The Eurozone’s Delayed Reckoning

Nouriel Roubini

17 December 2012

NEW YORKThe risks facing the eurozone have been reduced since the summer, when a Greek exit looked imminent and borrowing costs for Spain and Italy reached new and unsustainable heights. But, while financial strains have since eased, economic conditions on the eurozone’s periphery remain shaky.

Several factors account for the reduction in risks. For starters, the European Central Bank’soutright monetary transactionsprogram has been incredibly effective: interest-rate spreads for Spain and Italy have fallen by about 250 basis points, even before a single euro has been spent to purchase government bonds. The introduction of the European Stability Mechanism (ESM), which provides another €500 billion ($650 billion) to be used to backstop banks and sovereigns, has also helped, as has European leaders’ recognition that a monetary union alone is unstable and incomplete, requiring deeper banking, fiscal, economic, and political integration.

But, perhaps most important, Germany’s attitude toward the eurozone in general, and Greece in particular, has changed. German officials now understand that, given extensive trade and financial links, a disorderly eurozone hurts not just the periphery but the core. They have stopped making public statements about a possible Greek exit, and just supported a third bailout package for the country. As long as Spain and Italy remain vulnerable, a Greek blowup could spark severe contagion before Germany’s election next year, jeopardizing Chancellor Angela Merkel’s chances of winning another term. So Germany will continue to finance Greece for the time being.

Nonetheless, the eurozone periphery shows little sign of recovery: GDP continues to shrink, owing to ongoing fiscal austerity, the euro’s excessive strength, a severe credit crunch underpinned by banks’ shortage of capital, and depressed business and consumer confidence. Moreover, recession on the periphery is now spreading to the eurozone core, with French output contracting and even Germany stalling as growth in its two main export markets is either falling (the rest of the eurozone) or slowing (China and elsewhere in Asia).

Moreover, balkanization of economic activity, banking systems, and public-debt markets continues, as foreign investors flee the eurozone periphery and seek safety in the core. Private and public debt levels are high and possibly unsustainable. After all, the loss of competitiveness that led to large external deficits remains largely unaddressed, while adverse demographic trends, weak productivity gains, and slow implementation of structural reforms depress potential growth.

To be sure, there has been some progress in the eurozone periphery in the last few years: fiscal deficits have been reduced, and some countries are now running primary budget surpluses (the fiscal balance excluding interest payments). Likewise, competitiveness losses have been partly reversed as wages have lagged productivity growth, thus reducing unit labor costs, and some structural reforms are ongoing.

But, in the short run, austerity, lower wages, and reforms are recessionary, while the adjustment process in the eurozone has been asymmetric and recessionary/deflationary. The countries that were spending more than their incomes have been forced to spend less and save more, thereby reducing their trade deficits; but countries like Germany, which were over-saving and running external surpluses, have not been forced to adjust by increasing domestic demand, so their trade surpluses have remained large.

Meanwhile, the monetary union remains an unstable disequilibrium: either the eurozone moves toward fuller integration (capped by political union to provide democratic legitimacy to the loss of national sovereignty on banking, fiscal, and economic affairs), or it will undergo disunion, dis-integration, fragmentation, and eventual breakup. And, while European Union leaders have issued proposals for a banking and fiscal union, now Germany is pushing back.

German leaders fear that the risk-sharing elements of deeper integration (the ESM’s recapitalization of banks, a common resolution fund for insolvent banks, eurozone-wide deposit insurance, greater EU fiscal authority, and debt mutualization) imply a politically unacceptable transfer union whereby Germany and the core unilaterally and permanently subsidize the periphery. Germany thus believes that the periphery’s problems are not the result of the absence of a banking or fiscal union; rather, on the German view, large fiscal deficits and debt reflect low potential growth and loss of competitiveness due to the lack of structural reforms.

Of course, Germany fails to recognize that successful monetary unions like the United States have a full banking union with significant risk-sharing elements, and a fiscal union whereby idiosyncratic shocks to specific states’ output are absorbed by the federal budget. The US is also a large transfer union, in which richer states permanently subsidize the poorer ones.

At the same time, while proposals for a banking, fiscal, and political union are being mooted, there is little discussion of how to restore growth in the short run. Europeans are willing to tighten their belts, but they need to see a light at the end of the tunnel in the form of income and job growth. If recessions deepen, the social and political backlash against austerity will become overwhelming: strikes, riots, violence, demonstrations, the rise of extremist political parties, and the collapse of weak governments. And, to stabilize debt/GDP ratios, the denominator must start rising; otherwise, debt levels will become unsustainable, despite all efforts to reduce deficits.

