Monthly Archives: September 2011

Financial markets are driving the world towards another Great Depression with incalculable political consequences. The authorities, particularly in Europe, have lost control of the situation. They need to regain control and they need to do so now.

Three bold steps are needed. First, the governments of the eurozone must agree in principle on a new treaty creating a common treasury for the eurozone. In the meantime, the major banks must be put under European Central Bank direction in return for a temporary guarantee and permanent recapitalisation. The ECB would direct the banks to maintain their credit lines and outstanding loans, while closely monitoring risks taken for their own accounts. Third, the ECB would enable countries such as Italy and Spain to temporarily refinance their debt at a very low cost. These steps would calm the markets and give Europe time to develop a growth strategy, without which the debt problem cannot be solved.

This is how it would work. Since a eurozone treaty establishing a common treasury would take a long time to conclude, in the interim the member states have to appeal to the ECB to fill the vacuum. The European Financial Stabilisation Fund is still being formed but in its present form the new common treasury is only a source of funds and how the funds are spent is left to the member states. It would require a newly created intergovernmental agency to enable the EFSF to cooperate with Europe’s central bank. This would have to be authorised by Germany’s Bundestag and perhaps by the legislatures of other states as well.

The immediate task is to erect  the necessary safeguards against contagion from a possible Greek default. There are two vulnerable groups – the banks and the government bonds of countries such as Italy and Spain – that need to be protected. These two tasks could be accomplished as follows.

The EFSF would be used primarily to guarantee and recapitalise banks. The systemically important banks would have to sign an undertaking with the EFSF that they would abide by the instructions of the ECB as long as the guarantees were in force. Banks that refused to sign would not be guaranteed. Europe’s central bank would then instruct the banks to maintain their credit lines and loan portfolios while closely monitoring the risks they run for their own account. These arrangements would stop the concentrated deleveraging that is one of the main causes of the crisis. Completing the recapitalisation would remove the incentive to deleverage. The blanket guarantee could then be withdrawn.

To relieve the pressure on the government bonds of countries such as Italy, the ECB would lower its discount rate. It would then encourage the countries concerned to finance themselves entirely by issuing treasury bills and encourage the banks to buy the bills. The banks could rediscount the bills with the ECB but they would not do so as long as they earned more on the bills than on the cash. This would allow Italy and the other countries to refinance themselves for about 1 per cent a year during this emergency period. Yet the countries concerned would be subject to strict discipline because if they went beyond agreed limits the facility would be withdrawn. Neither the ECB nor the EFSF would buy any more bonds in the market, allowing the market to set risk premiums. If and when the premiums returned to more normal levels the countries concerned would start issuing longer-duration debt.

These measures would allow Greece to default without causing a global meltdown. That does not mean that Greece would be forced into default. If Greece met its targets, the EFSF could underwrite a “voluntary” restructuring at, say 50 cents on the euro. The EFSF would have enough money left to guarantee and recapitalise the European banks and it would be left to the International Monetary Fund to recapitalise the Greek banks. How Greece fared under those circumstances would be up to the Greeks.

I believe these steps would bring the acute phase of the euro crisis to an end by staunching its two main sources and reassuring the markets that a longer-term solution was in sight. The longer-term solution would be more complicated because the regime imposed by the ECB would leave no room for fiscal stimulus and the debt problem could not be resolved without growth. How to create viable fiscal rules for the euro would be left to the treaty negotiations.

There are many other proposals under discussion behind closed doors. Most of these proposals seek to leverage the EFSF by turning it into a bank or an insurance company or by using a special purpose vehicle. While practically any proposal is liable to bring temporary relief, disappointment could push financial markets over the brink. Markets are likely to see through inadequate proposals, especially if they violate Article 123 of the Lisbon treaty, which is scrupulously respected by my proposal. That said, some form of leverage could be useful in recapitalising the banks.

The course of action outlined here does not require leveraging or increasing the size of the EFSF but it is more radical because it puts the banks under European control. That is liable to arouse the opposition of both the banks and the national authorities. Only public pressure can make it happen.

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

Response by Gavyn Davies

A radical plan that would take Europe all the way to economic union

George Soros has certainly recognised the seriousness of the eurozone crisis , and has suggested  a really radical plan of action. But it faces enormous obstacles.

Under these proposals the eurozone would become a genuine nation state, at least from an economic viewpoint. Fiscal policy would eventually be set by the zone as a whole. The banks would be forcibly recapitalised, using common funds from the EFSF. These banks would then be required to make loans as directed by the ECB, which would take on the role of a super regulator of the entire eurozone banking system. Finally, the ECB would provide liquidity to the banks, enabling them to fund Italian and Spanish budget  deficits by buying those countries’ treasury bills.

It also seems that the commercial banks would be heavily “encouraged” to finance budget deficits in the weakest economies.The eurozone would therefore have a common fiscal policy; part or wholly-nationalised banks; a single financial regulator; and a central bank which would indirectly monetise the budget deficits of several member states.

If Europe were a genuine nation state already it might have already implemented parts of this plan, somewhat like the US actually did in the dark hours of 2008. But the Soros proposal would require Germany and France to accept the principle of making some very large fiscal and monetary transfers to the periphery. They would also need to accept the monetisation of budget deficits, and (to say the very least) a dirigiste approach to commercial bank ownership and regulation.

If they were ready to do any of this, the crisis would already have been solved. And even in the eurozone, surely none of this could be done without reference to the electorate. After all, it would take the zone’s economic policy all the way to that of a full political union.

The writer is a macroeconomist, co-founder of Prisma Capital Partners and former head of the global economics team at Goldman Sachs

Martin Wolf talks to Lawrence Summers about the European crisis

The European Commission has not distinguished itself during the eurozone crisis. Such leadership as we have seen has come from national governments, or indeed from Washington, where both Christine Lagarde, International Monetary Fund president, and Tim Geithner, US Treasury secretary, have shown initiative and urgency,  rather than from Brussels. Now, in what looks to be a make-or-break week for the whole euro project, commissioner Michel Barnier’s contribution has been to propose extending the French system of joint audits across the continent. Fiddling while the Treaty of Rome burns doesn’t quite capture it.

José Manuel Barroso, European Commission president, now seems to have an answer to the “what did you do in the war, daddy” question. He has proposed, for the umpteenth time, a financial transactions tax.  The tax would raise, he assumes, about €50bn, half of which would go back to member states, and half would end up in his own pocket at the commission.

How good an idea is this? And if it is a good idea, is this the right time to advance it? To take the timing point first, it is clear that Mr Barroso needed to have something to say to the European parliament in his “state of the union” address. Leaving aside the folie de grandeur aspect of this packaging, the timing has otherwise little to commend it.

The tax cannot be a realistic part of the new settlement needed to save the single currency; indeed it plays into the hands of those who argue that European policymakers simply do not understand the pace of events. And since Mr Geithner has made it clear that the US wants no part of such a tax, there is a risk of further damage to transatlantic relations, already poor, at a time when a coherent global response to the economic slowdown is of paramount importance.

So the time is not ripe, but what of the principle? There is a Colbertian appeal to Tobin taxes. Why not take a tiny sliver off every financial trade? The golden goose will  hardly notice and its hisses will be drowned out by the boos of the crowd baying for bankers’ blood. It seems likely to throw sand in the wheels of some potentially dangerous financial activity, notably high frequency trading, surely one of the dullest ways of making a living that mankind has so far devised.

Yet  you cannot take €50bn out of the economy without a significant economic impact. James Tobin distanced himself from those who wanted to adopt his tax as a disguised revenue raiser. Mr Barroso clearly sees it as an added tax, not a redistribution of the burden. And he has not offered a solution to the avoidance obstacle. If there is no parallel imposition in New York, the cost to Europe of displaced activity could be large.

