Germany’s Choice

George Soros

09 April 2013

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FRANKFURTThe euro crisis has already transformed the European Union from a voluntary association of equal states into a creditor-debtor relationship from which there is no easy escape. The creditors stand to lose large sums should a member state exit the monetary union, yet debtors are subjected to policies that deepen their depression, aggravate their debt burden, and perpetuate their subordinate position. As a result, the crisis is now threatening to destroy the EU itself. That would be a tragedy of historic proportions, which only German leadership can prevent.
The causes of the crisis cannot be properly understood without recognizing the euro’s fatal flaw: By creating an independent central bank, member countries have become indebted in a currency that they do not control. At first, both the authorities and market participants treated all government bonds as if they were riskless, creating a perverse incentive for banks to load up on the weaker bonds. When the Greek crisis raised the specter of default, financial markets reacted with a vengeance, relegating all heavily indebted eurozone members to the status of a Third World country over-extended in a foreign currency. Subsequently, the heavily indebted member countries were treated as if they were solely responsible for their misfortunes, and the structural defect of the euro remained uncorrected.
Once this is understood, the solution practically suggests itself. It can be summed up in one word: Eurobonds.
If countries that abide by the EU’s new Fiscal Compact were allowed to convert their entire stock of government debt into Eurobonds, the positive impact would be little short of the miraculous. The danger of default would disappear, as would risk premiums. Banks’ balance sheets would receive an immediate boost, as would the heavily indebted countries’ budgets.
Italy, for example, would save up to 4% of its GDP; its budget would move into surplus; and fiscal stimulus would replace austerity. As a result, its economy would grow, and its debt ratio would fall. Most of the seemingly intractable problems would vanish into thin air. It would be like waking from a nightmare.
In accordance with the Fiscal Compact, member countries would be allowed to issue new Eurobonds only to replace maturing ones; after five years, the debts outstanding would be gradually reduced to 60% of GDP. If a member country ran up additional debts, it could borrow only in its own name.
Admittedly, the Fiscal Compact needs some modifications to ensure that the penalties for noncompliance are automatic, prompt, and not too severe to be credible. A tighter Fiscal Compact would practically eliminate the risk of default.
Thus, Eurobonds would not ruin Germany’s credit rating. On the contrary, they would compare favorably with the bonds of the United States, the United Kingdom, and Japan.
To be sure, Eurobonds are not a panacea. The boost derived from Eurobonds may not be sufficient to ensure recovery; additional fiscal and/or monetary stimulus may be needed. But having such a problem would be a luxury. More troubling, Eurobonds would not eliminate divergences in competitiveness.

Individual countries would still need to undertake structural reforms. The EU would also need a banking union to make credit available on equal terms in every country. (The Cyprus rescue made the need more acute by making the field even more uneven.) But Germany’s acceptance of Eurobonds would transform the atmosphere and facilitate the needed reforms.
Unfortunately, Germany remains adamantly opposed to Eurobonds. Since Chancellor Angela Merkel vetoed the idea, it has not been given any consideration. The German public does not recognize that agreeing to Eurobonds would be much less risky and costly than continuing to do only the minimum to preserve the euro.
Germany has the right to reject Eurobonds. But it has no right to prevent the heavily indebted countries from escaping their misery by banding together and issuing them. If Germany is opposed to Eurobonds, it should consider leaving the euro. Surprisingly, Eurobonds issued by a Germany-less Eurozone would still compare favorably with those of the US, UK, and Japanese bonds.
The reason is simple. Because all of the accumulated debt is denominated in euros, it makes all the difference which country leaves the euro. If Germany left, the euro would depreciate. The debtor countries would regain their competitiveness. Their debt would diminish in real terms and, if they issued Eurobonds, the threat of default would disappear. Their debt would suddenly become sustainable.
At the same time, most of the burden of adjustment would fall on the countries that left the euro. Their exports would become less competitive, and they would encounter heavy competition from the rump eurozone in their home markets. They would also incur losses on their claims and investments denominated in euros.
By contrast, if Italy left the eurozone, its euro-denominated debt burden would become unsustainable and would have to be restructured, plunging the global financial system into chaos. So, if anyone must leave, it should be Germany, not Italy.
There is a strong case for Germany to decide whether to accept Eurobonds or leave the eurozone, but it is less obvious which of the two alternatives would be better for the country. Only the German electorate is qualified to decide.
If a referendum in Germany were held today, the supporters of a eurozone exit would win hands down. But more intensive consideration could change people’s mind. They would discover that the cost to Germany of authorizing Eurobonds has been greatly exaggerated, and the cost of leaving the euro understated.
The trouble is that Germany has not been forced to choose. It can continue to do no more than the minimum to preserve the euro. This is clearly Merkel’s preferred choice, at least until after the next election.
Europe would be infinitely better off if Germany made a definitive choice between Eurobonds and a eurozone exit, regardless of the outcome; indeed, Germany would be better off as well. The situation is deteriorating, and, in the longer term, it is bound to become unsustainable. A disorderly disintegration resulting in mutual recriminations and unsettled claims would leave Europe worse off than it was when it embarked on the bold experiment of unification. Surely that is not in Germany’s interest.
George Soros is Chairman of Soros Fund Management and Chairman of the Open Society Foundations. A pioneer of the hedge-fund industry, he is the author of many books, including The Alchemy of Finance and The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means.

