Monthly Archives: March 2012

Just when you thought it was safe to go outside, it turns out that another storm is gathering on the eurozone horizon.

Spain was always on the “one to watch” list. It now finds itself in that most awkward of positions: the financial equivalent of a vicious circle. The interest rate on its sovereign debt is rising, the economy is stalling and the government is fast losing the enthusiasm to deliver the austerity demanded by Brussels. The process then repeats itself.

Reflecting both the economy’s descent into recession and the significant budget deficit overshoot last year, the Popular government led by Mariano Rajoy informed Brussels earlier this year that it was aiming for a budget deficit this year of 5.8 per cent of gross domestic product, significantly higher than the 4.4 per cent agreed earlier. An almighty row then broke out – one that essentially focused on the degree to which Spain is able to enjoy fiscal sovereignty – which led to a compromise deficit target of 5.3 per cent.

Even if that number is achieved, and with 17 autonomous regional governments in Spain all happily spending away, there is no guarantee that it will be, the thorny matter of reducing the deficit further to 3 per cent of GDP in 2013 remains.

For an economy shrinking rapidly, deficit reduction on this scale is not easy. Whatever one thinks about Greece’s initial fiscal problems, for example, they were made far worse as a result of subsequent economic collapse. In the autumn of 2010, the International Monetary Fund thought Greece would shrink by a rather modest 2.6 per cent in 2011. We now know the economy last year fell about 7 per cent. The Greek fiscal position was bad not only because of a lack of effort but also because the economic problems were far stronger than expected.

Major deficit reduction in the wake of economic collapse is near enough impossible, particularly when the population starts to protest. Spain is preparing for a general strike on March 29. Yet the more Spain resists deficit reduction, the greater will be the suspicion that the authorities are merely dragging their feet. Perhaps, for example, they’re hoping for further help from the European Central Bank’s long term refinancing operations to push Spanish yields back down, thereby saving the day for the government, for its banks (now up to their gills in Spanish government debt thanks to the carry trades generated by the first two LTROs) and for the single currency, without the need for excessively painful austerity.

Here, then, is the problem. Have Spanish yields risen because investors no longer believe the country is either willing or capable of delivering the necessary austerity? Or have they risen because investors think the eurozone’s creditor nations, and their acolytes at the European Commission, are just running out of patience? Either argument could be used to explain the rise in yields yet there’s a world of difference between deliberate slippage on behalf of the Spanish and a loss of confidence on behalf of their eurozone partners.

Olli Rehn, the EU commissioner for economic and monetary affairs, has made his views known. He’d like more fiscal pain in Spain. “Because there was a perception Spain was relaxing its fiscal targets for this year, there has been already a market reaction of several dozen basis points on yields of Spanish bonds,” he said. The fault, according to him, lies solely with Spain and it is up to the Spanish to convince investors that they can bring their fiscal plans back on track.

This has become a familiar lament. Yet it does not deal properly with the interaction between growth shortfalls and the cost of borrowing within the eurozone. In the old days, weak growth was synonymous with low interest rates. In the topsy-turvy world of the eurozone, weak growth is now more often associated with high interest rates. Austerity, by delivering even weaker growth, leads to even higher interest rates.

The only way to get around this problem is to recognise the symbiotic relationship between creditors and debtors. In the eurozone, that means a fiscal union, not the constant bullying of debtors by creditors.

The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. He is the author of ‘Losing Control: The Emerging Threats to Western Prosperity’

Years ago, a simple chant united millions of Latin Americans in their desire to move away from dictatorship: cambia, todo cambia or everything changes. Well, the monopolistic, feudal and entitlement-based approach to appointing the president of the World Bank appears to be finally giving way to a more open, competitive, transparent and merit-based system.

As we count down to the official deadline on Friday, three highly credible professionals are on the verge of being nominated as official candidates to replace former president Robert Zoellick, namely José Antonio Ocampo from Colombia, Ngozi Okonjo-Iweala from Nigeria and Jeff Sachs from the US.

All three have strong developmental qualifications. Their track records are both solid and of direct relevance to the position.

Mr Ocampo is a professor at Columbia University, a former UN under-secretary-general, and former finance minister of his native Colombia. Ms Okonjo-Iweala is Nigeria’s finance minister, a position that she excelled at earlier before a stint as a managing director at the World Bank. And Mr Sachs, a respected professor and practitioner of development economics, is the director of the Earth Institute at Columbia University and a special adviser to Ban Ki-moon, UN secretary-general. Crucially, all three have already secured the backing of some of the Bank’s member countries, as well as endorsements from knowledgeable and credible observers.

This constitutes by far the biggest challenge ever to the US government’s automatic entitlement to the presidency of the World Bank. Due to these individuals’ courage, this year could mark the end of the outdated and harmful tradition of selecting the leader of the world’s premier developmental institution based, not on merit and qualifications, but on nationality, internal politics and bureaucratic largesse. And, with that, the International Monetary Fund is sure to follow suit when Christine Lagarde eventually steps down, thereby relaxing Europe’s stronghold on that international institution.

Mr Sachs led the way by boldly launching a public campaign on March 1. He put forward credible proposals for strengthening an institution that can, and should, play an even larger role in alleviating poverty and in helping developing countries achieve their potential. And he argued forcefully why he is best placed to implement the required changes.

His move opened the way for other credible candidates to express interest or be encouraged to do so. Those likely to be nominated on Friday include two from the developing world, confirming what many already know: that neither America nor Europe hold a monopoly on talent, qualifications and experience for the top jobs at the international financial institutions.

The US is yet to announce its official nominee. And when it does, this person will, for the first time in almost 70 years, actually have to compete to secure the post.

This is not to say that the US administration will not get its way. It could well do so, especially if the Europeans provide overwhelming support. After all, they would have the votes needed . But in order for this to materialise, the US must first come up with a highly credible candidate given the quality of the other candidates.

Once the nomination period closes, the Bank’s executive board is committed to conducting a thorough assessment process. In delivering on this important pledge, they should have no hesitation in running appropriate background checks and collecting whatever information is needed for a proper and fair evaluation – again something that is essential for good governance and yet appeared to have been lacking in prior episodes.

The world has waited a very long time for a more suitable and defensible system for selecting the leaders of the two most important international financial institutions. It could well be on the verge of getting it due to the courage of talented individuals, and the perseverance of many advocates for this sensible and overdue change. It is now up to the Bank’s executive directors to step up to their responsibilities.

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

The most controversial announcement in George Osborne’s Budget was the cut in the top rate of income tax from 50 per cent to 45 per cent from next year. The opposition party’s response was directed toward this single measure, although it accounted for a mere £50m of estimated lost revenue in its first year. Mr Osborne must have calculated that the economic gain would outweigh the political pain.

He was supported in his economic case by an impressive new study by HM Revenue & Customs, based on the actual tax returns of the 300,000 people with incomes above £150,000, which puts them into the highest tax bracket. They comprise about one per cent of UK taxpayers and account for about 30 per cent of income tax revenues. Studies from other countries have shown that higher earners are more likely to change their behaviour in response to tax changes than lower earners. This was indeed borne out in the UK with the potential yield from the 50 per cent tax payers decreased by more than 80 per cent through legal behavioural changes. These ranged from bringing forward income via dividends to working less and emigrating. The Swiss Federal Migration Office reported a 29 per cent increase in Britons given long-term work permits in 2010 compared with the previous year. While this is only one example, the HMRC estimates are consistent with other academic studies (such as the Mirrlees review), which show that such a high marginal rate is a highly distortionary and ineffective form of taxation. Continue reading »

Why is Russia so adamant in defence of Syria’s Bashar al-Assad? Much to the consternation of US and European officials, Moscow has blocked efforts within the UN Security Council to sanction and further isolate the Syrian regime. Russian foreign minister Sergey Lavrov says his government feels burned by the way Nato used a resolution on Libya to bomb Muammar Gaddafi last year. That’s not credible. Mr Lavrov is an experienced diplomat who served ably as his country’s ambassador to the UN. He knows precisely how the language of a security council resolution is crafted-and how it can be interpreted.

No, Russia protects Mr Assad because Moscow needs his government right where it is. Syria is Russia’s most reliable Middle Eastern commercial partner. In fact, Mr Assad, like his father before him, buys most of his country’s military hardware from Moscow. Over the years, father and son have taken on considerable debt in the process. Russia forgave about 75 per cent of those obligations in 2006 in exchange for Russian use of Syria’s Mediterranean naval bases at Latakia and Tartus. For Russia, access to a Mediterranean port holds considerable strategic value.

The Russian government has invested heavily in long-term plans for both sites, using Latakia as a submarine base and hopes to add the space and capacity to use Tartus for missile cruisers. The Russians apparently fear that the loss of Mr Assad could mean the loss of these valuable Mediterranean ports.