If these problems could be overcome, a financial transactions tax might be a useful addition to the Treasury’s armoury. After all, stamp duty has not destroyed the London equity market. But Barroso’s presentation of the idea in this way, at this time, will do nothing to advance the cause.

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

Response by Tim Leunig

A very low level Tobin tax is a proposal worth considering

A Tobin Tax (opposed, of course, by Tobin) is back on the agenda. For many, support for or against is an article of faith. Yet as others have noted, stamp duty is the equivalent of a Tobin Tax on share trading in Britain. It offends economic theory, the market doesn’t like it, but London survives perfectly well.

The reality is that London’s other advantages outweigh the disadvantage of stamp duty. The question is whether this holds for European forex trading as well as it holds for share trading in London. The answer is basically yes. Time zones matter and Europe’s forex trading is unlikely to move en bloc either east or west and there is no strong financial centre to the south.

A small Tobin tax is therefore feasible. Note the word “small”. Every tax has a Laffer curve. If you tax the poor too heavily, they choose to live on benefits. If you tax forex transactions too heavily, some trade and traders will move away. That matters: traders earn a lot of money, and pay a lot of income tax.

Over a quarter of UK income tax receipts come from the highest earning 1 per cent. Scaring the golden goose away does not make sense. Once they have gone, it is hard to get them back. For that reason any Tobin tax should begin at a very low level, say one tenth of the level suggested by Barroso. That is a proposal that would be worth considering

Whether the money should go to the UK government, the European government or to development is a separate matter. One imagines that Osborne’s objections might be more limited were the money to arrive in his coffers, allowing him to cut other taxes that we know harm the economy.

The writer is chief economist at CentreForum, the liberal think tank

Despite the Greek parliament’s support last night for an unpopular new property tax, Europe’s divisions over the terms of any new bailoutgive credence to talk of a looming euro exit. But such an exit would be terrible news for Greece, and equally terrible for the eurozone. The bottom line is this: Greece isn’t going anywhere.

First, no legal framework exists for an exit from the euro. Greece would have to negotiate with its eurozone partners, and most likely with the 27-member European Union. It would be a prolonged and messy process, creating a political and economic drag for everyone involved.

If Greece were to leaves the eurozone, sovereign default would also be accompanied by corporate default. Shutting down the country’s banks will be complex, costly and contagious. Also, Greece is a democracy. This makes things even messier.

Yet even if Greece could pull off this technical feat, what would it stand to gain? As the argument goes, Greece could reinstate the drachma, devalued relative to the euro. This would make Greek exports more competitive, and could ultimately put the country back on sound fiscal footing.

The problem with this line of argument, however, is that Greece actually is less exposed to international trade than any other eurozone country. Only €16bn of its €230bn gross domestic product is export-based. True, the tourism industry does comprise a significant 15 per cent of GDP, but a devaluation would have limited upside against Greece’s less expensive Mediterranean competitors such as Turkey.

Worse, Greece has a mountain of debt denominated in euros. A switch to a new drachma would not change this. In fact, the drachma’s devaluation would only make the debt that remains that much harder to pay off.

Any limited competitive advantage gained by euro exit (and devaluation) would not hold for long. And that wouldn’t be the end of it. Post-exit, the rest of the eurozone and EU would punish Greece by imposing tariffs, while Greece would also lose EU structural funds.

Tellingly, the Greeks have tried this experiment before. In the 1980s, the country went through a process of devaluation and inflation. But it failed to improve competitiveness, while high inflation eroded citizens’ savings. Today the same would happen: depreciation would not help much with exports or debt, but it would kill domestic demand and send inflation much higher, further undermining domestic spending, savings and standards of living.

Despite huge public anger over austerity measures, the consensus in Athens recognises the lack of logic – or support – for a euro exit. The only faction of parliament promoting an exit from the EU is the Communist Party of Greece (KKE), which has 21 of the 300 parliamentary seats. In the latest opinion polls, 60 per cent of the Greek population still favours the euro.

Greece, therefore, has zero interest in leaving. On the other side, while Greece may be in trouble with its eurozone neighbours, it will not be punished with expulsion. Indeed, the eurozone’s core countries have ample incentive to keep Greece in the club – and even bar the exits.

Why would Portugal or Ireland let Greece go, shifting the savage market spotlight to themselves? More importantly, why would Germany agree? German exports — the lifeblood of the eurozone — would decline as a result of the currency appreciation precipitated by a Greek exit. On a broader level, if Greece left the eurozone, it would set a very dangerous political and economic precedent for other debt-ridden countries — Italy in particular.

The end result of all this? Don’t listen to the doom and gloom merchants. Greece’s ratio of debt to GDP may have topped 150 per cent, but its eurozone status remains 100 per cent secure.

Greece will stay put. It is the smart decision. Indeed, it is the only decision.

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

Response by Sony Kapoor

The Greek crisis has distracted us from the much more serious problems facing the eurozone’s banks

Like Ian Bremmer, and for many of the same reasons, I too have argued that Greece’s future is firmly within the eurozone. That said, however, thinking through the costs that Greece’s problems have imposed on the eurozone as a whole offers some insights into the stance euro-exit fantasists have taken, and highlights the urgency of decisively addressing these issues.

Some argue that without the revelation of Greece’s hidden fiscal problems the European sovereign debt crisis may never have happened. That is not entirely credible. While Greece did light the match, the European edifice was made of highly flammable material. With excessively large and under-capitalised banks, persistent structural imbalances and a governance structure that was designed to take decisions in peacetime, not handle crises, European financial stability was vulnerable to a host of triggers. With hindsight we might actually be grateful to Greece for highlighting these vulnerabilities before an even bigger crisis struck.

On a more serious note, it is now clear that the revelation of Greece’s fiscal problems was responsible for prematurely turning the European narrative of the crisis into a fiscal one, neglecting that fact that this was first and foremost a banking crisis.

It distracted us from addressing the vulnerabilities in our banking system, which have now come back to haunt us. Sensible options, such as imposing moratoriums on bank dividends and bonus payments so as to coerce banks into building up capital, were rejected as policy makers focused on sovereigns.

Having viewed all subsequent problems through the tainted lens of Greece’s problems, European leaders have wrongly concluded that fiscal profligacy is at the root of the crisis and that austerity is the right medicine. Banking, not fiscal, problems lie at the heart of the Spanish and Irish crisis. A lack of growth has driven Portugal over the edge. The now-standard prescription of and the single-minded focus on austerity is hugely damaging.

Even more damaging is the mistrust that has been built up and the waste of scarce political capital that has resulted from the complete failure of European Union’s policy makers to handle what remains a containable crisis. This has poisoned the atmosphere and made decisions on other more important issues harder to reach. It has also eroded market confidence, perhaps permanently. If policy makers cannot be trusted to handle the relatively small problems of Greece over an 18 month period, how can anyone trust them to handle the much bigger and more urgent challenge posed by Italy?

Greece’s problems have been eating away at the European project from the inside, like a cancer. But, like Mr Bremmer, I think that surgery in the form of exit from the eurozone is not an option. The cancer will respond to non-invasive treatment within the currency union. This needs to take the form a reduction in debt stock, EU support for investments and growth-enhancing reforms.

The writer is managing director of Re-Define, a think tank, and a visiting fellow at the London School of Economics.

It’s the eve of Rosh Hashanah, the Jewish New Year, so in the interest of a happy one amid the gathering global gloom can I make a request of Republican Christian evangelical politicians professing to be friends of Israel? Next time the temptation to sound off on the best interests of the Jewish state strikes, CAN IT! Israel has enough on its plate without being exploited as campaign fodder by blowhards who, every time, they open their mouths on the subject reveal their shocking ignorance of its past history, present political reality and future security.

