Monthly Archives: October 2011

Economics is competing with Thomas Malthus as the world’s seventh billion inhabitant is born. Global population has grown from 2.5bn to 7bn just in my lifetime, so there is plenty to alarm doomsayers. But this landmark arrives at a very different cultural moment to the six billionth baby, twelve years ago.

Some see beyond the extra hungry mouths to feed or scarce natural resources exhausted, and are excited by the prospect of new consumers that will power global demand and growth in the future. They have a point. The last decade or so of dizzy economic growth, however precarious it currently looks, has lifted up large, heavily-populated countries such as China, India and Brazil. At the same time, the Malthusian expectation of the world running out of energy and food has also been pushed back. The development of shale gas deposits has started to turn assumptions about any early exhaustion of non-renewable energy resources on its head.

Over the last forty years we have seen a three and a half fold increase in food production. Food supply has largely kept up with population and famine. The bread riots in Tunisia and Egypt at the beginning of the Arab Spring, were more often a consequence of low incomes or rising prices, not global shortage. Indeed, in a savage challenge to conventional thinking, there are now more obese than hungry people in the world.

Population patterns stack up very differently in an increasingly urbanised world of cities with apartment buildings and tightly-packed homes. Although it brings social dislocation and often poverty, the great movement of surplus labour from an inefficient, over-crowded agricultural sector to metropolitan areas makes the former more efficient, and the latter an ever-growing market not just for farmers but for a range of goods and services as the new urbanites step onto the consumer escalator.

But population growth is slowing. It is now half the annual rate of what it was in the 1960s. Indeed many rich countries, notably in Europe, face imminent labour shortages unless they relax their immigration laws. It won’t be until 2050 that world population grows by the next 2bn. Almost none will be born in Europe.

This global demographic slowdown is down to parents responding to a fundamental shift in their economic lives where children are no longer a resource to help in the fields, but a cost. They are turning to family planning to limit the size of their families.

But this extra population is not going to bear as heavily on global climate change as many of us here already. Leaving aside the possible impact of green technologies, most of the newcomers will be born into countries that emit about a twentieth of the carbon of those in developed countries. They are not the problem.

Does that mean we should be entirely sanguine in greeting Monday’s birth of the world’s seventh billionth person? No. The fastest rates of population growth are in the poorest countries, notably Africa. Indeed, more than half of the growth between now and 2050 will be in that continent. While parts of Africa may be able to absorb these extra numbers, some countries are caught in a trap of endemic economic and political weakness, environmental degradation and food insecurity without any of the incentives of modern employment to encourage the transition to smaller family size. So famine, as at present in Somalia, is going to remain with us.

While modern Malthusians may have been wrong for now about the energy situation, it is doubtful that similar happy surprises lie around the corner when it comes to water scarcity, or the slower gains in agricultural productivity as urban diets increase food demand at a much faster rate than population growth. We have a western development model, which has had the few, if not yet the many, living way beyond the world’s means. As fast-growing middle classes in countries such as China and India emulate western consumption patterns, the real stresses on our global systems will be exposed.

The world is an over-burdened place, but not because there is no room for our seventh billion neighbour. The problem is less about how many of us there are, and more about how we choose to live. Malthus might feel he has not lost the argument yet.

The writer is chairman for Europe, Middle East and Africa at FTI Consulting, and former head of UN Development Programme.

The financial markets have enthusiastically welcomed the agreements reached in Brussels on Thursday, and understandably so – not only for their immediate content but also for what they signal about how far European leaders are willing to go to finally catch up with the realities of the region’s crisis.

But the feel good factor will only last if this is followed quickly by two other important developments.

First, and most immediate, there is a long list of details that must be specified over the next few weeks to put into practice what was agreed to in Brussels. Many of these are technically very complex. Indeed, implementation may prove as tricky as the original negotiations, if not more so.

How will the reduction of Greek debt actually be executed? Will the banks that need capital be able to find sufficient private funds to meet the new prudential targets? In the event that they do not, what conditions should be attached to the financing coming from taxpayers? How will the European Financial Stability Facility be levered? How will its funds be allocated among competing claims, including between stabilising the old stock of debt and providing partial risk insurance for new issuance? And what roles will the European Central Bank and the International Monetary Fund play, as well as other countries?

Second, and critical for long-term sustainability, Europe must still address two big issues. While these were not scheduled to be addressed in this week’s summit, they must be tackled, and decisively, over the coming months.

Europe desperately needs an effective plan to boost employment and promote inclusive economic growth. Without this, it will be virtually impossible to stabilise the region’s sovereign debt markets, and counter fragilities in its banking system. Bold structural reforms are needed, especially in the peripheral countries but also in the core.

Politicians also need to decide how they will strengthen the institutional underpinnings of the eurozone. Can they deliver a fiscal union with much greater political integration? Or will they be forced to settle for a eurozone consisting of a smaller number of countries with similar initial conditions? Until they answer this basic – basic, but very difficult – question, healthy balance sheets around the world will continue to hesitate to engage in Europe’s recovery.

Policymakers should be commended for the important steps that they took this week. They shifted the emphasis from focusing on liquidity to solvency; and from ad hoc measures, to more comprehensive ones.

But to succeed in the longer term, they must do more than just transform these recent agreements into detailed measures. Indeed, crucial inflows of fresh capital from the private sector and from outside Europe will only materialise in size if the big issues are also resolved.

If any of this is to happen, the region’s leaders will soon find themselves engaged in yet another set of difficult, long, and uncertain negotiations.

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

Response by Iain Begg

Thursday’s agreement marks a political sea-change

It is easy to be cynical about the responses of European Union leaders. Their track-record in the two years since the Greek crisis first erupted is hardly encouraging. Nevertheless, the agreements reached earlier this week are, as Mohamed El-Erian states, greatly to be welcomed. While he is correct to sound a note of caution about the details, it is important to recognise that a political sea-change has been achieved, which can now be the basis for a credible way out of the crisis that has been weighing on the eurozone.

It is important also to distinguish between the huge uncertainty about whether or not the euro has a future, and the risk that there will still be specific problems. Crucially, the uncertainty that has been so damaging to investor confidence should now abate, because Thursday’s deal should reassure markets that the euro is here to stay and that scenarios of default or break-up can be greatly down-played, if not dismissed outright.

There are undoubted risks and they have to be taken seriously, but they are predictable and can be managed. Difficulties are bound to arise as the details of the package are negotiated. Few will be surprised if there are episodes of brinkmanship or attempts by political groups or other interests to extract a price for cooperation. Similarly, the chances are high that individual governments will not live up fully to their commitments to timely structural reform. But the foot-draggers will now know that they cannot easily hide and that they will be severely punished, whether by electorates that have had enough of vacillation or by markets.

There are still plenty of questions to be addressed about the longer term development of eurozone governance, notably around whether mutualisation of debt becomes fully-fledged eurobonds. This week’s deal is, however, a political breakthrough and demonstrates that the politicians have at last confronted the threats facing the EU and the eurozone. To coin a phrase, this time is different.

The writer is professorial research fellow at the European Institute at the London School of Economics and Political Science.

The day may yet come when the eurozone finally agrees a comprehensive package to end the crisis, but this was not the day. What policymakers agreed at 4am Brussels time on Thursday came close to what they set out to do. They secured a “voluntary” deal with the banks, and they agreed the outer perimeters of a system to leverage the European financial stability facility. But none of this is going to end the crisis.

The deal with the Institute of International Finance is for a “voluntary” 50 per cent haircut on Greek debt on behalf of their member banks. This would amount to €100bn, and would be supplemented by a contribution from eurozone governments to the tune of €30bn. The goal is to achieve a ratio of Greek sovereign debt to gross domestic product of 120 per cent by 2020.

I do not believe this is going to work. First, the agreement with the IIF is not binding on the banks. The IIF has yet to deliver the voluntary participation. Many banks would be better off if the haircut was involuntary, given their offsetting positions in credit default swaps. The whole point of a CDS is to ensure creditors against an involuntary default. By agreeing a voluntary deal, the insurance will not kick in. In other words, there is a significant probability that we will end up with an involuntary agreement – which is precisely the outcome the eurozone governments, except perhaps a small group of northern countries, had sought to avoid.

My second reason for scepticism concerns the forecast of sustainable 120 per cent debt-to-GDP ratio. The European Union has been consistently wrong in its economic forecasts for Greece. They misjudged the impact of austerity on economic growth and public sector deficits. This misjudgement is the reason why the voluntary bank haircut of 21 per cent, agreed in July, has now grown to 50 per cent. What happens if the outlook were to deteriorate further? There is no sign yet of a turnaround.

Third, in the unlikely event that the banks come up with the money, and that Greece manages to hit a 120 per cent debt-to-GDP level in 2020, it is far from clear that Greece can return to the capital markets even then. I believe that Greece will require a much lower debt-to-GDP level, perhaps around 80 per cent, to achieve sustainability and access to market funding. Italy has a debt-to-GDP of 120 per cent now – this number may have served as a benchmark for policymakers. But Italy has a far more solid base of domestic savers than Greece, and this level is not sustainable for Italy either.

On the EFSF, the leaders reached political agreement to leverage it up to about €1,000bn. Herman van Rompuy, the president of the European Council, made a revealing comment following the meeting when he said that banks have been doing this forever. Why should governments not do so as well?

The reason is simple. Banks can only do this because central banks and governments act as ultimate guarantors of the financial system. There exists an implicit insurance of unlimited liability. In the case of the European financial stability facility the very opposite is the case: there is an explicit insurance of limited liability. Germany wants its exposure capped to a maximum of €210bn. I doubt that global investors will rush into the tranches of the special purpose vehicle through which the eurozone wants to leverage the EFSF. I struggle to see how this structure can lead to a significant and sustained fall in bond spreads.

Leveraging can work, but only if the eurozone were willing to provide an unlimited backstop. This would be either in the form of an explicit lender-of-last-resort guarantee by the European Central Bank, or through a eurobond – or ideally both.

Now that is something I would consider to be a comprehensive agreement. It may yet happen, but not for a long time. The crisis, meanwhile, continues.

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

Being stuck in traffic is more bearable if the other lanes are moving. If all lanes are jammed for a long time, tempers flare. And if the police eventually arrive and let a few selected cars get out of their lanes and move through a special path, a riot is likely to ensue. This in short is the sentiment that propels the Occupy Wall St protests. We should take note.

The traffic jam metaphor for the political consequences of economic mobility was originally proposed by Albert Hirschman, the noted economist, in 1973 to explain changes in tolerance for income in equality in poor countries. The idea was as simple as it was powerful: even a modicum of social mobility – sparked by economic growth – buys patience and political stability in developing countries. As people see their relatives and neighbours improve their lot they are willing to wait for their turn.

This idea, which was offered to explain the tolerance for inequality in poor countries, is now in theory applicable to some of the world’s wealthiest nations – except that the Occupy Wall Street crowds, the protesters in the City of London, or the Italian and Greek protesters are getting out of their “cars”, and clashing with the police not just because they see their “traffic lane” horribly jammed. It’s also because they are moving backwards.

They are also paying more attention to the fact that others are advancing thanks to what they perceive as tricks, special privileges and corner-cutting. This is not about hopes sparked by others doing well, but about the collective rage at an elite doing obscenely well while the rest backslides.

Over a century ago Alexis De Tocqueville wrote that Americans’ higher tolerance for inequality relative to Europe’s was the result of more social mobility in the US.

This is over; at least for now. The long, peaceful coexistence with income and wealth inequality is ending. Americans are now infuriated by the fact that chief executives at some of the nation’s largest companies earned around 340 times more than a typical American worker.

While the numbers are unnerving and US income disparities are growing even more unequal, this is not new. What is new is the intolerance towards the hoarding by the “few” of unfathomable wealth, and also towards their profiting even in the midst of the crisis. The rich are seen to be either benefiting from bail-outs and other stimulus measures, or to be immune to the fiscal austerity that governments in many countries have had to adopt to stabilise their economies.

Nothing makes people take to the streets in protest like public budget cuts. In a recent study, Jacopo Ponticelli and Hans-Joachim Voth, professors at Pompeu Fabra University in Barcelona, looked at a large data base that tracked political violence in 26 European countries between 1919 and 2009. They found that “expenditure cuts carry a significant risk of increasing the frequency of riots, anti-government demonstrations, strikes, political assassinations, and attempts at revolutionary overthrow of the established order.” While such events have a low probability in normal years, they concluded, they become much more common as austerity measures are implemented.

We know we have entered new political territory when Mitt Romney, the leading contender for the Republican party presidential nomination, who initially called the Occupy Wall Street movement “dangerous”, is quoted as saying: “I look at what’s happening on Wall Street and my own view is, boy I understand how those people feel …The people in this country are upset.” Yes, they are. They will stay that way until their lanes start moving again. Or, at least, those of their friends and neighbours.

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

Days and nights, Europe’s leaders have discussed the minutiae of private-sector involvement in the Greek debt restructuring. They have immersed themselves in financial engineering with the aim of leveraging the European financial stability facility. This is all necessary, but it’s the job of finance ministers or Treasury officials. What citizens and markets alike expect from the heads of state and government is that they do the job for which they are indispensable, and map out the political choices Europe is now screaming for.

A key reason why the eurozone is under challenge is that markets have become conscious of a fundamental weaknesses in its design. It relies on three hardly-compatible principles: national banking systems, which both finance the sovereign and rely on it as a potential backstop; states that are supposed to be solely responsible for their own debt, so that they cannot rely on partners when in trouble; and a central bank that has not been given the mandate to be a lender of last resort. This trio of principles was assessed consistent in normal times, because banks were sound and state solvency was not in doubt. But in crisis times, a perverse interaction between bank and sovereign weakness develops. And the central bank has no mandate to put a stop to it.

There are several, partially compatible ways out of this. One is to make states individually safe by going far beyond the requirements of the Maastricht treaty and bringing public debts down to levels where solvency cannot be challenged anymore. It implies decades-long austerity. Another way is to make the financial system safe by putting limits to the banks’ exposure to their sovereigns and creating a eurozone-wide deposit insurance. It implies that states renounce the convenience of having ‘their’ banks. The third way is to change the mandate of the European Central Bank. This implies breaking with the Bundesbank’s heritage and giving the ECB a governance structure adequate to a new, quasi-fiscal role. A last option is to move towards fiscal union so that individual state solvency stops being a concern for markets. It means accepting both shared responsibility over public debts and ex-ante oversight of national budgetary decisions.

