-the-board tax increasesat a time when the economy as a whole is on course to deliver at best just 2 per cent in annual growth.


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Wednesday’s decision signals that America is falling further behind its first best policy responses. And while the Fed should be commended for trying to deliver a second best, net benefits will prove even more difficult to secure. In the process, look for greater distortions that will take years to resolve.

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The Ill Wind from the West

Jaswant Singh

20 June 2012
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NEW DELHIAt the nadir of the financial crisis four years ago, many Asian governments came to believe that robust growth had led to a near-“decoupling” of their economies from the West and its ongoing problems. But now, as the eurozone teeters and America’s recovery weakens, Asia, too, is showing signs of faltering.


.Some Asian politicians will, quite conveniently, blame the West for any softening of growth. But their failure to pursue necessary structural reforms and economic opportunities is equally responsible, if not more so, for the region’s growing travails.



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Consider India. According to the forecaster International Market Assessment, “capital flows that have dried up are not a reflection of global market conditions,” but of a loss in confidence among investors, arising principally from fiscal mismanagement, which has led to “price instability, falling investments and eventually a decline in growth.” With the “government in dormancy,” IMA concludes, “India is quickly losing the plot.”


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India’s situation is indeed worrisome. Double-digit food-price inflation has been accompanied by debate about the share of Indians living below the poverty line, and, indeed, where the poverty line should be drawn. Official statistics use an average daily income of 32 rupees ($0.57) a day to separate the merely poor from the desperately impoverished.



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Instead of addressing the central paradox of contemporary Indian societypoverty amidst plentyIndia’s government has buried its head in the sand. It proclaims bold reforms, which it then repudiates before the ink is dry. Even worse, growing official corruption is sapping private-sector dynamism.


.But India is not alone in stumbling. China, too, is fearful of a growth slowdown and rising wage inflation. In response, China’s central bank is lowering interest rates to spur domestic investment, and the resulting depreciation of the renminbi’s exchange rate has helped to keep exports afloat. But China’s import figures for the first half of this year have virtually flat-lined, suggesting that Chinese firms are not investing in new equipment – and thus that China’s economy may hit the doldrums soon.

Although their political systems are mirror opposites, there are striking parallels in some of China’s and India’s deepest structural problems. Both countries undertook reformsChina in the 1980’s and India in the 1990’s – that decentralized decision-making, and both progressed rapidly. India was compelled by its democracy to pursue a politically decentralizing route, yet much economic decision-making authority remained embedded in New Delhi’s ossified bureaucracy, retarding growth. By contrast, China achieved economic decentralization, but preserved centralized political power, transferring economic-management responsibilities largely to provincial officials, which has created its own imbalances.


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Thus, even as China is compelled to shift from exports to domestic consumption in order to sustain growth, India continues to rely on inward investment, exports of services and raw materials, and lower fiscal and current-account deficits to maintain its growth course. But its most damaging deficit is to be found in governance, as is true of China, where the Bo Xilai scandal has exposed the pathological underside of China’s vaunted technocratic leadership.



Elsewhere in Asia, structural problems are also mounting. In Vietnam, inflation has hovered near 20% or more, with the government seemingly unwilling to embrace deeper reforms. Thailand’s interminable political imbroglio has left its economy at stall speed; the reformist zeal of Indonesian President Susilo Bambang Yudhoyono has petered out in his second term following the departure of Finance Minister Sri Mulyani Indrawati; and Japan seems to remain in a state of suspended animation.



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Europe’s malaise, and the resulting rise of populist politics, suggests that Asia’s governments can ill afford to sit on their growth laurels. Indeed, they should heed a recent comment by Oxford University’s Pavlos Eleftheriadis about a Greek electorate livid at being led by those who dishonestly caused the problem.” Indeed, according to Eleftheriadis, tax collectors in Greece today are confronted by bull-whip-wielding citizens. That sounds a lot like India nowadays.



There are bold ideas in circulation in Asia that could sustain and promote growth. The recent decision by the leaders of China, Japan, and South Korea to launch talks on a trilateral free-trade agreement among, respectively, the world’s second, third, and 12th largest economies is certainly audacious, though reaching an agreement between two of Asia’s great democracies and China will likely make the failed Doha Round of global trade talks seem simple.