April 7, 2013 6:57 pm
This is a golden age of global growth (yes, you read that right)
An unequal world is becoming less so, writes Arvind Subramanian
This general view shows the Makati financial district of Manila©AFP

When the world’s policy makers meet in Washington this month, the travails of advanced countries will be the focus. Five years into the global financial crises, the economic landscape remains largely cheerless. A depressed eurozone is struggling with high and rising unemployment. The US recovery is fitful. The blistering pace of emerging market growth has cooled.

But all this risks obscuring the good news: that the golden age of global economic growth, which began in the mid-to-late 1990s, has mostly survived. These continue to be the best of economic times.

Lant Pritchett of Harvard famously described the phenomenon whereby the living standards of a few countries pulled away from the rest in the aftermath of the industrial revolution as “divergence, big time”. My 2011 book, Eclipse , documented the converse: never had the living standards of so many poorer nations begun to “converge” or catch up with those of advanced countries. What we are seeing today, despite the crises, is convergence with a vengeance. An unequal world is becoming less so.

Convergence occurs when a country’s rate of economic growth per head exceeds that of the typical advanced country, say the US. Between 1960 and 2000, the US grew at about 2.5 per cent. About 20 poor countries (excluding oil exporters and small countries) grew faster than the US by 1.5 per cent on average, among them remarkable growth stories such as Japan, Korea, Singapore, China and India.

About a decade before the global crisis struck, a shift occurred. Eighty countries four times as many as in the previous period, located in sub-Saharan Africa and Latin America as well as Asiastarted catching up with US living standards. Their growth exceeded that of the US on average by nearly 3.25 per cent, implying that this broader group was catching up twice as fast as did countries following the second world war. Put simply, prosperity was spreading across the globe, and at an accelerating pace.

The implications are enormous. For example, if this pace continues, sub-Saharan Africa – and, indeed, 80 per cent of all countries – could in 50 years be in a situation comparable to that of Chile today.

Did the subprime and eurozone crises set back this process? Between 2008 and 2012, developing countries’ growth did decelerate in absolute terms, from about 4.5 per cent to about 3 per cent. But the pace at which they were catching up with rich ones did not slow significantly.

These numbers help to clarify confused discussions about the decoupling of rich and poor nations. Cyclicallythat is, in the short runeveryone is coupled: if the US slows, so will China; and vice versa. That is a fact of interdependence. But the phenomenon of convergence suggests there is structural decoupling: in the medium to long term, the rise in living standards relative to that of the rich world depends mostly on what developing countries themselves do and less on the external environment.

And what have they been doing? Many have shed the most egregious forms of dirigisme and embraced markets. New information and communication technologies have created investment opportunities to galvanise growth, and unleashed social and economic churn. The full consequences are yet to be felt.

Developing countries have embraced macroeconomic stability as an end in itself and as a pre-requisite for sustained growth, a lesson industrial countries forgot in the run-up to the crisis. The failure to deliver stability lay behind the poor growth performance of Latin America and sub-Saharan Africa in the 1970s and 1980s. Macroeconomic prudence ensured that they emerged from the crises relatively unscathed.

