Monthly Archives: July 2011

The Saudis and Iranians don’t agree on much, but they do share a deep dislike for Muammer Gaddafi. In fact, outside of Venezuela’s President Hugo Chávez, there really is no one in the international community who does. That is why it was so easy to build international support for a Nato bid to push him from power.

The trouble is that, unless it gets exceptionally lucky, Nato is unlikely to either force Col Gaddafi from his stronghold or cut a politically saleable deal with him anytime soon. Meanwhile, the opposition are making little progress, a fact now worsened by the death of their military leader, Abdel Fattah Younis, who defected from Col Gaddafi in February. The most likely outcome remains a country in pieces, with substantial volumes of crude oil offline for at least the new few months.

This now creates considerable risk for the western governments implicated in the efforts to oust him. The ease with which Nato entered this fight has in turn made it easier to become more deeply enmeshed in it. Few strenuously objected when the mission began to creep, and now it seems that nothing short of Col Gaddafi’s departure, on a plane or in a coffin, can can truly bring this conflict to an end.

This is an especially bad situation for President Barack Obama, a man most comfortable steering conflict toward compromise. Though Britain and France now say that Col Gaddafi can remain in Libya as long as he relinquishes power, there appears to be no true middle ground to allow this compromise to come about.

In power since The Beatles were cutting new albums, Col Gaddafi has made clear that he won’t retire, particularly since the International Criminal Court has issued a warrant for his arrest. He already lives with the risk that the next whistling noise in the skies above might be the last sound he hears.

Nor are Libya’s rebels likely to allow his children to inherit his power, or to create a government of their own with their father living happily in a tent in Libya’s desert, lobbing threats in their direction. Nor is Col Gaddafi likely to be willing to live inside Libya with less than total political control: he knows that when a new government comes to arrest him, no one will object.

As Robert Gates made plain in his final address as US defence secretary to Nato members, Europe’s commitment to funding this adventure is also on the wane – though it was the Europeans who initially led this charge – and American lawmakers, now playing chicken with their country’s credit rating, are in no mood to pick up another cheque.

So the transatlantic military alliance now faces two unsavoury choices. It can put the proverbial “boots on the ground”  to oust Col Gaddafi, and bring the military chapter of this mission to a definitive close. That would satisfy some, but enrage many others. Or they can cut a deal that leaves the rebels where they are with Gaddafi as mayor of Tripoli. This de facto partition plan would frustrate virtually everyone. Understandably, no one is prepared to make this choice.

And so the stalemate will continue. Nato must now hope it gets lucky. In the mean time, its participants should reflect on the moral of this story for those western powers anxious to write its final chapter: a lack of international resistance can lead governments to start wars they don’t know how to win.

The writer is the president of Eurasia Group, a political risk consultancy, and author of ‘The End of the Free Market’


It is time for real compromise in Libya. The principal reason to support the intervention in the first place was to protect the people of Libya. Decisive action aligned the west with popular movements sweeping the Middle East and north Africa — a goal justified by both ideals and interests.  For the same reasons, stopping the fighting now is more important than an opposition victory on the current terms advocated by the National Transitional Council in Benghazi.

Some conditions remain non-negotiable. Muammer Gaddafi must step down. If he remains inside Libya, it must be in a place and on terms that prevent him from maintaining a personal power base. The fighting must stop and both sides must pull out of population centres. But everything else should be on the table.

Remember how the intervention began. The only ground on which the Arab world and then the United Nations could agree on the use of force was the protection of Libyan civilians. Security Council resolution 1973, which authorised the no-fly zone and other measures, listed a long set of humanitarian concerns and justifications, beginning with  “the responsibility of the Libyan authorities to protect the Libyan population”, and noting the perpetration of gross and systematic human rights violations and possible crimes against humanity. On April 14 Nato and its partners announced that they would continue “a high operational tempo against legitimate targets” (ie,  intensive bombing) until Col Gaddafi ended attacks and threats of attacks against civilians and civilian-populated areas, verifiably withdrew all his forces to bases, and permitted humanitarian access to all Libyans who need help.

Those are genuine humanitarian conditions, but de facto they would require Col Gaddafi to give up all the military gains he has made against opposition forces by pulling out of all the cities that are currently contested. He has no incentive to give up the fruits of his military victories except in return for an acceptable political agreement with the opposition.

Here is where the views of leading coalition members come into play. The US, Britain and France appear to have political red lines of their own, most notably the non-participation of any Gaddafi family members in some kind of transitional governing arrangement. Since Col Gaddafi himself has refused any suggestion that does not include the face-saving formula of allowing him to transition at least some power to one of his sons, real progress is stymied until Col Gaddafi is killed either by a bomb or one of his own associates. Yet none of his family members have any incentive to advocate compromise, as his fate and theirs are tied.

I fully understand why the idea of any member of the Gaddafi family continuing to hold power of any kind is so repugnant. I in no way accept a moral equivalence between the two sides; Col Gaddafi’s abuse of his own people extends back nearly a half century. I was an early and vocal supporter of the UN intervention in Libya precisely because I foresaw that Col Gaddafi’s ruthlessness and disregard for the lives and prospects of his citizens imperiled a city of 700,000 people. I also share the genuine commitment of many in the NTC to create a liberal democratic Libya that protects and empowers all Libyans.

Yet it is time to rethink, because the longer the fighting continues, the longer it is likely to continue. This is counter-intuitive; both sides assume that each is wearing the other down and thus “victory” is just a matter of weeks or months. But in a conflict like this one, where for various reasons neither side has the ability to deliver a decisive blow, the fighting itself creates a cycle of radicalisation and entrenchment that makes it progressively harder rather than easier to reach a settlement.

At the outset, I and many others saw the conflict not as a civil war but as an uprising of the Libyan people against their government. I continue to think that widespread opposition to Gaddafi exists in Tripoli and across Western Libya. But opposition to Gaddafi has not translated into mass uprising or manifest support for the Benghazi forces, in no small part because the more family members lose loved ones, suffer prolonged privation and life disruption, and are victims of the kinds of human rights abuses that reporters and non-government organisation observers are beginning to document on the part of opposition forces, the more reason they have to believe Col Gaddafi’s propaganda and conclude that the devil they know is better than the devil they don’t.

The more sacrifices individual fighters make for their cause the more they hate and harden their positions, on the grounds that only a complete victory can justify the mounting costs of the struggle. The longer the fighting continues, the more opposition members will have blood on their hands as well. Moreover, the destruction of ongoing warfare undermines the economic and social preconditions for any meaningful political order in Libya over the coming years.

Meanwhile, the human costs to the Libyan people that Nato seeks to protect mount daily. In battle zones, widespread death and rape, with the attendant destruction of families and the all-too-human desire for revenge. The destruction of vital infrastructure necessary for economic activity, from oil production to ordinary small business. The flooding of the country as a whole with arms, which will spur further conflicts and raise the overall levels of violence in communities across the country. The continued shortages of food, medicine, power and other basic necessities of life, the disruption of education, business, travel, and interaction with the outside world. The deepening of tribal divisions and ancient enmities across the country.

All this will make it much harder to rebuild a Libya with a government that actually serves rather than oppresses its people: the ultimate goal not just in Tripoli, but across north Africa and the Middle East. We have seen such a political tragedy unfold many times before, in Iraq, Afghanistan, Somalia and the Democratic Republic of Congo. The relative success stories, such as East Timor and Kosovo, are ones where the fighting ended quickly once the basic objective had been achieved. It is time to explore all possible avenues to add Libya to that list.

The writer is the Bert G. Kerstetter ’66 University Professor of Politics and International Affairs at Princeton University and former director of policy planning for the US state department

Response by Shashank Joshi

Moral superiority does not ensure military victory

Humanitarian intervention seems to afflict different ends of the political spectrum with different pathologies. For swathes of the right, humanitarian intervention can never be sound strategy; for the left, never humanitarian. But the onset of war reveals a new type: the pure interventionist, convinced that the righteousness of the cause entails the imminence of victory and the impossibility of compromise.

Regarding Libya, this cognitive dissonance is widespread.

Many remain unable to understand that moral and military superiority do not overlap. But in the absence of overwhelming strength, obstinacy is a recipe for a prolonged war that could poison the fruits of eventual victory (and some manner of victory is near-certain, given the progressive withering of every supply line into Tripoli). As Anne-Marie Slaughter astutely notes, it is difficult to understand the enduring effects of war on the people until political institutions and social relations stand in tatters at the end.

Many draw false analogies from Nato’s war for Kosovo, a campaign in which limited means were commensurate with limited objectives, falling well short of regime change.

More still are unwilling or unable to distinguish between
Gaddafi’s departure comprising a necessary outcome, as opposed to a precondition, of negotiations. The result has been the demonisation of those, like Slaughter, who favour a negotiated rather than a purely military solution.

This reflects a sharp paradox. The moralisation of foreign policy is the sine qua non of liberal intervention, but in furnishing the ideological basis of such wars it renders a settlement all the harder – whether the Taliban or the Gaddafi regime, engaging with evil is a hard sell.

Effective strategy however, requires more than sticks; it requires handing carrots to those who are manifestly undeserving. The international coalition is entitled to have different objectives to those of the Libyan opposition without thereby abandoning their cause or betraying their trust. Indeed, the rebels’ proximity to the war, and the sacrifices they have made in an obviously noble cause, may all the more cloud their own assessments of the war’s likely course.

British leaders, repeating overconfident projections for months
now, and obscuring to parliament and people the full costs of the operation, are in danger of discrediting the vitally important concept of humanitarian intervention in the long-term. That would be a shame, for it is an instrument of foreign policy which will inevitably be required in the years ahead when the next democratic wave hits the rocks.

The writer is an associate fellow at the Royal United Services Institute

Our country cannot afford politics as usual at a moment of such vital import for now and for the longer term. Many Americans have experienced great hardship since the recession began; unemployment has become long-term for large numbers, with potentially permanent damage through loss of skills; and current economic conditions could well remain stressed for an extended time due to the strong headwinds we face. Policy decisions can make a real difference to these conditions, for better or for worse.

Looking to the longer term, we could well be at an historic crossroads.  With our dynamic culture and other strengths, we should succeed if we meet our policy challenges. If we don’t, we will likely languish.

The issues we face are complex and there are very different views about what to do. But policy makers who operated on facts and analysis, not ideology and politics, who worked to find common ground and who made politically tough decisions could reach enough agreement to ameliorate our shorter term duress and position us for longer term success. The key is the political will of our people and our leaders.

It is imperative, for both the nearer term and the longer term, that we meet the deficit commission’s goal of $4,000bn of deficit reduction over roughly 10 years, which would first stabilise and then begin to reduce our debt to gross domestic product ratio. That programme must include room for public investment in areas critical to our economic future, a balance of revenue increases and reductions in all categories of spending that enables the government to provide the services and safety net that most Americans expect (albeit with appropriate reform), and an effective date two or three years from now to allow time for recovery to hopefully take hold.

The argument against raising taxes during a recession is a red herring given the deferred effective date, and in any case would apply equally to spending cuts. Opponents of President Bill Clinton’s 1993 deficit reduction programme also said that the tax increases – almost entirely on the most affluent – would lead to recession or worse. Instead, we had the longest economic expansion in the nation’s history – in part because of the confidence created by sound fiscal conditions – with massive job creation, widespread income increases, and ultimately the first fiscal surplus in 30 years. That notwithstanding, the ideological opposition to revenue increases continues, creating deeply counter-productive pressure on programmes critical to our economic future and the economic security of our people.

It is delusional to think that our fiscal problems can be solved predominantly by cutting non-defence discretionary spending, which can be roughly defined as the regular functions of government apart from defence, social security and the healthcare programmes. The numbers simply won’t work – the Congressional Budget Office estimates that on a realistic appraisal of our current policy outlook, our deficit will be 7.5 per cent of GDP in 2021, and non-defence discretionary spending is roughly 4.4 per cent of GDP today. Moreover, the damage to our economic future from focusing predominantly on non-defence discretionary spending (which includes education, infrastructure and the many other aspects of public investment) would be enormous.

A serious deficit reduction programme could be attached to increasing the debt limit, which is an absolute imperative, given the effects not doing so could have on market risks and on confidence in our political system. At the very least, the debt limit should be raised without harmful conditions.

Meanwhile, work must continue toward accomplishing the full fiscal objective. As many specifics as possible could be set now, with guidelines for the rest that are concrete and structured to be as hard to evade as possible in future years.

Such an approach would greatly reduce the severely dangerous bond and currency market risks of our current fiscal trajectory. Those risks are more likely to materialise in the longer run but market psychology is unpredictable and disruption in the shorter term cannot be ruled out.

Moreover, our current unsound fiscal outlook is likely to increasingly undermine business and consumer confidence, both by creating uncertainty about future economic conditions and policy and by symbolising a broader inability to manage our economic affairs and provide effective governance. Conversely, the 1993 deficit reduction programme showed how strongly a sound fiscal programme can improve confidence, which in turn increases investment and hiring.

Because of the corrosive effects of our fiscal outlook on confidence, which will worsen as our debt to GDP ratio deteriorates, I do not believe a healthy recovery can begin without a sound fiscal regime.

Serious longer-term deficit reduction would also make a temporary stimulus safer and more effective, by countering the market risks and adverse confidence effects that could be associated with additional deficit measures. Linked to such a fiscal programme, a temporary stimulus, such as continuation of the payroll tax holiday and of the unemployment insurance extension, could well be warranted to combat the paucity of demand.

Without serious deficit reduction, the balance of effects of a temporary stimulus is a much harder question. We do need additional demand, especially with the increasing incidence of long-term unemployment and the fiscal drag in 2012 from the end of the current stimulus. The risk is that the political system could be seen as unable to address the difficult issues of serious deficit reduction, but able to act only on providing lower taxes or increasing programmes. That could possibly become the straw that breaks the camel’s back on market psychology. And business and consumer confidence could be further undermined, partly offsetting the stimulus and possibly with more lasting effects. Moreover there are real issues about whether a stand-alone stimulus would be likely to have an ongoing benefit, given our unsound fiscal underpinnings and other headwinds, and whether it will pay for itself, even over time. The points here are not dispositive either way on a free standing stimulus, but simply show that the decision is not simple or one-sided.

For the longer term, our success – and avoidance of unsatisfactory performance – depends on a sound fiscal regime. That regime would prevent an otherwise virtually inescapable market and economic crisis, create an interest rate environment conducive to growth, buttress confidence, and provide the resources for essential public investment, economic security and national defence, which would otherwise inevitably be significantly under-funded.

The writer was US Treasury Secretary from 1995 to 1999 and is co-chairman of the Council on Foreign Relations

Response by Uri Dadush

US can afford to be bolder in repairing its finances

Robert Rubin is correct in pointing to the critical state of US public finances and also in underscoring that that any realistic solution must combine tax increases and expenditure cuts across the whole spectrum of government spending. He is also correct in his claim that permanent expenditure cuts are just as likely to have a depressing effect on demand as permanent tax increases.

Precisely because of concerns about the US fiscal trajectory, however, and given that the US economy is in the middle of a recovery, I am less convinced by his call to hold on implementation of the programme “over the next two to three years until the recovery takes hold”. Though there is a case for targeted support for the unemployed – unemployment remains high and long-term unemployment is higher still (45 per cent of the unemployed have been so for more than six months compared to an average of 18 per cent since 1980) – the US economy is likely to continue to expand and create new jobs.

Recent indicators point to a US corporate sector in good shape, with capacity utilisation only about 2 per cent below the 20-year average, consumer confidence resilient and world trade continuing to grow rapidly; these factors together with low interest rates will play an important role in propping up demand. Again delaying budget consolidation in this situation may well be counterproductive, especially if it undermines confidence about the government’s determination to put its fiscal house in order, as it might well.

Partly because it has paid so little attention to it so far, there is lot that the US can do to correct its fiscal trajectory. US tax revenue over the last decade is the second lowest among the larger advanced countries, after Japan – whose public finances are in disastrous shape. The taxes paid by US corporations represent a much lower share of gross domestic product than either Greece or Italy , according to the Organisation for Economic Co-operation and Development. The US gasoline tax is a fraction of the OECD average.

The International Monetary Fund projects that US gross debt will reach 112 per cent of GDP in 2016; the only countries with higher debt are Japan and three European periphery countries under market attack: Italy , Greece and Ireland . However, among this group, only Japan will see a larger deterioration in its debt/GDP ratio than the US over the next five years. Net debt levels (excluding US government debt held by the Federal Reserve and other public agencies) are lower all around, but tell the same story. The US is also a complete outlier in its spending on healthcare and defence. And, like most other advanced countries, the US will see a large deterioration in its fiscal balances just as a result of aging: its old age dependency ratio is projected to rise from 19.5 per cent in 2010 to 32.7 per cent in 2030.

Unlike Italy , Greece and other European countries in bad fiscal shape, the US can count on a highly competitive and flexible private sector, an independent monetary policy, flexible exchange rate and, for the time being at least, its safe haven status and unparalleled ability to attract foreign investors. For these reasons, it can afford to be bolder than even Mr Rubin suggests in tackling its large fiscal problem.

The writer is senior associate and director for the International Economics Program at the Carnegie Endowment for International Peace

European leaders have called for a comprehensive strategy for growth and investment in Greece and a task force will be appointed to set out the details of how European Union structural funds could be used to that end. We had floated such ideas in February. Here is what the EU should do.

Money is available in substantial amounts. According to our calculations, Greece still has more than €12bn in unused structural funds, which could be used to leverage loans from the European Investment Bank, potentially increasing the funds available over the next two to three years to €16bn. This, equivalent to 7 per cent of Greece’s gross domestic product, would not involve any additional transfer to Greece beyond what has been already allocated to it in the EU budget.

However, governance must be reformed. The EU structural funds are earmarked for regional development and subject to long procedures, not least because of political give-and-take. Spending priorities have little to do with current urgencies. The EU should pass emergency legislation reallocating the money available to an Economic Revival Fund for the duration of the IMF/EU assistance programme. Spending priorities for this fund should be set to match the economic objectives of the programme, with a focus on growth and competitiveness. And disbursement procedures should be expedited.  

In setting priorities, we propose to earmark the €16bn for the following purposes.

First, to increase the quality of higher education. Before the crisis, the quality of education was identified by the OECD and others as an important impediment to Greek growth. There is now a serious risk that budgetary cuts will further worsen the quality of higher education. €4bn should be allocated to funding institutions of excellence, providing means-tested scholarships and financing mobility programmes on strict condition that the funds are used for education only.

Second, it should be used to foster internal devaluation. Greece’s exports amount to 20 per cent of GDP only, too small a proportion for a country of its size. Greek corporations already have  some export basis and demand for services such as tourism is very sensitive to price changes. Lower labour costs would thus quickly benefit exports through an improvement in cost competitiveness. The Fund should set aside €4bn for temporary wage subsidies in the tradable sectors (manufacturing and hotel and restaurants), to be introduced on 1st January 2012 and phased out in 2013-2015. These subsidies should serve to front-load the reduction of labour costs while offsetting part of the cost to employees. Some wage subsidies might more specifically target R&D intensive sectors to raise their growth potential. To avoid wage cost reduction being captured by rents, internal devaluation must be accompanied by strong measures to reduce market power and stimulate competition.

Third, the fund should better support enterprise. Economies grow by upgrading the products they already produce and by introducing the production of similar products. In the case of Greece, there is a high potential for upgrading. For this to succeed, small and medium sized start-ups must have access to finance. This is even more urgent in a situation where weakened banks may restrict access to credit. The Economic Revival Fund should allocate €4bn to supporting loans to small and medium sized enterprises and providing capital for entry in the production of new products. Public support should be given on a competitive basis to the sectors with most potential.

Fourth, the fund should support “Lighthouse” innovation products. Greece must target more varied, and higher value-added, production if it wishes to substantially increase exports and income. A further €4bn should be earmarked to foster the creation of local centres of innovation combining centres of academic excellence with special business zones that allow for technological spin-off. Top European research institutions (Oxford, Max-Planck society, etc) should be given a financial incentive to set up campuses in Greece. These subsidiaries should focus on a few key areas (such as bio-technology or green growth technology), with independent management to ensure excellence at a global level by avoiding influence from other parties and being able to attract top international researchers with attractive salaries. Such academic centres of excellence could be the nucleus of a new growth centre.

For sure, financial incentives by themselves will not be enough. Economic institutions need to be improved. The rule of law, a corruption-free environment and an efficient state apparatus are key determinants of innovation and investment. Now and in the future, the European funds should be conditioned on improving the institutional environment.

Our programme has a strong interventionist flavour. This is because as long as the price system delivers the wrong signals, only intervention will trigger the necessary shift of resources towards the tradables sector. A hands-on approach is temporarily needed. Money should be put at its service.

This article was co-authored with Benedicta Marzinotto and Guntram B. Wolff. The writers are scholars from Bruegel, the European think tank


Response by Miranda Xafa

Cut back the red tape to make Greece competitive

There has been no shortage of proposals to help restart growth in Greece, where the economy is contracting for the third year running with no prospect of a quick recovery. What is different about this proposal is that it is clear both about the interventions that are needed and the resources that can be tapped. The authors propose diverting some €12bn in unused structural funds already earmarked for Greece to an Economic Revival Fund to directly support education, enterprise and innovation. This would expedite disbursement procedures and directly support export-oriented enterprises and sectors during the three year adjustment programme backed by the European Union and International Monetary Fund.