According to Mitt Romney, Barack Obama has “thrown Israel under the bus”. Was he even listening to the president’s speech at the UN? To what, precisely could even the most hardline defender of Israeli foreign policy take exception, exactly?

Or take governor Rick Perry who lately has used every opportunity available, to denounce President Obama’s Middle East policy as some sort of betrayal of the Jewish state. This new-found vocalisation comes hard on Mr Perry’s response to a question about the potential for the Taliban to secure Pakistani nuclear weapons that consisted of comments so inanely incoherent that by comparison they made Sarah Palin look like Henry Kissinger. Somebody in Mr Perry’s entourage has discovered the phrase “moral equivalence” as the governor can’t stop using it every opportunity he gets to assert that President Obama treats Palestinian grievances and Israeli concerns with impartiality. Just setting aside the fact that no one in Israel (and in the Jewish community world wide) would deny that Palestinians have suffered tragically over the past half century, Mr Perry’s assertion that President Obama treats rocket attacks by Hamas and Jewish settlement construction on the West Bank as “equivalent” threats to peace is manifestly absurd and unfounded.

But then Mr Perry – and others among the evangelicals aspiring to the White House like Michelle Bachmann – share the fundamentalist vision of the settlers themselves that they are fulfilling a Biblical covenant on the “Land of Israel” when they evict Palestinian villagers, demolish their houses, bulldoze their olive groves and embitter the possibility of any future coexistence of the two peoples in their own respective states.

Mr Perry is fond of calling President Obama “naive” but every time he opens his mouth on this subject he reveals his comical unfamiliarity with what has actually been happening in Israeli-Palestinian relations over the past 20 years. Insisting on “direct negotiations” between the parties, he fails to notice that that is exactly what happened at Oslo and at Sharm el-Sheikh. In both cases the Palestine Liberation Organisation formally recognised Israel’s right to exist and to live in peace and security within mutually-agreed borders. When he upbraids President Obama for saying that the starting point of those frontiers ought to be the Green Line of 1967; that has been exactly the position of Israeli and US governments (including Republican administrations) for a long time; with adjustments made through territorial swaps. That was the basis on which Ehud Olmert - not exactly a pinko peacenik – and Tzipi Livni negotiated with Mahmoud Abbas in 2008.

If not made on the basis of the 1967 frontier, then it is incumbent on the likes of Mr Perry, Mr Romney and Ms Bachmann to say where secure boundaries might lie that would not involve the permanent Israeli occupation of the West Bank, inhabited as it is by a large Palestinian population? No Israeli government with any sense of a secure future – from Menahem Begin to Ariel Sharon to Mr Olmert – has clung to the dangerous fantasy of annexation, involving as it must either the subjugation of a permanently alienated population or their catastrophic and immoral displacement.

But of course there are those among the most feverishly intransigent and irredentist Jewish settlers who dream and speak of nothing else and, like the Christian evangelicals, invoke the scriptural covenant promising “Judea and Samaria” to the Jews as enough of a warrant on which to base foreign and domestic policy. They represent the Israel Mr Perry, and Ms Bachmann have in mind when they purport to defend its future.

There is of course, another Israel entirely, increasingly impatient with the settlers and with the ultra-orthodox who bear none of the burdens of serving in the military, yet sustain their religious schools from public funds while the rest of Israel’s people live in increasing economic distress as the furious mass demonstrations against Benjamin Netanyahu’s government made abundantly clear. But to the likes of the radio ranter Glenn Beck who had the chutzpah to present himself as “restoring courage” to Israel (I hadn’t noticed that it had lost it) near the Western Wall in August, those hundreds of thousands of Israelis must have been stooges of the “hard left”. According to polling done by the Harry Truman Institute of the Hebrew University of Jerusalem in May 2010, a clear and growing majority of Israelis are willing to dismantle the majority of West Bank settlements as part of a comprehensive peace policy.

To Texas evangelicals like Pastor John Hagee who led the prayer assembly that kicked off Mr Perry’s campaign, and who presides over Christians United for Israel, this secular, tolerant, pragmatic, culturally daring ethnically diverse Jewish nation is not the authentic Israel at all. When Tel Aviv stages a massive and spectacular gay pride march, it turns into Sodom and is in the same state of “rebellion” against God’s commandment that Mr Hagee in his Jerusalem Countdown asserted had been the origin of anti-semitism. (Ah, so it’s the fault of the Jews, I see).

This, of course, is the real divide in the politics of the Jews, as in the politics of Muslims and the politics of the US: between zealots and pragmatists; between those who ultimately shape their policy in accordance with revelation and those who depend on reason. When Mr Perry says “as a Christian I have a directive to support Israel”, we know that it’s the Campaign Manager Up There who is whispering in his ear. If these were normal times and he was just another doctrinally-driven fundamentalist we could leave him, and rest of the evangelical tribe to their own imaginings. But they are aspiring to the presidency of the United States and are in a position, even before the campaign gets going in earnest, to do terrible harm to the people they profess to hold so close to their hearts.

So leshana tova to you governor Perry but if you want to give the Jews anything approaching a Happy New Year, for God’s sake give it a rest.

The writer is an FT contributing editor and best-selling author of books about America, Britain and Israel.

Response by Tobias Buck

The unconditional Republican support poses more risks than opportunities for Israel

Benjamin Netanyahu has already managed to leverage Republican all-out support for Israel to his advantage. Over the past few months, Barack Obama’s administration has adopted a markedly less critical stance towards Israel – most notably in the context of the Palestinian bid for UN membership last week. The shift will have been motivated not least by concern that the GOP is making inroads into the Jewish vote, a particular concern ahead of next year´s presidential elections.

In the longer term, however, the unconditional Republican embrace of Israel poses more risks than opportunities for the country. That is because it threatens to undermine one of the greatest strengths of the US-Israeli relationship – the bipartisan nature of political support for Israel. Indeed, one of the very few policies on which both Democrats and Republicans can still agree even today is the paramount importance of strong ties between Israel and America. Year after year, pro-Israel resolutions in Congress are carried by Mubarak-style majorities, and with the support of deputies from both sides of an otherwise deeply-divided legislature.

That situation is, of course, unlikely to change in the near future. But Republican efforts to paint themselves as the party of authentic, unwavering support for Israel – coupled with unfounded attacks on the president´s pro-Israel record – are certain to damage Israel´s cause among Democrats and liberal American voters. Should Mr Obama win a second term in office next year, Israel may yet rue the current Republican rhetoric.

The writer is the FT’s Jerusalem correspondent.

The world markets expected concrete steps from Washington over the weekend on how governments would resolve the European crisis. They did not get it. Instead, the International Monetary Fund’s policy setting body asserted that the “Euro-area countries will do whatever is necessary to resolve the euro-area sovereign debt crisis”. Unfortunately, this statement seems to be based more on hope and prayer than on evidence.

Hope, unfortunately, cannot convince markets at times like these. With luck, Italy may get a credible government of national unity in the next few weeks, Spain will obtain a new government in November with a mandate for change, and Greece will do enough to avoid roiling the markets. But none of this can be relied upon.

So what needs to be done? First, eurozone banks have to be recapitalised. Second, enough funding has to be available so that Italy’s and Spain’s needs can be met over the next year or so, if the markets dry up. Third, Greece has to be managed in a way that does not infect the other periphery countries. All this requires financing – bank recapitalisation alone could require hundreds of billions of euros — but no new commitments were made in Washington.

In the short run, it is unlikely that Germany (and northern Europe in general) will put up more money. Germans are upset at being asked to support countries that do not seem to want to adjust – unlike Germany, which is competitive because it endured pain. It had years of low wage increases post-unification to absorb East Germany’s workers and deep labour market and pension reforms. The unwillingness of the Greek rich to pay taxes or of Italian parliamentarians to cut their own perks confirms their worst fears. At the same time, German politicians have done a poor job explaining to their people how much they have gained from being in the eurozone.

