Monthly Archives: November 2011

The euro currency may soon collapse even though there is no fundamental reason for it to fail. Everything depends on Italy, because financial markets now fear that it may be insolvent. If the Italian government has to continue paying a seven or even eight per cent interest rate to finance its debt, the country’s total debt will grow faster than its annual output and therefore faster than its ability to service that debt. If investors expect that to persist, they will stop lending to Italy. At that point, it will be forced to leave the euro. And if it does, the value of the “new lira” will reduce the price of Italian goods in general and Italian exports in particular. The resulting competitive pressure could then force France to leave the euro as well, bringing the monetary union to an end.

But this need not happen. Italy can save both its own economic sovereignty and the euro if it acts decisively and quickly to convince the financial markets that it will balance its budget and increase its rate of economic growth so that the ratio of its public debt to its gross domestic product will decline in a steady and predictable way. If markets have confidence in that, Italy’s interest rate could decline to the four per cent that it paid before the crisis began.

Italy is in a good position to achieve this. It already has a “primary budget surplus”, with tax revenues exceeding total non-interest government outlays. It can eliminate its small overall budget deficit if it cuts spending and raises revenue by a total of just three per cent of its GDP – an amount not impossible to find in a public budget that now equals 50 per cent of GDP.

The country also has a positive growth rate of about one per cent per year. If reforms to strengthen incentives and reduce regulatory impediments raise that growth rate to two per cent, that together with a long-term balanced budget would cause Italy’s public debt to decline from today’s 120 per cent of GDP to about 65 per cent over the next 15 years. That is similar to what happened in the US after the second world war when a combination of a balanced budgets, 2.3 per cent growth and 3.3 per cent inflation brought the debt to GDP ratio from 109 per cent in 1946 to 46 per cent in 1960.)

Italy’s situation is totally different from Greece’s. The latter has a budget deficit of nine per cent of GDP and its real GDP is declining at seven per cent, driving its debt from 150 per cent of GDP today to 170 per cent after just one year. The over-valued exchange rate results in a current account deficit of ten per cent of its GDP. Greece would be better off if it abandons the euro, devalues its new currency, and defaults on its debt.

A decision by Athens to leave the euro and default could cause a run on the euro and on Italian debt in particular. That’s why it is so important for Italy to stress that its conditions are totally different from those in Greece, and that its new policies will soon produce budget balance and a declining ratio of debt to GDP.

Italy can do all of this itself. It does not need assistance from Frankfurt, Brussels, or Washington. The proposed policies for help from the European Central Bank, the European Commission, and the International Monetary Fund would ultimately weaken Italy and undermine its economic independence.

There are strong voices, including the French government, calling for the ECB to buy the sovereign debt of Italy and other countries in order to keep the level of their interest rates within about 200 basis points of the rate on German bonds and therefore low enough to avoid an automatic rise in their debt to GDP ratios. But this would violate the “no bail-out” provision of the Maastricht treaty, put Germany at risk if any countries are eventually forced to default, cause an explosive inflationary supply of euros, and remove any market feedback about whether Italy and other governments have done enough to control future deficits.

In exchange for supporting the debt of these countries, the ECB or the EC would have to be able to veto national budget decisions. Italy, like Greece today, would become an economic vassal of Germany.

After the clear failure to expand the European Financial Stability Facility from €400bn euros to the thousands of billions needed to backstop borrowing by Italy and Spain, the EC recently proposed an alternative policy of creating ‘stability bonds’. Every EMU country would be able to issue these ‘eurobonds’ that would be guaranteed by all 17 eurozone members. This would only be feasible if the national budgets were subject to control by the EC, which would be dominated by Germany as the primary guarantor of the new bonds.

The IMF in turn has suggested that it create a fund that would lend to troubled eurozone members and perhaps be used to put a cap on their interest rates. This fund would be financed by loans from the ECB, thus deftly circumventing the Maastricht treaty’s rules against bail-outs and against buying new bonds issued by member governments. Under this plan, some combination of the IMF and the EC would have to control the budgets of the borrowing nations.

Any of these proposed programmes would create new conflicts within Europe as borrower governments are forced to relinquish their ability to set their own national tax and spending policies. Moreover, what would start as EC limits on fiscal irresponsibility could evolve into limits designed to prevent trade advantages. Ireland’s low corporate tax rate would be an obvious target for its eurozone competitors. The riots and political upheavals in Greece are a symptom of what would happen more generally if the Brussels bureaucracy and the German Chancellor came to dominate national economic policies.

Fortunately, none of this is necessary if Italy now acts forcefully to create budget and growth conditions that imply sustainable debt outcomes. But impatience and scepticism in financial markets may cause a deeper financial crisis before Italy has time to prove itself.

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

The autumn statement has two objectives in the British budgetary process. It provides an updated economic forecast and it makes a mid-course correction in fiscal policy, if thought necessary in light of the new outlook. George Osborne had a tricky task in front of Parliament on Tuesday. He had to admit to a much gloomier outlook, while justifying his decision to stick to the multi-year deficit reduction plan that he laid out last spring. With some clever footwork, he managed to square this circle.

Previous chancellors had more room to manoeuvre. They could, and did, tilt their forecasts to align with their desired policy outcomes, as Alistair Darling describes in his recent book. Much post-budget commentary used to focus on the credibility of the Chancellor’s forecast. Those days ended with the establishment of the independent Office of Budget Responsibility. It provided a stiff rod for Mr Osborne’s back.

He did not attempt to belittle or explain away the OBR’s starkly downgraded growth forecast. Instead he highlighted their analysis that the expected stagnation for the next two years (less than one per cent growth per year) was due to the eurozone debt crisis, the squeeze on UK households from external rises in fuel and food prices, and lower trend growth. The last is a judgement call that may prove too gloomy, but the Chancellor accepted it for now.

The autumn statement was delivered against the backdrop of extremely febrile conditions in the bond markets, and battered business and consumer confidence at home. Mr Osborne used a two-pronged approach to address these challenges. To reassure the markets, he stressed policy stability in the UK, which contrasts strikingly with the policy uncertainty and political turbulence abroad. The British coalition government is unique among the major economies in having an electoral mandate for deficit reduction and a long election-free future to achieve it. The bond markets have recognised and rewarded this superior political capital, along with Britain’s exchange rate flexibility, with significantly lower interest rates. Mr Osborne noted that even a one per cent rise in the cost of government debt would cost £21bn in higher interest payments – and neighbouring countries have seen rises of five per cent in just a few weeks once credibility is lost. This is an advantage the Chancellor took great pains to retain. It is also a politically useful bit of clear water between the coalition’s fiscal strategy and that of the opposition Labour party.

The task of restoring confidence was addressed by laying out a medium-term growth strategy based on infrastructure investments already identified, mainly for road and rail improvements, and targeted incentives for small and medium businesses. Public sector expenditure is necessarily limited but if the bulk of the investment can be obtained from UK pension funds and external sovereign wealth funds, so much the better for the British taxpayer. This will require firm long-term contracts, which themselves rest on a stable tax and policy environment.

Policy stability means sticking to the announced public spending cuts and pension reforms that will have a big cumulative impact on curbing government debt. It does not mean inaction or callousness in the face of slower growth. The built-in stabilisers, such as unemployment compensation and the pension credit, will continue to provide income support to the vulnerable.

A tight fiscal stance provides the space for the Bank of England to continue with a loose monetary policy. Both will cushion the effects of the downturn. The cap on fare increases by trains and buses will also keep inflation down in the short-term, which will help the Bank’s credibility with the public.

Mr Osborne’s autumn statement, overall, was a strong defense of the coalition’s unchanged fiscal strategy coupled with a set of small, but cleverly targeted, incentives to promote investment and growth. The test of success will rest with the market response over the next week, and the strength of the economic recovery over the rest of this Parliament. But just as Gordon Brown’s watchword while he was chancellor was ‘prudence’, Mr Osborne’s should be ‘stability’. Only time will tell if he lives up to his word better than Mr Brown did.

The writer is chairman of Chatham House and former member of the Monetary Policy Committee of the Bank of England

This is an updated version of this article following the Chancellor’s speech

It is increasingly clear that Italy’s public debt is unsustainable and needs an orderly restructuring to avert a disorderly default. The eurozone’s wish to exclude private sector involvement from the design of the new European Stability Mechanism is pig-headed – and lacks all credibility.

With public debt at 120 per cent of gross domestic product, real interest rates close to 5 per cent and zero growth, Italy would need a primary surplus of 5 per cent of gross domestic product – not the current near-zero – merely to stabilise its debt. Soon real rates will be higher and growth negative. Moreover, the austerity that the European Central Bank and Germany are imposing on Italy will turn recession into depression.

While the technocratic government headed by Mario Monti is much more credible than Silvio Berlusconi’s former government, the constraints it faces are unchanged: debt is unsustainable and the policy to reduce it will make matters worse. That is why markets have shrugged off news of the new government and pushed Italian spreads to yet more unsustainable levels. The government is born wounded and weakened, as Mr Berlusconi can pull the plug on it at any time.

Even if austerity and reforms were eventually to restore debt sustainability, Italy and countries in a similar position would need a lender of last resort to support them and prevent sovereign spreads exploding while they regained market credibility. But Italy’s financing needs for the next twelve months alone are not confined to the €400bn of debt maturing. At this point most investors would dump their entire holdings of Italian debt to any sucker – the ECB, European Financial Stability Facility, IMF or whoever – willing to buy it at current yields. If a lender of last resort appears, Italy’s entire debt stock of €1,900bn will be soon supplied.

So using precious official resources to prevent the unavoidable would simply finance the exit of others. Moreover, there is no official money – some €2,000bn would be needed – to backstop Italy, and soon Spain and possibly Belgium, for the next three years.

Even current attempts to ramp up EFSF resources from the IMF (which is reportedly readying a €400bn-€600bn programme to backstop Italy for the next 12-18 months), and from Brics, sovereign wealth funds and elsewhere, are bound to fail if the eurozone’s core is unwilling to increase its own contributions, and if the ECB is unwilling to play the role of an unlimited lender of last resort.

If, as appears likely, Italy remains stuck in an uncompetitive recession and is unable to regain market access in the next twelve months, then even if such large official resources were mobilised, they would be wasted on financing investors’ exit and thus postponing an inevitable debt restructuring that would then be more disorderly.

So Italy’s public debt needs to be reduced now to at worst 90 per cent of GDP from the current 120 per cent. This could be done by offering investors the choice to exchange their securities either for a par bond – with a longer maturity and a low enough coupon to reduce the net present value by 25 per cent – or for a discount bond that has a face value reduction of 25 per cent. The par bond would suit banks that hold bonds to maturity and don’t mark to market. There should be a credible commitment not to pay investors who hold out against participating in the offer – even if this triggers the payment of credit default swaps.

With appropriate regulatory forbearance, it would allow banks to pretend for a while that no losses had occurred and thus give them more time to raise fresh capital. Since about 40 per cent of Italy’s public debt is held by non-residents, a debt restructuring will also imply some burden sharing with foreign creditors.

Some influential figures in Italy have suggested a capital levy, or wealth tax, could achieve the same reduction in public debt. But a debt restructuring is superior. To reduce the debt ratio to 90 per cent of GDP, a wealth tax would need to raise €450bn (30 per cent of GDP). Even if payment of such a levy were spread over a decade that would imply an increase in taxes equivalent to three per cent of GDP for ten years running; the resulting drop in disposable income and consumption would make Italy’s recession a depression.

To reduce such negative effects one would have to focus the tax on the wealthy – raising the rate to ten per cent of their wealth. Leaving aside the political risks of such a move, a debt restructuring is still preferable, as the burden would be shared with foreign investors. It would therefore hit consumption and growth less. Since Italy is running a small primary surplus, a debt restructuring would be feasible even without significant official external financing.

So debt restructuring is preferable to a plan A that will fail and then cause a bigger, disorderly restructuring or default down the line. Even a debt restructuring would not resolve the problems of lack of growth and outright recession, lack of competitiveness and a large current account deficit. Resolving those requires a real depreciation that may well demand the eventual exit of Italy and other member states from the euro.

But exit can be postponed for a while. Restructuring, however, has to be implemented now. The alternative is much worse.

The writer is chairman of Roubini Global Economics and professor at the Stern School of Business at New York University

Europe’s leaders may still harbour secret hopes that the European Central Bank will come to their rescue, but at least they seem to have understood that the surest way to make that happen is to deliver on what they have responsibility for, starting with budgets. Fiscal union is now officially on the European agenda.

For some, this is all about strengthening sanctions for budgetary slippages through more automatic decision procedures and granting the power to veto national budgets to a European body. Angela Merkel, the German chancellor has spoken along these lines recently and Mark Rutte, the Dutch prime minister, is on a similar page. However, this plan alone is not likely to deliver much more than another layer of half-effective measures.

