The Fed’s Policy Mechanics Retool for a Rise in Interest Rates


The Federal Reserve, headed by Janet L. Yellen, will soon, if not this week, raise interest rates for the first time since the crisis. Credit Michael Reynolds/European Pressphoto Agency                    

It’s easy to take for granted the Federal Reserve’s ability to raise interest rates. Even among the legions who doubt that Fed officials will pick the ideal moment to start increasing rates for the first time since 2008, few question the Fed’s technical competence. The central bank has a long history. The engine is known to work.
So it may come as a surprise to learn that the old engine is broken. When the Fed decides that it’s time to “lift off” — perhaps this week, but more likely later this year — it will be relying on a new system, assembled from spare parts, to make interest rates rise.
There is a general agreement among economists and market analysts that the Fed’s plans make sense in theory. A team led by Simon Potter, a former academic who now heads the Fed’s market desk in New York, has been testing and fine-tuning the details by moving billions of dollars around the financial system.
But markets have a long history of scrambling the best-laid plans.
The stakes are huge. The Fed is in charge of keeping economic growth on an even keel: minimal unemployment, moderate inflation. It tends to operate conservatively and to change very slowly because when it errs, the nation suffers.
Yet the Fed has found itself forced to experiment. The immense stimulus campaign that it started in response to the 2008 financial crisis changed its relationship with the financial markets. It has pumped so many dollars into the system that it cannot easily drain enough money to discourage lending, its traditional approach. Instead, the Fed plans to throw more money at the problem, paying lenders not to make loans.
The Fed, embedded in the banking system, has also concluded that working through the banks is no longer sufficient to influence the broader economy. It plans to strengthen its hold by working directly with an expanded range of lenders.
Fed officials have repeatedly expressed confidence that the plan will work. “The committee is confident that it has the tools it needs to raise short-term interest rates when it becomes appropriate to do so,” Janet L. Yellen, the Fed’s chairwoman, told Congress earlier this year, referring to its policy-making body, the Federal Open Market Committee.
And if the new approach does not work at first, Mr. Potter said in a recent speech, then his team of monetary mechanics “stands ready to innovate” until it does.

Freezing, Not Draining

The markets desk at the New York Fed has put monetary policy into practice since the mid-1930s. In the decades before the Great Recession, the desk exercised its remarkable influence over the American economy through its control of an odd little marketplace in which banks could come to borrow money for a single night.
The Fed requires banks to set aside reserves in proportion to the deposits the banks accept from customers. The reserves can be kept in cash or held in an account at the Fed. Banks that need reserves at the end of a given day can borrow from banks that have a surplus. Before the crisis, the Fed controlled the interest rate on those loans by modulating the supply of reserves: It lowered interest rates by buying Treasury securities from banks and crediting their accounts, increasing the supply of reserves; it raised rates by selling Treasuries to banks and debiting their accounts.
As the crisis hit in 2008, the Fed pressed this machine to its limits. It bought enough securities and pumped enough reserves into the banking system to drive interest rates on short-term loans to nearly zero. The federal government now pays about a dime to borrow $1,000 for one month. Companies with good credit pay about a dollar to borrow $1,000 from money market funds and other investors.
But the Fed didn’t stop there. It kept buying Treasuries and mortgage bonds to eliminate safe havens, forcing money into riskier investments that might generate economic activity. As a byproduct, the Fed kept expanding the supply of reserves.
One result is a banking system almost comically awash in money. In June 2008, banks had about $10.1 billion in their Fed accounts. The total is now $2.6 trillion. Picture all of the money in June 2008 as a single brick; the Fed has added 256 bricks of the same size. On top of that first brick, there is now a stack five stories tall.
Bank of America, for example, had $388 million in its Fed account at the end of June 2008.
Seven years later, at the end of June 2015, it had $107 billion. The bank could double in size and double again and still have more reserves than it needs.
To switch metaphors, the old monetary-policy machine sits at the bottom of a lake of excess reserves.
The Fed would need to sell most of the securities it has accumulated before short-term rates would start to rise. Selling quickly could roil markets; selling slowly could allow the economy to overheat.
So the Fed decided to find another way.
Instead of draining all that excess money, the Fed decided to freeze it.

Paying Banks Not to Lend

For the last seven years, the Fed has encouraged financial risk-taking in the service of its campaign to increase employment and economic growth. By starting to raise interest rates, the Fed intends to gradually discourage risk-taking.
The straightforward part of the plan is persuading banks not to make loans.
In a serendipitous stroke, Congress passed a law shortly before the financial crisis that let the Fed pay interest on the reserves that banks kept at the Fed. Written as a sop to the banking industry, it has become the new linchpin of monetary policy.
Say the Fed wanted to raise short-term interest rates to 1 percent, meaning that it did not want banks to lend at lower rates. Because the glut of reserves is so great, the Fed could not easily raise rates by reducing the availability of money. Instead, the Fed plans to pre-empt the market, paying banks 1 percent interest on reserves in their Fed accounts, so banks have little reason to lend at lower rates. “Why would you lend to anyone else when you can lend to the Fed?” Kevin Logan, chief United States economist at HSBC, asked rhetorically.
This is not a cheap trick. Since the crisis, the Fed has paid banks a token annual rate of 0.25 percent on reserves. Last year alone, that cost $6.7 billion that the Fed would have otherwise handed over to the Treasury. Paying 1 percent interest would cost four times as much. The Fed has sent roughly $500 billion to the Treasury since 2008. As the Fed raises rates, some projections show that it may not transfer a single dollar in some years. Instead, the Fed will pay banks tens of billions of dollars not to use the trillions it paid them previously.
At first, Fed officials thought that paying interest to banks would establish a minimum rate for all short-term loans, exerting the same kind of broad influence as the old system. It soon became clear, however, that rates on most such loans remained lower than 0.25 percent. Even banks that needed overnight loans found they could borrow more cheaply. The average rate in July was 0.13 percent — about half of the Fed’s new benchmark rate.
The rest of the financial system is also awash in cash, and lenders — like money market mutual funds — put downward pressure on interest rates as they fight to attract borrowers.
And here’s where the Fed’s plans got a little less orthodox.
The Fed lacks the legal authority to pay these lenders a minimum interest rate on deposits, as it does to the banks. But two years ago, Lorie Logan, one of Mr. Potter’s top aides, suggested the Fed could achieve the same goal by borrowing from these companies at a minimum interest rate.
The resulting deals, known as overnight reverse repurchase agreements, signal a significant break from the Fed’s history of working through only the banking industry.
“We’re pushing more activity out of the regulated banking sector, and so monetary policy has to take account of the unregulated sector,” said Jon Faust, an economist at Johns Hopkins University who until recently served as an adviser to Ms. Yellen, and before that to her predecessor, Ben S. Bernanke. “The world is changing, and I think the bigger risk is not changing along with it.”
When liftoff arrives, however, the Fed plans to place this machinery inside the familiar language of the old system. It is likely to announce that it is raising the federal funds rate, the interest rate that banks pay to borrow reserves, from its current range of 0 to 0.25 percent to a new range of 0.25 to 0.5 percent. The Fed does not plan to emphasize that this rate is now a stage prop or that the real work of raising rates will be done outside the limelight by its new tolos.