Not everything about the convergence phenomenon is rosy. Poor countries on average may be catching up, but the gains are not being shared widely among their citizens because of rising inequality. And corruption and weak governance are endemic across the world, which could yet hold back investment and growth.

For the vast majority in the developing world, then, the real challenge lies at home: to make sure that strong economic growth and the resulting catch-up with rich countries become, in the words of John Maynard Keynes, “normal, certain, and permanent”.

The writer is senior fellow, Peterson Institute for International Economics

Copyright The Financial Times Limited 2013

Markets Insight

April 8, 2013 11:58 am
Markets Insight: Days of inflation targeting are numbered
Rotation is less about asset allocation and more on sectors

A significant change in monetary policy is under way around the world. From Abenomics in Japan, to the greater flexibility just afforded to the Bank of England with regards to pursuing its inflation target, and the Federal Reserve introducing an explicit unemployment target, it is clear that the days of inflation targeting are numbered.

The focus on lower inflation has lasted more than 30 years, resulting in three decades of falling inflation. In the US it dropped from 12 per cent in 1979 to below 2 per cent before the credit crunch hit. The policy also produced a 30-year bull market for bonds, as US Treasury yields fell from more than 15 per cent in the early 1980s to below 4 per cent by the mid-2000s.

However, this success in beating inflation has been achieved at the cost of a declining share of labour in national income.

It is not a coincidence that the share of labour in GDP peaks in the 1970s for both the US and the UK. Given that the largest element of costs was – and remainslabour, the fight against inflation amounted to a campaign to squeeze labour incomes.

The benefit to bondholders of such a policy framework has been readily apparent. Less clear, however, is the way that the anti-inflation monetary regime helped shape the corporate business models that were successful for managements and equity investors alike.

By squeezing the labour share of GDP, policy makers implicitly changed the relative cost of labour and physical capital, in part, through the persistence of high real interest rates.

With most developed economies adopting similar strategies for controlling inflation, currency volatility also fell. As a result, companies had an incentive to adoptcapital light models using limited physical capital (preferring outsourcing) and low-cost labour.

Over the past 30 years, it has been “capital heavysectors such as utilities, automobiles and real estate that have been the worst performing equities. The “capital lightsectors, by contrast, with low capital expenditure relative to revenue, such as retail, healthcare and food and beverages, were among the leading sectors. Banks and insurance (service sector industries with high labour costs and low capex) were winners until the credit crunch.

While investors may have realised that a less rigid focus on inflation targeting will mean a shift in favour of equities and away from bonds, it is less clear that equity managers, or corporate managements, have realised that this change in the monetary policy framework in favour of “nominalism” will have a profound impact on the type of equities that outperform in coming years.

The current outperformance of “quality” and “cash flow richstocks is clearly linked to the bond-like qualities these equities have acquired. In a world where the yield on bonds was falling, managements were increasingly incentivised to run their companies for cash and deliver strong dividends.

It is tempting to think that the change in monetary policy will trigger a shift in this strategy towards lower-quality and low cash flow stocks. While this is an appealing conclusion, it may, in part be false. Quality and cash flow will probably remain crucial, but the stocks and sectors in which they are found may differ.

Back in the 1970s world of utility banking, with limited private sector cross-border financing, it was “capital heavyareas, such as real estate, that provided a key source of wealth. Indeed, in a world of negative real interest rates, where governments are using inflation to reduce the real value of their debt (dressed as a willingness to boost employment) we should expect the “top-line” to become more important than the “bottom-line”.

In such a situation, quality will be redefined and cash flow will most likely be found in companies that have hard assets backing their activities, low direct exposure to rising labour costs, and an ability to pass through increased inflationary pressures.

As governments move to more debtor friendlymonetary regimes, rather than the “creditor friendly regimes of the past three decades, the corporate sector will be unable to be a simple observer. Imaginative group structures, rather than the imaginative financial engineering of the past decade, will become increasingly necessary. Investors will need to find businesses that have strong cash flows and couple them with growing, but capital consuming, businesses.

The irony is that this combination is most likely to be found in the out-of-favour basic resource stocks, rather than the consumer staples that currently dominate investor portfolios. Changing monetary regimes may mean that the “great rotation” is less about asset allocation and more about sectors.