The principle underpinning budgetary surveillance is that each country is solely responsible for its own debt, but that it can be sanctioned ex post for misbehaviour. Alternatively, countries participating in the eurozone could have joint responsibility over at least part of their public debt, but they would also agree to give their partners the right to veto their budgets before they are implemented. To be clear, this would imply that eurozone members agree to provide a guarantee to the holders of, say, Italian debt and have the right to prevent the issuance of Italian debt.

Both principles are logically consistent. The choice today is whether to move towards adopting the latter instead of the former. But the idea of establishing an ex ante veto procedure without a quid pro quo is a dream. The unilateral surrender of budgetary sovereignty – a fundamental parliamentary right – is not something democratic countries will easily agree to if they do not get anything in exchange.

This is why, if serious, the debate on fiscal union is bound to involve discussion about the issuance of eurozone bonds. However, these come in many different shapes and colours. The European Commission presented a number of proposals earlier this week. The German Council of Economic Experts also suggested its own version.

Ideally, the scheme for issuing eurozone bonds would ensure that in order to be attractive to overseas investors they are at least as safe as and more liquid than existing high-quality government bonds. It should also involve incentives to fiscal discipline so that participating governments contribute to keeping the new bonds on a sound footing. In view of these criteria, the incentives-focused ‘blue bond’ proposal by Jacques Delpla and Jakob von Weizsäcker remains the best on offer.

However, recent developments at the German constitutional court complicate matters. The court has ruled that Germany cannot enter into unlimited, open-ended commitments vis-à-vis partners.

The German experts’ proposal addresses these concerns by proposing a temporary guarantee scheme covering current debt in excess of 60 per cent of gross domestic product. They envisage the creation of a temporary redemption fund that would benefit from joint and several liability and through which participating countries could issue debt in the next few years until they have reached their quota (namely, their current debt less 60 per cent). This debt would be paid off and gradually extinguished over time. To this end, each participating country would be required to earmark specific tax revenues.

There are shortcomings in this proposal. One may wonder what would be the attractiveness of temporary eurozone bonds. Countries with high debt, such as Italy, would benefit from it more than those with low debt, such as Spain, though the scheme could be tweaked to correct this imbalance. It would also lack the permanent incentive property of the blue bond scheme. But it has two advantages. First, the temporary possibility to issue new debt under joint and several liability would give breathing space to countries in trouble, leaving them time to adjust. Second, it would be an instrument to rebuild trust. For these two reasons, it deserves serious consideration.

The writer is director of Bruegel, a European think-tank focusing on global economic policymaking

Britain is not Italy, Greece or Spain. George Osborne will want us to cling to that thought when on Tuesday the chancellor of the exchequer gives parliament his assessment of the economy. Whereas those countries are paying about 7 per cent for new debt, the UK borrows at about 2 per cent. While some of our continental neighbours contemplate economic ruin, we have no difficulty in funding our deficit.

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The chancellor claims that this happy position owes everything to the government’s commitment to reduce the structural deficit. There is evidence to support him. When the 2010 general election produced a hung parliament, senior civil servants pleaded with the party leaders to form a government quickly, for fear that Britain would be unable to sell its gilts and would lose its triple A credit rating.

The argument convinced Nick Clegg, who within a few hours accepted that the Conservatives had been right to argue for reducing our borrowings faster. He committed himself to the coalition and an austerity programme. The government’s determination impressed the markets. Gilts have sold smoothly, our credit rating is intact and sterling has been steady.

For the Labour party, Ed Balls argues that cutting public spending and raising tax depress growth. Well, of course they do. But, as the coalition would retort, without such severe measures, the markets would rank us alongside the Mediterranean countries and like them we would be contemplating the abyss.


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However, the government hardly feels comfortable with our economic progress. Spending cuts and tax rises were designed to calm the market and to shrink the state, leaving light and air for the private sector. Mr Osborne always knew that in themselves those measures were insufficient to tackle the deficit. For that we needed growth.

If this were a standard post-war recession, the economy would by now be racing to recover lost ground. We could expect several years of growth above trend. The unemployed would return to jobs, pay would boom, and the Treasury’s coffers would swell with tax receipts. But this depression is shaped like that of the 1930s, when for most of the decade growth was below trend.

So, the government is realising that throughout the parliament gross domestic product may remain flat. Over these five years many will lose their jobs. Pensions will be cut. Benefits and pay settlements will fall behind prices. The nation will endure all that, and at the end, the deficit will still tower over the economy. It’s not a cheerful prospect for the Conservatives and Liberal Democrats, whether seeking re-election together or separately.

They have two hopes. First, the country seems to have decided that Ed Miliband is not prime ministerial, and from the evidence of Neil Kinnock, William Hague and Michael Howard, leaders of the opposition find the electorate’s opinion, once formed, hard to alter. Second, the coalition leaders may hope that, like Margaret Thatcher, they will be credited with having done the difficult but right thing, and be re-elected despite their unpopularity. They can take inspiration from Meryl Streep’s performance in The Iron Lady, which certainly reminded me of what true grit looks like.

Paradoxically, the low rate of interest that Britain pays on its sovereign debt throws up a political problem for the government. For not everyone agrees that it results from the coalition’s impressive austerity. It is pointed out that the US, without a convincing deficit reduction programme, can also borrow cheaply. Conversely, a state strongly committed to tough measures – Spain – is paying 7 per cent. The key may be that money is readily on offer to a sovereign state that has its own currency. The exchange rate will adjust to economic reality, allowing a country to trade out of its difficulties, even if its deficit is large. In which case, why shouldn’t Britain indulge in a little fiscal stimulus?

Mr Osborne has to weigh up whether our felicitous standing in the markets is a prize won at enormous cost that it would be folly to sacrifice, or whether lenders are pleading with him to borrow more and stoke recovery.

The signs are that he will not waver. Ministers may be nervous, but the government looks steady. It was impressive that during the Liberal Democrat conference, despite pressure from the membership to put distance between the two parties, Mr Clegg and Danny Alexander, the chief secretary, maintained a robust defence of the austerity package.

It must cross ministers’ minds that the grim prospect of five years without growth should now be regarded as the most optimistic scenario. It takes no account of what may happen if the euro falls apart in disorder. So it may seem logical that the government’s policy is to wish the single currency well and urge the eurozone to use all measures to save it, such as requiring the European Central Bank to act as lender of last resort and accelerating moves towards fiscal union. But now that it is clear that countries such as Spain are paying crippling interest rates precisely because they are shackled to the euro, it is at best perverse to will the currency to survive, and at worst immoral, given the impact on unemployment and other human miseries. Moreover, how exactly a continental fiscal union dominated by Germany could be in Britain’s foreign policy interests eludes me.

If we weather these prolonged economic doldrums, Britain will find itself at the start of a process. The recession affecting the west – but not the east – surely indicates that the old industrialised world now fails to compete with the new. China’s sovereign wealth fund told the Group of 20 summit that it was disinclined to invest in Europe because welfare systems are out of kilter, encouraging indolence and sloth.

Britain will have to reduce welfare and public sector employment dramatically. The state will need to step back from education and health where it simply doesn’t do a good enough job. Such changes may be too draconian for a coalition, yet the public may find them too radical to accept from a single-party government. The only question, however, is whether we will tackle those big issues soon, or merely ensure prolonged stagnation by postponing the inevitable.

The writer is a former Conservative cabinet minister

Just when you think the European crisis cannot get much worse, Wednesday’s shunned Bund auction showed that it can. With this, the risks for the global economy as a whole, and for virtually every country, increase materially.

Given this week’s developments, there should be no doubt in anyone’s mind that what started out as a dislocation in the periphery of the eurozone has now decisively breached the firewalls protecting the outer core and is seriously threatening the inner core. Unless this is countered quickly, European policymakers will find it even harder to catch up with the crisis, let alone get ahead of it.

Europe must still stabilise its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.

In the eyes of the markets, the capital cushion of Europe’s banking system as a whole is no longer sufficient to support its balance sheet. This concern is not limited to the markets. Judging from their eagerness to dispose of assets, bank managements also believe that balance sheet delevering is key to the institutions’ survival and wellbeing.

In today’s environment, selling begets more selling; and it is not just about other unhealthy balance sheets also being forced to delever. The vast majority of healthy balance sheets -fortunately there are still a few - are reluctant to engage. Some are even taking risk off further, including those that believe that this enhances their relative market standing. It brings to mind the period of ”macho provisioning” by US banks during the Latin American crisis of the 1980s. Ironically, this may be intensified by Tuesday’s announcement that the Federal Reserve will impose another stress test on large American banks.

None of this helps liquidity management. Not surprisingly, a growing number of European banks are now either materially or wholly dependent on the European Central Bank and related facilities (such as the national emergency liquidity assistance programmes). The situation is particularly acute for those that previously relied on wholesale funding, which has essentially disappeared, and those suffering deposit outflows, which are accelerating in very troubled countries such as Greece.

All this makes it very hard for the banking system to get back on side quickly, especially at a time when three other issues are making it difficult to manage balance sheet risk. First, traditional asset diversification no longer affords the same degree of risk mitigation given the scope and scale of the European crisis. Second, with historically low interest rates on government bonds issued by the strongest economies, such holdings offer only limited protection in today’s environment. Third, confidence in market-based hedging instruments, including credit default swaps, is eroding due to uncertainty about what will happen to them during major market dislocation.

Problems in the banking sector have a nasty habit of accelerating and amplifying crises. Indeed, they significantly increase the risk of policymakers losing control. It is therefore critical for Europe to add this policy challenge to an already long ‘to do’ list.

Europe must now go well beyond the steps proposed at the October 26 summit. In addition to specifying higher prudential capital ratios, governments must now bully banks to act immediately. Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalisation must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.

The urgent stabilisation and reform of the banking system is one of the five key areas that will determine the future of the eurozone. With little time to waste, success will also require progress on the other areas – namely, more appropriate reform programmes on the part of heavily-indebted economies, a better delineation between solvency and liquidity cases, more effective circuit breakers from the ECB, and decisions on the urgent strengthening of the institutional underpinning of the eurozone (as currently configured or in a smaller version).

Europe’s already long list of ‘must do’s’ is getting longer and harder by the day. Denial, obfuscation and further dithering by policymakers serves only to make the situation even more daunting, and the eurozone’s future more uncertain.

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

Response by Sony Kapoor

Eurozone sovereigns must be stabilised before the banking sector

Europe’s dance of death between sovereigns and banks has now turned frantic and much more dangerous. Troubled countries, such as Italy and Spain, continue to weigh their banks down. Growing problems in French, Cypriot and Belgian banks are putting pressure on the countries.

As Mohamed El-Erian argues, action is needed on multiple fronts to stem the worsening crisis but I don’t fully share his priorities.

Fact is that no amount of capital or funding support for Europe’s banks will be enough to restore confidence so long as doubts remain about the solvency of Spain, Italy and other eurozone economies. With borrowing costs at almost seven per cent, the two large countries may soon face a debt snowball – particularly as austerity measures push the region into deep recession.

Given the worsening economic outlook and the institutional and political gridlock in the European Union, almost everyone expects the economic situation to worsen. In the absence a clear political endgame and more substantial economic support from European Central Bank, there is no visibility on how bad the economy could get. Irresponsible talk of a possible break-up of the eurozone, only adds fuel to the fire.

Unless borrowing costs for sovereigns are brought down to sustainable levels first, most policy measures to strengthen EU banks would be ineffective and may even backfire.

The best, and perhaps only, way to provide credible sovereign support would be for the ECB to set a yield target of four to five per cent for illiquid, but solvent, sovereigns, such as Spain and Italy. This is also necessary to repair the broken transmission of monetary policy and enable the banking system to restart the flow of affordable credit to the real economy.

Even with lower borrowing costs, the eurozone’s most indebted countries could be faced with unsustainable debt levels as economies shrink sharply under the weight of austerity measures. Policymakers must use the economic space provided by any additional ECB support to slow down deficit reduction programmes in troubled economies, trigger stimulus spending in healthy economies and embark on a growth-enhancing infrastructure projects financed by a doubling of the European Investment Bank’s callable capital.

Greece’s problems meant that EU policymakers prematurely shifted their focus away from the still-unresolved problems in the EU banking sector. Now those endemic capital and funding problems faced by financial institutions have resurfaced at a critical juncture. The kind of sovereign funding guarantees and recapitalisations that pulled EU banks back from the brink before are simply not possible now, particularly for banks in troubled sovereigns that most need such support.

In fact, asking countries such as Spain and Italy, at this point, to guarantee bank funding and provide capital backstop will not just be ineffective but would actually worsen the already fragile sovereign credit. The repeated rejection by eurozone leaders of proposals for providing pan-European funding guarantees and capital support has meant that the dance of death between countries and banks has become increasingly frantic.

