Daily Archives: January 25, 2012

The longer-term refinancing operations launched by the European Central Bank in December have relieved the liquidity problems of European banks, but not the financing disadvantage of the highly indebted member states. Since high-risk premiums on government bonds endanger banks’ capital adequacy, half a solution is not enough. It leaves half the eurozone relegated to the status of developing countries that became highly indebted in a foreign currency. Instead of the International Monetary Fund, Germany is acting as the taskmaster imposing fiscal discipline. This will generate tensions that could destroy the European Union.

I have proposed a plan, inspired by Tomasso Padoa-Schioppa, the Italian central banker, that would allow Italy and Spain to refinance their debt by issuing treasury bills at about 1 per cent. It is complicated, but legally and technically sound.

The authorities rejected my plan in favour of the LTRO. The difference between the two schemes is that mine would provide instant relief to Italy and Spain, while the LTRO allows Italian and Spanish banks to engage in a very profitable and practically riskless arbitrage but has kept government bonds hovering on the edge of a precipice – though the last few days brought some relief.

My proposal is to use the European Financial Stability Facility and the European Stability Mechanism to insure the ECB against the solvency risk on any newly issued Italian or Spanish treasury bills they may buy from commercial banks. This would allow the European Banking Authority to treat the T-bills as the equivalent of cash, since they could be sold to the ECB at any time. Banks would then find it advantageous to hold their surplus liquidity in the form of T-bills as long as these bills yielded more than bank deposits held at the ECB. Italy and Spain would then be able to refinance their debt at close to the deposit rate of the ECB, which is currently 1 per cent on mandatory reserves and 25 basis points on excess reserve accounts. This would greatly improve the sustainability of their debt. Italy, for instance, would see its average cost of borrowing decline rather than increase from the current 4.3 per cent. Confidence would gradually return, yields on outstanding bonds would decline, banks would no longer be penalised for owning Italian government bonds and Italy would regain market access at more reasonable interest rates.

One obvious objection is that this would reduce the average maturity of Italian and Spanish debt. I argue that, on the contrary, this would be an advantage in current exceptional circumstances, because it would keep governments on a short leash; they could not afford to lose the ECB facility. In Italy, it would deter Silvio Berlusconi from toppling Mario Monti – if he triggered an election he would be punished by voters.

The EFSF would have practically unlimited capacity to insure T-bills because no country could default as long as the scheme is in operation. Nor could a country abuse the privilege: it would be automatically withdrawn and the country’s cost of borrowing would immediately rise.

My proposal meets both the letter and the spirit of the Lisbon Treaty. The task of the ECB is to provide liquidity to the banks, while the EFSF and ESM are designed to absorb solvency risk. The ECB would not be facilitating additional borrowing by member countries; it would merely allow them to refinance their debt at a lower cost. Together, the ECB and the EFSF could do what the ECB cannot do on its own: act as a lender of last resort. This would bring temporary relief from a fatal flaw in the design of the euro until member countries can devise a lasting solution.

For the first time in this crisis, the European authorities would undertake an operation with more than sufficient resources. That would come as a positive surprise to the markets and reverse their mood – and markets do have moods; that is what the authorities have to learn.

Contrary to the current discourse, the long-term solution must provide a stimulus to get Europe out of a deflationary vicious circle: structural reform alone will not do it. The stimulus must come from the EU because individual countries will be under strict fiscal discipline. It will have to be guaranteed jointly and severally – and that means eurobonds in one guise or another.

The writer is chairman of Soros Fund Management. His latest book is ‘Coming Soon: Financial Turmoil in Europe and the United States’

One of the few potential areas for bipartisan cooperation in Congress this year is tax reform. There is broad agreement on both the right and left that the US tax system is a mess. Since the last major tax overhaul in 1986, the tax code has become cluttered with far too many special tax breaks that cost a great deal of revenue and show little proof of effectiveness. Meanwhile, American corporations are hobbled by one of the highest statutory tax rates and grave uncertainty about what tax regime will be in effect in 2013, as many tax provisions are scheduled to expire under current law at the end of this year. Unfortunately, Barack Obama effectively threw cold water on any tax reform effort in his State of the Union Address on Tuesday.

There is a consensus between Republicans and Democrats, at least among the tax experts, that the current situation is highly undesirable and in dire need of a permanent fix. They agree that the tax base needs to be broadened and tax rates reduced and that perpetually expiring provisions such as the research and development tax credit should either be made permanent or scrapped. Others, such as the alternative minimum tax, need be updated to better target those it was originally intended to cover and not those with modest incomes.

Since there are so many elements of the tax code that require rethinking and review, it would be best to do so in a comprehensive way, rather than in an ad hoc fashion. There is enough general agreement on what needs to be done that it is realistic to believe that something meaningful might be accomplished and enacted into law in the not too distant future.

But rather than proposing a cleaning-up of the tax code, Mr Obama is proposing several new tax preferences. He wants a special deduction available only to companies engaged in manufacturing to be doubled, but most tax specialists think this should just be abolished. He’s in favour of extending a tuition tax credit, which mostly gets capitalised into higher tuition fees and does little to improve access to higher education for middle class families. There’s also special tax relief for small businesses “that are raising wages and creating good jobs” that he wants to introduce even though no one knows how to target such incentives and past efforts have failed. Finally, he would like a new tax credit for “clean energy” and tax credits for companies hiring military veterans.

At the same time, Mr Obama proposes a variety of gimmicky new tax penalties, to punish companies that move jobs overseas for example. He wants to force every US-based multinational corporation to pay a minimum tax, and made individuals earning at least $1m per year to pay at least 30 per cent of their income in tax.

Whatever the merits of these specific tax proposals, they do not move towards tax reform. They move in the opposite direction, by cluttering up the tax code with still more special tax breaks for activities in current political favour and penalties for individuals and businesses in disfavor. This is exactly the sort of thing that created America’s current tax mess.

At a minimum, Mr Obama should have directed the Treasury Department to begin a study of tax reform as Ronald Reagan did in his 1984 State of the Union Address, which paved the way for the Tax Reform Act. Mr Obama’s decision to move away from reforming the tax code this year is both a substantive and political error that I believe he will come to regret.

The writer a former senior economist at the White House, US Congress and Treasury. He is author of ‘The Benefit and the Burden: Tax Reform—Why We Need It and What It Will Take’

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