As the authors acknowledge, financial incentives alone will not be enough. Economic institutions and the investment climate need improving to attract investment. Greece ranks 109th out of 155 countries in the World Bank’s Doing Business report, lower than some in Africa. Competitiveness is eroded by impediments to domestic competition, restrictive labor practices and red tape. The IMF/EU-supported programme is already tackling the first two of these problems. What is needed is for the Greek government to set up a Sunset Legislation Committee, similar to the one established under the Reagan administration in the US, to abolish useless rules and regulations that increase the cost of doing business and can be a source of corruption. EU officials and private sector representatives should participate in the committee to prevent political horsetrading and resistance from special interest groups, mainly from inside the state apparatus.

No state bureaucracy can function efficiently without performance-related rewards and penalties. The ongoing effort to link pay to performance in the public sector should also come under this committee’s purview. Its work would be facilitated by a positive outcome to the referendum prime minister George Papandreou plans to hold in September, in which one question would be whether life tenure for civil servants should be abolished.

Finally, the Greek government’s intention to reform the tax system should also be used as an opportunity to simplify the tax code so that it can fit into no more than 50 pages. The current maze of tax rules and regulations make the system impossible to administer and prone to corruption.

The crowning achievement of the proposed Economic Revival Fund would be to abolish the Greek ministry of development at the end of the three year adjustment programme. The ministry’s role in the past has been to distribute budget subsidies to preferred regions and sectors. Thrace in northern Greece – a poor border region – is littered with the remnants of short-lived factories. By creating a far more efficient, temporary mechanism to allocate structural funds, the Fund would allow the ministry’s operations to be wound down.

The latest figures show that Britain’s economy grew by only 0.2 per cent in the second quarter, which the Office for National Statistics says was equivalent to 0.7 per cent after taking account of the extra bank holiday for the royal wedding, and the effects of the Japanese earthquake. One excuse after another! Taking a slightly longer view, the economy has barely grown at all, according to the official statisticians, over the past three quarters. What should be done about this?

The answer depends on why growth has slowed down so sharply in the official statistics. One strong possibility is that the ONS is significantly underestimating the true level and growth rate of gross domestic product, as it has done for long periods during previous economic recoveries.

Alternative  economic indicators continue to look more buoyant than the GDP figures. For example, business survey data indicate that the economy may have grown by about 1 per cent in the first quarter, and by 0.6 per cent in the second quarter. Furthermore, labour market data have not weakened in the manner that would be expected if the economy had stagnated.
On these alternative estimates, the slowdown in UK growth would be in line with the pattern in other major economies this year. Growth would now be roughly in line with trend, with the path headed slightly downwards. That would provide no cause for complacency, but no cause for panic either.

The next question is how much of the growth slowdown has been caused by supply side factors, which cannot be addressed by conventional demand management. The shrinkage of the financial and construction sectors has certainly affected the economy adversely, but these effects need not be permanent, since resources can be redeployed in other industries.  More recently, however, the rise in oil prices has clearly acted as an adverse supply shock, simultaneously raising inflation and cutting output growth. There is nothing that fiscal or monetary policy can do about that, if the inflation target is to be respected.
However, once the commodity shock has passed, and assuming the economy stays subdued, there will be a strong case for a boost to demand through macroeconomic policy. Should this come from the fiscal or the monetary side? The government’s budgetary regime allows the fiscal stabilisers to work, and they are already doing so with the overshoot of the budget deficit relative to target in the new fiscal year. But this will only amount to around 0.5 per cent of GDP, which is fairly negligible.

Other ideas for fiscal easing include a temporary cut in VAT on the Labour side, or an early elimination of the 50 per cent income tax rate on the Conservative side. The Chancellor George Osborne continues to argue against this kind of emergency fiscal action, which would undermine the confidence effects he hopes to see from the control of public debt.

There is no doubt that the fiscal tightening has slowed the economy. The idea that the budget deficit could be cut by 2 per cent of GDP per annum without this affecting GDP was always a pipedream. But these effects were intended to be cushioned by expansionary monetary policy and a lower exchange rate, and that still remains the best route to easier demand policy.

Inflation is still too high for the Bank of England to ease policy immediately. The headline rate of consumer price inflation in June was 4.2 per cent. But underlying inflation rates are now falling sharply, with some measures of core inflation having dropped below 1 per cent. This is consistent with the very subdued behaviour of wage increases and labour costs, which will determine inflation in the long run.

The Bank’s monetary policy committee looked set to increase interest rates earlier in the year. We now know that this would have been a serious mistake. The case for another round of quantitative easing is growing.

The writer is chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners


Response by Jonathan Portes

Calls for more QE are passing the buck to the Bank

As Gavyn Davies says, the idea that the very sharp fiscal contraction now in train in the UK would not be contractionary was always a pipe dream, and there is now a strong case for a boost to demand. Like Vince Cable and the International Monetary Fund, he argues that monetary policy – in particular, another round of quantitative easing – should pick up the slack.

But there are several reasons to believe that  monetary and fiscal policy are far from being perfect substitutes in current circumstances.  Monetary policy works, in Milton Friedman’s famous phrase, with “long and variable lags”, while fiscal policy, if it takes the form of changes to government spending, can work quickly. Simulations using the National Institute of Economic and Social Research’s model suggest that, in the UK, the contractionary effect of spending cuts is offset in the short term to a very limited extent by a monetary policy response. 

Moreover, one main channel through which monetary policy could, in theory, boost demand is via a lower exchange rate.  But we’ve already seen the trade-weighted exchange rate fall below trend, and we have been importing inflation; while this fall is welcome, and things would definitely be even worse without it, a further significant fall would be of questionable benefit. 

And finally, while QE has clearly helped, it is likely to be subject to diminishing returns, with long term interest rates at historic lows. This is the result not of “confidence”, as the Chancellor has misleadingly argued, but, as in the US and Japan, economic weakness; UK long-term interest rates have fallen as expectations for future economic growth have been reduced.

Calling for more QE is understandable, but it amounts to passing the buck to the Bank of England at a time when it has limited room for manoeuvre.  Instead, calls for action should be directed at the government.  A more comprehensive growth strategy would include action on fiscal policy in the short-term – slowing the pace of spending cuts – and measures to boost the supply side over the medium term. 

The writer is director of the National Institute of Economic and Social Research

Since the devastating Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against virtually all the risks exposed by those extremely low probability events. But should they? Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges.

The buffer may encompass expensive building materials whose earthquake flexibility is needed for only a minute or two every century, or an extensive stock of vaccines for a feared epidemic that may never occur. Any excess bank equity capital also would constitute a buffer that is not otherwise available to finance productivity-enhancing capital investment.

The choice of funding buffers is one of the most important decisions that societies must make, whether by conscious policy or by default. If policymakers choose to buffer their populations against every conceivable risk, their standards of living would almost certainly decline. It is no accident that earthquake protection of the extent employed in Japan has not been chosen by less prosperous countries at similar risk of a serious earthquake. Those countries have either explicitly, or implicitly, chosen not to divert current consumption for such an eventuality. Buffers are largely a luxury of rich nations. It does not matter whether we perceive an increased buffer as part of a nation’s capital stock, or part of the net equity of the country. They are the same magnitude from different perspectives. Consolidated, the net capital stock of a nation must equal the sum of the equity of households, businesses and governments, adjusted for the nation’s net international investment position.

How much of its ongoing output should a society wish to devote to fending off once-in-50 or 100-year crises? How is such a decision reached, and by whom? In the 19th century, when caveat emptor ruled, such risk judgments were not separable from the overall price, interest rate and other capital-allocating decisions struck in the marketplace.

Today, while the decisions of what risks to take remain predominantly with private decision-makers, the responses to the global financial and, of course, the Japanese earthquakes have been largely government scripted. In the immediate aftermath of such crises, it is very difficult to convince people that the recent wrenching events are not likely to recur any time soon, because, with a (very) low probability, they might. This is especially the case having just been through the brunt of a financial crisis that is likely to be judged the most virulent ever.

In the wake of the Lehman bankruptcy in 2008, private markets and regulators are requiring much larger capital, ie buffers, to support the liabilities of financial institutions. Had banks and other financial entities maintained adequate equity capital-to-asset ratios before the 2008 crash, then by definition, no defaults or contagion would have occurred as the housing bubble deflated. A resulting recession, though possibly severe, would almost certainly not have been as prolonged or required bail-outs.

Bank managements, currently repairing their demonstrably flawed risk management paradigm, have been moving aggressively to build adequate capital to enable them to lend. For the moment they are expanding their loan portfolios only marginally. Most of the new capital appears to have buffer status, rather than being directly involved in spurring day-to-day lending. Deep uncertainty about our economic future, as well as the potential level of regulatory capital, has unsettled bank lending. More than $1,600bn in deposits (excess reserves) at Federal Reserve banks are lying largely dormant despite available commercial and industrial loans that, according to the Fed, entail “minimal risk” and are yielding far more than the 25 basis points reserve banks are paying on such deposits. The excess reserves thus seem to have taken on the status of a buffer, rather than actively participating in, and engendering, lending and economic activity.

The “frozen” reserves appear the result, at least in large part, of the unexpected sequence of bank bail-outs in 2008. Had Bear Stearns failed in March 2008 (without government intervention), Lehman Brothers, and possibly AIG, would have been induced to take capital-building actions during the subsequent six months to fend off insolvency. But Bear Stearns was bailed out, creating a widespread perception that if it was “too big to fail”, so were all its larger competitors. Lehman’s fear of insolvency was dangerously assuaged. What sequence of events would have emerged had Bear been left to fend for itself will always remain conjectural.

What is not conjectural, however, is that American policymakers, in recent years, faced with the choice to assist a major company or risk negative economic fallout, have regrettably almost always chosen to intervene. Failure to act would have evoked little praise, even if no problems subsequently arose; but scorn, and worse from Congress, if inaction was followed by severe economic repercussions. Regulatory policy, as a consequence, has become highly skewed towards maximising short-term bail-out assistance at a cost to long-term prosperity.

This bias leads to an excess of buffers at the expense of our standards of living. Public policy needs to address such concerns in a far more visible manner than we have tried to date. I suspect it will ultimately become part of the current debate over the proper role of government in influencing economic activity.

The writer is a former chairman of the US Federal Reserve and is now president of Greenspan Associates LLC

Response by Howard Davies

Risk averse regulators must be clear how much capital and liquidity is enough

Counter-factual history can be thought-provoking: Niall Ferguson has revived it usefully in recent years. Now Alan Greenspan threatens to undo all his good work, arguing that if only the US authorities had allowed Bear Stearns to expire, rather than handing it over to Nurse Jamie Dimon at JPMorgan Chase, the crisis would not have escalated. Of course it is impossible to be sure, as Mr Greenspan recognises, but it seems unlikely that Lehman Brothers and others would have been able to find enough new capital to survive. By the early summer of 2008 I suspect the die was cast.

But Mr Greenspan, while he dislikes rescues, is surely right to reassert the value of the lender of last resort role of central banks. Without that backstop banks would be obliged to be far more liquid, and bank borrowings would be prohibitively expensive. Some advocates of tougher regulation seem to argue that banks must be recapitalised to such a level that they will survive unaided in all conceivable circumstances. That amounts to reckless prudence: those who argue for capital ratios of over 20 per cent are in that dangerous territory.

Nonetheless, in the light of the crisis we can see that banks, especially those with large trading books, were too thinly capitalised, and capital providers are themselves demanding more equity. Without it, bank debt would be more expensive. We do not need to believe that the pure milk of the Modigliani and Miller theorem (which asserts that the overall cost of capital cannot be changed by altering the balance of debt and equity) to see that with more equity banks will be safer. The trick is to strike the right balance. We must fatten the geese, without damaging their ability to lend golden eggs. The current Basel proposals strike me as a reasonable stab, though I would be hesitant about going further.

Mr Greenspan does score a palpable hit when he points to the damage of continued regulatory uncertainty. For some regulators, no amount of capital and liquidity seems enough. As soon as banks digest a new regime there is talk of another, even tougher than the last. Basel 2 gave way to 2.5 and soon to 3.0. Buffers proliferate, as in a Pall Mall club. We should now accept that this is an imperfect science, and let the new system bed in, with a moratorium on further change until we see whether the new dispensation delivers a banking system which can support a dynamic economy.

The writer is former chairman of the UK Financial Services Authority, former deputy governor of the Bank of England and former director of London School of Economics. He is now a professor of practice at Sciences Po in Paris

The US unemployment rate reached 9.2 per cent in June, up from 8.8 per cent in March of this year and double the 4.6 per cent rate in 2007 just before the recession began. Even if a short-term deal is done on the US debt ceiling, this high and rising unemployment hurts consumer confidence and weakens President Barack Obama’s chances for re-election. To bring the unemployment rate down to 8 per cent by the time of the November 2012 election would require employment to rise by more than 200,000 jobs a month, more than four times the rate of job growth in the most recent two months.

Labour market conditions are even worse than the unemployment rate implies. Against the backdrop of uncertainty created by the debt talks in Washington, about 3m Americans who would like to work but cannot find jobs are not officially counted as unemployed because they have not looked for work in the past month. And there are another 9m employees who would like to work full-time but are only able to get part-time work. Add together all of this and we find 29m Americans who cannot find the full-time work they want, a number equal to almost 20 per cent of the labour force.

The high unemployment reflects the lack of demand rather than any fundamental problems with the US labour market. The bursting of the house price bubble caused a collapse of residential construction and a sharp fall in household wealth that led to a decline in consumer spending. Nominal house prices are still falling, continuing to depress construction and household spending. The reduced spending by consumers has caused companies to cut back on production. With little prospect for an upturn of demand for their products, businesses have laid off large numbers of workers, reducing incomes and raising the unemployment rate.

These problems were exacerbated by the dysfunctional credit markets in 2008 and 2009. Since the central bank had not caused the downturn by raising interest rates, it could not cure the downturn by lowering rates. It focused successfully on fixing the credit markets but that was not enough to turn the economy around.

The policies of the Obama administration did not reverse the large initial fall in demand and have actually made the recession longer and deeper than it should have been. Although the “stimulus” package enacted in 2009 was too badly designed to add much to national spending, it did add more than $800bn to budget deficits, causing households and businesses to worry about the consequences of the exploding national debt. The health plan that Mr Obama forced through Congress will add an additional trillion dollars of spending to the national debt in the coming decade. And the president’s February budget plan would, if enacted, raise the national debt by another $3,800bn in the coming decade.

President Obama’s relentless call for higher taxes discourages spending by businesses and households. The administration’s policies to fix the problems of housing and small businesses have failed. And, despite talking about increasing exports, the president has not achieved any free trade agreements because he made that legislation conditional on increases in government transfer payments that are not acceptable to the Congress.

Reducing the unemployment rate requires increased spending by households and businesses. The American economy has achieved recovery from a deep recession before and can do it again. The unemployment rate reached 9.7 per cent in 1982 but was back down to 5.5 per cent by 1988. That fall in unemployment reflected a 30 per cent rise in real gross domestic product during those six years.

Even when demand does increase, the fall in the unemployment rate will probably be slower this time than in previous recoveries. Almost half of all those officially classified as unemployed have been out of work for six months or more, making a return to employment more difficult. In contrast, the median duration of unemployment is typically less than three months and in 1983, during the worst of that deep recession, it was only 10 weeks. In addition, fewer of the unemployed are now on temporary lay-off with the expectation of being recalled to their old jobs. And companies will shift many part-time workers to full-time before they hire new employees.

But, despite all of these problems, there is good reason for Americans to be optimistic that the unemployment rate will eventually get back to the traditional US “full employment” rate of about 5.5 per cent. Unlike the situation in the major European countries where the unemployment rate rose from less than 3 per cent in the 1960s to more than 9 percent in the 1990s, the US unemployment rate has shown no long-term upward trend.

The key to this stable long-term employment condition and to the future full recovery of employment is the flexibility of the US labour market. Real wages are flexible and are currently falling. Employees are mobile both geographically and among industries. Unionisation is low, with only 7 per cent of the private sector labour force being union members. The minimum wage is also relatively low and acts as a barrier to employment only for the young and very low skilled.

A good indication of the flexibility of the American labour market is the fact that manufacturing employment fell from 27 per cent of all jobs in 1965 to just 17 per cent in 1990 with no increase in the overall unemployment rate because employees shifted from manufacturing to other industries. Another indicator is that the labour force participation rate of adult women rose from 42 per cent in 1970 to 60 per cent in 1990 with no increase in the national unemployment rate. And the US has absorbed some 8m additional immigrant workers between 1994 and 2004 – equivalent to about 8 per cent of the labour force – without any rise in the unemployment rate until the recession began in 2007.

The US unemployment rate will come down when the government in Washington develops policies that encourage business investment, housing construction, small business hiring, stronger exports and other increases in demand. Unfortunately, it does not look like the Obama administration has a strategy for achieving any of that.

The writer is professor of economics at Harvard University and former chairman of the Council of Economic Advisers and President Ronald Reagan’s chief economic adviser

Response by Douglas Holtz-Eakin

Fiscal issues lie at heart of preserving America’s social contract

I wholeheartedly concur with Martin Feldstein that the Obama administration is clueless when it comes to policies that “encourage business investment, housing construction, small business hiring, stronger exports” and that these are essential to improved economic performance.  Put differently, growth considerations must trump other objectives, instead of President Barack Obama’s track record of the reverse: social engineering over growth in health reform, the green agenda over growth in the Environmental Protection Agency, a union agenda over growth in trade and labour relations, and the list goes on.

But derelict deficit policies are at the heart of the problem: political spending desires have trumped growth imperatives.  The US already displays a gross debt-to-gross domestic product ratio exceeding 90 per cent and, thus, has entered the zone of slower growth documented by Carmen Reinhart and Kenneth Rogoff.  Worse, future deficits lead directly to a debt spiral and debt crisis that would cripple the economy and kill jobs.

The debt derives directly from the broken entitlement programmes.  Social Security, Medicare and Medicaid are all bleeding red ink and will not survive in their current form.  It is a dis-service to future seniors and needy Americans to not move to a durable social safety.  It is a greater dis-service to let these broken programmes feed a debt explosion that undermines the US economy and costs jobs.

So, in the end, President Obama will and must be judged on his handling of the deficit and debt.  Fiscal issues lie at the heart of preserving the social contract in America. Fiscal issues lie at the heart of a more prosperous future – jobs.  Mr Obama has spilled many words over these issues, but spent no political capital and has not reached a deal.  He must.

The writer is president of the American Action Forum and a former director of the Congressional Budget Office and commissioner with the Financial Crisis Inquiry Commission

Europe may have taken an historic step in its meeting on Thursday – it seems, for once, to have done more than “just kick the can down the road”.  First, its leaders recognised that it is not just Greece that faces a problem; it is a European problem, which requires a European solution.  The euro was, at birth, an unfinished project; it took away two key instruments of adjustment – interest and exchange rates – and put nothing in their place.  As President Nicolas Sarkozy has emphasised, this is a major step in correcting this deficiency, creating a European monetary fund.

Second, the leaders recognised that Greece’s problems require a focus on debt sustainability – lowering the debt burden and increasing gross domestic product, and Europe is doing something about both.  Not only are maturities being extended, but interest rates are being lowered; but even more important is the commitment to investments that will stimulate the economy, create jobs and increase tax revenues.  Growth cannot be restored unless lending, especially for small and medium-sized enterprises, increases.  The increased flexibility given to the European financial stability facility may help, but I suspect more needs to be done, for instance through creating a small business revolving fund.

The communiqué from the leaders recognised too the enormous strides that Greece has made and renews the commitment to technical assistance to help Athens implement the reforms that it has undertaken.

There were other important policy reforms – or at least moves in the right direction.  The clear statement  that public authorities should place less reliance on private rating agencies – the European Central Bank should not delegate responsibility to judging what is and is not acceptable as collateral – was long overdue, especially given the rating agencies’ terrible record in making judgments and the continued flaws in governance (often being paid by those that they are asked to rate).  If the ECB is concerned that a credit event will lead to turmoil in financial markets, it should take a more active stance to address the underlying problems:  eliminating the non-transparent over-the-counter derivatives, ensuring that banks are adequately capitalised and preventing banks from being excessively interconnected.

Making the private sector bear more responsibility for its lending is also long overdue.  The repeated bail-outs of banks around the world (and the bail-outs in Latin America, east Asia, Mexico, etc) have encouraged reckless lending.  The socialisation of losses accompanied with the privatisation of gains that occurred in the 2008 bail-outs in Europe and the US leads to a perversion of the market economy.   The private sector once again tried to blackmail governments – saying that the consequences of not bailing out the lenders would be disastrous – and Europe should be congratulated for not giving in, even if the ECB did what it could to give this argument support.  The details of the private sector involvement are not yet clear, but what is clear is that they should have a significant “haircut”.

With all these kudos, I have four cautionary comments.  The European Union has once again reiterated its resolve to a quick return to fiscal rectitude (at least for those countries not in crisis).  Europe’s recovery, however, is still frail and excessively quick cutbacks will slow growth, and even risks a double-dip recession.  Lower economic growth will be bad even from a narrow view of deficits and debt.  Moreover, Ireland and Spain both had budget surpluses and low debt-to-GDP ratios;  that should serve as a reminder that these restrictions are neither necessary to ensure future growth and prosperity.  Unfettered markets – and especially under-regulated banks – were central in causing the crisis; and too little has yet to be done.

Secondly, revenues from Greece’s privatisations may help address the country’s financial difficulties, but not if privatisation is pushed too rapidly, with a rigid timescale.  Fire sales worsen a country’s balance sheets – and the market responds to these rigid time frames with lower prices.  Greece should be committed to rapidly preparing its assets for sale, but the timing of the sales themselves should be sensitive to market conditions.

Thirdly, the greater flexibility given the EFSF is important, but some of the proposals being bandied around need to be treated with caution.  One entails moving to variable rate loans.  Ask America’s homeowners about the wisdom of that!  Better risk instruments – including the appropriate use of GDP bonds – could improve risk sharing and enhance the likelihood of a strong recovery.

