September 11, 2012 7:51 pm

Draghi alone cannot save the euro

Ingram Pinn illustration

Last week’s decision by the European Central Bank to make unlimited purchases of government bonds in secondary markets was both necessary and bold. Mario Draghi, the ECB’s president, deserves credit for having obtained agreement for this controversial step, against the sole, albeit significant, opposition of Jens Weidmann, president of Germany’s redoubtable Bundesbank. It is a pity that the ECB did not do this before the crisis in sovereign debt reached Spain and Italy. Yet this delay is not surprising: eurozone policy makers have, perhaps inevitably, done too little, too late.

It is not the ECB’s fault that this action is too little. Its aim is to eliminate the risk of a eurozone breakup forced by the markets. But it cannot achieve this on its own. Ensuring the survival of the eurozone is a political decision. The ECB can only influence, not determine, the outcome.

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The rationale offered for the programme of “Outright Monetary Transactions” is ingenious. The ECB insists that it does not aim to finance governments in difficulty. That, it insists, is a mere byproduct. At last week’s press conference, Mr Draghi stated that: “We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance to the real economy throughout the area. OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro.” In making this case, Mr Draghi argued that “you have large parts of the euro area in what we call a ‘bad equilibrium ... So, there is a case for intervening ... to “break” these expectations, which ... do not concern only the specific countries, but the euro area as a whole. And this would justify the intervention of the central bank”. This then marks belated acceptance of strong arguments made by the Belgian economist, Paul de Grauwe, at the London School of Economics.

In its “Article IVconsultation with the eurozone, published in July, the staff of the International Monetary Fund argues that despite the low policy rates, credit conditions are extremely tight in some member countries. This, it argues, is due to divergent perceptions of the interlinked sovereign and banking risks, as well as a shrinkage in cross-border lending, as efforts are made to increase capital and liquidity buffers at home and place overnight deposits at the ECB. Today, in consequence, “financing conditions are the least supportive in countries where the crisis is the most acute.” This dire situation gives a strong rationale for the new policy. (See charts.)

Yet the ECB will not intervene unconditionally. It will, instead, intervene if and only if countries meet specific conditions. The precise conditions will not be set by the ECB. Mr Draghi said that it was up to the governments, the European Union, the European Commission and the IMF to decide on the precise nature of these conditions. But, once agreed, they would need to be respected. That is the ECB’s demand.

Such conditionality is perfectly understandable. But it must militate against the goals of the new programme. The ECB is saying that it will seek to eliminate the threat of a break-up, except when this threat is most real, which is of course, precisely when the country is failing to meet policy conditions.

Investors know that electorates might choose a government that has no intention of sticking to agreed conditions. What happens then? The answer is: either the ECB stops buying, in which case the bond market implodes, or the ECB continues, in which case conditionality is jettisoned.

This latter possibility seems the more likely: it will be hard for the ECB to stop. But that, too, might have dire consequences. Spurred on by opposition to this scheme from the Bundesbank, postwar Germany’s most respected institution, swathes of German opinion hate what is happening to their money, as my colleague, Wolfgang Munchau, explained a recent column. It is easy to imagine what would happen within Germany if an important member country started to backslide on agreed policy conditions, while the ECB went on buying its bonds. The swelling rage would hardly strengthen confidence in the irreversibility of the euro. Nobody could be sure how German politicians would choose to respond – or be allowed to respond. At present, the government is quite supportive of the ECB. But that would surely not endure under all circumstances.

In brief, a conditional programme of bond purchases, implemented against the opposition of the Bundesbank, just cannot make the eurozone credibly irreversible.

Is there any way the ECB on its own could make it more credible that the eurozone will last?
The answer is: yes and no.

Yes, if people believed membership of the eurozone were clearly in everyone’s interests, its survival would become far more credible. For that to happen, deficit countries need growth and jobs. The ECB could contribute by stepping harder on the monetary accelerator. After all, short-term economic prospects are dismal: the ECB forecasts real economic growth in the eurozone at -0.6 to -0.2 per cent this year and -0.4 to 1.4 per cent in 2013. By the second quarter of 2012, the eurozone’s nominal gross domestic product was a mere 3.4 per cent higher than in the first quarter of 2008.

Yet the answer is also, alas, “no”, because a more aggressive monetary policy would confirm German fears that the ECB was becoming the Banca d’Italia. The difficulty for the ECB is that relevant and appropriate measures are viewed, in Germany, as a giant step on the dismal path to hyperinflationary ruin. So long as this is the case, the ECB cannot make the euro look irreversible. That fact will undermine markets. That would force the ECB to buy more, so making the policy still less credible.

The ECB has done what it can, given the politics. The decision of the German constitutional court and the result of the Dutch election may help. But the risks of a breakup cannot be eliminated. If these are to disappear, citizens of debtor countries must see a credible path to growth, while citizens of creditor countries must believe they are not throwing money down a bottomless pit. What the ECB has done is win some time. It has not won the game.