But India is nowhere to be seen in all of this. Indeed, with Burma’s economy opening to the world, India ought to be taking the lead in seeking to stimulate South Asian growth and economic integration, for only by doing so can it anchor its neighbor within the region. Yet, when Prime Minister Manmohan Singh recently visited Burma, he had little to offer aside from the usual investment proposals. A bold initiative toward Bangladesh would also yield a strongly positive impact on growth, and yet nothing is happening there, either.



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With the major emerging countries, particularly China and India, already in trouble, Asia can expect to be hit hard if the euro sinks. Before that happens, governments must seize the policy initiative, thereby strengthening global financial markets’ confidence in Asia’s ability to withstand the ill wind from the West.


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Jaswant Singh is the only person to have served as India’s finance minister (1996, 2002-2004), foreign minister (1998-2004), and defense minister (2000-2001). While in office, he launched the first free-trade agreement (with Sri Lanka) in South Asia’s history, initiated India’s most daring diplomatic opening to Pakistan, revitalized relations with the US, and reoriented the Indian military, abandoning its Soviet-inspired doctrines and weaponry for close ties with the West. His most recent book is Jinnah: India-Partition-Independence







Markets Insight

June 19, 2012 8:01 pm

EU policies lead to chaotic resolution



The eurozone member states, says the G20 communiqué, are dedicated to “breaking the feedback loop between sovereigns and banks”. Is this a Hallelujah moment for Europe? It would be good to think so, but recognition of the problem comes dangerously late in the day, while experience suggests that eurozone policy makers have a genius for creating unintended consequences with every new incremental firefighting move.



Consider how awareness of this problem dawned, starting with the European Central Bank’s longer-term refinancing operations. Since late last year the ECB has encouraged European banks to take up cheap three-year money to help meet the refinancing needs of southern European governments.


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In effect, this meant undercapitalised banks were propping up over-indebted sovereign debtors, who were supporting undercapitalised banks. The Basel regulatory regime underpinned the process by according risk-free status to government debt despite the fact that such debt cannot be risk free in the eurozone because national eurozone central banks are unable to print money.




We saw by the end of last month that it was temporary medicine. As the impact of the liquidity injection ran out, the yields of Spanish and Italian government debt started rising back towards the danger levels that prevailed before the ECB’s supposed master stroke. In other words, for the remedy to be more than a short-term palliative it would have been necessary to go on pumping out liquidity to prevent yields reverting to a genuine market rate.



Then we had a serious issue over the subordination of debt held by private sector investors to official creditors such as the ECB, national eurozone central banks and the European Investment Bank arising from Greece’s voluntary debt exchange. This was followed by last week’s proposal for a €100bn rescue of the Spanish savings banks.



If, as expected, the money is provided through Spain’s Fund for Orderly Bank Restructuring, a government-guaranteed body, this would add about 9 or 10 percentage points to public sector debt in relation to gross domestic product. The official forecast for this year from the Spanish treasury, before the proposed bailout, was slightly less than 80 per cent of GDP. It is a feedback loop that looks dangerously like a noose.



Worse, there are fears among the banks that the funds may be channelled via the European Stability Mechanism, which will enjoy preferred creditor status second only to that of the International Monetary Fund. The impact of such a retrospective, arbitrary move would cause credit risk on private sector holdings of government bonds to rise, squeezing investors and making the paper less attractive in future.



According to the Institute of International Finance, which speaks for the global banking industry, some €240bn of Spanish government bonds are held by Spanish banks, which amounts to 6.5 per cent of total Spanish bank assets. The IIF’s dry conclusion is that it might bechallenging” for banks to add to these holdings.



Maybe this proposal is just a way station en route to a full bailout of the Spanish government – an outcome that seems increasingly likely. Maybe the ECB will come back with further liquidity injections or purchases of government bonds in the secondary market. The subordination problem could of course be resolved by having the ESM recapitalise the banks directly, while moving towards a banking union with a single supervisor.