Provided it is implemented consistently, each of these responses would be recognised by markets as a watershed. Each has advantages and drawbacks. Each has broader implications for Europe. Each involves risks. But a way has to be chosen. As the Pierre Mendès-France, the late French prime minister, used to say, “gouverner, c’est choisir”.

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

Response by Olaf Cramme

Politicans’ objective is to keep options open, not to spell out the endgame

The debate about how to solve the eurozone crisis has been going around in circles for months. Seasoned observers of European Union integration, such as Jean Pisani-Ferry, present credible proposals of how to put an end to the downward spiral of market fear, deteriorating public finances and stagnating or falling growth. Political leaders in the member states then fail to implement a “comprehensive” package at one or other of their meetings, the overall situation worsens, market pressure increases and before you know it, new, more radical proposals are being made.

Indeed, governing means making tough choices. But politics is also about keeping options open. To understand why the current see-saw is happening we need to capture the latter, and not just demand the former. In other words, Wednesday’s summit is likely to reinforce political manoeuvring: the basic objective is to gain more “breathing space”, not to spell out the endgame.

This endgame scenario is a particular worry for Angela Merkel. Does she believe in the political strength of a big eurozone, yet one in which growth prospects remain dismal for the foreseeable future? Can the European Central Bank be trusted on inflation if its mandate changes? How much joint liability is a price worth paying for European unity? Each of these questions flows from the various proposals spelt out by Mr Pisani-Ferry. And each of them remains highly controversial among Germany’s political class, let alone its population.

As long as the total collapse of Europe’s economy is not right at the doorstep – read the continental European press and you will notice a difference to the doomsday reporting in the Anglo-Saxon world – Berlin will stick one plaster after another on the wound. Deep down, most German politicians of the political mainstream seem to favour a smaller eurozone of like-minded, fiscally prudent countries. But they simply don’t know how to get there without causing deep rifts or derailing European integration.

The consequence? Keeping the options open and no short-term solution in sight.

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

1) Member states of the eurozone agree on the need for a new treaty creating a common treasury in due course.  They appeal to European Central Bank to co-operate with the European financial stability facility in dealing with the financial crisis in the interim – the ECB to provide liquidity; the EFSF to accept the solvency risks.

2) Accordingly, the EFSF takes over the Greek bonds held by the ECB and the International Monetary Fund.  This will re-establish co-operation between the ECB and eurozone governments and allow a meaningful voluntary reduction in the Greek debt with EFSF participation.

3) The EFSF is then used to guarantee the banking system, not government bonds.  Recapitalisation is postponed but it will still be on a national basis when it occurs.  This is in accordance with the German position and more helpful to France than immediate recapitalisation.

4) In return for the guarantee big banks agree to take instructions from the ECB acting on behalf of governments.  Those who refuse are denied access to the discount window of the ECB.

5) The ECB instructs banks to maintain credit lines and loan portfolios while installing inspectors to control risks banks take for their own account.  This removes one of the main sources of the current credit crunch and reassures financial markets.

6) To deal with the other major problem – the inability of some governments to borrow at reasonable interest rates – the ECB lowers the discount rate,  encourages these governments to issue treasury bills and encourages the banks to keep their liquidity in the form of these bills instead of deposits at the ECB.  Any ECB purchases are sterilised by the ECB issuing its own bills.  The solvency risk is guaranteed by the EFSF.  The ECB stops open market purchases.  All this enables countries such as Italy to borrow short-term at very low cost while the ECB is not lending to the governments and not printing money.  The creditor countries can indirectly impose discipline on Italy by controlling how much Rome can borrow in this way.

7) Markets will be impressed by the fact that the authorities are united and have sufficient funds at their disposal.  Soon Italy will be able to borrow in the market at reasonable rates.  Banks can be recapitalised and the eurozone member states can agree on a common fiscal policy in a calmer atmosphere.

The writer is chairman of Soros Fund Management and a philanthropist. He is author of ‘The Crash of 2008′ and ‘What it Means’

Bromley

The central irony of financial crisis is that while it is caused by too much confidence, too much borrowing and lending and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending. Most policy failures in the US stem from a failure to appreciate this truism and therefore to take steps that would have been productive pre-crisis but are counterproductive now with the economy severely constrained by lack of confidence and demand.

Thus even as the gap between the economy’s production and its capacity increases, fiscal policy turns contractionary, financial regulation focuses on discouraging risk-taking and monetary policy is constrained by concerns about excess liquidity. Most significantly US housing policies especially with regard to Fannie Mae and Freddie Mac, institutions whose purpose is to mitigate cyclicality, have become a case of disastrous procyclical policy.

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Construction of new single family homes has plummeted from about 1.7m in the middle of the last decade to about 450,000 at present. With housing starts averaging well over a million during the 1990s, the shortfall in housing construction now dwarfs the excess during the bubble and is the largest single component of the shortfall in gross domestic product.

Losses on owner-occupied housing have reduced consumers’ wealth by more than $7,000bn over the past five years, and uncertainty about the future value of their homes and the inability to refinance at reasonable rates deters household outlays on durable goods. The continuing weakness of the housing sector is a major risk for US financial institutions, raising significantly the costs of the loans they offer.

In retrospect it would have been better if financial institutions and those involved in regulating them, especially the Federal Housing Finance Agency, recognised that house prices can go down as well as up, if more rigour had been applied in providing credit, if the government-sponsored enterprises had been more careful in monitoring those originating and servicing loans, and if there had been more vigilance about fraudulent behaviour.

The question now is what should be done to address the housing market given the drag it represents on the economy. With virtually all mortgages in the US provided by the federal government or guaranteed by the GSEs, this is inevitably a matter of government policy.

Unfortunately past policy has been preoccupied with backward-looking attempts to address the consequences of errors in mortgage extension by addressing homeowners on a case by case basis and decisions regarding the GSEs have been left to their conservator, the FHFA, which has taken a narrow view of the public interest. The FHFA has not acted to ensure the GSEs stabilise the US housing market, and taken no account that the narrow financial interest of the GSEs depends on a national housing recovery. Instead of focusing on the stabilisation of the market, it has been reversing its previous policies heedless of changes in the environment and in treating mortgage finance as a morality play involving homeowners, financial institutions and banks rather than an important component of economic policy. A better approach would involve several changes in policy.

First, and perhaps most fundamentally, credit standards for those seeking to buy homes are too high and rigorous. This reduces demand for houses, lowering prices and driving increases in foreclosures, leading to further tightening of credit standards and a vicious growth-destroying cycle. Statistics suggest the characteristics of the average applicant in 2004 would make an applicant among the most risky today. Of course the pattern should be the opposite given that the odds of a further 35 per cent decline in house prices are much lower than they were at past bubble valuations.

Second, as Barack Obama stressed in presenting his jobs programme, there is no reason why those on GSE-guaranteed mortgages should not be able to take advantage of lower rates. From the point of view of the guarantor, lower rates are good since they reduce the risk of default. Yet, until now the GSEs have made refinancing very difficult by insisting on significant fees and requiring that any new refinancier take on all the liability for errors in underwriting the original mortgage at a cost to American households of tens of billions of dollars a year.

Third, stabilising the housing market will require doing something about the large and growing inventory of foreclosed properties. The same property sold in a foreclosure sale nets about 30 per cent less than if sold in the ordinary way and the knowledge that there is a huge overhang of foreclosed properties deters home purchases. Aggressive efforts by the GSEs to finance mass sales of foreclosed properties to those prepared to rent them out could benefit both potential renters and the housing market.

Fourth, there is the prevention of foreclosures which was the initial focus of policy efforts. The truth is it is far from clear what the right way forward is. While the Obama administration’s home affordability modification programme has been criticised for overly restrictive eligibility criteria, the reality is that a large fraction of those receiving assistance have ultimately been unable to meet even their reduced obligations. This suggests the task of helping homeowners without either damaging the financial system or simply delaying inevitable outcomes is more difficult than often supposed. Surely there is a strong case for experimentation with principal reduction strategies at the local level. The GSEs should be required to drop their posture of opposition to experimentation and move on a more constructive position.

Fifth, there were substantial abuses by financial institutions and almost everyone in the mortgage industry during the bubble. Just compensation to the victims is a legitimate objective of public policy. But allowing negotiation over the past to dominate present policy creates overhangs of uncertainty that impose huge costs on the financial system and inhibits lending. It is equally in the interests of bank shareholders and the housing market that a rapid resolution of disputes be achieved. The FHFA should strive to quickly end this uncertainty.

While the GSEs are the most important actors in the mortgage market and hence the FHFA is the most important player in housing policy, others can make a difference. Bank regulators could facilitate inevitable restructuring of underwater mortgages by requiring banks to treat second mortgages and home equity loans in realistic ways. The Federal Reserve could support demand and the housing market by again expanding purchases of mortgage-backed securities.

With a constructive approach by independent regulators, far better policies could be in place six months from now. The anticipation of a change to supportive policies could change the tone of the market even sooner. There is nothing else on the feasible political horizon that can make as large a difference in driving American economic recovery.
The writer is Charles W. Eliot university professor at Harvard

The humiliating death of Muammer Gaddafi, gunned down and apparently dragged through the streets of his home town Sirte, would seem at first sight to be a final punctuation point in the tumultuous change of power in Libya. Another dictator, like Saddam Hussein before him, found cowering in a bolt hole. Finally, Libyans can breathe easier knowing this monstrous and unpredictable figure is gone from their lives.

But his shadow will only be truly lifted if the new Libyan leadership draws the right lessons, not the wrong ones, from his demise. The right lesson is that it is a cathartic moment that clears the ground for Libyan politics to move forward. The wrong one would be to assume that with the death of Gaddafi all those supporters, whose reasons for so tenaciously defending Sirte are now clearer, will fall in line behind the new government in Tripoli. The first statement from interim prime minister Mahmoud Jibril hit all the right notes on reconciliation. But his words have to compete with the powerful image of Col Gaddafi’s body being dragged through the streets. This is much uglier.

The removal of a leader who capriciously threatened his country and its people as if they were his personal property lifts the fear and loathing that had deep frozen any kind of normal politics in Libya for more than 40 years. This now allows a political space free from the fear of disappearance and life-imprisonment that had been the lot of any dissenter for so long. And, given Col Gaddafi’s lingering hold on the minds of his countrymen, nothing less than his very public end was likely to release them from his last padlock on their freedom.

But if the manner of his going is interpreted by part of the country or the region as a crude revenge – as a summary execution not a combat death, let alone the result of a proper justice process – then it could revive, even in death, Col Gaddafi’s power to divide. Martyrs cast long shadows. Those former leaders cooling their heels in The Hague or elsewhere, such as Charles Taylor of Liberia, assorted former Yugoslavian leaders or Manuel Noriega of Panama, are better managed alive than dead, as court exposure of their misdeeds often aids national healing.

But Libya today is where it is: Col Gaddafi is dead. The good news is politics can move on; the question remains how. The leadership of the National Transitional Council has always stressed its temporary character. Now is the time for an act of magnanimity: now its battlefield success is secure, it should form a government of all Libyans, including clans close to Gaddafi and Berber groups who have felt under-represented. There was a long tail to this conflict after Col Gaddafi’s fall, not only because of a residual emotional loyalty but because of the very real stakes his extended kinsmen had in the old system.

When I last visited Sirte, well before the conflict, it showed Col Gaddafi’s beneficence to relatives as well as his capriciousness as a ruler. He had built out the town, once his home village, with fully-fledged ministries, imagining he could make it his Washington. However he had forgotten to include hotels, so had placed many African foreign ministers he was hosting on an Italian cruise ship he had rented for the occasion, an African Union summit. When it looked as though they would vote against his proposal for a united Africa, he briefly tried to ship them out to sea.

This vindictive anger against opponents was felt more seriously by African leaders, who often found he armed and funded their opponents when they opposed him. So with one or two exceptions, few tears will be shed in Africa’s presidential palaces, even though – like all of us – they will be uneasy at the manner of his going. Like his remaining supporters at home, they will want his death to presage a new chapter of reconciliation and healing rather than revenge and score settling. The Arab world, too, will view the violent end of an authoritarian leader who was widely disliked with relief but also disquiet at the violent precedent for regime change in the region.

For Libya’s western backers, particularly France, the UK and US, this is not therefore a moment for euphoria but for quiet relief, and a public call to Tripoli for restraint and reconciliation.

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

Concerns about a hard landing resurfaced earlier this week as China reported a lower-than-expected growth rate in the third quarter.

The fundamentals of the country’s economy, however, remain robust. In spite of the problems surrounding small businesses in the south, industrial growth only moderately eased to 10.5 per cent on an annualised basis, from 10.9 per cent in the second quarter. Consumption growth has remained strong.

The real estate sector is the only domestic sector that has significantly lost steam. Among the 70 cities the National Bureau of Statistics monitors, housing prices did not change in September from August in 29 cities and declined in 17. Thus growth in investment in real estate fell 16.5 per cent annualised, from 22 per cent in August.

The slowdown of the property sector is a result of the government’s efforts to control prices. Inflated prices not only prevent ordinary people from owning a home, but also discourage investment in the productive sectors, engendering China’s future growth. The stabilisation of property prices should therefore be a welcome sign.

The real cloud hanging over China now is the slowdown of exports. The sector grew only 17.1 per cent annualised in September, considerably lower than the 22.7 per cent rate in the first three quarters combined. Growth in imports also fell back, but at a slower pace than export. Hence, the slowdown in the third quarter was entirely caused by the drop of net export.

The prospects for exports are not optimistic for the current quarter and beyond. News from the upcoming Canton Fair, the most important trade fair in China, suggests that the volume of overseas orders will probably be flat on last year.

While the current mood of the market is that a hard landing is a distant possibility, this optimism could well be proved wrong if Europe sinks further or the situation in the US worsen. Problems in these economies are clearly weighing on the Chinese economy.

But this is not the first time that China is feeling the pain of external shocks. The situation today resembles what happened in the mid-1990s. The inflation rate reached 24 per cent in 1994, prompting the government to launch a serious austerity programme to curb domestic expansion. It could have been a soft landing if the Asian financial crisis had not happened. But it did, and it took a serious toll on China with several painful years of deflation.

Despite all the years spent calling for structural adjustments, the Chinese economy still relies heavily on the export sector to generate growth. The slowdown in global demand should be a loud wake-up call for China to take real action to rebalance its economic structure. The robust growth of the domestic sectors amid the global weaknesses is an encouraging sign that healthy growth can be maintained by the country’s economy.