Mission Control

On weekdays at about 12:45 p.m., the New York Fed’s trading portal, known as FedTrade, plays three musical notes — F-E-D — signaling that Mr. Potter’s shop is open for business. So begins another day of training camp, another test of the Fed’s plans to borrow money from nonbank financial companies.
The Fed’s traders sit at terminals in a converted conference room. Along one wall are five chairs and five sets of computer monitors beneath five historical photographs of the trading desk: men answering phones, men writing bids in chalk on a long board and, in the most recent photograph, from the 1980s, a glimpse of a woman in the background. On another wall is a screen that links the room in New York by videoconference with a backup trading room at the Chicago Fed.
Potential lenders — a preapproved group of 168, including a bevy of money market funds and the housing finance companies Fannie Mae and Freddie Mac — have 30 minutes to offer the Fed up to $30 billion each. At 1:13 p.m., a warning message starts blinking red. At 1:15 p.m., the Fed closes the auction and accepts up to $300 billion in loans at an interest rate of 0.05 percent.
During two years of experiments, the Fed team has adjusted the rates it pays, the amounts it accepts and the time it enters the market, among other variables. Mr. Potter and his lieutenants have also held lunch meetings with investors on the other side of the portal to solicit advice and complaints.
The size of the program poses the most obvious risk. Fed officials limited daily borrowing to $300 billion because they didn’t want to freeze more money than necessary. They also worry about exacerbating market downturns by giving investors a new place to flee. These concerns were heightened by reports that some investment companies were interested in creating money market funds that would be advertised as the safest place to park money — because the money would be parked at the Fed.
Last year, at the end of September, shortly after the cap was imposed, lenders offered the Fed $407 billion on a single day. Demand was so high that instead of asking for interest, some lenders offered to pay the Fed to take the money. The Fed ended up borrowing at zero percent and turning away $107 billion in loans.
A cardinal rule of central banking is that you don’t starve financial markets during panics, and the Fed has been leaning in the direction of doing more. It has already announced that it is willing to borrow at least $200 billion through a parallel program at the end of September this year, for a total of $500 billion. It has also suggested that it may raise the cap during liftoff.
“My sense is we’re better off making sure we can maintain control,” James Bullard, president of the St. Louis Fed, said in a recent interview.
Mr. Blinder’s point was that markets ultimately determined the cost of borrowing money, particularly for longer-term loans like mortgages and corporate bonds. The Fed can be precise in its planning, but the market is unpredictable in its reactions.
Fed officials have emphasized that they do not want the liftoff to surprise investors. “This has probably been the most telegraphed 25-point rate hike in history,” said Wayne Schmidt, chief investment officer at Gradient Investments in Arden Hills, Minn. “I think when they actually do something, it will be more of a nonevent.”
But there are at least three reasons markets are becoming less predictable.
The rise of an interconnected global financial system has weakened the Fed’s influence over interest rates. When the Fed last raised short-term rates, beginning in 2004, officials were surprised that long-term rates failed to rise because foreign money was pouring into the housing market and other domestic investments. This time, there are plenty of warnings that the weaknesses of other developed economies could once again make it harder for the Fed to raise domestic interest rates.
“Financial market conditions have come to depend increasingly not only on developments at home but also on developments abroad,” William C. Dudley, the president of the Federal Reserve Bank of New York, said in a February speech in which he cautioned the Fed’s control over those conditions had been “loosened.”
The Fed’s audience also increasingly consists of computer programs that will start buying and selling securities before people have time to read the first words of the Fed’s policy statement, creating the potential for new kinds of chaos.
On Oct. 15, for example, automated trading programs drove up the price of 10-year Treasuries in a burst of buying so intense that a government report later found the machines bought more than 10 percent of the securities from their own firms. Then, just as quickly, the computers turned around and drove prices back down.
The 12-minute spree was among the largest price movements ever seen in one of the world’s most liquid markets, yet the government report found no clear cause.
Finally, investors say regulatory changes are keeping some large traders on the sidelines, making it harder to buy and sell, even in the highly liquid market for Treasuries. That can exacerbate market movements because when people are in a hurry to buy or sell, they tend to chase the best available offers. “The depth of the market is not what it used to be,” said Tad Rivelle, chief investment officer for fixed income at TCW, a Los Angeles investment firm that manages some of the world’s largest bond funds. “You can get the same trades done, but it takes more time.”
Other observers, however, urge a broader perspective.
“People are very concerned about those 12 minutes last year,” said Mr. Cecchetti, now a professor of finance at the Brandeis International Business School. “I’m very reassured by the fact that there were only 12 minutes.”
Moreover, Mr. Cecchetti said that removing some liquidity was a good thing because much of that liquidity was a result of public subsidies for the banking system that had encouraged undue risk-taking.
“Does it mean that there’s going to be more high-frequency volatility? Sure,” he said. “It means the Simon Potters of the world are going to have to be much more careful about what they’re doing. But that seems to me to be kind of O.K.”

Volcker’s Messy Lesson

Mr. Potter has worked at the New York Fed since the late 1990s, but he spent most of his career there in the research department before taking over the markets desk in 2012. He became more involved in the practical side of the Fed’s work during the financial crisis. In a 2012 speech at New York University, Mr. Potter said the experience — particularly during a four-week period at the peak of the crisis — had impressed upon him the limits of theory, the need to understand what investors are thinking and the value of flexibility in policy making.
“For economists who did not have the opportunity to observe the panic up close as I and most of my colleagues had, the developments in this four-week period must have been bewildering, given how widely events on the ground and theory diverged,” he said.
That perspective may come in handy. The last time the Fed shifted the basic mechanics of monetary policy was in the early 1980s, when Paul Volcker was its chairman. That campaign is remembered as a triumph of central banking. Mr. Volcker succeeded in driving inflation down toward modern levels, ending a long period in which governments had floundered helplessly to prevent rising prices.
But Mr. Faust, the Johns Hopkins economist, says the messiness of Mr. Volcker’s triumph is often overlooked. The Fed’s initial plans did not work and were revised and did not work and were revised again — and still didn’t work.
He said the Volcker episode was a reminder that monetary policy is not figure skating. The Fed is likely to flail, he says, but it will be measured by its success in getting interest rates to rise, not by the grace of its performance.
“If you’re into the internal plumbing, I suspect there will be times when that looks messy because this is new,” Mr. Faust said. “But central banks can raise interest rates, and they will.

And as long as that happens, from the standpoint of the broader economy, everything is fine and the rest will be forgotten or become a footnote of history.”

China Hardens Peg and Brazil Goes to Junk

Doug Nolan

Let’s this week begin with a cursory glance at the world through the eyes of the bulls. First, the global backdrop provides the Fed convenient cover to delay “liftoff” at next week’s widely anticipated FOMC meeting. Even if they do move, it’s likely “one and done.” While on a downward trajectory, China’s $3.5 TN international reserve hoard is ample to stabilize the renminbi. Chinese officials clearly subscribe to their own commanding version of do “whatever it takes” to control finance and the economy. One way or another, they will sufficiently stabilize growth - for now. The U.S. economy enjoys general isolation from China and EM travails. 

Investment grade bond issuance – the lifeblood of share buybacks and M&A – has already bounced back robustly. The U.S. currency, economy and securities markets remain the envy of the world. “Money” fleeing faltering EM will continue to support U.S. asset markets along with the real economy.

September 10 – Financial Times (Netty Idayu Ismail): “The European Central Bank will ensure its policy stance remains as accommodative as needed amid financial-market turbulence, according to Executive Board member Peter Praet. ‘The Governing Council will remain vigilant that recent volatility does not materially affect the broad array of financial conditions and therefore lead to an unwarranted tightening of the monetary-policy stance,’ Praet said… ‘It has emphasized its willingness and ability to act, if warranted, by using all the instruments available within its mandate.’”

The ECB’s “unwarranted tightening of the monetary-policy stance” comes from the same playbook as Bernanke’s (the Fed’s) “push back against a tightening of financial conditions.” In a world where financial markets dictate general Credit Availability as never before, central bankers have essentially signaled open-ended commitment to liquidity injections as necessary to counteract risk aversion. Such extraordinary market exploitation underpins the fundamental bullish view that global policymakers have things under control.

On a near-term basis, policymakers retain tools to stabilize markets, though officials at the troubled Periphery are rapidly running short of policy flexibility. September’s “triple-witch” expiration of options and futures is now only a week away. Between the passing of time and the pull back in put premiums (“implied volatility”), bearish hedges and directional bets have lost tremendous value over the past two weeks.

