Monthly Archives: May 2012

Imagine – if you possibly can – that the eurozone crisis is finally resolved. The dust has settled. The euro is still in one piece. How would we have got there?

A lasting solution will require a shift in belief. Belief, in turn, can be measured through bond spreads and, in particular, the level of German yields.

Many investors now expect – and more than a handful of policy makers now fear – that the end is nigh, that the euro is on its last legs. As that belief festers, its self-fulfilling qualities threaten the euro’s survival.

The consequences of that belief are all around us. Slow motion bank runs, widening sovereign spreads and biting recession are symptoms of an underlying fear that the euro will crumble.

The fear is most obviously expressed through capital flight. One oddity of the crisis to date is that, while some countries in the eurozone are suffering enormously, others are doing perfectly well, largely thanks to capital heading northwards. Thus whereas the cost of borrowing is painfully high in Spain, it is ridiculously low in Germany.

Capital flight has created a quasi-currency market within the single currency area. If investors fear euro break-up, they’ll invest today in anticipation of where newly-independent national currencies might head tomorrow. No one has any sure way of working out where a future German euro might trade versus a future Spanish euro, but it’s not hard to believe that the German euro would appreciate dramatically against its southern rivals.

That belief is precisely why we’re witnessing capital flight. Why would investors choose to hold Spanish assets which, in a post-euro world, might lose their value remarkably quickly when they could, instead, opt for German assets which might appreciate thanks to the introduction of a German euro?

Even if the initial probability of a euro break-up is deemed to be low, it might nevertheless be high enough to trigger the capital flight which, day by day, increases the likelihood of eventual euro break-up.

Other than the copious use of effective capital controls, the only way to stop capital flight is to provide a cast-iron political commitment that the euro will survive (no one, after all, believes that the Californian dollar will appreciate against the Illinois dollar). That’s not easy. Imagine, though, that the commitment is provided and that investors believe the politicians are serious. What would then happen?

The flow of capital would reverse. No longer would there be any reason to treat the eurozone as a quasi-currency market. And the narrative which has so bedevilled the eurozone until now would disappear in a puff of smoke.

That narrative is based on the idea of good creditors and bad debtors. The idea is simple. It is also dangerously wrong. Spanish yields are high, apparently, because Spain finds itself in a poor fiscal and banking position whereas German yields are remarkably low because the Germans have delivered the right reforms. It follows, therefore, that other countries in the eurozone should become more Germanic.

It’s a nice idea but also utterly implausible. Not all countries in the eurozone can benefit from 10 year bond yields at below 1.3 per cent. German yields are down at this ludicrously low level because of capital flight, not economic fundamentals.

It follows, then, that a lasting political commitment to the eurozone would encourage capital to head south again. German bond yields would have to rise even as Spanish yields fell. And that conclusion, in turn, provides a clue as to what a lasting political solution might look like.

It’s likely to include some form of common bond issuance alongside a low-level fiscal union and, perhaps, a eurozone-wide deposit insurance scheme for the banking sector. Institutional arrangements would need to be established to stop the process of capital flight unfairly creating winners and losers leading, in turn, to the rise of political extremism.

In other words, there needs to be burden-sharing. The winners have to give something back. Germany cannot insist on austerity for others while benefiting from capital flight. The flow of capital has to be reversed triggering higher German bond yields. If and when that happens, policymakers will finally have convinced themselves and, indeed, everyone else that the euro will survive.

And what if German yields don’t rise? Barring a massive bout of ECB-led quantitative easing, two explanations spring to mind. Either the euro is left teetering on the brink or the recession in southern Europe has begun to drag Germany down too.

Policies designed to save the euro should be judged by the German yield yardstick. Higher German yields should be welcomed everywhere. And that includes Berlin and Frankfurt.

Tuesday’s Wall Street Journal carried an article by Robert Rubin, former Treasury secretary, arguing that political and economic conditions after the election in November will be unusually favourable for a grand bargain that would get federal finances on a sustainable path.

Mr Rubin argues that the expiring of various tax cuts and implementation of automatic spending cuts, already enacted into law, will compel congressional and presidential action. He also argues that between now and congressional elections in 2014 is the ideal time to bite the bullet on unpopular tax and spending decisions.

With all due respect, I think Mr Rubin is engaging in wishful thinking. Rather than being a propitious time for cutting a deal on taxes and spending, it is almost a certainty the opposite will be the case. Here are some reasons.

First, nothing will happen before the election. Both sides believe the election will strengthen their hand and put them in a position to drive a better bargain. Both can’t be right, but until the election results are in neither side has any incentive to search for common ground.

Although theoretically some sort of backroom negotiating could begin, this is unlikely. Word inevitably would leak and there isn’t much to add to the work of last summer’s Joint Select Committee on Deficit Reduction, which ended in failure and set in motion next year’s sequester that will automatically cut $1.2tn in spending – $600bn each from defence and domestic accounts.