I am not arguing that EU banks don’t urgently need more capital and access to unsecured funding, they clearly do. But they have lost access to sources of funding for two main reasons. First, the possibility of incalculable losses due to their exposures to various eurozone sovereigns. Second, the increasing potential losses on their holdings of private assets in deteriorating eurozone economies. No one wants to be exposed to banks that can lose so much money.

ECB support for countries will instantly minimise the first. Growth will significantly reduce the second. This will reopen access to private funding and capital markets, as EU banks would cease to be seen as bottomless wells.

Policies such as a two-year moratorium on bonus and dividend pay-outs, an European Financial Stability Facility-backed bank capital backstop and a EFSF-backed term funding guarantee will put the eurozone banking system back on its feet. However, this will only work if all doubts about the solvency of the sovereigns have been put to rest for good.

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

Jeffrey Sachs tells Gideon Rachman that eurozone leaders have been ‘miserable’ in handling the debt crisis so the emerging world must now step in

There was a time when European summits would provide glimpses of the future world order. Those times are gone. Today, those searching for portents of thing to come will have to look at East Asian Summits, like the one that just ended in Bali, Indonesia.

The US and Russia participated for the first time. The Association of Southeast Asian Nations, the hosts of the EAS, did not push for their participation. Instead, both asked to be invited. Why did Washington decide to add another overseas summit to Barack Obama’s already heavy schedule? The answer is China.

Throughout history, the most important geopolitical relationship has been between the world’s greatest power  currently the US – and the world’s greatest emerging power – currently China. Normally, we should have seen rising geopolitical tensions between the two. Instead, we have witnessed unusual calm.

That era is now coming to an end. Two factors have triggered this. Notably, a series of unfortunate foreign policy missteps by China in 2009 and last year (such as the fishing boat incident, the North Korean shelling, aggressive statements on the South China Sea and the mishandling of President Obama’s visit in November 2009) tore away the carefully cultivated perception of China “rising peacefully”. Hence, concerns about China’s ascent have grown in the region and in the US.

Secondly, a once-confident US that viewed China’s rise with equanimity is now replaced with a US that is feeling weaker and more insecure. This is why Mitt Romney, who is otherwise calm and centrist in his foreign policy positions, has decided to go on a China-bashing campaign, preying on concerns that the Chinese are taking more and more US jobs. It will win him votes.

For years, China tried to avoid waking up the American “sleeping tiger”. Now the tiger is stirring. A new great game is beginning.

It would be wise for Beijing to take heed of this rising angst in the American and global body politic. So far, China has fiercely resisted American calls for a meaningful re-evaluation of the renminbi. This is why Premier Wen Jiabao’s decision to request an additional meeting with President Obama in Bali and to signal that he would allow the renminbi to be traded more flexibly were important steps. Equally significantly, Mr Wen’s pledge on currency reform was carried by China Central Television. Clearly a high-level decision has been made by Beijing to address American concerns. The EAS provided the best venue for the world’s two greatest powers to talk to each other as tensions rose.

All this has also demonstrated the wisdom of ASEAN in moving towards open architecture regional reforms, instead of the European-style rigidly legal multilateral fora. There was no extended process to admit the US and Russia into the EAS. Instead a calm, pragmatic approach paved the way for their entry.

The region will certainly benefit if Washington engages with east Asia more fully. The US decision to boost the Trans-Pacific Partnership had already provided a powerful signal that it will not allow China to dominate the regional cooperation processes, even though it comes ten years after Beijing signed the Asean-China free trade agreement. But the US push for the TPP also reflects a new economic reality. Last year US exports to east Asia were, for the first time, larger than US exports to Europe.

A certain degree of geopolitical rivalry between Washington and Beijing – as long as it does not get too focused on military prowess – may be healthy for the region. Both should compete to provide visions of how they can create better forms of regional and global cooperation. Economic cooperation is a win-win and not a zero-sum game.

These two competing visions will provide glimpses of the new world order that will emerge. Yan Xuetong, a scholar at Tsinghua University, has wisely advised China that in the inevitable contest between the two powers, “it is the battle for people’s hearts and minds that will determine who eventually prevails. And as China’s ancient philosophers predicted, the country that displays more humane authority will win”.

If the new great game between America and China plays out along these lines, the world should breathe a sigh of relief. If not, we are headed for “interesting times”, to use a popular expression. Stay tuned to future EAS meetings to understand our new world.

The writer is dean of the Lee Kuan Yew School of Public Policy, National University of Singapore, and author of ‘The New Asian Hemisphere’

Response by Jonathan Fenby

China must get its foreign policy house in order if it wants greater geopolitical influence

The recent flurry of Asia-Pacific summits is, indeed, a clear sign of the shifting global balance, as Kishore Mahbubani rightly points out. But they also raise pertinent questions at a more basic level than the “humane authority” advocated by Yan Xuetong (which, itself, involves some tricky questions where China is concerned).

What is striking about the evolving regional situation is the extent to which China has walked into trouble. Under Deng Xiaoping, it followed a policy of “biding time and hiding one’s talents” while it grew economically. That has been abandoned. But Beijing has failed to craft a coherent regional – let alone global – policy in its place as interest groups, from the army to the export lobby, make their influence felt. The foreign ministry appears to have little clout.

Regionally, China says it is all for cooperation and variable geometry with Asean but it has generally sought to deal with its neighbours on a bilateral basis. Its insistence that it has sovereignty over the whole of the South China Sea runs into claims from other states, notably Vietnam and the Philippines. Its trawlers have got into a series of maritime clashes against the backdrop of tough nationalistic rhetoric from Global Times, the Communist party tabloid. Though small in scale, such incidents and the underlying tussle for under-sea energy deposits have served only to remind smaller east Asia states (not to mention Japan and South Korea) that their security depends on the US. In some cases it has driven them into one another’s arms.

China’s problems are compounded by the shift of focus by the Obama administration to the Asia-Pacific region. This has been in the making ever since Hillary Clinton spoke last year of her country as a “resident power” in the area, and asserted that freedom of navigation in the South China Sea was a US national interest. Barack Obama’s recent bid to boost the Trans-Pacific Partnership, which does not include China, was a clear sign of intent in spreading the US push from the post-1945 strategic underpinning of east Asia to the economic sphere. Beyond the immediate region, the US is scoring points in Australia and India in a way Beijing cannot enjoy.

If there is to be the kind of cooperative progress of which Mr Mahbubani writes, China is going to have to put its rackety foreign policy house in order and raise its game. That is not the kind of lesson Beijing relishes or will find it easy.

The writer is head of China research at Trusted Sources, the research service

To many the budgetary gridlock in the US may appear as intractable as that in Europe. But the reality is that the American situation is vastly more favourable. The reason is that  Congress has already passed laws sufficient to permanently fix its budgetary problem and put the nation’s finances on a stable path. All that is necessary is to do nothing and to let the laws on the books take effect.

As is well-known, America’s most serious budgetary problem is Medicare, the national health programme for the elderly. Its spending has been growing faster than the economy for years, a key reason why total US health spending as a share of gross domestic product is double that of countries such as the UK.

Back in 1997 Republicans and Democrats joined together to implement a programme that would permanently restrain the growth of Medicare spending. The key provision limited payments to doctors to those established by a formula called “the sustainable growth rate”.

The SGR formula worked fine for a few years, but as soon as it began to bite in 2003, Congress intervened to prevent doctors’ fees from being cut. It has continued to do so every year since. This annual exercise is known in Washington as the “doc-fix”.

But the original law remains in force. If it were simply allowed to take effect without congressional interference, payment to doctors for Medicare services would be cut by 30 per cent on January 1. That is not likely to happen. But if Congress would just rebase the SGR formula to this year, and allow it to operate from now on, it would save about $300bn over the next 10 years, plus another $50bn in debt service.

On the revenue side, a large number of tax cuts enacted since 2001 are scheduled to expire at the end of this year and next year. There is also a tax provision called “the alternative minimum tax” that has also been subject to an annual congressional fix to keep it from affecting too many taxpayers.

The largest of the expiring tax cuts are those enacted in 2001 and 2003 that cut the top income tax rate from 39.6 per cent to 35 per cent and reduced the rate on dividends and capital gains to just 15 per cent, among other things. These were previously scheduled to expire at the end of 2010, but at the last minute Barack Obama agreed to extend them for two years.

The so-called Bush tax cuts are now scheduled to expire at the end of next year. The Congressional Budget Office estimates that allowing them to expire on schedule, as well as foregoing another minimum tax fix, will raise revenues by almost $4,000bn through to 2021, plus saving almost $700bn in debt service.

Finally, there are $1,200bn in cuts for discretionary spending programmes, including national security, which will take effect automatically unless Congress comes up with a different deficit reduction package of equal size. A special congressional committee has been working for six weeks to come up with such a package by November 23.

On Monday, the joint select committee on deficit reduction announced that it could not agree on a viable alternative, thus leaving in place a $1,200bn spending cut beginning in 2013.

Thus we see that laws already in force would reduce projected deficits by approximately $5,500bn over the next 10 years, plus another $1,000bn in debt service savings. This is not enough to balance the budget, but it is sufficient to stabilise the debt-to-GDP ratio at its current level of about 60 per cent.

The problem, of course, is that neither Congress nor the White House has shown any inclination to allow the laws on the books to take effect. There are reasonable concerns about allowing a large fiscal contraction to take effect when the economy is still fragile, and it is not hard to come up with better ways of reducing the deficit than those now scheduled to take effect.

But the main constraint is politics. With the big scheduled spending cuts and tax increases taking effect in 2013, neither party is anxious to promise specific austerity measures going into next year’s presidential election. Everyone hopes their hand will be strengthened by voters and the burden of fiscal adjustment can be shifted elsewhere.

The fact remains that no new laws are needed to get the US on a stable fiscal course. At least as a political matter, this suggests that the prospects for deficit reduction are better in the US than Europe, where legislation still needs to be enacted to get debt under control.

The writer was a Treasury department and White House official in the Ronald Reagan and George H.W. Bush administrations. His book on tax reform, ‘The Benefit and the Burden’, will be published in January

The current turmoil in the eurozone bonds markets shows striking parallels to the situation in autumn 2008. Then, bank depositors had lost confidence in the stability of the institutions holding their assets, and the threat of a bank-run could only be avoided by comprehensive government guarantees for all banks. Today, we are observing a bond-run: a self-fulfilling crisis of confidence in the stability of most eurozone sovereign borrowers. This is driving long-term rates up, so that for more and more countries a temporary liquidity problem is becoming a permanent solvency problem. As regulators still treat government bonds as the safe core of the financial system, this vicious circle threatens the stability of financial institutions not only in the eurozone but also in the rest of the world. It intensifies the recessionary tendencies in the global economy so that in turn the financial situation of governments becomes worse. It’s a perfect vicious circle.

It can be broken only by stopping the bond-run as soon as possible. One way out would be a joint liability for the debt of eurozone members. But as the reaction of Angela Merkel’s government to a recent proposal of the German Council of Economic Experts has shown, the prospects for such a solution are not very good.

An alternative is the Soros plan as outlined in the Financial Times on October 24. The authorities could use the Emergency Financial Stability Facility to enable the European Central Bank to act as a lender of last resort without violating its statutes. The ECB would provide practically unlimited amounts of liquidity while the EFSF guaranteed the ECB against the solvency risks that it would incur. Acting together, they could resolve the liquidity problems facing the banks, and enable fiscally-responsible governments to issue treasury bills for less than one per cent.

Unfortunately the policymakers have not even started to consider this plan seriously. They originally envisioned the EFSF as a way of guaranteeing government bonds. They would have to reorient their thinking if the EFSF were to be used to guarantee the banking system. In July, when the EFSF was first proposed, it would have been large enough to take care of Greece, Portugal and Ireland. Since then, contagion has spread to Italy and Spain and the efforts to leverage the EFSF have run into legal and technical difficulties.

Since the Soros plan would take some time to prepare, in the interim the ECB is left to deal with a rapidly deteriorating situation on its own. On Monday the Bundesbank’s president questioned the right of the ECB to act as a lender of last resort. On Tuesday contagion spread to the rest of the eurozone. The financial markets are testing the ECB and want to find out what it is allowed to do.

It is imperative that the ECB should not fail that test. The central bank must stop the bond run at all costs because it is endangering the stability of the single currency. The best way to do it in the near term is to impose a ceiling on the yield of sovereign bonds issued by governments that follow responsible fiscal policies and are not subject to adjustment programmes. The ceiling could be initially fixed, at say 5 per cent, and lowered gradually as conditions permit. By standing ready to buy unlimited amounts the ECB would effectively turn the interest rate ceiling into a floor from which bond prices would gradually rise without the ECB actually having to buy unlimited amounts. That is what the Swiss government did successfully when it tied the franc to the euro at 120.

