July 22, 2012 8:46 pm
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Time for Monti to tell Italy the truth
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It is always dangerous to claim a victory against Angela Merkel. After the last eurozone summit, Mario Monti and Mariano Rajoy emerged triumphalist. The agreement and Italy’s football victory over Germany were “a double satisfaction”, the Italian prime minister crowed. His Spanish counterpart returned to Madrid in celebratory mood, too. Rescue fund cash could now be injected directly into Spanish banks. But he forgot that in the eurozone crisis, there are no victoriesonly deals.





Four weeks later, Spaniards have discovered the true price of Mr Rajoy’svictory”: another austerity package and probable losses for small investors who gave money to the banks. Bond yields are near euro-era highs. Miners, firefighters and civil servants have taken to the streets. They blame the government for deceiving them until the truth was too ugly to conceal.




The speed with which the tide has turned in Spain should act as a warning to Mr Monti, the otherwinner” at last month’s meeting. Despite his natural caution, he announced that he had secured the right to use eurozone rescue funds to buy Italian bonds, shielding his country against ballooning borrowing costs. What is more, there would be no additional strings attached to the rescue – a claim that the Italian press trumpeted emphatically but was swiftly denied by Germany and other creditor countries.





Italy may, of course, never have to use this mechanism. But as external demand for Italian debt dries up and domestic banks struggle to replace foreign investors, it is ever more likely that Rome will have to tap the rescue funds. Were Italy to demand some help from Europesome analysts predict this could happen as early as the autumnRome would not get away with the pot of money and a pat on the back. The main lesson of the June summit – and of what has subsequently happened to Madrid – is that creditor countries will only open the tap in return for more supervision. Cash begets control.





Mr Monti has only one way to avoid sounding like Mr Rajoyspeaking truth to the political parties that support him and to the Italian people. While he has a right to deny that Italy will need external help, he should make it clear that if it happens additional conditions will almost certainly be imposed.



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Having dispelled the illusion of an easy way out of crisis, Mr Monti should double his reform efforts, which fizzled after a promising start. The government’s spending review should go much further, freeing up resources to cut taxes on labour. He should also take steps to improve competitiveness, including moves to overhaul the justice system.





The government should also be clear about the costs of the project of closer integration it is pursuing in Europe. A fiscal union and a banking union are an agreement and not a gift. While many in Rome consider them a quick way to bring down sovereign yields, these involve considerable transfers of power to Brussels.



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Centralised supervision will draw the curtain on the cosy relationship between the banks and politicians that Italians are used to. Parliament will lose at least some of its control over the budget.





For closer integration to succeed, voters need be made aware – if not consulted on – the cost that this entails in terms of lost sovereignty. Without engaging with Italians, any deal Mr Monti strikes in Brussels will backfire at home, just like Mr Rajoy’s Pyrrhic victory last month.




The Italian prime minister is running out of time to make his case. Voters now associate Europe with austerity and unemployment, which is above 10 per cent. Nor is there much light ahead, as creditor countries such as Germany refuse to unfold in detail their vision for the single currency.



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Italy remains, at heart, a europhile country. Widespread mistrust towards an ineffective, often corrupt domestic political class means that Italians are typically more willing than most to hand over powers to Brussels.




And in many instances, Brussels has delivered. External constraints such as the Maastricht treaty and the stability and growth pact have brought order to the country’s public finances. European regulations have helped to shake up sectors such as banking or telecoms, with tangible benefits for consumers.




Unless he makes his case for Europe, the project Mr Monti holds so close to his heart could collapse in his own backyard. Voters who feel they have been deceived could turn their heads to eurosceptic forces. And, with an election in 2013, there will be no shortage of politicians willing to ride the anti-euro wave.



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Mr Monti would then look back at the time he has spent celebrating victory over Ms Merkel and wish he had devoted more of it to explaining the stakes to his own citizens.




The writer is an FT leader writer



Copyright The Financial Times Limited 2012.

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OPINION
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July 22, 2012, 6:09 p.m. ET
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How Bernanke Can Get Banks Lending Again
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If the Fed reduces the reward for holding excess reserves, banks will have to find something else to do with their money, like making loans or putting it in the capital markets.
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By ALAN S. BLINDER

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The U.S. economy could use another boost, and it won't come from fiscal policy. Can the Federal Reserve provide it?