Finally, the commitment to growth is essential.  Evidently, references to a “Marshall plan” contained in earlier drafts of the communiqué, were eliminated.  I hope that this does not signal a move away from a strong commitment, requiring potentially significant resources.

Europe has, at last, been forced to do a cold calculation of the costs and benefits of taking the next steps to create a successful euro, and not doing so.  Any rational calculation showed that the benefits of doing what it has done vastly outweighed the costs.  As I wrote earlier, the question was not one of economics but of politics.  The politics finally came together.  There is more to be done, but these were critical steps.

The writer is a recipient of the 2001 Nobel Memorial Prize in economics and University Professor at Columbia University

European leaders took a big and important step towards dealing properly with the eurozone debt crisis at their summit on Thursday. This required courageous compromises on the part of many, most importantly Germany and the European Central Bank. But further design enhancements and skilful execution will be required if yesterday’s decisions are to translate into the durable restoration of growth and financial stability to the region’s troubled peripheral economies.

Debt solvency, growth and contagion have been, and are, at the core of the problems of Europe’s periphery. They speak to both the causes of this painful homegrown crisis, and to the manner in which it has been spreading. It is therefore highly encouraging that European leaders are finally taking more aggressive steps to address all three aspects.

Firstly, on solvency, the programme countries (Greece, Ireland and Portugal) will now benefit from lower interest rates and a significant extension of loan maturities.

Secondly, greater focus is being placed on promoting growth in the periphery, though this is still too restrained relative to what is required.

Finally, contagion risk – especially for Italy, Spain and the Europe-wide financial system – is being lowered through a new, flexible and fast-disbursing credit facility available both to sovereigns and banks.

This all constitutes a major step for leaders that, for almost two years, were essentially in denial. Having persisted too long with a liquidity cure for a solvency problem, they are now taking a major step towards deploying better instruments for the challenge at hand.

But success is far from guaranteed. It depends in particular on two factors: further enhancements to Thursday’s agreement, and ensuring proper execution.

As it stands, the package still lacks sufficient upfront debt relief for the most troubled economies, Greece in particular. Putting this in place quickly is central to fiscal solvency and growth promotion. Given the starting point, there is simply no substitute for some form of immediate debt reduction whose benefits flow directly to highly troubled sovereign debtors.

In addition to dealing more decisively with the crushing debt overhang, such debt relief would also assist in ensuring the proper level of overall financing and, critically, fairer burden sharing between the private sector and taxpayers.

Then there is the execution risk. Four parties will have to deliver simultaneously, and in a focused fashion, to make this package effective.

Governments in core countries – Germany, Finland and the Netherlands in particular – must convince their sceptical citizens that this is a good use of their hard-earned tax euros.

The ECB must also come up with a skilful way to compensate for the balance sheet hit it will have to take at some point on account of its peripheral bond purchases and repo operations.

Private banks must waste no time in taking advantage of favourable market reactions to raise additional capital.

Finally, the peripheral economies must deliver an internal economic adjustment that is both substantial and acceptable in socio-political terms.

History will show that, on July 21 2011 European leaders met and, jointly, stepped up to the plate to respond better to an internal crisis. But history will only label this a success if Thursday’s courageous compromises are followed by proper enhancements and skilful execution.

There is still much to do if this historic summit is to mark the beginning of the end of Europe’s painful debt crisis.

The writer is the chief executive and co-chief investment officer of Pimco

Response by Sony Kapoor

Don’t mistake Europe’s tiny step for a giant leap forward

The steps taken by European leaders may look big but only because their actions thus far have fallen so short. The compromises look courageous only because the conflicts have been so shrill. What feels like a giant step to European leaders is, once you strip away the rhetoric, merely a small one.

The skillful execution Mr El-Erian refers to can only so much when the fundamental problem of the sustainability of Greek debt has only been addressed marginally. Yes, solvency and growth have been the main problems driving this crisis, but lip service aside EU leaders have done little to address them.

On solvency, yes offering a lower interest rate of 3.5% on EU loans to Greece, Ireland and Portugal would help particularly the latter two but since the three countries were already paying a of around 5% on existing debt any benefits would be incremental. The extension of maturities on public lending is also helpful but in tackling illiquidity, not insolvency.

The history of public lending to sovereigns is littered with multiple rounds of debt relief in the form of interest reductions and maturity extensions, particularly in Africa and Latin America that failed to restore solvency. As in these cases, what was needed for Greece was debt cancellation, not the debt relief that has been delivered.

The much-discussed private sector involvement is a damp squib and will, under an optimistic scenario, provide only Euro 20 – 25 billion of debt reduction out of a stock of Euro 350 billion. Markets and holders of peripheral country debt are celebrating as the burden is borne mostly by EU taxpayers and Greece, not them. But the calm will be shattered when realization dawns that the fundamental problems at the heart of the EU such as the solvency of Greece remain unaddressed.

I agree with the importance of growth, but fail to see how merely talking about growth or the phrase ‘Marshall Plan’ used in the leaders’ declaration will deliver it. The Marshall Plan provided aid while the EU is only providing loans. It stimulated investment, while Greece and other program countries face gut-wrenching austerity for the foreseeable future.

The expansion of the crisis toolkit available to the EFSF was indeed positive, but it was first discussed and then rejected in 2010. It still needs to be approved by parliaments and this carries execution risk but much of the rest of what the leaders said was once again too little, too late, as we have highlighted in our commentary on the conclusions.

The writer is managing director of Re-Define, an international think tank

Updated at 15.00 London time

It looks like there will be deal on a eurozone package for Greece. The full details are still missing, but it appears that the eurozone is forcing Greece into a selective default. As part of such a package, short-term Greek debt will be more or less forcibly converted into long-term debt. The wretched bank tax is mercifully off the table. And the European financial stability facility will most likely be allowed to purchase Greek debt at a discount. Let us not mince words here. This would be a default, the first by a western industrialised country in a generation. I am not quite sure how it is possible for the European Central Bank to agree to this, or to all of this. But I will surely be intrigued to hear how Jean-Claude Trichet will manage to be consistent with what he said a few days ago. There are also reports that the eurozone leaders may accept a more flexible EFSF beyond those bond purchases.

So would this be a good deal? Those who are in the thick of it are running the danger that they got so obsessed with the formidable technical complexities that they lose sight of the bigger picture. The problem of the eurozone is not Greece, or some other small country on its periphery. The existential danger is the rise in market interest rates of Italy and Spain, two large countries in the eurozone’s core. To state the goal of today’s meeting in simple terms would be to say: the survival of the eurozone depends on whether its leaders will be able to take decisions that would allow Italy and Spain, and everybody else as well, to remain inside the eurozone on a sustainable basis. Greece is now just a side-show.

If that is the goal, I would judge today’s outcome in terms two priorities. The first, and most important, is the size and flexibility of the European financial stability facility, the rescue umbrella. At present, the overall size of the EFSF is €450bn. With a second Greek credit about to be agreed and second programmes for Ireland and Portugal very likely, the ceiling will not be big enough to bring in Spain, let alone Italy. To do that that the ceiling would have to be doubled, or trebled. Without this increase, it is inconceivable that the eurozone can get through this crisis intact. One could think of other constructions, such as having no fixed limits at all or sliding limits. The structure of the EFSF would have to be changed if it was going to be made this big. It would have to be properly capitalised. Italy’s 18 per cent share in the EFSF would otherwise not be credible.

This will not be agreed today and this alone is why the summit will fall short of what is required. As it stands, the eurozone has a mechanism that can deal with Greece, Ireland and Portugal, but no other country.

Size and flexibility go together. At present the EFSF can only lend money to governments. In turn, the applicant countries are subject to a full European Union/International Monetary Fund supervised austerity programme. You are either in or out. It is important that the EFSF can act pre-emptively, even in respect of countries that are not part of an official programme. The EFSF should also be able to purchase bonds on primary and secondary markets, help refinance banks or give emergency credits during a crisis. It cannot do any of these things now. The bigger and the more flexible the EFSF becomes, the greater the chance that Italy and Spain can get through the crisis.

Second, of course, would be a plausible programme for Greece. The construction currently discussed has some merits, but I am still not sure to which extent it will help Greece. If one accepts the logic of an involuntary private-sector participation, and the advent of a selective default rating, then one should better make sure that one ends up in a situation where Greece defaults, and yet is still not in a position to repay its debt in the long run.

What’s the point of default in such a scenario? If the final construction leads to a reduction in the Greek debt from an estimate year-end level of 175 per cent of gross domestic product to 130 per cent after a default – with no changes to its real exchange rate – it is not clear at all how Greece can be solvent at such a still high level of debt.

The outlines of the agreement, as they have been presented so far, still fall short of the main goals – to have an EFSF capable of dealing with Italy and Spain – and to have a Greek package that reasserts debt sustainability one way or the other. Like all decisions in the European Council, this is a compromise for sure. But there are limits to compromises when you are dealing with a contagious debt crisis. You either do enough, or you do not. They are still lacking a strategy to deal with the wider crisis.

The writer is an associate editor of the Financial Times and president of Eurointelligence ASBL

Europe faces a critical juncture on Thursday – one that may determine not only whether the euro will survive, but whether the global economy will be once again plunged into turmoil. To an economist what needs to be done is simple and clear: Greece’s debt has to be brought to a sustainable level. That can only be done by lowering the interest rate that Greece pays, lowering its indebtedness, and/or increasing gross domestic product. There are several ways this can be accomplished. But the institutional details are less important than an understanding of what will, and what will not, work.

The strategy of the past 18 months of dealing with Greece’s debt difficulties – the minimal response necessary to deal with the moment – has (predictably) not worked. Nor will more of the same. Official lending (from the International Monetary Fund and the European Union) has seniority over the private sector. The riskiness of new private sector lending is thereby increased, with obvious implications for interest rates. Meanwhile, as official lending replaces private sector lending, the risks associated with past lending is shifted to the public. The pattern, and the disappointment, should be familiar to those who watched IMF/G7 programmes of the past.

Economists may differ on whether the austerity prescription will work – though the evidence from Ireland, Greece, Spain, Latvia, and host of other experiments shows that the ensuing economic downturns reduce tax revenue, so the improvement in the fiscal position is inevitably disappointing – but the market has rendered its verdict: it too is signalling that more of the same will not work. Lowering GDP worsens debt-sustainability (typically measured by the debt to GDP ratio) every bit as much as increasing indebtedness. The speculators have been handed an opportunity, and they have seized it. They make money from volatility. Of this we can be certain: Europe’s response so far has amplified uncertainty concerning the future of the euro. “Contagion” has now spread from the periphery to the centre, namely Spain and Italy.

So too “reprofiling” – changing the timing of payments leaving the level of indebtedness unchanged – simply postpones the day of reckoning. If, as often happens, it is accompanied by higher interest payments, the likelihood of an even worse crisis down the line is enhanced. The reason that Greece and the other crisis countries of the periphery face a liquidity problem is that markets believe, probably correctly, that – without access to better terms and/or a debt writedown – there is a real risk of non-repayment.

The problem facing Europe is not so much economic as political. It is easy to see what should be done. If Europe issues eurobonds – supported by the collective commitment of all the governments – and passes on the low interest to those in need – debts are manageable. Even a 150 per cent debt to GDP ratio can be handled if interest rates are low enough, but if rates are high they cannot be. At 6 per cent it takes a primary surplus of 9 per cent just to service the debt. Europe can access capital at low interest rates; after all, its collective debt to GDP ratio is actually better than that of the US.

Those who, putting aside any sense of European solidarity, worry about creating a “transfer union” should be comforted: at such low interest rates the likelihood of a need for real subsidies is limited. But even if there were some subsidy, Europe could afford it. With a $16,000bn dollar economy, even if Europe had to bear costs commensurate with the size of Greece’s debt, these are minuscule compared to what will be lost if Europe does not come to the assistance of the countries facing trouble.

The current strategy has reached not only its economic, but also its political, limits. In at least some of the countries, citizens have put the EU on notice – not just through protests, but though actions. With free mobility of labour and capital, neither workers nor entrepreneurs can be forced to pay too much for the sins of the past. They can move, and they are moving.

Europe is lucky that in most of the countries in its periphery, there were responsible governments that did not take populist stands. What George Papandreou has done in the past eighteen months has been truly impressive. One could hardly have expected more. That the improvement in Greece’s fiscal position has been less than what was hoped is not because he did not deliver but because the benefits of structural reforms take time to be realised – more time than the political process allows; because austerity seldom works and because Greece’s trading partners’ economies have not done as well as hoped.

In at least one of the countries – and perhaps in the future, in others – there wait in the wings less responsible politicians who would take advantage of widespread views that Europe has not done what it should, while imposing harsh conditions. Rather than shared sacrifice, they are even calling for tax cuts. The IMF may have been able to impose harsh conditions in Asia and Latin America, but Europe has vibrant democracies, with an informed and active citizenry. What was possible there may not be possible here.

There is one more ingredient to a successful response: restoring growth. The current uncertainty has had an especially adverse effect on banks and bank lending. Even well-run small and medium-sized businesses are being starved of funds. Growth tax revenues languish, even if governments do a good job at tax collection. A solidarity fund for stabilisation could, together with the European Investment Bank, make needed investments in the countries in trouble – investments that would more than pay off at the low current interest rates. A small business revolving loan fund could provide money to proven enterprises, to help restart the engines of growth.

Europe’s problems today are not the result of a natural disaster, like those confronting Japan. They are man-made, partly the result of a well-intentioned, but imperfectly-conceived, monetary union. It was hoped that, in spite of the marked differences, if countries only managed their debts, all would work well. Spain and Ireland, which both had surpluses and low debt to GDP ratios before the crisis, showed the fallacy in this logic.

As Europe stands at the precipice, it is time to end brinkmanship and political squabbles. The European Central Bank should realise that a restructuring – even if it entails a “credit event” as determined by some American rating agencies – means that Greek bonds are safer than they were before. If they were acceptable as collateral before, they should be more acceptable after. Put bluntly, to not accept Greek bonds is to end Greece’s membership in the euro, with all the consequences thereto.

The ECB must recognise too that for citizens of many countries, a deal without shared sacrifice of the private sector – meaning debt reduction – is politically unacceptable. But those advocating private sector involvement need to realise that the private sector will be reluctant to take a haircut on old loans, and will refuse to accept less than a risk-adjusted interest rate on new.

The resolution of this crisis is easily within Europe’s grasp. It is not a matter of economics. It is only a matter of political will.

The writer is a recipient of the 2001 Nobel Memorial Prize in economics and University Professor at Columbia University

Response by Olaf Cramme

EU members must address integration-sovereignty trade-off

Joseph Stiglitz has given weight to the rising chorus of voices blaming politics, and not economics, for the eurozone crisis. In fact, a consensus is now forming about what needs to be done, but no one seems to know how to do it. National politicians are caught between irreconcilable positions: what is salvation for one interest group is treason for another. Why has it come about this way?

The best explanation I have come across is Dani Rodrick’s “political trilemma”, which outlines the inherent tensions between the simultaneous goals of deepening economic integration, hanging on to national control and providing democratic accountability. Kevin O’Rourke, in turn, has tried to show that Mr Rodrick’s conundrum does not only apply to globalisation, but also to European integration and the economic and monetary union in particular. Their accounts are compelling.

For too long, policymakers in Europe and liberal democracies more broadly have ignored the trade-offs that sit firmly on their table. Political parties have continued to play the traditional left-right tune on standard policy issues, ignoring the significance of constitutional politics: how should we govern – and be governed – in a region (and world) where borders count less and less?

In the crisis, then, worries about legitimacy have given way to concerns over sovereignty. Will the repudiation of European integration come next?

Against this background, it is somewhat surprising that populism has not spread further. The European Union remains a high-profile target for all those who want to challenge either its economic or cultural grounds. Its conditionality regime is easily set against democratic choice and self-determination; or both. This is only reinforced by a prevalent national rhetoric that presents external constraints as matter of malpractice and injustice.

To get out of this trap, and hence take on the political trilemma, EU member states must find a way to internalise and constitutionalise these constraints – so long as they cannot be legitimated at a higher political level (namely via federalism or true global governance). If conditions are deemed to be beneficial and reasonable, then they must enter the realm of domestic debate and political contestation. Silence will only make things worse.

The writer is director of Policy Network and a visiting fellow at the LSE’s European Institute

Eurozone leaders face a fundamental choice when they meet on Thursday. Either they declare, once again, that they stand ready to do “whatever is necessary” to overcome the eurozone crisis, or they actually do it. In the first case, markets are likely to step up to the next stage of their challenge to the European authorities. They will target larger countries, such as Italy and Spain, thus making the “whatever necessary” ever more costly and ever less credible.

Alternatively, the eurozone leaders could show leadership. Markets, so far, have been winning a game of divide and conquer, simply because countries are not providing a common response. Eurozone governments have been seeking “financial stability” by committing ever larger amounts of their taxpayers’ money. Yet, these sums merely measure the eventual cost to citizens of their leaders’ attempts to behave as if they were not part of a monetary union.

A more effective strategy would be to surprise the markets with a genuinely common policy. For such response to be agreed on, the government of the leading eurozone country, Germany, has to provide leadership among the member states and at home. This means convincing Germans that they are benefiting from the European Union, its single market and the euro; that the German “culture of stability” is permeating the rest of the union; and that Germany would be the biggest loser – in terms of stability, competitiveness and the financial cost – if the eurozone were to break up.

A German government that promotes common policies focused on the long term would be better able to protect German taxpayers’ interests than one which, in focusing on their shorter-term interests, convinces neither the markets nor its citizens. It is this lack of credibility that would generate, further down the road, a disruptive ‘transfer union’ that would likely lead to acrimony domestically and across borders.

Luckily for Chancellor Angela Merkel and for Europe, the two main opposition parties in Germany – the Social Democrats and the Greens – are pro-EU. Although the SPD initially opposed the euro and Chancellor Gerhard Schroeder, with President Jacques Chirac, undermined the credibility of the Stability Pact in 2003, earlier this week SDP leaders pledged support for unpopular measures to deal with the eurozone crisis.

This creates a fresh opportunity for Ms Merkel and Wolfgang Schäuble, German finance minister, to support the use of eurobonds – an initiative that would reinforce Germany’s real and perceived ties to the euro.

Commissioner Olli Rehn said last month in the European Parliament that, as part of an economic governance package, the Commission will be ready to propose the setting up of a system of common issuance of euro-denominated government bonds before the end of the year. This would be aimed at strengthening fiscal discipline and increasing stability in the euro area through market mechanisms, ensuring that those member states that enjoy the highest credit standards would not suffer from higher interest rates. The Commission’s report will, if appropriate, be accompanied by legislative proposals.

The proposal is for the use of eurobonds as an instrument of debt management, not as a financing instrument for new expenditures. It was put forward to the president of the Commission last May*, and introduced in the European Parliament in December by Sylvie Goulard**, based on research by Jacques Delpla and Jakob von Weiszäcker, among others.

Many options are possible, including giving the European Financial Stability Facility new powers. The new bonds would assert the euro currency in the global markets. It is not obvious that there would be a higher (absolute or relative) financing cost for the most creditworthy member states, when considering both the liquidity of the new eurobond market but also the existing turbulence of the sovereign debt markets. To liberate the European Central Bank from the role it has been obliged to play would also be in the general best interests and in line with the best German traditions.

There is growing consensus that it would be difficult to find a lasting solution to the eurozone crisis without the use of eurobonds. This week’s eurozone summit could give at least a clear political signal that it is worth considering the eurobond proposal. A European vision, based on the creation of a European instrument, backed by a precise timetable, could be a good way to restore trust and stability.

Mario Monti is president of Bocconi University and former European commissioner. Sylvie Goulard, co-author, is a member of the European Parliament and rapporteur on the economic governance package.

* ‘A new strategy for the single market: A report to the President of the European Commission’ by Mario Monti, May 2010.
** Report on economic governance, Sylvie Goulard, June 2011.

Response by Dag Detter

Privatisation should be part of Europe’s long-term growth plan

Many of the countries whose precarious fiscal positions most worry the European leaders meeting on Thursday actually have substantial portfolios of commercial assets: not only the usual suspects of utilities, banks and transportation assets, but also a very significant portfolio of real estate assets.

These are often barely managed, and there is a certain lack of transparency in what is held. Yet the so-called ‘state-owned commercial assets’ are now one of the larger asset classes globally – many times that of private equity and hedge funds combined – but yielding a very small return to their ultimate owners, taxpayers. Making these assets not just more transparent but also more efficient and profitable could be one part of the solution of improving the long-term prospects for countries such as Greece, Ireland and Portugal.

The concept of a government acting as an asset manager is not new, but tends to be more popular in wealthy export-oriented economies. Singapore and its National Wealth Fund, Temasek, is an obvious example. In the developed world, Sweden was one of the first countries to restructure its portfolio in the late 1990s. As a result, the value of the portfolio outperformed the local stock market for more than eighteen months.

Privatisation of state assets, as has been suggested in Greece, is often the most instinctive response from the financial perspective when considering this asset class. However this may not be the fastest or the most efficient reaction. The current timing and conditions might result in a hasty fire sale.

Instead, troubled countries could – once a fix is found for their immediate problems – attempt a longer-term solution by raising bonds on the back of a new national wealth fund created to manage the asset portfolio. Portugal and Spain already have such a fund, while Greece is in the process of setting one up.

Economists and analysts recognise­ the importance of restructuring these assets. It leads to a more efficient use of capital and resources, and enhanced competition in the affected sectors. As a substantial part of the domestic economy, the bonds from the national wealth fund would help introduce private sector discipline to the assets class and the portfolio, and thereby contribute to economic growth.