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

Response by Kerry Brown

China’s economic model is still a work in progress

Nine per cent growth, in the current circumstances, is pretty astounding. Especially in view of the overall target under the current five-year plan that’s aiming for a more modest seven per cent growth over the period to 2015.

The days of double digit increases were always going to come to an end – it is remarkable they continued as long as they did. For housing, the government’s measures look like they will work – restricting properties people can own, trying to cool the market down, and avoiding what one speculator called “the mother of all asset bubbles”.

For exports, again, the surprise is that there are no surprises. Where exactly, in the current straightened circumstances in the European Union and the US, are Chinese going to send their goods? Recent reports suggest that some manufacturers are even shifting production back to developed markets because it is becoming cheaper. Government subsidies over factors of production such as electricity, water, land are coming to an end in China – as are cheap labour costs.

The period in which China weans itself off the need to have export-led growth has begun – and surely that, at least, will cool some of the political heat about China’s booming deficits in the EU and US in particular.

Is there real evidence yet that China’s sleeping domestic consumer market is about to stir awake? That has been the big hope since 2008. But those middle class purchasers of Chinese and imported goods remain as illusive as ever. Yao Yang is right – for the export market to diminish, locals need to step in and fill the gap. But so far, there is little sign that this is happening.

Chinese remain as worried as ever about healthcare costs, education costs, and paying their mortgages. The ambition to create a strong enough social welfare system to give some certainty to people in these areas is still just that – an ambition. China’s pension problems, while so far concealed, are more frightening than those the west confronts – which is really saying something.

The current trade data are fascinating because they represent a work in progress – the gigantic shift towards a more mature economic model, and greater balance. But on this latest set of data, for the long term, the new leadership coming in late next year really have their work cut out. They have to implement the major realignments that are necessary for China to take its economic development to what it itself states is the next stage – middle income level status by 2020.

The writer is head of the Asia programme at Chatham House, leading the Europe China Research and Advice Network. The views here are the author’s own and do not reflect those of the EU.

That China’s third quarter growth rate of 9.1 per cent, just marginally below forecasts, would spark a sell-off in the markets says a lot about the gloomy state of the global economy. Analysts have not yet decided whether a rate below expectations is good or bad, given the concerns about inflation.

Some have focused on the minor changes in sector growth patterns; evidence that China is finally rebalancing, with consumption rising relatively faster than output; and signs that fixed investment is becoming more judicious, with a slowdown in property development. While the general sense is that macroeconomic policies do not need major adjustments, globalists tend to worry more about whether China will continue to be a strong source of demand given the weakness of the US and eurozone economies.

Ostensibly, Beijing’s goal is to manage a “soft landing”. But even at home, many have not fully accepted the premise of the current five-year plan that slower, but higher quality growth, averaging seven per cent, is better. Skeptics believe that this target is no more credible than the 7.5 per cent target (compared with the actual 11 per cent achieved) in the just-completed plan.

Many recognise that slower growth would be more environmentally sustainable. Yet some vested interests still feel that these are issues for richer, more developed countries.

Thus making a credible case that seven per cent growth is better than ten means challenging the traditional objectives that have preoccupied China’s leaders during the post-Mao reform era. Two targets have been sacrosanct – price stability and employment generation – with the understanding that rapid economic growth makes them more achievable.

But times have changed. Keeping prices stable was much simpler when the main concern was providing access to a range of basic consumer goods at affordable prices. Having become the world’s assembly plant for such items has solved that problem. Instead, the current bout of inflation stem from the demand of a rising middle class for a varied diet of modern goods and services that are more costly to provide. Part of this is driven by the search for housing in cities where real estate prices have surged with urbanisation and speculative pressures. Pushing the economy to grow too fast will make it only harder to maintain price stability in the future.

However, employment generation made considerable sense when the stock of surplus labour in the countryside and in bloated state enterprises had to be absorbed by a small, but expanding, private industrial sector. China had to grow out of its past distortions and inefficiencies. But its employment needs today are quite different from those a generation ago. Faced with a declining labor force due to a rapidly aging population, creating copious, but relatively low-skilled, jobs is no longer the priority. The focus now is on fewer, but higher value-added, positions.

On both scores, Beijing and the rest of the world need to be more relaxed about China’s declining growth rates, provided that the process is managed well – which, of course, is a big if.

The writer is a senior associate at the Carnegie Endowment and a former country director for the World Bank in China

Response by Jonathan Fenby

Cast your mind back a couple of years. The world’s second biggest economy was growing at an unsustainable rate. Exports, the pundits and the markets agreed, had recovered too well from the late 2008 downturn. Property and infrastructure spending under the stimulus package launched in response to the dip was too high and badly allocated. The accompanying credit boom was producing excess liquidity and a plethora of impending bad loans. Then inflation more than doubled from the two to three per cent China had enjoyed for much of the first decade of this century.

Now consider what we have today. Growth is slowing. The property market has cooled. The authorities have put the brake on credit growth. Though inflation is still 6.1 per cent and will remain a structural problem until Beijing reforms agriculture, consumer prices seem to have peaked.

That might appear to be a success story. But, as Yukon Huang writes, times have changed. Markets and the media prefer the bad news story, so that a 9.1 per cent growth rate is cause for concern. The expanding trade surplus in the second and third quarters is ignored, while the fall in export growth is highlighted.

On top of this, China, as the nation which has benefited so much from globalisation, cannot avoid being caught up in the deep uncertainties about the eurozone and the US – and fears about the effect on the People’s Republic despite efforts to diversify its export markets.

A recession in the developed would, of course, be a major blow. But a sense of proportion is needed. The current account’s share of gross domestic output has fallen from 20 per cent in the middle of this decade to ten per cent in 2007, and to five per cent last year. Yes, small private sector companies face a potentially crushing combination of rising wages, credit curbs and late payment by western buyers as highlighted in a stream of reports from the manufacturing hub of Wenzhou. Two dozen firms are reported having gone bust. No doubt the true figure is much higher compounded by the contagion effect of lending between individuals and firms in the shadow banking sector, but there are anywhere from 250,000 to 400,000 enterprises in the city.

If China faces a serious downturn, its leadership will take remedial action as it did in late 2008, probably by selective stimulus measures. That may introduce distortions and create a fresh set of problems. But it is the way the last major Communist-ruled state on earth operates.

The writer is China director at Trusted Sources

As this weekend’s eurozone summit looms into view, the key question for markets is whether the new financing arrangements will be sufficient to handle three separate problems: the necessary writedown of Greek debt; the recapitalisation of eurozone banks; and the restoration of private funding for Italian and Spanish budget deficits.

It has been clear for a long while that the €440bn currently available to the European financial stability facility is far from sufficient to do the job. Consequently, it seems that the summit will agree to “leverage” the bail-out fund to give it much greater scale. This has triggered optimistic talk about a “big bazooka”, but achieving the right order of magnitude still looks to be a very tall order.

Unfortunately, the three problems that the EFSF needs to handle are interrelated. Financing the future needs of Greece, Ireland and Portugal is likely to absorb around €100bn of the fund’s resources. The recapitalisation of eurozone banks will need at least €200bn in total. It would surely be prudent to assume that the EFSF will need to provide half of this. Finally, the possibility of that the fund would be involved in a potential rescue for Belgium, and other contingencies, must be considered.

This leaves only about €200bn of “free” capital at the EFSF, available for leverage. Anything more than this threatens to undermine the credibility and triple A status of the fund itself.

The €200bn will apparently be used to insure future purchasers of Italian and Spanish bonds against the first tranche of any losses they may suffer in a sovereign default. If the first 20 per cent of losses are insured, the EFSF could cover €1,000bn of bond purchases.

The key question is whether this would be a sufficient inducement to bring a large amount of fresh capital into the troubled bond markets. The subsidy would be worth 180 basis points on new Italian bonds, according to Andrew Bevan, Fulcrum’s bond specialist, given the market’s assumption that a sovereign default is 40 per cent likely over the next five years, and assuming that there would be a 50 per cent recovery to bond holders after that default.

It is not clear that this will be enough to transform the market’s perceptions of government debt in these struggling economies. The eurozone could increase the incentives to future bond purchasers by increasing the insured amount of any future loss from 20 per cent to (say) 40 per cent. But that would automatically reduce the amount of bonds covered from €1,000bn to a modest €500bn.

At its absolute maximum, the subsidy can never be worth more than €200bn, which is equal to 8 per cent of the current outstanding debt of Italy and Spain. The eurozone cannot make this subsidy any bigger by using the smoke and mirrors involved in leverage. Talk of trillions of new money, apparently conjured out of thin air by financial engineering, is inherently misleading.

The only way of squaring this circle is to increase the size of the EFSF itself. Germany remains steadfastly opposed to this, as it would increase the potential size of fiscal transfers to other countries. If this is Germany’s final word, then the fund will remain too small, and the eurozone will once again discover that it cannot make a silk purse out of a sow’s ear.

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

Predictions and prescriptions for a eurozone break-up are skyrocketing – but there is no chance of the eurozone dissolving. Peripheral countries such as Greece will stay put. Germany will never leave.

Germany accounts for little more than one per cent of the world’s population – and nearly nine per cent of its exports. A common currency ties Germany’s strength to the eurozone’s relative weakness. The shared single currency is significantly weaker than the standalone German currency would be. This subsidises German exports, making them more affordable internationally.

The eurozone is a single trading body. This institutionalises efficiency, eases transfer, and defangs protectionism between Germany and its largest source of demand – the eurozone itself. Integration handcuffs many of Germany’s would-be competitors. Historically, weaker European economies would undercut the stronger ones with beggar-thy-neighbour devaluations. The monetary union precludes this. Unsurprisingly, Germany’s balance of payments has gone from a small deficit to the world’s second largest surplus since adopting the single currency in 1999.

Germans are understandably frustrated with the moral hazard of bail-outs for profligate periphery nations that could run up deficits again. They don’t want to write a blank cheque – and they won’t have to. Money talks: financing the periphery buys Germany a leading role recasting the eurozone governance framework. The recent ‘six pack’ of legislative reforms hints at what’s to come: institutionalised fiscal discipline and an excessive imbalances procedure that protects against future moral hazard. The whole eurozone will tilt toward the German surplus model as we get more fiscal integration and more German leverage.

Without Germany, the European Union would disintegrate. When the dust settles, Germans would end up with less friendly neighbours from an economic and from a security perspective. In the near term, unpredictable global contagion and crisis aside, we’d see a flight to German bonds, putting immense pressure on the real exchange rate and crippling exports and competitiveness. The bottom line: people would buy Bunds instead of Benzs. A new D-Mark would follow the trajectory of the Swiss franc’s recent rise, only to another order of magnitude.

While the liberal Free Democratic Party has complicated Germany’s pro-euro strategy, its outlier stance matches its dwindling support (it won 15 per cent of the vote in 2009 – now it often polls below the 5 per cent required to enter parliament). Overall, the constellation of German political parties supports deeper integration to solve the debt crisis. Politicians are overwhelmingly pro-euro and pro-eurozone, even if they will drag their feet before putting Germany’s money where its mouth is. Business leaders also advocate more euro integration.

Public opinion is contradictory. Do Germans want to fund the periphery? No. Do they want the euro? Yes. As the crisis worsens, the public will choose both instead of neither. But this won’t come easy. Politicians need to make painful decisions. Explaining them to the public may be the single most dramatic reckoning that Germany faces. Yet even if opinion did turn against the eurozone, elite support wouldn’t. Living standards and prosperity are fundamentally tied to the EU and the euro. These countries are historically linked by the second world war and it will remain so. Finally, there is no legal exit mechanism from the eurozone.

When Germany joined the eurozone, it came with a price: abandoning the D-Mark for the euro. Happily, it turned out the price was a prize. The political benefits of the current situation are clear – Germany can shape fiscal integration on its terms, even if it comes with a steep price tag. Explaining this to the German public will not be easy, and it will be a long and winding road to European fiscal health. But this road goes through the eurozone – and Germany will pay top dollar for the driver’s seat.

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

Response by Ferdinando Giugliano

Germany must change if it wants things to stay as they are

Germany’s gut instincts towards the eurozone crisis are evident in the country’s coat of arms. The black eagle’s wings stand proudly open, its gaze is fiercely held. The display is there to instil fear and admiration into the weaker birds.

This notwithstanding, a country that should be using its full economic power to dictate the terms of any agreements, now risks punching below its weight. To truly shape Europe’s fiscal integration in its own terms, the bold eagle must first transform itself in the sly leopard. As in Tommasi di Lampedusa’s famous novel, if Germans want things to stay as they are, things – and Germany among them – will have to change.

Berlin’s commitment to the common currency is here to stay, as Ian Bremmer argues above. By providing Germany with both captive markets and a competitive exchange rate, the eurozone has allowed the country to unleash the full potential of its producers. As a result, Germany was able to enjoy remarkable trade surpluses and a fast spurt of economic growth. Between 2000 and 2008, exports made up as much as two-thirds of the growth in total German output. Ditching this recipe for success to enter unknown territory would simply be inconceivable.

Yet, since the flip side of Germany’s success has been the trade deficits of the other eurozone countries, any credible plan to rescue the euro must resolve the problem of intra-European imbalances. Though peripheral countries must improve their own competitiveness and tighten belts to reduce fiscal deficits, the core must provide a market for the goods of the less virtuous. If not, it should be prepared to fund their walk to redemption for many years to come.

This is indeed a “top dollar”-priced process – what is dearer than changing one’s identity? Yet, it is a price worth paying, and not just to keep the euro. As the warden of the union’s coffers, Germany is the most obvious candidate to lead the recasting of the eurozone governance framework. However, unless it convinces its partners and the markets that it willing to deal with the problem of imbalances, it risks losing control of the process. The fixation with orthodoxy has already led Germany to relinquish its control of the European Central Bank. It can ill-afford this other loss.

The writer is the Peter Martin fellow at the Financial Times.

The economic policy debate in Washington has come down to a boxing match between two opposing remedies – ‘stimulus’ in one corner and ‘austerity’ in the other. Unfortunately, considering each so-called solution in isolation has hampered both analysis and decision-making. The proponents of stimulus argue that the losses in aggregate demand following the global financial crisis must be reversed. Their opponents say that austerity is needed to restore fiscal sustainability. But to understand how elements of each fit together, a different approach is needed, one that “connects the dots” and integrates the sets of economic logic and data employed by the two sides.