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Chairman Ben Bernanke keeps insisting that the central bank is not out of ammunition, and in a literal sense he is right. After all, the Fed has not yet exhausted its bag of tricks. It is still twisting the yield curve. It can purchase more assets. It can tell us that its federal funds target interest rate will remain 0-25 basis points beyond late 2014. It can even nudge the funds rate down within that range. The operational question is: How powerful are any of these weapons?






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Let's start with Operation Twist, which was recently extended through the end of this year. The Fed seeks to flatten the yield curve by buying longer-term Treasurys and selling shorter-term ones. And it's probably succeeding—a bit. But Federal Reserve activity in the Treasury markets is modest compared with the vast volume of trading.



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Realistically, the U.S. yield curve is probably influenced far more by daily developments in Europe. In any case, the Fed will be out of short-term Treasurys to sell by December.






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The logical next step would be more quantitative easingQE3—or, as the Fed likes to call it, more large-scale asset purchases.




Purchases of what? There are two main choices. One is Treasurys. But does anyone really think that lower U.S. Treasury rates are what this country needs?




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Mortgage-backed securities (MBS) are a better choice, the idea being to reduce mortgage rates by shrinking the spread between MBS and Treasurys. But mortgage rates are already falling toward 3.5%. With 10-year expected inflation around 2.1%, can a 1.4% real interest rate be deterring many prospective home buyers? No, they are shut out of the market by the unavailability of credit. Posted rates are low, but try getting a mortgage.





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The third available weapon is what the Fed calls "forward guidance"—that is, indicating (please don't say promising!) that the 0-25 basis points funds rate will be maintained for years to come. The Fed's current guidance (please don't call it a pledge!) extends "at least through late 2014." While that's pretty far into the future, the Fed could stretch it to 2015, 2016 or 2025 for that matter.





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In rational models, the yield curve should flatten a bit every time the Fed pushes that date out further. But the key words here are "rational" and "a bit." To most bond traders, two and a half years is already an eternity. Would they really respond much if 2015 replaced 2014?





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This brief analysis paints a pretty grim picture: The Fed has three weak weapons, one of which will be exhausted by year's end.






.Fortunately, there is more the Fed can do. I have two out-of-the-box suggestions to make, one in today's column and another in a companion piece soon.






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The simpler option is one I've been urging on the Fed for more than two years: Lower the interest rate paid on excess reserves. The basic idea is simple. If the Fed reduces the reward for holding excess reserves, banks will hold less of them—which means they will have to find something else to do with the money, such as lending it out or putting it in the capital markets.





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The Fed sees this as a radical change. But remember that it paid no interest on reserves before the 2008 crisis and, not surprisingly, banks held practically no excess reserves then. In early October of that year, Congress gave the Fed authority to pay interest on reserves, which it promptly started doing.





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When the Fed trimmed the federal funds rate to its current 0-25 basis-point range in December 2008, it also lowered the interest rate on reserves to 25 basis points, where it has been ever since.






.My suggestion is to push it lower in two stages. First, test the waters by cutting the interest on excess reserves (in Fedspeak, the "IOER") to zero. Then, if nothing goes wrong, drop it to, say, minus-25 basis points—that is, charge banks a fee for holding their money at the Fed. Doing so would provide a powerful incentive for banks to disgorge some of their idle reserves. True, most of the money would probably find its way into short-term money-market instruments such as fed funds, T-bills and commercial paper. But some would probably flow into increased lending, which is just what the economy needs.





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The Fed has steadfastly opposed this idea for years. Why? One objection is true but silly: Lowering the IOER might not be a very powerful instrument. No kidding. Are there a lot of powerful instruments sitting around unused?





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The other objection is that making the IOER zero or negative would push other money-market rates even closer to zero than they are now, thereby hurting money-market funds and otherwise impeding the functioning of money markets. My answer two years ago was that we have more important things to worry about. My answer today is that it has mostly happened anyway: U.S. money-market rates are negligible.





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It is noteworthy that the European Central Bank just jumped ahead of the Fed by cutting the rate it pays on bank deposits to zero—and European money markets did not die. Denmark's National Bank went even further, dropping its deposit rate to minus 20 basis points. Yet the Little Mermaid still sits in Copenhagen harbor.





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The Fed's hostility toward lowering the interest on excess reserves is almost self-contradictory. When Mr. Bernanke lists the weapons the Fed plans to use when the time comes to tighten monetary policy, he always gives raising the IOER a prominent role.



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His reasoning is straightforward and sound: If the Fed makes holding reserves more attractive, banks will hold more of them. Why doesn't the same reasoning apply in the other direction?