Correctly implemented, these commercial assets can become an engine for structural reform and growth in Europe.

The writer is an independent advisor and state asset specialist. He is the former president of Stattum, the Swedish government holding company, and the government director of state-owned enterprises.

The Greek government is on the knife-edge of solvency. Public debt is estimated to be around 160 per cent of the country’s gross domestic product, of which around three quarters is owed to foreign creditors. We cannot be sure whether it can service its debts within the boundaries of political, social, and economic stability. But following from my previous article, I believe a route to Greek solvency is possible.

To repay its debts, the Greek government must make two net resource transfers: from Greece to foreign creditors, and from the budget to all private creditors, domestic and foreign. Greece can probably sustain payments abroad of around two to three per cent of GDP per year, but larger transfers could trigger a political and social explosion. Internal payments are less explosive politically and a primary budget surplus can probably be sustained at around three to four per cent of GDP per year.

“Solvency” is therefore not a precise economic condition, but a reflection of long-term economic, social, and political conditions. Greece is close to the edge and, without a prospect of recovering economic growth and employment, even the limits just described will be unmanageable.

Greece’s ability to “pay down” its debts and restore long-term confidence in its solvency will depend on the future real interest rates it will have to pay – balanced against the real growth rate of its economy. If it is pushed too soon to the private capital markets it will face sky-high rates, if it is able to borrow at all. Insolvency and default would then become inevitable.

Almost all of the proposals advanced in Europe until now, including many circulating before this Thursday’s summit, have effective real interest rates of at least four per cent per year, against a prospective annual growth rate of perhaps three per cent, Greece’s historic average. On this basis, debt would still be around 150 per cent of GDP in 2032. This has led many observers to conclude that Greece’s default is inevitable. Yet that is an unjustified and hasty conclusion.

Interest rates are high because of the likelihood of default, and vice versa. Of course the risk of default reflects a very high debt burden and uncertain growth and fiscal trajectories. Yet suppose Greece could refinance its debts at a suitably low, “safe” market interest rate, and with a recovery of growth to historic averages. Greece could then work itself out of the debt debacle within a generation without unbearable net resource transfers or fiscal surpluses. It’s a close call, but repayment in the long term is possible.

There are three courses of action at this point. The first is to muddle through with measures such as the “rescue” packages of last March and the one announced earlier this month. This approach, providing temporary liquidity at high interest rates, will probably collapse within months: there is little prospect of the Greek parliament voting for another short-term austerity package to earn another short-term rollover.

The second approach is an early default. Greece would partly suspend debt payments, buy back its debts at below-market rates, coax some or all of its private creditors to exchange current bond instruments for new securities with lower par values (which might also carry official guarantees on the reduced par values, as in Brady bonds), or some combination of these actions.

The consequences here would depend on how the default is handled by regulators, market participants, foreign governments, the International Monetary Fund, and the European Central Bank. But advocates of default generally believe, wrongly, that Greece is already insolvent and default inevitable. They also generally believe a default can be predicted and smoothly managed.

Those are dangerous guesses. The most likely consequence of a Greek default will be a profound crisis of confidence that could swallow the Greek banks and possibly tear Greece from the euro.

If that were to happen, the costs to the entire eurozone would be devastating. The loss of credibility would lead to higher interest rates for a generation. Weaker countries would face repeated speculative attacks. Banking crises could become the norm.

Yet there is a further problem. German leaders in particular have been pushing this option in the belief that it is the only way to involve the private sector in refinancing Greece’s debts. This is a tactical mistake. Rather than pushing for a bond exchange that will trigger a default, it would be better to tax the banks to build an insurance fund against a future Greek default.

The third approach, therefore, is to try to engineer a full Greek repayment of its debts in the long term. This requires a political agreement within Europe. Greece would consent to years of fiscal austerity and primary budget surpluses, but these would be moderate and predictable, as would net foreign resource transfers. The prospects for a recovery of economic growth, combined with an eventual pay down of the debts without default, would be widely understood and accepted by a majority of the Greek citizens as reflected in a sustainable parliamentary majority.

The key to this approach, as I argued in my previous article, is to lock in low long-term interest rates at the “safe” rate, close to the current German or French long-term borrowing rate. This could be achieved most directly through guarantees offered by the European Financial Stability Facility on Greece’s future borrowing.

Here is one way the arrangement could work. The ESFS could borrow on the behalf of Greece as debts fall due. The EFSF borrowing rate, reflecting the backing of eurozone countries and hence an AAA rating, would be around 3.5 per cent per year on a 20-year maturity. All existing IMF, ECB, and EU debts (around €110bn) would be refinanced through the EFSF directly.

Greece would need around €250bn of EFSF borrowing to repay the outstanding bonds held by the private sector: €100bn by the end of 2014, and most of the rest before 2020. This would be used to pay off debts and interest payments as they fall due. By 2016, Greece would owe some €250bn to the EFSF. All EFSF debts would be at 3.5 per cent interest rates fixed over a 20-year maturity (around two per cent real, given the eurozone trend inflation of around 1.5 per cent per year).

One further problem is that taxpayers would be put at risk by this arrangement, while banks would be advantaged. But there are several ways to compensate taxpayers by imposing a levy on the banks.

As Greek debt servicing is made to the private creditors, financial regulators in each country could require existing private creditors that are receiving debt payments to put some portion, perhaps 30 per cent of the repayments, into an interest-bearing escrow account that would serve as a “guarantee fund” in the event of a Greek default.

By the end of 2014, the combined sums in these accounts would total around €30bn, to be invested at around the safe market rate of 3.5 per cent. If Greece defaulted on principal or interest, the escrow account would be drawn down to repay the EFSF. If Greece ultimately repaid all its debts, the escrow accounts would revert to the financial institutions that are Greece’s current creditors.

Alternatively, the guarantee fund to back the EFSF could be raised through a tax on the banking sector as a whole, rather than on the holders of Greek bonds in particular. The levy could incorporate a variable tax rate based on the share of risky sovereign bonds in the bank’s balance sheet, or could be set independently of the specific asset composition of the bank. The details would depend on national laws and regulatory judgments.

There is a reasonable chance that this approach would avoid a default at any stage. Greece would service its debts at a real interest rate of two per cent and have the chance to restore economic growth of three per cent. The debt burden would come down gradually. In no year would Greece have to make net external resource transfers greater than 2.5 per cent of GDP, or primary budget surpluses greater than 3.5 per cent of GDP.

This would be no easy ride. The Greek government would be paying its creditors for more than a generation. The current fiscal austerity programme would continue, albeit with much better prospects of an early return to growth and an eventual restoration of creditworthiness. Structural reforms and encouragement of foreign investment inflows would help Greece restore sustained growth. The arduous national effort would be rewarded in time, and help to improve confidence even in the short term.

There is a chance – a rather good one, I believe – that in the end Greece would prove able to repay its debts over the course of 20 years at the low, safe interest rates established by the EFSF. It may be the last clear chance for Greece and Europe to avoid a potential calamity. It is an attempt well worth making.

The writer is director of the Earth Institute at Columbia University.

Response by Sony Kapoor

Greece needs quick, decisive action and the promise of a better tomorrow

Jeffrey Sachs asserts that Greek debt, at 160 per cent is on the ‘knife edge of solvency’. Yet, solvency is the ability to repay all debt on contractual terms so Greece has already tipped. The debt is now projected to peak at 170 per cent to 180 per cent even if his prescription for lowering interest rates on public lending to Greece is followed without delay. This interest reduction is necessary but no longer sufficient.

He is right in saying that solvency is not a precise economic condition but reflects economic, social and political reality. In fact (even if the numbers for Greece had made a better case) the reality of recession-inducing austerity and job cuts, a potentially explosive social situation, entrenched interests and poisoned politics where the ‘new’ government is already lagging in public opinion, all undermine it fatally.

What Greece needs is decisive action that demonstrates, once and for all, both to the domestic population being asked to make huge sacrifices and to investors and entrepreneurs being asked to help finance and trigger growth in the Greek private sector, that there is light at the end of the tunnel. Staying at the knife edge of solvency with a large debt overhang and the prospect of further austerity does not inspire confidence. Without a clear hope of a better tomorrow that only a significant reduction in debt stock can bring, depositors and taxpayers will continue to flee, entrepreneurs to emigrate and growth-inducing private investment will not take off.

While some proponents of restructuring may indeed not have thought all the consequences through, I have outlined a Plan B. The recent stress tests confirm thesis that the European Union financial system has ample loss-absorption capacity.

The EU’s inability to put to rest doubts about Greece’s solvency – justified or not – has already spread contagion and now threatens the too-big-to-fail Spain and Italy. Any solution that does not unambiguously restore Greece’s solvency soon and reduces the interest on Portugal and Ireland will fail to arrest the spread of the crisis.

I share Mr Sachs’ scepticism about voluntary buy-back schemes and believe that only a coercive and heavily discounted European Financial Stability Facility-funded purchase of privately-held debt would work. It is better not to have any private sector involvement at all than to have something that is merely cosmetic.

Overall, Mr Sachs’ proposal is a useful contribution but one that is perhaps more applicable to helping Ireland and Portugal at this stage, not Greece.

The writer is managing director of Re-Define, an international think tank.

The sociologist Ashis Nandy once noted that “in India the choice could never be between chaos and stability, but between manageable and unmanageable chaos”. He wrote this in the 1980s, a decade marked by ethnic strife, caste violence, and bloody religious riots. But it applies even more so to the India of today, and is being made worse by the steady deterioration and corruption of India’s ruling political elite.

Throughout India’s history the manifestations of its chaos have been largely social and political: from secessionist movements and sectarian pogroms, to its enduring territorial conflicts with China and Pakistan. The bomb blasts in Mumbai last week are but the latest example. The perpetrators are as yet unidentified: like the 2008 Mumbai attacks, they may have originated from Pakistan, but whoever they turn out to be, this was a familiar example of one of India’s pervasive and long-standing fault lines.

Yet the Republic of India today faces challenges that are as much moral as social or political, with the Mumbai blasts having only temporarily shifted off the front pages the corruption scandals that more recently dominated. These have revealed that manner in which our politicians have abused the state’s power of eminent domain, its control of infrastructural contracts, and its monopoly of natural resources, to enrich themselves. Rectifying this is now arguably India’s defining challenge.

These scandals implicate many of the country’s most powerful leaders. They include the large scale looting of mineral resources in southern and eastern India; graft during the organising of the Commonwealth Games in New Delhi; the underpricing of mobile phone contracts to the tune of billions of dollars; and also numerous property and housing scandals in Mumbai. Corruption is not new in India, but the scale and ubiquity of these problems is genuinely unprecedented.

This activity cuts across political parties – small and large, regional and national. It has tainted the media too, with influential editors now commonly lobbying pliant politicians to bend the law to favour particular corporations. But while journalists may collude, and many companies and corporate titans have benefited, the chief promoters of this malaise have been the politicians themselves.

There is a curious paradox here; for India is the creation of a generation of visionary and selfless leaders who governed it in the first decades of freedom. These men and women united a disparate nation from its fragments; gave it a democratic constitution; and respected linguistic and especially religious pluralism, out of the conviction that India should not become a Hindu Pakistan. Today’s scandals, however, have their origin in the steady deterioration in the character of this Indian political class.

Surging growth is another proximate cause. Economic liberalisation has created wealth and jobs, and a class of entrepreneurs unshackled by the state. But its darker side is manifest in rising income inequalities and sweetheart deals between politicians and favoured businessmen, leading to the loss of billions of dollars to the public exchequer.

Was this necessary or inevitable? Perhaps not. The truth is that since 1991, the word “reform” has been defined in narrowly commercial terms, as meaning the withdrawal of the state from economic activity. The reform and renewal of public institutions has been ignored. It is this neglect that has led to a steady corrosion in state capacity, as manifest in the growing failure to moderate inequalities, manage social conflict, and enforce fair and efficient governance.

This could have been anticipated. Over the past three decades, a series of commissions have highlighted the need for institutional reforms, that, among other things, would insulate administrators and judges from interference by capricious politicians; prohibit criminals from contesting elections; curb abuse of the power of eminent domain; provide proper compensation for villagers displaced by industrial projects; make more efficient the now mostly malfunctioning public health system.

Many, perhaps all, of these reports have been read by Manmohan Singh, India’s scholarly prime minister; indeed, several were commissioned by him. Which is why the inaction on their recommendations is so disheartening. When Mr Singh became prime minister seven years ago, his appointment was widely welcomed. He was seen as incorruptible, and with the added advantage of a lifetime of public service. Tragically, in terms of concrete institutional reform these have been seven wasted years.

To single out an honest and intelligent man when corruption and criminality flourish may seem unfair. But W.B. Yeats was right: it is when the best lack intensity and conviction that we must fear for ourselves and our future. Mr Singh has been content to let things ride. He has not asserted himself against corrupt cabinet colleagues, nor has he promoted greater efficiency in public administration. Whatever the cause – personal diffidence or a dependence, in political terms, on Sonia Gandhi,  his party president – this inactivity has greatly damaged his credibility, not to say India itself.

If nothing else, the current wave of corruption scandals will put at least a temporary halt to premature talk of India’s imminent rise to superstardom. Such fancies are characteristic of editors in New Delhi and businessmen in Mumbai, who dream often of catching up with and even surpassing China. Yet the truth is that India is in no position to become a superpower. It is not a rising power, nor even an emerging power. It is merely a fascinating, complex, and perhaps unique experiment in nationhood and democracy, whose leaders need still to attend to the fault lines within, rather than presume to take on the world without.

The writer is a historian whose books include India after Gandhi and Makers of Modern India. He lives in Bangalore.

Response by Brahma Chellaney

India’s biggest problem is its old and tired leadership

Corruption in India is not only pervasive but threatens to reach predatory levels. This has spurred pessimism in some quarters about India’s future. Such gloom, however, misses the larger picture.

No nation’s potential can be measured by one yardstick alone. Corruption poses a serious challenge to India, but to contend that it will block India’s great-power ambitions is to forget history. The United States, for example, rose as a world power in spite its robber barons. And now China is demonstrating that rampant corruption is no barrier to a country’s dramatic rise on the world stage.

The pessimists also miss out one key development in India – there is already a public backlash against corruption that has galvanised judicial activism, sent several important politicians to jail, put the government on the defensive, and created new crusading icons. Contrast this with the Chinese system, which reeks of unbridled and unchecked corruption, with the public helpless.

In world history, periods of rapid economic growth have often been accompanied by rising wealth and income inequality and widespread corruption. It took the US more than half a century to bring the era of robber barons to an end, although big-bucks corruption still remains a challenge. In India, the backlash against crooked politicians and entrepreneurs – and the public campaign for cleaner politics and business practices – has started in earnest barely two decades after the advent of rapid growth.

India’s economic and military rise is threatened neither by corruption nor by its ethnic diversity. India has demonstrated that unlike the traditionally homogenous societies of East Asia, a nation can manage diversity – and thrive on it. As one of the oldest and most-assimilative civilisations in the world, India can truly play the role of a bridge between the East and the West.

Rather, India’s rise is threatened by a political factor – a leadership deficit, which is compounded by a splintered polity. India is still governed by a pre-independence leadership – an anomaly even in Asia, where age is supposed to be wisdom. India today boasts the world’s oldest head of government and oldest foreign minister. Old, tired, risk-averse leadership can hardly propel any country to greatness. Worse, India’s coalition federal governments, which have become a norm, tend to function by the rule of parochial politics – in fact, by the lowest common denominator.

Yet, democracy remains India’s greatest asset. It not only helps instil fear among the corrupt, but also makes India’s future less uncertain than China’s.

The writer is professor of strategic studies at the Centre for Policy Research in New Delhi, and the author of ‘Asian Juggernaut’ and ‘Water: Asia’s New Battlefield’.

The row in Washington over the US federal debt ceiling raises the question of whether we are observing political theatre or a serious struggle with a large and complicated problem. The answer is a bit of both.

The theatre is obvious. President Barack Obama’s call for a grand bargain with $4,000bn in deficit reduction over a decade belies the fact that in his initial budget proposal in February he ignored his own deficit commission’s recommendations. There was also a conspicuous lack of detail on the “plan” offered in his budget speech in April. Many congressional Republicans have put aside a deal for three parts spending reduction, one part revenue increase. Meanwhile, congressional Democrats have attacked the fiscal plan offered by Congressman Paul Ryan, while offering no serious thoughts of their own.

But the political actors are also grappling with a complicated problem that US budget rules were not set up to address. The US debt-to-gross domestic product ratio is set to cross 90 per cent in a decade, with significant further increases due to higher entitlement spending on Social Security, Medicare and Medicaid.

Previous run-ups in the debt-to-GDP ratio were associated with wars and fell with modest spending restraint and economic growth. No such self-correcting possibility emerges for rising debt levels from social spending. As a consequence, debt-ceiling rows are likely to occur more frequently, with necessarily contentious discussions of federal spending. Beneath the bluster and bargaining positions, participants are beginning to notice this thorny problem and the difficulty of solving it.

So, where do we go from here? Any path forward should be judged according to progress in two areas – reducing spending over the long term and supporting economic growth. As the non-partisan Congressional Budget Office’s Long-Term Outlook reminds us, the nation’s long-term deficit woes are principally due to escalating spending, particularly on entitlement programmes. Strong economic growth provides further help in reducing the debt-to-GDP ratio over time.

While there are many possible outcomes, three are particularly considering.

First, increase the debt ceiling full stop. The president prefers a “clean” increase in the debt ceiling, with discussion of spending and tax changes to take place later. Such an outcome makes no progress on spending restraint, leaving individuals and businesses fearing both higher interest rates as debt mounts and higher taxes (as the president has called repeatedly for higher marginal tax rates on work, saving and investment), discouraging economic growth. And many increases in the debt ceiling have been accompanied by substantive fiscal changes (six times over the past two decades).

Second, raise the stakes and risk default. An alternative would be for both sides to solidify their positions and risk technical default. This outcome is reckless, with financially costly political theatre surrounding a showdown. It is also irresponsible, as it signals a lack of understanding about the essential need to address spending restraint. Higher borrowing costs as a result would worsen the fiscal outlook, and anticipated tax increases will choke the recovery and growth.

A third choice has two parts – first, marry an increase in the debt ceiling with as much spending restraint as both sides can agree on (possibly as much as $3,000bn over the next decade). A variant of this step was hinted at last week in different forms by Senator Mitch McConnell and by Mr Obama.

To be meaningful, such spending restraint should slow the long-run growth in entitlement costs. This first-step outcome sends a clear signal that spending restraint is understood and real. Such a move can reduce long-term interest rates without a risky QE3 gambit by Ben Bernanke, chairman of the Federal Reserve .

Leaving the current tax code in place in this first step provides support for the recovery, while tabling the tax discussion. That second-step discussion – through next year’s election – would address whether tax changes should promote only tax reform (lower tax expenditures and marginal tax rates) as the Republican leadership suggests; both tax reform and contributing revenue to deficit reduction as the Bowles-Simpson Commission suggests; or revenue from increasing marginal tax rates and accommodating higher future spending levels as the president suggests.

The need for long-term spending restraint cannot be debated – it is unfeasible and economically suicidal to raise taxes to accommodate the future spending trajectory. But the discussion of tax reform versus tax increases is a political question (though with economic consequences) ripe for public debate in the next year’s presidential campaign, generating a mandate for action for the victor.

While it is part political theatre, part grappling with a serious problem, the debt ceiling debate has to be understood as a floor on the real debt that must be established for the country’s fiscal and economic future.

The writer is dean and Russell L. Carson professor of finance and economics at Columbia Business School, and former chairman of the Council of Economic Advisers under President George W. Bush

Response by Uri Dadush

America’s ’safe haven’ status cannot shelter it indefinitely

Glenn Hubbard is entirely correct in pointing to the perils of America’s unsustainable fiscal trajectory. As Italy showed just last week, a country’s ability to borrow at moderate interest rates should provide no comfort – confronted with high and rising debt, things are fine until suddenly they are not. Together with the other politically-paralysed economic giant, Japan, the US is alone among the advanced countries not to have taken measures to redress the effects of the financial crisis on its public debt trajectory, even though the crisis originated there.

Whereas other advanced countries have been forced to raise taxes and cut spending by immediate financial market pressure or the fear of it, the US has been sheltered by its safe haven status and, in uncertain times, the world’s continued hunger for dollars – still the global reserve currency. Moreover, in contrast to the UK’s parliamentary system, America’s checks and balances would prevent strong executive action, even if there was stomach for it. Farcical (or tragic) as it may be, the political theatre featuring the debt ceiling is America’s way of confronting the problem before the market forces it to do so.

The rest of the world has a big stake in the outcome. With the eurozone in terrible trouble, and Japan in a quagmire, the risk of losing confidence in the world’s largest economy – still three times the size of China’s – is too dire to contemplate. Deep concerns about America’s fiscal deficits, and the Fed’s attempts to engineer lower long-term interest rates through quantitative easing, contribute massively to international tensions on currency levels (as the dollar comes under pressure), hot money flows and capital controls (as emerging markets overheat), and excessive reserve levels (as China and others amass Treasury Bills).

Finally, if done right, US tax reforms and expenditure cuts can help redress global imbalances. America’s structural current account deficit is not helped by China’s and Germany’s anti-consumption policies. But its deeper roots lie in US fiscal policy, with its comparatively low taxes (especially on corporations and and its top 1 per cent of earners who account for 17.6 per cent of total income), which directly and indirectly promotes consumption. Compared to other advanced countries, America under-taxes gasoline consumption and, indirectly, imported oil. Home building is artificially encouraged by its large mortgage interest rate reduction and many other tax incentives, diverting resources from the traded sectors. The US does not apply value added tax, a consumption tax, and another large potential source of revenues. It spends hugely more on healthcare than all other advanced countries without a pay-off in terms of improved health. And it still accounts for about half of global defence spending.