Ian Harnett is joint managing director of Absolute Strategy Research. David Bowers, joint managing director, is the co-writer

Copyright The Financial Times Limited 2013.

Kuroda Leapfrogs Bernanke

April 5, 2013

by Doug Noland

The Kuroda Bank of Japan leapfrogs the Bernanke Fed.

Last August, in a CBB titledDo Whatever it Takes,” I drew parallels between the progression of experimental global central bankmoney printing” to the escalation of aerial attacks against civilians during WWII.

“As the war commenced, efforts were indeed made by most 'belligerents' to limit aerial attacks to military targets away from innocent civilians. It wasn’t long, however, before civilian deaths mounted as bombs were unleashed ever closer to population centers. And then not much time elapsed until industrial targets were viewed as fair game, with civilians paying a progressively devastating price. Somehow, an increasingly desperate war mindset saw targeting population centers in much less unacceptable terms. Soon it was perfectly acceptable. War-time justification and rationalization saw conventional bombing of civilian targets regress into direct firebombing and incendiary raids of major cities in Europe and Asia. Less than six years passed between President Roosevelt’sAppeal” and the dropping of nuclear bombs on Hiroshima and Nagasaki.”

Thursday, the Bank of Japan (BOJ) announced the Japanese version of “Do Whatever it Takes.” What commenced during the Greenspan era as central planning of pegged interest-rates and market liquidity backstops, later evolving to ever-expanding crisis-period bailouts, market interventions and debt monetization, has escalated to an unprecedented global free-for-all of monetary inflation and debt purchases in a non-crisis environment. Amazingly, the Japanese – with 4.3% unemployment and approaching 25 years since the bursting of their Bubble somehow succeeded in leapfrogging the Bernanke Federal Reserve.

April 4Reuters (Leika Kihara and Stanley While) - The Bank of Japan unleashed the world’s most intense burst of monetary stimulus on Thursday, promising to inject about $1.4 trillion into the economy in less than two years, a radical gamble that sent the yen reeling and bond yields to record lows. New Governor Haruhiko Kuroda committed the BOJ to open-ended asset buying and said the monetary base would nearly double to 270 trillion yen ($2.9 trillion) by the end of 2014, a dose of shock therapy officials hope will end two decades of stagnation. The policy was viewed as a radical gamble to boost growth and lift inflation expectations and is unmatched in scope even by the U.S. Federal Reserve’s own quantitative easing program. The Fed may buy more debt, but since Japan's economy is about one-third the size of the economy, Kuroda’s plan looks even bolder. ‘This is an unprecedented degree of monetary easing,’ a smiling Kuroda told a news conference after his first policy meeting at the helm of the central bank. ‘We took all available steps we can think of. I’m confident that all necessary measures to achieve 2% inflation in two years were taken today,’ he said.”

And a few notable Kuroda quotes courtesy of Dow Jones: “This is an entirely new dimension of monetary easing, both in terms of quantity and qualityI will not use my fighting power in an incremental manner… Our stance is to take all the policy measures imaginable at this point to achieve the 2% target in two years."

Well, this is insanity. Not surprisingly, Kuroda’s gambit was cheered by Fed doves (quotes from Reuters): “Watching Japan struggle to beat deflation and revive an ailing economy ‘is not a healthy element of the global scene, Atlanta Fed President Dennis Lockhart said… ‘So their preparedness to take more aggressive action, if it works, will certainly help everyone.’” “Charles Evans, president of the Chicago Fed, called the movepretty aggressive, adding:’ ‘I certainly hope that every foreign central bank around the world is able to adopt policies that ultimately lead to the most vibrant economies that those economies can have because we need it around the world.’”

A few notablemasters of the universe” (having already profited handsomely shorting yen) warned of a potential yen free-fall. For sure, the Bank of Japan’s shock and awe inflation strategy strives to convince Japanese consumers and businesses that prices and business activity is in the process of being inflated higher. The big unknown is to what degree the clearer message “your yen is going to be devalued lower!” will incite Japanese institutions and savers to exit the yen in search of better returns throughout global securities markets. The thought of Japan’s savers joining forces with U.S. savers in a quest to protect their “money” from central bank-orchestrated devaluation must be enough to have the global leveraged speculating community salivating all over themselves.