Are they right? We’re likely to find out. Mr Assad has so far survived the increasingly violent challenge from his country’s rebels. Defections from his army have been limited. The country’s business elite, based mainly in Damascus and Aleppo, have yet to abandon him. But as his regime becomes increasingly isolated, Russia’s protection and the regime’s willingness to hang onto power by any means necessary probably won’t be enough. Mr Assad’s days are likely numbered, and Syria’s next government may not be favorably disposed toward Moscow.

So where can Russia turn to maintain a Mediterranean base for its navy? How about Greece? Political officials in Germany and other core EU countries should take note.

Greece, as you may have heard, desperately needs a reliable long-term source of revenue. The country’s citizens are wondering how they can grow their economy toward health while embracing the austerity prescribed in Brussels and Berlin. Outsiders are wondering what Greece has to sell.

But as Western investors retreat, state-owned Russian and Chinese companies have gone bargain hunting. The Chinese have already invested significantly in the Greek port at Piraeus via a 35-year concession worth nearly $5bn for Cosco, a Chinese state-owned shipping company. Gazprom, Russia’s gas monopoly, is reportedly eyeing the privatization of Greek gas company Depa and grid operator Desfa.

A 30- or 50-year deal that provides Russia’s navy with basing rights at Piraeus might one day make sense for both sides. Over time, the deal could bring Greece’s cash-starved government as much as $200bn.

It’s impossible for Lucas Papademos and his technocratic government to cut such a deal, in part because Greece’s Nato allies would strongly object. But a future Greek coalition led by the New Democracy Party, facing enormous populist pressure to raise money and to resist political and economic demands from Berlin and Brussels, is another matter.

The potential implications are worth considering. Uncompetitive Greece may have more financial flexibility (and leverage) than its European negotiating partners yet recognize. And if some combination of Greek resentment and European demands were one day to force Greece out of the European Union, Nato could be in for a fresh round of hostility between Greece and Turkey. In fact, if EU and Nato membership were meant in part to create new bonds between these traditional antagonists, a Greek exit might throw that trend into reverse.

Greece has every reason to remain in the EU, and European institutions have plenty of leverage with the country. Greece just received about 170bn euros from the EU and IMF to cover the country’s financing needs through 2014, and both institutions have made clear that more help is possible. The European Central Bank has provided about 130bn euros in support of Greek banks. The EU and IMF will hold about two-thirds of Greece’s debt. Nato membership provides other benefits. These are a few of the reasons that Greece is unlikely to leave the union anytime soon.

But over time, the long-term effects of austerity on Greece’s economy, and the public resentment that comes with it toward Germany and European institutions, could change the terms of debate-both inside Greece and across Europe. That’s why the rest of Europe should take note. Greece has no parachute today. But over time, it might have more options than we think.

The fall of Bo Xilai, former party secretary of Chongqing, has raised concerns among China observers. Early last month, his right hand man and Chongqing police chief, Wang Lijun, went to the American consulate in Chengdu and stayed there overnight. It remains a mystery why Mr Wang did that, but what is clear is that the incident has led to Mr Bo’s sacking.

Yet the police chief’s odd behaviour was only a catalyst for Mr Bo’s fall. Over the past few years, the party secretary has waged a campaign in Chongqing to crack down on organised crime. He also started a movement to sing “red songs”, the songs that were popular in the first thirty years of the communist rule. Most China observers believed that he was angling for a position in the next standing committee of the political bureau.

But his campaigns were perhaps the very reason for his sacking. Mr Bo’s moves have garnered him loud applause from the people, but raised concerns among the top leadership. This was made clear in premier Wen Jiabao’s answer to a question regarding Mr Wang in a press conference a day before the central committee sacked Mr Bo. Pointedly, Mr Wen remarked on the disasters China experienced during the Cultural Revolution when populist movements led to great destruction of the society.

The sacking of Mr Bo signals that the party will continue on its pragmatic and centralist policy set long-ago by Deng Xiaoping. It has now been widely recognised that the reform process stalled in the last decade. However, it was a key theme in Mr Wen’s address to the recently-concluded annual People’s Congress. It seems that this was not just lip service, but would be backed by real actions.

An example is the government’s new hukou, or household, registration policy. In small cities and towns, people can register as local residents as long as they have a job and a home (even if it is rented). In medium-sized cities, people can do the same if they have worked and lived there for three consecutive years. This new policy, if it is carried out as outlined, will end the discrimination against migrant workers. Its impacts on China’s political and social landscapes will be felt only after it is fully implemented.

The recent ‘China: 2030′ report by the World Bank supports the thesis that the government is back on the path of reform. Among other recommendations, it calls on China to seriously reform its state-owned enterprises. The report is a joint effort between the World Bank and the Development Research Center of the State Council, China’s executive branch headed up by premier Wen. So the reform proposal is at least endorsed by some key sections of the government.

To see real changes, though, one may have to wait until the Communist party concludes its 18th congress and a new leadership takes shape in October. But the recent political developments and policy changes have raised hopes that reform is back on the agenda.

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

The recent payroll gains and the declining unemployment rate in the US have raised hopes that the economy will now start growing faster than the tepid 1.7 per cent rate last year. Optimists are expecting growth rates as high as three per cent for this year and next.

I hope they are correct. The recession that began in December 2007 was deep and painful and the recovery that began in June 2009 has been slow and grinding in spite of unprecedented fiscal outlays and even larger monetary stimulus. House prices have continued to fall and housing construction remains dormant because of Barack Obama’s government’s failure to reduce the large number of homeowners whose mortgage debt exceeds the value of their homes. Business investment has been depressed by the anti-business rhetoric and policies of Mr Obama’s administration.

While payroll employment has recently been rising by more than enough to absorb the growth of the labour force, the expansion in gross domestic product has been weak and most of that increased production has gone into inventories rather than into final sales to households, businesses and foreign buyers. The latest official estimate indicated GDP grew at three per cent in the fourth quarter of last year but final sales constituted only 1.1 per cent of that, with the rest going into inventories. Estimates by Macroeconomic Advisers for January indicate an annualised GDP growth rate of 2.5 per cent, but also suggest that final sales actually declined.

The jump in the consumer price index for February resulted in real average hourly earnings falling in that month. Higher prices and falling real incomes caused the Michigan consumer sentiment survey to decline this month.

Looking to the future, there are strong headwinds that will make it difficult to achieve a robust recovery. Higher petrol prices will reduce real incomes and cut spending on domestic goods and services. The weaknesses in many European economies will cut US exports to those countries.

But the most important cloud on the horizon is the large tax increase that will occur next year unless there is legislation to block it. The Congressional Budget Office predicts that, under current law, the revenue of the federal government will rise from $2,456bn in the current fiscal year, which ends in September, to $2,968bn in the following fiscal year. That increase of $512bn is equivalent to 2.9 per cent of GDP, bringing federal revenue as a share of GDP from 15.8 per cent this year to 18.7 per cent next year.

The higher revenue would reflect an increase in personal tax rates, higher payroll taxes, as well as increased taxes on dividends, capital gains and corporate incomes. Revenue would continue to rise in future years – as a share of GDP it would increase to 19.8 per cent in 2014 and would stay above 20 per cent for the remainder of the decade.

A sustained tax increase of that magnitude would push the US into a new and deep recession next year. So, it is important to recognise that legislation is required to prevent such a tax rise.

Getting that legislation passed will be difficult. Mr Obama has said he wants to keep the high taxes for upper income taxpayers and to raise total taxes on corporations and other businesses. The Republicans in Congress and the Republican presidential candidates have indicated they want to avoid all of the tax increases that are specified in current law and to start a process of tax reform. So the 2013 tax rates will depend on the outcome of the presidential elections in November.

Many political analysts are predicting that Republicans will maintain control of the House of Representatives and become the majority in the Senate but that Mr Obama will be re-elected. While this “most likely” outcome may not occur, the potential tax consequences pose a serious risk to the economy not only in 2013 but this year as well.

A Republican Congress could vote to eliminate the tax increases but a re-elected President Obama could veto the legislation. While neither side would want to see the economic downturn that would result from failure to achieve a compromise, political accidents happen.

The risk of dramatic tax increases and an economic downturn next year affects the behaviour of businesses and households today. Companies that expect large tax increases in 2013 and potentially another downturn in the near future will be reluctant to invest or hire this year. And individuals who think their personal taxes may rise next year will also cut back on current spending on “big-ticket” and other discretionary items.

America needs to reform its tax rules and entitlement programmes. But we can do that in a way that strengthens confidence and raises the rate of economic growth. The dramatic rise in federal revenue starting next year that is built into current law would undermine the economy and threaten this year’s rate of expansion. The political choice has never been more important for our economic outlook.