The apparent stabilization in China has been integral to calmer global markets. Clearly, Chinese officials are in full-fledged crisis management mode. A series of measures and determined official support have stabilized the wobbly Chinese currency. Wednesday from Reuters: “Chinese Premier Li Keqiang said… that the recent adjustment in the yuan was ‘very small’ and that there is no basis for continued devaluation in the currency.”

And Thursday from the Financial Times (Jamil Anderlini): “Chinese Premier Li Keqiang… sought to reassure investors over the health of China’s economy… ‘China is not a source of risk but a source of growth for the world,’ Mr Li said in a speech to the World Economic Forum… ‘Despite some moderation in speed, the performance of the Chinese economy is stable and it is moving in a positive direction.’ …In a meeting with global business leaders at the forum, Mr Li dismissed the suggestion that China had been the trigger for instability in global markets in recent months. ‘The fluctuations in global financial markets recently are a continuation of the 2008 global financial crisis… Relevant Chinese authorities took steps to stabilise the market to prevent any spread of risks. Now we can say we have successfully forestalled potential systemic financial risks … what we did is common international practice and is in keeping with China’s national conditions.’”
“Steps to stabilize the market” have included arresting journalists and other rumor mongers accused by the central government of “destabilizing the market.” There has been a hard crackdown on hedge funds and other “manipulators”. Beijing has imposed a series of onerous measures against currency and securities markets derivatives trading. The Chinese government has also put in place controls to help impede financial outflows. Meanwhile, the state-directed “national team” has spent over $200bn buying stocks. The central bank has cut rates, slashed reserve requirements and injected enormous amounts of liquidity.

The bullish viewpoint holds that economies dictate market performance. As such, draconian measures from Chinese officials support the perception that Chinese policymakers have regained control over their markets and economy – in the process removing a major potential catalyst for global systemic dislocation. Though appalling, most take quiet comfort that Chinese-style “whatever it takes” works in the best interest of U.S. markets and the economy. The long-term rather long ago lost much of its relevance within the bull camp.

For me, it boils down to fundamental disagreement with the bulls on how the world actually works. For starters, finance is king. Credit and the financial markets drive economic activity - and not vice versa. My bursting global government finance Bubble thesis rests on the premise that global finance has by now suffered irreparable harm. Confidence is being broken and faith is being shattered. A difficult new era has begun, and it will be a long time before confidence returns to EM. De-risking/de-leveraging has taken hold, with contagion gaining momentum. 

And China can use all the duct tape in the world – including strips to silent the mouths of naysayers – to try to holds its stock market and Credit system together. The damage is done.

For a while now, global investors and speculators have been willing to ignore China’s shortcomings. In general, a world of over-liquefied markets tends to disregard risk while allowing a sanguine imagination to run absolutely wild. And the more finance that flooded into China and EM the more the optimists reveled in the “developing” world’s pursuit of the fruits of Capitalism. The Chinese talked a good commitment to steady free-market reform. Their aspirations for global financial and economic power seemed to ensure that they would adhere to the rules of Western finance.

In the past I gave Chinese officials too much Credit. They devoted a lot of resources to the endeavor, and at one time I believed the Chinese had gleaned valuable insight from the study of the Japanese Bubble experience. But Bubbles are both seductive and incredibly powerful, especially at the hands of authoritarian communist regimes. Massive post-2008 stimulus stoked runaway Bubble excess. Later, Chinese markets scoffed at timid little central bank measures meant to tenderly rein in excess. And the longer the Bubble inflated the greater the financial, economic, social and political risks.

In the end, the major lesson drawn from Japan’s experience was the wrong one. It was much belated, but the Japanese actually moved to pierce their Bubble. Chinese officials not only let their Credit Bubble run, they adopted the Fed’s approach to using the stock market as an expedient for system-wide inflation. That policy blunder was the Chinese Bubble’s proverbial nail in the coffin.

I’ll assume that after priority number one – stabilizing its currency – the Chinese will implement even more aggressive fiscal and monetary stimulus. EM policymakers notoriously lose flexibility at the hands of faltering currencies and attendant financial outflows (“capital flight”). Contemporary finance also ensures that deflating Bubbles entice bearish hedges and speculations that can so swiftly overwhelm already liquidity-challenged markets. The Chinese were confronting just such a scenario, before abruptly changing the course of policymaking. 

The adoption of onerous derivative market regulations and other measures are akin to loose capital controls – punishing measures to take pressure off the Chinese currency. After initially seeking benefits associated with greater currency market flexibility, market tumult instead forced the Chinese into a rigid yuan peg to the dollar.

So long as the peg to the dollar holds, China retains significant control over state-directed finance. It will run big fiscal deficits, print “money” and dictate lending and spending by the huge banks, financial institutions, local governments and industrial conglomerates. But can it at the same time somehow harness all this finance and keep it from fleeing the faltering Bubble? Only through capital controls.

The Shanghai Composite rallied 6.1% this week. There were some spectacular short-squeezes as well, certainly including the Nikkei’s 7.7% Wednesday surge, “The Biggest Gain Since 2008.” Copper jumped 6.3% this week. U.S. tech and biotech bounced hard. In the currencies, the Australian dollar jumped 2.7%, the South African rand 2.2%, and the euro 1.7%.

It was not, however, an encouraging week for EM’s troubled economies. Brazil’s real slipped further after last week’s 7% plunge. The Indonesia rupiah declined another 1.1%, and the Malaysian ringgit fell 1.3%. The Turkish lira dropped 1.2%. On the back of weak crude prices, the Goldman Sachs Commodities Index slipped 0.4% this week.

The crisis is taking a decisive turn for the worse in Brazil. On the back of S&P downgrading Brazilian debt to junk, the country’s CDS surged to multi-year highs. The Brazilian banking and corporate sectors have been in a six-year debt fueled borrowing binge. It’s all coming home to roost.

September 10 – Bloomberg (Michael J Moore): “Banco Bradesco SA and state-owned Banco do Brasil SA were among 13 financial-services firms in Brazil that had their global scale ratings lowered by Standard & Poor’s after the nation’s credit grade was cut to junk. The two banks were reduced to speculative grade with a negative outlook, S&P said… Itau Unibanco SA and Banco BTG Pactual also were among lenders that faced downgrades.”
September 10 – Bloomberg (Denyse Godoy): “A plunge in Petroleo Brasileiro SA, the world’s most-indebted oil producer, to a 12-year low put the Ibovespa on pace for a second week of losses. The state-controlled company extended a three-day slide to 11% after Standard & Poor’s cut its credit rating to junk, adding to speculation it will struggle to shore up its balance sheet.”
Many question how an EM crisis could possibly have a significant impact on U.S. markets. 

Well, for starters, Brazil has big financial institutions. The Brazilian financial sector has issued large amounts of dollar-denominated debt, while borrowing significantly from international banks. Enticing Brazilian yields have been a magnet for “hot money” flows. Now, Brazil faces the terrible prospect of a disorderly run from its currency, its securities market and its banking system. Market dislocation would have global ramifications for investors, derivative counterparties, multinational banks and the leveraged speculating community.

The degree of market complacency remains alarming. The bullish view holds that Brazil, China and others retain sufficient international reserves to defend against crisis dynamics. But with EM currencies in virtual free-fall and debt market liquidity disappearing, it sure looks and acts like an expanding crisis.

So far, it’s a different type of crisis – market tumult in the face of global QE, in the face of ultra-low interest rates and the perception of a concerted global central bank liquidity backstop. It’s the kind of crisis that’s so far been able to achieve a decent head of steam without causing much angst. And it’s difficult to interpret this bullishly. If Brazil goes into a tailspin, it will likely pull down Latin American neighbors, along with vulnerable Indonesia, Malaysia, Turkey and others. And then a full-fledged “risk off” de-risking/de-leveraging would have far-reaching ramifications, perhaps even dislocation and a collapse of the currency peg in China. 

China does have a number of major trading partners in trouble. Hard for me to believe the sophisticated players aren’t planning on slashing risk.