April 5 – Reuters (Leika Kihara and Stanley White): “Bank of Japan Governor Haruhiko Kuroda played down concerns his unprecedented burst of monetary stimulus would créate asset-price bubbles even as it delivered an immediate pay-off in global markets, with government bond yields at a record low, the yen hitting a 3-1/2 year trough and stocks surging to multi-year highsWe will be vigilant of the risk of a bubble. I don’t think there’s a bond or stock market bubble now and I don’t see one emerging any time soon. But we will be vigilant of the risk,’ Kuroda told the lower house of parliament.”

I’ll have to disagree with Mr. Kuroda. Japanese debt is a historic Bubble – and I’d suggest a rather conspicuous one at that. And Japan’s move to follow the Fed down the path of 24/7 monetary inflation is a key facet of the “global government finance Bubblemore generally. Japanese institutions were said to be major buyers of European bonds this week. French 10-year yields dropped 24 bps Thursday and Friday to a record low 1.75%. French yields were down about 50 bps in five weeks. Spain’s 10-year yields were down 32 bps points this week to 4.73%, and Italian yields sank 39 bps to 4.37%. Ten-year Treasury yields were down 12 bps in two sessions to end the week 14 bps lower at 1.71%. No Bubble?

In Tokyo, wild Friday trading saw the 10-yearJGByield trade as low as 32 bps and as high as 64.5 bps before ending the week at 0.53%. Japanese stocks jumped another 3.5% this week, increasing the Nikkei 225’s y-t-d gain to 23.5%. The yen sank 3.4% this week, pushing its 2013 decline to 11.1%.

April 5 - Financial Times (Jonathan Soble and Ben McLannahan): “Use it or lose it. That was the upshot of Haruhiko Kuroda’s message to Japanese savers on Thursday as he hurtled the country’s central bank into a ‘new phaseof super-loose monetary policy. By pledging to degrade the value of hoarded cash through inflation and all but snatching the safe-haven government bond market away from private investors, analysts say the Bank of Japan governor is trying to force citizens, banks and companies to deploy their money in ways that do more to boost the economy. The approach will have far-reaching consequences, some of which were already being felt in financial markets on Friday as bond prices swung wildly and stocks pushed to four-year highs.”

Well written, Misters Soble and McLannahan. Yes, absolutelyfar-reaching consequences.” Monetary inflations and fiascos and their wretched consequences have inspired a great amount of thinking and writing over the centuries. All for not, as a small cadre of like-minded New Age global central bankers push deeper into their untested experiment in electronicmoneyinflation. I have a hard time believing anyone with a sound grasp of monetary history doesn't see this as anything other than an unfolding disaster.

It’s interesting. The more apparent it becomes that monetary measures are not working as prescribed the greater the impetus to just do a whole lot more. Japan has been down this road before - for too long now. And, already, the global inflationist community is busy laying the "intellectual" groundwork for the next phase of this monetary battle. Calls are turning louder for central banks to just purchase government debt and simplyextinguishit. The nuclear option.

It seemed like an opportune time to return to a little History of Monetary and Credit Theory (From John Law to the Present Day),” written by the late French economist and Bank of France official Charles Rist (1938).

“But let us tackle the essential argument, the argument in which [John] Law is a real forerunner, the crushing argument which, since his time, has been used by all the currency cranks and by all plundering states. What is money but a simple exchange voucher conferring the right to a certain quantity of goods? And if that is its function, what is the point of using a costly metal? Here we reach the cardinal point of Law’s theory. Money is only a voucher for buying goods. It is a formula which has provided the starting point for all currency cranks, an apparently self-evident axiom on which have been based all systems which deny the citizen the right to a means of storing value. Money is made only to purchase with. Money is not the durable and indestructible good, of stable value and unlimited acceptability, with the help of which man has been able to put by the product of his labor, the instrument for saving by means of which a bridge is built between the present and the future and without which all provisions for the future would become impossible. No!”