The writer is professor of economics at Harvard University and President Ronald Reagan’s chief economic adviser

The markets seem to have coped relatively well with “the biggest sovereign restructuring ever” last week. But they are already focusing on the next possible victim: Portugal’s bond yields have soared to levels close to those on Greek bonds a few months ago.

European authorities have declared that Greece was unique and that there will be no more debt restructuring. Undoubtedly, though, they will be tested in the coming months. Two strategies are possible.

One is to behave in the same way as in the past. This means helplessly observing the widening of credit default swap spreads on sovereign bonds until it becomes obvious that the country in question will not be able to refinance itself in the markets; then publicly denying that restructuring is even an option, but privately considering involving private creditors and even discussing the details with some market participants; finally, hastily putting in place an additional package and asking the various countries’ parliaments for approval, which they might be willing to consider… but only in exchange for debt restructuring.

Unless this approach is quickly abandoned, Greece will turn out not to be an exception after all. Markets would turn to the next prey, like in Agatha Christie’s Ten Little Indians. Who will be next? Ireland? Spain? Italy? Where would the process stop?

The alternative strategy is to immediately build a firewall that would ensure Greece is an exception. First, it should be recognised right away that Portugal may not be able to return to the markets next year and needs an additional bailout package. If it is unable to finance itself until 2016, it will need approximately €100bn. The European Financial Stability Facility has sufficient capability to provide these funds.

Second, the same could be done for Ireland, which requires an additional €80bn. The procedure to allocate these funds should be started right away by the national and European authorities. Third, the size of the EFSF and European Stability Mechanism should be further increased to allow them to provide additional funds to other countries. Fourth, the International Monetary Fund’s European shareholders should arrive at its spring meetings with sufficient support from other advanced economies, including the US, and from emerging markets to obtain an increase in the funds available to the IMF.

The problem with this strategy is avoiding moral hazard. How can it be ensured that countries receiving increased financial assistance, starting with Portugal, will implement the agreed adjustment programme and not become complacent, as happened with Greece?

One way is to agree that the rules and procedures foreseen by the proposed fiscal compact, including sanctions, become immediately enforceable, even before ratification. There must be stronger monitoring of whether budgetary adjustments are being implemented, to avoid a repeat of the embarrassing situation in Spain, where it was discovered on Monday morning that the budget deficit was 30 per cent higher than expected the previous Friday. Countries receiving upfront assistance should also be required to present privatisation programmes, involving their banking system, that would be automatically triggered if the country failed to meet the adjustment target.

Only by acting forcefully, in anticipation of what the markets will focus on next rather than under their pressure, can European authorities convince us that Greece was an exception and prove their commitment to do all that is needed to preserve the euro as a currency.

The writer is a visiting scholar at Harvard’s Weatherhead Center for International Studies and a former member of the ECB’s executive board

Tuesday’s release by the Federal Reserve of the results of its annual round of “stress tests” of the 19 largest American banks was yet another confirmation of the deftness with which the US government has handled the financial crisis.

In stark contrast to the feeling of ennui that has often accompanied Europe’s initiatives to shore up its own financial system, the latest news from Washington was greeted with enthusiasm, with share prices jumping 1.8 per cent by the end of the day and the S&P financials index up by 3.9 per cent.

The positive reaction is but the latest in a string of successes for US policymakers since the bankruptcy of Lehman Brothers, which snapped the free market orientated administration of George W. Bush into action.

There is much to praise. The much-maligned $700bn Troubled Asset Relief Program provided in late 2008 a solid financial firewall and stemmed the tide of fear and near-panic that had surrounded the banking system. It even turned a profit for the US Treasury, which invested just under $205bn in 707 banks and has so far received about $211bn back.

Tarp was aided by a dizzying, but necessary, array of other assistance programmes, including guaranteeing money market funds and providing liquidity to frozen security securitisation markets.

A few months later, the bank stress tests, which were championed by Treasury secretary Timothy Geithner, achieved a number of critical aims.

First, as Tuesday’s reaction demonstrated once again, they provided essential reassurance to global markets that have at times been deeply skeptical and fearful. Equally importantly, the first set of results, completed in the spring of 2009, stemmed calls for more drastic and ill-advised actions, such as nationalisation and even liquidation of the largest financial institutions. And, to some degree, the success of the stress tests restrained the angry demands to lock up the bankers and throw away the key.

However, with the benefit of hindsight, some decisions might have been taken differently. In particular, providing Tarp and other forms of capital to the banks on quite cheap terms fuelled grievances that financiers have continued to get rich at the expense of taxpayers.

Clearly, the banking system is not yet perfect. Four banks failed the latest tests, most notably Citigroup, which said it would resubmit its capital plan, as required. However, even these failures must be seen in light of the severity of the stress test scenario, which assumes 13 per cent unemployment, a halving of stock market valuations and the kind of “market shock” that might be triggered by the collapse of a bank in Europe.

Pernickety commentators will no doubt continue to find fault with the handling of the financial crisis. But as we say in America, anyone can call plays from the grandstand. As someone who was on the field for a bit of the game, I offer only commendations to both the Bush and Obama administrations for their post-Lehman Brothers handling of a daunting set of challenges.

The writer is former head of the US government task force that oversaw the bail-out of Chrysler and General Motors

Many investors wish to wave a final goodbye to the disruption the Greek debt crisis has had on market valuations. Meanwhile, European policymakers are already trying to move away from the dramas on the periphery and focus on restoring growth in Europe. Both impulses are understandable. Unfortunately, they are premature.

The debt reduction agreement put in place last week is the biggest sovereign restructuring  so far. Yet it goes only part of the way in helping Greece overcome its core problem of too much debt and too little growth. And it won’t be long before this latest deal also comes under pressure. So here is what to look for and what to do about it.

With debt reduction only one of three components of the recent €130bn bailout, expect more details this week on the other two. On Tuesday and Thursday we will find out how much money the European Union and the International Monetary Fund are willing to release to Athens upfront. Markets are hoping for heavily front-loaded payments, while official creditors prefer them to be more back-loaded.

This difference relates to Greece’s ability to deliver on its part of the bargain – particularly an additional dose of heavy austerity at a time when youth unemployment is already 51 per cent and the economy is contracting at a rate of seven per cent a year. Even if socially and technically feasible, the upcoming elections in Greece will introduce yet another element of complexity.

Going beyond the next few weeks, it is highly likely that the Greek bailout will again be found wanting. Were it to be fully implemented – highly unlikely – the result would still be an unsustainable debt stock of 120 per cent of gross domestic product in 2020. With such a prospect, new private capital will not engage in Greece, robbing the country of the oxygen needed for investment, growth, competitiveness and jobs.

No wonder markets are already pricing in a significant probability that Greece will have to again restructure its debt. And the next round is likely to be a lot messier. Talk about “PSI 2” is already accompanied by growing awareness of “exit risk” (the possibility that Greece will have no choice but to exit the eurozone to restore competitiveness and growth).

Whenever it occurs, PSI 2 will be a very tricky affair because of what Greece has just agreed to. By shifting the legal jurisdiction governing most of its outstanding bonds from Greek to UK law, the country is giving up significant flexibility and narrowing its range of options. It is also exposed to a lot more risk in the event of a future restructuring. Finally, the overwhelming majority of new loans comes from the official sector. With this large accumulation of liabilities to “senior creditors”, any disruption in payments could quickly spiral out of control.

Already official holders of Greek bonds, such as the European Central Bank and European Investment Bank, refused to participate in last week’s restructuring deal. If Greece were to default on such creditors, let alone on the IMF, it would undermine the one source of new financing that is still available.

Finally, Greece cannot – and should not – rely on its European partners and the IMF to maintain indefinitely an approach that repeatedly fails to deliver. With a referendum in Ireland and presidential elections in France (held against the background of seven governments having lost office in Europe since 2010) we should expect many more calls for a fundamental redesign of the eurozone. Few will favour more exceptional large-scale financing for Greece.

What last week’s debt reduction deal really delivers is a bit more time for others to reposition for the next, more disruptive, act in this unfolding Greek drama. For European policymakers, this means even more urgent building of firewalls to protect countries such as Italy and Spain, continuing to strengthen the core through better fiscal and political integration and forcing banks to raise capital. For investors, it is about reducing their exposure not only to another default by Greece, but also the risk of the country’s exit from the euro.

If this were to happen, the latest agreement would end up being characterised in history books as more than just a costly failure.

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

In an army of 150,000 US and Nato soldiers in Afghanistan one rogue solider who massacres 16 civilians, including nine children, does not necessarily mean that discipline and morale of the whole force is breaking down. However, when the spate of recent incidents are put together – US soldiers burning copies of the Koran, footage apparently showing US Marines urinating on bodies of dead Taliban fighters and a spate of accidental killings of civilians during US attacks on the Taliban – the situation looks far more grim. There can be no doubt that the western presence in Afghanistan faces a grave crisis of confidence across the Muslim world and in their home countries.