Wall Street's Best Minds

Citigroup: ‘Rapidly Rising Risk’ of Global Recession

A global downturn fueled by China’s woes could very well soon be upon us, warns Citi’s top economist..

By Willem Buiter

Editor’s Note: This is excerpted from a much longer piece with charts by Buiter, chief global economist with Citigroup.

This paper develops the idea that a global recession – a period of global output below potential output – is a high and rapidly rising risk. We argue that recession may now be the most likely outcome over the next few years. This is indeed the view now held by Citi’s Global Economics team, although the debate across our broader economics team remains fervent.
It is to be expected that economists – even economists working for the same team – have different views about the likelihood of different future outcomes. Economics isn’t rocket science, and even rockets frequently land in the wrong place or explode in mid-air. We believe we provide a better service to our clients if we don’t pretend there is a consensus if there isn’t one. It is better to provide a range of alternative forecasts, and to explain the reasons for the differences between them, than to present a phony consensus.
A global recession was not envisaged in the last round of Citi’s benchmark global growth forecasts made in August 2015; however the theme of a China-led global slowdown has been a consistent risk scenario in our Global Economic Outlook and Strategy for a considerable time.

Since 2010, Citi’s global growth forecasts for the next year, like the consensus global growth forecasts, have started each year at a consistently high level, only to be revised downwards systematically during that year. The forecast for the next year, made at the beginning of that year, was invariably higher than the final estimate of growth in the previous year.

Over the course of this year our downgrades have been mostly for emerging markets while our upgrades have been mostly for developed markets. That has also been the pattern for the earlier years. A notable exception is the US, where the pattern of starting high and ending low has also been evident. For instance, the January 2015 forecast for US real GDP growth for the year 2015 was 3.6%.

By August 2015 it had fallen to 2.5%.

This scenario of a global recession of moderate depth and duration, starting in the second half of 2016, is not yet reflected in Citi’s benchmark forecasts for China’s growth, emerging markets growth and global growth.

When Citi’s most recent forecasts for global economic growth and for economic growth in China were made, in the August 2015 issue of our Global Economic Outlook and Strategy (GEOS), a global recession was not the most likely scenario.

These forecasts are clearly too optimistic to be consistent with a modal recession scenario. Our best guess of potential output growth for the global economy is 3% per annum or just below it. According to Citi’s benchmark forecast, actual global growth is therefore likely to be at or just below potential growth for the current year, rising slightly above it for the four years following. In the Global Economics team, however, we believe that a moderate global recession scenario has become the most likely global macroeconomic scenario for the next two years or so. That does not mean that a moderate recession as described in this paper, starting in the second half of 2016, has a likelihood of more than 50%.

We do believe that a recession is the most likely outcome during the next few years, but it is important to distinguish between a moderate recession without a regional or global financial crisis and a deep or severe recession accompanied by a regional or global financial crisis.

To clarify further, the most likely scenario (40% probability), in our view, for the next few years is that global real GDP growth at market exchange rates will decline steadily from here on and reach or fall below 2% around the middle of 2016. Growth is likely to bottom out in 2017 and start recovering again from late 2017 or early 2018. The output gap could be closed (the world exits recession) late 2018 or 2019. The next most likely outcome (30%) is that the global economy will avoid recession during the next few years and grow at a rate roughly equal to that of potential.

There is also a probability of 15% that the global economy goes into severe recession and financial crisis, and a 15% likelihood that the global economy will enter a boom (a period of overheating), with output above potential and, for a while, growing faster than potential.

In our view, the probability of some kind of recession, moderate or severe, is therefore 55%. A global recession of some kind is our modal forecast. A moderate recession is our modal forecast if we decompose recession outcomes into moderate and severe ones and assign separate probabilities to them.

In this publication, we analyze how, starting from where we are now, the world economy could slide into recession, defined as an extended period of excess capacity: the level of potential output exceeds the level of actual output, or the actual unemployment rate is above the natural rate or Nairu. The recession scenario is that of a recession of moderate depth and duration, without a major regional or global financial crisis. We conclude that if the global economy slides into a recession of moderate depth and duration during 2016 and stays there for most of 2017 before staging a recovery, it will most likely be dragged down by slow growth in a number of key emerging markets (EMs), and especially in China. We see such a scenario as increasingly likely. Indeed, we consider China to be at high and rapidly rising risk of a cyclical hard landing.
The reasons behind China’s downturn and likely recession are familiar from the long history of business cycles everywhere: rising excess capacity in a growing number of sectors, excessive leverage in the private sector and episodes of irrational exuberance in asset markets – in China there were two thus far, for residential real estate and equity – resulting in booms, bubbles and busts. This is the classical recipe for a recession in capitalist market economies. This time is unlikely to be different for China. Policy options to prevent a recession exist but are, in our view, unlikely to be exercised in time.

Should China enter a recession – and with Russia and Brazil already in recession – we believe that many other EMs, already weakened, will follow, driven in part by the effects of China’s downturn on the demand for their exports and, for the commodity exporters, on commodity prices.

We also consider it likely that, should the EMs enter recession territory, the advanced economies or developed markets (DMs) will not have enough resilience, either spontaneous or policy-driven, to prevent a global slowdown and recession, even though many large developed markets will not experience recessions themselves but will merely grow more slowly, and possibly more slowly than potential, and more slowly than expected.

When forecasting the outlook for growth in China we have the further problem that the official GDP data are ‘manipulated’ to such an extent that ‘true’ real GDP growth is likely to be at most weakly positively correlated with real GDP growth according to the official data. There has been a long history in China of the official GDP data understating true GDP during a boom and overstating it during a slowdown, but the degree of overstatement of ‘true’ growth by the official data since about 2010 goes well beyond such ‘smoothing’. Incorporated in our August forecast in Figure 3 is our best forecast of what the official data will report as real GDP growth for 2015 (6.8%) and for the next four years between 6.2% and 6.5%.
The world appears to be at material and rising risk of entering a recession, led by emerging markets and in particular by China. This should not come as a surprise. Capitalism is cyclical – and always has been. It is likely that this recession will be shallower than the last one.
Helicopter money drops in China, the euro area, the UK and the US, and debt restructuring in the corporate, local government and banking sectors in China, in the private non-financial, banking and government sectors in the euro area, and in the banking sector in the UK can mitigate and, if implemented immediately, prevent a recession during the next two years without raising the risk of a deeper and longer recession later.

There are two risks that could worsen the outlook:

1) The first is that we get another systemic debt crisis, in developed markets, in emerging markets, or both. The emerging and developed markets remain very highly leveraged. In many advanced countries, the public debt burden is higher than it has ever been except during and in the aftermath of major wars, when the political economy of spending cuts and tax increases was very different.

Combined public and private non-financial gross debt burdens are at a record high. In many EMs, private leverage has soared.

We simply don’t know much about how to engage in effective macroeconomic stabilization in highly leveraged environments, or how to manage a financial crisis and limit the immediate damage it does without increasing the likelihood and the magnitude of the next crisis, and bringing it forward. The track record of the supervisory and regulatory authorities, central banks and finance ministries in most DMs (and in all large DMs) before, during and since the Great Financial Crisis has been poor.

For some of these actors, this may have been because of political constraints, beyond their control, on their ability to act. Many of the supervisory, regulatory, monetary and fiscal authorities in the EMs are untested in a severe financial crisis.

The last time we faced a situation like this there were, outside Japan, policy interest rates that could be cut, and most countries had more fiscal space. Today, the interest rate is out of commission as a policy instrument in most DMs and fiscal space is more severely constrained than in 2008 almost everywhere.

2) The second risk is that the world lapses into protectionism. Competitive devaluations (currency wars) by themselves would not damage the global recovery. When every nation tries to devalue its currency against every other currency, all will fail. Even then, however, the uncoordinated attempts to depreciate each currency against all others will produce a globally expansionary set of national monetary and credit policies.

If, however, protectionist measures other than competitive devaluations are resorted to support and boost national economic activity, things could get much worse and stay that way for much longer.