But we are where we are. A glimmer of hope in Washington was the European willingness to use the European financial stability facility imaginatively – as equity, or first loss cover. Clearly, some of the EFSF funds will have to go to recapitalise banks that cannot raise money from the markets. But of the rest, the amount that is not already committed to the periphery countries can be used to support borrowing by Italy and Spain.

There is, however, no consensus on how to do this. Some propose bringing the EFSF and the European Central Bank together, to leverage the EFSF’s funds. This is a recipe for trouble. Giving the ECB a quasi-fiscal role, even if it is somewhat insulated from losses, risks undermining its credibility. And if Italy is helped, Mario Draghi, the ECB’s incoming president, will be criticised no matter how dire the country’s needs.

Moreover, financing will have to be accompanied by stronger conditionality, and these institutions neither have the requisite expertise nor the distance from the countries at risk to apply appropriate conditions. Finally, both the EFSF and the ECB ultimately rely on the same eurozone resources for their financial strength. If markets start panicking about large eurozone defaults, they could question whether even a willing Germany has the necessary capacity to support the EFSF and ECB combined. Put differently, these institutions do not offer a credible, non-inflationary, outside source of strength.

The world has to recognise that the eurozone’s problems are too big to leave to eurozone countries alone to deal with. The world has a stake in their resolution. And it has an institution that can channel help, the IMF.

The IMF could set up a special vehicle along the lines of its current New Arrangements to Borrow, which would be capitalised by a first-loss layer from the EFSF and a second layer of the IMF’s own capital. This vehicle could borrow as needed from countries, including the US and China, as well as the financial markets. The special vehicle would offer large lines of credit to illiquid countries like Italy, with conditionality intended to help the countries resume borrowing from markets at reasonable cost.

Why a special vehicle? Because the amounts that need to be made available far exceed what IMF members usually have access to, and it is only right that if the eurozone seeks such amounts for its countries, it should bear a significant portion of any potential losses. At the same time, the IMF’s capital resources would back the vehicle if the eurozone-provided first loss buffer is eaten through, so the market will understand that there is strength from outside the eurozone that can be brought to bear.

The IMF should start taking the lead in managing the crisis rather than playing second fiddle. The eurozone should suppress any wounded pride, and not only acknowledge that it needs help but also provide quickly what it has already promised. The rest of the world should pitch in recognising that, unresolved, the crisis will spare no one. And what about Greece? Its debt will almost surely have to be restructured, but we must have the funding structures in place for Italy and Spain before any resolution. So while others have to step forward to do their bit, it is perhaps best if Greece stepped back from the brink.

The writer is professor of finance at the University of Chicago’s Booth School and author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

Response by Simon Tilford

Europe doesn’t lack funds, just political will

The current strategy for addressing the crisis has failed and International Monetary Fund’s official support for that strategy is a threat to the organisation’s credibility. But it is unclear what purpose greater IMF involvement would serve. Increased funding, as suggested by Mr Rajan, would provide a stopgap, but not a solution to the key problem facing the indebted members of the eurozone: how will they generate economic growth?

IMF involvement, along the lines suggested – additional firepower, but more of the same in terms of policy prescriptions – will not provide a long-term solution to the euro crisis but would pose a further threat to the IMF’s credibility. Why, the emerging economies would rightly ask, is the IMF getting ever more involved in what is essentially an internal European political problem? The debtors and creditors are both members of a currency union, which also happens to be one of the wealthiest regions in the world. It is up to Europe to sort out this mess. It is not that Europeans lacks the firepower to deal with the crisis: they lack the political will to acknowledge the implications of their creation.

The eurozone needs debt mutualisation, not an IMF programme. But it also needs expansionary macroeconomic policies. There is no devaluation option for the likes of Spain and Italy, so if they are to cut their costs relative to Germany – without experiencing deflation and debt traps – German inflation will need to rise more quickly than the current projections of around one per cent. Aggressively expansionary fiscal policy (in those countries with the scope) and a massive programme of unsterilized bond purchases by the European Central Bank, would help arrest the slide in stagnation and debt deflation. The inflationary implications of such a strategy should not be feared. Without some inflation, the euro is not going to survive.

The writer is the chief economist at the Centre for European Reform, a London-based think-tank.

As George Osborne prepares his big speech for the Conservative party conference in 10 days time,  the UK chancellor of the exchequer faces some momentous decisions. A year ago it seemed reasonable to hope for a brighter 2012, with the chance that next summer’s Olympic Games in London might mark a turning point on the way to sunny economic uplands in time for the general election in 2015.

Now it is clear that the growth assumptions on which his austerity package had been based were way too optimistic. So the budget numbers no longer add up, and there is a risk that British voters will go into the next election with years of falling living standards under their belts and not much benefit to show for them. The economic and social costs would be very serious. And Mr Osborne could be thinking about a new line of work.

He is a bold and ambitious politician. He cannot pretend that there are easy ways out. But nor can he accept that there is little he can do to change this gloomy picture, and that the best he can offer is a few more micro initiatives along the lines of the unmemorable growth plan launched by the coalition in the first half of the year, and then ask us to sit back for however long it takes for the storm to pass.

So what are his options?

What the economy needs now above all is a shot of entrepreneurial dynamism – a burst of activity from those small and medium-sized companies that are essential to job creation and innovation across the land. That will not come easily at a time when confidence is so low. But it has to be the objective that shapes policy for the short and medium term – and the driving force behind his message to the party faithful.

Step one is to emphasise that the austerity package is not quite as inflexible as was presented last year. Borrowing can rise above target if slow growth causes temporary shortfalls in tax revenues and rises in benefit payments. Policy will still be on track if the deficit does not close until a year later than originally promised. Debt financing costs will have been reduced by low interest rates and the savings could be used to fund badly-needed investment in the country’s infrastructure. Government assets could be sold for the same purpose – such as land or spectrum sales.

There is room for manoeuvre on the monetary side as well. Interest rates cannot be cut any further. But an increasingly strong case can be made for a further round of quantitative easing and this week’s minutes from the Bank of England’s monetary policy committee suggested that such a move was likely in the next couple of months.

All this will be helpful, but will not add up to a game changer. As Spencer Dale, the Bank’s chief economist, put it this week: “At the risk of stating the bleeding obvious, we need the banks to be working for our economy to grow and prosper.” And right now, they are not.

Net lending to businesses is still shrinking, and the interest rate on new facilities for smaller businesses is pushing over 5 per cent. This means the spread over the Bank rate has more than doubled since the end of 2008, in good part because the banks’ own funding costs have risen as tensions have spread across the eurozone. This financing problem is crushing the entrepreneurial spirit and Mr Osborne can address it in two ways.

First, he can make it clear that the job of the Bank’s new financial policy committee is to check excessive falls as well as rises in credit and debt. Lending to small businesses makes up only a tiny fraction of the big banks’ balance sheets and the capital cushion required to support such loans should be temporarily reduced.

Second, the chancellor should consider the case for a bolder approach to quantitative easing. Instead of restricting itself to buying government bonds, the Bank could be encouraged to inject finance directly into small company balance sheets, perhaps by investing in securitised bundles of loans to such businesses. This would call for a new kind of relationship between the Treasury and the Bank, which would not be able to take on such risks by itself. The need to protect the Bank’s independence should not be allowed to prevent closer collaboration between the monetary and fiscal authorities at this time of national need.

On top of these initiatives, Mr Osborne needs a big idea for the medium term. In his days in opposition, he used to emphasise his aim of turning Britain from a nation of consumers and borrowers into one of savers and investors, and that challenge is even more urgent today. The country languishes near the bottom of the global league tables of savings and investment as a share of national output and this just has to change if the economy is to be rebalanced on to a more sustainable base. Nothing can be done to fix the immediate problem, which is that with interest rates close to zero and inflation running at 5 per cent, savers today are getting a terrible deal.