Normally central banks fix only short-term interest rates but these are not normal times. Government bonds that were considered risk-free when financial institutions acquired them, and are still treated as such by the regulators, have turned into the riskiest of assets. Italian and Spanish bonds are viewed as too risky to buy with a yield of seven per cent because they are regarded as toxic, and the yield could just as easily rise to ten per cent. Yet the same bonds would be attractive long-term investments in the current deflationary environment, at say four per cent, as long as the excessive risk is removed by imposing a five per cent ceiling on interest rates.

The recent bond-runs have developed because the authorities hold sharply clashing views on the propriety of bond purchases by the ECB. The Bundesbank has been and remains vociferously opposed. But the deflationary threat is real and is beginning to be recognised even in Germany. The statutes of the ECB call for the maintenance of price stability and that requires equal diligence with regard to inflation and deflation. The asymmetry is not in the statutes of the ECB but in the minds of Germans who have been traumatised by hyperinflation. However, the board of the ECB is an independent authority whose independence has to be respected even by the Bundesbank.

The interest rate ceiling should be regarded as an emergency measure. In the medium term it could encourage politicians to abandon fiscal discipline. In Italy, for instance, Silvio Berlusconi will be waiting for Mario Monti to trip up. Therefore the breathing space gained by imposing it should be used to establish appropriate fiscal rules and to devise a growth strategy that would enable the eurozone to grow out of its excessive indebtedness.

This article was co-written with Peter Bofinger, who is professor of economics at Würzburg University. George Soros is chairman of Soros Fund Management and a philanthropist

Response by Raoul Ruparel

Greater intervention by the ECB raises more problems than it solves

George Soros and Peter Bofinger present a measured approach for the intervention of the European Central Bank in eurozone bond markets, essentially envisioning it as a temporary liquidity provider of last resort. However, the ECB is already playing this role to a large extent. It has along with the eurozone bail-outs bought European politicians 18 months in which to devise the fiscal rules and growth strategy the authors call for. Unfortunately, leaders have repeatedly failed to reach any semblance of consensus on a lasting solution to the crisis.

Therefore, the exit strategy envisioned here for the ECB is dubious. Without a clear mechanism for winding down the ECB bond purchases, it becomes impossible to imagine a situation where the ECB could end its bond buying programme without causing huge market distortions.

The authors approvingly cite the example of the unlimited liquidity provision given to banks. However, this could equally be used as an illustration of the risks mentioned above. Although the ECB’s unlimited liquidity provision for the banking sector may have avoided a bank run, it simultaneously created a set of so-called ‘zombie banks’. Precisely because of the absence of an exit strategy, these banks have now become reliant on ECB liquidity to survive, while stripping them of the incentive to reform the bad practices and mismanagement which got them into this situation in the first place. The cost of this is now becoming clearer, with some banks on the precipice of failure, forcing a widespread recapitalisation of the banking sector – of which some cost will undoubtedly fall onto taxpayers. Against this backdrop, it becomes a huge risk for the ECB to stake its independence and credibility on the hope that such a solution will be achieved in the near term.

Targeting the spread between German bunds and other eurozone bonds would also significantly undermine the ECB’s independence. Ultimately, the spreads are reliant on the fiscal policy and domestic politics of each member state. Any failure or uncertainty in either area spooks markets. As such, the level of ECB bond buying could become almost directly influenced by the political and policy decisions in member states. The ECB is already treading perilously close to this line. One step further and it would cease being the independent central bank that is so essential to future monetary stability, and instead become a fiscal actor highly susceptible to political wrangling.

This also raises questions over the definition of the bond run. It’s true that the yields may not currently accurately represent the economic fundamentals of each nation, however they are a result of the markets trying to price in the domestic and European political risk as well as the structural flaws in the eurozone exposed by the current crisis. Using the ECB to try to ‘correct’ these issues not only damages the price determination mechanism in markets but takes the ECB far beyond its mandate.

Moreover, the German fears over hyperinflation cannot be seen as an anomaly – it is a political reality that goes to the heart of the German post-world war settlement. The day the ECB is turned into a politicised lender of last resort, may also be the day when the Germans start to seriously question whether they wish to be a part of the single currency.

The struggling eurozone countries need to press ahead with economic and institutional reform. But in the longer term it has now got to the point where the eurozone will have to reassess its structure and membership if it is to survive. Having the ECB act as a full lender of last resort will detract from these requirements and may throw up more problems in the longer term; making it ultimately self-defeating.

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

Comment drawing

The principal problem facing the US and Europe for the next few years is an output shortfall caused by a lack of demand. Nothing would increase the incomes of all citizens – poor, middle-class and rich – as much as an increase in demand and associated increases in incomes, living standards and confidence in institutions and the future.

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It would, however, be a serious mistake to suppose that our problems are only cyclical or amenable to macroeconomic solution. Just as the evolution from an agricultural to an industrial economy has far-reaching implications for almost all institutions, so too does the evolution from an industrial to a knowledge economy. Trends that pre-date the Great Recession will be with us long after any recovery.

The most important of these is the strong shift in the market reward for a small minority of citizens relative to the rewards available to most citizens. According to a recent Congressional Budget Office study, the incomes of the top 1 per cent of the US population, after adjusting for inflation, rose by 275 per cent from 1979 to 2007. At the same time, the income for the middle class grew by only 40 per cent. Even this dismal figure overstates the case of typical Americans, as the number unable to find work or who have abandoned the search has risen. In 1965, only 1 in 20 men between 25 and 54 was not working; by the end of this decade it will probably be 1 in 6, even if the full cyclical recovery is achieved.

Those who remain serene in the face of these trends or favour policies that would disproportionately cut taxes at the high end assert that snapshot inequality is acceptable as long as there is social mobility within lifetimes and across generations. The reality is that there is too little of both. Inequality in lifetime incomes is only marginally smaller than inequality in a single year. According to the best available information, intergenerational mobility in the US is now poor by global standards and probably for the first time no longer improving. Take just one statistic: the share of US college students that comes from families in the lowest quartile has fallen over the last generation while that from the richest has increased.

Why has the top 1 per cent of the population done so well relative to the rest? The answer probably lies substantially in changing technology and globalisation. When George Eastman revolutionised photography, he did very well and, because he needed a large number of Americans to carry out his vision, the city of Rochester had a thriving middle class for two generations. By contrast, when Steve Jobs revolutionised personal computing, he and the shareholders in Apple (who are spread all over the world) did very well but a much smaller benefit flowed to middle-class American workers both because production was outsourced and because the production of computers and software was not terribly labour intensive.


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There is no question that this will be more important to the politics of the industrialised world than its response to a market system that distributes rewards increasingly inequitably. To date the debate has been distressingly polarised.

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On one side it is framed in zero-sum terms and the disappointing lack of income growth for middle-class workers is blamed on the success of the wealthy. Those with this view should ask themselves whether it would be better if the US had more entrepreneurs like those who founded Apple, Google, Microsoft and Facebook, or fewer. Each contributed significantly to rising inequality but it bears emphasising that companies with a single owner, such as a private equity firm, pay successful CEOs more than public companies do. Where great fortunes are earned by providing great products or services that benefit large numbers of people, they should not be denigrated.

At the same time, those who are quick to label any expression of concern about rising inequality as misplaced or a product of class warfare are even further off base. The extent of the change in income distribution is such that it is no longer true that the overall growth rate of the economy is the principal determinant of middle-class income growth – how the growth pie is distributed is at least as important. That most of the increase in inequality reflects gains for those at the very top at the expense of everyone else further belies the idea that simply strengthening the economy will reduce inequality.

Indeed, focusing on American competitiveness could exacerbate inequality, if that means corporate tax cuts or the protection of intellectual property for the benefit of companies that are not primarily producing in the US.

What then is the right response to rising inequality? There are too few good ideas in current political discourse and the development of better ones is crucial. Here are three.

First, government must be careful that it does not facilitate increases in inequality by rewarding the wealthy with special concessions. Where governments dispose of assets or allocate licences, there is a compelling case for more use of auctions to which all have access. Where government provides insurance implicitly or explicitly, premiums must be set as much as possible on a market basis rather than in consultation with the affected industry. A general posture for government of standing up for capitalism rather than particular well-connected capitalists would also serve to mitigate inequality.

Second, there is scope for pro-fairness, pro-growth tax reform. When there are more and more great fortunes being created and the government is in larger and larger deficit, it is hardly a time for the estate tax to be eviscerated. With smaller families and ever more bifurcation in the investment opportunities open to those with wealth, there is a real risk that the old notion of “shirtsleeves to shirtsleeves in three generations” will become obsolete, and those with wealth will endow dynasties.

Third, the public sector must insure that there is greater equity in areas of the most fundamental importance. It will always be the case in a market economy that some will have mansions, art and the ability to travel in lavish fashion. What is more troubling is that the ability of the children of middle-class families to attend college has been seriously compromised by increasing tuition fees and sharp cutbacks at public universities and colleges.

At the same time, in many parts of the country a gap has opened between the quality of the private school education offered to the children of the rich and the public school educations enjoyed by everyone else. Most alarming is the near doubling over the last generation in the gap between the life expectancy of the affluent and the ordinary.

Neither the politics of polarisation nor those of noblesse oblige will serve to protect the interests of the middle class in the post-industrial economy. We will have to find ways to do better.

The writer is Charles W. Eliot university professor at Harvard, and a former US Treasury secretary (1999-2001) and director of the National Economic Council (2009-2010)

The elites didn’t revolt and the people didn’t take to the streets. What ended Silvio Berlusconi’s long run as Italy’s most powerful man was the skyrocketing spread between Italian bonds and the German bunds. Had this stayed at under 5 per cent, Il Cavaliere would still be in power today.

Mr Berlusconi’s fall is another manifestation of the clash between global money and local politics. George Papandreou’s is another. Mixing the constraints of local politics with the demands of global money creates a witches’ brew whose effusions can topple governments and shape the global economy. Managing this tension is one of the major challenges of our time.

‘All politics is local’ is an old truism popularised by the late US congressman Tip O’Neill. Understanding local problems, and even personal ones, and promising solutions to them, is far more critical for political success than hatching initiatives to address global threats. Planetary problems feel too remote to the average voter. Even in this information-saturated age, polls show that only a minority think about problems beyond their nation’s borders when deciding who to vote for or what political party to support.

O’Neill’s phrase about politics collides with another that is just as common: ‘money has gone global’. The crisis of the eurozone’s periphery is merely the latest example of the contradictory requirements of international finance and local politics. Nothing stokes public demonstrations and political violence like cuts in public budgets. Nothing assuages the anxieties of jittery foreign investors more than a government fiercely committed to making budget cuts. While this tension has always existed, the globalisation of finance coupled with the speed at which money now crosses borders makes it even harder for politicians to respond to the demands of financial markets without infuriating voters.

The figures are extraordinary. The global foreign exchange market is eight times larger today than it was only 20 years ago. Last year alone the daily volume of currencies traded was 220 per cent higher than that in 2001, and 65 per cent of the transactions were cross-border ― up from 54 per cent in 1998. Since 1990 foreign direct investment increased more than six fold. International credit flows have multiplied by two and a half times since 2000, while in the ten years to 2007 the number of non-US companies listing their shares on the NY stock exchange has quadrupled.

But if money is global and politics is local, international trade in manufactured goods is still regional. Contrary to common wisdom, globalisation has not reached this section of the economy.

Intra-regional trade of manufacturing accounts for a large part of trade in many economies. In east Asia about 65 per cent of manufacturing trade is intra-regional, 47 per cent in developing east Asia and 58 per cent in the European Union. This is very relevant, since manufacturing is an important source of well paid jobs.

And while capital and trade are internationalising, the workforce is not. Indeed it is almost immovable. Migrants make up only a paltry three per cent of humanity.

When added to the cocktail of local politics, global money, a trade in manufactured goods that is largely between neighbours and a labour pool mostly confined to national borders, the brews’ toxicity is even more harmful. Money that moves at the speed of light, trade that moves nearby at the speed of cargo containers, governments that move at the speed of politics and labour that does not move much: this is Europe today.

Unfortunately, we have no antidote for this toxic brew. Protecting economies from the vagaries of global money sounds tempting and surely something must be done to mitigate the risks. But it is difficult, expensive and it easily leads to decisions that make the problem worse. ’Globalise’ local politics is also a project that is as attractive as it is difficult. Undoubtedly politicians should do a much better job of explaining to their constituents’ that what happens beyond the borders of their country-or city has implications for what happens inside their homes. This task is now easier in Europe. Sadly, for millions this crisis has become a quick but painful lesson on the direct links between ‘out there’ and ‘right here’.

Despite all these problems, we have no choice: we must make local politics more attuned to global imperatives and make global finance more responsive to local needs.

Undoubtedly, this is easier said than done. It may even sound naïve to suggest it. But I wonder if it would not be even more naïve to dismiss the urgent need to find ways to bridge the gap between the two.