The Afghan people are exhausted by a war that has gone on in one form or other since 1979, when most American soldiers now in Afghanistan were not even born. Increasing numbers of Afghans would agree with what the Taliban have been arguing for almost a decade: that the western presence in Afghanistan is prolonging the war, causing misery and bloodshed. The hundreds of civilians killed already this year across the country are almost forgotten now in the aftermath of the children killed by a “farengi” or foreigner.

Moreover, faced with an increasingly corrupt and incompetent government, Afghans are seeing fewer improvements on the ground. So-called “nation building” has ground to a halt, simple justice and rule of law is unobtainable and one third of the population is suffering from malnutrition. The people blame not just the Americans but equally Hamid Karzai and his inner circle that gives him conflicting and contradictory advice, leading him to flip and flop on policy issues.

Mr Karzai’s desire to seek a strategic partnership agreement with the Americans is becoming more and more unacceptable to the Afghan people. At the same time he also wants to make peace with the Taliban, but they have no desire for a pact with Washington. His dilemma, which he still refuses to understand, is that he can either ask for a long-term US presence or peace with the Taliban, but not both.

America is clearly also exhausted by the two wars it has waged in Iraq and Afghanistan – the latter becoming the longest war in US history. Officers and soldiers have done several tours of duty in both countries, while the wars themselves have been virtually ignored at home. Neither war has yielded the dividends that Washington once hoped for. Osama bin Laden may be dead, but al-Qaeda’s beliefs have spread their net into many more countries since 2001, while the Taliban have proved to be far more resilient than western forces could conceive of a few years ago.

Yet the US military high command has been lobbying in Washington, insisting that some kind of victory in Afghanistan is still possible if only Barack Obama would not withdraw so many troops so soon and if only Congress would keep the funding flowing. US generals have done their best to delay and undermine the still-weak hand played by the State Department in its efforts to get talks with the Taliban going. But now even the Republicans, many of whom have supported the military and condemned Mr Obama for daring to open talks with the Taliban, appear to be at a loss as to how to move forward in Afghanistan.

After the spate of incidents this year, there should be no doubt in Washington that seeking a negotiated settlement to end the war with the Taliban as quickly as possible is the only way out. Mr Obama has to put his weight behind this strategy to ensure an orderly withdrawal and to give the Afghan people the chance of an end to this war. A power-sharing formula with the Taliban, which now appears increasingly unavoidable, and an accord with neighbouring states, to limit their interference, will be key.

In 1989, it was America and Pakistan who refused to allow for a political solution to end the fighting because they wanted not only the Soviets gone but also Moscow’s Afghan protégées led by Mohammad Najibullah. Instead he hung on for three years, resulting in a civil war. America cannot again leave Afghanistan with a civil war as its bequest to the Afghans. Washington, and Nato, must seek an end to the war before withdrawing their forces. Despite the tragic death of so many innocent children, this is still possible if there is a concerted diplomatic and political push.

The writer is author of several books about Afghanistan, Pakistan and Central Asia, most recently “Descent into Chaos”

The US employment report for February contains further evidence that, on the surface at least, the American labour market is returning to normal. The unemployment rate of 8.3 per cent is 1.7 percentage points below its peak in October 2009 and private sector employment has risen by a healthy 2.1 per cent in the past 12 months.

Yet consumer pessimism about job prospects remains almost as bleak as it was in the darkest hour of the recession. If the labour market is really improving as much as the official data imply, no one seems to have told middle America.

Ben Bernanke, chairman of the Federal Reserve, is also puzzled. Last week, he pointed to the fact that the jobs data have improved much more than they should have done, given the relatively weak growth rate of real gross domestic product in recent quarters. The link between changes in the unemployment rate and real GDP growth is captured by “Okun’s Law”, named after John F. Kennedy’s economic adviser, Arthur Okun.

This law, which celebrates its 50th birthday this year, has held up rather better than most economic relationships. However, it does not explain the recent decline in the unemployment rate.

Real GDP has grown by only 2.5 per cent per annum since unemployment peaked. This is close to the trend growth in productivity. Using Okun’s Law, this implies that there should have been no decline at all in unemployment during the economic “recovery”. In the past 12 months alone, the unemployment rate has fallen about 1.3 percentage points more than implied by Okun. So what is going on?

Employment gains have certainly been strong in recent months. But over a longer period, the most credible explanation for these puzzles is that the labour force has been growing much less strongly than normal. The participation rate, defined as the sum total of employed plus unemployed as a percentage of the relevant population, has actually fallen from 65 per cent at the height of the recession to 63.9 per cent now.

Normally, it would be expected to rise during a recovery, as previously disaffected workers are drawn back into the jobs market. This time, potential workers seem to have drifted away from the labour market, and not come back.

The labour force has therefore “downsized” itself in line with the economy. Part of this is due to demography and particularly to the rise in the proportion of workers who are near retirement age. They often choose to retire early. But it also seems to be due to the exceptional depth of the recession, which has persuaded many workers that there is no point in actively seeking work.

The shrinkage of the labour force, part voluntary and part involuntary, leaves the potential output of the economy lower than it was before and may explain why Americans do not perceive this recovery in the labour market as a genuine one.

It is a major relief that the labour market is now clearly improving. But the financial crash of 2008 continues to cast a very long shadow on America’s economic potential.

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

The release of February’s economic data confirmed that Chinese growth is slowing down. Consumer inflation fell to 3.2 per cent last month, the lowest since June 2010. Weaker industrial production, retail sales and export data all support the same pattern. China’s days of double digit growth are, at least for this century, probably over. The data releases following a “forecast” from outgoing premier Wen Jiabao that gross domestic production growth would be “only” 7.5 per cent this year, an estimate that seemed to surprise many observers. Does this mean China’s glory days are numbered and reforms including currency reform are over? Not at all.

Much of China’s slowing is neither unexpected nor undesired. Premier Wen’s forecast was not news to those who follow developments in the country closely. In the 12th five-year plan released about a year ago, the leadership had already said that it expected real GDP growth of 7.5 per cent. It was seen at the time as confirmation that Beijing was no longer pursuing as fast a rate of GDP growth as possible. While such assumptions are only a vague gauge of policy intentions, they are nevertheless a broad signal of what the leadership desires to achieve. While actual GDP growth has consistently exceeded expected growth for many years, this didn’t stop Beijing from lowering their stated and assumed target.

A number of factors explain this plan. First, it has been clear since 2008 that the days of massive Chinese export growth to the west were over. Second, this can’t be replaced by generous government investment spending. Third, rapid GDP growth has become self-defeating, placing considerable strains on China’s resources and environment, forcing up commodity prices, bringing inflationary pressures and rising wealth inequality. Too fast GDP growth had outlived its purpose. Fourth, inflation is threatening social stability as low income urban citizens see their real wealth eroded. All of this meant lower economic growth has become not only necessary but desirable.

But let’s get things in perspective. A real growth rate of 7.5 per cent, if it occurs, along with four per cent inflation will still see China’s GDP, in US dollar terms, close to doubling in five years so long as the currency doesn’t nosedive. By early next decade China’s economy would near $15tn and be on track to surpass the US. For the rest of the world, 7.5 per cent growth in China is effectively the same as US growth of around four per cent. As I have become fond of saying, China today creates the equivalent of another Greek economy every eleven and a half weeks, and one-tenth of another eurozone economy every year.

Seen in these terms, lower GDP growth is not a hindrance to reforms, it is an essential ingredient. Softer but more balanced, sustainable and higher quality growth requires reforms, including of the renminbi. To complicate matters, currency reform does not equal currency appreciation. The renminbi is going to become more volatile like other currencies. It will go up as well as down against the dollar, partly because China’s current account surpluses are coming to an end, but also because it is opening up its capital account. In recent weeks, policymakers have published detailed guidelines and in some ways, a timetable for all sorts of reforms. Many of them can’t be achieved without currency reform. This includes better-quality GDP albeit at a slower rate.

By 2015 there is a good chance that the renminbi will be part of the ‘special drawing rights’ basket, the International Monetary Fund’s key accounting tool that lies at the heart of the world’s monetary system. The value of the renminbi will go up before then, and it will also go down. Just as with teenagers, it’s all part of growing up.

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

Calls to fundamentally change the way governments appoint the heads of the International Monetary Fund and the World Bank have been growing louder in the past decade, and rightly so. But these demands for a merit-based process have failed to overcome America’s and Europe’s grip on a feudal entitlement that suits their interest but is unquestionably outdated and harmful.

Now that it is time to select a new World Bank president, I have the feeling that perhaps some progress may finally be made, not because of the enlightened vision of governments, but due to the courage of some highly-qualified individuals.