But now is the time to start working on the big picture – practical steps towards a different and more prosperous future. And right on cue, the Institute for Fiscal Studies published this week the final report of the Mirrlees review of the UK’s chaotic tax system, spelling out the necessary reforms of a corporate tax system which today favours debt over equity finance, and showing how a radical overhaul of savings taxes could encourage the long-term savings that our society so badly needs.

This is the blueprint Mr Osborne can use to shape a different kind of economy for the future. Together with a better flow of credit for the short term, it provides a story not just to rally the party faithful but also to lift the animal spirits of industry. And that, more than anything, is what the country needs today.

The writer is former director-general of the CBI employers’ group and a former editor of the Financial Times

The showdown at the UN corral has been averted, for now. Palestinian president Mahmoud Abbas will deliver a letter seeking statehood to the UN Security Council, but has made clear that he does not expect an immediate vote, thereby at least delaying, the need for a US veto. But no one should be breathing a sigh of relief, because without swift action, the Middle East is now teetering on the edge of a new period of armed conflict.

In recent months the existing order in the Middle East and north Africa has been upended; new powers are jockeying for position and old ones (including Israel) have many reasons to deflect attention from internal unrest by magnifying external threats. Avoiding a vote on the current proposal for Palestinian statehood is the right short-term expedient for all concerned, but a new international strategy to move the peace process forward is now a regional and global imperative.

The US and Israel have recently pushed abstention strategy, getting enough Security Council members to abstain to avoid a veto. Diplomatic observers and the media have framed this process as a case of America and Israel versus the world. But in fact all Security Council members have an overriding responsibility to avoid a vote. The Security Council is meant to act promptly to stop any “threat to the peace”. A vote on the Palestinian request for statehood, or any US veto of such a request, would be just such a threat.

The potential paths to a future war in the region are increasingly easy to trace. In recent weeks Turkish Prime Minister Erdogan has called Israel a “spoiled child” and stated that the Turkish Navy would challenge Israel in the Eastern Mediterranean. Recent Israeli behaviour, most notably a refusal to apologise even for a disproportionate use of force in the exercise of rightful self-defence, also shows a state that is becoming dangerously defensive and defiant.

In theory, any UN Security Council resolution in favour of Palestinian statehood ought to increase international leverage to bring Israel to the peace table. In practice, it will probably deepen Israeli intransigence and trigger a frightening round of brinkmanship. Just imagine the domestic Israeli impact of statements that statehood is a “step to wiping out Israel,” as Iran’s ambassador to Egypt noted last week.

The disappearance of Hosni Mubarak, Israel’s staunchest peace partner in the region, followed by widespread protests against Israel and a violent attack on the Israeli embassy in Cairo, intensify the sense among many Israelis that the Arab spring means nothing but bad news. Many, myself included, would disagree; indeed, many would argue that Israel has backed itself into its present corner.

So, fine, let the US issue its veto. Then what? The move is likely to trigger violence in Gaza and possibly the West Bank; Israeli countermeasures risk igniting more anti-Israel demonstrations across the Middle East, particularly in Egypt, and possibly in Syria. In both cases a direct clash between the Israeli and Egyptian or Syrian soldiers in the Sinai or the Golan Heights is all too possible, with potentially catastrophic consequences.

Beyond Israel’s immediate neighbourhood the situation is just as bad. Saudi Prince Turki al-Faisal has already said that a US veto would trigger a Saudi re-evaluation of the extent to which it will work with the US, particularly with respect to Iraq and possibly Yemen too.

Saudi opposition to the Shia government in Baghdad would destabilise Iraq, and heighten tensions between Saudi Arabia and Iran. The beleaguered Yemeni president is currently in Riyadh; Saudi refusal to co-ordinate its diplomacy in Yemen with the US would make it nearly impossible to resolve the current impasse.

These are threats growing daily on the horizon. The move from threat to confrontation may seem unlikely, but remember the inexorable, deadly sequence of mobilisation that turned the assassination of an Austrian archduke into first world war. These things can get out of hand quickly.

An abstention strategy is at best a holding pattern, creating a moment of respite. The Security Council should now move to adopt – and the US should allow – a resolution endorsing the Palestinian aspiration to UN membership, while also condemning the steady Israeli encroachment on Palestinian land. It should set forth the parameters for negotiating that President Barack Obama set out in May. Oversight should be delegated to the Quartet.

The US can and should stop the Palestinian request going forward in the Security Council as a request divorced from a larger process of negotiations. But it cannot put the genii back in the bottle and insist that resolution of the Israeli-Palestinian conflict be a purely or even primarily US preserve. A threat to international peace and security is just that. The world must respond.

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

Conventional wisdom may now be only half right when it comes to solving Europe’s mess. Fixing the sovereign debt problem is still necessary, but it may no longer be sufficient. Europe must also move quickly to stabilise the banks at its core in ways that go far beyond what the European Central Bank announced on Wednesday. As senior BNP Paribas executives prepare to tour the Middle East in an attempt to raise fresh funds and shore up confidence, other banks must also show greater urgency and seriousness in dealing with capital and asset quality shortfalls.

Much of the discussion on the crisis is based on the assumption that sovereign debt is both the problem and the solution. Initially, this was correct. The combination of too much debt and too little growth pushed the most vulnerable countries (Greece, Ireland and Portugal) into a classic debt trap. Timid policy responses then fuelled contagion waves that undermined other sectors.

The problem today has become much more complicated. In addition to being on the receiving end, some of these sectors have become standalone sources of regional dislocations.

Italy is, of course, the most visible example. Interest rates on what is the third-largest government debt market in the world remain stubbornly high in spite of persistent market intervention by the ECB. Wednesday’s rating cuts of some of Italy’s leading banks, following Standard & Poor’s downgrade of the country’s sovereign debt on Monday, complicates matters.

Yet, as notable as this is, it is not the most immediately threatening issue for a global economy that, in the words of Christine Lagarde, International Monetary Fund managing director, has entered “a dangerous phase”. The rapidly burning fuse is in the European banking system, particularly in France, and Europe is getting very close to yet another tipping point.

The facts are striking and worrisome. Private institutions around the world, and even some public ones, have sharply reduced short-term lending to French banks. Credit markets now put their risk of default at levels indicative of a doulbe B rating, which is fundamentally inconsistent with sound banking operations. Bank equity now trades at a 50 per cent discount to tangible book value on average. To make things worse, the ratio of market capital to total assets has fallen to 1–1.5 per cent (compared with 6-8 per cent for healthier banks).

These are all signs of an institutional run on French banks. If it persists, the banks would have no choice but to delever their balance sheets in a very drastic and disorderly fashion. Retail depositors would get edgy and be tempted to follow trading and institutional clients through the exit doors. Europe would thus be thrown into a full-blown banking crisis that aggravates the sovereign debt trap, renders certain another economic recession and significantly worsens the outlook for the global economy.

So far neither the authorities nor the banks have done, or are doing, enough to stop – let alone reverse – this trend. While the ECB has stepped in to offset the liquidity crunch, including by relaxing collateral requirements to make it easier for banks to access the central bank’s repo window, capital cushions and asset quality remain unaddressed. As a result, Europe is on the verge of losing control of orderly solutions to its debt crisis.

To counter this, fiscal authorities and banks must work with the ECB on three immediate, simultaneous and drastic measures. They must inject capital through public-private partnerships, including through Tarp (US troubled asset relief programme)-like mechanisms, present a realistic assessment of the asset side of the balance sheet and enhance depositor protection. Greater burden sharing with the private sector may also prove necessary.