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The speed with which political impetus is building up for such a union is striking. Yet this looks another crabwise movement by eurozone policy makers towards a backdoor form of fiscal federalism of precisely the kind that has produced bond market rallies of shorter and shorter duration while leaving Spanish and Italian bond yields at levels that put these countries’ solvency back into question.




Now the Constitutional Court in Karlsruhe has – not unpredictablymuddied the waters by deciding that the German government failed to consult Bundestag members adequately over the European Stability Mechanism. More importantly, the political complexion of the eurozone has changed significantly with the shift to the left in France under François Hollande who is, if anything, more Gaullist on the point of national sovereignty than his predecessor. And there is little popular support in the eurozone for “more Europe”.



In the end, it boils down to the old issue of who pays to keep the monetary union show on the road. Angela Merkel no doubt has no wish to go down in history as the German chancellor who presided over the break-up of the eurozone. But nor will she want to dish her electoral prospects next year by signing a blank cheque at German taxpayers’ expense. There are just too many circles here to be squared for a quick resolution. Bar a chaotic, market-induced resolution, that is.


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The author is an FT columnist

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Copyright The Financial Times Limited 2012


A European economic renaissance is still within reach

Summer 2012

by Norbert Walter
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A European renaissance is not only possible but is within reach, argues Norbert Walter. He analyses the different components that make up the eurozone crisis, and assesses the strengths that could overcome them.