If the debt ceiling debate helps Americans begin to confront these anomalies, it is to be warmly welcomed.

The writer is a senior associate at the Carnegie Endowment for International Peace

Matt kenyon illustration

With last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase. Where the crisis had been existential for small economies on the periphery of Europe but not systemically threatening to either the idea of European monetary union or to the functioning of the global financial system, it now threatens both European integration and the global recovery. Last week’s drama over bond auctions in Europe’s third leading economy should convince even the most hardened bureaucrat that the world can no longer let policy responses be shaped by dogma, bureaucratic agenda and expediency. It is to be hoped that European officials can engineer a decisive change of direction but if not, the world can no longer afford the deference that the International Monetary Fund and non-European G20 officials have shown European policymakers in the past 15 months.

Three realities must be recognised if there is to be a chance of success. First, the maintenance of systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish not a policy. US policymakers were applauded for about 12 hours for their willingness to let Lehman go bankrupt. The adverse consequences of the shattering effect that had on confidence are still being felt now. The European Central Bank is right in its concern that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence. Those who let Lehman go believed that because time had passed since the Bear Stearns’ bail-out, the market had learnt lessons and so was prepared. In fact, the main lessons learnt were on how best to find the exits, and so uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

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Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates currently charged by the official sector for credit – let alone the private sector – would involve burdens on Greece, Ireland and Portugal comparable to the reparations’ burdens Keynes warned about in The Economic Consequences of the Peace.

Third, whether or not a country is solvent depends not just on its debt burdens and its commitment to strong domestic policies, but on the broader economic context. Liquidity problems left unattended become confidence problems. Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates are likely to become insolvent at higher interest rates, putting further pressure on rates and exacerbating solvency worries in a vicious cycle. This has already happened in Greece, Portugal and Ireland, and is in danger of happening in Italy and Spain.

In short, the approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative. Assertions that the most indebted countries can service their debts in full at current interest rates only undermine the credibility of policymakers when they go on to assert that the fundamentals are relatively sound in Spain and Italy. Further lending at premium interest rates only increases the scale of the necessary restructuring. It is reasonable to argue that the recognition of debt unsustainability in Greece has been excessively deferred. It is not reasonable to argue that Greek reprofiling or restructuring alone will address a general crisis of confidence.

A fundamental shift of tack is required, towards an approach focused on avoiding systemic risk, restarting growth and restoring arithmetic credibility rather than simply staving off disaster. The twin realities that Greece, Italy and Ireland need debt relief and that the creditors have only limited capacity to take immediate losses, mean that all approaches require increased efforts from the European centre. Fortunately, the likely consequence of doing more upfront is a lower cost in the long run. The details are less relevant than having an appropriate approach overall, aligned with EU political realities. But some elements are crucial to any viable strategy.

European authorities must restate their commitment to solidarity as embodied in a common currency and recognise that the failure of any European economy is unacceptable. If they can find the political will, the technicalities of a policy response are not that difficult. But it should include these further commitments.


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First, for programme countries, interest rates on debt to the official sector should be reduced to a European borrowing rate, defined as the rate at which common European entitities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated, so there is no reason to charge a needless risk premium that puts the whole enterprise at risk.

Second, countries whose borrowing rate exceeds some threshold – perhaps 200 basis points over the lowest national borrowing rate in the euro system – should be exempted from contributing to bail-out funds. The last thing the marginal need is to be pulled down by the weak.

Third, there must be a clear commitment that, whatever else happens, no big financial institution in any country will be allowed to fail. The most serious financial breakdowns – in Indonesia in 1997, Russia in 1998, and the US in 2008 – came when authorities allowed doubt over the basic functioning of the financial system. This responsibility should rest with the ECB, with the requisite political support.

Fourth, countries judged to be pursuing sound policies will be permitted to buy EU guarantees on new debt issuances at a reasonable price, payable on a deferred basis.

These measures would do much to contain the storm. They would lower payments for debtor nations, protect states at risk from participation in rescue efforts or from shortfalls in market confidence, and ensure the ECB could continue backstopping the stability of European banks.

This leaves the question of what is to be done with sovereign private debt. Creditors gain nothing from breakdown. Some will want to sell out of their exposures at prices marginally above their current market value. Others, who are still regarding sovereign European debts as worth par, should be given appropriate, reduced interest rate longer maturity options. Debt repurchases are a possibility if the private sector accepts sufficiently large present-value debt reductions. But any approach should be judged on the sustainability of programme country debt repayments.

Much of this will seem unrealistic given the terms of Europe’s debate. It seemed highly unrealistic even 10 days ago that Italy’s solvency would come into substantial doubt. The alternative to forthright action today is much more expensive action – to much less benefit – in the not too distant future. The next few weeks may be the most important in the history of the EU.

The writer is Charles W. Eliot university professor and president emeritus at Harvard University. He was Treasury secretary under President Bill Clinton

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In the dim and distant past, before September 2007, banking supervisors typically believed that the less said about a bank in trouble, the better. “Least said, soonest mended” was the motto of prudential regulators on both sides of the Atlantic. Any public hint that a bank might not be meeting regulatory capital standards created the risk of a bank run. Far better to work privately with management in an attempt to resolve the problems, leaving outsiders in the dark until a deal was done. That “deal” might be closure, but in an orderly manner, usually involving a managed and ostensibly “friendly” takeover. The UK’s secondary banking crisis in the 1970s was handled on these principles, and few people knew much about it until it was over.

How different it is today. “Least said, soonest mended” has been replaced by “let it all hang out” on the sign over the regulator’s door. Under the living will regime, some think the sign now reads “abandon hope all ye who enter here”.

Of course we all understand this change of approach. In retrospect we can see that banks had been allowed to operate with too little capital to withstand a sharp market correction. Too little attention had been paid to the quality and duration of their funding, or to the movements in their loan-to-deposit ratios. Capital requirements imperfectly captured the risks of different asset classes and the correlations between those risks. And there was simply too little capital in the trading books.

So regulators are rightly much tougher. Anyone on the board of a bank (I chair the risk committee of Morgan Stanley) knows they now impose far tougher internal stress tests, and the dialogue between companies and their supervisors is radically improved. Previously boards had to rely almost exclusively on what management told them. Now they have direct access to another triangulation point. And that dialogue results in changes to capital and liquidity levels – or should do.

So what is the value of public exercises such as the European-wide stress tests published by the European Banking Authority on Friday?

European regulators are copying what was perceived to have succeeded in the US in the early aftermath of the crisis, when confidence in the banking system as a whole had collapsed. The exercise, conducted after quite a large recapitalisation exercise involving the federal government, was broadly reassuring, though bank failures in the middle and lower tiers of the US banking sector have continued.

The European exercise is far more complex, not least because the respective responsibilities of the EBA and national supervisors are still far from clear. It is also widely recognised that the first iteration of the exercise was weakly specified. Some banks that passed with flying colours were effectively bankrupt shortly after. Moreover, it is hard for supervisors to require banks to plan against a break-up of the eurozone, the outcome the markets most fear.

So the latest exercise is almost bound to raise more questions than it answers. The headline results indicate that nine banks failed, with 16 close to the line. But what Europe needs is not a league table of the good, the less good and the capitally challenged; but a plan, country by country and bank by bank, to fortify the banking sector. If there are one or more sovereign defaults, as now seems likely, that may require member states to provide new capital for banks that suffer significant write-downs. Overall, a Greek “selective default” is manageable, but some banks will be embarrassed. As governments have encouraged them to keep their Greek bonds, it is not unreasonable that they should look in that direction for assistance.

We will not soon return to a supervisory regime in which, as a former Bank of England governor liked to say, the regulator’s actions were “clouded in decent obscurity”, although some in the City look back on those times with nostalgia. But the stress test exercise, which may generate more heat than light, should not distract from the painstaking work needed to restore the challenged parts of the European banking sector to health.

That will require individual capital plans worked through by supervisors and management, and almost certainly some injections by governments if the eurozone crisis continues to deepen. The EBA can draw attention to the problem areas, but it cannot solve them. But drawing attention to them makes them more urgent, a point that governments need to understand.

The writer is a former chairman of the UK Financial Services Authority

After a long and costly delay, European officials’ narrative about the debt crisis is changing. This is the good news. The bad news is that Europe still lacks the political and technical leadership needed finally to catch up with this damaging crisis. As a result, Europe will soon be forced to consider radical options.

For too long, Europe has pretended that the crisis in its periphery was liquidity-driven rather than solvency-induced. Officials dismissed the need for debt restructuring, preferring a bail-out for Greece, Ireland and Portugal that piled new debt on top of an already unsustainable burden.

At first glance, this had the merit of delaying decisions that involve highly complex – and uncomfortable – financial engineering and political agreements. It also gave time to the weaker entities, be they countries or banks, to reduce their vulnerability.

But the delay has been costly. Peripherals implementing courageous austerity measures have been losing the support of citizens who feel, rightly, that their sacrifices have done little to improve prospects for their country.

Healthy balance sheets, including that of the European Central Bank, have also been contaminated by debt that will most likely be restructured. Sizeable liabilities have been transferred from the private to the public sector. And less sickly European economies – most recently Italy – have been undermined by the general loss of confidence in Europe’s ability to deal with a homegrown crisis.

Ironically, it was left to George Papandreou, prime minister of Greece, to acknowledge these disappointments this week, and to point to a better way forward. In a powerful letter sent to Jean-Claude Juncker, president of the Eurogroup of eurozone finance ministers and prime minister of Luxembourg, he argues that “going from crisis to crisis at such a weak stage of recovery, with such a cacophonous press and frightened public, is not any longer an option Greece can sustain”.

Mr Papandreou is right to point to the need for a better solution that covers debt sustainability, access to markets and growth. He is also right to warn of the danger of allowing politics to undermine the proper design of technical solutions. If Europe’s policymakers take the Greek prime minister’s words to heart they will conclude that the time for a strategic retooling of the eurozone is approaching.

This will be done in one of two basic ways. Europe could opt for greater fiscal union, first de facto and then de jure. Cost-effective guarantees and transfers, rather than just loans, would stabilise the region’s debt dynamics through the aggressive use of a unified European balance sheet. In return, individual countries would sacrifice a significant amount of national sovereignty and fiscal policy discretion.

If this is politically impossible to implement, and I suspect it may be, Europe should opt for a restructuring of the debt of the weak peripherals, recapitalising the ECB, protecting the payments and settlement system, countering other collateral damage, and restoring conditions for growth. At some stage, this could even involve a country taking a sabbatical from the eurozone – but not the EU - in order to regain the policy flexibility needed to restore competitiveness.

Neither of these approaches is easy or pleasant to implement. Each involves significant dislocations and requires skilful damage containment – a consequence of delaying necessary but difficult decisions. But the alternative of continuing to muddle along with a discredited approach would have even higher costs, and would quickly undermine the institutional integrity of the eurozone as a whole.

Mr Papandreou is right. It is “crunch time” and Europe is at “a fateful juncture”. The longer European officials dither, the smaller the scope for catching up with the spreading crisis.

The writer is the chief executive and co-chief investment officer of Pimco

The American public gets it, even if successive US administrations have not. There are more than 12m families who get it particularly well: they are those who owe more on their mortgage than their homes are worth. They know we have been running on empty for years. Now Barack Obama has officially withdrawn from the current round of budget talks, reducing hopes of a deal on tax rises and spending cuts, a new era of American austerity is the only way to put things right.

No wonder this is being called the most predictable crisis in US history. For who could dispute, when our government must borrow $4.5bn a day just to keep going, that our national debt is now an existential threat? Wimpy, a character in the cartoon Popeye, got our attitude right: “I’ll gladly pay you Tuesday for a hamburger today.”

Knowledgeable people in finance are aware that the US Federal Reserve has been buying 70 per cent of all new Treasury paper, making the government by far the largest client of its own debt. This is possible only by increasing the money supply and the balance sheet of the Fed itself, a practice that sooner or later must blow up.

That is not the only risk: the economists Carmen Reinhart and Kenneth Rogoff have shown that economic growth deteriorates as total government debt exceeds 90 per cent of gross domestic product. America is already in that range. Indeed, the real facts are even worse, for we are also now in the midst of the familiar Washington game of kidding ourselves about the size of the deficit. It is already at $1,645bn for the next fiscal year. The Congressional Budget Office concludes that President Obama’s most recent budget underestimates spending while also overestimates revenues.

But for now politics as usual predominates. The Republicans, elected to reduce debt, are struggling to find good reasons to raise the limit. To avoid humiliation in front of their constituents they feel they must secure unprecedented cuts. Tapping into America’s gut sense that getting out of debt means cutting up your credit cards, the House speaker John Boehner feels he is on solid ground insisting on cuts but no tax increases in any deal.

Mr Obama’s initial response was just as divisive, attempting to play-off the rest of America against cruel Republicans and the wealthy. Yet his harsh tone then made a rational bipartisan agreement more difficult. And any deal must be bipartisan, so neither party can blame the other for necessarily unpopular action. Both must therefore make concessions.

Yet cuts and tax rises remains politically treacherous. Senior citizens, in particular, will vote against any changes to healthcare and retirement programmes. Both parties hope to keep their bases on side, while seeking support from those independent voters – who are focused on fiscal probity and represent 29 per cent of the electorate – whose views will be crucial during the next year’s presidential election.

In truth there is no politically viable way to raise sufficient taxes to solve our deficit problem. Given this, the only serious way forward is through long-term spending reductions, especially in entitlement programmes. But the Democrats are in hock to the unions, and refuse to cut the two programmes that dominate the nation’s long-term balance sheet, Social Security and Medicare. Most conservatives, meanwhile, won’t touch spending on their own pet programmes, not least defence and farm subsidies.

Given we can’t raise taxes enough to cover the scale of our deficit problem, America now has no choice but to enter our own age of austerity, namely long-term spending reductions. Britain has gone down this path, and is managing well. There have been protests, but their government has held fast – because it understands, as we must, that the scale of deficits and debt demands nothing less.

This is a new world for America, and one requiring firm new policies. Yet, to date, we become only more politically dysfunctional. Mr Obama is in a delicate position. He can’t let the country default on his watch, but risks just that if he insists on tax rises Republicans can’t stomach. Nor, except in vague terms, has he offered adequate spending cuts of his own. His talk of $1,000bn in cuts seems large, but in truth it is nowhere near enough to change the trajectory of our debt.

There was a brief moment when most of us thought a large scale deal was possible, providing $4,000bn of deficit reductions over the next decade. No longer: now all we have is a smaller $2,000bn package on the table. Even then both parties now worry that short-term cuts might harm America’s faltering growth, extend the recession and reduce tax revenues – and therefore increase the federal deficit.

The best that can be said is that both parties are now talking about constraints on spending, rather than new programmes, and of increasing revenues not by tax increases but through the elimination of special tax allowances. It may even be beginning to dawn on both sides that they are arguing in the path of an avalanche. Just think: in the few minutes that it took you to read this column, the US national debt went up by more than $6m. It will take more than a short-term deal to put that right.

The writer is editor-in-chief of US News & World Report and chairman, chief executive and co-founder of Boston Properties, a leading US real estate group.

Response by William Galston

America will do the right thing, once it’s exhausted the alternatives

As the US careens toward possible default on its debt obligations, Mort Zuckerman’s piece raises two obvious questions: how did a great nation end up in this fix? And how can it change course?

A number of trends have combined to produce the impasse. Supply-side economics has hardened into an anti-tax orthodoxy, and the Republican party now pays fealty to the views of the anti-tax crusader Grover Norquist and his loophole-free pledge, to which virtually all Republicans in the House of Representatives and the Senate are signatories.

John Boehner, the speaker of the House, inclines toward the older fiscal conservatism, but he has few supporters. When news of his would-be “grand bargain” with President Barack Obama broke, his rank-and-file, egged on by his lean and hungry young lieutenant, revolted and forced him to beat a humiliating retreat. The alternative was wagering, and probably forfeiting, his speakership.

During this same period, the US has become an entitlement state, with programmes such as Social Security, Medicare and Medicaid constituting an ever-increasing share of the US federal budget and gross domestic product. Many Democrats see the defence of these programmes as their raison d’être and resist even modest proposals for reform.

It has also become increasingly polarised, although the Republicans are more monolithically conservative than the Democrats are liberal. Had the grand bargain  remained on offer, Mr Obama could have carried more of his party with him than Mr Boehner; how much more is unclear.

Against this backdrop, few leaders in either party have been willing to level with the American people about problems the country faces. The people have been given to understand that default can occur without serious consequences, that deficits don’t matter, that government functions can continue as the revenue base withers – and that if there is a problem, it can be solved without any sacrifice on the part of the middle class. As a result the people are unprepared for what lies ahead.

So what can be done? In the short-term default is unthinkable, which means that the ramshackle political system will muddle its way through. Senator Mitch McConnell, leader of the Senate Republicans, has offered a plan to allow the debt ceiling to rise without direct Republican complicity. Some members of his party are denouncing him as Pontius Pilate, while others are privately sighing with relief. In the end, Mr McConnell’s proposal, combined with a modest package of spending cuts plus an extension of payroll tax cuts, might receiving grudging support.

In the longer run, there is no choice: the US must pivot toward a fiscal policy that reverses the alarming rise in our debt-to-GDP ratio. And that means reducing our commitments, at home as well as abroad, and raising taxes – and not just on the rich.

Americans have the opportunity to do both of these things, while boosting growth, by reforming their obsolete tax code and making strategic investments in education, research, entrepreneurial innovation, and infrastructure. Winston Churchill once observed that you can count on Americans to do the right thing—after they have exhausted all the alternatives. Before the end of the decade, we’ll find out whether his optimism about American policy-making still holds true.

The writer is a senior fellow at the Brookings Institution.

The eurozone crisis has finally knocked on Italy’s door – and rather brutally at that. At one level this is surprising. Unlike Greece, Italy has gradually brought its deficit under control in recent years. Unlike Ireland, Italian banks have been only moderately affected by the crisis. Unlike Spain, Italy had not been characterised by an over expansion in either construction or private sector indebtedness.

So why has Italy been hit by sudden mistrust, expressed in words by rating agencies and in deeds by the markets? The answer is found in the combination of two factors: first, a tendency to defer to the Greek calends (in Brussels more than in Athens); and second, a revival of commedia all’italiana (in Rome, of course).

It would be unfair not to recognise that the European Union’s response to the Greek crisis has been vigorous and fairly well-co-ordinated. But the cacophony of statements from the leaders of the eurozone, the Eurogroup and the Euruopean Central Bank, when combined with the problems of reaching speedy agreement on a final strategy, is clearly increasing the appetite of the markets to test the EU’s response.

The market’s new front might well have been Spain, whose underlying problems are by no means less serious. So if Italy has been chosen as the target – and a target whose size and seniority within the EU makes it a more severe test of the eurozone’s resilience – it is probably because of the recent intensification of belligerence within prime minister Silvio Berlusconi’s government.

Describing that as commedia is, I admit, a form of understatement. Yet even if these moves against Italy are not wholly justified by fundamentals, the pronouncements by rating agencies and markets have triggered a sense of urgency reminiscent of days in which Italy regularly found itself in financial difficulties before the launch of the euro.

Masterminded by president of the republic, Giorgio Napolitano, the reaction has in fact been prompt and unexpectedly cohesive. True, finance minister Giulio Tremonti’s manoeuvre, a new set of budgetary adjustments and other measures, has seen its fair share of criticisms. But it is widely regarded as necessary to reassure both the EU and the markets, and the opposition parties have promised that the package will be adopted by this Friday. In turn, the majority in parliament is likely to accept at least some of the opposition’s amendments.

It is sad that it has taken an attack by “a conspiracy of speculators”, as many Italians see them, to push the political system towards common responsibility. Even so, the reaction has been remarkable. Few would have put money on this outcome; indeed, many had already placed huge bets against it.

Of course this will not be the end of Italy’s pains. Even if Friday’s announcement discourages further speculation, a fundamental reorientation of economic policy is urgently needed. It is now vital to stick to the fiscal discipline being pushed by Mr Tremonti, and to make sure, if anything, that it is reinforced in the implementation phase. It is equally vital, however, to leave behind the policies – and even the philosophy – followed by Mr Tremonti himself, in the three governments led by Mr Berlusconi, all of which have failed to recognise the need to raise Italy’s productivity, competitiveness and growth, and lower its pronounced social inequalities.

None of this will be achieved by reducing the current drive for fiscal discipline, even though many members of the centre-right majority (and some important ministers) have been pressuring Mr Tremonti to do just that. Instead, only the removal of structural impediments to growth can make a difference.

Sadly these are numerous and well-entrenched, flowing from Italy’s tradition of corporatism and low competition. These problems are caused in part by the limited powers, independence and resources given to the competition authority as well as to other regulatory agencies, and also in part by a whole host of restrictions to competition generated by the policies of the government itself. Even the rating agencies, who normally concentrate on short-term financial conditions, have this week emphasised Italy’s weak policies on growth. There can be no clearer reminder that issue is critical to achieving sustained improvements in Italy’s public finances.

This new growth strategy must also be matched at EU level, where fiscal discipline must be combined with moves to make Europe more competitive through deeper market integration. But it is Italy that now faces the most immediate threat. The need for a new generation of reforms capable of raising levels of growth and productivity is not widely accepted on either Italian right or left. When the worst of this week’s turbulence is passed, ensuring that they occur is now Italy’s next big challenge.

The writer is president of Bocconi University and a former European commissioner.