Through the bitter experience of the last two years, Europe now understands that a sovereign debt problem is difficult to solve. It must now realise that the challenges and costs to society multiply astronomically when this is accompanied with a banking crisis; and it must act accordingly.

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

Response by BNP Paribas

Both Mr Mohamed El-Erian’s article and Mr Magnus’s response include inaccuracies, as far as BNP Paribas is concerned.

Senior executives are not preparing a tour to the Middle East in an attempt to raise fresh funds, as confirmed this morning by our CEO Baudouin Prot. He reminded the market that BNP Paribas, which currently has a common equity Tier one ratio of 9.6 per cent, intends to be at nine per cent under the full Basel 3 rules by 1st of January 2013, six years ahead of the official schedule. The only people to tour the Gulf at present are members of our investor relations department, who are not members of the Executive Commitee of the bank, and who go to this region as a part of their usual global roadshow programme.

The article mentions that private institutions around the world have sharply reduced short-term lending to french banks. Regarding BNP Paribas, most of our short term lending and deposits are in euro, and we therefore didn’t observe such a move. Concerning our funding in dollars, we had anticipated, from the beginning of 2011, that deposits from American money market funds were going to be reduced and took appropriate measures to ensure the appropriate level of short term liquidity, using a range of means provided by our global presence. Our short term liquidity in dollars is thus fully ensured.

We didn’t urge the french regulators to do any kind of stress test.

Regarding Greece, BNP Paribas has a very clear situation : €3.5bn of sovereign debt, but almost no exposure to the private sector. This figure needs to be compared to our first half 2011 pretax profit of €7.4bn: this shows that whatever happens to Greece, the outcome is easily manageable.

Interest rates on US, German and UK government bonds have fallen to all-time lows.  Yields on 10-year US Treasury securities, for example, are below 2 per cent.  That is the lowest recorded since the Federal Reserve began publishing market data in 1953.  In addition, yields on the inflation-protected 10-year Treasuries are zero.  These are almost incomprehensible levels whose implications are profoundly negative. Namely that Tuesday’s International Monetary Fund report is quite correct to warn that America and Europe are on the verge of renewed recession. It is only the anticipation of negligible demand for capital and negligible inflation – both hallmarks of recession – that could drive rates this low.

For the American and western European economies to decline again, when unemployment levels are already so high, would be disastrous. It would shock consumers, businesses and financial markets. Fearful, they would retrench further, causing the economic decline to accelerate. Weak labour markets would worsen as would the already swollen government deficits and debt.  Overall, we could be in for a repeat of the experience of 1937, when America fell back into recession after three years of recovery from the Great Depression.

How do we know that another recession is approaching? For starters, there is no other credible explanation for the relentless fall in interest rates. Yes, monetary policy is on maximum ease and that controls short-term rates.  Safe haven psychology also is at work. However, these cannot explain such low yields on longer-term government and corporate bonds. Further, bond markets usually signal recession through an inverted yield curve, when long-term rates are lower than short-term ones. Technically, this is impossible now given short-term rates are zero. But the recent movement in long-term rates is the equivalent.

Moreover, recent US and European economic data convey serious weakness. US household net worth has begun to fall again and jobless claims have been rising for several weeks. Retail sales are flat and consumer confidence is hovering around modern lows. Onshore corporate liquidity has reached a record $13,000bn, which signals that businesses are uncertain over the outlook.

Across the Atlantic, the trend is also poor. Neither Germany nor France grew in the second quarter.  Household consumption in the eurozone actually fell during that period. Moreover, the European Commission is forecasting only 0.2 per cent and 0.1 per cent growth across the region for the third and fourth quarter respectively. The worsening of the sovereign debt crisis surely means that actual results will be worse.

It is the debilitating sovereign debt crisis in Europe that is pushing both regions back towards the brink. It is causing credit conditions to tighten again for sovereign credits, weaker borrowers and small and mid-sized business. It also is suppressing consumer and business confidence and the export outlook.

The never-ending nature of this crisis was avoidable. At every opportunity Europe’s leaders have delayed, taken the tiniest steps possible and generally averted their eyes to the elephants in the room.  Yes, everyone knows that the country-by-country politics are difficult, starting with Germany.  But the risk of another Lehman-like market collapse and subsequent economic contraction is huge. Faced with this, European leaders must confront the politics. Instead, their grudging incrementalism is deepening the risks. Implicitly, this was the message behind Treasury Secretary Geithner’s presence in Poland last week.

A single currency representing 17 separate nations inevitably requires a unified balance sheet behind it and, following that, a form of fiscal union.  The time for denying the latter is over. The European financial stability facility must be enlarged exponentially so that it can stand behind nations such as Italy or Spain. In addition, the mandate of the European Central Bank must be expanded. Just like the Federal Reserve, it should be responsible for maintaining a sound banking system and stable capital markets. This requires a permanent capacity to finance banks directly, just as a group of central banks did last week. It also requires the flexibility to buy and sell sovereign debt securities in secondary markets. These reforms must be accompanied by tighter, eurozone-wide bank regulation and supervision. It also requires IMF-like conditionality to accompany direct EFSF loans to member nations. Finally, the ECB should ease monetary policy now as there is no visible inflation risk.

America also must stop its own partisan bickering and undertake one last round of fiscal stimulus. The $447bn job-creation plan by President Obama, or another quick-acting plan of similar magnitude, should be enacted immediately.  The Fed should also initiate further moves to promote credit availability and lending.

Another recession would be profoundly damaging to labour markets and public confidence. It would take years to fully overcome. We must try to avoid such an outcome at all costs. That requires the type of far-sighted leadership that we haven’t seen much of lately.

The writer is founder and chairman of Evercore Partners and former US deputy Treasury secretary under President Bill Clinton

Response by Peter Spiegel

The EU is hoping structural reforms can stave off a double-dip

While Roger Altman is right that national politics has hampered a European response to the ongoing debt crisis, there is a mounting realisation in Brussels and elsewhere on the continent that the constant drumbeat for austerity risks pushing the European Union into a double-dip recession.

Olli Rehn, the European Union’s economic chief, has in recent weeks taken to imploring countries with room to manoeuvre to start implementing the kinds of jobs and growth-promoting policies Mr Altman advocates – though instead of using fiscal stimulus, as the Obama administration is proposing, he has argued that structural reforms, particularly wholesale economic liberalisation, can do the trick. As Mr Rehn recently told the European Parliament, “The scope of macroeconomic stimulus is very limited – nonexistent in many member states - [so] growth-enhancing structural reforms have become even more central.”

The writer is FT’s Brussels bureau chief

The expectation that China might swoop down and rescue the euro in its hour of need is running high. Wen Jiabao, the premier, last week told a meeting of the World Economic Forum that “China is willing to give a helping hand, and we’ll continue to invest there”. But those expecting China to offer anything more than symbolic assistance will soon be disappointed.

China knows that greater eurozone stability is in its national interest. The European Union is its second largest trading partner, and a disorderly collapse in Greece and other southern European countries would have dire consequences for Europe’s economic prospects. Neither turmoil in currency markets, nor sharp changes to trade flows, nor potential moves towards greater protectionism would be at all welcome in Beijing.

More strategically, the euro’s ongoing success is vital if China is ever to escape the “dollar trap” that currently ensnares its economy. Analysts believe that two-thirds of China’s $3,200bn foreign reserves are dollar-denominated, leaving it constantly fearful of a falling dollar. China’s long-term goal is to make the renminbi an international currency, but this will take time. In the meantime, its interests are clearly served by a strong euro.

For all that, however, any more than notional support for the eurozone would come with significant political risks. China is not stupid: it can see that the deadlock over Greece is less about money and more about political will. To end the crisis every EU country, starting with Germany, must put aside its short-sighted self-interest. But with both Germany’s people and politicians so divided, this is not going to happen.