“But apart from that, [Law] misunderstood the real character of metallic money, and it is this that makes him so representative of all the currency cranks. He ignored the function of money as a means of storing value in a world where men are so anxious to preserve the product of their labour and their saving from price fluctuations and vicissitudes of all kinds. It is that which ruined [Law’s] System. That metallic money is not an ideal instrument of circulation, and that it can be conveniently replaced in this respect by all sorts of circulating credits has been known from the earliest times. But nobody has yet shown that circulating credits can replace the precious metals in their function as a store of value. None of the monetary systems yet know to us, even the most advanced, has dispensed with the precious metals, that ultima ratio of trade.”

And the famous quote from John Law: “Money is not the value for which goods are exchanged, but the value by which they are exchanged: The use of Money is to buy goods, and silver while money is of no other use.”

Some years ago, I noted parallels between the unfolding experiment in contemporary managed electronicmoney” and Credit and John Law’s disastrous experimental introduction of paper money in eighteenth century France. Similar to Law, contemporary central bankers see “moneysimply as a mediuman expedient - for spurring spendingthroughout the real economy as well as in securities and asset markets. The failure of the Federal Reserve to create a sufficient supply of money is central to Dr. Bernanke’s thesis of the causes of The Great Depression. Central banks are now in the process of creating Trillions of additional money” in order to inflate prices and economic activity. Trillions. They’ve been busily adding electronic zeros.

I’ll be the first to admit that it’s a real challenge to explain to the average person (or academic or Wall Street professional) the flaws in current inflationary central bank doctrine. If inflation isn’t a problem, why not create some additional money”? Central bankers can always reverse course and withdraw stimulus if necessary, right? And what’s the problem with higher asset prices? With markets at or near record highs, the myriad risks associated with currency devaluation, monetary degradation, mispriced finance, deleterious market incentives, resource misallocation, asset Bubbles, inequitable wealth distribution and economic maladjustment don’t resonate all that well. Somehow, even recent social upheaval in Greece, Ireland, Portugal, Spain and Cyprus are viewed as domestic problems and not the consequence of unanchored global finance. And do these central bankers actually believe they will be able to exit this policy course?

From Rist: “…The function of money as a means of storing value in a world where men are so anxious to preserve the product of their labour and their saving from price fluctuations and vicissitudes of all kinds.”

Rist titled his first chapter, “Confusion between Credit and Money in the Political Economy in the Eighteenth Century.” In our 21st Century age of runaway electronic debits and Credits based finance, the distinction between “money” and Credit has completely blurred. I’ve tried to make the case that there is in reality an exceedingly important difference: Credit is much about confidence, while money is “precious.” Credit, as was on full display between 2006 and 2008, can be robust, whimsical, fleeting and frighteningly fragile. “Money” – perceived as a trusted liquid store of nominal value – is the rock foundation for the entire financial system. As such, “moneyenjoys almost insatiable demand. And this attribute has ensured repeated episodes of gross over-issuance that has plagued mankind for centuries. These days, “money” is the domain of the government debt and central banking nexus. The monetary black plague is back and it has spread globally like never before. Yet it’s virtually invisible and comes with a surprisingly protracted incubation period.

When his “Mississippi Bubblescheme was faltering in 1720, John Law moved to devalue competing hard currencies. He was desperate to keep investors and, particularly, the manic crowd of speculators in his monetary instruments in order to stave off Credit collapse. The Fed, BOJ, BOE, ECB and others have been working desperately to keep investors and speculators fully engaged in global debt, equities and risk markets. With near zero interest-rates and Trillions of monetization, “money” is being methodically devalued around the world. Federal Reserve devaluation is forcing savers out of “money” and into risk markets, apparently believing that asset inflation will spur wealth-creation, risk-taking and economic activity. The Bank of Japan is devaluing yen-denominatedmoney,” hoping a weaker yen and expectations for higher inflation will jumpstart the Japanese economy.

These central bankers seem oblivious to the fact that they are on a perilous course that risks a crisis of confidence in “money,” not to mention global risk markets. The history of monetary fiascos is replete with out of control inflations. Once the money printing gets heated up, there is a strong proclivity for one year of elevated money printing ensuring only more intense pressure for even greater printing the next. Actually, this dynamic has been in play for years now. After having carefully studied these types of dynamics, I’ll confess it’s almost surreal to witness them in real time.