If the right combined monetary and fiscal stimuli are implemented immediately, a recession in 2016 can be avoided. Even the belated application of helicopter money drops in the cyclically afflicted countries can ensure that the coming bout of cyclical stagnation does not worsen the problem of secular stagnation. If, during and following the global recession, significant debt restructuring takes place in both EMs and DMs, and in both public and private sectors, we can look forward to a more durable and robust recovery after the next recession than we had following the last one. If in addition the necessary structural reforms of labor markets, professions, product markets and financial markets are initiated in a serious manner, if we can move from rule by law to rule of law in some key countries and from rule by lawyers to rule of law in others, if structures, institutions and policies are adapted to rapidly changing conditions, then future potential output growth will be enhanced and secular stagnation avoided. We are not holding our breath.

Europe faces political war on two fronts as backlash builds

The EU's Eastern states shocked to lose their sovereignty over borders, just as southern Europe lost economic sovereignty by joining the euro

By Ambrose Evans-Pritchard

The European Union is fracturing along multiple lines of cleavage, torn by an emerging Kulturkampf over migrant flows before it has overcome the bitter conflict at the heart of monetary union.

“The bell tolls, the time has come,” said Jean-Claude Juncker, the head of the European Commission, in his State of the Union speech.
"We have to look at the huge issues with which the European Union is now confronted. Our Union is not in a good situation,” he said.
Perhaps it would be churlish to point out that the cause of this near existential breakdown is a series of moves that have his fingerprints all over them:
The fateful decision to launch the euro at Maastricht in 1991 without first establishing an EU political union to make it viable, and to do this despite crystal-clear warnings from experts within the Commission and the Bundesbank that it would inevitably lead to a crisis - the "beneficial crisis" as the EMU enthusiasts mischievously supposed.

A migrant group walks between the railroad tracks near Roszke village of the Hungarian-Serbian border
A migrant group walks between the railroad tracks near Roszke village of the Hungarian-Serbian border  Photo: AFP

The escalating treaties of Amsterdam, Nice and Lisbon, each concentrating power further in the hands of a deformed institutional system, sapping at the parliamentary lifeblood of the ancient nation-states that can alone be the fora of authentic democracy in Europe.

Above all, to destroy trust by overruling the categorical "No" of French and Dutch voters to the European Constitution in 2005, and bringing back the same treaty by executive Putsch, with a disgusted but complicit British prime minister signing the document in a side-room in Lisbon safely screened from the cameras.

One might have thought that the proper conclusion to draw is that the EU can only save itself at this stage by abandoning the Monnet method of treaty-creep and reflexive attempts to force integration beyond proper limits, and retreat instead to the surer ground of bedrock nation states wherever possible.

But no, Mr Juncker wishes to invoke treaty powers to force countries to accept 160,000 refugees by a quota, whether or not they agree with his solutions, or indeed whether or not they think it is highly dangerous given the state of total war that now exists between Western liberal civilisation and Jihadi fundamentalism.

Personally, I think Europe's nations should open their doors to those fleeing war and persecution, with proper screening, in accordance with international treaties on refugees, and in keeping with moral tradition.

Those countries that etched the lines of Sykes-Picot on the map of the Middle East in 1916 as the Ottoman Empire was crumbling, or those that uncorked chaos by toppling nasty but stable regimes in Iraq and Libya, have a special duty of care. But the point is where the final authority lies.

By invoking EU law to impose quotas under pain of sanctions, Brussels has unwisely brought home the reality that states have given up sovereignty over their borders, police and judicial systems, just as they gave up economic sovereignty by joining the euro.

This comes as a rude shock, creating a new East-West rift within European affairs to match the North-South battles over EMU. With certain nuances, the peoples of Hungary, Slovakia, the Czech Republic, Poland and the Baltic states do not accept the legitimacy of the demands being made upon them.

There is a paradox to Europe's crisis. Italy's ex-premier Mario Monti says all three of the immediate dramas eating at Europe involve issues in which people - in a sense - want to cleave more closely to the Union.
For refugees coming in biblical proportions, EU soil is the promised land. The crisis with Russia erupted because Ukraine wanted to join the club. The perennial saga in Greece is dragging on because the Greek people want to stay in the euro.

This is true, but it is also meaningless if the project is disintegrating at the core. Marine Le Pen's Front National in France has lost no time seizing on events, insisting that nearly all the refugees are in fact migrants, and claiming for good measure that Germany is letting them in only to work as "economic slaves".

She continues to lead the polls in France, rock solid at 29pc in the latest Figaro survey despite expelling her own father from the party in an astonishing spectacle of political parricide.

There is a high chance that her lead will increase as the initial burst of generosity and warm feelings in parts of French society start to fade, and the long slog begins.

The eurozone is still in a structural economic depression. Do not be fooled the short-term cyclical recovery under way. It comes very late in a global expansion that is already long in the tooth, and is too anaemic to stop political revolt festering across much of southern Europe.

The European Central Bank expects growth of 1.4pc this year and 1.7pc next year. This is thin gruel, given that all the stars are briefly aligned in favour of what should be a roaring boom.

Fiscal policy is neutral after years of pro-cyclical tightening. The ECB is conducting €60bn a month of quantitative easing. The euro has fallen 24pc against the dollar over the past year. Oil prices have dropped by half. Yet even this blitz of stimulus cannot seem to close the output gap.

The rift between EMU's North and South was on vivid display last weekend at the Ambrosetti forum on Lake Como - a gathering of the EU elites - where a top French official accused the Germans to their faces of conducting "religious war", wrecking monetary union in a Calvinist urge for the moral cleansing of debt.

Even if the Teutonic "morality tale" of what went wrong in EMU were true - and Paris rejects the premise - it is too late to close the 20pc to 30pc gap in labour competiveness between the two halves of monetary union purely by forcing retrenchment on the South.

It is precisely such an asymmetric policy that pushed the eurozone into a 1930s contractionary vortex. It has been self-defeating, in any case. The deflationary effects have pushed up debt ratios even faster.

Germany's push for "competitiveness" is a cover for what has in reality been a wage squeeze, stealing a march on other countries within EMU by beggar-thy-neighbour tactics.

The French official said such policies are a zero-sum game in a monetary union. They should not be confused with genuine "productivity" gains, the real measure of economic progress.

Berlin's idee fix with moral hazard - its insistence that there should be no let up in austerity until reforms are delivered, lest there be back-sliding - flies in the face of the academic literature. Reforms need extra stimulus to cushion the shock.

German officials in the room smiled cherubically, unwilling to concede an inch of ideological ground. Not only are they certain of their moral cause, they also deem EMU policies to be vindicated. Just look at Spain. Shows what a country can do.

The French might retort that Spain has revived its car industry - now working "tres turnos" around the clock, and exporting 85pc of output - by luring production away from France to Spanish plants with a 27pc cut in wages. This way lies a race to the bottom.

As for Greece, nothing is resolved. There may or may not be a workable government in Athens after the elections next week. The creditors have yet to clarify what they mean by debt relief, if anything, and the International Monetary Fund refuses to participate in the latest €86bn loan package until they do.

The level of austerity agreed cannot plausibly be achieved. The primary surplus is once again a box to be ticked, a lawyer's concoction. The terms for Greece are even tougher than those rejected by Greek voters in a landslide referendum in July. "It is impossible to enforce," said Yanis Varoufakis, the former finance minister.

"The IMF does not think it can work, nor does the US Treasury, and I know Wolfgang Schauble doesn't think so either because he told me. There is no functioning banking system in Greece. Non-performing loans are 45pc, and any recapitalisation will be wasted. In six months we're going to have to go through exactly the same crisis again," he said.

The risk is that the global economy tips into another downturn over the next 18 months, before the eurozone is really back on its feet, with debt ratios much higher than in 2008, unemployment still stuck at almost 11pc and investment still 4.5 percentage points of GDP below pre-crisis levels (IMF data)

As the World Bank warned this week, all it will take is a mistake by the US Federal Reserve as it begins to tighten, setting off a chain-reaction through emerging markets.