The writer is a senior associate at the Carnegie Endowment for International Peace (Twitter @moisesnaim)

The recent assessment of China’s financial stability by the International Monetary Fund highlights increasing vulnerabilities stemming from the government’s role in the lending process, and an inflexible interest rate policy. Those who regard weaknesses in the banking sector as a likely trigger for a financial collapse have railed against China’s negative real interest rates and the speculative activity this has spawned. They see the heavy reliance on credit expansion to stimulate the economy during the global financial crises as eventually leading to a surge in non-performing loans. All this is viewed as part of a strategy of financial repression that postpones the day when China’s big four state banks can operate as real commercial banks.

But focusing on emerging financial risks is a case of treating the symptoms of the problem, rather than understanding and dealing with its origins. When Deng Xiaoping launched his efforts decades ago to boost economic growth, he needed to secure the resources to ramp up investments along the coast. But the Communist party leader faced the reality that government revenues had fallen to only 11 per cent of gross domestic product by the mid-1990s and the only alternative was to tap household savings in the banking system. Although revenues have been increasing steadily, China’s national budget still amounts to only 25 per cent of GDP, compared with an average of 35 per cent for other middle income countries and over 40 per cent for OECD economies.

With its responsibilities for providing a broad range of services for a mixed socialist economy, it is surprising how small China’s budgetary footprint actually is. Thus, Beijing has been using the financial system to fund public expenditure needs – many of which are not commercial in nature and would normally be undertaken through the budget. While this was unavoidable in the earlier years, it has turned out to be a politically attractive and effective option in dealing with the volatility of the global economy over the past decade. As such, these hidden banking losses are actually quasi-fiscal deficits, rather than traditional non-performing loans. While on paper China does not run major budgetary deficits, these quasi-fiscal deficits in the banking system have been accumulating over the years, awaiting the time (as in the past) when the non-performing loans are formally recognised and written off – with China’s substantial reserves and relatively low public debt ratios providing the cushion.

One cannot dispute that China needs to act on financial reforms, but the real challenge is for Beijing to recognise the importance of strengthening its fiscal system to undertake expenditure requirements in a more transparent and potentially less destabilising fashion. Unless the leadership takes this decision, admonitions for more flexible monetary policies and improved governance of key financial institutions will continue to fall on deaf ears.

Unfortunately the budgetary problems that have paralysed both the eurozone and US do not help the case. Beijing is watching with amazement as political leaders across both continents struggle to forge the consensus needed to strengthen their countrys’ fiscal positions. This only reinforces China’s view that budgetary processes are too politically cumbersome to deal with the unpredictable nature of the global economy. It makes it all the more likely that Beijing will continue to use the banking system for purposes that textbooks never saw as appropriate.

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

Response by Kerry Brown

Banks’ role won’t chance until the status quo becomes unsustainable

The function of banks in China is very particular, as Yukon Huang argues, but it is unlikely to change any time soon. When the country entered the World Trade Organisation almost exactly ten years ago, there was great excitement about the potential impact of liberalisation on its banks, with competition from outside, the opening up of new markets, and the general internationalisation of the biggest players. A decade on, we can see that banks still preserve their unique position in the Chinese firmament, as protected agents of the state, and of the Communist party in particular. Their remit is narrow, and they are used as accomplices for the provincial and central governments’ greater budgetary purposes.

Almost all Chinese banks are state-owned (with the possible exception of the partially-private Mingsheng bank), and that they march to the tune of government policy, in ways that banks elsewhere would find unimaginable. But to fundamentally change this would involve unleashing reforms in other areas of state-society-commerce relations, which the current leadership have shown they are profoundly resistant to. To them, the one lesson to be drawn from the global financial crises since 2008 is that state direction and involvement in enterprises, and in particular in those in the finance and banking sector, has been vindicated, and shown to be a good thing. All the shouting from outside China in the late 1990s urged them alter the banking model and to adopt ones more like those in the west, with high levels of entrepreneurship, but also risk. But if there is one thing this leadership dislike, that is risk.

It could be that as levels of provincial indebtedness grow, and issues of hidden loans and financial irregularities become harder to ignore, the government will start to clarify the roles of banks a little more clearly, and set tighter conditions on how they work with local, and national, government, and with party and business elites and their interests. However, this would have to be part of a bigger push for reform. But systemic reforms redefining the role of the party within society – that have been ongoing since 1980 – have yet to have a major breakthrough. At the moment, status quo is sustainable, and in the party’s political interests. So status quo is likely to be, in the short to medium term, how things stay. In the long term, of course, there will have to be reform – but that will always remain best for another day.

The writer is head of the Asia Programme at Chatham House

Japan’s 1.5 per cent rise in output in the third quarter was met with a yawn by the markets. Was this the right reaction? Even though it was six per cent on an annualised basis, and therefore impressive compared with the 2.5 per cent growth in the US, and even more so compared to the lower-than one per cent in the eurozone, the markets may be right.

These latest gross domestic product figures will probably encourage analysts to stick with the current broad outlook for next year. The consensus view is that Japan will grow by around 2.2 per cent, the US between 1.5 and two per cent, and the eurozone by around 0.5 per cent. It is quite remarkable that on average forecasters expects Japan to be stronger than either the US or the eurozone. In essence, the consensus – backed up by depressed equity markets and low bond yields for the G7 countries - expects a “Japanisation” of these countries’ economies. The markets are assuming Japan’s post-tsunami recovery is nothing other than a recalibration for lost GDP, and that the rest of the G7 will join Japan in years of dull, or worse, growth.

I am not so sure about a number of aspects of this outlook. If Japan could sustain GDP growth above two per cent for a full year, it would be a positive step. If key export markets, especially China, succeeded in achieving a so-called soft landing, perhaps post-tsunami Japan will exceed expectations. A positive economic surprise could have a powerful uplifting impact on Japanese equities at a time when the market’s dividend yield is higher than the yield on ten-year government bonds, and the country’s one year forward price to earnings ratio trades near its lowest levels for 30 years.

Is this why the Yen is so strong? If so, why did the Japanese authorities recently intervene so aggressively to halt it rising further? There is some disconnect between the depressed level of Japanese equities, the strong Yen and the country’s policymakers’ views – unless Japan really is simply the least worst of a very bad bunch. It is hard to justify the Yen at close to Y75 against the US dollar and Y100 against the euro. When the trade balance for the auto industry is adjusted for, Japan’s days of trade surpluses could be over. In this regard Tokyo needs to make sure its car companies don’t entirely move production offshore in the quest to stay competitive. If that happens, Japan would soon start to justify the darker thoughts of some.

With this in mind, does Japan look attractive relative to other markets? I recently asked a major investor if he finds Italian bonds at seven per cent or Japanese bonds at one per cent more attractive. Italy has debt to GDP ratio of 120 per cent, while Japan’s is more than 200 per cent. He couldn’t answer me.

The question is America really heading down Japan’s route of slow growth? I think the answer is no. Not only does US productivity continue to impress, but virtually all the reliable lead and coincident indicators I trust, such as weekly job claims, continue to improve – with one exception, housing. Can you imagine if that turned around? The fall in house prices in recent years has been so sharp that affordability is back to the levels of the early 1990s. Comparisons between the US and Japan seem inappropriate.

I think this is how to square all these circles when it comes to Japan. The country is still recovering following the 2008 global financial crisis and the tsunami. Its equity market is cheap and attractive. But the Yen needs to weaken, which it will do as soon as markets realise America isn’t going down Japan’s path. Once that happens, perhaps Japanese investors will start to add – now high-yielding – European bonds to all those other emerging markets ones, also high-yielding, they seem so keen on.

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

The Occupy Wall Street movement is a symptom of a growing public disquiet about the workings of market capitalism. As such, Monday night’s decision to close down the camp in New York City is unlikely to check the protests: if anything, the reverse may be true.

Public support for free markets is based on two broad arguments. The first is that they deliver more efficient outcomes than the alternatives. The second is that over time they create increased prosperity for society at large. Both these assumptions have taken a severe jolt in the past few years.

We now know that the efficient market theory is for the birds, and that market failures can have devastating consequences for wide sectors of the public. We also know that the fruits of economic success have become increasingly unevenly distributed. In the US, all the growth – and more – in recent years has flowed to those at the very top. The upper one per cent of Americans are now taking in nearly a quarter of the nation’s income every year, double the proportion 25 years ago. Those in the middle have seen their real incomes fall over the same period, precipitously so in the case of those with only high school qualifications.

Rising income inequality. Very slow economic growth. High unemployment. It’s no wonder that even a number of politicians on the right have started to express a degree of sympathy for those who have been demonstrating around the world in recent weeks. The fact that the protesters have no clear agenda is irrelevant. They represent concerns that many people can relate to, and they are unlikely to go away.

So it may be that capitalism is approaching some kind of tipping point, away from the winner takes all culture of the past three decades. If left unchecked, public disquiet will sooner or later bring a political response, maybe in the form of much more aggressive regulations and progressive tax systems. These could be at least as damaging as the free market fundamentalism that they would seek to replace.

Much better for business itself to recognise that it has a real economic interest in the well-being of the societies in which it operates; that success or failure is not just determined by earnings per share or profits per partner; and that a successful market economy has to be built on a degree of trust and mutual respect. Capitalism has adapted to changing political and social pressures in the past, and now is time for it to do so again.

The writer was director-general of the CBI and is a former editor of the FT

I don’t know whether to weep or laugh. Eurozone leaders have turned a €50bn Greek solvency problem into a €1,000bn existential crisis for the European Union. Barack Obama cannot remember “whether it was Merkel, Sarkozy or Barroso” – no first names or titles – who told him, as grand hopes for the Cannes summit turned to dust, “welcome to European politics”. And David Cameron calls on the European Commission – the embodiment of “Brussels” bureaucracy and elitism that his government loves to hate – to prevent the 17 countries of the eurozone running the EU show in their own interests.

The only people satisfied are eurosceptics and federalists. Both say ‘I told you so’. Both make valid points about weaknesses of Europe’s hybrid structure – part intergovernmental and part supranational. Both feed off each other to tell their own supporters that now is the moment to break with the compromises of the past.

Every political system is a balance of efficiency and legitimacy. The sceptics sacrifice efficiency for legitimacy. Their arguments about sovereignty ignore the reality of an interdependent world – in which regional co-ordination and collaboration is going to become increasingly important. The federalists substitute efficiency for legitimacy. They ignore the reality that national particularities, far from disappearing, are on the rise.

The Lisbon treaty tried to square the circle. The post of president of the European Council, a former head of government to chair the meetings of heads of government, was created expressly to “drive forward its work on a continuous and consistent basis” and “make the EU’s actions more visible and consistent”. In other words, bang heads together and reach out to the people.

But the truth is that European politics and politicians have been unable to cope with the triple blow of slow (and slowing) economic growth, rising sovereign debts and unstable financial institutions. Chancellor Angela Merkel and her senior colleagues have prime responsibility, but ‘President’ van Rompuy has been invisible.

The danger of the current situation is that both sceptics and federalists get their way as the EU splits between core and periphery. The eurozone does need a stronger centre. That will enlarge the gap between ins and outs, ‘vanguard’ and ‘rearguard’. And the eurozone countries will seek to get their way in the wider EU, or go it alone.

For Britain, it is a fateful development. Governments have sought to prevent a two-speed Europe for 40 years. Edward Heath celebrated our entry into “the framework of a single community”. Margaret Thatcher embraced the deepest of single markets. John Major played with ‘variable geometry’. Tony Blair put it into practice by supporting stronger European foreign, energy and environmental policy from outside the euro.

In every case the UK feared a two-speed Europe would leave us in the second division. And we have made the argument that the rest of the EU would be much worse off without us. British politicians need to make the case that Europe is better off with Britain on the inside as passionately as we argue that Britain needs a strong Europe.

The government’s decision to make the repatriation of powers from Brussels its top priority for European negotiations is deluded and dangerous. Deluded because the last thing other countries, including the other ‘outs’ from the eurozone, want is to ally themselves with a quixotic British campaign. Dangerous because the failure to negotiate these repatriations will only intensify the fury of the sceptics.

Second, every country needs an alliance with Germany. That is especially the case for a UK determined to avoid a slide to the European exit door. German fears of a transfer union provide the opening. We should be supporting the Berlin-inspired treaty change that enforces shared responsibility for the eurozone’s economic future across its members. The quid pro quo would be buffers against a two-speed Europe – safeguarding the rights of non-euro members and preserving enhanced co-operation in areas beyond macroeconomic policy.

Third, Britain needs to play to its comparative advantages in defence and foreign policy, and its interests in energy, to help move the EU forward. This is not about being “good Europeans”. It is about national interest in an outward-looking Europe.