The problems of the financial crisis and economic downturn are a case in point. Leading up to the crisis, market participants and policymakers failed to understand the interconnections within the “shadow banking” system. The ensuing freeze in the repo financing markets – particularly after Lehman Brothers’ bankruptcy – had severe adverse effects on credit demand and supply, and employment. But the US economy’s structural problems predated the financial crisis. Public policy and the financial system were geared to promote excessive reliance on consumption, with inadequate support for business investment and exports. Making the right connections would have exposed this imbalance, and the role of leverage in propping up economic growth that looked solid on the surface.

Understanding these links provides a clear direction to restart growth. The US economy must shift toward promoting investment and exports. This requires a return of confidence. Businesses need a shock to ‘animal spirits’ to promote investment, and the incentives to investment should be substantial. At the same time, debt-service burdens are constraining households’ ability to respond to policy actions. Consumers need to feel more secure about their net worth. Policies should facilitate these adjustments, and offer a foundation for growth and wealth appreciation.

There are three tangible steps to boost growth. First, fundamental tax reform is essential. The US must reduce marginal tax rates on household and business earnings and on savings and investment, while broadening the tax base. By lowering tax rates on corporate profits, dividends and capital gains, equity values and household wealth will rise immediately. It will also promote growth by raising investment.

Tax reform can add between one-half and a full percentage point to gross domestic product growth each year for a decade, according to research by Alan Auerbach of the University of California at Berkeley.

Second, a viable plan for medium and long-term fiscal consolidation is needed. The most straightforward would be a gradual slowing in the rate of growth of benefits in the Social Security and Medicare programmes. Such a move would reduce the likelihood of higher future taxes, thereby raising asset prices and expectations of household incomes and wealth. The shift could be gradual, but if credible, would generate significant positive effects today.

Third, financial frictions make it difficult for households and businesses to respond positively to fiscal stimulus or to low interest rates. Policy actions need to mitigate this broken link in the chain. In particular, frictions in the mortgage market and low equity levels have restricted the ability of tens of millions of borrowers to take advantage of very low interest rates by refinancing their mortgages.

This has blunted a key channel of monetary policy and led to large numbers of foreclosures. Household balance sheet repair would be accelerated if every homeowner with a mortgage through Fannie Mae and Freddie Mac who is current on payments were allowed to refinance their mortgage at the current very low rates. It would reduce debt-service burdens and offer the equivalent of a long-term tax cut (over the life of the mortgage) of up to $70bn annually. The credit risk of these mortgages has been borne by taxpayers since 2008 anyway, so the refinancing would not increase the Treasury’s risk exposure. It should reduce it, as defaults diminish. For businesses, significant investment incentives (as part of, or as a down payment on, fundamental tax reform) can directly lower the cost of capital for plant and equipment spending.

Focusing just on monetary stimulus and temporary tax cuts misses these important links. The positive effects of low interest rates on refinancing, household incomes and wealth have been cancelled out by mortgage market imperfections that can be straightforwardly fixed. Additional fiscal stimulus for business investment can mimic very low interest rates in the cost of capital.

These three seemingly disparate steps come into focus as one connects the dots in the causes of sluggish US economic growth. Taken together, they could improve growth sufficiently to bring the unemployment rate back to pre-crisis levels within four years. The proposed plan does not imply that short-term action by the government or the Federal Reserve is useless, but it should be consistent with the steps.

Otherwise, the debate we are having about stimulus versus austerity risks being as futile as rearranging the deck chairs on the Titanic.

The writer is dean of Columbia Business School and former chairman of the Council of Economic Advisers.

You cannot remove the fragilities in Europe’s banking system without solving the sovereign debt crisis… and you cannot solve the debt crisis without stabilising the banks. This much has finally been recognised by the Group of 20 finance ministers at their meetings in Paris over the weekend. They must now move on to addressing the underlying issues at next week’s European summit and the meeting of the G20 heads of state in November.

The bank-debt dynamics that grip the eurozone have all the elements of a destabilising feedback loop. As such, the longer they persist, the harder they are to overcome and the greater the economic and social costs. It is encouraging to see policymakers searching for a holistic policy, after months of ad hoc decisions. But for this to be reflected in more than just comforting rhetoric, they must quickly overcome disagreements on three key issues.

First, they have to make more explicit which balance sheets will do the heavy lifting. Current disagreements extend well beyond burden-sharing between the private and public sectors. There is also no agreement on the public sector component, including the allocation among tax payers in creditor and debtor countries, as well as the contribution of monetary institutions such as the European Central Bank and the International Monetary Fund.

Second, regardless of how the funding is organised, there are few mechanisms to inject it effectively into the system. Traditional transmission pipes are mostly clogged. The erection of new ones is hindered by an overall architecture that never envisaged the possibility, let alone the persistence, of the current challenges.

Finally, there is the even more difficult issue of conditionality. As America’s experience demonstrates, satisfying the first two conditions will fail the test of time if it is not accompanied by visible changes in behaviour by the recipients of the aid.

To make things yet more interesting, leaders must solve these three issues while countering the detrimental impact on economic growth, limiting the drain on public finances, and safeguarding the integrity of the monetary institutions. Much sharper (and politically bolder) distinctions between solvency and liquidity, austerity and structural reforms, old debt and new flows, and bail-outs and crowding in will need to be made.

Consider Greece where, by paying insufficient attention to these issues, the approach of the last two years has failed across the board. The country’s problems have been left unaddressed, contagion to the rest of the eurozone was not contained, and the institutional credibility and balance sheets of the ECB and IMF have not been safeguarded. Officials must now shake up Greece’s adjustment programme and its funding. This means much broader burden-sharing, including a bigger haircut for private holders of the sovreign debt. New private capital inflows should also be supported by partial guarantees, to help steer the exceptional funds Greece has received towards encouraging investment and future growth. The ECB and IMF should return to their core responsibilities, replaced by fiscal support from revamped European Union facilities. In the longer term, meaningful structural reforms would allow a shift away from excessive (and unrealistic) reliance on budget austerity and privatisation.

Finally, and most controversially, the architecture of the eurozone needs to be modified to enable a country in extreme difficulties, such as Greece, to regain control over a broader set of domestic adjustment instruments, including independent monetary and exchange rate policies.

Some, but not all, of these elements would extend to countries such as Italy and Spain, where liquidity and borrowing cost concerns must be countered before they morph into solvency ones. This includes using partial guarantees (as opposed to bond purchases by the ECB) to lower borrowing costs and attract private capital, insist on joint public-private equity recapitalisations for banks, and place greater emphasis on structural reforms, rather than just budgetary austerity.

Greater clarity on whether the medium-term stabilisation of the eurozone involves a fiscal union for the current configuration or among a smaller set of countries with similar initial profiles is also crucial. Make no mistake about it; there is no escaping these issues. Hopefully, the next few weeks will see elected leaders address them from a position of leadership. If they do not, they will find it even harder to deal with a crisis that is consistently progressing from one bad outcome to an even worse one.

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

A week ago, I travelled to Lake Karoun in Fayoum, Egypt, to meet 100 young people selected to take part in the “Lifemakers” training course established by Amr Khaled, a tele-preacher to millions and social entrepreneur. They were the sons and daughters of the upper middle class, volunteering to tackle illiteracy and drug abuse, and spread micro-finance, in Egypt’s poorest parts.

The vast majority said they had been in Tahrir Square in the heady months of January and February. Now they were back at university, school or work, but still passionate about the future of their country. Pious and secular, with headscarves and without, men and women debating and training together, they believe in pluralist Islamic democracy – drawing strength from Islam while respecting personal choice. Yet the meeting was electrified by the fear expressed by a woman in a white headscarf: “The question we are asking is what happens if the majority do not share our vision of the future.”

Little did we know that the next day the stark immediacy of this concern would be tragically exposed an hour and a half away in Cairo. The attacks on members of the Christian Copt minority, and the killing of 25 of them, encapsulate concerns in Egypt and the wider world about the direction of the revolution. In essence, the question is simple: when can Egyptians trust democracy? The answer should be the sooner the better, and the fuller the democracy the better. I say this not out of some naive faith in the kindness of human nature, but rather as a calculated and principled response to the challenges facing the most important Arab state.

Early elections do not appear to be Egypt’s current trajectory. Eight months after the revolution, the Supreme Council of the Armed Forces, which runs the country, is hedging its bets. The emergency laws originally introduced by former president Hosni Mubarak have been tightened. The army’s economic privileges are jealously guarded. There is talk of the election of a president being slipped into 2013.

It is easy to see the grounds for caution. The violence against Copts is only the most obvious cause. The broader fear is that the essence of the revolution will be perverted. The experience in Gaza in 2006, when Hamas won elections against a discredited Fatah, is used by some in the west to warn of the perils of democracy.

In Egypt, some 44 per cent of respondents in a poll said the country they most admired was Saudi Arabia. For many Salafists – puritanical Islamism went underground in the Mubarak years – pluralist, democratic Islam is anathema. Earlier this month there were newspaper reports that Salafi leaders had attacked those opposing islamic law as “adulterers, thieves and immoral people”.

Meanwhile, the Islamist Muslim Brotherhood is not only the most vibrant social welfare organisation in the country, it also has the best electoral machine. The Brothers are savvy enough to appreciate the risk of being tainted with sectarianism. They have a Christian as the vice president of their political party. They have said they will contest only 40 per cent of seats (though their religious allies will have no such constraint). They have an on-again off-again alliance with the liberal Wafd party and will not be running a presidential candidate.

Few take these points at face value.This is fuelling pressure for the west to conform to the stereotype propagated by the hardest of hardline Islamists – that the only democracy we defend is that which produces results we like. But this would be a great mistake.

The recent violence against Copts should intensify the demand for early elections of a civilian government that can be held accountable. The military authorities are at best ill-equipped for sensitive political decisions, and at worst feathering their own nest. But there are further reasons to believe in democracy, not reject it.

First, article two of the Egyptian constitution already specifies that sharia is the fount of all law and Islam is the state religion. This is repeated in the constitutional declaration issued by the ruling military. So railing against Islamist reverence for Islamic law misses the point.

Second, the ballast of society continues to be its business and middle class. Elections are the way to produce a government that people can complain about as their own. The sooner it gets on with economic reform that powers growth and attracts back international investment – and the commitment of the diaspora – the better.

Third, it is vital to understand “Islamism”. It is understandable to be afraid of the strictures of Hamas or the Taliban. It is not reasonable to ignore the other workable models of what Egypt could be. Turkey’s AKP party is the most obvious. There are good grounds to criticise aspects of its rule, for example around media freedom, but I see in Turkey a drive to synthesise Islam and modernity, not to turn the clock back. There is also Indonesia – after all, the world’s largest Muslim country.

Fourth, there is a powerful case summarised by scholars at the University of North Carolina that the record shows not just that Islamist parties lose support as democracy takes root. They also seem to liberalise their platforms as democracy develops as the search for the culturally-conservative, politically-liberal swing voter drives them to the centre.

Finally, the greatest boost to the Islamist vote would be a sense of victimisation by the west. We should never appease views we hold to be objectionable. We should explain our differences. There is ample ammunition to challenge exclusive and sectarian definitions of Islam. But we should not fall into a rejectionist trap.

The Brotherhood is not any old Islamist group. It is where the movement started, in a country that should be the leader of the Arab world. So the stakes are serious. But so are history’s lessons. When you climb the Citadel in Cairo, built by Saladin in the 12th century, you can see the Rifai mosque. There is buried the Shah of Iran. Therein is the best riposte to the claim that dictatorship is the way to contain sectarianism. Dictatorship incubates sectarianism. The sooner it is replaced in Egypt, the better.

The writer is the MP for South Shields, and former British foreign secretary.

A group of almost 100 prominent Europeans delivered an open letter to the leaders of all 17 eurozone countries on Wednesday. The letter said, in so many words, what the leaders of Europe now appear to have understood: they cannot go on “kicking the can down the road”. The road has been blocked by the German constitutional court which has found the law establishing the European financial stability fund constitutional, but declared that no further transfers are allowed without Bundestag authorisation. The leaders have also understood that it is not enough to ensure that governments can finance their debt at reasonable interest rates, they must also do something about the banking system.

Faced with the prospect of having to raise additional capital at a time when their shares are selling at a fraction of their book value, the eurozone’s banks have a powerful incentive to reduce their balance sheets by withdrawing credit lines and shrinking their loan portfolios. The banking and sovereign debt problems are mutually self reinforcing. The decline in government bond prices has exposed the banks’ undercapitalisation and the prospect that governments will have to finance recapitalisation has driven up risk premiums on government bonds.

The financial markets are now anxiously waiting for the leaders’ next move. Greece clearly needs an orderly restructuring because a disorderly default could cause a meltdown. The next move will have fateful consequences. It will either calm the markets or drive them to new extremes.

I am afraid that the leaders are contemplating some inappropriate steps. They are talking about recapitalising the banking system, rather than guaranteeing it. They want to do it country-by-country, rather than for the eurozone as a whole. There is a good reason for this. Germany does not want to pay for recapitalising the French banks. While Angela Merkel is justified in her insistence, it is driving her in the wrong direction.

Let me stake out more precisely the narrow path that would allow Europe to pass through this minefield. The banking system needs to be guaranteed first and recapitalised later. National governments cannot afford to recapitalise the banks now. It would leave them with insufficient funds to deal with the sovereign debt problem. It will cost the governments much less to recapitalise the banks after the crisis has abated, and both government bonds and bank shares have returned to more normal levels.

The governments can however, provide a guarantee that is credible because they have the power to tax. It will take a new legally-binding agreement for the eurozone to mobilise that power, and that will take time to negotiate and ratify. In the meantime, they can call upon the European Central Bank, which is already fully guaranteed by the member states on a pro-rata basis. To be clear, I am not talking about a change to the Lisbon Treaty but a new agreement. A treaty change would encounter too many hurdles.

In exchange for a guarantee, the major banks would have to agree to abide by the instructions of the ECB. This is a radical step but necessary under the circumstances. Acting at the behest of the member states, the central bank has sufficient powers of persuasion. It could close its discount window to, and the governments could seize, the banks that refuse to co-operate.

The ECB would then instruct the banks to maintain their credit lines and loan portfolios while strictly monitoring the risks they take for their own account. This would remove one of the main driving forces of the current market turmoil.