Second, there is no reason to think that the Republican position of opposing any tax increase will change after the election. Virtually every Republican now in Congress or likely to be elected has signed a pledge that they will not support higher taxes for any reason. Without some give on taxes, Democrats will not negotiate, believing a deal that only cuts spending is unfair and unworkable.

It is conceivable that should Mitt Romney defeat Barack Obama he might be willing to put taxes on the table. But he certainly would not do so until after he became president. Then he will need time to get his own people into the Treasury and other agencies before negotiating a budget deal with Democrats.

There is a higher chance of Mr Obama plunging into negotiations after the election. But at that point he will be a lame duck, which will limit his influence. And if Republicans hold the House of Representatives and pick up seats in the Senate, as most political forecasters expect, it will be in their interest to wait until the new Congress convenes in January before negotiating.

Third, lame duck sessions of Congress are notorious for their dysfunction since many members will have retired or been defeated. They are more interested in cleaning out their offices than doing serious legislative work. The most they will do is enact a temporary stay on the tax increases and spending cuts so that the next Congress and administration can deal with them.

Although it is tempting to believe conditions are ripe for a grand bargain on the budget, the unfortunate fact is that the elections for both Congress and the White House this year make it impossible to take advantage of the opportunity.



What is Russia’s place in today’s world? Has its government built new bridges to the West? Hardly. After the Soviet Union collapsed, US and European leaders extended a hand toward Moscow. The G7 group of industrialised democracies became the G7+1. Nato, the West’s military alliance, created a Nato-Russia joint council. Russia inherited the Soviet seat in the UN Security Council.

How has all that worked out? When many of Russia’s neighbours moved to build new ties to the West, senior Russian leaders called it an American plot to encircle their country. When US leaders announced plans for a missile defence system in eastern Europe to counter threats from Iran, Russian officials warned that they were really designed to paralyse Russia’s defences in advance of a Western invasion.


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    US officials have tried to “reset” relations with Russia – to begin again in a more co-operative spirit to strengthen US-Russian ties. In March, President Obama asked (then president, now prime minister) Dmitry Medvedev to allow time to address Moscow’s missile defence fears. In May, a senior Russian general threatened pre-emptive attacks on the sites.

    Nor is Russian membership in Western organisations yielding positive results. The G7+1 can’t really become a G8 until Russia begins to act like a mature free market democracy. It’s hard to work up much optimism on that score with Vladimir Putin claiming that recent protests in his country are choreographed by Western spies and that he couldn’t make it to the latest G8 summit at Camp David because he was busy putting together his new cabinet – always a complicated chore in an authoritarian country. Mr Putin’s absence made little difference as discussion turned to Afghanistan and the Eurozone, where Russia can’t help, and to Iran and Syria, where Russia is part of the problem.

    So if its government isn’t interested in Western clubs, can we classify Russia as a dynamic emerging market? Not a chance. In China, a communist party has engineered a complex, high-powered economic engine that has lifted the country from abject poverty to become the world’s second-largest economy. India has produced some of the world’s most innovative private-sector companies. Brazil is now an increasingly self-confident democracy with a well-diversified economy and a growing international profile.

    Russia, by contrast, has become an authoritarian state built on (president, then prime minister, now president again) Mr Putin’s reputation as a tough guy and the export of oil, gas, other natural resources and little else. Corruption is endemic. Graft is a particular problem in most developing countries and Transparency International’s global corruption index ranks Turkey at 61, Brazil at 73 and China at 75. Russia ranks 143rd. Russian courts and judges are among the world’s most politically compromised.

    In addition, much of Russia’s commercial elite still views the country as a wealth generator but not a sound long-term investment bet. Capital flight, a chronic problem, has reportedly accelerated since Mr Putin’s re-election in March and it could get much worse if the country faces any extended period of civil unrest. The country’s population is falling because healthcare is poor, socially driven diseases, such as alcoholism, is rampant and because well-educated Russians are leaving in search of better opportunities elsewhere. When the Soviet Union collapsed in 1991, Russia inherited some 148m citizens. Today, there are fewer than 142m. UN studies have warned that the population could fall by 30 per cent over the next four decades, with obvious implications for the country’s growth trajectory and even its long-term territorial integrity (with Siberia barely populated with Russians).

    Are things improving? During Russia’s most recent Potemkin election campaign, Mr Putin spent more time bragging about the stability he established during his last stint as president than any grand plans for the country’s future. Russia is also about to become less transparent as Mr Putin has formed a cabinet with reformers who may not have real power and brings administrative heavyweights on to his presidential staff. The risk is that policy will be made not in Russia’s ministries but behind closed doors inside the Kremlin.