What constitutes a crisis? Is it sustainable misery, meaning lasting economic decline, both high and long-term unemployment, poverty, rampant inflation, a precipitate fall in the exchange rate of a currency, fiscal deficits and high-cost finance? Most would agree that any situation would be labeled a crisis if just some of thesemisery indices” were being registered. Yet although Europe is in the middle of what is widely perceived as a eurocrisis, only a handful of these variables are in place, and in only a few eurozone countries.
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Although repeatedly used, the “eurocrisislabel is inappropriate. The euro, which at birth was already a strong currency at 1.18 to the U.S. dollar, even though the consensus view was that its fair value was more like $1.10 to the euro – has become stronger still. Today, the euro is valued at $1.30, a good 10 % higher than at its launch. And how about its internal value, meaning the performance of the new currency’s inflation rate? The 12-year record is in line with the European Central Bank’s (ECB) inflation target of slightly below 2% and is clearly more impressive than the much-lauded performance over 50 years of its most stable predecessor, the German D-Mark at almost 3% Consumer Price Index increase per annum.
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So why is there a eurozone crisis and what is it? Time and again it is argued that the single currency does not fit the different needs of the countries using it. This in turn has encouraged predictions of unsustainable economic divergence that will require abandonment of the euro.
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What divergencies between these national economies would warrant such action? Those most commonly referred to are differing growth rates, job creation and unemployment levels and dramatic imbalances in countries’ current accounts. These divergences may be caused by wide deviations in unit labour costs. If perceptions of such divergencies exist, there will be considerable risk premiums for problem countries, with the inevitable result of accelerating capital flight to safe havens.
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These are all developments that can unquestionably be observed in the euro area, particularly in its peripheral countries. Risk premiums started rising above benign levels in 2009, and then more strongly in 2011-2012, while capital flight became rampant in 2011, when massively increasing balances in the TARGET2 accounts in the European Central Bank system began to show up.
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But if one considers the underlying factors that may have caused capital movements of this sort, suspicion must also fall on unsustainable policies that are wider and more numerous than just monetary and fiscal macro policies, and that also extend to countries well outside the eurozone. In Europe, countries like the UK or Hungary are as much afflicted by structural deficiencies as are some of the peripheral eurozone countries. They have not been greatly helped by having a flexible exchange rate, or at least they have chosen not to exploit it. And internationally there are countries with government debt problems as big if not bigger than Europe’s periphery – with the U.S. and Japan being prime examples. There are also countries like Norway and Switzerland with current account surpluses greater than 10% of their GDP that are resisting currency revaluation.
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It’s worth remembering that Germany, which is nowadays seen as the eternal paymaster in a European transfer union, was labelled the “sick man of Europe” for the decade up till 2005. It was a completely uncompetitive Germany that entered the eurozone thanks to excessive wage and price increases that had followed the country’s reunification after the fall of the Berlin wall. Most agree that Germany entered the euro with an overvalued currency – a problem that has since been overcome by competitiveness improvements within the single currency. A nominal devaluation was not therefore needed. And the same has held true for the most recent member to join the eurozone. Estonia’s rigorous wage restraint made the country competitive in the single market in a very short space of time.
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Why then should there be such fierce doubts about whether the euro can survive? Some say that the attempts of the IMF and the EU institutions to enforce sound policies in the peripheral countries are bound to fail, and that sacrificing some of their democratic rights in order to keep the currency union afloat is too high a price to pay.
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It is not at all clear that this is the right way to look at it. It seems rather more obvious that the efforts of governments and international institutions in fact point the way toward better conditions and more sustainable solutions. Who would have predicted the very welcome changes of government in almost all the peripheral countries? And who six months earlier would have believed that the fiscal pact adopted in March 2012 would have been possible? And despite fluctuations has there not been a considerable reduction of the risk premiums for the problem countries? And did this not happen without adding to the financing costs of donor countries?
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There are many questions that only time will answer. Are we currently seeing the tentative signs of our escape from the eurozone’s malaise? Will the readiness of others to help those most deeply affected be sustained? Will the debtor countries be able to stick to really tough reform programmes, or will the man in the street there reject these austere policy prescriptions? And will donors, too, succeed in staying the course and avoiding the sort of backlash that might push them into populist and protectionist actions?
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In my view, a European renaissance is not only possible but is within reach. Europe has strategic answers to pressing international issues like energy efficiency, environmental protection and coping with ageing. Europe holds the key for liveable cities and also knows how to overcome narrow nationalism.
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We need to keep these strengths in mind when assessing the crisis. Intelligent co-operation within the limits of ensuring we don’t create moral hazard, should be able to prevent panic, while reducing risk premiums and allowing the fuller use of resources. These include the potential for transnational migration flows which should certainly be made easier and more attractive. High levels of unemployment, particularly among young skilled workers, could be avoided if donor countries that need migrants to infuse new blood into their own workforces were able to attract them. More immigration would raise skills and income levels and reduce those governments’ fiscal problems by cutting expenditure on unemployment benefits. Greater labour mobility inside the EU single market would yield other benefits too; it would help create a more open European mindset and thus weaken old nationalistic prejudices.
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So will Europe be able to reconfigure its integration process? Will it commit to moving the agenda forward to political union, and thereby address the question of something that has remained missing despite the Single Market, the Schengen Agreement and the Single Currency? The model for a future United States of Europe is Switzerland, a country with four languages and ethnicities, fiscally strong cantons, a single quality top currency and a federal structure in Berne that has a parliament with genuine, even if limited, budget rights.
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Europe can achieve positive results it if makes better use of its social endowments, and by encouraging entrepreneurism. If the EU made the most of the competences it already has, and governed more effectively in areas like energy efficiency, alternative energies, environmental issues and liveable cities, it could help the EU as a whole to achieve faster economic growth for at least the next decade, with 2.5% a year certainly not out of reach. More generous support for countries in trouble is essential for achieving this, because the euro must be preserved, even if not necessarily on the base of a larger eurozone. Financial markets would be more easily convinced if support for servicing the peripheral countries’ high levels of government debt was complemented by their acceptance of the fiscal pact along with technical help to strengthen their governance. In Greece, anticorruption officers from the U.S., Italian specialists on increasing tax efficiency, German privatisation experts and Spanish tourism professionals should be made available to speed up the modernisation process there. This all amounts to the much-needed Marshall plan for Greece that is so often called for, but not in the shape of more funds. The shortcomings in Greece’s planning and administrative capabilities has meant over the last decade that the country could only make use of a fifth of the funds being made available by Brussels for modernisation.
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There’s a lesson in all this for Europe as a whole as EU member states grapple with the realities – and with the myths – of the euro crisis.
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Norbert Walter is the former chief economist of Deutsche Bank Group and head of Deutsche Bank Research. jz@walterundtoechter.de