Fourth, although Europe is now a danger to the rest of the world’s economic prospects, the rest of the world is not standing still. In the next two years, the EU negotiates a new budget for the seven years until 2020. The shock of the eurozone crisis needs to be a spur to budgetary reform (and not just budget limits). In universities, infrastructure and innovation Europe (beyond Germany) needs to chart a new growth path.

Fifth, we should be making the Lisbon treaty work. In spite of opposition to its passage, the government said they would make its innovations work. President van Rompuy is up for re-election in June. He needs to up his game in a big way – above all its vision and projection.

Finally, Britain must build coalitions across the euro in/out divide. It is no good confining ourselves to dinner with the outs. We need a positive vision for an open, prosperous Europe to sell across the 27 countries.

These are issues for politicians of all parties. But they are a matter for business too. It is no good complaining about the short term posturing of politicians if business and trade unions don’t speak up. Reform will be arduous. But the alternative, opting out by design or mistake, would be disastrous.

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

With interest rates on its sovereign debt surging well above seven per cent, there is a rising risk that Italy may soon lose market access. Given that it is too-big-to-fail but also too-big-to-save, this could lead to a forced restructuring of its public debt of €1,900bn. That would partially address its “stock” problem of large and unsustainable debt but it would not resolve its “flow” problem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.

To resolve the latter, Italy may, like other periphery countries, need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.

Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.

So Italy and other illiquid, but solvent, sovereigns need a “big bazooka” to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone.

One is urgently needed now. Eurobonds are out of the question as Germany is against them and they would require a change in treaties that would take years to approve. Quadrupling the eurozone bailout fund from €440bn to €2,000bn is a political non-starter in Germany and the “core” countries. The European Central Bank could do the dirty job of backstopping Italy and Spain, but it does not want to do it as it would take a huge credit risk. It also cannot do it, as unlimited support of these countries would be obviously illegal and against the treaty no-bailout clause.

Thus, since half of the European financial stability facility’s resources are already committed to Greece, Ireland, Portugal and to their banks, there is only about €200bn left for Italy and Spain. Attempts have been made to use financial engineering to turn this small sum into €2,000bn. But the leveraged EFSF is a turkey that will not fly, because the original EFSF was already a giant collateralised debt obligation, where a bunch of dodgy, sub-triple-A sovereigns try to achieve, by miracle, a triple-A rating via bilateral guarantees. So a leveraged EFSF is a giant CDO squared that will not work and will not reduce spreads to sustainable levels. The other “turkey” concocted by the EFSF was supposed to be a special purpose vehicle where reserves of central banks become the equity tranche that allows sovereign wealth funds and the Bric countries to inject resources in a triple-A super senior tranche. Does this sound like a giant sub-prime CDO scam? Yes, it does. This is why it was vetoed by the Bundesbank.

So, since the levered EFSF and the EFSF SPV will not fly – and there is not enough International Monetary Fund money to rescue Italy and/or Spain – the spreads for Italian debt have reached a point of no return.

After a patchwork of lending facilities are cobbled together, and found wanting by the markets, the only option will be a coercive but orderly restructuring of the country’s debt. Even a change in Italian government to a coalition headed by a respected technocrat will not change the fundamental problem – that spreads have reached a tipping point, that output is free-falling and that, given a debt to GDP ratio of 120 per cent, Italy needs a primary surplus of over 5 per cent of GDP just to prevent its debt from blowing up.

Output now is in a vicious free fall. More austerity and reforms – that are necessary for medium-term sustainability – will make this recession worse. Raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable.

Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness . That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies. It cannot occur either through depressionary deflation or structural reforms that take too long to reduce labour costs.

So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts.

The eurozone can survive with the debt restructuring and exit of a small country such as Greece or Portugal. But if Italy and/or Spain were to restructure and exit this would effectively be a break-up of the currency union. Unfortunately this slow-motion train wreck is now increasingly likely.

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster.

The writer is chairman of Roubini Global Economics, professor at the Stern School at New York University and co-author of ‘Crisis Economics’

When it comes to Iran, the best is consistently the enemy of the good. The International Atomic Energy Agency report issued on Tuesday on Iran’s nuclear programme uses strong language relative to earlier reports, but essentially affirms what western governments already know or believe. Parsing the bureaucratese, the IAEA details information that it believes to be “credible”, indicating “that Iran has carried out activities to the development of a nuclear explosive device”; that before 2004 “these activities took place under a structured program”; and “that some activities may still be ongoing.”

In short, for all the sanctions and diplomacy, Iran continues to make steady progress toward producing a nuclear weapon. We might be able to make a deal that would at least bring some Iranian stocks of low-enriched uranium into the custody of a third country – starting a process of multilateral cooperation to meet Iran’s legitimate needs for nuclear fuel, while constraining its illicit activities. This would still leave Iran enough LEU to produce a bomb, and could legitimise its enrichment efforts, allowing them to continue contrary to UN demands. That would be bad. But continuing with a policy of sanctions and pressure that is not working is worse. 

The IAEA report documents repeated Iranian violations of UN obligations and IAEA requests. It catalogues Iranian military efforts to obtain nuclear-related and dual-use equipment, to ramp up production of nuclear fuel by “undeclared pathways,” to acquire nuclear weapons development information from a “clandestine nuclear supply network,” and to design an actual weapon, including testing of components. Harvard Professor Graham Allison, a leading expert on nuclear proliferation, has a more direct approach. He has a chart showing a nuclear football field, with the endzone being the possession of enough highly-enriched uranium to create a bomb. It shows that Iran has enough low-enriched uranium (5 per cent) to create four bombs, but that the time needed to upgrade this keeps Iran 30 yards from the endzone. In addition, though, Iran is building a large stockpile of medium-enriched uranium (20 per cent), which takes much less effort to convert to bomb-grade material. That puts it on the 10-yard line – a very short distance from its goal.

The Stuxnet worm does appear to have set Iran back by perhaps two years, but that is being overcome. New generations of cyber-viruses may be harder to insert and easier to defend against. Military action will remain an option, but would run counter to the Obama administration’s entire strategy of integrating rising powers into a strong international order. It is also not certain to work, and would have deeply counter-productive political effects inside Iran and probably across the Muslim world.

That leaves diplomacy. In late 2009 the US, France and Russia proposed a deal whereby Iran would give up its own stocks of LEU in return for international provision of sufficient nuclear fuel to run a medical research reactor in Tehran. Mahmoud Ahmadi-Nejad originally seemed receptive, but Iran then backed out quickly. In the spring of 2011, Brazil and Turkey reached a weaker version of the same deal, in which Iran would transfer 1,200kg of LEU to Turkey in return for the same quantity of nuclear fuel for the Tehran reactor. That move widely was seen as an Iranian ploy to blunt another round of UN sanctions. The US pointed out, rightly, that Tehran was not committing to stop enrichment, and secured agreement on more and stronger sanctions. Meanwhile, it made its displeasure clear in Ankara and Brasilia; the deal fell through; and Tehran continued its programme. What was lost was any opportunity to establish a precedent of keeping Iranian fuel outside Iran, and working within a cooperative rather than a coercive frame that would allow Iran to save face.

Today, if Barack Obama were to put that deal on the table, he would be hammered by his Republican opponents, in Congress and on the presidential campaign trail, for giving away the store, negotiating from weakness, affirming US decline, and so on. But if we are really as worried about an Iranian bomb as we claim, results should trump political perceptions.

The IAEA report has the dual advantage of expressing global concern over Iranian behavior and of focusing attention on Iran’s violation of its international obligations. Western governments should now turn back to Turkey and Brazil. Turkish-Iranian frictions are on the rise, particularly over Syria and Arab uprisings across the region. But Turkey has a direct stake in avoiding an outcome in which Iran upstages it as the region’s only nuclear power besides Israel; and Iran has a stake in working with Turkey at least some of the time in the complex triangular politics emerging among Turkey, Iran, and Saudi Arabia. Dilma Rousseff, Brazil’s new president, has a stake in doing something that Lula was unable to accomplish; Brazil also has a strong incentive as a nation that flirted with developing nuclear weapons but then renounced its programme. Let them initiate a new round of negotiations under UN auspices – with full backing from the US, France, Russia and other powers concerned. At the least, it deprives the Iranian government of its familiar US whipping boy. At most, we might succeed in halting play on the 10-yard line and then changing the game. 

President Obama is riding high in national security matters these days, largely as a result of following his own instincts. He can afford a return to his initial policy of pragmatic engagement, particularly on an issue that does not pit the Iranian government against his own people. He may fail, but he has proved himself to be a leader willing to risk failure to get results. Given the price of continuing our current policy, it’s time to change course.

The writer is a professor at Princeton University and former director of policy planning at the US State department

Here we go again. Europe’s debt crisis has entered a new, more dangerous phase with the yield on Italian 10-year bonds crossing the seven per cent level on Wednesday morning. This is a eurozone-era record that, if sustained, would severely destabilise the debt situation of the world’s third largest bond issuer and one of the original six founders of the modern European project.

Those who lived through the horrid days of the various emerging market debt crises will quickly recognise the four distinct factors that have come together in the last few days to form a highly destabilising cocktail. And they may well agree on what needs to be done to stop a bad situation getting worse.

Messy domestic politics have undermined the already-complicated relations between those with the potential to solve Europe’s debt crisis – the highly-indebted countries, their official creditors and private holders of their debt.

As in Greece, Italy is now going through an uncertain political transition. While the media has understandably focused on when and how Prime Minister Silvio Berlusconi will resign, what Italy urgently needs is much more complex – namely, a new government that can credibly design, implement and shepherd multiyear efforts to lower debt and deficits, while also increasing economic growth.

Secondly, it has become fashionable not only to sell Italian bonds but also to tell the world about it, as loudly as you can.

In the last few days several banks have rushed to announce that they have been actively reducing their holdings of Italian debt – as a means of reducing market concerns about their own well-being. This phenomenon is similar to the 1980s phase of “macho provisioning” that saw banks trying to outdo each other in telling the world that they were fully protected against their past loans to Latin America. The result today is to encourage and push other Italian creditors to also sell, adding to the market pressures. In too many cases, the damage to the demand for Italian bonds is much more than transitory.

Third, a series of technical changes are disrupting the Italian bond market, adding to its instability. They range from Tuesday night’s increase in margin requirements imposed by a major clearing house, to the decrease in availability of hedging instruments in the derivative markets.

Finally, the European Central Bank has appeared more hesitant in recent days to purchase Italian bonds. Whether it is an issue of willingness or ability, the result has been to add to the mounting market instabilities.

Left to their own devices, several of these factors could get even more disruptive. Italy is now in the grips of what economists call a ‘path-dependent multiple equilibria’ – where one bad outcome raises the probability of another, even worse outcome.

There is only one institution that has an immediately-available balance sheet that could stabilise the situation in the next few days and weeks – the ECB. But before we all join the chorus urging the bank to do more, we should recognise that it, alone, cannot deliver good outcomes.

To act as a durable circuit breaker, the ECB needs others to help on four critical issues: a bold and lasting separation in how we deal with Europe’s insolvent nations and its illiquid ones; a regional programme to enhance growth and employment; immediate actions to counter the fragility of the banking system; and bold political decisions to strengthen the institutional underpinning of the eurozone, either as it is configured today or via a smaller and less imperfect one.

The European summit on October 23 came close to partially addressing some of these factors but slow progress and disruptive national political developments limited its impact. As a result, Europe’s crisis has entered a new and even more worrisome phase.

With neither the region nor the global economy in a position to afford many more slippages, let us hope that this latest development will serve as a loud, urgent and effective call for proper diagnosis and comprehensive action.

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

MF Global is not the first firm to be done in by bad bets in the casino known as Wall Street, nor will it be the last. With many questions still unanswered – perhaps most importantly what exactly happened to the $630m of customer money that was required to remain in segregated accounts – attempting to divine the meaning of its collapse may be premature. But a first rough draft of the meteoric history of the brokerage company offers a few lessons and timely reminders.

For starters, the financial world has always had, and will continue to have, a regular procession of rogue elephants – individuals who by virtue of bad investment judgement, avarice or dishonesty succeeded in wounding their employers, either mortally (think Barings) or less consequentially (think UBS). Guarding against these kinds of black swan disasters challenges even the most formidable internal controls.

Unusually, of course, MF Global went awry at the very top of the company. But that is also not without precedent. In 1998, the bets of Long Term Capital Management, the hedge fund, almost brought down the American financial system. Protecting against errors of that sort depends heavily on the regulators and their policies.

So this first post-Dodd-Frank failure of a significant financial institution provides an opportunity to assess the quality of regulatory oversight. The conclusion may ultimately confirm the fears of those who doubted the efficacy of the recent reform legislation.

Once again, we appear to be confronted by a company that was supervised by a patchwork of regulators, none fully in charge. Last February, shortly before the arrival of Jon Corzine (full disclosure: a friend of mine) as chief executive, MF Global had been lifted into the pantheon of ‘primary dealers’ by the Federal Reserve. After its bankruptcy, the Fed took pains to emphasise that it was not MF Global’s regulator.