First, the bad news. Despite public comments to the contrary, neither America nor Europe appear willing to support a better-functioning and more representative multilateral system. Rather than allow qualifications, transparency and competition to drive the selection process, they have done all they can to maintain a system that overwhelmingly favours them, as it is based on nationality, internal connections and bureaucratic largesse.

The consequences have been especially exasperating and detrimental in recent years. Both the appointment of Robert Zoellick to the presidency of the World Bank and Christine Lagarde last year to the IMF came on the heels of the sudden resignations of prior leaders, which damaged the external standing and internal functioning of these institutions and internal functioning of these institutions. It also highlighted the extent to which the credibility and legitimacy of the new leaders risks being undermined, not by their qualifications, but by the manner in which they are appointed.

If these two institutions were publicly traded companies, their shares would include a huge discount on account of the appalling way in which their chief executives are chosen. Most existing shareholders would be agitating against the minority that exercises undue influence in the selection process. Activists would be looking to get on the executive board to improve governance, enhance due diligence, unlock value and counter brand erosion. The media would be pointing to the companies as examples of crony capitalism

This is where the good news comes in. With key governments appearing still hesitant to reform the process, prominent and courageous experts from the development economics field are taking a public stand and seeking to disrupt the feudal selection process. There is also encouraging talk of other credible candidates from both developing and advanced economies, but they are yet to confirm their interest.

Though not their primary motivation, highly-regarded and unquestionably qualified individuals from across the political spectrum – including Jeff Sachs, the Columbia University professor and director of the Earth Institute, and Mike Spence, the Nobel Prize winner who teaches at New York University and led the work of the Growth Commission – are challenging a system that has failed miserably to reform itself. Rather than wait for their country’s bureaucrats to anoint them, they are bravely stepping forward to express interest and, in the process, are publicly taking on the current selection process.

Such individuals have the experience, talent and knowledge to lead. Unlike some that were granted the post in the past by government largesse, they would not wait to first step into the corner offices and then embark on a steep learning curve. Nor would they hesitate to propose that the two institutions reposition themselves to help member countries better navigate global realignments.

The global economy would be well served if the brave actions of such individuals were to serve as a tipping point. Let us hope that they provide the much-needed catalyst that prompts other qualified and interested candidates to also step forward, that effectively energises emerging countries to support strong candidates, and that forces Europe and the US to finally adopt the type of approach that they have no hesitation in advocating for others: one that is open, transparent, competitive and merit-based.

Call me an eternal optimist, but rays of hope may finally be emerging on an issue that is important for the wellbeing of the global economy.

The writer is chief executive of Pimco. While his name has been suggested by some as a candidate for the World Bank presidency, he has informed the FT that is not interested in being considered

A myth is developing that private creditors have accepted significant losses in the restructuring of Greece’s debt; while the official sector gets off scot free. International Monetary Fund claims have traditional seniority, but bonds held by the European Central Bank and other eurozone central banks are also escaping a haircut, as are loans from the eurozone’s rescue funds with the same legal status as private claims. So, the argument runs, private claims have been “subordinated” to official ones in a breach of accepted legal practice.

The reality is that private creditors got a very sweet deal while most actual and future losses have been transferred to the official creditors.

Even after private sector involvement, Greece’s public debt will be unsustainable at close to 140 per cent of gross domestic product: at best, it will fall to 120 per cent by 2020 and could rise as high as 160 per cent of GDP. Why? A “haircut” of €110bn on privately held bonds is matched by an increase of €130bn in the debt Greece owes to official creditors. A significant part of this increase in Greece’s official debt goes to bail out private creditors: €30bn for upfront cash sweeteners on the new bonds that effectively guarantee much of their face value. Any future further haircuts to make Greek debt sustainable will therefore fall disproportionately on the growing claims of the official sector. Loans of at least €25bn from the European Financial Stability Facility to the Greek government will go towards recapitalising banks in a scheme that will keep those banks in private hands and allow shareholders to buy back any public capital injection with sweetly priced warrants.

The new bonds will also be subject to English law, where the old bonds fell under Greek jurisdiction. So if Greece were to leave the eurozone, it could no longer pass legislation to convert euro-denominated debt into new drachma debt. This is an amazing sweetener for creditors.

Moreover, the official sector began restructuring its claims (both the IMF ones and those with equal status to private ones) well before private sector creditors. Maturities were lengthened – effectively a debt restructuring – and the interest rate on those loans reduced, repeatedly.

This was despite the fact that all official loans should have been senior to the private ones, as they were all extended after the crisis struck; an attempt to resolve it rather than its cause. Historically, bilateral official (Paris Club) claims are treated as equivalent to private ones (London Club) only because such debt builds up for decades as governments lend money to former colonies or allies for political reasons. But all official lending in the eurozone began after the crisis and should have been senior to private claims. Any senior creditor that extends new financing to a distressed debtor should be given seniority; this is the principle of “debtor in possession” financing in corporate debt restructuring.

Moreover, until PSI occurred, for the last two years official loans by the Troika allowed Greece’s private creditors to exit their maturing claims on time and in full (or with a modest discount for the bonds purchased at high prices by the ECB). PSI came too little, too late.

Also, while the Eurosystem will receive, in the debt exchange, new Greek bonds valued at par, all the accounting profits from this scheme (plus the coupon on the bonds) will be transferred to governments, who have the option of passing these gains to Greece. The result is a haircut of about 30 per cent on these official sector claims. And if the ECB’s Greek bonds are passed – with no loss – to the EFSF, the latter will end up taking the losses for the difference between the bonds’ current low market price and the price at which the ECB bought them.

In conclusion, the idea that Greece’s debt restructuring is all PSI and haircuts, with no official sector involvement, is a myth. OSI started well before PSI; the PSI deal has substantial sweeteners; and with three quarters of Greek debt in the hands of official creditors by 2014, Greece’s public debt will be almost entirely socialised. Official creditors will be left to suffer most of the huge additional losses that remain likely on Greece’s still unsustainable debt in future. Moreover, the second official sector rescue of Greece will not be the last. Greece will not regain market access for at least another decade; so its fiscal and current account deficits will have to be financed with additional official resources for the foreseeable future.

So, Greece’s private creditors should stop complaining and accept the deal offered to them this week. They will take some losses, but those losses are limited and, on a mark-to-market basis, the debt exchange offers them a potential capital gain. Indeed, the fact that the new bonds are expected to be worth more than the old bonds suggests that this PSI exercise has further transferred losses to Greece’s official creditors.

The reality is that most of the gains in good times – and until the PSI – were privatised while most of the losses have been now socialised. Taxpayers of Greece’s official creditors, not private bondholders, will end up paying for most of the losses deriving from Greece’s past, current and future insolvency.

The writer is chairman of Roubini Global Economics and professor at the Stern School of Business, NYU

As Barack Obama and Benjamin Netanyahu discuss next steps regarding Iran, investors are becoming increasingly jittery. At one point late last year, the Brent oil price was around $90 per barrel. Now, even after falling on Tuesday on news that talks with Tehran were to be reopened, it is still well above $120, reflecting both renewed economic optimism and fears over how, precisely, Iran’s nuclear ambitions can be contained.

We have been here before. At the beginning of last year, oil prices moved higher due to Tunisian and, more pointedly, Libyan concerns. At the time, economists mostly shrugged off these increases: recovery was on track and nothing, it seemed, could go wrong. Yet, within a few months, growth prospects had slumped, double-dip fears had returned and the Federal Reserve had again delved into its box of unconventional monetary tricks.

Whether we like it or not, the world economy is still addicted to oil and hence vulnerable to movements in oil prices. The effects vary, however. For the emerging world, the immediate problem is inflation, a threat that last year was thwarted through some aggressive – sometimes unconventional – policy tightening. Slower growth is now the result, notably in China.

For the developed world, growth is a far more immediate problem. Although higher oil prices inevitably push inflation up, economic permafrost rules out any kind of meaningful wage response. Real incomes are squeezed and demand slumps. Last year’s collapse in sentiment – an outcome that persuaded the Federal Reserve to launch the second round of quantative easing – owed a lot to the unanticipated effects of higher oil prices.

There is, however, more to the story than just Iran, important though it is. Oil prices have been steadily rising since the beginning of the millennium, a remarkable turn of events given persistently disappointing growth rates in the developed world. In the past, US economic weakness would have been associated with falling oil and other commodity prices. Not any more. Oil prices – and other commodity prices – are increasingly determined by burgeoning demand in China, India and other fast-growing emerging nations, particularly for resource-intensive infrastructure projects.