The tail risks of a Greek exit from the eurozone or a massive loss of market access in Italy and Spain have been reduced for 2013. But the fundamental crisis of the eurozone has not been resolved, and another year of muddling through could revive these risks in a more virulent form in 2014 and beyond. Unfortunately, the eurozone crisis is likely to remain with us for years to come, sustaining the likelihood of coercive debt restructurings and eurozone exits.

Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.

December 17, 2012 6:46 pm
Today’s challenges go beyond Keynes
A different kind of growth path is required, says Jeffrey Sachs

For more than 30 years, from the mid-1970s to 2008, Keynesian demand management was in intellectual eclipse. Yet it returned with the financial crisis to dominate the thinking of the Obama administration and much of the UK Labour party. It is time to reconsider the revival..

The rebound of Keynesianism, led in the US by Lawrence Summers, the former Treasury secretary, Paul Krugman, the economist-columnist, and the US Federal Reserve chairman Ben Bernanke, came with the belief that short-term fiscal and monetary expansion was needed to offset the collapse of the housing market.

The US policy choice has been four years of structural (cyclically adjusted) budget deficits of general government of 7 per cent of gross domestic product or more; interest rates near zero; another call by the White House for stimulus in 2013; and the Fed’s new policy to keep rates near zero until unemployment returns to 6.5 per cent. Since 2010, no European country has followed the US’s fiscal lead. However, the European Central Bank and Bank of England are not far behind the Fed on the monetary front.

We can’t know how successful (or otherwise) these policies have been because of the lack of convincing counterfactuals. But we should have serious doubts. The promised jobs recovery has not arrived. Growth has remained sluggish. The US debt-GDP ratio has almost doubled from about 36 per cent in 2007 to 72 per cent this year.

The crisis in southern Europe is often claimed by Keynesians to be the consequence of fiscal austerity, yet its primary cause is the countries’ and eurozone’s unresolved banking crises. And the UK’s slowdown has more to do with the eurozone crisis, declining North Sea oil and the inevitable contraction of the banking sector, than multiyear moves towards budget balance.

There are three more reasons to doubt the Keynesian view. First, the fiscal expansion has been mostly in the form of temporary tax cuts and transfer payments. Much of these were probably saved, not spent.

Second, the zero interest rate policy has a risk not acknowledged by the Fed: the creation of another bubble. The Fed has failed to appreciate that the 2008 bubble was partly caused by its own easy liquidity policies in the preceding six years. Friedrich Hayek was prescient: a surge of excessive liquidity can misdirect investments that lead to boom followed by bust.

Third, our real challenge was not a great depression, as the Keynesians argued, but deep structural change. Keynesians persuaded Washington it was stimulus or bust. This was questionable. There was indeed a brief depression risk in late 2008 and early 2009, but it resulted from the panic after the abrupt and maladroit closure of Lehman Brothers.

There is no going back to the pre-crisis economy, with or without stimulus. Unlike the Keynesian model that assumes a stable growth path hit by temporary shocks, our real challenge is that the growth path itself needs to be very different from even the recent past.

The American labour market is not recovering as Keynesians hoped. Indeed, most high-income economies continue to shed low-skilled jobs, either to automation or to offshoring. And while US employment is rising for those with college degrees, it is falling for those with no more than a high school education.

The infrastructure sector is a second case in point. Other than a much-hyped boom in gas fracking, investments in infrastructure are mostly paralysed. Every country needs to move to a low-carbon energy system. What is the US plan? There isn’t one. What is the plan for modernised transport?

There isn’t one. What is the plan for protecting the coastlines from more frequent and costly flooding? There isn’t one.

Trillions of dollars of public and private investments are held up for lack of a strategy. The Keynesian approach is ill-suited to this kind of sustained economic management, which needs to be on a timescale of 10-20 years, involving co-operation between public and private investments, and national and local governments.

Our world is not amenable to mechanistic rules, whether they are Keynesian multipliers, or ratios of budget cuts to tax increases. The UK, for example, needs increased infrastructure and education investments, backed by taxes and public tariffs. Therefore, spending cuts should not form the bulk of deficit reduction as George Osborne, UK chancellor, desires. Economics needs to focus on the government’s role not over a year or business cycle, but over an “investment cycle”.