Put simply, investing in Greek, Portuguese, Irish and even Italian government bonds is now a hazardous activity. China is not going to go ahead without some form of iron guarantee from Germany and France, which seems equally unlikely.

Naturally, Angela Merkel, the German chancellor, and France’s President Nicolas Sarkozy would be delighted if China took unilateral action, but that would put Beijing in an awkward position – both risking a backlash in European public opinion and doing nothing to move towards the type of a more fiscally united Europe that, ultimately, is required to sustain the single currency.

Then, think of the money. Bailing out Greece is an expensive business: €110bn has already been spent by the EU and the International Monetary Fund, with about €120bn more still needed. Ought China really pay this amount to be a wealthy market economy?

True, it might buy some temporary friendships, perhaps to be used when another country files yet more anti-dumping charges against China at the World Trade Organisation. It would also be a public statement confirming China’s commitment to playing a more constructive role in the international capitalist system. But this, on its own, is hardly temptation enough.

Some thinkers, including CNN’s Fareed Zakaria, have even suggested that China should be bribed to help out. Ideas include offering a bigger role in the international financial system or pledging that a Chinese candidate becomes the next head of the IMF. Yet even here, China may not be ready. There is a serious shortage of qualified candidates for the latter option; the former seems improbable for a country whose currency will not be fully convertible for some time.

The most likely outcome, therefore, is that China will risk almost none of its extensive foreign reserves to rescue the euro. It may buy some small symbolic quantity of southern European bonds, as an ersatz commitment to the future of the EU. But, in the end, China is an outsider. It knows that America is retreating from European affairs, but it is not yet ready to take its place. As seen from Beijing, the euro is a European affair. And the Europeans will have to make right their own mistakes.

The writer is director and professor at the China Center for Economic Research at Peking University

Response by Kerry Brown

China is missing a golden opportunity finally to become a world power

Yao Yang is probably right in saying that the Chinese – despite sitting on some $3,200bn of foreign reserves – are likely to keep their distance from purchasing large amounts of European bonds and coming to the rescue of the Greek economy. They do regard it as a problem arising from internal political disunity in the European Union. As Beijing sees it, the only real solution to the current crisis is for European leaders to get their acts together, show some political will, make clear that the crisis is soluble – and continue to sell unpopular bail-outs for the profligate Greeks to their own domestic constituencies.

In narrow terms, it is right for China to be cautious. But one cannot ignore this nagging feeling that China is missing a golden opportunity to finally become a world power. Bailing out the eurozone would create immense political goodwill and would drive further down the road towards the kind of world no longer dominated by the US but genuinely multipolar. It would integrate more deeply China’s economy into the global one, and might even form a kind of stepping stone to the internationalisation of the renminbi in a few years time.

The Chinese government’s mantra of focusing on domestic issues before looking to the world around it is becoming a bit tiresome now. Just as problems in China’s vast internal provinces are international because of their links to global supply chains and the stability of the country itself, so the woes of EU states are of intimate importance to China. It might get some satisfaction from seeing sanctimonious Europeans being hit by the kind of problems they once predicted for Asia. But if it looks beyond narrow self-interest, to a wider vision of its future as an international power, dealing with the Europeans on the EU debt issue makes political and, in the long-term, economic sense. Not doing so shows the same lack of political will that it berates western leaders about.

The writer is head of the Asia Programme at Chatham House, leading the Europe China Research and Advice Network (Ecran). The views expressed here are his own and do not reflect those of the EU

Greece is stuck in a vicious cycle of insolvency, low competitiveness and ever-deepening depression. Exacerbated by a draconian fiscal austerity, its public debt is heading towards 200 per cent of gross domestic product. To escape, Greece must now begin an orderly default, voluntarily exit the eurozone and return to the drachma.

The recent debt exchange deal Europe offered Greece was a rip-off, providing much less debt relief than the country needed. If you pick apart the figures, and take into account the large sweeteners the plan gave to creditors, the true debt relief is actually close to zero. The country’s best current option would be to reject this agreement and, under threat of default, renegotiate a better one.

Yet even if Greece were soon to be given real and significant relief on its public debt, it cannot return to growth unless competitiveness is rapidly restored. And without a return to growth, its debts will stay unsustainable. Problematically, however, all of the options that might restore competitiveness require real currency depreciation.

The first of these options, a sharp weakening of the euro, is unlikely while the US is economically weak and Germany über-competitive. A rapid reduction in unit labour costs, through structural reforms that increased productivity growth in excess of wages, is just as unlikely. Germany took 10 years to restore its competitiveness this way; Greece cannot wait in depression for a decade.

The third option is a rapid deflation in prices and wages, known as an “internal devaluation”. But this would lead to five years of ever-deepening depression, while making public debts more unsustainable.

Logically, therefore, if those three options are not possible, the only path left is to leave the eurozone. A return to a national currency and a sharp depreciation would quickly restore competitiveness and growth, as it did in Argentina and many other emerging markets that abandoned their currency pegs.

Of course, this process will be traumatic. The most significant problem would be capital losses for core eurozone financial institutions. Overnight, the foreign euro liabilities of Greece’s government, banks and companies would surge. Yet these problems can be overcome. Argentina did so in 2001, when it “pesified” its dollar debts. America actually did something similar too, in 1933 when it depreciated the dollar by 69 per cent and repealed the gold clause. A similar unilateral “drachmatisation” of euro debts would be necessary and unavoidable.

Major eurozone banks and investors would also suffer large losses in this process, but they would be manageable too – if these institutions are properly and aggressively recapitalised. Avoiding a post-exit implosion of the Greek banking system, however, may unfortunately require the imposition of Argentine-style measures – such as bank holidays and capital controls – to prevent a disorderly fallout.

Realistically, collateral damage will occur, but this could be limited if the exit process is orderly, and if international support was provided to recapitalise Greek banks and finance the difficult fiscal and external balance transition. Some argue that Greece’s real GDP will be much lower in an exit scenario than in the hard slog of deflation. But this is logically flawed: even with deflation the real purchasing power of the Greek economy and of its wealth will fall as the real depreciation occurs. Via nominal and real depreciation, the exit path will restore growth right away, avoiding a decade-long depressionary deflation.

Those who claim contagion will drag others into the crisis are also in denial too. Other peripheral countries have Greek-style debt sustainability and competitiveness problems too; Portugal, for example, may eventually have to restructure its debt and exit the euro too.

Illiquid but potentially solvent economies, such as Italy and Spain, will need support from Europe regardless of whether Greece exits; indeed, a self-fulfilling run on Italy and Spain’s public debt at this point is almost certain, if this liquidity support is not provided. The substantial official resources currently being wasted bailing out Greece’s private creditors could also then be used to ringfence these countries, and banks elsewhere in the periphery.

A Greek exit may have secondary benefits. Other crisis-stricken eurozone economies will then have a chance to decide for themselves whether they want to follow suit, or remain in the euro, with all the costs that come with that choice. Regardless of what Greece does, eurozone banks now need to be rapidly recapitalised. For this a new European Union-wide programme is needed, and one not reliant on fudged estimates and phoney stress tests. A Greek exit could be the catalyst for this approach.

The recent experiences of Iceland, along with many emerging markets in the past 20 years, show that the orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness and growth. Just as in these cases, the collateral damage to Greece of a euro exit will be significant, but it can be contained.

Like a broken marriage that requires a break-up, it is better to have rules that make separation less costly to both sides. Breaking up and divorcing is painful and costly, even when such rules exist. Make no mistake: an orderly euro exit will be hard. But watching the slow disorderly implosion of the Greek economy and society will be much worse.

Nouriel Roubini is Chairman of Roubini Global Economics, professor at the Stern School, New York University and co-author of ‘Crisis Economics’. A longer version of this article can be found on the RGE website

This article is part of the A-List series: Can the euro be saved?