The European Project has very little economic and political capital left to defend it if anything goes wrong now. As Mr Juncker says, the bell tolls.


The Breaking Point?

Germany's Asylum System Struggles to Cope

Photo Gallery: Nearing Capacity
As the migrant influx continues, the 'Refugees Welcome' high is beginning to wear off. People are beginning to wonder if Germany will really be able to cope with all the newcomers. And the system is already completely overwhelmed. By SPIEGEL Staff

The images were almost surreal. There were people who had just completed a brutally difficult journey, exhausted, but happy. And there was the crowd, lined up on both sides, cheering and clapping as though they themselves had made the trip.

Such scenes have played out across Germany in recent days, and they are more than a little reminiscent of the finish lines at marathons in Hamburg, Cologne, Berlin and elsewhere. The mood was almost festive, euphoric. One could almost forget that the refugees arriving at train stations around the country were not running against the clock. They were running for their lives. The expressions on some faces made it clear that they hadn't yet been able to completely grasp what was happening to them.

The scenes, which included dozens of people holding up signs reading "Refugees Welcome," were quite remarkable. The Germans -- not all, but enough that they are now seen as being "the Germans" everywhere else in the world -- were celebrating the Syrians, the Eritreans, the Iraqis and the Afghans who had made it to their country. And they were celebrating themselves.

It is as though the Germans are standing up and saying: "We are not who you have long thought we were." We are not closed hegemons. We are open-hearted. It was half-truth and half-staged, but it was appealing enough that one could bask in the feeling without pangs of guilt. Even Chancellor Angela Merkel, the perennial skeptic, was moved.

But what will happen if the influx of refugees doesn't abate? What will be left when the initial euphoria wears off and everyday life returns? How will Germans react when the celebratory images of this week are replaced with the reality of housing tens of thousands of newcomers?

The chancellor has made her decision: more help, which likely also means more refugees. Refugees Welcome. It is a position that will be difficult to back away from should the public mood shift, and it is a position she will be judged on in the next election in 2017.

She has already lost one close ally: Horst Seehofer, head of the Christian Social Union (CSU), the Bavarian sister party to Merkel's Christian Democratic Union (CDU). Seehofer, who is also the governor of Bavaria, has invited Hungary's hardline nationalist prime minister, Viktor Orbán, to the next conference of his party's state parliament group. Seehofer says the invitation gives the CSU an opportunity to "find a solution together with (Orbán)," but it is also a clear affront to the chancellor.

Seehofer says it was wrong for Merkel to circumvent existing EU asylum rules by encouraging refugees in Hungary to continue on to Germany. "That was a mistake that will be with us for a long time. I don't see a way to put the cork back in the bottle," Seehofer says. "We will soon find ourselves in an emergency situation that we will no longer be able to control."

'Uncoordinated Influx'

Meanwhile, Hannelore Kraft, the Social Democratic (SPD) governor of North Rhine-Westphalia, Germany's most populous state, made clear at the beginning of the week that the number of refugees to be expected this year will likely rise from the 800,000 the federal government forecast in August. She also made clear that the effort needed to deal with the influx will be much greater than previously thought.

Just how great that effort might be became clear on Thursday morning during a conference call of all state interior ministries in addition to the federal Interior Ministry in Berlin. As part of the meeting, states indicated how much shelter capacity they possessed, and the results, according to the phone conference's protocol, were not particularly promising. Seven states -- including Baden-Württemberg, Hesse and Rhineland-Palatinate -- reported that they had no remaining capacity whatsoever. Bavaria complained of "uncontrolled access pathways." And Schleswig-Holstein lamented the "uncoordinated influx into the reception facilities." The Interior Ministry in Berlin also had an alarm bell to sound: Austria, through which refugees must travel on their way from Hungary to Germany, is beginning to diverge from the joint approach.

The conference call provides a small insight into the immense challenges facing Germany this year and in the years to come. Indeed, the effects are likely to remain with the country for decades to come -- and will have consequences for Germany's identity, its prosperity and for its self-image. Against that backdrop, the question arises: Can we handle the crisis? Or will the crisis handle us?

Either is possible. It could be that Germany, with its gleeful welcoming party, is currently sowing the seeds for problems that the country will face in 2040. It could be that the foreigners will remain foreign, that they will create a new, parallel underclass. Simultaneously, it could also be that Germany is currently solving those problems that would, without immigration, face the country in 2040: Labor market problems, pension fund problems and old-age care problems.

It will take many years before it becomes clear in which direction the pendulum is swinging. But if Germany wants the opportunities to win out over the dangers, then that state will have to confront the chaos and do all it can to integrate the newcomers, the majority of whom are likely to stay. And that project will have to begin soon, even if the state is currently having difficulties accelerating asylum procedures, providing therapy to traumatized children and training adults for the labor market.


Indeed, even the very first requirement -- that of finding shelter -- is proving a challenge. Many cities are running out of facilities that can be quickly transformed into asylum hostels. And shelters made of containers, an idea that many have sought to apply, are in short supply, as became clear during a refugee summit held by CDU lawmakers in Rhineland-Palatinate earlier this week. And if they can be bought, the prices are high and the waiting list is months long. By then, winter will long since have set in, rendering insufficient the tents where many refugees are currently being sheltered.

German bureaucracy and building ordinances, not surprisingly, are exacerbating the challenge. "At times, it is grotesque what is being blocked," complains Olaf Kühn, mayor of the small Hesse town of Seeheim-Jugenheim. He relates a case where the banister of a staircase was just a few centimeters too low. Another time, he says, steps were just a tiny bit higher than allowed.

But the most common hurdle is fire protection regulations. That was even a problem for three apartments belonging to the protestant charity Diakonie in the town of Mühltal near Darmstadt. The apartments had earlier provided housing to the disabled, but fire protection rules are stricter for apartments housing refugees -- as Mühltal Mayor Astrid Mannes was shocked to learn.

Still, some things are likely to change. As part of the new "German flexibility" that Merkel recently called for, an "expediting law" will be on the agenda of the state-federal refugee summit planned for Sept. 24. Preparatory meetings have already established widespread agreement that more refugee hostels could be built in industrial areas and that noise and proximity regulations could be "modestly relaxed." Lawmakers also want to relax standards that apply to the conversion of former schools or hospitals.

It's not just municipal politicians who are waiting eagerly for such changes. States, which are responsible for reception facilities, are also facing extreme difficulties that could be slightly alleviated by even the smallest change made to the regulations. Recent weeks in Berlin, for example, have seen refugees being forced to sleep out in the open in front of the main reception center there.

The situation in Dortmund isn't quite that bad, but the path to a bed is long. First, those arriving by train are taken to a hall near the main train station, where aid workers are waiting with water and, should it be needed, clothing. But they are only allowed a few hours rest before being bused out to an emergency shelter somewhere else in the state, usually a tent, a gymnasium or an unused school.

A Free Bed

It used to be that refugees arriving at the train station were able to rest for five days at a reception center. But the closest such facility, in the Dortmund neighborhood of Hacheney, only has 350 beds. Today, that is barely enough to shelter pregnant women, families with small children and the sick. Everyone else, those who are assigned to emergency shelters strewn about the state, must be bused to Hacheney to register and then bused back. Not long later, they are relocated to a central shelter before, finally, being sent to one of the more permanent facilities located in a town, provided a free bed can be found.

"It's all worse than a conveyor belt," says Wahed Kabir, the deputy director of the facility in Hacheney. And already this year, that conveyor belt has come to a screeching halt nine times and asylum seekers who had arrived for registration found themselves standing in front of a locked door. The reason: With 1,000 people on the premises, the facility had reached capacity.

The situation may soon become even worse. Merkel's cabinet recently agreed on a procedure aimed at speeding up the repatriation of migrants from the Balkans, who have virtually no chance of being granted asylum status. Part of that plan foresees not distributing such migrants among smaller facilities in towns and villages. Bavaria has already opened a special hostel for such migrants. But other states are simply intending to keep them in normal, central reception facilities for longer. That, though, will mean a shortage of beds for refugees from Syria and other countries whose applications are likely to be accepted.