The other driving force – the lack of financing for sovereign debt – could be dealt with by the ECB lowering its discount rate and encouraging countries in difficulties to issue treasury bills and prompting the banks to subscribe. The bills could be sold to the central bank at any time, so that it would count as cash. As long as they yield more than deposits with the ECB, the banks would find it advantageous to hold them. In this way, governments could meet their financing needs within agreed limits at very low cost during this emergency period, yet article 123 of the Lisbon Treaty would not be violated. I owe this idea to Tommaso Padoa-Schioppa.

These measures would be sufficient to calm markets and bring the acute phase of the crisis to an end. The recapitalisation of the banks should wait until then. Only the holes created by restructuring the Greek debt would have to be filled immediately. In conformity with the German demands, the additional capital would come first from the market and then from the individual governments. Only in case of need would the EFSF be involved. This would preserve the firepower of the fund.

A new agreement for the eurozone, negotiated in a calmer atmosphere, should not only codify the practices established during the emergency but also lay the groundwork for a growth strategy. During the emergency period fiscal retrenchment and austerity are unavoidable. But the debt burden will become unsustainable without growth in the long term – and so will the European Union itself. This opens up a whole new set of difficult but not insurmountable problems.

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

Response by Sony Kapoor

Europe’s dance of death between sovereigns and banks

George Soros is right in saying the discussion on recapitalisation of European banks is flawed. However, the best way to address the panic in the banking system is not through guaranteeing the banks, but through restoring full faith in the solvency of large eurozone economies instead.

Weaknesses in the European banking system have been known for some time, so why the sudden panic?

European Union policymakers have let Greece’s unique fiscal problems colour their prescription for countries such as Spain and Ireland which had banking, not fiscal, crises. Growth has also suffered in other countries, as austerity measures became fashionable. This economic slowdown, weak stress tests and the EU’s inability to handle the relatively small problems of Greece, combined to also erode confidence in Spain and Italy.

As interest rates paid by Italy and Spain soared, bond prices fell and led to deterioration in perceived soundness of banks holding these bonds. With more than €2,000bn in Spanish and Italian government bonds outstanding, even a small deterioration in their quality can put a significant dent in the capital banks hold. Investors and counterparties first shunned banks that held these bonds and then banks exposed to banks that held these bonds. Now we have a systemic crisis.

Today Europe is stuck in a dance of death between sovereigns and banks. In countries such as Ireland, banks have brought the sovereign to its knees, whereas in Greece the weakness of the sovereign has cost its banks dearly. Weak banks, such as some Spanish cajas, continue to weigh their sovereign down, whereas deteriorating sovereigns such as Italy are casting a dark shadow on the soundness of banks.

We must break this sovereign-bank loop and Mr Soros is right to point out that national level recapitalisation will only reinforce it. No amount of bank capital that could be raised, or guarantees that could be offered, would be sufficient to save European banks if doubts about the solvency of Italy and Spain are allowed to persist.

Greece was insolvent, but was it handled as though it had liquidity problems. Spain and Italy, which are solvent but illiquid, are being allowed to drift down towards bankruptcy through an insufficient provision of liquidity support. At this rate, they will take the EU banking system down with them.

The European Central Bank needs to provide an open-ended commitment to support illiquid countries and refinance their debt at affordable rates. It will make bond prices perk up and remove the biggest source of capital shortfall in EU banks. The European financial stability facility could step in, but only temporarily, if the ECB refuses to act.

Capital buffers can be built up through enacting a moratorium on bonus and dividend payouts, with the EFSF potentially supporting weak banks in weak countries. In the future, robust bank resolution legislation would help reduce the dangers weak banks pose to their sovereigns. Some form of eurobonds could be held by banks as protection against overexposure to weak sovereigns.

To restore growth, the callable capital of the European Investment Bank should be doubled to finance a growth-enhancing programme of investments in pan-European infrastructure. Greek debt stock needs to be brought down to not exceed the size of the country’s gross domestic product. Europe’s single-minded focus on austerity needs to go the way of its flawed bank recapitalisation plan.

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

The world wants the eurozone to act, to do something that impresses the financial markets, a “big bazooka”, as David Cameron puts it. Among the recommendations generally given are an increase in the size of the European financial stability facility; a debt-monetisation programme by the European Central Bank; standby arrangements by the International Monetary Fund; bank recapitalisation, and a once-and-for-all resolution to the Greek debt problem. No matter what you do, do it now, and do it big, eurozone leaders have been told.

This is unhelpful advice, and if followed, it would make the crisis worse.My argument is not about symptoms and causes. It is about financial stability. A big bazooka, without a simultaneous commitment to a fiscal union in the distant future, could turn out to be extremely destabilising.

When the EFSF was first agreed last May, it was supposed to be the big bazooka. A shock-and-awe strategy, as one analyst famously called it. But it turned out to be a crisis propagator. The fundamental problem of the EFSF is that everybody guarantees each other in a game of domino. Italy’s guarantees make up 18 per cent of the system. But this 18 per cent lacks credibility. Italy is hardly in a position to pay its own debt, let alone guarantee someone else’s. While France is healthier, its guarantees to Italy also lack credibility. And so do German guarantees for France. If you follow the line to the end, there is no ultimate backstop.

If you double or treble the size of the EFSF without changing its underlying structure,all you do is double or treble the lack of credibility. If you really want to increase the size of the EFSF without destroying it, then you are left with two options: you have to back it through an unlimited guarantee by the ECB, the only organ in the eurozone that is in a position to give such a commitment. Or you have to change the EFSF’s legal status through the adoption of joint and several liability. This means that member states jointly agree everybody’s debt. The two options ultimately mean the same. The liabilities of the system will be shared jointly by all of its participants. If you want to annoy certain people, you could also call the latter a eurobond.

The fallacy of the national guarantees also applies to a recapitalisation of the banking sector. I would strongly favour an across-the-board increase in the core tier 1 capital ratios for all banks. But if member states end up providing the cash, the overall risk of the system remains the same. That also applies if the EFSF were to recapitalises the banks, since its ultimate liability also rests with member states. The best option to handle the bank recapitalisation would be through the European Investment Bank if only because it has unlimited access to ECB funds. Again, some form of joint and several liability is needed, or the facility of an unlimited ECB bailout. Both options are, of course, precluded by current law, and would require deep changes to national constitutions and European treaties. We are not talking about a bazooka here, but about some of the biggest political changes in the history of European integration.

If the European Council were to agree a three-stage for a fiscal union by 2025, the big bazooka might just work. The prospect of joint and several liability, and a eurozone treasury in the distance could pave for a temporary backstop of infinite size today.

But without even a faint prospect of a fiscal union, any increase in the size of national liabilities is politically and financially unsustainable. Just look at what happen in Slovakia this week, where the parliament vote against the ratification of the latest and comparatively modest EFSF treaty, forcing the resignation of the prime minister. This will not be the last political upset. So far, nobody has even transferred a single euro cent across their borders. Just imagine the politics and the financial contagion, once your doubled or treble guarantees fall due.

We have reached the end of the line with the present system of a monetary union that refuses to be a fiscal union. We are right at the edge of what is legally, politically and financially possible under the current legal and political structures. That is why the Europeans are tinkering, and not firing. To move, they need a new monetary union.

I always thought that the eurozone would eventually reach a bifurcation point when it will have to decide whether to adopt a fiscal union or break up. We are getting closer to this point. A big bazooka, not backed by any credible commitment to fiscal union, sounds like a great idea, but it would end up accelerating the break-up. If you want to preserve global financial stability, the message you should send to Angela Merkel and Nicolas Sarkozy is adopt joint and several liability, rather than encourage them to search for another elusive quick fix.

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

Response by Iain Begg

Wolfgang Münchau is right to argue that simply shifting financial liabilities around does not make the underlying problems go away. Precarious banks will still be precarious and governments will still need to find pathways to fiscal consolidation.

But the reason for deploying the “big bazooka” is not so much about actually firing it, as persuading markets that it is there and could be fired. Knowing this, markets will be more hesitant about picking on the next victim, be it a bank or a sovereign. In this game of poker, the big bankroll does make sense because the speculators risk being burnt. Having it in place sooner rather than later must make sense.

Between them, governments and central banks unquestionably have the ability to generate large amounts of liquidity – it used to be called printing money. Even if the Italian contribution is open to doubt, the Austrians, the Germans and the Dutch are not constrained and a bigger commitment from them alone could make a huge difference. It is also arguable that, despite its formal structure, the current EFSF would in practice become joint and several guarantees if it ever actually had to cover for defaults.

Mr Münchau is also right to argue that a choice will soon have to be made between fragmentation and fiscal union, but he doesn’t spell out what the latter means. Fiscal union in the sense of commitments to fiscal rules is slowly taking shape in the euro area – too slowly perhaps and with the critical issue of compliance still to be tested, but far-reaching nonetheless.

Gradually, too, the euro is moving towards fiscal union in the sense of mutualising liquidity provision. Eurobonds are the logical end point of this form of union. It can be argued that we are now only one or two crises away from even the visceral German opposition to such a development being overcome.

Fiscal union in the sense of Germans paying directly for Greek public services is so far beyond the pale that it has become a pretext for inaction. Nor does it have any real bearing on the immediate financing challenges. Instead, what is needed is a short-term strategy for crisis management and a longer-term redesign of euro governance that includes eurobonds. A big and rapidly deployed bazooka is part of the former. Let’s not confuse it with the longer term solutions.

The writer is professorial research fellow at the European Institute at the London School of Economics and Political Science.

The financial crisis struck the US harder and more quickly than it did Europe. The complete freezing of credit markets required an immediate and overwhelming intervention – and the American fiscal and monetary authorities delivered it. Between the Federal Reserve, Treasury and the Federal Deposit Insurance Corporation, approximately $13,000bn of credit support was arranged for financial institutions in late 2008 and 2009. There was no alternative to this massive reaction, and it worked. US credit markets are now healthy, and the recapitalised banking system is stable. History will look favourably on the boldness of America’s response.

In contrast, the European Union has had much more time to strengthen its financial institutions but hasn’t developed any of the necessary tools. Not a powerful and flexible central bank. Not an effective central banking regulator. Not a sufficient political consensus. As a result, the world has watched a steadily deepening sovereign debt problem metastasise into a full blown banking crisis. Global markets fear big losses on bank holdings of sovereign debt. And, total liabilities of eurozone banks are now estimated to exceed 300 per cent of the region’s gross domestic product. That’s exponentially higher than the comparable US ratio at the worst moment in 2008.

Germany and France recently committed to producing a bank rescue plan by November 3 but have provided no details. This is a golden chance to redeem the fading credibility of Europe’s leaders. Especially if they apply the blueprint of America’s banking intervention. Both what went right and what went wrong.

Most crucial is that the financial equivalent of overwhelming force is applied. The goal is to restore market confidence in the banks, not satisfy technical requirements on capital ratios. To achieve this always requires a larger commitment than financial markets are expecting. The International Monetary Fund originally estimated that at least €200bn of new capital was required. Despite other lower estimates, this is the right target.

This rule of overwhelming force will be the hardest for them to follow. It mandates that their painfully incrementalist mindset of the past 18 months be set aside. But, Europe is facing renewed recession. If this banking crisis is not truly solved, that will materialise. Then, its current political problems may look small.

Second, this bank recapitalisation fund – the “euro Tarp” – must reside in a central facility. The capital need is too big, and time is too short for each nation to handle its own banks. Had the US Tarp been divided among multiple parties, it would have failed. The natural central authority here is the European financial stability fund, provided that expanding it for this purpose doesn’t require approval of 17 different parliaments.

Third, the banks need direct infusions of equity. The US Treasury initially designed the Tarp to acquire bad assets from the banks, but then reversed itself and only made such equity investments. It realised that the banks needed permanent capital more than the sale of dubious assets at low prices. If the euro-Tarp does not follow this pattern, its actions will not be taken seriously by financial markets.

Fourth, the first round of bank investments should be made quickly and unilaterally. The US Treasury did not negotiate with the first ten banking institutions which, simultaneously, received Tarp capital. It determined the necessary amounts for each, developed identical terms, and directed that they be accepted. Realising their own fragility, the institutions agreed.

Fifth, these investments should be accompanied by further support from the European Central Bank. The US Tarp investments were supplemented by a program of FDIC guarantees on certain, senior bank borrowings. This way, bank balance sheets were strengthened from top to bottom. For European banks, a standby facility like this, which might or might not be necessary to activate, should come from the ECB.

Sixth, the euro Tarp investments must carry both strong protections and equity upside for the taxpayers. That means taking back preferred shares, not common stock; separately receiving long-term warrants to purchase new shares of bank common stock at current market prices; and restrictions on executive compensation, dividends and acquisitions until the preferred shares are redeemed in full by the banks.

Here, Europe can learn from an American mistake. The US Treasury sold its Tarp warrants as soon as it could. For political reasons, it wanted to quickly terminate its ownership positions in banks. But, this approach sacrificed future upside gains for taxpayers, which they deserved. The euro Tarp should take a longer term approach.

Finally, bank recapitalisations should be accompanied by credible stress tests, like those Washington applied. The European Banking Authority’s tests continue to be too lenient, and markets do not believe them. Stricter tests, however uncomfortable the results, are necessary for restoring confidence.

That eurozone banks require injections of government capital may be a blessing in disguise. The beleaguered EU leadership now has a fresh opportunity to rebuild market confidence and thwart recession. It need only apply the lessons of America’s banking rescue, which are right there in black and white.

The writer is founder and chairman of Evercore Partners and was US deputy treasury secretary under President Bill Clinton.

Response by Daniel Gros

A ‘euro Tarp’ can’t fix the banks, and could even exacerbate the crisis

US Tarp was launched in 2008 in response to the banks’ losses on real estate lending and securities. Hence recapitalisation of the banks by the government was required. European banks had also made losses on their US investments, mainly residential mortgage-backed securities, and they also needed support from their governments.

In contrast today European banks are under water because the value of government bonds they hold has gone down. Their governments cannot get them out of this hole because the region’s banks and governments are now linked so closely that they should be considered to have a consolidated balance sheet. In effect, recapitalisation by national governments is just a shift from the left to the right pocket. This is why a “euro Tarp” will not solve the eurozone’s key problem: the loss of confidence in government debt.

A badly-designed bank rescue operation might actually make things worse. It would increase the burden on governments, in terms of outright debt and potential liabilities, thus depressing peripheral bond prices even further. It may even lead to a spread of the crisis to the eurozone’s core countries, with France as the most likely first victim.

The writer is the director of the Centre for European Policy Studies, a Brussels-based think-tank.