When the world is changing rapidly and consequentially, as it is today, it is misguided to expect a “general theory”. As Hayek once recommended to Keynes, we instead need a tract for our times; one that responds to the new challenges posed by globalisation, climate change and information technology.

The writer is director of the Earth Institute at Columbia University

Copyright The Financial Times Limited 2012.

12/17/2012 04:43 PM
The Road to Shared Liability
Hidden Risks Plague Euro-Zone Bank Oversight Plan
By Michael Sauga


German Chancellor Angela Merkel was full of praise for the euro-zone bank oversight plan passed last week at the EU summit in Brussels. But the deal is not nearly as watertight as she claimed. It lacks a legal foundation and could lead to a conflict of interest at the highest levels of the European Central Bank.

Angela Merkel received recognition from the highest possible level -- herself. The most recent resolutions made by the European Union in its ongoing effort to save the common currency, she said last Thursday, "can't be spoken of highly enough." Her administration had been able to "push through Germany's core demands," she said.

Self praise, of course, is often inaccurate. But in this case, the gap between fiction and reality is particularly wide. The agreement reached by European leaders and their finance ministers during last week's summits in Brussels could ultimately destroy Merkel's reputation as a level-headed and firm savior of the common currency.

Her strategy in the crisis has long been praised for being one focused on a series of systematic small steps. The results of last week's negotiations, however, can best be described as large steps backwards.

Merkel has tirelessly called for EU leaders to push forward with the political integration of Europe. But at the most recent EU summit, she personally ensured that plans to that effect, created by European Council President Herman Van Rompuy, didn't even make it onto the agenda. At the same time, German Foreign Minister Wolfgang Schäuble voted in favor of a new banking supervisory agency under the authority of the European Central Bank.

It is a plan that Germany's own central bankers view with concern. Lawyers at the Bundesbank object that the responsibilities of the new super-agency remain nebulous. The project has no "lasting, sustainable legal foundation," they say.

The German Vision

No longer is "more Europe" the focus of EU efforts. Instead, German taxpayers could be made liable for billions in risk taken on by large European financial institutions. There is little left of Merkel's motto calling for "increased liability only in the case of increased integration."

Merkel's administration had sought to push through its own vision of a banking union. To prevent a situation whereby struggling lenders in Spain or Ireland could easily access German tax revenues, large countries such as Germany were to have a greater role in the future banking watchdog.

Schäuble also wanted to see the new agency strictly separated from the ECB Governing Council. He wanted to ensure that, in propping up ailing banks, the ECB didn't succumb to a conflict of interest with its true mission -- that of maintaining price stability.

Schäuble demanded nothing less than a "Great Wall of China." No Governing Council member, he said, should be involved in the supervisory agency and that agency must be the final authority.

That is not what emerged from last week's summits, though. According to the agreement, the new oversight agency must submit all of its important decisions for authorization. In the case of conflicts, the agency must also submit to the decision of a mediation committee -- a provision which, according to German central bankers, is not sufficiently grounded in European law.

Could a situation arise in which the ECB Governing Council has the final word over the oversight agency's work, then? German central bank lawyers say that it can't be ruled out. And that would represent a significant failure for Schäuble and his negotiating team.


Not Enough Legal Protections

Furthermore, the personnel of the ECB council and the future banking oversight agency could overlap to a degree that Berlin had been hoping to avoid. Euro-zone member states cannot be prevented from nominating members of the ECB council to serve on the new mediation committee.

First and foremost, however, Merkel was unsuccessful in ensuring that larger euro-zone members have more influence in the oversight agency. As has been the case thus far in the ECB, a vote from Malta counts just as much as a vote from Germany. It is a situation that makes in possible for expensive bailout packages for Irish or Spanish banks to be pushed through despite German opposition.

The deal marks just the latest milestone on the road to joint liability in the euro zone -- and the danger of a collapse has still not been precluded. Europe's economic crisis, say experts, will only continue to get worse next year.

No wonder, then, that financially powerful countries outside the euro zone are less than impressed by the new banking watchdog. The oversight regime is open to non-euro-zone EU members as well, but Sweden, for example, isn't even considering it. The risk, says Finance Minister Anders Borg, is simply too great. "We don't believe it contains enough legal protection for taxpayers," he says, "so that they won't be made liable for mistakes made by foreign banks."