The new procedure explains why Hesse's central reception facility is overcrowded. Indeed, the state is constantly being forced to open new shelters in other cities and towns. The problem, though, is that the Federal Office for Migration and Refugees (BAMF), which has been charged with rapidly processing migrants from the Balkans, doesn't always have branch offices in such towns. And that makes the government's new plan largely worthless.

BAMF President Manfred Schmidt, for his part, has cast blame at the states -- for continually opening up new reception facilities. His agency, Schmidt says, "can't keep up by constantly opening up new branches."

It is the same old blame game. Though in this instance, the federal government and the German states are largely in agreement that BAMF is to blame. "BAMF isn't up to the task," said North Rhine-Westphalian Governor Kraft. A leading SPD politician in Berlin said that the agency "is definitely not a problem solver."

A Quarter Million Unresolved Cases

State and federal officials accuse Schmidt's agency of having dragged its feet for years in the resolution of tens of thousands of asylum cases. He has also been accused of not doing enough to secure additional federal funding to hire more asylum agents.

And the problem isn't getting any easier to solve. There were 150,000 unresolved cases last October. By April of this year, that number had risen to 200,000 and now the total is more than a quarter million. Every month, BAMF adds more unresolved cases to the pile. The result is that those refugees with good chances of obtaining asylum status have to wait extended periods before they can start their new lives and the deportations of the others are repeatedly delayed.

Somewhere in these statistics, Tesfalem Beyene, a 31-year-old asylum applicant from Eritrea, can be found. For the last 13 months, he has been sitting in a refugee hostel in Anklam, a small town just inland from the Baltic Sea coast, waiting for his case to be resolved. But nothing happens, even though most Eritreans are granted asylum.

Beyene would like to restart his life, move into his own apartment and find work. He envisions himself driving construction machinery, like he used to, or working in a care home. At the end of August, he finally received a letter from BAMF. But it wasn't the long-awaited decision.

"Because of the increased number of asylum applications," the letter read, he would have to continue waiting patiently.

Still, four new application processing centers are to be built soon in Nuremberg, Unna, Berlin and Mannheim, which should speed things up, BAMF President Schmidt hopes. Cases such as Beyene's -- where the outcome is largely clear -- are to be sped up in particular. By the end of 2016, the agency is to make 2,000 new hires, including several hundred people authorized to make case decisions.

But even that is too little, says migration expert Dietrich Thränhardt. "We need to make a much bigger effort," he says. According to his calculations, BAMF decided on an average of 20,000 applications a month during the first half of the year. But even if that number were to be doubled, the number of unresolved cases would continue to grow. To work through the 250,000 pending cases, in addition to handling the new ones to come, Thränhardt says, thousands of new decision-makers, and not hundreds, would be necessary.

'The Situation Is Too Serious'

Such numbers could help explain why Schmidt sometimes seems so despondent. They also, though, provide insight into the deepening conflict between the federal government and the German states. The situation is such that one agency leader is no longer a large enough scapegoat.

"How are things going to end?" groans a refugee official from one of Germany's three city-states. "The Federal Interior Ministry is doing nothing except for sending us new numbers every day." Many state governors are bristling for a fight and are angry at the results of a recent meeting on the refugee crisis among leaders of Merkel's governing coalition. "The money won't be enough," says Torsten Albig, governor of Schleswig-Holstein.

Berlin Mayor Michael Müller is even more explicit. "We don't have any more time. The situation is too serious. The federal government must finally abandon its stalling tactics," he says. The response to the crisis has been too limited, too parsimonious and too tentative, he believes. "In July, we agreed with the chancellor on flexible help from the federal government," Müller says. "Fixed amounts don't help us when the number of refugees is climbing by the day."

Meanwhile, the federal government in Berlin is disappointed in the states. "Now is not the time to complain. It's time to roll up your sleeves" and get to work, says Ole Schröder, a state secretary in the Interior Ministry. He says that SPD complaints about a coalition agreement made on the watch of Vice Chancellor Sigmar Gabriel, who is also head of the SPD, and Hamburg's SPD Mayor Olaf Scholz are the height of hypocrisy.

The anger on both sides is more than just bravado. But no matter how intense the differences between Berlin and the German states become, the decisive battle in the refugee crisis is being fought elsewhere: in Brussels. For the first time, Germany opened the door for refugees in Hungary. But if the majority of EU states continue to keep their doors locked, Germany's "Refugees Welcome" project is in trouble.

A New Cold War

On Wednesday, Denmark suspended train connections with Germany in order to prevent asylum-seekers from traveling through the country on their way to Sweden. The political signal was clear: Even if Germany has softened to the plight of refugees in Hungary, Denmark is not going to play along.

According to an internal European Commission paper from the beginning of July, the EU executive expects an additional 2 million Syrians to leave their homes by the end of this year.

Greek diplomats fear that more than 100,000 refugees are planning to head to Greece from Turkey in the coming weeks. On the Greek island of Lesbos alone, there are 18,000 refugees hoping desperately that they will soon be able to continue their journeys. They are sleeping in parks and on the streets -- and they don't have enough to eat and drink.

Most are hoping to make it to Germany. Which is why Germany is hoping to establish a quota requiring refugees to be distributed among all EU states.

Many countries are continuing to reject the plan, despite European Commission President Jean-Claude Juncker's emotional speech on Wednesday in which he accused some EU member states of being too selfish in the crisis. The Committee of Permanent Representatives in Brussels -- made up of ambassadors from each member state -- is deeply divided. On the one side are those countries in favor of a quota, like Germany, France and Austria. The other side is made up primarily of Eastern European countries like Hungary, Czech Republic, Slovakia and Poland. East vs. West: One Western European diplomat even referred to it as a "Cold War."

A Chance of Integration

Juncker and Luxembourg Prime Minister Xavier Bettel, whose country currently holds the rotating presidency of the European Council, would like to obtain a decision on the quota as early as Monday at a meeting of European interior and justice ministers. "Monday is an important meeting and, because voluntary commitments don't appear to be enforceable, we should agree on a quota. We don't have to wait for European heads of state and government to do so," Bettel says.

There's a reason for the haste. EU leaders generally make their decisions unanimously, but within the circle of interior and justice ministers, those seeking to block a proposal can be overruled. And if that doesn't work? Then two hopes would be lost at once -- the idea that Germany's burden could be shared. And that the refugees have a realistic chance of integration in the country.

Quickly providing a roof over people's heads alone isn't necessarily going to win hearts.

Successful integration hinges on what happens over the longer term in the schools, on the labor market and through the efforts of social workers. In all of those respects, the number of refugees cannot be permitted to get so large that the integrative momentum crumbles -- when it comes, for example, to helping return stability to the life of a minor who has been traumatized and has fled on his or her own to Europe. A related and urgently needed law will go into effect on Jan. 1 that will make it possible to distribute young migrants among all German states. This group, too, has grown so large that major cities like Berlin and Munich are no longer able to care for all of them.

In 2014, German youth welfare offices were responsible for a total of 10,400 children who fled their country without a guardian. But this year, Munich alone has already registered 6,000 children and youth, with most coming from Afghanistan, Eritrea and Somalia. The German states have pledged to provide care for these children based on youth welfare policy standards, but it's a big promise and one that is already being broken in thousands of cases.

'Can You Really Call that Child Welfare?'

Some 700 youth, for example, are currently being cared for according to "bare minimum standards" at Munich's Bayern-Kaserne military barracks, laments Andreas Dexheimer, the social education worker with Diakonie, the social welfare organization of Germany's Protestant churches, in charge of social services at the refugee center. He says that youth are only transferred to social care homes or homes for curative education after it is determined where they came from, how old they are and their name. In those facilities, each social worker is responsible for caring for a maximum of five youth. But in and around Munich right now, social workers are caring for an average of 10 youths each, with the number rising.