Less than three weeks before the next G20 meeting in France, the eyes of the world are firmly fixed on Europe. President Nicolas Sarkozy seems to share the desire of many of his predecessors for grand global meetings. Well, this one is going to be just as, if not more, important than many such meetings of the past. The power of the G20 meetings in the spring of 2009 in London, the success of the Plaza September 1985 gathering and the Louvre Accord 1987 will need to be matched, if not exceeded, if we are to get past the current eurozone crisis.

A number of key policymakers from outside of the eurozone, including Tim Geithner and George Osborne, have highlighted the November 3 meetings as critical in setting global financial markets on a better footing. On Sunday UK prime minister David Cameron urged European leaders to take a “big bazooka” approach to resolving the crisis, warning they have just a matter of weeks to avert economic disaster. Unsurprisingly, expectations have been raised. The credibility of the Europeans’ stance will be crucial, possibly in a way that it hasn’t been at any global leaders’ gathering yet.

Unfortunately, eurozone’s policymakers seem to be fond of the “muddle through” approach to policymaking. This has been a feature of European solutions to issues arising from the European Monetary Union since its creation in 1999, through dealing with challenges such as the adjustment of the Growth and Stability Pact and, of course, repeatedly since the Greek debt crisis exploded last spring. Yet it seems as though muddling through is no longer enough to keep financial markets at bay. If no credible “big bang” is unveiled next month to convince the markets, consequences are likely to be severe.

Firstly, given hardly anyone still believes Greece can avoid a major debt restructuring, it would be better to get it over and done with. The country appears to have neither the aptitude or flexibility to cope with the repayments it faces, and it clearly can’t grow its way out of such debts. By offering a decisive restructuring, agreed and recognised by key European and G20 policymakers, this would show eurozone leaders were finally facing up to reality.

Secondly, policymakers need to agree to a framework for the adequate recapitalisation of Europe’s banking system. If there is going to be a successful debt restructuring for Greece, with minimum adverse contagion effects, this will be vital. President Sarkozy and Chancellor Angela Merkel appear to have agreed in Berlin this weekend that they will have a comprehensive package by the end of the month. Taking guidance from the successful US stress tests of early 2009, it is time for them to take the lead, and put an end to the constant second guessing by the financial markets about the capital adequacy of Europe’s banks.

Thirdly, leaders must make clear that while Greece has a solvency challenge, the bigger economies of Italy and Spain only have problems with liquidity. In order to convince the markets of the distinction, both Italy and Spain need to demonstrate that their medium to long term fiscal paths are credible and improving. Adopting Germany’s constitutional budget stability model could be a major feature.

Lastly, and perhaps most importantly, all the key eurozone policymakers have to show that that they are on the same page. This is true with respect to Germany and France, as well as the European Union itself and the European Central Bank. While it is important that the ECB’s cherished independence be respected, events have demonstrated throughout the past troubled 18 months, that the bank has been forced to undertake a number of policies it had not planned to do. It needs to embrace a different spirit if agreements made by Europe’s leaders and the G20 are to be successful. Many other independent central banks have considerable flexibility without abandoning their prime goals. Just look at the Federal Reserve Board, the Reserve Bank of New Zealand, which pioneered inflation targetting and, most recently, the Swiss National Bank.

By using the phrase “unlimited” in describing their how far they would go to intervene to support a lower limit for the Swiss Franc’s value, the SNB has not had to spend much at all to achieve these goals (so far at least). By adopting the same bold approach to direct liquidity-provision for the European bond markets, or possibly through leverage for the expanded European financial stability facility, the ECB could turn the current situation around. Longer term, steps towards genuine fiscal union including the development of a true euro-denominated bond market seem sensible goals. But unless Europe’s policymakers stop trying to “muddle through”, all these goals will be pointless.

The writer is chairman of the asset management division of Goldman Sachs and former chief economist at the investment bank.

Response by Raoul Ruparel

Keeping the ECB independent is key to the euro’s survival

Jim O’Neill sets out some important and necessary steps for how to solve the eurozone crisis – including a restructuring of Greece’s debt, recapitalising Europe’s banks and greater leadership from the European Union leaders. However, the problem in the eurozone crisis was never primarily one of not knowing what to do, but how to get there within the constraints of a supranational currency, pegged to national democracies and fiscal policies. What’s clear, however, is that spraying more liquidity at the eurozone crisis is in itself not a magic panacea – and could even make the single currency less sustainable in the long term.

The notion that the European Central Bank should offer an “unlimited” backstop for eurozone nation states, as Mr O’Neill mentions, is a case in point. Clearly, the loser from the “muddling through” approach employed by EU leaders over the past year has been the ECB. It has seen its credibility drained and its independence compromised (for example through its U-turns on accepting junk bonds as collateral). In fact, an important component of finding a long-lasting solution to this crisis is that any financial backstop for the eurozone is established at the intergovernmental level, not through the ECB.

There are a number of reasons for this, many of which stem from the central bank’s experiences during this crisis. First, the cheap and plentiful liquidity that the ECB has provided to European banks created perverse incentives and moral hazard, possibly leading banks to chase profits through higher yields on peripheral sovereign debt, thereby increasing exposure to the crisis. In addition, this unlimited credit created a set of so-called ‘zombie banks’ reliant on ECB liquidity to survive, but without any conditionality to reform the bad practices and mismanagement that got them into this situation in the first place. The lack of an exit strategy from these policies shows why transferring this model to the sovereign debt markets would be dangerous and undesirable.

Furthermore, let us not forget that, unlike the Federal Reserve and other central banks, the ECB does not have a dual mandate – its primary aim is that of price stability. If markets do not believe it can achieve this, and if the line between politics and monetary policy become increasingly blurred, then market instability and fluctuations may become the norm for the eurozone. That the eurozone lacks a lender of last resort, is a structural flaw in its fabric which has been sorely exposed by the current crisis.However, papering over it with unlimited liquidity in the near term will not solve the problem. And perhaps most importantly, forcing the ECB into the role of lender of last resort could seriously jeopardise German support for the entire euro project, with the ultimate outcome equally unpredictable to that of the current market turmoil. The Germans still take ECB independence seriously, as witnessed by the dramatic resignation of Jürgen Stark over the ECB’s bond-buying programme. As attractive as it may sound at first glance, we should be wary of the temptation of sacrificing the ECB’s credibility at the altar of a short-term fix.

Finally, let’s not forget that, even following a solution to this crisis, a vast array of countries will be left with mismatched interest rates, an overvalued currency and a convoluted decision making process. The problems in the eurozone run much deeper than additional liquidity can solve. Yes, Greece needs to restructure, banks need to be recapitalised and if an inter-governmental, democratic way can be found to top up the European financial stability facility, with more focus on banks, this should also be explored. Alas, this may not be enough to save the euro.

The writer is an economist at Open Europe, an independent think tank on the European Union.

Last week resolved the remaining questions about which Republicans are running for president. Chris Christie, the outspoken governor of New Jersey, and Sarah Palin, the misspoken conservative celebrity, will not. The field is set and pointed towards a surprising outcome. In the most conservative moment in the US in decades, a party dominated by Tea Party radicalism is on course to nominate the mild and moderate Mitt Romney.

In the interminable debates that punctuate the primaries, Mr Romney stands aloft from a quarrelling chorus of patriotic anarchists: Rick Perry, the gallows-loving governor of Texas; Ron Paul, the ascetic libertarian; Herman Cain, an African-American pizza magnate; Rick Santorum, who appeals to the religious right; and Michele Bachmann, who appeals to late-night talk-show hosts in search of material. Newt Gingrich, abandoned by his own staff, remains irrelevantly in the race. So too does Jon Huntsman, who has great appeal, but not to Republican voters. These seven dwarves run against Mr Romney while he runs against Barack Obama.

There is sure to be more drama before it is settled, if only because the media cannot tolerate a stagnant race. It is not certain that southern Baptists will get behind a Mormon. But the Republican nomination is now Mr Romney’s to lose, and there is no reason why he should.

To the disappointment of radical conservatives and Obama liberals, the former Massachusetts governor is sane, intelligent and reasonable. Unlike some of his rivals, he does not deny the facts of climate change or evolution. He is not proposing vast tax cuts or reductions in social spending. His politics express the world view of a successful businessman who became the technocratic governor of America’s most liberal state.

When he ran in 2008, Mr Romney swung too far and too fast from his Massachusetts persona, and came across as pandering and incoherent. This time, he has given up being anyone’s first choice and striven to become everyone’s second. His strategy has been to make himself tolerable to the Tea Party, while developing positions with an eye toward the general election.

Mr Romney made this approach clear in May when he declined to disown the universal healthcare plan he championed in Massachusetts. This plan, based on a requirement that individuals buy insurance with the help of a subsidy, is essentially the same as Mr Obama’s, done at the state level. Arguing that Obamacare is procedurally rather than substantively wrong is tricky, but disowning his chief accomplishment would have been disastrous.

In other areas such as abortion and immigration, Mr Romney has simply reversed his prior positions. He can do this because he is, like Mr Obama, a pragmatist. One can cast this as insincerity or lack of principle, but in truth it is simply the problem-solving mindset of the management consultant and corporate turnround artist Mr Romney was before he entered politics. Faced with a new competitive challenge or evolving consumer preferences, the shrewd businessman swiftly adapts.

In moving from the liberal Massachusetts market to the ultraconservative Republican primary one, Mr Romney faced a daunting challenge in rebranding. Being pro-choice on abortion, supportive of gay rights, lenient on immigration and concerned about climate change helped him gain market share a decade ago. In the 2008 presidential race, he replaced those positions too precipitately with a new product line, spawning a consumer backlash. In 2012, he is positioning himself between the Romney of 2002 and the Romney of 2008.

This managerial malleability alarms Tea Partiers, but should be a relief to everyone else. Mr Romney is not a radical and will not govern from the far right, unless the country has gone there first. When the time comes for him to behave responsibly, he will have less trouble in accepting the necessity of higher taxes. For those interested in the economic choices the next president will face, Mr Romney’s non-ideological nature is a major plus.

The greatest risk he faces in the primaries and as a potential nominee is becoming a Republican John Kerry. He does not suffer from Mr Kerry’s pomposity or tin ear, but courts mockery by sounding too much like the product of focus-group testing. He lacks humour and spontaneity. Few detest him, but no one outside of his equally flawless family can be said to love him.

Mr Obama’s team has to choose whether to depict him as an extremist in mufti or a flip-flopper, which was how the 2004 Bush campaign devastatingly defined Mr Kerry. The problem with the first line is that it is not true. The problem with the second is it may be Mr Romney’s greatest advantage.

The writer is chairman and editor-in-chief of The Slate Group and author of ‘The Bush Tragedy’

The eurozone is confronted with a crisis of not just labour costs and prices – but culture. The burden is primarily on southern Europe, where sovereign bond credit spreads (relative to the German Bund) range from 370 basis points (Italy) to 1,960 basis points (Greece). The northern eurozone countries have tight spreads against Germany – a narrow 40 to 80 basis points for the Netherlands, Austria, Finland and France. There are thus two distinctly defined eurozone areas: in the north and in the south.

The ranking of credit risk spreads by size across the eurozone in 2010 was almost identical to the ranking of the level of unit labour costs (relative to that of Germany), suggesting that the higher labour costs and prices have rendered “euro-south” less competitive and so more subject to credit risk. The more competitively priced net exports of the northern eurozone participants, in effect, more than covered the rising level of net imports of the south. In short, between 1999 and the first quarter of 2011, there has been a continuous net transfer of goods and services shipped from the north to the south. Northern Europe in effect has been subsidising southern European consumption from the onset of the euro on January 1 1999. It is not a recent phenomenon.

I recall that in the early years of the eurozone there was a general notion in the markets that the Greeks were behaving like the Germans. But there is scant evidence that on embracing the euro southern members significantly altered their behaviour – behaviour that precipitated chronically depreciating exchange rates against the D-Mark. From 1990 through to the end of 1998, euro-south unit labour costs and prices rose faster than in the north. In the years following the onset of a single currency, that pace barely slowed. In fact, the underlying trend was stopped only by the financial crisis of 2008. Since then there have been signs of price level stabilisation in the north and the south.

The ability for the south to sustain its pre-euro financial excess after 1999 was facilitated by borrowings subsidised by the credit ratings of euro-north members. Before 1999, borrowing in the legacy currencies of the south was far more expensive than in the north. But, anticipating the euro, drachma-denominated  10-year sovereign bonds fell more than 450 basis points relative to German Bund rates in the three years leading up to Greece’s adoption of the euro in 2001. Likewise, Portugal’s escudo yields fell almost 375 basis points and Italy’s lira yields fell by nearly 500 basis points in the three years preceding the formation of the eurozone on January 1 1999. Changes in pre-euro entry bond rates for France, Austria, the Netherlands, Finland and Belgium were negligible.

Subsidised borrowing may have accounted for much of the acceleration in the ratio of euro-south consumption relative to that of Germany. It rose between 1995 and 1998 at a 1.26 per cent annual rate. Presumably as a consequence of subsidised euro credit, that ratio accelerated to a 1.63 per cent annual rate of increase between 1998 and 2007.

Euro-north has historically been characterised by high saving rates and low inflation, the metrics of a culture that emphasises longer-term investments rather than immediate consumption. In contrast, negative saving rates – excess consumption – have been a common feature of Greece and Portugal since 2003.

There remains the question of whether most, or all, of the south would ever voluntarily adopt northern prudence. The future of the euro beyond a select group of northern countries with a similar culture will depend on the ability of all eurozone nations to follow suit.

Failing that, the eurozone will not have the ability to address the key concern of currency-pooling arrangements: that the value created by a pooling arrangement tends to be distributed disproportionately in favour of the financially less collegial and less prudent members of the pool. We observed this tendency as growth of the south relative to Germany accelerated following the creation of the euro. Thus, unless restrained, the less collegial members of the pool will try and often succeed in exploiting their advantage, as Greece so brazenly did recently.

If the euro is to remain a viable currency across the eurozone, members must behave in the responsible manner contemplated in the Maastricht treaty. But it is not clear that culture, so integral to a nation’s personality, can be easily altered. As Kieran Kelly noted last week: “ . . . if I lived in a country like this [Greece], I would find it hard to stir myself into a Germanic taxpaying life of capital accumulation and arduous labour. The surrounds just aren’t conducive.”

It seems inevitable that for the euro to prevail, something more formidable than the failed stability and growth pact is needed to constrain aberrant behaviour. It may be that nothing short of a politically united eurozone, or Europe, will, in the end, be seen as the only way to embrace the valued single currency.