Oddly enough, the west’s pursuit of quantitative easing may simply have hastened this process. With western households and companies busily deleveraging and with investors still on a quest for yield, the benefits of loose monetary policy have increasingly flowed to the more dynamic – and more resource-intensive – parts of the world. The recent increase in oil prices reflects not only the impact of Iran (both the fear of conflict and the impact on global oil supply of sanctions) but also misjudged attempts by western policymakers to kick-start their own economies.

Too often, the market worries about oil price spikes alone. Admittedly, outright conflict in the Gulf could potentially take oil prices all the way up to $150 or even $200 per barrel, an outcome that would send the west into a recessionary tailspin. Spikes, however, tend to be reversed. The past 12 years have seen, instead, a slow but relentless increase in oil prices, which demonstrates how the global economy is steadily being reshaped. For all the gloom in the west, we have just lived through a period of incredibly impressive global economic expansion. Higher oil prices are but one reflection of this success. They are also, unfortunately, a key reason behind the failure of the western economic recovery to gain traction.

The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. He is the author of ‘Losing Control: The Emerging Threats to Western Prosperity’

During the past decade the US sat on the sidelines while many nations around the world competed aggressively to win larger shares of manufacturing output and employment. The next decade is likely to be different. In several recent speeches and policy proposals, President Barack Obama has laid out a compelling case for why manufacturing matters for the health of the American economy and has signalled that the US will be a more active player in the intense global competition for manufacturing.

The manufacturing sector has led the US economic recovery in the past two years, expanding by about 10 per cent and adding more than 330,000 jobs since December 2009. This is a small number compared with overall private-sector job gains of 3.7m during the same period, but US manufacturing employment is growing for the first time since the late 1990s. And there are promising signs that American companies are beginning to shift some of their foreign operations back home. Rising wages abroad, the decline in the dollar’s value, increasing supply-chain co-ordination and transportation costs, and strong productivity are combining to foster this “insourcing” trend.

A resurgence of manufacturing in the American economy is important for several reasons.

First, the US must rebalance growth away from consumption and imports financed by foreign borrowing and towards exports. Manufactured goods account for about 86 per cent of its merchandise exports and about 60 per cent of exports of goods and services. Even though service exports are becoming more important, the only way the US can rebalance growth and make a significant dent in its trade deficit is by increasing exports of manufactured goods.

Second, on average manufacturing jobs are high-productivity jobs with good pay and benefits. Even though the premium on manufacturing wages has been declining over time, it remains significant. Both workers with only a high-school degree and those with a college degree earn significantly more on average in manufacturing than their peers in the rest of the economy.

After staying roughly constant during the 1990s, manufacturing employment dropped by about 32 per cent between 2000 and 2011. This precipitous decline was a major factor behind the increase in wage inequality and the polarisation of job opportunities between the top and bottom of the wage and skill distribution. Contrary to conventional wisdom, the loss of manufacturing jobs was not the inevitable result of productivity gains. In the 1990s, with comparable productivity growth, manufacturing employment was roughly constant.

During the coming decade, with the right incentives, US manufacturers can again win larger shares of global value added as they did in the 1990s.

Third, manufacturing plays a substantial and disproportionate role in innovation. A strong manufacturing sector supports the key building blocks of the nation’s innovation ecosystem – its skilled scientific, engineering and technical work force, its research and development, its ability to identify technical challenges and provide creative solutions.

Manufacturing only accounts for about 9 nine per cent of the nation’s jobs and 11 per cent of the nation’s output. But it employs about 36 per cent of the nation’s engineers and accounts for 68 per cent of R&D spending by business which in turn accounts for about 70per cent of total R&D in the US. American leadership in science and technology depends on R&D investment by manufacturing companies, and the social returns to such investment are substantial, far exceeding the returns to the companies that fund it.

Despite the offshoring of parts of their supply chain, American multinational manufacturing companies continue to locate most of their R&D investment and research work force in the US.

But this share is gradually declining as they shift some of their R&D from both the US and Europe to Asia in response to rapidly growing markets, ample supplies of technical workers and engineers, and generous subsidies.

China and other emerging economies are actively building their research capabilities and aggressively competing for the R&D of American manufacturing companies. At the same time, the comparative attractiveness of the US as a location for such activities is slipping in part because of shortages in the scientific, engineering and technical labour force and restrictions on the number of immigrants with these skills.

President Obama’s 2012 budget proposal calls for $1tn in discretionary spending cuts over the next decade, reducing the share of discretionary spending to five per cent of gross domestic product by 2022. Despite its overall austerity, the proposal contains measures to boost manufacturing. Many of these – including policies to increase high-school graduation rates; workforce training programs at community colleges; more funding for basic research, infrastructure investment, and scientific, engineering and technical education; and immigration reform – would benefit other sectors as well.

President Obama’s plan for business tax reform would also benefit manufacturing. The plan would reduce the statutory corporate tax rate from 35 per cent, soon to be the highest in the OECD countries, to 28 per cent. The US rate would fall to 25 per cent for manufacturing and even lower for advanced manufacturing which is targeted for a 19 per cent increase in R&D funding in the budget.

Given its outsized share of R&D investment, manufacturing would also benefit disproportionately from the President’s proposal to expand and simplify the research and experimentation tax credit and to make it permanent. Although the US was the first nation to introduce a tax credit for R&D in the 1980s, many countries provide far more generous incentives now. Recent research confirms that the credit is a cost-effective way to encourage business research spending and that the society-wide returns to such spending exceed the private returns to the investors who fund it, often by a considerable margin.

President Obama recognises that manufacturing matters for the health of the American economy. And despite severe budgetary constraints, he has laid out an ambitious set of policies to achieve that goal.

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

Benjamin Netanyahu’s meeting with president Barack Obama on Monday went as well as could be hoped. The Israeli prime minister stressed his oft-repeated desire for the US to establish “red lines” for Iran, but avoided any appearance of a disconnect with Washington. Mr Obama promised that the US will watch Israel’s back and continue to deploy the newest tool in its diplomatic arsenal: targeted financial sanctions, in this case powerful disincentives for countries and institutions to import Iranian oil. As a result we are unlikely to see an Israeli military strike anytime soon, as ‘Bibi’ seems willing to give sanctions time to work.

That’s the good news for Mr Obama. The bad news? That Bibi seems willing to give sanctions time to work.

Mr Obama now faces an extremely difficult task: remaining tough on Iran without sabotaging the US economic recovery. While the strategy of squeezing Iran financially is logical, it comes with serious economic risks that are not often recognised. We’ve entered a new era in which the distinction between the financial and security spheres no longer holds: geopolitics drive markets even as markets drive geopolitics.

Enforcing oil sanctions against Iran could threaten the global economy. In the context of improving global growth, removing too much Iranian oil from the world’s energy supply could cause an oil price spike that that would halt the recovery even as it does some financial damage to Iran. For perhaps the first time sanctions have the potential to be “too successful”, hurting the sanctioners as much as the sanctioned.

Since the US began a concerted effort at the end of last year to dissuade and disrupt the purchase of Iran’s oil among its customary buyers in Europe and Asia, we have seen Japan, South Korea and the European Union all agree to reduce or stop entirely their imports of Iranian crude. To the surprise of oil traders, global markets, and perhaps even US policymakers, other buyers have not stepped up their purchase of Iranian oil in response. China has not yet indicated that it will increase volume as many expected and India seems poised to make at least modest cuts. It’s this last fact, not just geopolitical tensions, that accounts for much of the increase in world oil prices in the past week.

Countries’ willingness to toe the line on sanctions – driven by fear both of a nuclear Iran and of loss of access to the US financial system – puts paid to the notion that US power has markedly declined, but also presents a severe risk to the US and world economies. Successful sanctions threaten substantial macroeconomic damage worldwide.

Those involved in the oil market do not believe that oil-producing countries possess the spare capacity to replace more than a small amount of Iranian crude without causing a price spike. Despite what US government officials may say publicly, the alarmingly high price levels that we see today already take into account the existence of any marginal alternative supplies, as from Angola. Even if Saudi Arabia makes up most of the displaced volume in global markets, the resulting thin spare capacity worldwide would place the market right where it was in early 2008, when oil prices surged to record highs. Suffice to say that this helps no one involved: not Israel, not Mr Obama’s re-election bid and not anyone seeking to prevent Iranian acquisition of nuclear weapons.

This presents Mr Obama with a dilemma. The main economic risk to his re-election is that the US plunges back into a recession. The main foreign-policy risk is a mishandling of the Iranian situation. But sanctions, the best method for handling Iran, imperil the economy, while relieving financial pressure on Iran could reduce oil prices and aid the US recovery -but would also lead to undesirable outcomes in the Gulf, whether an Israel strike or, worst of all, Iranian development of weaponised nuclear capacity.