Meanwhile, the Commodities Futures Trading Commission was responsible for overseeing how the accounts of the brokerage’s customers were handled, but did not appear to have authority over MF Global’s balance sheet.

Those that did – the Securities and Exchange Commission and an industry self-regulator – eventually forced it to increase its capital but by then it was too late for the company, which was leveraged around 44 to 1, well in excess of Lehman Brothers levels. (Leverage, of course, is the crack cocaine of Wall Street, amplifying the highs but risking terrifying falls.)

Then there’s the Volcker rule. Even without knowing exactly what happened with customer deposits and whether they were used to purchase risky sovereign debt, it is not hard to see the events at MF Global as confirming the wisdom of the principle that the money of depositors or other customers of financial institutions should not be used in imprudent ways.

Finally, let’s be careful not to see only what we wish in the MF Global collapse. I reject the notion that this is another example of financial industry compensation run amok. Mr Corzine received a salary of $1.5m, a signing bonus of $1.5m and $11m of stock options, very small beer by Wall Street standards.

Nor is this is an example of the unfortunate consequences of an asymmetrical risk-return prospect for the company’s managers. It’s unquestionably true that Mr Corzine had more to gain financially from a success with MF Global than he had to lose in its collapse. But in the end, he lost something far more valuable than his salary, his bonus, or the $23m of severance and stock options that vaporised in the bankruptcy. He lost his reputation at a moment when he was tipped as a possible successor to Treasury Secretary Timothy Geithner. That will haunt him far more than any monetary consequences.

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 Doug Holtz-Eakin

MF Global collapse raises doubts about wisdom of Dodd-Frank reforms

The very public collapse of MF Global is strewn with salacious titbits: a hint of scandal, disgrace for a high-flying leader, and an exemplar of the dangerous state of global finance. But what are the real lessons for financial market policies, especially in the wake of the passage of the contentious Dodd-Frank reforms?

Perhaps the greatest lesson – and greatest relief – is that MF Global was allowed to fail. The Federal Reserve did not step in with an extraordinary lending programme. The Treasury did not stretch the boundaries of existing financial authorities and infuse it with capital. Congress did not tap the American taxpayer for relief. Instead, equity investors were wiped out, the management lost its jobs and reputations, and those who failed to impose and execute adequate internal controls suffered the consequences.

This is all to the good, and in striking contrast to the precedents set during the 2008 financial crisis.

The bankruptcy is a useful reminder that, in the end, the only sound economic buffer is to hold sufficient capital. MF Global did not, and it went bankrupt. It remains unclear whether the Dodd-Frank and Basel processes will create a regime of sensible capital reserves, that provide prudent cushions without overly handicapping the provisions of financial services and incentives for innovation.

It is increasingly becoming obvious that the Dodd-Frank reforms “fixed” things that were not at the roots of the 2008 crisis, and missed the mark completely on some real problems.

There is no indication that confused or overwhelmed consumers were affected by the collapse, and there never was a real need for the Consumer Financial Protection Bureau. There is no hint that proprietary trading was at the root of the bankruptcy, just as there is no evidence that the Volcker Rule would solve any real problem (even if one could figure out how it worked!). But it is another example of the lunacy of continuing to have both the Securities and Exchange Commission and the Commodity Futures Trading Commission when any serious reform would have provided a unified regulator.

MF Global’s collapse is a clear mark against the fundamental conceit of the Dodd-Frank approach where highly-empowered, super-smart regulators are somehow able to conduct extraordinary surveillance; identify institutional, consumer, and systemic risks in a timely fashion; and keep the world safe from financial volatility. Well, MF Global had multiple sets of eyes on its operations, was affected by closely-scrutinised global events, and it still failed.

No amount of regulatory authority will ever substitute for solid internal controls, relentless risk management, and capital market scrutiny and discipline.

The writer is president of the American Action Forum and former senior policy adviser to John McCain

Last week’s G20 meeting marked the demise of the eurozone’s three-year effort to save itself. The monetary union will be saved, but not from the inside. Its survival will come at the hands of the International Monetary Fund and the emerging economies.

The meeting itself was an embarrassment for France on its own turf. Despite President Nicolas Sarkozy’s call for a “New World – New Ideas” summit, the meeting was about the old world and old squabbles. With Germany, France, Greece, Italy, and other neighbours hardly on speaking terms, the rest of the G20 was astonished by the intra-European bickering.

The eurozone mess has exploded from a containable regional crisis in 2009 to a global crisis today. The simple truth is that Europe has been unable to clean up its own act. There are three reasons.

The first is that agreeing on how to share losses is always difficult, but nearly impossible in a world of 17 eurozone states, powerful banks, overlapping official European bodies, aggrieved public opinion, and dozens of political parties, with some of the smallest having the largest bargaining leverage. As game theory predicts, free riding by the True Finns, the Slovaks, the European Central Bank, creditor banks, and others has made it nearly impossible to reach a sensible agreement on anything. Without clear fundamentals and a credible lender of last resort, Europe’s financial markets are buffeted by waves of self-fulfilling panic.

The second is the collapse of technical processes, not unrelated to the first syndrome. Europe hangs on the words of Chancellor Angela Merkel, which are sporadic and often doled out on the eve of eurozone summits. There is little technical preparation of highly technical issues. German coalition politics predominates. The Germans themselves speak with multiple voices, including political parties, Chancellery, finance ministry, Bundesbank, and Bundestag. Even France learns the latest German strategy in the Merkel-Sarkozy meetings that precede each summit.

The third has been the specific failures of the European Commission and the European Central Bank. There are many reasons for this, ranging from Jean-Claude Trichet’s spent leadership, to the unworkability of the Lisbon Treaty, to the sidelining of Brussels by Germany and France. Mario Draghi’s arrival at the helm of the ECB will be a partial tonic.

Europe’s weaknesses were on full display at the meeting in Cannes. Mr Sarkozy did not hesitate to upbraid his Greek and Italian colleagues. Italy’s premier Silvio Berlusconi displayed a further retreat from reality. Ms Merkel, as usual, said very little. The US said even less. The decline of America’s economic power was patent.

The rest of the G20 evinced a desire to help, but not to throw money directly into such a scrum. No country declared an interest in investing in the European bailout fund. The message from China, Brazil, Russia, and other emerging economies was clear: external help would be channelled through the IMF, because it is global, technocratic, and detached from daily European politics. External help, in short, requires conditionality.

The next weeks are crucial, and the IMF, ECB, and the commission have a last chance to respond before a eurozone meltdown. The new leadership of the IMF has by far the biggest responsibility, the first among equals in the design of a comprehensive programme. The European politicians, and the rest of the G20, would do well to encourage Greece to work with the IMF, EC, and ECB to resolve several critical and still outstanding issues. The IMF, on its part, must be especially wise to craft socially acceptable and economically realistic programs.

First, Greece needs its debt-service burden cut decisively and sustainably, whether by cutting the interest rate, the face value of the debt, or some combination. The debt reduction needs to cover both publicly held debt as well as privately held Greek government bonds. It should be deep enough to permit a gradual and credible reduction of the debt-gross domestic product ratio to manageable levels within a decade. A clear strategy must also address the problem of holdout creditors, such as vulture funds, that refuse to participate in a voluntary restructuring.

Greece’s banks (and indeed many in Europe) also urgently need liquidity, because the withdrawal of deposits and credits from Greek banks is destroying the economy and with it the ability to collect taxes. Ensuring liquidity has to proceed even faster than recapitalisation. The ECB needs to swing into urgent action at long last. If the Germans continue to oppose this vital ECB function, the IMF should weigh in on the importance of the ECB’s lender-of-last resort function.

As part of a credible adjustment, Europe needs an infusion of financial support from beyond the eurozone, channelled through the IMF. We are therefore at the end of an era, not only in Europe, but globally. The rising economic powers have financial surpluses, economic growth, and high stakes in global stability. They have the means to provide new bulwarks of the multilateral system. The traditional powers will have to make more room for them at the head table. That should happen in a cooperative and orderly manner rather than through crisis and collapse.

The writer is director of the Earth Institute at Columbia University, and author of The Price of Civilization

Response by Sony Kapoor

Helping a eurozone intent on committing hara-kiri would be throwing good money after bad

The eurozone’s problems are entirely self-inflicted, and the solutions too must come from within.

However, the European Union may be ‘institutionally incapable’ of getting a handle on the crisis now. Its fragmented structure makes decision-making slow and difficult at the best of times. Petty parochial politics and procrastination has transformed a treatable birth-defect into a near-fatal malady.

The speed, scale and cross-border nature that characterise the crisis now, probably rule out any solutions that come from the divided European Council, which is incapable of moving fast enough to restore confidence. The crisis that has already engulfed six of the seventeen euro member states limits their financial ability to act even if they could make quicker decisions. The European Commission, which can act faster, has no money to help.

By default, no pun intended, this leaves the European Central Bank as the only institution with both the financial capacity and a faster, majority-based decision-making structure that can act to stem the crisis. While it has not been inactive, it refuses to do what it takes. It is now playing a high-stakes game of chicken with politicians, the consequences of which can easily be fatal for the eurozone. This will not only be disastrous for the EU but also for the global economy.

Given this sorry state of affairs, should the eurozone turn to cash-rich emerging economies? Would they help? Should they? Will this end the crisis? Jeff Sachs’ answer to most of these questions is yes, but I am afraid everywhere I look, I see a differenct picture.

Unless the EU grasps the nature and seriousness of the problem it faces and acts accordingly, no amount of politically-feasible external help would suffice. Helping a eurozone intent on committing hara-kiri would be throwing good money after bad.

If the EU does get the diagnoses right, the solution stares us right in the face and is purely domestic – the ECB need to support illiquid sovereigns fully according them the political and economic space they need to reform. Without ECB support, external help would only be a sticking plaster. If the ECB acted, no external help is necessary.

As we have witnessed in the past two weeks, any talk of external help, no matter how vague, simply gives EU leaders and institutions room to procrastinate some more. In fact the International Monetary Fund, the US and emerging economies should ramp up the pressure on the ECB and EU governments to get their act together. Additional support can then be offered, but is not a substitute for self-help.

Germany has rejected the use of the IMF’s special drawing rights to support the European financial stability facility. Italy turned down an offer of a substantial precautionary credit line from the IMF. Both the US and the EU remain arrogant enough not to offer emerging economies a fair share of power in global institutions that they would doubtless demand in return for their financial support. The EU may want to be helped, but only on its own terms.

While the emerging economies may have substantial reserves, these are not lying idle in a bank account. To provide the scale of help that the EU needs, emerging economies will need to shift the allocation of both the stock and new build-up of reserves away from exiting assets such as US governments bonds. This could be disruptive if done quickly.

Last but not least, there is the bigger question of whether the Brics, who between them still have the majority of the world’s poorest people, should be using funds that could be much more gainfully employed investing in each other’s economies or in the developing world to bail out one of the wealthiest regions in the world that refuses to help itself.

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

With leaders of the Group of 20 leading nations now focusing on the International Monetary Fund as their preferred conduit for any bail-out in the eurozone, it is imperative they ask what concrete purpose the fund’s capital will serve. Unless the IMF is granted considerable power to enforce conditionality at the eurozone level, it is hard to see much benefit in its involvement, aside from providing a fig leaf for large-scale European Central Bank purchases of euro sovereign junk bonds.

All eyes are on the Greek drama, but of course the problem is far deeper and more pervasive. There are at least five key flaws in the eurozone’s present interim design.

First, the Maastricht treaty debt limits were not nearly strict enough, in size or enforcement.

Second, there is no mechanism for large, automatic fiscal transfers that would allow risk to be shared as in a single-country currency. If Europe’s national governments are to have their borrowing sharply restricted, then there must be another mechanism to smooth consumption during recessions. (In theory, financial markets could be used to hedge macroeconomic risk across countries, but in practice there are many obstacles.)

Third, there is no clear lender of last resort for private financial institutions in the fiscally-weaker countries. Even if the Italian central government is still marginally solvent, it lacks the wherewithal to provide a convincing backstop to the country’s banks. If Italy still had the lira, it could simply print money if it ran out of other options. But it cannot unilaterally force the ECB to do so.

Fourth, Europe needs a powerful centralised financial regulator, for no other reason than to limit national explosions in privately-held debt. The Maastricht treaty limits only apply to public debt. Yet, in practice, private debts often become public debts in a crisis, as Carmen Reinhart and I have shown in our research.

Finally, too many eurozone decisions require unanimity, which adds a layer of dysfunction on top of national governments that sometimes already struggle with this.