Response by Ferdinando Giugliano

Italy’s leaders lack the credibility to reassure the markets

It may be hard to spot, but even in a financial storm every cloud can have a silver lining. As Mario Monti rightly points out, in the case of the turmoil that has affected the Italian markets over the last week, this silver lining came in the shape of a strong and cohesive response by the country’s political system. Both the government and the opposition appear to have abandoned the temptation to ditch austerity for profligacy, and Giulio Tremonti’s budgetary adjustment has rightly been fast tracked in parliament.

The manoeuvre is a necessary but, alas, insufficient step, and not only because more austerity is needed. As Mr Monti correctly argues, structural reforms must follow, and soon. He rightly focuses on the role that an effective competition policy can play in relaunching Italy’s sluggish economy.

Yet, other problems must be addressed too. As it has been repeatedly emphasised by Tito Boeri, an economist at Bocconi University, Italy should take care of the schizophrenia of its labour market, parts of which are much too rigid while others are much too loose, thereby weighing down the country’s productivity. The policy towards research and development must be corrected too, starting with Italian universities which, as it was pointed out in the this year’s Economic Survey by the Organisation for Economic Co-operation and Development, are badly in need of mending.

That these reforms are long overdue means that their returns could be high. Yet, no one should expect these benefits to come quickly. Time is needed but, as this last week has shown, time is a luxury that Italy does not have at the moment. The market needs to be convinced that Italy is, at last, seriously committed to a shake-up in the supply-side of its economy.

Unfortunately, with its record of dithering and postponing, the current Italian political class does not have much credibility. It can reacquire it only through tough and quick decisions that shock the market as much as the recent turbulence has shaken Italy. If this proves impossible, a change of leadership should seriously be taken into account. Having just lost two decades, Italy cannot afford to waste more time.

The writer is a lecturer in economics at Pembroke College, Oxford university.

As the debt negotiators square off in Congress, much attention will focus on the size of the 10-year budget deal they come up with. As almost everyone agrees, there is much more risk of doing too little than too much given the scale of America’s fiscal challenge.

The truth is that the expected impact of the deal over a 10-year period will not be its most important aspect except in the context of the current media cycle. Very little hinges on whether the deal picks up the low-hanging fruit with respect to entitlements and revenues – or even breaks some new ground – this year or in the next couple of years.

Agreements reached now are subject to revision, potentially radical revision following next year’s election. Businesses are basing their investment decisions on the size of their current order books, not their guesses of fiscal policy in 2015. Consumers are deciding whether or not to spend based on how confident they are that they can hold on to their jobs.

Here is what is not getting its due attention. Decisions about spending and taxing over the next year or two will have a significant impact on job creation over the next year, the economy over the next decade and on the path of US national debt over an even longer horizon.

Suppose any proposed deal could be adjusted, thereby adding an extra one per cent to gross domestic product growth over the next year. A reasonable assumption is that the increase in output might not be sustained as inflation slows down, investment is increased, fewer workers abandon the search for jobs, and so forth.

Assume the impact falls from 1 per cent to zero over the course of a decade. The consequence would be an increment to GDP of 0.5 per cent or about $1,000bn over the period. That would represent close to 4m job years. And it would reduce deficits by about $400bn – more than it looks like Democrats will be able to come up with in revenue raising or Republicans in cuts to the cost of healthcare.

Is there scope for adding fiscal measures that would contribute 1 per cent of GDP or more over the next year and a half? Absolutely. With economic demand constrained and in a liquidity trap where interest rates cannot fall further, fiscal policies have larger than normal effects. With even very conservative estimates of multiplier effects, a combination of continuing payroll tax cuts, maintaining support for unemployed workers, and accelerating infrastructure maintenance could add closer to 2 per cent of GDP growth over the next year and a half.

Usually the media and Washington take too short a view. Now is the rare time when all need to remember that you only get to the long run through the short run. Given the current weakness of the US economy what is most important is that any budget deal be pushed forward as soon as possible.

The writer is Charles W. Eliot university professor and president emeritus at Harvard University. He was Treasury secretary under President Bill Clinton

The Chinese Communist party celebrated its 90th birthday on July 1. In the days before this event, the airwaves were full of historical dramas depicting heroic People’s Liberation Army soldiers and party cadres struggling against a variety of enemies. There is a new, neo-Maoist faction within the party led by Bo Xilai, the party chief of the western city of Chongqing, who began promoting the singing of classic Communist songs such as “The East is Red” in workplaces and schools throughout the country. Henry Kissinger, in China for a book tour, managed to attend a sing-along there with some 70,000 other people.

This “red culture” revival has nothing to do with the Communist party’s original ideals of equality and social justice. Rather, it is being promoted by national party leaders as a means of strengthening stability in a country that has seen a massive rise in inequality in recent years. One of the songs not being promoted is the Marxist “Internationale”, with its call for revolution, lest this suggest the need for an Arab spring in China.

The older Chinese who lived through the Cultural Revolution understand its horrors, and how much the new China is dependent on their generation’s determination never to let something like that happen again. The term limits imposed on party leaders and their need for collective decision-making are practices designed to prevent another Mao Zedong from arising. But because the party has never permitted an honest accounting of Mao’s real legacy, it is possible for younger Chinese to look back on that era today with nostalgia, and to imagine it as a time of stability and community.

Chinese history did not, of course, begin with the Communist victory in 1949. In a fascinating turn, an older alternative historical narrative is being formulated alongside the Communist one through a revival of the serious study of classical Chinese philosophy, literature and history. Mao attacked Confucius as a reactionary, but today academics such as Zhao Tingyang and Yan Xuetong have tried to revive a Confucian approach to international relations. The American scholar Tu Weiming left his position as director of the Harvard-Yenching Institute in 2009 to take up a post at Beijing University promoting the study of Confucianism as a serious ethical system on a par with western philosophy. Chinese dynastic history is once again being regularly taught in the school system and there is renewed interest in traditional Chinese medicine, music and art.

The government has permitted, and even encouraged, this revival of Confucianism in order to provide a justification for a modern, authoritarian China that does not depend on western theories of history. The latter necessarily see China as an uncompleted project: while the Chinese may have developed a strong, bureaucratic state already by the time of the Qin unification in 221BC, the country never evolved a rule of law or democratic accountability. After the fall of the last Chinese dynasty in 1911, many Chinese lost faith in their own institutions and believed they would have to be replaced by western ones. Only now, with the emergence in the early 21st century of a powerful China, is there an effort to recover this disrupted historical tradition. Best-selling authors such as Zhang Wei Wei are able to argue that China is not a democracy manqué, but rather a separate civilisation founded on different but equally valid principles from the west.

Many of the new Confucianists argue that in the Chinese tradition, political power is not limited by formal rules such as constitutions and multiparty elections as in the west. Rather, power was limited by Confucian morality, which required benevolence of emperors who had to act through a highly institutionalised Mandarinate. Ancient China did have a pure power doctrine in the form of the school known as Legalism, elaborated by the philosopher Han Feizi and ruthlessly implemented in the state of Qin that would ultimately unify China. It is perhaps not surprising that favoured Legalism and oversaw its revival. But just as Confucianism replaced Legalism as the dominant state ideology in early China, so too contemporary Confucianists see the present-day party as better grounded in moral terms than it was under Mao.

The Communist party is itself of two minds about this Confucian revival. It is eager to find alternative sources of legitimacy for itself in a world where liberal democracy is the default ideology, and it has established almost 300 Confucius Institutes in 78 countries. On the other hand, a modernised Confucianism is potentially threatening because it is, after all, a more genuinely indigenous Chinese product than Marxism-Leninism, the invention of some dead white European males. It is perhaps for this reason that a large statue of Confucius, erected earlier this year in Tiananmen Square, was suddenly dismantled a few months later.

Contemporary China thus has two alternative sources of tradition to look back on, a neo-Maoist one and a neo-Confucian one. Both are being promoted as alternatives to democracy. Neo-Maoism is purely retrograde and could easily erode what freedoms the Chinese have gained over the past generation. Neo-Confucianism is more complex: as Tu Weiming has argued, Confucianism can be interpreted in ways that support liberal democracy; on the other hand, it could become the basis for a narrow Chinese nationalism. That the Chinese need to find their own way to modernity seems incontrovertible. Whether either of these ideas will bear the weight of regime legitimation, or indeed whether they can ultimately co-exist with one another, is something yet to be seen.

The writer is a senior fellow at Stanford’s Freeman Spogli Institute and author of ‘The Origins of Political Order: From Prehuman Times to the French Revolution’

Response by Jonathan Fenby

Influence of the past tempered by a regime that prizes control above all else

The neo-Maoism and neo-Confucianism that Francis Fukuyama describes both need to be taken with a substantial dose of salt – or Sichuan pepper in the case of the former.

Bo Xilai has been doing his “red” thing for some time now, but it is for show and needs to be put in wider political context. The Communist party congress in next October will select a new standing committee of the Politburo. Mr Bo, party boss of the mega-municipality of Chongqing, is campaigning for promotion to the nine-person committee, which runs China, from the wider Politburo where he has sat since 2007. It is thought that perhaps he wants to take national responsibility for internal security.

His “red” campaign is part of this, not a sign that Maoism is back stalking the land. Mass performances of Mao-era songs, and a push to get convicts to study “red” poems, are aimed at burnishing Mr Bo’s credentials as a member of the party’s aristocracy. His father was Mao’s finance minister. That gives him, like Xi Jinping, the next party leader, credentials to rule that cannot be matched by mere bureaucrats such as Hu Jintao, who will step down as party leader next year, or Li Keqiang, the likely next premier.

The campaign, which Mr Xi has backed, does, indeed, include evocations of a supposedly purer era. But one may question how many young Chinese look back to the past they never knew with affection – most Chinese I have met who speak nostalgically of the old days are elderly folk who lost their Mao-era entitlements in the rush for material wealth. Anybody who has visited Chongqing will see instantly how far the place is from anything that could be defined as Maoism as it hooks into globalisation with a vengeance and spawns a class of upwardly-mobile consumers. Its high-technology park houses western companies attracted by cheap land and low labour costs. Ford has a big plant. Mr Bo himself burnished his credentials as commerce minister after China’s accession to the World Trade Organisation.

As for Confucianism, yes, there is a growing body of writing about its virtues by intellectuals. State television staged prime time lectures on its virtues. Yan Xuetong in particular has written much about the virtues of ethical behaviour as preached by the pre-Qing philosophers. But the basic appeal of the Confucian creed to rulers down the centuries remains – it is they who define the benevolence, in return for which the population owes them loyalty and obedience. Everybody knows their place and had better keep to it. Hardly a model likely to be embraced by today’s upwardly mobile society. The much tougher practice of Legalism lies behind the mask, as can be seen from the way in which a number of dissidents and human rights lawyers have “disappeared” in recent months. Nor, one may add, is Beijing’s current foreign policy much marked by qualities Mr Yan praises.

As Mr Fukuyama notes, the statues of the sage has been removed from Tiananmen Square and, this week, a plan for a theme park in Chongqing to celebrate the Mao era was abruptly abandoned. Both “neos” serve a purpose, but their influence is tempered by a regime that prizes control above everything else – in that it does, indeed, perpetuate the past.

The writer is head of China research at Trusted Sources

The European Union was brought into existence by what Karl Popper called “piecemeal social engineering”. A group of far-sighted statesmen, inspired by the vision of a United States of Europe, recognised that this ideal could be approached only gradually, by setting limited objectives, mobilising the political will needed to achieve them and concluding treaties that required states to surrender only as much sovereignty as they could bear politically. That is how the postwar Coal and Steel Community was transformed into the EU – one step at a time, understanding that each step was incomplete and would require further steps in due course.

The EU’s architects generated the necessary political will by drawing on the memory of the second world war, the threat posed by the Soviet Union and the economic benefits of greater integration. The process fed on its own success and, as the Soviet Union crumbled, it received a powerful boost from the prospect of German reunification.

Germany recognised that it could be reunified only in the context of greater European unification, and it was willing to pay the price. With the Germans helping to reconcile conflicting national interests by putting a little extra on the table, the process of European integration reached its apogee with the Maastricht treaty and the introduction of the euro.

But the euro was an incomplete currency: it had a central bank but no treasury. Its architects were fully aware of this deficiency, but believed that when the need arose, the political will could be summoned to take the next step forward.

That is not what happened, because the euro had other deficiencies of which its architects were unaware. They laboured under the misconception that financial markets can correct their own excesses, so the rules were designed to rein in only public-sector excesses. Even there, they relied too heavily on self-policing by sovereign states.

The excesses, however, were mainly in the private sector, as interest-rate convergence generated economic divergence. Lower interest rates in the weaker countries fuelled housing bubbles, while the strongest country, Germany, had to tighten its belt in order to cope with the burden of reunification. Meanwhile, the financial sector was thoroughly compromised by the spread of unsound financial instruments and poor lending practices.

With Germany reunified, the main impetus behind the integration process was removed. Then, the financial crisis unleashed a process of disintegration. The decisive moment came after Lehman Brothers collapsed, and authorities had to guarantee that no other systemically important financial institution would be allowed to fail. The German chancellor Angela Merkel insisted that there should be no joint EU guarantee; each country would have to take care of its own institutions. That was the root cause of today’s euro crisis.

The financial crisis forced sovereign states to substitute their own credit for the credit that had collapsed, and in Europe each state had to do so on its own, calling into question the creditworthiness of European government bonds. Risk premiums widened, and the eurozone was divided into creditor and debtor countries. Germany changed course 180 degrees from being the main driver of integration to the main opponent of a “transfer union”.

This created a two-speed Europe, with debtor countries sinking under the weight of their liabilities, and surplus countries forging ahead. As the largest creditor, Germany could dictate the terms of assistance, which were punitive and pushed debtor countries towards insolvency. Meanwhile, Germany benefited from the euro crisis, which depressed the exchange rate and boosted its competitiveness further.

As integration has turned into disintegration, the role of the European political establishment was also reversed, from spearheading further unification to defending the status quo. As a result, anyone who considers the status quo undesirable, unacceptable or unsustainable has had to take an anti-European stance. And, as heavily indebted countries are pushed towards insolvency, the number of the disaffected continues to grow, together with support for anti-European parties such as True Finns in Finland.

Yet Europe’s political establishment continues to argue that there is no alternative to the status quo. Financial authorities resort to increasingly desperate measures in order to buy time. But time is working against them: the two-speed Europe is driving member countries further apart. Greece is heading towards disorderly default and/or devaluation, with incalculable consequences.

If this seemingly inexorable process is to be arrested and reversed, both Greece and the eurozone must urgently adopt a plan B. A Greek default may be inevitable, but it need not be disorderly. And, while some contagion will be unavoidable – whatever happens to Greece is likely to spread to Portugal, and Ireland’s financial position, too, could become unsustainable – the rest of the eurozone needs to be ringfenced. That means strengthening the eurozone, which would probably require wider use of Eurobonds and a eurozone-wide deposit-insurance scheme of some kind.

Generating the political will would require a plan B for the EU itself. The European elite needs to revert to the principles that guided the union’s creation, recognising that our understanding of reality is inherently imperfect, and that perceptions are bound to be biased and institutions flawed. An open society does not treat prevailing arrangements as sacrosanct; it allows for alternatives when those arrangements fail.

It should be possible to mobilise a pro-European silent majority behind the idea that when the status quo becomes untenable, we should look for a European solution rather than national ones. “True Europeans” ought to outnumber true Finns and other anti-Europeans in Germany and elsewhere.

The writer is chairman of Soros Fund Management and founder of the Open Society Foundations.

Response by Charles Grant

European leaders must step up their game

George Soros is right that Germany’s new approach to Europe bears some responsibility for the eurozone crisis. Germany’s leaders are finding it hard to consider broader European rather than immediate national interests. The medicine they pushed the European Union to prescribe for Greece, Ireland and Portugal – fiscal austerity and structural reform – was necessary but not sufficient. Germany’s obsession with supply-side economics and its reluctance to take small steps towards a “transfer union” prevented the EU from coming up with plans to promote investment and growth in the struggling countries. So the medicine is failing, and the rest of the eurozone cannot be ring-fenced from Greece’s problems unless the EU does more to boost growth in Portugal, Ireland and elsewhere.

Mr Soros is also right to berate EU leaders for defending the status quo. But there is a reason for their conservatism: they fear being on the wrong side of public opinion, which is an increasingly powerful actor in European politics. The founding fathers did not have to worry about voter sentiment. But now many voters in the surplus countries oppose bail-outs for the southern countries, which they blame on the EU. And in the deficit countries, electors have had enough austerity, which they also blame on the EU.

As Mr Soros writes, a viable plan B will require stronger eurozone governance through schemes such as Eurobonds. But in many parts of the EU, voters have never been more hostile to “more Europe”. Of course, the current generation of European leaders is particularly ill-equipped to explain to voters the need for change.

But Mr Soros does not refer to another fundamental cause of the eurozone’s travails. During the 20 years since the Maastricht treaty was negotiated, the large member-states have become more dominant in the EU, and the European Commission relatively weaker. We are moving towards the Europe des patries, a Europe of nation states, that General Charles de Gaulle wanted. This trend has accelerated during the euro crisis: the French and the Germans have sought to sideline the Commission and create ‘inter-governmental’ rescue mechanisms.

For all its imperfections – the current team of commissioners contains few stars – only the Commission can consider the wider European good, protect the interests of smaller member states and ensure that EU rules (such as on deficits and the single market) are respected. The Commission (like France) doubted that the Germanic medicine the EU has prescribed for debtor countries would work, but lacked the authority to resist Berlin.

Mr Soros’s plan B is not viable unless European leaders raise their game. Those in Germany need to rediscover some of the Helmut Kohl spirit, and remember that leadership carries responsibilities. Encouragingly, some Social Democratic and Green politicians seem to get the point. In surplus countries and debtor countries, leaders need to shape public opinion by explaining the benefits of the euro and why sacrifices are required. And all across the EU, leaders need to treat the Commission with more respect. A sustainable euro needs strong institutions and rules, rather than late-night deals among leaders of big member states.

The writer is director of the Centre for European Reform.

The revolutions across the Arab world have been political blood sport. And we, the spectators, are consumed by the contest. But as the fight staggers into interminable rounds is our eye on the right fight?

The politics, and the military campaign in the case of Libya, appear to be grinding to a desert stalemate. In Egypt and Tunisia, interim governments are slowing the pace of democratic transition. In Syria and Yemen, internal conflicts swell, as brave civilians take to the streets, but there is little outsiders can do, it seems, to influence the outcome. We impotently watch Syrian protesters being attacked. In Bahrain the government seems to be back on top. As an Arab friend put it, this is becoming less spring and more the other three seasons.

But there is a further dimension – arguably a crucial variable in this – which is dryer stuff and so less noticed: economics. Soberer, perhaps, but it may have more to do with who ends up in the winners’ circle. For economics may change the final outcomes in each of these countries.

In Libya, there is a real issue of who runs out of money first. While Nato is hammering away at targets in Tripoli it has still not found a way to pay the rebels’ bills. These now run at about $300m a month, once Muammer Gaddafi’s subsidies, which they dare not dismantle, are added in. There is an air of desperation in Benghazi as the rebels watch their western patrons slowly try to free up tens of billions of dollars from frozen Libyan assets. Nato has bombed Col Gaddafi’s oilfields, creating a level playing field of sorts, given the rebels can no longer afford to import petrol. So the conflict in oil-rich Libya may now turn on who runs out of fuel first.

In Tunisia and Egypt, the reforms both countries need most – aggressive disposals of state enterprises, economic liberalisation and the inflow of foreign investment – have all been discredited. The old regimes used these policies to push growth, but at a high political and social cost. With wealth and power so unevenly distributed, they turned into an ugly wealth grab for the regime’s cronies. Now, when they are needed most, they are distrusted.

Efforts have been made to get the World Bank and the European Bank for Reconstruction and Development involved. But the first is compromised by its involvement with the earlier reforms. The second, which has an impressive record of reform in eastern Europe, is considered just too European by a sceptical, nationalist population.

Yet elsewhere the economic noose may bring better news. The UN Security Council could not bring itself to condemn, let alone sanction, Syria. But the regime is running out of money, and will need loans if it is to survive. Lenders may be harder to placate than diplomats. By any standard the regime is now a credit risk and is unlikely to find affordable international funds. Certainly there will be no international rescue package, so money may speak where diplomacy fudged it.

International policymakers should be asking if these economic realities can be pulled together into a new and coherent strategy for change. As countries such as Egypt and Tunisia emerge from the political shadows, imaginative offerings of transition finance, incentives for foreign investment, trade access and, above all, a social safety net, might still empower the bold reform it will take to create jobs and growth.

Any democratic experiment needs these to survive. The funds – and they can be loans in many cases, due to the innate wealth of Arab countries – should be concentrated on those countries that are turning the corner, rather than subsidising the survival of regimes in countries such as Yemen and Syria. Too often, the international bureaucrats managing these programmes believe they can buy change but instead end up subsidising a failed status quo.

With Europe in the midst of its own financial crisis, there will be little tolerance for aid hand-outs. Even so, this is a moment for bold investment in Arab success. As the politics and security situation become bogged down, economics remains the best agent of change. Let us put our money, or at least our loans, behind real change.

The writer is chairman for Europe, Middle East and Africa at FTI Consulting, and former UN deputy secretary-general.

The revolutions across the Arab world have been political blood sport. And we, the spectators, are consumed by the contest. But as the fight staggers into interminable rounds is our eye on the right fight?

The politics, and the military campaign in the case of Libya, appear to be grinding to a desert stalemate. In Egypt and Tunisia, interim governments are slowing the pace of democratic transition. In Syria and Yemen, internal conflicts swell, as brave civilians take to the streets, but there is little outsiders can do, it seems, to influence the outcome. We impotently watch Syrian protesters being attacked. In Bahrain the government seems to be back on top. As an Arab friend put it, this is becoming less spring and more the other three seasons.