Copyright The Financial Times Limited 2012.


September 11, 2012, 7:38 p.m. ET

Gramm and Taylor: The Hidden Costs of Monetary Easing

Inflation is not the only danger posed by the central bank's ballooning balance sheet.



Since mid-September of 2008, the Federal Reserve balance sheet has grown to $2,814 billion from $924 billion as it purchased massive amounts of U.S. Treasurys and mortgage backed securities. To finance those purchases the Fed increased currency and bank reserves (base money).

That kind of monetary expansion would normally be a harbinger of inflation. However, with banks holding excess reserves rather than lending them out—and with velocity (the rate at which money turns over generating national income) at a 50-year low and falling—the inflation rate has stayed close to the Fed's 2% target.

While the Fed considered its previous rounds of easingQE1, QE2 and Operation Twist—the argument was consistently made that the cost of such actions was low because inflation was nowhere on the horizon. The same argument is now being made as the central bank contemplates QE3 during the Federal Open Market Committee meetings on Wednesday and Thursday.

Inflation is not, however, the only cost of these unconventional monetary interventions. As investors try to predict the timing and effect of Fed policy on financial markets and the economy, monetary policy adds to the climate of economic uncertainty and stasis already caused by current fiscal policy. There will be even greater costs when the economy begins to grow and the Fed, to prevent inflation, has to reverse course and sell bonds and securities to the public.

Since September 2008, the Fed has acquired $1.16 trillion of government securities—in fiscal year 2011 (Oct. 1, 2010-Sept. 30, 2011), the central bank bought 77% of all the additional debt issued by the Treasury. Aside from the monetary impact of these debt purchases, the Fed allowed the federal government to borrow a trillion dollars without raising the external debt of the Treasury and without having to pay net interest on that portion of the debt, since the central bank rebated the interest payments to the Treasury.

When the Fed must, in Chairman Ben Bernanke's words, begin "removing liquidity," by selling bonds, the external debt of the federal government will rise and the Treasury will then have to pay interest on that debt to the public. Selling a trillion dollars of Treasury bonds on the market—at the same time the government is running trillion-dollar annual deficits—will drive up interest rates, crowd out private-sector borrowers and impede the recovery. Debt-service costs to the Treasury will spiral as every 1% increase in federal borrowing costs add $100 billion to the annual budget deficit.

In addition, Operation Twist, by shortening the average maturity date of externally held debt, will require the Treasury to borrow more money sooner when the economy recovers and interest rates start to rise. This too will drive up interest costs and the deficit.

The same problems will occur as the Fed begins to sell its holdings of mortgage-backed securities to reduce the monetary base. When the Fed bought these securities, it may have marginally reduced mortgage interest rates. Selling them during a real recovery will likely cause mortgage rates to rise.

Proponents of QE3 argue that while the Fed's balance sheet must be reduced at some future time, it has the tools to minimize the impact on interest rates by slowing down the pace of the sales. But the Fed's ability to act has already been compromised by its pledge to maintain low interest rates through 2014. Having to time open-market sales to minimize interest-rate increases will further limit the Fed's ability to preserve price stability. In short, the Federal Reserve in future years will face significant constraints that are being forged now.

The Fed could raise the interest rate that it pays banks on reserves they hold in lieu of reducing its balance sheet. Where would the money come from? It has to come out of the money the Fed is currently paying the Treasury, driving up the federal budget deficit. How will taxpayers feel about subsidizing banks not to lend them money?

Rational decision making comes down to a comprehensive measure of cost and benefits. The Fed's effort to use monetary policy to overcome bad fiscal and regulatory policy long ago reached the point of diminishing returns. The benefits of a third round of quantitative easing will almost certainly be de minimis. But when economic growth does return, Fed actions will have to be reversed in an era of rising interest rates, and the marginal cost of a QE3 tomorrow will almost certainly be far greater than the marginal benefit today.

Someday, hopefully next year, the American economy will come back to life. Banks will begin to lend, the money supply will expand, and the velocity of money will rise. Unless the Fed responds by reducing its balance sheet, inflationary pressures will build rapidly.

At that point the cost of our current monetary policy will be all too clear. Like Mr. Obama's stimulus policy, Mr. Bernanke's monetary expansion will ultimately have to be paid for.

The Fed softened the recession by its decisive actions during the panic of 2008, but the marginal benefits of its subsequent policy have almost certainly been small. We may find the policies that had little positive impact on the recovery will have high costs indeed when they must be reversed in a full blown expansion.

Mr. Gramm was chairman of the Senate Banking Committee and is senior partner of US Policy Metrics. Mr. Taylor is a professor of economics at Stanford University and a senior fellow at the Hoover Institution. He was undersecretary of the Treasury for international affairs in the first George W. Bush administration.