"Can you really call that youth welfare?" Dexheimer asks before answering the question himself. "No, the system has been collapsing for the past year and a half." Meanwhile, Klaus Honigschnabel of Munich's Inner Mission, likewise a Protestant social services organization, adds, "It's as if the ocean were being emptied out and all the water has to be captured in a test tube." It isn't money that's the problem, either. "Working together with politicians is going very well," he says. The problem is a lack of workers.

The market for social workers in Germany's metropolitan areas is virtually empty. Yet hundreds are needed to address the youth issue alone. If you add to that the remainder of the refugees, then thousands of social workers are required. But there aren't any and there won't be a fresh supply of social workers available anytime soon.

Even the 10,000 positions the federal government is creating in the Federal Volunteer Service won't do much to alleviate the situation. What are needed are real experts equipped in dealing with youth suffering from serious psychological problems, not volunteers keen to help.

Daniela Schneckenburger, the head of youth welfare in Dortmund, is sitting in her office on the eighth floor of city hall and trying to bring order to the almost uncontrollable chaos. By the end of the year, she estimates that 1,400 unaccompanied refugee children will arrive in her city, almost four times as many as last year. Currently, the city is taking incoming youth as far away as the state of Lower Saxony if there is a bed free. "We want to manage this and we will manage, but nobody knows how," says Schneckenburger, who admits to moments of pure despair. Even youth welfare offices are running out of personnel for dealing with the situation.

In Munich right now, each guardian is required to take responsibility for 60 unaccompanied young refugees. Even the best of good will and good intentions by all the volunteers isn't enough to tackle the problem. Ultimately, it's the professionals who will have to step up to the plate -- in schools, too.

Putting German Schools to the Test

Take the example of Schifferstadt, a town in the state of Rhineland-Palatinate. At the Nord Elementary School, students in class 4D recently conducted a test of bicycle riding skills that involved navigating an obstacle course. Only one boy required assistance from the teachers to get on his bike. He began wobbling and then fell over, scratching on his elbow. Teachers at the school must now determine what the 10-year-old is capable of doing, but also what he can't do.

It may be that the next few days are less painful, but they certainly won't be easy.

Ibrahim came to Schifferstadt with his mother and two siblings, and school attendance was mandatory upon his arrival. "That happens overnight," says school director Merten Eichert.

The government ministries and teachers are facing a unique challenge: They have to absorb thousands of refugee children within a matter of days whom they hadn't even known about before departing for summer vacation.

They must now teach them German and slowly integrate them into normal classrooms. They also have to be incorporated into meal planning as well as the day-care and recreational offerings of all-day schools. At the same time, they have to help these children overcome the horrors they have escaped in their home country.

During her work on her doctoral thesis, Munich psychologist Seval Soykök came to the conclusion that 22 percent of Syrian refugees aged 14 and under suffer from post-traumatic stress disorder. An additional 16 percent suffer from other psychological effects of the terrible things they have experienced. Teachers told Schifferstadt principal Eichert that some refugee children had reacted to a fire drill as though a bombing raid had begun.

'We'll Have to Wing It'

It's a massive task for the schools. Is it too big? In the state of North Rhine-Westphalia alone, 10,000 more children showed up in classrooms this year than expected. And that doesn't include those who are still in reception centers or who only just arrived by train from Hungary.

"We can't plan for the future," says Sylvia Löhrmann, the state's education and research minister. It is estimated that one-third of all refugees are under the age of 18.

"Immigrant children are not a novelty for us," school director Eichert says calmly. He says the schools will just be fuller now. But he also adds that the "range of the students abilities will also widen, creating a more difficult teaching environment."

Educational professionals are thus warning against putting three or more refugees in a single class. Stefani Droll, the head of the Koblenz's Integrated Comprehensive School (IGS) says the refugees provide an excellent opportunity at German schools for both sides. During this school year, IGS Koblenz took in 11 children from Syria and two from the Balkans. They receive new queries from interested people every day. Droll says that the education levels Syrian children already have assure they will be successful learners in German schools.

At the same time, she warns, "that only works up to a certain threshold." She says it's easy to integrate two students in each classroom but beyond that it gets difficult.

'Initial Costs Are Enormous'

Vocational schools are being particularly challenged and overwhelmed. Many refugees are arriving at the doors to these schools in order to prepare for working life. "The young refugees are motivated and want to learn German," says Herbert Huber, the chairman of the Association of Vocational School Teachers in the state of Baden-Württemberg. "But integration requires considerable time, money and effort." He says that if you include preparation courses and the actual professional training, then the time it takes for a refugee to complete everything is five to seven years. "The initial costs are enormous," says Huber. "And politicians are doing too little to explain this."

For vocational schools in his state alone, his organization is calling for 200 new teaching positions per year. Meanwhile, the national association of vocational school teachers is calling for 20,000 such positons across the country, not including social workers and interpreters. If you estimate that each position will cost at least €55,000 per year as the Education Ministry in Baden-Württemberg does, then it quickly becomes clear that the government is facing billions in costs.

The same also applies to the labor market authorities -- the only difference being that they have a little more time to prepare than the schools do. Under current rules, refugees are allowed to start working after three months, but only if an EU citizen is not interested in the position.

Most end up being the responsibility of the Federal Labor Office. And it takes months before the job center is responsible for making welfare payments.

If you go by the current official forecast that 800,000 refugees will come to Germany this year -- one that is already considered by many to be out of date -- and that as many will arrive next year, then the Federal Labor Office will require an estimated 3,300 additional staff members.

But as with almost all figures these days, this one too will likely be obsolete in a matter of weeks, if not days.

'Early Intervention'

The hope of many at the job centers, but also their greatest burden, is that public opinion in Germany won't shift. There is no single argument that can quiet skeptics as quickly as the one that Germany urgently needs workers. Many expect the job centers to quickly help refugees find work so that they won't have to rely on state welfare payments in the first place.

Still, the Federal Labor Office is no different from the rest of the government's agencies in the sense that its staffers know very little about the refugees who have arrived. They know their ages, their gender and their nationality -- assuming the information provided is correct. But they know little else.

That's why the agency has sent people into the refugee accommodations in order to learn more -- like the languages spoken by the refugees, what kind work they would like to have and the skills they might bring to those jobs. The pilot program, called "Early Intervention," has been tested in nine cities since 2014 and will become the national standard in January 2016.

The aim of the project is to help prevent disappointing both refugees' and German expectations. But the early results have been sobering. In an analysis for the Federal Interior Ministry, the Federal Labor Office wrote that, of the 850 refugees who participated in the project, only 65 found work immediately.

The most common problem is insufficient knowledge of German. When asked what they would do to remedy the situation, Labor Office staff said they would like to see German language courses offered to all from the moment their asylum procedures start and not only at the point when refugees are given residence permits.

So what will happen to Germany and its refugees? Will the majority opinion hold, or will it begin to shift? The country still has 2.8 million unemployed. What happens if these people start to believe that they are being passed over for jobs in favor of refugees? And what happens if, when they get asylum protection, the refugees start competing with locals for apartments in the low-price market in major cities, for which the demand is already highest?

On Monday, many conservative parliamentarians returned to Berlin after visits to their electoral districts. "Normally, all we hear is praise for the chancellor," says one CDU politician. "This time, there was quite a bit of skepticism mixed in."

It was the fear of having begun something that can no longer be stopped -- and the unpleasant feeling of not knowing where things are heading. One thing is clear though: Regardless how the refugee crisis proceeds, it will definitely continue.

By Melanie Amann, Matthias Bartsch, Jürgen Dahlkamp, Markus Dettmer, Jan Friedmann, Christine Haas, Veronika Hackenbroch, Horand Knaup, Peter Müller, Conny Neumann, Maximilian Popp, Cornelia Schmergal, Barbara Schmid, Fidelius Schmid, Andreas Ulrich and Wolf Wiedmann-Schmidt