The writer is former chairman of the US Federal Reserve

Response by Miranda Xafa

The focus must be on solving the immediate crisis of confidence

Alan Greenspan correctly identifies the north-south divide between the surplus countries in northern Europe and the deficit countries in the south as the main force that drives the eurozone apart. Its leaders recognise this and have agreed to a ‘pact for the euro’ that will tighten the fiscal discipline needed for a common currency area to survive. The pact, agreed at the European Union Summit on March 25, seeks to impose much closer economic and financial surveillance through balanced-budget amendments and by monitoring unit labour costs to ensure they are in line with productivity growth.

This is all fine, but the immediate problem facing the eurozone now is a loss of confidence. It has driven credit spreads to all-time highs. Countries such as Italy and Spain, which are illiquid but solvent, must pay a high risk premium to roll over their debts. This premium raises debt service costs and will eventually undermine their solvency, triggering a further increase in credit spreads. European policymakers fully understand that it is essential to break this vicious circle by making it possible for these countries to borrow at lower interest rates. Indeed, the eurozone parliaments are in the process of revising the European financial stability facility’s charter to permit the bail out fund to make loans to countries such as Spain and Italy that have not lost access to the markets, to enable them to fund their deficits more cheaply and to recapitalise their banks.

Will this be enough? With contagion risking to spread even beyond Spain and Italy to France and Belgium, the answer is almost certainly no. Given the size of these countries’ gross borrowing needs, the €250bn the EFSF will have available – after allowing for prospective commitments to Greece, Ireland and Portugal – will not be enough to “wow” markets. European policymakers are said to be looking into ways of leveraging EFSF resources, possibly with the help of the European Central Bank, to increase its firepower.

The problem is not just dealing with the flow of debt service payments falling due, but also with the debt overhang of countries such as Greece, which is insolvent. Markets know that attempts to restore fiscal sustainability via austerity in the midst of a deep recession are bound to fail. What is needed is debt reduction. The agreement reached in the Eurogroup summit meeting on July 21 to “bail in” private creditors through a 21 per cent haircut on the Greek government bonds they hold is insufficient to restore Greek debt sustainability. Hopefully the haircut will be revised to something closer to 50 per cent to reassure markets that there will not be a re-restructuring of the Greek debt down the road. If so, new stress tests will be needed to assess bank recapitalisation needs.

Mr Greenspan is correct that greater political union is needed in Europe. The groundwork already has been laid with the ‘pact for the euro’ and the constitutional amendments to a balanced budget that will be required of all eurozone members. But first, the immediate confidence crisis and the debt overhang need to be addressed.

The writer is senior strategist at IJPartners, a wealth management company based in Geneva.

Charles Schumer is stirring up tensions between the US and China again. It is the fourth time the Democratic senator from New York has proposed legislation aimed at imposing high tariffs on “currency manipulators”, a pseudonym for China. But this bill is unlikely to fare any better than the previous incarnations because it shoots America in the foot.

The US would not have a smaller trade deficit if the Chinese renminbi appreciated against the dollar. And a strengthened renminbi would not reduce Chinese exports to the US as much as many expect. In part, this is because Chinese exporters are able to absorb the costs of moderate appreciation. But another reason is that China’s trade surplus has been entirely created by processing trade, where imported components are assembled at factories in the country. This is less sensitive to the appreciation of the currency than ordinary trade because companies can save on the imports, even while exports suffer.

However, that range of appreciation is still too small for Mr Schumer. He is probably looking for something in the range of 20 to 40 per cent. That would certainly slam Chinese exports but it would not mean that the US would necessarily start producing the things China exports today. In many cases it would simply be too expensive to produce certain goods in the US. Chinese assembly-line workers are earning one dollar an hour, less than one-10th of the rate their American peers enjoy.

In fact it would be very likely that any vacuum left by China would quickly be taken up by other exporter countries such as Mexico and Malaysia. Because these countries have higher wages than China, American consumers would end up paying higher prices, while the US’s total trade deficit would remain more or less the same.

John Boehner, Republican speaker of the US House of Representatives, has already raised doubts over Mr Schumer’s bill. The White House has also voiced concerns about the proposed bill’s consistency with the international obligations of the US. The retaliatory tariffs proposed by the bill would not find support from the World Trade Organisation and, in fact, the US would be likely to face a serious legal challenge if China brought the case to the organisation. In the worst case scenario, though, Beijing could choose to reciprocate with higher tariffs on American exports to China. People on both sides would lose out in that scenario and neither government would gain.

Instead of pressing for the renminbi’s appreciation, it would be much wiser for Mr Schumer to work to persuade both governments to enter a free trade agreement. Less than 3 per cent of China’s $1,400bn imports last year were made up of consumer goods, primarily because China still imposes high tariffs on such imports. American consumer goods would then be more likely to enter the Chinese market as many US products are currently more expensive there than in the US.

From a purely American perspective, a trade deal could be better than currency revaluation. The recent mild appreciation of the renminbi may not continue because it is subject to volatile market movements. A trade deal would not add any burden to the US, while a revaluation may force American consumers to pay higher prices.

Beijing authorities would also love the idea – gaining more imports from the US would serve multiple purposes for China. Americans would complain less; China’s blooming foreign reserves would grow more slowly and, for that matter, inflation would slow down. Added to that, ordinary Chinese would also be able to consume cheaper and better American goods.

But perhaps the most important element would be that a free trade agreement would represent a welcome acknowledgment from Washington that China is now a country of its own rank.

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

Once again the US Congress is finding it more convenient to play the China currency card as the panacea for America’s economic woes, rather than deal with the difficult issues in President Barack Obama’s recent employment bill.

China’s response to the proposed bill pressuring it into allowing the renminbi to appreciate was predictable, with simultaneous protests from all the relevant agencies. Given the threat to the global economy from the problems in the eurozone and the US, China’s leadership regards the currency bill as a distraction from the real issues that need to be resolved. At a time when China is one of the few sources of global growth, ratcheting up protectionist sentiments only makes it harder to secure the necessary multilateral co-operation. The country’s government sees the currency debate as yet another sign of why the American political system is broken.

Beijing is quick to note that the history of rapid appreciation of the yen under the Plaza Accord under pressure from the US did not eliminate its trade deficit with Japan but in China’s view only contributed to the latter’s long-term economic ills.  Moreover America’s trade deficit began to increase sharply in the late 1990s, well before China’s trade surplus began to take off in 2005.  America’s trade problems are thus seen as stemming from its large fiscal deficits that emerged with increased military expenditures abroad.

Many within China thought that given recent developments, criticism of its exchange rate policies would become more muted. After all, China has continued its policy of gradual appreciation of 5-6 six per cent annually. With the euro crisis and strengthening US dollar, the renminbi has been the exception in appreciating, while other major currencies have depreciated. China also notes that its trade surplus has declined sharply from 7 per cent to 8 per cent of gross domestic product five years ago to a projected 1-2 per cent for this year. And while reserves continue to pile up, this is seen as having more to do with capital inflows seeking higher returns – encouraged by expansionary US monetary policies – than by misaligned exchange rates.

Moreover, Beijing argues that bilateral trade balances are meaningless in a world dominated by production networks using China as the assembly plant for the world. More than half of the country’s exports come from “processing” trade, with China accounting for some 20 per cent of the value produced and the rest from components imported from other Asian countries, Europe and America. China’s trade surplus comes from processing trade. Thus America’s large bilateral trade deficit is not really with China but with east Asia more broadly. Take the iPod: it is recorded as a $150 export from China to the US – yet only $5 of the value added originates in China, the rest comes from half a dozen other countries with the bulk accruing to Apple itself.

In this context if Congress gets its way, the net impact will not be more American jobs but reduced global demand and higher prices for US consumers. As the recent ‘Spillover Report’ by the International Monetary Fund concluded – a 10 per cent appreciation of the renminbi would have a negligible effect on the US trade balance or its GDP. The positive impact would be greater although still marginal for other Asian economies.  Thus any jobs lost by China from a major appreciation would gravitate not to the US but to other developing countries.

Yet China has little appetite to turn this affair into a full-blown trade war since it has benefited greatly from open markets. Thus while the leadership will not let any perceived negative action go unchecked, its motivation will be to work towards constructive solutions.  But there is a danger that in the transition to its next generation of leaders, Beijing may find it necessary to take a harder line in response to any perceived politically driven actions by the US.

America should worry more about maintaining its position at the upper end of the technology spectrum as China may feel the need to reinvent itself if the pressure to sharply appreciate its exchange rate continues. Currently China exports an unusually wide range of technologically sophisticated products for its income level.  However, its high-technology exports are really processed finished products with the more sophisticated components coming from elsewhere. No wonder most US companies are more concerned about market access and technology transfer than futile currency wars.

The writer is a senior associate at the Carnegie Endowment and a former country director for the World Bank in China

Response by Rodger Baker

The more China reaches, the more insecure it feels

Beijing has embarked on a relatively steady appreciation of the renminbi since shifting to a managed peg last year. The Obama administration is mostly satisfied with this slower pace and has refrained from using the levers available to pressure China for any more rapid adjustments. However, as Yukon Huang argues, the current US domestic situation may be conducive to using the China issue for political gain. When there is a tough economic problem at home that cannot be resolved easily or quickly, it is often politically expedient to accuse a foreign power of unfair practices. The debate alone can often serve as a rallying point for political support.

Whether the bill is a serious attempt to curtail trade or just a source of renewed rhetoric, China must still respond on the basis of potential implications, rather than the likelihood of passage or action. As Beijing’s power increases, and its economy pushes Chinese interests farther from home, it is increasingly in competition with Washington. But the more China reaches, the more insecure it feels, making it particularly sensitive to any perceived pressure from the US.

Domestic issues facing China today – including an economic slowdown and stability concerns – are pushing the government to avoid any rapid shift in the renminbi’s value. And with a leadership transition planned for 2012, China could yet determine it beneficial to ratchet up tensions with the US in response to the currency bill.

The writer is vice president of strategic intelligence and lead China analyst at Stratfor, a Texas-based private intelligence company.

The repeated refrain during recent days and weeks has been that there is an absence of political leadership in addressing the crisis of the euro. That is unsurprising given the complexities of the issues and the fact that whatever is done – or not done – will lead to some redistribution of wealth and income.

Nevertheless, there are some simple truths that can and must be explained to Europe’s electorates. Until these truths are accepted, it will be impossible to move forward with the vast range of technical work that needs to be done to put new institutional arrangements in place. And the casualty list – this week Dexia, next week who knows – will continue to lengthen.

Europe’s leaders, especially those in creditor countries, need to explain three things that need to happen and one that cannot.

To start with the last: there are still people convinced that the current crisis can quickly be solved if one or more countries leave the euro. Maybe eventual divorce is possible, even though the euro was sold as marriage without that option. But divorce is not a simple matter, and some of the historical cases in Latin America or the former eastern bloc are false parallels. Leaving a currency that will continue to exist elsewhere, within a single financial market, is highly problematic.

No one knows today which euro-denominated contracts, which are found all over the world, should be redenominated into one or more new currencies. Would it be on the basis of nationality, or residence, or intended place of settlement of the contract, or law of jurisdiction over the contract? Who would decide? Which courts could enforce whatever was decided? In every case of redenomination there would be a winner and a loser, so every attempt to enforce a change would be disputed. Then arrangements for the new currency(ies) would be needed. Intricate preparations were made over many years to introduce the euro – we were involved.

It is conceivable that, after the passage of years, Greece, for example, will not be able to restore competitiveness even after a writedown of much of its debt and the implementation of a draconian austerity programme. At such a point its position within the eurozone would need serious scrutiny. But pressing the ejector button now could send the whole aircraft tumbling earthward.

Then there are three things that do need to be explained. The first is that the existing governance arrangements for the euro cannot simply be tweaked. We now know it makes no sense to hope that somehow, uniquely in a monetary union, every political unit can run a totally self-sustainable budget. No one expects this of Saxony or Sicily or even Virginia. Over the medium term there is no alternative to some form of federal fiscal arrangements. This is increasingly recognised by some German politicians. Leaders now need to explain that this must happen and start work on the difficult negotiations and treaty changes that will be needed.

The second is that we also now know that, in the period before longer term fiscal transfer arrangements can be put in place, some euro area governments will need debt relief. The social and political consequences of seeking to enforce debt collection, or war reparations, in full are well known. Leaders of creditor countries must explain to their electorates that responsibility for these debts is shared. Without willing lenders in creditor countries, these debts might not have been incurred, and without this lending, exports effectively financed by this lending and hence the overall economic performance of the creditor countries would have been far poorer. Debt relief is not charity. It is a mutual necessity within a monetary union. How much is needed by whom and on what terms is all for the future and depends on circumstances. But electorates need to know that it is going to and should happen.

Lastly, the European Central Bank must provide liquidity indefinitely to maintain the machinery of day-to-day economic activity. This is not bailing out banks. It is bailing out their customers. Banks that get themselves into difficulties need not, over time, survive as corporate entities. But their customers have to be supported. This is not an issue of moral hazard.

The ECB’s balance sheet will be extended and is likely to need support – which can ultimately only come from governments. Central banks are almost always ultimately backed by taxpayers. This need not affect their operational independence. Leaders must assure their electorates that explicit fiscal support for the ECB by eurozone governments, if it were needed, would only put the ECB in the same position as other central banks whose operational independence is unquestioned. In the rest of the world central banks support markets by buying government debt with the taxpayer, through governments, as ultimate guarantor of their soundness.

Until the eurozone’s leaders have explained to their electorates these four unavoidable facts we will all be going up blind alleys, when time is of the essence in averting potential economic and social disaster.

The writer is a former chairman of the UK’s Financial Services Authority. David Green, a former head of international policy at the FSA, is co-author. Their book, “Banking on the Future: The Fall and Rise of Central Banking”, is published by Princeton University Press

Europeans, and with them the rest of the world, are discovering what all doctors know – a persistently misdiagnosed and incorrectly treated infection can eventually threaten even the healthiest part of the body, thus requiring more drastic medical intervention whose effectiveness is less assured.

This is what is happening in Europe today. A debt and growth crisis in the outer periphery of the eurozone (Greece) has been allowed to destabilise the inner periphery and the outer core (Ireland, Italy, Portugal and Spain). In addition, signs of dislocations are now visible in the inner core – both through the banking system and directly.