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

jueves, septiembre 13, 2012



China’s Evolving Web

Andrew Sheng

11 September 2012


HONG KONGIn a recent article, the economist Axel Leijonhufvud defines the market system as a web of contracts. Because contracts are linked with each other, one default can trigger an avalanche of broken promises, “[making] it possible to destroy virtually the entire web of formal and informal contracts which the market system requires for its functioning.” The state’s role is to protect, enforce, and regulate these contracts and related property rights, as well as to intervene to prevent systemic failure.
This web of contractsoften taken for granted in mainstream economics, to the extent that it becomes almost invisibleembodies the formal and informal rules embedded in the market system that shape and constrain individual and social behavior. They form the fabric of all human institutions.
Advanced economic systems have very complex webs of contracts, such as financial derivatives. For Europe, Leijonhufvud argues, this implies a three-pronged approach that focuses on “levels of leverage,” “maturity mismatches,” and “the topology of the web,” – that is, “its connectivity and the presence of critical nodes that are ‘too big to fail.’” This is because “the web of contracts has developed serious inconsistencies.” To insist that all contracts be fulfilled would “cause a collapse of very large portions of the web,” with “serious economic and incalculable social and political consequences.”
By contrast, emerging markets like China have less sophisticated systems and evolve more complex contractual/institutional links over time, particularly through globalized transactions. Under China’s planned economy, most contracts were between individuals and the state, whereas more sophisticated market contracts have emerged or re-emerged only over the last 30 years. Indeed, the widespread use of market contracts with publicly-owned companies was a recent and important adaptation in the move toward a “socialist market economy.”
The web of contracts, however, can also be understood as complex adaptive market systems, which encompass the state and family relations as well. To understand China’s socialist market economy, it is essential to examine systematically these different forms of contracts and their institutional structures.
Family and kinship contracts, which govern marriage, adoption, cohabitation, inheritance, etc., form the basic unit of human society. These contracts are the most ancient and remain the foundation of social relationships in China today.
Corporate contracts place the profit-oriented legal person at the center of the transaction and bind all of its stakeholders. Chinese corporate contracts have grown exponentially over the last 30 years, but they have special characteristics that reflect the primary role of Chinese state-owned enterprises.
Market contracts between producers and consumers – and/or among producers in supply chains link individuals, families, firms, governments, and public organizations through local or global markets. Over the last few decades, China has begun to practice modern contract law and joined the World Trade Organization, committing itself to international rules governing trade and investment.
Non-governmental and non-profit civil contracts bind people together for communal, religious, social, and political activities. These contracts are still relatively new and evolving in China.
Social contracts created by constitutional and administrative laws define the powers and responsibilities of the state and its constituent bodies vis-à-vis individuals and the private sector. They include the authority to impose taxes and restraints on individuals and private entities through criminal, administrative, and civil law, as well as the state’s obligation to provide public goods and services. China has strengthened its unitary state with important institutional innovations that have delivered growth and middle-income prosperity, but it still retains the basic five-level administrative structurecentral government on top, with provincial, city, town, and village bodies below – that first emerged two millennia ago.
Deciphering the structure of the web of contracts holds the key to understanding how an economy behaves, including its dynamic non-linear adaptation to internal and external forces. Following the physicist Fritjof Capra, one should regard living organisms, social systems, and ecosystems as an interconnected and interdependent, complex adaptive system. This means that we should view the economy and society not as rigid hierarchies or mechanical markets, but as networks or webs of life, in which contracts, formal and informal, fulfilled or violated, are the essence of human activity.
Examining webs of contracts should be similar to a biologist’s examination of cell structure and DNA.

China has created four functioning global-scale modern supply chains in manufacturing, infrastructure, finance, and government services, thanks to its evolving, expanding, and complex web of contracts. But how was China able to build a modern industrial base within a relatively short period of time from its traditional, patrimonial family contracts and archaic constitutional structures?
Through experimentation, adaptation, and evolution – a process that has been described as “crossing the river by feeling the stones” – China has been able to evolve a higher-order, or fifth, supply chain in political decision-making. This “top-level governance architecture,” as it is known in China, has been essential for coordinating and orchestrating the different supply chains and the overall web of contracts to achieve the delicate balance among individual, family, corporate, social, and national objectives.
This top-level governance architecture is analogous to a computer’s operating system, which orchestrates the other software and hardware components to form a holistic unity. Such a structure exists in many economies, but, in the Chinese context, where the state plays a central role in the economy, it is critical to the system’s effectiveness. How it is shaped will depend on how China’s history, culture, institutional context, and evolving web of contracts affect the country’s social fabric.
Andrew Sheng, President of the Fung Global Institute, is a former chairman of the Hong Kong Securities and Futures Commission and is currently an adjunct professor at Tsinghua University, Beijing. His latest book is From Asian to Global Financial Crisis.