Response to Lawrence Summers

There is a big difference between the Vietnam War and the euro battle: it is hard to think that the former could have been won whatever the means deployed. But as regards the latter Lawrence Summers is right to point out that instead of acting promptly with overwhelming force, Europe has consistently been one day late and one euro short. The Greek crisis was after all a very small problem when it emerged. Denial, procrastination and parsimony have now led to contagion to the core.

Bygones are bygones, however, and the only question that matters is, what to do now? Mr Summers advocates a bold view of the future, a swift recapitalisation of banks and a reversal of the macroeconomic policy stance. All three are necessary, with the important caveat that most eurozone countries cannot afford a fiscal stimulus. Among the significant players only Germany has the possibility of changing course, and it will not do it. It may, at most, slow down consolidation, and this only will not change the landscape.

The proposed recipe is furthermore incomplete. The two immediate urgencies are to extinguish the Greek fire and to contain the widening of spreads on Italian and Spanish sovreign debt. To achieve the former, a debt relief for Greece should be organised, over and above the voluntary and limited private sector involvement initiative agreed upon in July. Ensuring that Greece remains solvent over a wide range of macroeconomic and financial scenarios would help address lingering market concerns. Obviously, such an initiative would require to be accompanied by bank recapitalisation. As soon as ratification authorises it, the European financial facility should be used to this end – especially in Greece itself.

To stabilise Italy and Spain, the euro area should make clear that it will do whatever it takes to quell self-fulfilling debt crises. At present this is the task of the European Central Bank, but it has no explicit mandate for it and central bankers are divided about bond purchases. This leads markets to doubt its resolve. In a few weeks, hopefully, the baton will be passed to the EFSF, which will have a mandate. But it lacks significant firepower. The solution is to leverage the EFSF by giving it a credit line from the ECB and the possibility to repo sovereign bonds purchased on the secondary market. A scheme of this sort would give it at least €2,000bn in firepower, perhaps significantly more. Secretary Geithner alluded to the idea in Wroclaw last week. The Europeans should seriously consider it.

The writer is a French economist and director of Bruegel, a Brussels-based think-tank focusing on global economic policy-making.

This article is part of the A-List series: Can the euro be saved?

Bromley illustration

In his celebrated essay The Quagmire Myth and the Stalemate Machine, published in 1972, Daniel Ellsberg drew out the lesson regarding the Vietnam war that came out of the 8,000 pages of the Pentagon Papers, which he had secretly copied a few years earlier. It was simply this: policymakers acted without illusion. At every juncture they made the minimum commitments necessary to avoid imminent disaster – offering optimistic rhetoric, but never taking the steps that even they believed could offer the prospect of decisive victory. They were tragically caught in a kind of no-man’s-land – unable to reverse a course to which they had committed so much, but also unable to generate the political will to take forward steps that gave any realistic prospect of success. Ultimately, after years of needless suffering, their policy collapsed around them.

Much the same process has played out in Europe over the past two years. At every stage of this process, from the first signs of trouble in Greece, to the spread of problems to Portugal and Ireland, to the recognition of Greece’s inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have played out the stalemate machine. They have done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence. Perhaps inevitably, the gaps between emergency summits grow shorter and shorter.


On this story

The process has taken its toll on policymakers’ credibility. As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 per cent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view on the latter point is a reasonable one. After the spectacle of European bank stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators’ assertions about the solvency of certain key financial institutions?

A continuation of the grudging incrementalism of the past two years now risks catastrophe. What was a task of defining the parameters of “too big to fail” has become the challenge of figuring out what to do when important insolvent debtors are too large to save. There are many differences between the environment today and the environment in the autumn of 2008, or indeed at any other historical moment. But any student of recent financial history should know that breakdowns that seemed inconceivable at one moment can seem inevitable at the next.

To her very great credit Christine Lagarde, the new managing director of the International Monetary Fund, has already pointed up the three principles that any approach to Europe’s financial problems must respect. First, Europe must work backwards from a vision of where its monetary system will be several years hence. The reality is that Europe’s politicians have for the past decade dismissed the widespread view among experienced monetary economists that multiple sovereigns with independent budgeting and banking regulation will over time place unsustainable strains on a common currency. The European Monetary Union has been a classic case of the late economist Rudiger Dornbusch’s dictum: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” So it has been with the build-up of pressures on the eurozone system.

There can be no return to the pre-crisis status quo. It is now clear that market discipline within monetary union is insufficiently potent and credible to assure sound finance. It is equally clear that the risk of self-fulfilling confidence crises becomes substantial when banks and sovereigns have no access to lender of last resort financing. The responsibilities of the ECB, national financial and regulatory authorities and EU officials can be defined in different ways. But there must now be simultaneously an increase in the central financial commitment to the financial stability of member states, and a reduction in their financial autonomy, if the common currency is to survive.

The A-List

An exciting new comment section featuring agenda-setting commentary on global finance, economics and politics

Contributors will include financier and philanthropist George Soros, chief executive of Pimco Mohamed El-Erian, chairman of Goldman Sachs Asset Management Jim O’Neill, political scientist Francis Fukuyama, professor of politics Anne-Marie Slaughter and former EU trade commissioner Peter Mandelson

Second, Ms Lagarde is right to point out serious issues of inadequate capital in European banks. Taking even relatively optimistic views about sovereign debt and growth prospects, European banks are in at least as problematic a condition as American banks were in the summer of 2008. Unfortunately, in many cases they are far larger relative to their national economies. Now is the time for realistic stress testing, and then resorting to private capital markets if possible, and to public capital infusions if necessary. With delay, private capital markets will close completely and nervous managements will rein in the provision of credit just when credit contraction is most likely to damage real economic prospects.

Third, like her predecessor, Ms. Lagarde has broken with IMF orthodoxy in noting that expansionary policies are necessary in the face of substantial economic slack. The oxymoronic doctrine of expansionary fiscal contraction is being discredited with every passing month. Europe needs a growth strategy. Yet almost everywhere, and certainly in the most indebted countries, binding commitments to eventual deficit reductions are a necessity. And in some places credibility has been lost to the point where immediate actions are needed. But Europe can handle its debts and contribute to a stronger global economy only if it grows. This will require both aggregate fiscal and monetary expansion.

This last point is an essential lesson of recent American experience. Even though credit spreads and equity values had normalised by the end of 2009, and the financial system was again functioning reasonably normally a year after the 2008 panic, lack of demand has continued to constrain growth. While any single household or nation can improve its balance sheet by saving more and spending less, the effort by all to cut back means reduced incomes and ultimately less saving for all. Germany, in particular, needs to recognise that if other European nations are going to borrow less then it will be able to lend less, and that as a matter of arithmetic this will mean a smaller trade surplus.

The world’s finance ministers and central bank governors will gather in Washington next weekend for their annual meetings. The meetings will have been a failure if a clearer way forward for Europe does not emerge. Remarkably, the European authorities that drove Ms Lagarde’s selection just three months ago have rejected important components of her analysis. In normal circumstances comity would require deference by others to European authorities on the resolution of European problems. Now, when these problems have the potential to disrupt growth around the world, all nations have an obligation to insist that Europe find a viable way forward. Failure would be yet another example of what Churchill called “want of foresight, unwillingness to act when action would be simple and effective, lack of clear thinking, confusion of counsel until the emergency comes, until self- preservation strikes its jarring gong – these are features which constitute the endless repetition of history”.

The writer is Charles W. Eliot University Professor at Harvard

In response, Jean Pisani-Ferry argues that the eurozone cannot afford further fiscal stimulus.

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The FT’s A-List returns today with a week of debate on the future of Europe’s troubled single currency. Visit the site to read new contributions from Lawrence Summers, Nouriel Roubini, Jean Pisani-Ferry, Mario Monti, Yang Yao and others.

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