But there is a further dimension – arguably a crucial variable in this – which is dryer stuff and so less noticed: economics. Soberer, perhaps, but it may have more to do with who ends up in the winners’ circle. For economics may change the final outcomes in each of these countries.

In Libya, there is a real issue of who runs out of money first. While Nato is hammering away at targets in Tripoli it has still not found a way to pay the rebels’ bills. These now run at about $300m a month, once Muammer Gaddafi’s subsidies, which they dare not dismantle, are added in. There is an air of desperation in Benghazi as the rebels watch their western patrons slowly try to free up tens of billions of dollars from frozen Libyan assets. Nato has bombed Col Gaddafi’s oilfields, creating a level playing field of sorts, given the rebels can no longer afford to import petrol. So the conflict in oil-rich Libya may now turn on who runs out of fuel first.

In Tunisia and Egypt, the reforms both countries need most – aggressive disposals of state enterprises, economic liberalisation and the inflow of foreign investment – have all been discredited. The old regimes used these policies to push growth, but at a high political and social cost. With wealth and power so unevenly distributed, they turned into an ugly wealth grab for the regime’s cronies. Now, when they are needed most, they are distrusted.

Efforts have been made to get the World Bank and the European Bank for Reconstruction and Development involved. But the first is compromised by its involvement with the earlier reforms. The second, which has an impressive record of reform in eastern Europe, is considered just too European by a sceptical, nationalist population.

Yet elsewhere the economic noose may bring better news. The UN Security Council could not bring itself to condemn, let alone sanction, Syria. But the regime is running out of money, and will need loans if it is to survive. Lenders may be harder to placate than diplomats. By any standard the regime is now a credit risk and is unlikely to find affordable international funds. Certainly there will be no international rescue package, so money may speak where diplomacy fudged it.

International policymakers should be asking if these economic realities can be pulled together into a new and coherent strategy for change. As countries such as Egypt and Tunisia emerge from the political shadows, imaginative offerings of transition finance, incentives for foreign investment, trade access and, above all, a social safety net, might still empower the bold reform it will take to create jobs and growth.

Any democratic experiment needs these to survive. The funds – and they can be loans in many cases, due to the innate wealth of Arab countries – should be concentrated on those countries that are turning the corner, rather than subsidising the survival of regimes in countries such as Yemen and Syria. Too often, the international bureaucrats managing these programmes believe they can buy change but instead end up subsidising a failed status quo.

With Europe in the midst of its own financial crisis, there will be little tolerance for aid hand-outs. Even so, this is a moment for bold investment in Arab success. As the politics and security situation become bogged down, economics remains the best agent of change. Let us put our money, or at least our loans, behind real change.

The writer is chairman for Europe, Middle East and Africa at FTI Consulting, and former UN deputy secretary-general

Response by Gerard Lyons

Institutional change is needed for investments to have a real impact

Inclusive economic growth is a necessity for the Middle East and north Africa. Mark Malloch-Brown rightly highlights the vital role of economics, although his conclusion that we should put, “our money, or at least our loans, behind real change in the region” is only part of the answer.

The biggest challenge in proposing economic policies for the region is that one size does not fit all. Not only are there wide economic differences, but the combination of social, political and religious issues means the solutions are complex. There is no easy or quick answer. Moreover, it is no use outside countries offering help unless local populations want it or need it. Ideally change must come from within.

Given all this, what region-wide agendas should be pushed?

First, policy needs to be geared to diversifying local economies. There are growing young populations. Without jobs this demographic dividend becomes a disaster. Youth unemployment is already the biggest regional problem.

Diversification means boosting the service sector. Even the energy rich nations need to recognise that their capital intensive nature does not provide much needed jobs. They must diversify too. This is already happening in some countries.

Diversification also means encouraging the private sector. The old economic model where the public sector was expected to provide graduate employment no longer holds.

Second is the need for institutional change. Here the best help multilateral organisations can offer is technical assistance and cooperation.

More money may help, but can create problems if not part of wider reform. Take even the cash rich Gulf countries. They have pumped huge sums into their economies. That is good, but now the break-even price of oil to achieve balance on their domestic budgets is sky high. Even they can only pump money in for so long.

For others, more money, in the absence of political reform, might be destabilising. Across Africa, for example, pumping money into national economies was mostly wasted because of weak governance, corruption and political instability. Thus institutional change is needed, not as an ultimate goal, but for any money spent to have a real impact.

Third, inclusive growth can only be achieved with a vibrant domestic economy. This requires other features to be put in place, including social safety nets, more women in the workforce, help for small- and medium-sized firms as they are key for job creation, and developing local financial markets to channel savings into investment.

All of these take time, suggesting the need for patience and to manage local expectations. Given the need to keep everyone on side, there is a case for economic plans with clear goals and measurable targets. Central to this is a stable tax, regulatory and policy environment for business and a social contract between government and the people. With these changes in place, good economics may become good politics.

The writer is chief economist at Standard Chartered Bank.

The crisis over Rupert Murdoch’s newspaper empire illuminates the structural crisis in Britain’s broken system of newspaper self-regulation. The closure of the News of the World, the crumbling of the edifice of obfuscations and lies erected over the past five years by News International to defend its indefensible activities, the widespread belief that more revelations about similar activities in other papers are yet to come and the manifest incompetence of self regulation in the British newspaper industry call for a radically different solution.

David Cameron, prime minister, rightly said that the Press Complaints Commission, the industry’s self-regulatory body, should be scrapped. But to create a new and better system there is a familiar dilemma about the regulation of newspapers, which must now be cut through.

On the one hand: they exist in a liberal democracy which values and guarantees freedom of opinion, freedom to publish and the right to hold powers to account. On the other: their wide distribution and power over news means that, when they lie, distort or report wrongfully – or, as with the current scandal, habitually break the law – then their actions affect the health of the society. This means they must be regulated.

This same dilemma is not true for broadcasters. They are regulated in Britain, and have a history which, for the most part, speaks to their independence, impartiality and willingness to investigate and expose abuse. Yet a significant part of the rationale for regulation is to ensure that the broadcasters are objective. Newspapers do not have that requirement, nor should they.

Regulation by the industry itself has been for two decades the only answer to calls for some form of public protection against press abuse. Yet this is clearly inadequate to the task. Those with an interest in a free and transparent press are many; currently, the only stakeholder in the PCC is the press itself, and it has failed in the largest challenge to its ability to self-regulate.

So we have a dilemma. State-backed regulation is seen as illiberal, and would be opposed (on liberal grounds) by all of the press. Yet self-regulation – paid for by the newspapers, dominated by News International and Associated Newspapers – has proved self-serving and supine.

The answer to this dilemma is not to create a new regulator with statutory backing. Instead it is to increase the group’s base of stakeholders – and to include in the number of institutions making up that base the government itself, as a representative of the public interest.

How would this work? When the PCC is replaced, a new organisation should be established, which I would call the Journalism Society, in a similar vein to the Law Society, the representative body for solicitors in England and Wales. This body should be open to being as global as the media are fast becoming. And it should be independent.

The Journalism Society’s stakeholders should include representatives of the government; the educational establishment; civil society (for instance relevant non-government organisations and policy institutes); industry and finance; and the news media. All of these would be committed, under its charter, to pluralist, independent, opinionated news media, working within the law.

This move would have a number of advantages. First, it would make clear that the interest in such news media is much wider than the press itself. Second, no one interest would dominate: the board would be so constructed as to preserve a balance of interests, and it would have no statutory powers.

Third, it would increase the financial backing for the organisation itself, allowing it to extend its scope, to conduct research and investigations and to be proactive in describing and managing the huge changes now under way in the news media – with a brief to ensure that these changes are in the public interest.

Finally, and more importantly, it would allow journalism to take itself seriously as a trade claiming a democratic mandate. It could set and patrol ethical standards, monitor training and qualifications and above all be a forum within which journalists could map out the nature and future of their craft at a time of rapid change.

Dame Onora O’Neil argued, almost a decade ago in her Reith Lectures, that the news media press the need for trust and transparency on others, but not on themselves. The News International affair will have done unintentional good if it ends that period of silence.

The writer is a contributing editor at the FT.

Response by Sunder Katwala

The age of accountability has come to the media at last

“I’m with you on the free press; it’s the newspapers I can’t stand”, as one of Tom Stoppard’s characters, Ruth, says in his play Night and Day.

The News of the World scandal, showing journalism at its criminal worst and dogged best creates an urgent task for defenders of a free press: how can its principles now be defended from the worst practices of the newspapers?

John Lloyd identifies genuine dilemmas about statutory regulation, acknowledging that they have been used too in a self-serving way by newspapers which are scathing about self-regulation in every other domain.

There is now an immediate opportunity – before any inquiry – for media practitioners to set out and publicly debate what a reformed Press Complaints Commission with teeth would look like.

But the media can now longer expect this debate to remain in-house.

And it is important to understand why cogent critics of the media’s ethos and sense of accountability have been marginalised within debate about media practice over the last decade. Figures such as Mr Lloyd or Onora O’Neill, the philosophy professor at Cambridge university, have been caricatured as lofty ivory tower academics and commentators, though their warnings about the threat to the media’s public legitimacy and licence to operate have been borne out.

Too many journalists see these as important debate for journalism schools, but not so much for newsrooms themselves. Inside every newsroom lurks the “dirty hands” theory of how to get results. It is held by liberal broadsheet editors as well as those of the red tops. The News of the World’s had legitimate scoops – such as the Pakistan bribery scandal – through subterfuge too.

The test of an effective PCC would be one that was aggressive and formidable when being stonewalled and lied to, but robust in defending aggressive journalism in the public interest.

Could that ever be captured by a rule book? It is about the ethos, powers – but it is about personalities too.

Peer review is necessary to media scrutiny. But we have a very clubbable media elite – and there is little confidence within it that really big calls would go against the proprietors or editors of the most powerful organisations.

So our media culture has been opened up by the rough and tumble of civic scrutiny and discourse. Some fear the blogosphere and social media can too easily turn into a tweeting mob. But the age of accountability has come to the media too at last.

The question of how journalism restores trust will no longer be for journalists alone.

The writer is director of a soon-to-be-launched organisation that will contribute to and inform media and public debate on migration, integration and identity. He is a former general secretary of the Fabian Society, a think tank.

As the August 2nd debt ceiling deadline looms ever closer, President Barack Obama has asked congressional leaders to work through the weekend. The hope is for agreement on a “grand bargain” that avoids disorderly disruptions to government payment obligations and creates, quoting the president’s remarks of yesterday, “an environment in which we can grow the economy and make sure that more and more people are being put back to work”. The likelihood is that the disruptions will indeed be avoided but, unfortunately, only through a “mini deal”.

To address its economic woes, America desperately needs to transition from a series of ad hoc measures to a more holistic policy approach. The notion of a grand bargain can be a critical enabler in this regard, especially if four conditions are met.

First, a grand bargain can serve as the catalyst for unifying diverse policy actions into clearer, more comprehensive drivers for growth and medium-term fiscal sustainability.

Vital areas include tax and spending reforms, much greater emphasis on growth enablers (including infrastructure, education and retraining), and meaningful steps to restore a more normal functioning of the housing, labour and credit markets. To be effective, they must be implemented as a package of reinforcing measures and not a series of standalone announcements.

Second, the grand bargain itself – especially if centred on the urgent need to address the country’s growing unemployment crisis – can help overcome the repeated difficulties that the administration has faced in outlining a credible economic vision. This is central to unlocking the considerable idle capital that is waiting on the sidelines for a medium-term roadmap before being committed to investment spending.

Third, it would help counter increasing nervousness among America’s foreign creditors. With the Federal Reserve completing its purchase of treasuries under QE2 last week, these creditors now hold the key to maintaining the low interest rates that are so critical for limiting the deterioration of the country’s debt dynamics.

Fourth, it would intensify pressure on other systemically-important parts of the world – particularly Europe and China – to join the US in striking their own grand bargains.

In Europe, this would take the form of a more credible and effective approach to the peripheral debt crisis, including opting for either greater fiscal union or proper debt restructuring and a meaningful improvement in competitiveness.

For its part, China needs to place greater faith in its consumers, allowing them to influence policy formulation as much as producers do.

All this is what should – indeed, must – happen if the US, and the global economy more broadly, are to put in place the conditions for high growth and financial stability. However, I worry that what is likely to occur in the coming days could be insufficient.

Aided by President Obama’s personal and highly visible involvement, American politicians are likely to meet the August 2nd deadline. The bad news in that this may only result in a mini-deal that repeats the bipartisan agreement that overcame the threat of a government shutdown on account of the continuing budgetary problems, though involving more meaningful commitments.

Such a disappointing outcome would fall short of what is required to energise America’s economy, accelerate job creation and enhance medium-term fiscal sustainability. Also, it would contribute very little to improving the outlook for the grand bargains needed elsewhere in the global economy.

Let us therefore hope that, if it indeed materialises, the mini-deal is only a means to a grand bargain down the road. It would be a tragedy if, instead, it were an end in itself.

The writer is the chief executive and co-CIO of Pimco, the world’s largest bond investor

Response by George Magnus

Even a mini-deal could get some Americans back to work

Mohamed El-Erian is unquestionably correct that the US needs a grand bargain to reform the country’s fiscal structure, reboot the economy’s employment-generative capacity and improve housing, labour and credit markets. But he’s also right, alas, to suspect this isn’t going to happen soon. I would add, “or pre-emptively”.

Politicians are too focused on the surge in populism and the increasingly ideological  wings in both major parties to offer the political leadership and imaginative thinking required for an effective bargain. They, and many others, have forgotten already the nature of the profound 2008-09 shock to our financial and economic system, and its Japanese-style consequences. The US is by no means unique in this regard, for the same leadership failures  are evident both in Europe’s approach to sovereign debt crisis management and in China’s approach to economic rebalancing. But the significance of US leadership for itself and the global system cannot be underestimated.

This summer, there probably will be a mini-deal to get the debt
ceiling raised, but it will be mechanistic and short-term, rather than the start of a comprehensive strategy, designed to lift America out of debt and repair its own economic imbalances.  One of the most worrisome “metrics” of America’s current malaise is that the proportion of working age people at work is no higher than it was in 1955.

So if the Congress is not under enough pressure yet to come up with a grand bargain, it could at the very least do two constructive
things. It could confirm its commitment to a significant,
medium-term debt reduction programme by agreeing some details about expenditure restraints and tax revenue expansion. And it could agree to cut employer payroll taxes or payroll tax holidays, and other measures to help get some of the 10m who have dropped out of the labour force since 2007 back to work.

George Magnus is a senior economic advisor at UBS

The US economy has just marked two years of recovery from its worst recession since the Great Depression. But few Americans are celebrating; indeed, most believe that the economy is still in recession. No wonder. Although gross domestic product has recovered to its pre-recession peak, employment has not.

The employment decline during the 2008 recession was more than twice as large as those of previous postwar recessions, according to the McKinsey Global Institute. Even if June’s employment report is much better than expected, 14m Americans will remain unemployed and more than 8m will be working part-time because they cannot find full-time jobs.

More than 2m discouraged workers will have stopped looking for work. The fraction of the population working is near a 25-year low. According to calculations by the Hamilton Project, the US will face a “jobs gap” of about 21m jobs – the number of jobs needed to return the economy to its pre-recession employment level and absorb the 125,000 people who enter the labour force each month. At the current growth rate, that gap will not be filled for another decade.

The jobless recovery is also a wageless recovery for most Americans. Corporate profits have soared, claiming an unprecedented share – more than 80 per cent – of the growth in national income since the recovery began. But real average weekly earnings for production and non-supervisory workers have increased by less than 1 per cent since the recovery started. Real median weekly earnings have fallen. Real median household income in 2009 was 4 per cent lower than its pre-recession high and about the same as it was in 1997.

The economy’s shortlived expansion after the 2000-01 recession was the only postwar expansion during which the real income of the median family declined. And job growth during that expansion was less than half of what it was in the previous two decades. In response to meagre income gains and disappointing job opportunities, many households slashed their savings, borrowed against the value of their homes and assumed significant amounts of debt.

In the wake of the recession households are now being forced to curb their spending, increase their saving and reduce their debt. The process of deleveraging has barely started. Household debt has fallen to 115 per cent of disposable personal income from a peak of 130 per cent in 2007, according to Yale university’s Stephen Roach. But the 1975-2000 average was only 75 per cent, so there is still a long way to go.

It is not surprising that many Americans are pessimistic about their economic future. Nor is it surprising that they think jobs should be the top priority for policymakers. They are right. Unfortunately, many members of Congress are not listening. Urged on by Tea Party Republicans interested more in the size of government than the size of the government’s debt, the debate in Washington is focused on deficit reduction rather than on job creation.

It is true that the US faces a major fiscal challenge that must be addressed. But this is a long-run challenge that is primarily the result of rising healthcare costs, the ageing of the population and unwise fiscal choices made before the recession. The short-run challenge is inadequate demand – a gap between the amount of goods and services the economy can produce and the demand for them, caused mainly by the private-sector deleveraging. The long-run challenge calls for fiscal contraction. The short-run challenge calls for fiscal support.

There is a logical way out of this policy conundrum: pair temporary fiscal measures targeted at job creation during the next few years with a multiyear, multitrillion-dollar deficit reduction plan that would begin to take effect once the economy is closer to full employment. Pass both now as a package.

Current signals from Washington indicate that this way out will be not taken: instead, partisanship and politics will trump logic and premature fiscal contraction will undermine the already anaemic recovery. Even worse, a political stalemate over the debt limit could precipitate a financial crisis and necessitate immediate large cuts in government spending that would tip the economy back into recession, driving the unemployment rate into double digits.

But imagine for a moment that logic prevails. What should the federal government do to promote job creation? At the very least, it should introduce additional stimulus measures to offset the substantial fiscal drag – in excess of 2 per cent of GDP – that is slated to occur in this year and next when current stimulus measures introduced at the end of last year expire. On the spending side, it should invest more in infrastructure maintenance and replacement. Such investment raises demand, creates jobs and increases the growth potential of the economy.

Each $1bn of infrastructure investment creates between 11,000 and 30,000 jobs. On the revenue side, the government should extend some of the targeted tax measures enacted at the end of last year including the payroll tax cut for employees and the capital investment expense deduction. But it should also go further and cut payroll taxes for employers on all new hires, including hires by new businessses. This cut should be linked to the unemployment rate and should be maintained until it falls to the 5-6 per cent range.

History suggests that recovery from a debt-fuelled asset bubble and the ensuing balance-sheet recession can be long and painful, with significantly lower GDP growth and significantly higher unemployment for at least a decade. Right now, it looks like the US is on such a course. For many Americans, the first decade of the 21st century was a lost decade for the economy. A second lost decade has already begun. No wonder they think the economy is still in recession – for them, it is.

The writer is a professor at the Haas School of Business at the University of California at Berkeley. She was chair of the Council of Economic Advisers under President Bill Clinton

Response by John Makin

Stimulus measures over-promise and under-deliver

With the first two fiscal stimulus packages winding down, having failed to produce the promised “lift-off” with self-sustaining growth and improving employment, stimulus advocates are now pointing to upcoming “fiscal drag” when the measures are withdrawn as a reason for still more stimulus. These calls, namely for further additions to debt and deficits, are being heard in the midst talks aimed at major deficit reduction.

Consider the disappointing impact of last December’s stimulus package. Passed just after the Federal Reserve’s November QE2 balance sheet expansion, most forecasters were expecting a growth rate close to 4 per cent during the first half of this year. The outcome will probably be below 2 per cent. Many are blaming the negative effects of higher fuel prices and Japan’s earthquake for slower-than-expected growth.

But part of the disappointing outcome is due to the waning impact of the first stimulus package and a related collapse in construction spending. That the June employment report showed an increase of only 18,000 additional jobs surely falls short of the promises made by advocates fiscal stimulus. The list of disappointments goes on. When the last December’s stimulus is withdrawn at the end of the year, it is estimated to reduce next year’s growth by 1.5 percentage points – and all we have to show for it is a larger national debt mountain, coupled with the need for greater future deficit reduction.

We are learning a basic truth. Fiscal stimulus produces a temporary positive impact on growth and perhaps on employment after it is enacted. This is followed by a drag on growth when it is withdrawn. The net effect over time is highly uncertain but disappointing overall. The stimulus-on, stimulus-off sequence reflects the fact that the spending must be financed by an increase in debt that carries with it the prospect of higher expected future taxes and/or spending cuts. This is especially true as the US debt to gross domestic product ratio approaches level associated with fiscal crises.

With the president and some policy makers calling for $2,000bn to $4,000bn in defect reduction over the next decade – another stimulus package of, say $500bn would only leave us looking for $2,500bn to $4,500bn of defect reduction over the next nine years. That is unless we want to put off deficit reduction steps – again. But that is how we got into this deficit box in the first place.

The writer is a resident scholar at the American Enterprise Institute

Tunisia, Egypt, Bahrain, Yemen, and Libya have had their turn; now Syria occupies centre stage. More than 1,000 people have been killed in recent fighting, while hundreds of thousands still risk their lives challenging the regime. Syria’s future rests on whether a handful of Alawite generals are prepared to keep killing their fellow citizens to preserve the Assad regime and, more fundamentally, Alawite primacy. The outside world, fearing the alternative and bogged down in Libya, is little more than a bystander. Syria’s violence is just one further sign that the promise of the Arab spring has given way to a long, hot summer in which the geopolitics of the Middle East are being reset for the worse.

Syria is not unique. Other threatened leaders around the regions have clearly now decided against emulating the former presidents of Tunisia and Egypt, who went gently into the night. Violence, along with the threat of imprisonment and international tribunals, has persuaded them that the future is winner takes all and loser loses all. Not surprisingly, they have chosen to resist.