Last updated:September 12, 2012 8:50 pm
Incentives for banks to stray will persist
Ingram Pinn illustration

If regrets, apologies and promises to behave better were redeemable for cash, the world’s banks would be rolling in it.

On Monday, Rich Ricci, Barclays’ head of investment banking, promised to “redefine what we are here to do, and the way in which we conduct ourselves”. On Tuesday Anshu Jain, Deutsche Bank’s joint chief executive, conceded that “tremendous mistakes have been made”. Vikram Pandit of Citigroup talks of “a profound responsibility to keep [the financial system] safe”.

The words have been matched by some action. Barclays and Deutsche have lowered profit targets from the high levels that encouraged banks to take trading risks, sell poor products to customers, and gamble with their reputations. Barclays will shrink its infamous and highly profitabletax structuring unit.

There is plenty for which to apologise. Rampant personal and corporate lending during the bubble, followed by a squeeze on credit; the invention and trading of volatile credit derivatives; the mis-selling of costly payment protection insurance by UK banks; distortion of Libor by traders; global tax avoidance and arbitrage. And so on.

But what are the odds of these noble promises enduring past the usual period of sackcloth and ashes at the bottom of the banking cycle? Not very high, I’m afraid. Although the new generation of bank leaders probably has good intentions – as well as needing to assuage public outrage – these pledges will be difficult to enforce, or even recall, when it matters.

The structure of modern finance, and the pressure from shareholders to increase revenues and keep them growing, makes it difficult to impose much restraint. Incentives to misbehave are deeply embedded in the system and have outlasted all past efforts at reform.

Here is an example. A quarter of a century ago, I was mis-sold an endowment policy tied to a mortgage that was designed to repay the capital while I met the monthly interest. Like other innocents, I had no idea of how such policies worked and took the word of a salesperson – an expensive mistake that has crystallised 25 years later.

My policy embodied several problems in the reform of finance. One is the complexity and opacity of many products, which give those selling them plenty of leeway for abuse. Whether the buyer is a mortgage borrower or an insurer seeking a mortgage-backed collateralised debt obligation, he or she is easy to hoodwink.

The second problem is time. This incident happened shortly after Big Bang, the deregulation of the City of London that revolutionised finance. By the time the damage became clear, about a decade after I had bought my policy, the seller had long moved on. If you buy a television, it is immediately plain whether the product works; in finance, it can take years to discover.

The third problem is financial incentives. I don’t suppose that the person who sold me the endowment believed it would underperform but nor, probably, did he care. He was being paid a commission to persuade me to buy that product and so was hopelessly biased.

In theory, individual incentives are solubleinvestment banks are altering bonus structures to stop traders from exploiting customers for short-term gain and retail banks plan to do the same in branches. But the biggest incentive problem binds the banks themselves.

The core profitability of both investment and retail banking has steadily eroded. The end of fixed commissions in securities broking made the sale of ordinary low-margin securities uneconomic. Meanwhile, many retail banks ceased charging those in credit. The bulk of profits had to come from trading and “innovativeproducts, ranging from my endowment to CDOs.

Reducing the targets for return on equity – in Barclays’ case to just above its cost of capital – is a sound first step because it reduces the pressure on staff to sell high-risk products. The key is whether banks will gain financially from behaving more ethically.

That, I doubt. It need not be rational to grab short-term revenues at any long-term cost. Many banks seemed to be highly profitable in the good times but later lost the lot in one-off writedowns. More cautious institutions achieved a higher risk-adjusted return on capital.

But having a bad reputation is not as financially damaging as making a bad loan. In my case, it was so long ago that I can hardly remember which building society directed me to the salesperson. Even those who dislike their banks tend to stick with them because it is hard to move and the alternatives are similar.

Take Goldman Sachs, the investment bank whose reputation was badly hurt by the 2008 crash. It is a byword for Wall Street excess, yet it did not lose many customers by settling with the Securities and Exchange Commission on charges of securities fraud. The US Treasury this week named Goldman as one of the group of underwriters that will try to sell $2.7bn of its AIG shares.

For now, shareholders will accept lower targets for return on equity and will swallow, and even support, initiatives that reduce revenues. In the longer-term, when the self-flagellation is forgotten and exciting new opportunities arise, they will be less indulgent.

This generation of bankers is no doubt genuine in wanting to redeem past sins. No one likes to be vilified and, as Giles Fraser, the Church of England priest who resigned from St Paul’s Cathedral in protest at the eviction of the Occupy London demonstrators, says: “I reject the idea that bankers are more morally corrupt than anyone else.”

Despite that, the smart money is against them.

Copyright The Financial Times Limited 2012.