The Obama administration knows that whichever policy choice the president makes, his Republican rival, most likely Mitt Romney, will be sure to highlight its failings. If he loosens sanctions, Mr Romney will call the president weak on Iran and insufficiently supportive of Israel; if overly successful sanctions cause an oil-price spike, the GOP will say that Mr Obama’s energy policy is hurting Americans. The predicament threatens to make foreign policy, an issue on which Mr Obama seemed to have little vulnerability, a serious liability electorally.

All is not lost for the president, however, and there is a path forward. The US can pressure Iran without sabotaging the economic recovery. What he must do is maintain his tough public rhetoric on sanctions, no matter how harsh it appears, while privately signaling China and India – and only China and India – that it is fine for them to purchase Iranian crude, but at a significant discount from market price. Forcing Tehran to sell discounted barrels would provide the desired result: a substantial reduction in Iranian revenue with less impact on global energy prices and less harm to the US and world economies.

It’s a tricky diplomatic line to walk, to be sure. It will likely not assuage the administration’s critics either domestically or in Israel. But it may be the only way out of the dilemma. It would ensure that sanctions work as intended: hurting Iran and not the world – or the president’s re-election chances.

This article is co-authored with David Gordon, head of research, and Clifford Kupchan, Eurasia practice head at Eurasia Group. Ian Bremmer is the president of Eurasia Group and author of the forthcoming book, ‘Every Nation for Itself: Winners and Losers in a G-Zero World’

This year’s session of the National People’s Congress takes on added significance with the impending anointment of the next generation of senior leaders. China would seem to have many reasons to be self-satisfied given the strong prospects for a “soft landing”, a mountain of foreign assets that Europe is eager to tap, and an expanding regional presence that the US has had to take notice of.

Yet the leadership recognises that the country faces daunting economic, social and environmental challenges including vulnerabilities created by past excessive credit expansion. Wen Jiabao, China’s premier, warned on Monday that growth is set to slow this year. It is aiming for a 7.5 per cent rise in gross domestic product, the first time since 2004 that the annual target has dropped below 8 per cent.

But these are likely to be seen as technicalities among those gathered in Beijing. Far more worrisome for the political elite is the question of how to deal with rising social unrest. This was underscored by the global attention given to the Wukan village land-related protests that pushed provincial leaders to support more open local elections. Other disturbances such as last year’s strikes by truck drivers in Shanghai and recent unrest by migrant workers at Foxconn reflect the tensions stemming from decades of widening social inequality that seems out of place for a regime that originated from egalitarian ideals.

For all of China’s economic successes – which lifted some 600m out of poverty – income disparities nevertheless have ratcheted up with the gini coefficient now at 0.47 compared with around 0.25 in the mid-1980s. This has fostered a sense that the system is uncaring, and that opportunities are now being determined by one’s status rather than initiatives.

There is a strong link between the growth in social unrest and the reality that the reform process launched by Deng Xiaoping three decades ago has stalled. Rising social tensions come broadly from two forces, namely limitations of China’s national budget and banking systems in addressing distributional needs and distortions arising from controls over use of land and labour.

A key weakness of the process of economic liberalisation is its failure to provide the fiscal means for the authorities to limit inequalities that came with rapid growth. China’s banking system – which is unique in handling a large share of the financing of public services that would normally go through the budget – accentuates these problems.

The unusually limited role that the national budget plays in supporting expenditures makes it difficult to respond to rising expectations, particularly for an economy where the state controls the bulk of resources. The budget as a proportion of the size of the economy is only two-thirds that of other middle income countries, and half that of European Union. As a consequence, welfare spending has been inadequate, amounting to around half the level (as a share of GDP) of comparable countries.

Rather than strengthening its fiscal system, Beijing relies on its banks to fund much of the growing demand for infrastructure. This has led to episodes of expanded lending to local governments, which (due to concerns regarding repayment) has skewed credit in favour of better off localities and towards the larger state enterprises, rather than private small-scale operators.

Thus the ability to make redistributive transfers (handled elsewhere either by decentralised budgets or through the quasi-fiscal expenditures of banks) has not been available.

No segment of society feels these social pressures more than the 250m migrant workers who do not have access to the same services and employment choices as established residents. As a younger generation without the pre-reform poverty experience matures, their semi-indentured status no longer matches their aspirations in a modernising China. Even with real wage increases of 10-15 per cent annually, increasing numbers of migrants have either returned to their native provinces or increased their demands for more rights.

Migration pressures are also linked to the frequent disputes over land. This reflects the failure to clarify use rights and establish more transparent and equitable transfer systems since all land is formally owned by the state. Local authorities are starved of much needed revenues in the absence of structured property taxes that could serve as the fulcrum for their revenue base. Thus they have been forced to sell off land use rights to balance their budgets. By under paying owners and charging premiums to developers, local bureaucrats are able to capture countless multiples of what they originally paid. The process offers considerable opportunities for corruption and thus weakens trust at community levels. This accounts for some of the more contentious acts of social protest as in Wukan.

If the incoming senior leadership wants to deal with the issues that have spawned rising social unrest, it needs to rethink some of the unintended consequences of its current growth-driven model. Paramount is to reshape China’s economic institutions and control over basic resources in ways that moderate, rather than exacerbate, disparities.

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

As it begins the search for a new president of the World Bank, the Obama White House risks repeating the very same mistakes that all too often in the past have led to the wrong person being appointed.

Every time this process begins, those in charge ponderously – and mendaciously – announce it will be “open, transparent and merit-based”. They know this is not true, as some of the best candidates are automatically disqualified: only US citizens connected to the occupant of the White House at the time are considered and the process is closed, and only tenuously determined by merit.

The reason is, as is well known (and regularly and futilely derided), that leadership selection for the World Bank and the International Monetary Fund is based on a shameful colonial arrangement whereby the bank’s boss is always American and the IMF’s always European. And this will not change until new powers, such as China, India or Brazil agree to join forces to end it – which is not on the cards for now.

So how might this flawed process be reformed? In the past, it has led to the appointment of candidates who knew little about the bank. The consequences were confusion over its mission and obstacles in the way of providing assistance to countries in need. This is partly the result of the fact that those in charge of making – or influencing – the decision often base it on wrong notions about the ideal background of the Bank’s president. For example:

1. The World Bank is a bank and thus its leader should be a banker. No! The Bank is more than a bank. It is a consulting company for developing countries, a multilateral organisation, an intensely political entity as well as a highly technical one. Its role as an international lending bank is declining relative to its advisory role.

2. Its leader needs to be a politician with access to the US President and a stellar Rolodex. No! Being chums with the president and other heavyweights of course helps. But just having access to power without also having a vision for the institution has been disastrous. The World Bank is first and foremost a development agency that tries to foster change in poor countries, a mission that is difficult for experienced hands and impossible for the inexperienced. Hoping for “on-the-job-training” for appointees with scant experience in development has been a common mistake that has cost the bank, its clients and shareholders dearly.

3. The candidate needs to be a development expert. No! Academics and development experts may be good at understanding the challenges and perhaps even recommending smart solutions. But unless they are proven, effective managers of complex, public-sector-like systems they will fail. If vision and knowledge are not backed up by good managing skills a tenure ends in failure. In this case you have to know how to get a large, culturally heterogeneous, technically sophisticated and, at times, recalcitrant bureaucracy to move in the direction you set.

4. It’s a multilateral organisation and so the head needs to be a diplomat. No! An instinctive diplomacy is critical of course, but few diplomats are sufficiently versed in economics, public finance and the other technical fields on which the bank’s core competence rests.

5. The bank is a global institution and it needs the CEO of a large multinational corporation. No! The bank is indeed an international institution, but its natural habitat – and the skills needed to survive and thrive in it – are closer to those found in a well-run public sector than in the private sector.

So, does all this means that only a superhuman can be successful? No. It means that Mr Obama should look for a professional who already knows this field, its ideas, players and traps, who has a vision for the World Bank rooted in practical experience with development and who has already run successfully a global organisation. This is not the time nor the place for “on-the-job-training”. Nor for paying back political favours.

The writer is a senior associate at the Carnegie Endowment for International Peace, is a former minister of trade and industry in Venezuela and executive director of the World Bank

For some time economists have been engaged in an arcane controversy about the significance of the imbalances in the joint settlement system used by eurozone central banks, called Target 2.

In a series of contributions, Hans-Werner Sinn of the CESifo research group in Munich has drawn attention to the fact that central banks in the northern part of the eurozone were accumulating claims on central banks in the southern part via Target 2. From about zero in 2007, these claims have risen to €400bn in 2010 and €800bn lately. Mr Sinn argues that this amounts to backdoor financing of southern Europe and asks for these claims to be settled periodically.

A letter (not yet made public) by the Bundesbank president Jens Weidmann to Mario Draghi, president of the European Central Bank, is set to change the nature of the Target 2 debate and make it a policy issue of major importance. The Frankfurter Allgemeine reports that the Bundesbank would like its Target 2 balances to be collateralised.