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But suppose it doesn't work. Suppose the Fed cuts the IOER from 25 basis points to minus 25 basis points, and banks don't lend one penny more. In that case, the Fed stops paying banks almost $4 billion a year in interest and, instead, starts collecting roughly equal fees from banks. That would be almost an $8 billion swing from banks to taxpayers. There are worse things.




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Mr. Blinder, a professor of economics and public affairs at Princeton University, is a former vice chairman of the Federal Reserve.




.Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

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Bubbles without Markets

Robert J. Shiller

23 July 2012

 

A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest. The excitement then lures more and more people into the market, which causes prices to increase further, attracting yet more people and fuelingnew erastories, and so on, in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.





But, before we conclude that we should now, after the crisis, pursue policies to rein in the markets, we need to consider the alternative. In fact, speculative bubbles are just one example of social epidemics, which can be even worse in the absence of financial markets. In a speculative bubble, the contagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices to get public attention and spread quickly.



.Some examples of social epidemics unsupported by any speculative markets can be found in Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. The book made some historical bubbles famous: the Mississippi bubble 1719-20, the South Sea Company Bubble 1711-20, and the tulip mania of the 1630’s. But the book contained other, non-market, examples as well.



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MacKay gave examples, over the centuries, of social epidemics involving belief in alchemists, prophets of Judgment Day, fortune tellers, astrologers, physicians employing magnets, witch hunters, and crusaders. Some of these epidemics had profound economic consequences. The Crusades from the eleventh to the thirteenth century, for example, brought forth what MacKay described as “epidemic frenzy” among would-be crusaders in Europe, accompanied by delusions that God would send armies of saints to fight alongside them. Between one and three million people died in the Crusades.



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There was no way, of course, for anyone either to invest in or to bet against the success of any of the activities promoted by the social epidemicsno professional opinion or outlet for analysts’ reports on these activities. So there was nothing to stop these social epidemics from attaining ridiculous proportions.



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MacKay’s examples may seem a bit remote to us now. Some examples that we might relate to better can be found in the communist, centrally planned economies of much of the twentieth century, which also had no speculative markets. To be sure, events in these economies might seem attributable simply to their leaders’ commands. But social contagions took hold in these countries even more powerfully than they have in our “bubbleeconomies.




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China’s Great Leap Forward in 1958-61 was a market-less investment bubble. The plan involved both agricultural collectivization and aggressive promotion of industry. There were no market prices, no published profit-and-loss statements, and no independent analyses. At first, there was a lot of uninformed enthusiasm for the new plan. Steel production was promoted by primitive backyard furnaces that industry analysts would consider laughable, but people who understood that had no influence in China then. Of course, there was no way to short the Great Leap Forward. The result was that agricultural labor and resources were rapidly diverted to industry, resulting in a famine that killed tens of millions.



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The Great Leap Forward had aspects of a Ponzi scheme, an investment fraud which attempts to draw in successive rounds of investors through word-of-mouth tales of outsize returns. Ponzi schemes have managed to produce great profits for their promoters, at least for a while, by encouraging a social contagion of enthusiasm.




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Mao Zedong, on visiting and talking to experts at a modern steel plant in Manchuria, is reported to have lost confidence that the backyard furnaces were a good idea after all, but feared the effects of a loss of momentum. He appears to have been worried, like the manager of a Ponzi scheme, that any hint of doubt could cause the whole movement to crash. The Great Leap Forward, and the Cultural Revolution that followed it, was a calculated effort to create a social contagion of ideas.



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Some might object that these events were not really social epidemics like speculative bubbles, because a totalitarian government ordered them, and the resulting deaths reflect government mismanagement more than investment error. Still, they do have aspects of bubbles: collectivization was indeed a plan for prosperity with a contagion of popular excitement, however misguided it looks in retrospect.



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The recent and ongoing world financial crisis pales in comparison with these events. And it is important to appreciate why. Modern economies have free markets, along with business analysts with their recommendations, ratings agencies with their classifications of securities, and accountants with their balance sheets and income statements. And then, too, there are auditors, lawyers and regulators.



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All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders really serious economic catastrophes – the kind that dwarf the 2008 crisisvirtually impossible.




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Robert J. Shiller is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. His book Irrational Exuberance presciently warned of the dot-com bubble, and a second edition, released in 2005, predicted the coming collapse of the real-estate bubble. His most recent book, co-written with George Akerlof, is Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.