Meanwhile, the most organised groups in Arab societies tend to be the army and other security organs on one hand and Islamist entities on the other. Secular liberal groups (if they exist) tend to be weak and divided, and unlikely to prevail in any political competition in the near term. Facebook and Twitter matter but not enough.

Looked at more broadly, the stalling of the Arab spring has both revealed and widened the breach between the US and Saudi Arabia. Saudi leaders were alienated by what they saw as the US abandoning the regime in Egypt after three decades of close cooperation. The Americans, for their part, were unhappy with the Saudi decision to intervene militarily in Bahrain. But such independent, uncoordinated policies are now likely to become more frequent, especially if international efforts to stop Iran’s nuclear program come up short.

Iran itself has both gained and lost from recent events. Higher oil prices, the fall of the staunchly anti-Iranian regime in Egypt, and projected reductions in US military presence in Iraq and Afghanistan have all strengthened its hand. These gains are offset at least in part by the weakened status of Iran’s close partner Syria – and by signs that Iran’s leadership is divided against itself.

The effects go wider still. Relations between Israelis and Palestinians are increasingly strained. Israelis are more reluctant than ever to make concessions in light of the disarray on their borders, while the new voice for Arab publics emerging from the upheavals makes it more difficult for Arab governments to compromise. And while terrorist groups had nothing to do with the upheavals, they are in a position to benefit as governments with strong anti-terrorist records are weakened or ousted. Signs of exactly this are popping up in Yemen, and it only a matter of time before they do so in Libya.

Take all this together, and you see a series of developments that are beginning to produce a region that is less tolerant, less prosperous, and less stable that what existed. To be sure, the authoritarian old guard that still dominates much of the Middle East could yet be forced or eased out and replaced with something relatively democratic and open. Unfortunately, the odds now seem against this happening.

What, then, can outsiders do to affect the course of events? The honest answer is not all that much. Interests are greater than influence. There is little in foreign policy more difficult than trying to steer the course of reform in another country.

That doesn’t mean that there is nothing to be done. Wherever possible wise outsiders should promote gradual political change. Constitutions need to be rewritten, checks and balances created. But economics counts as much as politics, if not more. This means providing assistance, so long as reforms are implemented. The scale of the generosity should be matched by the scale of the conditionality.

Elsewhere, it is still worth exploring further the role diplomacy can play in reducing tensions between Israelis and Palestinians. But the Quartet needs to work with, not dictate to, local parties. Launching a new negotiation is surely preferable to taking the issue to the UN General Assembly, where positions are likely to harden. In addition, the process of building a modern, effective Palestinian state from the ground up in the West Bank needs to be accelerated.

Yet the most important lessons from the Arab spring are also the simplest. Military intervention should, as a rule, be avoided. It is easier to oust a regime than it is to help put something clearly better in its place. Iraq, Afghanistan, and Libya all stand as warnings. Islamists who eschew violence should be talked to, not written off. And no one should be lulled by recent drops in oil prices: the world is only one major crisis in Saudi Arabia away from $200 per barrel oil. Governments might want to use the respite to take additional steps to reduce their dependence on the region’s energy resources. There is no better hedge against the strong possibility that it will not be springtime any time soon in the Middle East.

The writer is president of the Council on Foreign Relations and former director of policy planning at the US state department, 2001-03.

Response by Jane Kinninmont

The West must let young Arabs forge their own future

The political transitions under way in Egypt, Tunisia and Libya provide an opportunity for western policymakers to get serious about supporting democracy in the Arab world. But there is a lack of trust in western promises to support people’s aspirations for self-determination. That’s partly because of the historical record, but it also reflects continuing doubts in part of the western policy community about whether Arabs or Muslims are “ready” for democracy. Much the same was said about Catholics in Latin America in the past – a view now consigned to history.

Western analysts need to rethink their fixation on “Islamists” – a catch-all term so wide it is barely useful. They may praise secular, liberal groups today, but when these groups actually dominated the political scene in the 1950s and 1960s – their influence stretching from Egypt to Bahrain and Oman – the West opposed them too, because they were deemed too nationalist, too anti-colonialist and too leftwing.

The record in the long term has not been to oppose Islamists per se, but to oppose popular movements that have sought to challenge western dominance. Genuine support for democracy also means supporting the right of people to vote for parties that we don’t like.

Indeed, if the army and the Islamists are the most powerful political forces in Egypt today, this is because of the policies of the Mubarak government – a government that the West supported and an army that it closely cooperates with – which invested heavily in building up a huge security state, trained to crush dissent. Politics therefore moved into the mosques.

The role of the Egyptian army is certainly a concern, and military human rights abuses are worrying. However, the military council has also proved susceptible to pressure from a new force: a newly energised public that can no longer be painted as apolitical, apathetic and submissive. The council’s recent rejection of loans from the International Monetary Fund followed pressure from civil society groups who argued an interim military government lacked the legitimacy to tie the country into conditionality. Assuming that fair elections are on their way, the Muslim Brotherhood too will have to change. Its own hierarchical structure was developed to cope in a context of repression. Already, new factions are emerging from the movement.

Mr Haas argued that “wise outsiders” should promote gradual political change, with checks and balances and new constitutions, as well as ensuring any economic assistance comes with conditionality on western-supported economic reforms. It’s not clear to me why young Arabs who were attacked with US-made tear gas should trust the “wise outsiders” who have a record of supporting unpopular, corrupt and brutal regimes.

However, strong constitutions, protections of the rights of minorities, and provisions against what Alexander de Tocqueville called the “tyranny of the majority” are certainly important. The good news is that Egyptians and Tunisians are already working on these issues themselves. In Egypt, both Mohammed ElBaradei and Al-Azhar, the ancient Islamic university in Cairo, have proposed bills of rights. Meanwhile, top lawyers and civil society campaigners are working unpaid to draft suggestions for anti-corruption legislation. The new-found energy of Egyptian civil society is breathtaking, and the outside world needs to listen to them more.

The writer is senior research fellow at the Middle East and North Africa programme at Chatham House.

Like a video game in which the combatants periodically ascend to a higher, more intense level, the budget talks in Washington have ratcheted up, with Barack Obama now engaged in direct talks with Republican leaders. And while the initial goal of an agreement by July 2nd has been missed, the president has successfully bullied the Senate into cancelling its Independence Day recess and returning to Washington today, allowing negotiations to resume early this week.

As the equanimity in financial markets is signalling, some deal to avoid default will probably be cobbled together; the consequences for America and for the world of failing are just too great.

But even if the talks succeed, the outcome will do far less to address America’s fiscal problem than was hoped when the formal discussions were launched under vice-president Joe Biden’s leadership in April.

Back then, the goal was to achieve at least $4,000bn of deficit reduction over the coming decade, consistent with the proposals of the National Commission on Fiscal Responsibility and Reform, better known as the Bowles-Simpson Commission.

The recommendations of that bipartisan, blue ribbon panel  – an unprecedented package of spending reductions and new tax revenue – garnered considerable press attention and little support from the Obama administration or the Republican leadership. An even more ambitious budget proposal, from the Republican chair of the House budget committee, Paul Ryan, received similar treatment.

Now, with each passing week, expectations of the outcome of the Biden talks have steadily reduced and the $4,000bn goal seems ludicrously out of reach. Smoke signals emerging from the surprising silence surrounding the talks suggest that the two sides have “soft circled” about $1,000bn of spending reductions, while remaining deadlocked over the inclusion of new revenues.

Absurdly, Mr Obama’s modest suggestion of eliminating a bunch of tax subsidies for corporations and wealthy individuals has been met by howls of opposition from Tea Party Republicans, insisting that nothing that looks or smells like a tax increase would be acceptable.

This is all both dispiriting and ridiculous. Even under Bowles-Simpson, Washington’s debt would still rise from $9,000bn in 2010 to $15,100bn in 2020. The Republican opposition to new revenues is not only wrong on policy grounds, it is also irresponsible.

The numbers simply don’t work without tax increases. Similarly, while Democrats have shown modestly more flexibility toward cuts in Medicare, their accommodation stops well short of the surgery that is needed in both health care entitlements and Social Security.

A disproportionate amount of the coverage of the budget talks has focused on the messiness of the American process. The problem is not the process, the problem is the outcome. All the sound and fury would be more amusing if it signified something.

Alas, it appears to signal only that America’s fiscal challenges remain just as daunting as they were before the last months of political theatre. The coming presidential election augurs poorly for major reform before 2013. The first job of the new president will be to lead the country to a more responsible place.

The writer contributes a monthly column to the FT and was formerly counsellor to the secretary of the Treasury.

Response by Sebastian Mallaby

Republicans are playing with fire as they flirt with not raising the debt ceiling

Steve Rattner rightly sums up the frustrating US budget negotiations – frustrating not just because they are so torturous but because they are unlikely to deliver serious deficit reduction. Yet he omits the most bizarre aspect of this drama: the idea, popular among some Republicans, that it would be fine not to raise the federal debt ceiling and leave the government’s borrowing authority to expire.

If the do-nothing caucus gets its way, the federal government will have two options when the national debt hits its permitted ceiling next month. Either it can cut spending in order to get by with no further borrowing, or it can default on its debt-service obligations and use the savings to keep financing government programmes. To some Republicans, perhaps, the first option sounds like a Reaganite triumph – a case of “starving the beast” of public spending – while the second option might sound like just retribution for the evil money lenders who engineered the financial crisis. But the truth is that both spending cuts and default lead directly to mayhem.

If the government went for the starve-the-beast option, the sudden contraction in public spending would send the economy off a cliff. The federal budget deficit is running at around 9.3 per cent of gross domestic product. Balancing the budget implies taking a huge slice of total demand off the table at a time when growth is already weak. If the prospect of a deep recession does not worry the deficit hawks, perhaps they should remind themselves that a sharp contraction in output implies an increase in debt to GDP.

If the government went for the default option, the consequences could be even more extreme. Investment portfolios all over the world are constructed on the assumption that US treasuries are the risk-free benchmark; other financial assets are priced in relation to them. But if risk-free becomes risky, portfolio managers will lose their moorings. Where will they turn for a reliable store of value? They can not buy renminbi bonds and there are not enough German euro bonds. Will they bid gold up to even sillier levels than it has reached already? The confusion and panic could make the aftermath of the Lehman Brothers bankruptcy look like a picnic.

In today’s Financial Times, Gideon Rachman draws attention to the similarities between the debt traumas in the United States and Europe. But one hair-raising contrast is surely worth noting. In Europe, policymakers are bending over backward to finesse their way out of a Greek default, even though Greece is a marginal player in the international financial system. In Washington, meanwhile, some members of Congress appear alarmingly unalarmed about the prospect of a US default, even though the US is the issuer of the world’s dominant reserve currency.

The writer is an FT contributing editor and a director of the Maurice R Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations. He is the author of ‘More Money Than God‘.

The European Parliament will on Tuesday be asked to endorse an increase in the European Union’s target for greenhouse gas reductions, from 20 to 30 per cent by 2020, compared to 1990. This makes good economic sense, and would be a major step forward in the battle against climate change — but 20 per cent is not enough, and the EU must now move quickly to make more ambitious cuts in their emissions.

The problem is that the existing 20 per cent target is too low, making it very difficult for the EU to reach its ultimate target of reducing emissions by 80-to-95 per cent by 2050. Yet here the economic downturn has created an unexpected opportunity to make more progress: annual EU emissions in 2009 were actually 7.1 per cent lower than the year before. Emissions did rise again last year, but Europe is now on a significantly lower carbon path than before the financial crisis. This means the 30 per cent goal is now easier to reach.

The argument that the EU cannot afford a more ambitious target is simply wrong. The European Commission says the new goal would “cost” €81bn, or 0.54 per cent of EU gross domestic product, up from €70bn for the 20 per cent target. But this should be understood as an investment.

Europe badly needs a new growth strategy, and this target would send a strong signal to the private sector, strengthening confidence in the returns from investing in low-carbon technologies and infrastructure. The EU also needs to upgrade its power infrastructure, and faces a choice between reliance on fossil fuels or developing renewable energy sources that offer greater security of supply.

Confirming the EU’s plan would put Europe in the vanguard of a technological transformation set to drive global economic growth over the next few decades: the low-carbon industrial revolution. It would also add great momentum for change in countries outside of Europe, creating opportunities for those that embrace these new technologies.

Opponents claim that companies will be unable to bear the additional costs, and will leave. But the evidence shows that the costs of complying with environmental regulations over the past few decades have been far outweighed by other factors that boost profitability, such as the wider investment climate and the availability of skilled labour.

In truth, the exit fear is being played up by companies pleading their own particular short-term self-interests. The relatively small number of companies that genuinely are badly affected can and should be helped to adjust through targeted measures. But if they do not change, they too will ultimately miss out on major technological advances and could eventually be shut out of “cleaner” markets.

The real risk here is that Europe, without further action, will soon be surpassed by countries like China and South Korea, as they invest heavily in low-carbon technologies. The history of past waves of technological change shows that investment flows to the pioneers. It is this understanding of the opportunities of this transformation that underpins the important agreements on green technologies established by Angela Merkel, the German chancellor, and Wen Jiabao, the Chinese premier, earlier this week.

While the 30 per cent target by 2020 provides a clear signal and will strengthen EU Emissions Trading System carbon prices, it should be buttressed by urgent action in promoting energy efficiency and new technologies across the whole European economy as well as developing a new, smart and efficient, pan-European smart grid.

We must also remember the big picture. While all of the major emitters — including the two largest, the US and China — have made pledges for 2020, global plans are not enough to give a 50-50 chance of avoiding global warming of more than 2°C, compared with the mid-19th century.

Today, emissions match a path that, if sustained for the rest of the century, would actually bring a 50-50 chance of a warming of more than 4°C — a temperature not seen on Earth for more than 30m years, risking severe damage and dislocation to the lives and livelihoods of hundreds of millions, if not billions, of people across the world. The risk is a warmer world of severe and extended conflict, and massive migration, where any attempt at “high-carbon growth” is likely ultimately to destroy itself.

Tuesday’s vote at present is thought to be close, while a clear vote in favour would exert pressure on any waverers in the European Council, thought to include Poland, which currently holds the EU Presidency. Without a strong vote in favour, and then support at the Council, the risk is that we could go into the UN conference in Durban in December with the EU looking divided and equivocal instead of united and strong on emissions reductions.

The decision that the European Parliament and other policymakers face is whether the EU should join the front runners in the low-carbon race, or lag behind. The history of technological change shows that industrial revolutions are periods of great creativity, learning, innovation, investment and growth. Competitive advantage goes to the pioneers. Europe must now do more, or risk being overtaken by those who do.

The writer is I.G. Patel Professor of Economics and Government and chair of the Grantham Research Institute on Climate Change and the Environment at the LSE.

Response by Neil O’Brien

Europe’s self-sacrifices are in vain if China’s emissions continue to accelerate

Nicholas Stern shows neatly how the intellectual mistakes of current climate change policy all reinforce one another. Climate change is a real problem, but current policy is the wrong way to address it.

Let’s start from the top. On a consumption basis, emissions from the European Union’s six largest economies have risen 47 per cent since 1990, not fallen. As industry has shifted east, domestic production of carbon emissions has decreased. But it is a bit odd to complain about the emissions of China when much of their production is for our consumption. We are deluding ourselves if we believe that it is virtuous to outsource our emissions to a less efficient economy with much higher energy and carbon intensity. This is not real progress.

Jacking up domestic energy in the EU costs would further accelerate this trend. In 1990 it might have been plausible that the billions of people in developing countries living on a dollar a day would soon be inspired to follow our example and reduce their emissions and their economic growth. But after 21 years of failure, with no signs of an emissions cap in developing countries, this idea has surely had its day.

Mr Stern mentions that China has set a “target”, but he omits to mention that this (non-binding) goal allows its emissions to more than double within nine years. Remember that the country is already the world’s largest emitter. In this context, further self-sacrificing moves like the shift to a 30 per cent target in Europe are almost the contemporary equivalent of unilateral nuclear disarmament.

Let us assume that the European Commission is right in saying that the cost of the 30 per cent target is a mere €81bn. Even if that is true, it is difficult to see this as an “investment”. The nature of the EU’s 2020 targets and the policies that support them – particularly the renewables target – inevitably mean heavily subsidising the mass roll-out of known technologies.

In the UK’s case, this is principally offshore wind, an expensive technology which has limited potential to get cheaper, and also limited global relevance. Mr Stern also rejects the point that industry will leave because of these costs, but this seems wishful at best.

It is time to stop thinking like this is still 1990, and only the North Atlantic region matters. Most importantly it is also time to stop thinking of the climate debate in self-sacrificial terms of “if it’s not hurting, it’s not working”. But to do this, and for Europe to have any impact on the path of global emissions in this century, we need to put our effort into developing new technologies that developing economies will actually want to use.

Unlike current European and UK policy, heavier spending on research and development actually could be an “investment”, meaning that it could yield a return. More direct investment in innovation is really the only realistic way the very real problems Mr Stern describes can be avoided.

The writer is director of Policy Exchange, a UK-based think-tank focused on public policy.

The decision by Harry Reid, the majority leader in the Senate, to cancel next week’s planned recess in order to advance discussions on the US debt ceiling is a welcome indication that Washington is beginning to view the debt issue with more urgency. Viewed from overseas, the American political system has started to appear dysfunctional in recent weeks.

Democracy is inherently a messy process, but it is still unsettling for foreign holders of US debt to see the Congress openly discussing whether there might be advantages in forcing the Treasury to “prioritise” its future payments so that the flow of interest obligations can be maintained. As Tim Geithner, Treasury secretary, has pointed out, “prioritisation” means that the US would fail to meet many of its domestic obligations which have previously been legislated. That would be taken as a strong signal of a nation in financial distress. Even worse, there would be an immediate deflationary shock to the system of up to 10 per cent of gross national product as the budget deficit is forcibly closed, which would certainly send the global economy back into recession.

No one seriously believes that any of this will be allowed to happen. But the atmosphere of political posturing does not build confidence that the longer-term problems in the US public accounts can be seriously addressed. And the country might one day need all the foreign confidence it can get. According to this week’s International Monetary Fund report on the American economy, a fiscal consolidation of 7.5 per cent of GDP will be needed to stabilise the debt ratio in the next five years. Washington should be focused on how and when such an adjustment should occur instead of attempting to score empty political points on the debt ceiling.

On this more important question, the experience of the UK is instructive. Faced with many of the same fundamental problems as the US, the coalition government in the UK has already embarked on a fiscal tightening of roughly the same scale as the IMF is now recommending for the US. Accompanying this fiscal tightening, the UK  has simultaneously eased monetary policy dramatically, and encouraged a 20 per cent devaluation in the sterling exchange rate. In contrast, the Obama administration has avoided any fiscal tightening, on the grounds that the economy is too weak to absorb this.

So far, the slower American approach to fiscal tightening seems to have worked rather better than the faster British approach. Real GDP growth in the US has been maintained at about two per cent, while growth in the UK has virtually ground to a complete halt. With both countries clearly still handicapped by a severe shortage of demand, the absence of any fiscal tightening in the US may account for its superior recent growth performance.

But, in the longer term, the British approach may prove its worth. Because the medium-term fiscal adjustment programme has improved market confidence, the UK could have increased room for manoeuvre to adopt further quantitative easing if the economy weakens further, even if inflation remains temporarily high. And the automatic fiscal stabilisers could be allowed to work, without necessarily casting doubt on the sustainability of fiscal policy in the long run. Finally, the shift in the fiscal/monetary mix is helping to maintain a competitive exchange rate, which is a key requirement for the rebalancing of the British economy, as indeed it is in America.

The Federal Reserve and the IMF have both advised the political system in Washington to embark on a credible programme of fiscal consolidation, while avoiding a tightening in the fiscal stance which is too sharp in the immediate future. The IMF, and probably the Fed, see this as the precondition for a prolonged period of monetary accommodation, and (secretly) both would probably be happy to see a drop in the US dollar. None of this can be accomplished while Washington remains gridlocked, even if the Senate does cancel its vacation next week.

The writer is chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners.

Response by Mark Thoma

Austerity Can Wait for Sunnier Days

I agree with Gavyn Davies that America has much to gain if Congress can make progress on the long-run budget problem. But I disagree on how soon the required austerity needs to begin.

Mr Davies acknowledges that “so far, the slower American approach to fiscal tightening seems to have worked rather better than the faster British approach,” and then he says, “But, in the longer term, the British approach may prove its worth.”

Though the basis for it is different, the argument is, essentially, the same as Carmen Reinhart’s. They argue that, yes, austerity is painful in the short-run but putting off the adjustments needed to bring the budget under control makes things even worse. Thus, painful as it is, immediate austerity reduces the chances of even bigger problems down the road.

I disagree with them that immediate austerity is needed. The long-term budget problem in the US is driven mainly by rising health costs, and we have many years to go before this begins to create big budget problems. Thus waiting, say, two years to begin reducing the deficit will not substantially change the probability of big problems down the road. But delaying austerity measures avoids placing a further drag on an already struggling economy, so the likely benefits are relatively large.

One of the arguments for austerity is that it would give the Federal Reserve “increased room for manoeuvre to adopt further quantitative easing if the economy weakens further”. I agree that the Fed fears being placed in the position of appearing to monetise the debt, but again I do not think immediate action is needed. A budget plan that both political parties can agree to, which is implimented only when the economy is stronger, would do a lot to give the Fed the confidence it needs to act.

I think the Fed should do more than it has been doing in any case, but it does appear that a credible budget plan is a precondition for the more hawkish members to even consider doing more.

The writer is professor of economics at the university of Oregon.

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