December 16, 2012 8:10 pm
How to fix costly and unjust US tax system
Too many provisions favour a very small minority of fortunate taxpayers

Sooner or later the American tax code will be reformed. Probably sooner. Raising revenue will be the main motivation, but at a time of sharply increasing economic polarisation issues of fairness will be prominent too. There are also legitimate concerns about the complexity of current tax rules and their adverse effects on the economy.


So far, the debate has focused on scaling back provisions of the tax code that have favoured activities traditionally deemed to be valuable. For example, there is talk of reducing reliefs for charitable contributions, taxes paid to state and local governments, home mortgages, employer-provided health insurance and many less important provisions.

There are reasonable arguments to be made in each case. But taking only the “limit tax incentivesapproach to tax reform has several major defects.

First, if reform is designed to avoid perverse outcomes, such as the crushing of charitable contributions or more pressure on state budgets, then it will raise limited amounts of revenue.

Second, this approach will address very little of the complexity in the code and is not likely to do much for recovery, since it will do little to increase demand.

Third, it will do little to address concerns about fairness: the richest taxpayers actually make relatively little use of deductions and credits.

What is needed is an additional element, one that has largely been absent to date: the numerous exclusions from the definition of adjusted gross income that enable the accumulation of great wealth with the payment of little or no taxes. The issue of the special capital gains treatment of carried interestperformance fee income for investment managers – is only the tip of a very large iceberg.

There are far too many provisions that favour a small minority of very fortunate taxpayers. Because these provisions effectively permit the accumulation of wealth to go substantially underreported on income and estate tax returns, they force the federal government to consider excessive increases in tax rates if it is to reach any given revenue target.

All parties – whether their primary concern is preserving incentives for small businesses, closing prospective budget deficits or protecting the social safety net – should be able to come together around the idea that it should not be possible to accumulate and transfer large fortunes while avoiding taxation almost entirely. Yet this is all too possible today.

Here are some issues the Obama administration and Democrats and Republicans in the US Congress should consider given the magnitude of prospective deficits and the extraordinary good fortune of those at the top of the income distribution.

Why do current valuation practices built into the tax code make it possible for investment partners to end up with $50m or more in entirely tax-free individual retirement accounts when the vast majority of Americans are constrained by a $5,000 annual contribution limit?

A simple calculation shows that the US estate tax system is broken. Assets that are passed to relatives or other personal relations are often badly misvalued relative to what they cost on an open market. The total wealth of American households is estimated at more than $60tn. It is heavily concentrated in very few hands.

A conservative estimate given the lifespans of Americans would be that 2 per cent ($1.2tn) is passed down each year, mostly from the very rich. Yet estate and gift taxes raise less than $12bn, or 1 per cent, of this figure each year.

If a family’s home rises in value by more than a $500,000 exclusion over the course of its dwelling, then it pays capital gains tax on the difference between the value now and the value at purchase. But real estate investment operators, who sell properties whose value is measured in the hundreds of millions if not the billions of dollars, are able to take tax deductions for “depreciation” on their properties. And they are then able sell these properties at an appreciated price while avoiding capital gains tax through what is known as a “like kind exchange” – but is in fact a sale.

Why should international companies be able to locate the lion’s share of their foreign income in small, low-tax jurisdictions such as Bermuda, the Netherlands and Ireland, and avoid paying taxes?
There are sound arguments for a preferential rate on capital gains. But is there any real justification for allowing those who do not need to sell their assets to finance retirement to avoid capital gains taxes entirely by including them in their estates?

These tax rules, which permit the taxes of the most fortunate Americans to be far less than commensurate with their good fortune, have the virtue of being relatively comprehensible. There are many others, involving issues such as derivative accounting, pooled interests and leveraged leases, that are neither easily explainable nor easily justified.

The failure to tax capital gains at the point of death costs the federal government about $50bn a year. Since its removal would both raise money in the future, and induce earlier and greater realisations of capital gains in the short term, its removal would likely add well over $500bn during a 10-year period. I believe it is plausible to raise $1tn over the next 10 years by going after provisions that cause what adds to wealth and spending not to be regarded as income.

It has been observed that the greatest scandals are not the illegal things that people do but the things that are fully legal. This is surely true with respect to a tax code in urgent need of reform.

The writer is Charles W. Eliot university professor at Harvard and a former US Treasury secretary

Copyright The Financial Times Limited 2012.