In the last few weeks, European banks have come under increasing market pressure. In one case, that of Dexia, governments are being forced to counter worrisome fragility. Moreover, as recognised by policymakers, a banking system that previously was just on the receiving end of the sovereign debt crisis (because of large holdings of peripheral debt) now risks becoming a standalone source of disruptions – multiplying the policy challenges.

Stress is no longer limited to the continent. Reflecting the high interconnectivity of global banking, some American institutions have also come under pressure as contagion concerns amplify the detrimental impact of an economic slowdown and structural weaknesses that persist three years after the last global financial crisis.

Also interesting, and less noticed, is what is happening in a still-obscure market segment that sheds light on sovereign credit risk, albeit imperfectly. There, spreads on German credit default swap have quietly widened to around 120 basis points in the last few days.

Such previously unthinkable levels are fundamentally inconsistent with Germany’s very strong sovereign balance sheet and its impressive record of successful multi-year economic reforms. Admittedly, the situation is mainly a reflection of bank-related counterparty risk issues and imperfect portfolio hedging. Yet, at around twice the US level, the CDS spreads may also speak to market uncertainties regarding the size of the contingent liabilities that Germany could face on account of the eurozone crisis.

By defining a new stage in the crisis, these developments undermine a regional policy approach built on the presumption that the inner core of the eurozone – sovereigns with rock solid balance sheets and their banks – can help pull up those in the struggling rest committed to put their domestic house in order.

The priority now is to urgently reestablish this presumption, and do so in a decisive manner. To this end, Europe should move immediately on three mutually-reinforcing fronts whose impact can be reinforced by appropriate policy actions in America and the emerging world:

First, Europe needs more effective circuit breakers to stabilise the banking system. In some cases, this would require immediate equity injections and a broader range of emergency liquidity facilities. It is encouraging that European Union ministers were reported last night to be looking at bank aid plans.

Success here is closely linked to the second issue that materially impacts the asset quality of banks balance sheets – the paramount importance of a more refined and effective approach towards the peripheral sovereign debt crisis.

Europe needs to differentiate more definitively between countries whose main problem is high and volatile interest rates, such as Spain, and those where underlying solvency issues require immediate debt reduction, such as Greece. The latter implies a reformulation of the program supported by the Troika (European Central Bank, International Monetary Fund and EU) to incorporate realistic fiscal and privatisation components and a more aggressive private sector involvement.

Third, Europe should decide what it wants to look like in the future, and press forward on related structural and institutional reforms. As the largest actual and potential financier, Germany would need to choose between two corner solutions: a politically-driven, but costly, fiscal union involving the current membership (conceptually similar to what West Germany did with East Germany twenty years ago). Or a smaller, less imperfect and thus stronger eurozone, but one involving tricky transitional aspects.

Many around the world have witnessed the deepening crisis with a mix of astonishment, concern and, now, fear. Those who already rang the alarm in the hope of spurring effective policy actions are being joined by others who previously refrained from doing so due to worries that the alarm could, instead, contribute to policy paralysis. In the context of European actions on three fronts, all could contribute to containing a crisis that also risks to seriously undermine global economic growth, jobs, financial stability and social cohesion.

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

Let’s agree that a lot of bad stuff happened along the way to the 2008 financial meltdown and that a good portion of the responsibility can justifiably be laid at the feet of the Wall Street community. Whether or not laws were broken, the lack of discipline and inadequate controls around many lending and risk taking practices certainly merit some version of the vigorous rethink of the regulatory apparatus that is now in process.

That said, it is still possible to feel Jamie Dimon’s pain as he vented his frustration over new regulatory proposals at Mark Carney, Bank of Canada governor, while perhaps not always loving his tonality. As the chief executive of JPMorgan Chase (full disclosure: also a friend of mine), Mr Dimon presides over a bank that emerged the least scathed from the meltdown and arguably conducted itself more responsibly than most of its peers.

For its trouble, JPMorgan is now at the short end of the stick: potentially penalised for being American (because of the tougher US response to the crisis, at least so far) and penalised again by elements of the proposed Basel III rules, such as the potential requirement for an extra capital charge as a financial institution considered too big to fail.

That may be unfair but it’s not totally surprising. As New York was at the epicentre of the debacle, it’s only logical that Washington would take a stronger hand in reworking the rules and the oversight. And within the US political process, overreaction can easily occur, as it did with the Sarbanes-Oxley Act, which was intended to reform corporate governance and improve corporate accountability following a raft of fraud cases a decade ago.

Meanwhile, with no reliable mechanism yet in place to address the problem of ‘too big to fail’, a safety net of additional capital under these immense institutions is at least a political necessity, and arguably an economic necessity. In the fullness of time, Mr Dimon may well be proved right that such prudence is excessive, and a serious constraint on lending, not to mention shareholder returns. But in the meantime, bankers must appreciate that the understandable rage of the citizenry dictates nothing less.

Implicit in Mr Dimon’s commentary is the indisputably valid grievance that notwithstanding the broad recognition that financial markets around the world are interconnected and interdependent, we still lack a global supervisory framework. Just as US regulators may pursue toughness, so may – as many American bankers allege – some European supervisors choose a lighter touch.

A further conundrum is that the financial system consists of far more than just traditional lenders. Within the shadow banking system, hedge funds and other quasi-unregulated pools of capital can provide much of the same kinds of financing. The tougher the capital requirements and other strictures become on banks, the more business will flow to these dark pools, creating another set of risks to the financial system.

For the moment, the practical impact of Mr Dimon’s grievances may well be limited to his firm’s share price. Loan demand remains weak, and JPMorgan boasts a formidable capital base. With Europe deep in crisis, competition from continental banks will be muted for some time. And Basel III is years from taking effect.

What is urgently needed – but sadly nowhere on the horizon – is a comprehensive, worldwide system of regulation and supervision for a financial system that constitutes a sort of global circulatory system. While Mr Dimon may not agree with all the rules that would emerge from such an arrangement, at least all lenders would be competing on a level playing field.

The writer is former counsellor to the US secretary of the Treasury. He contributes a monthly column to the FT and blogs regularly.

Response by Desmond Lachman

We should be asking whether the banking reforms go far enough

Steven Rattner’s spirited defence of Jamie Dimon’s position in his row with Mark Carney is curious. For it comes at the very time that European events are pointing to the real likelihood of a second Lehman Brothers-style global banking crisis within the next year or so. If ever there was a time that the global banking system needed an enhanced safety net for banks that are too big to fail, it has to be now. Similarly, it would seem that this is the time to be thinking about not only more effective banking regulatory reforms, but deeper reforms of the global banking system that might minimise the possibility of yet another banking crisis down the road.

The 2008-2009 US-led subprime banking crisis could not have been as acute as it was without the ample and reckless financing provided by the American financial system over many years. So too is the case with the present European sovereign debt crisis. In the absence of an extended period of overly-generous provision of bank credit at low interest rates, the Greek government would not have been able to finance its excessive spending. Nor would the Irish and Spanish property bubbles occurred to anywhere near the degree that they did without reckless bank lending.

The European Central Bank is right to fear that a sovereign Greek default now could result in a major European banking crisis. For it is difficult to see how a Greek default will not trigger real contagion to Portugal, Ireland, and Spain at a time when the European banking system appears to be undercapitalised. The International Monetary Fund has recently suggested that Europe’s banks could be short of at least €200bn in capital needed to deal with a wave of potential defaults in the European periphery.

Before dismissing the pressing need for an enhanced safety net for the large banks that are too big to fail, Mr Rattner might have wanted to consider how exposed the US financial system is to the European banking system. In a recent study, the Fitch rating agency estimated that the US money market industry was exposed to Europe to the tune of $1,200bn. The US banks’ exposure to Germany and France is in excess of $1,000bn, according to numbers from the Bank for International Settlements. This exposure should be of deep concern to US bank regulators particularly since the intensification of the European crisis seems to be occurring at the very same time that a double-dip recession in America could put added strain on its banks’ balance sheets.

A possible second Lehman Brothers-style banking crisis has to raise the sort of questions that Mr Rattner is asking about the adequacy of global banking supervision. However, we should also question whether the 2009 banking sector reforms went nearly far enough. Instead of placing undue reliance on all-too-fallible bank supervisors and regulators, should we not now be considering doing something serious about the perverse incentives to overly risky bank lending, as well as to the ‘too big to fail’ problem in the US and global banking systems?

The writer is a resident fellow at the American Enterprise Institute.

The end of 2012 will mark a once in 20-year overlap of a presidential election in the US with a leadership transition in China. France also chooses its president in the spring of next year, Germany its chancellor later in 2013. Unfortunately, election year pressures threaten to complicate an already very difficult and unpredictable policy dynamic, particularly as the European crisis goes from bad to worse.

Ordinarily, a prospective clumping of elections might portend a classic political budget cycle. Anxious to please their constituencies, governments would be cutting taxes, raising transfers, and boosting spending on particularly visible projects. Their largesse would be financed not only by higher deficits, but also by deferring expenditures with less immediate visibility, and by levering the government balance sheet through off-budget loan guarantees and other non-transparent mechanisms. In earlier times, particularly before the advent of central bank independence, election year interest rate cuts might also be expected. The central bank would be timing stimulus so as to maximally impact pre-election output and employment, while hoping that the main effect on inflation would come later.

The late US president Richard Nixon is perhaps the all-time hero of political budget cycle researchers. In his 1972 re-election campaign, famous for the Watergate scandal, Mr Nixon left no stone unturned when it came to boosting transfers, spending and growth. He doubled social security benefit increases, and browbeat Federal Reserve chairman Arthur Burns into significantly increasing the money supply. Indeed many monetary scholars regard Mr Burns’ 20 per cent plus pre-election increase in the money supply as the real culprit for the inflation of the 1970s, not the Opec oil price increases as is commonly assumed.

It is a different story today. The world is still very much gripped by the aftermath of the financial crisis. The orgy of post-financial crisis spending and deficits has left both the public and investors wary of further red ink. More importantly, the prolonged period of slow growth has dramatically weakened incumbent governments. Few are commanding the kind of majority needed to engage in a Nixonian political budget cycle, even if it were desirable. Indeed, as highlighted both by this summer’s debilitating debt debate in the US, as well as by Europe’s continuing struggle with periphery insolvencies, macroeconomic policy is much closer to being paralysed, than to being manipulated.

In normal times, any dynamic that shut down the political business cycle might well be interpreted as a plus for longer-term stability and growth. But the risk of partisan political paralysis in the face of a potential euro crash is another matter. Imagine, for example, that US growth collapses so severely that once again a major financial company finds itself on the brink of bankruptcy. Will the Fed and the Treasury be able to prevent a full-scale panic and systemic collapse in a timely fashion? Perhaps, but pre-election paralysis might make the task even harder than it was in 2008, particularly thanks to Dodd-Frank legislation aimed at preventing bail-outs.

There is a presumption that China has both the will and the means to react forcefully to any global growth crisis, as it did in 2008. Having raised reserve requirements to over 21 per cent for the largest financial institutions, its central bank has ample scope for monetary easing. But even in China, the scope and timing could be complicated by the delicate dance between an outgoing government interested in ending on a strong note, and an incoming administration that may want to front-load badly needed rebalancing of demand.

In theory, central banks ought to be relatively immune to electioneering. In practice, however, central bank independence has its limits. The Fed has already come under severe political pressure from Republicans wary of further easing measures. It can resist such pressures, but it can hardly dismiss them. Congress ultimately controls over the Fed’s mandate and the president controls the appointment of governors. Given the highly skewed risks now facing the economy, it is absurd to be worrying excessively about a 1970s-style stagflation, though some continue to do so. The risks of a Japanese-style lost decade or even a second Great Depression are far more immediate. The Fed has very limited tools at its disposal, yet pre-election political pressures are constraining even these.

Similarly, the fact the European Central Bank has not already cut interest rates to zero reflects far more the need to preserve a semblance of independence than a sober calculation of the balance of risks. If the eurozone ultimately becomes unglued, will anyone care that during euro’s brief life, inflation expectations remained firmly anchored about 2 per cent?

The US, Europe and China all have big decisions to take over how their economies and societies are to be shaped in the future. If existing or new leaders emerge from the upcoming elections with a clear mandate, perhaps we will see the kind of structural reform that will help growth and stability over the longer term. But if the overhang of elections exacerbates paralysis around difficult policy decisions, it will create huge potential for amplification at the worst possible time. Even under the best scenario, 2012 promises to be a year of even greater politically-induced volatility than 2011.

The writer is professor of economics at Harvard University and co-author with Carmen M Reinhart of ‘This time is different’

Response by Olaf Cramme

Institutional change is vital if individual leadership is to return

Kenneth Rogoff puts the hook where it hurts most: not only has the economic crisis in the US and particularly in the eurozone turned political, but politics is now generally regarded as the major stumbling block to solving the problems. This is because politics invokes choices and trade-offs. Ideological polarisation and partisan promises can only increase uncertainty, delay important decisions, and favour short-sightedness. From this perspective, we need more technocratic governance, not less.

Present developments on both sides of the Atlantic seem to confirm Mr Rogoff’s fears. In the US, the Tea Party movement has acquired an agenda-setting power that would give any non-dogmatic policymaker a headache. In Europe, populism is now an established force of influence which politicians can no longer play down. For many citizens, the financial crash has revealed a deep crisis of democracy and legitimacy in our political systems. No wonder ideology is back on the table.

In this context, bold political leadership seems the only way out: taking the big, often unpopular decisions demanded by experts and the markets while responding to public concerns about representation and fairness. Unfortunately, this is unlikely to happen. Many have put the blame on today’s leaders, depicting weak personalities or their misguided priorities. Yet the actual reason may run much deeper: our present capitalist settlement has created degrees of economic interdependence which politicians find impossible to handle under domestic pressures and the prerogative of national sovereignty. The resulting tensions apply to both the world economy and the European Union. For individual leadership to return, institutional change is indispensable.

So what is likely to guide popular reaction in the years ahead? In Europe, at least, a majority of citizens seem to recognise that a credible solution to the unsustainable status quo is nowhere near. For the time being, they seem willing to settle for more technocratic governance. Indeed, it is no surprise that those politicians currently in high regard are centrist, competent managers with cross-party appeal: look at the popularity of Peer Steinbrück in Germany (the opponent German Chancellor Angela Merkel is said to fear most), or François Hollande, current frontrunner in the primaries of the Parti Socialiste and the likely rival of French President Nicolas Sarkozy.

Our political systems are undergoing radical change. Greater volatility, if not instability, could well be the ultimate consequence. Much will depend though on how successful the latest generation of “political engineers” will be.

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

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