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Worry about the euro; not price stability

Lorenzo Bini Smaghi

July 23, 2012






By assigning to the European Central Bank the task of “defining and implementing the monetary policy of the Community”, the EU Treaty implicitly considers that there should be only one monetary policy for the entire euro area. Yet, looking at a variety of indicators – from short or long term interest rates on a wide variety of assets to the flow of money and credit to the private sector – it is difficult to conclude that monetary conditions are currently uniform across the union.



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The central bank typically implements its monetary policy by setting the rate of interest at which it lends to the banking system. Such a rate, which influences asset prices and affects the savings and investment decisions of the private sector, is determined with a view to achieve price stability. A key assumption underlying this operational framework is that financial markets are efficient and support a smooth flow of funds across the union. In other words, the transmission mechanism of monetary policy is expected to be stable and predictable.





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This assumption is currently far from being satisfied. The euro area financial market, in all segments and maturities – including the very short term money marketsdoes not function properly, as banks deposit their excess liquidity with the central bank instead of lending to other banks. Cross-border banking flows have dried up. Households and firms across the union borrow at rates which depend more on the respective sovereign riskjust look at Spain, today, for example — than on their intrinsic creditworthiness. Interest rate decisions made by the central bank are not able to affect monetary conditions in the desired way in a large part of the euro area.



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There are two ways to address the issue. The first is that the central bank adopts measures aimed at circumventing the prevailing disruptions to the transmission mechanism of monetary policy. Over the last two years the ECB has taken several actions in this direction, such as the provision of unlimited long term refinancing to banks, at a fixed rate. These measures have been effective, at least for some time, and there is probably room for more, but the transmission mechanism of monetary policy has remained impaired.








The second way is to repair the transmission mechanism. But who’s task is it? Central bankers tend to think that the responsibility lies primarily with national governments and supervisors, given that the malfunctioning of the financial markets is mainly due to the heightened banking and sovereign risk.





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Governments, on their part, contend that they have already taken strong actions, and have committed to more, but markets are too slow to recognise progress. Only the central bank has sufficient firepower to push markets towards a sustainable equilibrium.







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Both are right, to some extent. But there can be no viable solution without actions being taken at the same time by governments and the central bank, each in their own field of competence. In allocating responsibilities, the euro area can build on the experience gained by the International Monetary Fund in dealing with crises for over 40 years. First, strong conditionality is needed to ensure that governments consistently implement their adjustment programs over time. Second, liquidity has to be provided in sufficiently large amounts so as to catalyse private financial flows and convince market participants that the system is stable.
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.To be effective, the solution requires confidence and trust between the policy authorities. The central bank has to be reassured that the conditionality adopted by the member states is sufficiently stringent, lasting and irreversible. In this respect, the experienced which followed last Summer’s ECB’s intervention in the secondary market for Spanish and Italian government debt has left a sour aftertaste.





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Governments, on their side, have to be reassured that the tough measures that they have committed are supported by the provision of sufficient liquidity to guarantee success over time. To be sure, the fiscal adjustments which are currently being implemented have little chance of succeeding unless the interest rates prevailing in these countries are rapidly brought down more in line with the rest of the euro area. This can hardly be done without the direct involvement of the central bank.





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The strategy is successful if market participants are convinced that policy makers stand ready to do all that is needed to solve the crisis. Communication is key, and needs to be consistent with this requirement. In this respect, focusing on what the central bank should not do or does not intend to do, rather than what it might eventually do, if necessary, in order to address the problem, can be counter-productive. For example, repeatedly raising concerns in the public about the size and the risks of the central bank balance sheet, about the dimension of the cross-border payment imbalances (Target2 balances) or about the limited ability of monetary policy to solve all problems may fuel doubts among market participants about the determination of the monetary authorities. In a fiat money system, even the slightest doubt that the central bank may face constrains in ensuring the convertibility of the currency can fuel bank runs and generate financial turmoil.



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The euro area crisis may have reached a point in which it can hardly be resolved unless the policy authorities are determined to take bold actions. This may require that the member states further strengthen their policy commitments, concerning in particular the structural reforms aimed at improving competitiveness and growth, and make these commitments irreversible, consistently with their membership of the euro area. It also requires that the central bank takes more drastic measures to ensure that there is a single monetary policy throughout the euro area, consistently with its mandate.



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Price stability is not in danger right now. The euro might be.





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The writer is a visiting scholar at Harvard’s Weatherhead Center for International Affairs and a former member of the ECB’s executive board