Is this imbalance a problem? It is certainly a worrying symptom. But the starting point of any analysis should be the recognition that Target 2 imbalances are not the direct result of current account imbalances. Among eurozone countries, the latter reached their climax in 2007, but they were entirely matched by private capital flows. The Target 2 deficit of the southern eurozone countries has helped finance shrinking current-account deficits but also, and in some cases much more, private capital outflows.

Indeed, the eurozone has in recent years experienced “sudden stops” of the sort common in emerging market balance of payment crises. Instead of flowing in, partly through the interbank market, private capital has suddenly started to flow out of southern European countries, including Italy at the end of 2011. Banks unable to access liquidity have turned to the Eurosystem, which has substituted the interbank market, thereby performing its classical role as a lender of last resort. Data on recent access to central bank liquidity confirm that although banks in the whole of the eurozone made use of it, it went disproportionately to southern Europe.

The very notion of a balance of payment crisis within the eurozone was alien to the concept of a monetary union. It was routinely assumed that for countries within it, balance of payments would become as irrelevant as they are between regions within a country. This assumption was wrong. Countries are not regions, largely because much of their banking systems are primarily exposed to their sovereign and to domestic borrowers. So when the sovereign is in distress or private borrowers partially insolvent, the banking system is contaminated and there is a stigma attached to being a bank from country X or Y. Foreign lenders become wary and stay put. Target 2 balances largely reflect this counterparty risk.

But a symptom is not a disease. It is the diseases that must be cured. This certainly requires more than letting the fever subside through a huge injection of central bank liquidity. Public finances must be made convincingly sustainable, bad loans on banks’ balance sheets must be provisioned and recapitalisation must take place wherever needed. Furthermore, a lesson from the euro crisis is that excessive credit booms leading to large current account imbalances must be avoided. In the very short term remaining large external deficits such as that of Greece, where it reaches 10 per cent of gross domestic product, must be shrunk. Wherever useful, the European Union should make use of the procedure it recently created to this end.

Only when the diseases are cured will private capital flows return. In the meantime, the Eurosystem is doing its job. It is to be commended for it and actions that would cast doubt on the future of the euro should be avoided.

The writer is director of Bruegel, the European economic think-tank

With the US presidential race heating up, the candidates are increasingly prone to make sweeping promises. They say they will do this or that in their first day in office – balance the budget, close the prison at Guantánamo, abolish the Federal Reserve, whatever – and their supporters all cheer that one of their cherished goals will be achieved instantly if only their man gets to sit in the Oval Office.

This is, of course, rank nonsense. And it has nothing to do with the relative absurdity of the promises being made. It has to do with the nature of US government, which is something even Americans often forget.

In the US system, the president is far weaker than the chief executive in most other countries. The reason is that it was baked in the cake by the framers of the constitution who were deeply sceptical about monarchism. They wanted a leader who was subservient to the legislature, not its overlord.

Congress was given most of the power in the American system. The executive branch is severely constrained. For example, all senior executives must be confirmed by the Senate, an enormously difficult and time-consuming process. Congress also controls the executive’s purse strings. The president’s budget is merely a proposal that is often “dead on arrival” in Congress.

But the founding fathers didn’t trust Congress either. They divided it into two branches, the House of Representatives and Senate. Each has powers denied to the other. The Senate, in addition to having sole jurisdiction over confirmations, is the only branch necessary to ratify international treaties. All revenue bills must originate in the House.

The founding fathers didn’t give much thought to political parties. It may not have occurred to them that Congress and the presidency could be under different party control or that the House and Senate could be controlled by different parties. Presently, the president is a Democrat and the Senate is controlled by his party, while the House is controlled by the Republican party.

Lastly, the American system bends over backwards to accommodate minority viewpoints in Congress, creating many choke-points in the legislative process where a small group of legislators can block and even defeat legislation that has majority support. In the 100-member Senate, it only takes 40 votes to kill a nomination or piece of legislation.

While it is possible that the next president will bring in with him an overwhelmingly large number of congressmen and senators of his own party, such that he really can implement his promises, no matter how extravagant, this is extremely unlikely. Even if one party gets control of the White House, Senate and House, the other party is almost certain to have at least 40 votes in the Senate, thus ensuring gridlock for any proposal that is remotely controversial.

Thus we can safely ignore sweeping promises from all the presidential candidates if they require the enactment of legislation. This is especially so regarding the federal budget. The vast bulk of spending is effectively on automatic pilot in the US because it involves entitlement programs such as Social Security and Medicare that are exceedingly difficult to change because so many people are affected by them.

Where the American president has a freer hand is in the area of foreign affairs. However, given that Barack Obama’s foreign policy is virtually identical to that of his predecessor’s, Republican George W. Bush, it’s unlikely that any significant changes will occur regardless of who is elected. The rhetoric may change, but the substance will be pretty much the same, I believe.

The American government is like a large ocean-going vessel – it changes direction only very slowly. This is both strength and a weakness. It’s a strength when momentary radical movements gain popularity and discover that they can’t really change anything, as leaders of the so-called Tea Party have discovered, to their dismay. It’s a weakness when some existing program desperately needs reform and a determined minority blocks action, thus perpetuating an undesirable status quo indefinitely.

The writer is 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’

With the €530bn lent to banks through its latest three-year longer-term refinancing operation, the size of the European Central Bank’s balance sheet has increased to unprecedented levels, raising three separate concerns. Not all are justified.

The first is that sooner or later the increase in central bank money will lead to inflation. However, there is no empirical evidence – across countries and over time – that the size of the central bank balance sheet in advanced economies is related to inflation. Even though inflation is ultimately a monetary phenomenon – to paraphrase Milton Friedman – the quantity of money circulating in the economy also depends on the motives underlying the demand for money by the private sector, in particular by the banking system. If the increase in central bank money helps commercial banks to finance additional private or public consumption and investment, over and above the economy’s productive potential, it may indeed fuel inflation. If, instead, the demand for central bank money reflects a change in the composition of financial market participants’ portfolios, towards less-risky assets, the increase in central bank money is not inflationary. It contributes instead to preventing deflation.

The data show that market participants’ current demand for central bank money does not reflect an intention to increase their balance sheets but rather their difficulty in accessing financial markets – the result of a generalised increase in risk aversion. Replacing market financing with central bank funding has prevented a sharp contraction in banks’ liabilities, which would have induced a drastic deleveraging and possibly a credit crunch. Money and credit statistics in the euro area confirm that there are no inflationary pressures, while aggregate demand growth is expected to be modest, if not negative; and below potential for some time.

The large amount of liquidity will, of course, have to be mopped up once financial markets have recovered, to avoid fuelling inflationary pressures. The process will be partly endogenous, as commercial banks in the eurozone will request less central bank money as risk aversion subsides, or will reimburse existing loans in advance, as the three-year LTROs allow. The ECB can hasten this process, if needed, by raising the refinancing rate, by increasing the spread between the refinancing and the deposit rate, by adopting variable rather than fixed-rate tenders for its operations, or by issuing term deposits or certificates of deposit.

The second concern relates to the overall risk a large balance sheet may create for the central bank and its shareholders. This concern is mitigated by the fact that the ECB lends against collateral. For a loss to materialise, the counterparty has to be insolvent and the collateral must be sold at a price lower than the central bank’s valuation (market price minus a haircut). These events are unlikely to occur simultaneously. In fact, markets are concerned about the opposite issue – that the ECB has de facto acquired preferred creditor status. The recent Greek bonds swap, which allowed the ECB to avoid loss, has confirmed this status. Under these circumstances, the larger the central bank balance sheet, the larger the risk shifted to the remaining unsecured bondholders, who might be more and more discouraged from lending to banks as they would find it harder to return to market financing.

This raises a third, more serious concern: that cheap three-year funding creates a disincentive for eurozone commercial banks to restructure their balance sheets and strengthen their capital base, as they must to stand on their own feet once the crisis is over. Banks may become addicted to easy central bank financing and delay the adjustment indefinitely. This can be prevented only if supervisors put sufficient pressure on bank managers and shareholders to continue adjustment, and to use central bank funds only as a temporary, exceptional source of financing. However, supervision in the eurozone is implemented at national level, with little incentive to pursue these objectives rigorously and on a level playing field.

With the three-year LTRO, the ECB has helped to reduce systemic risk and avoided a credit crunch. To minimise the inefficiencies and perverse incentives that may result from the increase in its balance sheet, and to reduce counter-party risk, the ECB should be given a greater role in co-ordinating and overseeing supervision of the eurozone banking system. The euro area needs a supervisory and regulatory compact, as much as – if not more than – a fiscal compact.

The writer is a visiting scholar at Harvard’s Weatherhead Center for International Studies and a former member of the ECB’s executive board

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