Even with constitutional reform to address these structural flaws, a political agreement is needed to deal with the acute debt imbalances that have already accumulated. Any solution is going to have to involve large one-way transfers from north to south. In return for aid, the southern countries will almost surely have to subordinate macroeconomic policy to their richer neighbours. Neither prospect seems politically viable on a sustained basis. It is hard to see how even copious liquidity from the IMF can alleviate this intranet-family problem of European governance, unless of course the fund is allowed to enforce heavy conditionality.

Perhaps the situation where outside money might be most useful is in preventing bank runs on solvent countries. Unfortunately, however, the distinction between liquidity and solvency is in practice very difficult to make. In spite of its tough reputation, the IMF far more often misjudged solvency problems for liquidity problems than vice versa. Of course, the fund could be used as an enforcement vehicle for imposing conditionality on the south, but the limits of how much austerity can be prescribed are already being tested throughout the periphery.

The risk of contagion from a Greek default is a palpable one. But G20 leaders need to articulate exactly what the IMF can bring to the table that is not already sitting there in front of a very wealthy, but politically dysfunctional, eurozone system.

The writer is a professor of economics and public policy at Harvard University and former chief economist at the IMF

After George Papandreou’s surprise decision to ask the Greek people if they would prefer five years of austerity or five years of austerity with a side order of chaos, Nicolas Sarkozy’s best-laid plans for Cannes have had to be, well, canned. He launched his presidency of the Group of 20 leading nations with calls for a new Bretton Woods – a wholesale reconstruction of the international monetary system – and a global plan for renewed growth. Even though the referendum has now been scraped, these grand French aims, some of which were unrealistic anyway, will inevitably take second place to the eurozone’s worsening agonies. Cue the visiting Americans and Chinese calling on the Old Continent to get its act together.

That is unfortunate, and Mr Sarkozy should try to wrest at least part of the agenda back on to the longer-term issues. Behind the scenes, on the lower slopes below the summit, a group of ‘sherpas’ have been working hard. There has been little appetite for fundamental reform a la française. The so-called mutual assessment process, which was supposed to lead to a set of indicators to measure global imbalances, and promote action to correct them, has run into predictable opposition from China, in particular.

But something could be rescued from the wreckage. Of course there will have to be a general commitment to sustaining economic growth. It will only be of value, however, if it is buttressed by specific commitments to strengthen the resources of the International Monetary Fund (and the European financial stability facility) to provide help to the walking wounded, whose problems threaten to derail the summit and, more importantly, the global economy. There is a clear common global interest there, and sometimes peering into the abyss, as the summiteers are now doing, can shift entrenched positions.

A British-led group has been working on unglamorous issues surrounding the Financial Stability Board, proposing that it be given a legal identity and added teeth. That would be a step forward. There are clear signs that the early enthusiasm for global regulatory agreements has dissipated, with many countries going their own way, creating damaging uncertainty in financial markets. That is partly because, between summits, there is no sustained global leadership.

Another group has been working on infrastructure finance. There is a huge need today for investment in transport networks and energy generation in particular. When long-term interest rates are so low there must be some positives from reconnecting finance with investment needs.

We cannot expect an earth-shattering headline deal from Cannes. But often the Palme d’Or winner at the film festival is a disappointment, while some of the second rank offerings can be rewarding, and longer-lasting. That may be the best we can expect this weekend. Ce n’est pas magnifique, but it’s the nature of the economic war we’re in.

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

China is likely to react sympathetically when Europe approaches it for assistance, directly or indirectly. But if Brussels is to persuade Beijing to make a substantial commitment to Europe, it has to demonstrate more geopolitical competence – and also more independence in managing relations with China.

A fundamental mistake European governments have made is to position themselves as geopolitical subsidiaries of the US. These interests are defined by geography. America has to handle Mexico as sensitively as Europe handles Russia. It is striking that Europe does not indulge in ideological grandstanding on democracy and human rights in Russia.

All Europe has to do is to treat China as pragmatically as it treats Russia. A few simple symbolic gestures could win significant favour in Beijing. The EU has so far denied China the status of “market economy”, even though it will gain this automatically in 2015 under current World Trade Organisation agreements. This could constrain the EU’s unilateral anti-dumping actions against China. Another possible symbolic gesture is to lift its arms embargo. This does not mean that the EU will begin arms sales to China. That will not happen. But the removal of the embargo would end a humiliating condition imposed on China, and not on Russia.

There is plenty of goodwill to help the eurozone deal with its current problems. It was barely twelve years ago that Asia appeared to be spinning out of control in the its own financial crisis. Europeans gloated visibly about the sudden crashing of the promised Asian century. I know this well as I experienced it personally. So as Europe lurches from one crisis to another, it would be perfectly natural for Asians to feel smug. Yet, amazingly, there is virtually no schadenfreude. Why not?

Most importantly, Asians realise that we are all now in the same boat. In this interconnected economic universe, no country is immune from financial crises. Asia is now experiencing its most propitious moment for rapid economic growth. A fundamental requirement for such rapid growth is global economic stability.

China has sound geopolitical interests in keeping Europe together. A strong, united Europe provides an alternative economic pole, reducing China’s reliance on the United States. After the Brussels meeting, Xinhua commented, “Obviously, it is up to the European countries themselves to tackle their financial problems. But China can do what it can within its capacity to help as a friend.”

Given all the brouhaha in the US Senate over China’s trade surpluses, few are aware that China exports more to Europe than the US. Indeed, Europe is China’s largest trade partner and China is Europe’s second largest trading partner. This is why Beijing welcomed the creation of the euro in 1999, while Washington reacted unenthusiastically to the creation of an economic alternative that could undermine the dominant role of the US dollar in the global economic system.

The symbolic moves I have suggested above would undoubtedly generate ripples in America. Yes, there will be some political costs for the EU. But it could also prompt Washington to treat Brussels with greater respect if the EU can, from time to time, demonstrate geopolitical independence. Ironically, it may also help the US reconsider its decision not to participate in the latest European rescue package. In short, geopolitical independence by Europe could lead to financial rewards from both Asia and America.

The writer is dean of the Lee Kuan Yew School of Public Policy at the National University of Singapore, and author of The New Asian Hemisphere

Response by Daniel Gros

China’s assistance could do more harm than good

Does Europe need ‘assistance’ from China? Not at all if it gets its own act together. Unlike the US, the eurozone does not have a external deficit that needs to be financed. Its current account is balanced, so there are enough savings within the monetary union to finance all public deficits. The problem is one of distribution. There is an excess of savings north of the Alps, but northern European savers do not want to finance the southern countried such as Italy, Spain, Greece.

Why should China buy Italian or other peripheral debt if Germans savers and banks do not want do it? The answer might be that China will be asking for an implicit guarantee from Germany for any ‘euro’ bond it buys. But this does not make sense for Germany. Why should it pay a political price for something – guaranteeing the debt of other countries – that it has consistently refused to consider even for its own banks?

A large inflow of funds from China and other ‘investors’ could in fact do more harm than good. The incoming capital would strengthen the euro and thus make a recovery in the periphery even more difficult. Germany’s exports are much less price sensitive than those of the periphery. Germany can thus get by with a stronger euro, but countries such as Italy and Greece, which must compete on price would be even further weakened. Why should Europe pay any political price for assistance which is not really needed and which might actually be counterproductive?

As there is the little difference between the euro area (the 17 countries out of 27 European Union members), any political concessions would have to be agreed by all 27. The non-euro members of the EU have little reason to agree to political concessions just because the eurozone is not capable of managing its own internal problems.

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

Which should come first: growth or austerity?

Debate is raging over whether government policy should favour short-term growth or short-term austerity. The British government has chosen austerity and the bond markets have rewarded it with low interest rates. But, a left-leaning think-tank claims to have the support of “100 leading economists” for its Plan B with higher public spending to boost the economy. Nevertheless, Britain should stick to its current path of cutting deficits.

Few would dispute that growth is needed – sooner or later – to pay off debt. If the economy is growing, young households can sensibly take on a large mortgage in the expectation that their incomes will grow over time to enable them to repay it. Countries can sensibly run budget deficits and build up debt during recessions because they anticipate reducing their debt through budget surpluses when growth rebounds. This is sound reasoning provided two conditions hold: that the debt-to-income ratio does not get too large, and that higher growth in the future is realistic without austerity now.

The eurozone crisis has cruelly exposed one of the key links between growth and debt. In the extreme case of Greece, being part of the eurozone enabled it to benefit from low interest rates that lulled it into delaying the politically difficult reforms that are necessary for it to become a competitive economy capable of sustained growth. Now there is no choice. The debt-to-gross domestic product ratio is above 100 per cent and accelerating as interest payments rise. Structural reforms such as better tax collection, fewer public sector workers and later state pension ages mean short-run austerity. But without them Greece cannot grow, even with a partial write-off of its debt. For Greece, with no exchange rate flexibility, austerity is a necessary condition for growth.

Outside the straitjacket of a currency union, the trade-off between growth and austerity is looser but still binding if debt is building. Both Britain and the US are in this camp. In both countries the budget deficit hovers around 10 per cent of GDP and the debt-to-GDP ratio is rising.

President Obama’s preferred policy is growth first, austerity later. During his first two years in office he pushed through two stimulus packages and has just sent another bill to Congress which would extend and broaden some of the earlier measures. Some eminent economists have supported such additional stimulus on Keynesian grounds, but the acrimonious debate over raising the government’s debt ceiling showed how deeply divided public opinion is on this subject.

If debt is the underlying problem and two previous attempts at deficit spending failed to ignite a sustained recovery, why should more do so now? In effect, the public is demonstrating what economists call ‘Ricardian equivalence’, namely the rational expectation that government spending now will require higher taxes later. Taxpayers react by increasing their savings now, rather than their spending. Perhaps the sharp falls in business and consumer confidence surveys reflect this view. If so, further fiscal stimulus in the US will not ignite growth.

Britain’s trade-off is starker than America’s. Its currency is not the global monetary anchor, nor is sterling considered a safe haven in turbulent markets. The Chinese do not need to buy gilts. With a quarter of Britain’s debt held by foreigners, the country’s borrowing costs are directly determined by the confidence that the global bond market has in its policy. Last year 23 per cent of government spending was financed by borrowing. Entitlement programmes consume 29 per cent of the budget and represent the largest component of the structural deficit. Either these must be reduced or taxes will have to be raised. But already tax rates on individuals are among the highest among developed countries. These stark facts are the reason that the coalition government has wisely chosen to put austerity first in order to create the conditions for growth later. Economists may debate, but the markets will decide.

The writer is chairman of Chatham House and former member of the Monetary Policy Committee of the Bank of England.

Response by Joe Cox

Austerity is hurting but it isn’t working

Britain’s high unemployment rates, low levels of investment, low consumer confidence, stagnating wages and stalled growth all indicate that the government’s Plan A is not working. It’s time for Plan B.

The government’s economic strategy is failing because it is based on two faulty assumptions, namely that the bond markets will not fund further borrowing to invest, and that there is a clear division between the public and private sector.

The “reward” of low interest rates given to the UK by the bond markets as a result of the government’s cuts isn’t a reward as such. It’s more an acknowledgement that private sector returns on investment are currently so low that the interest rates offered by gilts look attractive.

But the cost of borrowing will increase rapidly if the markets think the UK is heading down a deflationary spiral. This is a far more pressing concern than the historically small government deficit.

In reality Britain’s public and private sectors are very closely interlinked. That is why taking £130bn of spending out of the economy, over a period of just five years, at a time when demand is already weak has had a chilling effect.

If we make a conservative assumption that the government’s public spending cuts will have the effect of reducing gross domestic product by 1.3 per cent every year between 2011 and 2015, we can forecast (using a framework outlined by the National Institute of Economic and Social Research) that this will lead to 140,000 job losses every year over this period.

Job losses on such a scale are likely to cost the Treasury around £14bn in lost taxes and increased benefits payments. In addition it will reduce GDP by around £100bn by 2015. In the worst case scenario, Plan A could mean that the deficit actually increases.

In Plan B a number of short- and medium-term measures are put forward to help get the economy moving and to facilitate the transition to a low carbon, highly productive and highly skilled economy. This includes increasing benefits for the poorest, which would have a multiplier effect (forget ‘Ricardian equivalence’ – many of these people are so close to the poverty line that they will spend because they have to).

A Green New Deal to channel investments into energy efficiency and microgeneration would reduce carbon and produce jobs. A financial transaction tax and a genuine drive to plug the tax gap would help pay for these investments in the medium- to long-term.

The UK also has an ‘innovation deficit’ that urgently needs to be addressed. At the centre of Plan B is a recommendation for a new British investment bank. This state-backed, arms-length institution would leverage private investment to decarbonising sectors such as housing, transport and energy production.

The biggest risk to Britain’s economic health is a descent down a deflationary debt spiral as a result of the austerity measures, not its historically small deficit. Chancellor, it’s time for Plan B.

The writer is researcher and campaigner for Compass, a centre-left advocacy group.

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