    Republican presidential candidate Mitt Romney recently referred to Russia as America’s “No. 1 geopolitical foe”. That’s absurd, not because Russia isn’t increasingly antagonistic to US interests but because Russia is becoming increasingly less relevant – as a political power or as an attractive emerging market.

    There are those in Russia who argue they can become a modern European country rather than the “Eurasian nation” of Mr Putin’s dreams. These include some of the reformers around Mr Medvedev, much of the country’s urban middle class, internet and social media-savvy young people, a new generation of entrepreneurs fed up with Byzantine restrictions and regulations, intellectuals and much of the media. Members of all these groups want a democratic Russia with an innovative, modern economy driven by private-sector ingenuity and they have taken to the streets in recent months to make themselves heard.

    For the moment, the Kremlin has managed to ignore these voices. Washington should not make the same mistake. If US and European leaders genuinely want to build new ties with Moscow, these are the people they should be talking to.

    The writers are professor of economics at New York University’s Stern School of Business and president of Eurasia Group, a political risk consultancy

    Bank runs are not supposed to happen in a modern advanced economy. Yet, newspapers reported last week that Greek depositors were stepping up their withdrawal of savings held in local banks. Understanding why this is happening – and what we can do about it – is key to assessing the threat to European and global growth, jobs and financial stability.

    There are two critical safeguards against the start and disorderly acceleration of bank runs: national deposit insurances schemes and central bank provision of emergency liquidity. They kick in once the banking system’s first line of defence – which consists of strong capital and good assets on the balance sheet – is breached.

    Many banks were caught offside by the global financial crisis and the widespread economic and financial deterioration that followed. The result was a sharp erosion – both real and perceived – in capital cushions relative to the quality and size of the assets. Moreover, given the heavy concentration of government bonds on banks’ balance sheets, the situation took a further and significant turn for the worse with the downgrading of sovereign creditworthiness in some European countries, and most prominently in Greece.

    Worsening sovereign risk also served to undermine the credibility of the circuit breakers designed to minimise the probability of bank runs. After all, national deposit insurance schemes are as credible as the sovereigns that stand behind them. And with access to emergency central bank liquidity involving the pledging of assets that themselves are now under severe pressures, such funding becomes less straightforward.

    These dynamics are dramatically playing out in Greece due to self-reinforcing concerns about another debt default, the imposition of capital controls, and currency denomination that would accompany a possible eurozone exit. In addition to pushing the country further to the edge, they raise legitimate worries about the risk of yet another wave of negative contagion for some other European countries – particularly through the further destabilisation of bank deposits.

    Greece’s “bank jog” needs to be immediately stopped if it is not to evolve into a full-fledged bank run with region-wide implications. And to do so, Greece requires even greater support from its already (and understandably) reluctant eurozone partners.

    An incredibly disruptive situation could be avoided if Greek depositors were given quick access to a region-wide (as opposed to just national) deposit insurance scheme that is unambiguously supported by the fiscal authorities in the strongest eurozone countries. This would need to be coupled with even larger liquidity support from the European Central Bank, along with direct capital injection into the Greek banks from regional funds (e.g., the European Stability Mechanism, or ESM) and multilateral institutions (namely the International Monetary Fund). Finally, agreement would be needed on how and when to impose burden sharing on banks’ equity holders and bond creditors.

    Add these financial requirements to the considerable sums already committed to Greece to cover its primary budget deficit, meet interest payments, roll over maturing debt, and facilitate much needed structural reforms. Each serves to complicate an already tense and stretched relationship between Greece and the troika (ECB, EU and IMF). Together they pose a considerable and urgent challenge – and one that makes it even more difficult to reconcile simultaneously cascading financial demands, economic imperatives, conditionality design, and democratic realities.

    Whichever way you look at this troubling situation, last week’s intensification of deposit flight in Greece is much more than just a new wrinkle in what has become a protracted European crisis. If the phenomenon spreads, and it will in the absence of a credible region-wide policy response, control of Greece’s destiny within the eurozone would slip even further away from politicians and policymakers and more directly into the hands of a population that is approaching the June 17 election in a mood of rejection. Already this rejection is not that far from tipping Greece into a classic funding panic and the eurozone into even greater turmoil.

    China’s economy seems to be going gradually downhill but with the dips particularly steep at times. When Premier Wen Jiabao announced in March that the growth target would be 7.5 per cent this year, no one took him too seriously since outcomes have always been significantly higher. Beijing was comfortable with growth moderating to around 8.5 per cent for this year compared with last year’s 9.2 per cent but prolonged uncertainties in the eurozone combined with the continuing lid on housing purchases now suggest that a soft landing may be more difficult to realise.

    April’s economic indicators took markets and seemingly even Beijing by surprise in the uniformity of the shortfalls from forecasts. Some have speculated that the leadership has been distracted by the Bo Xilai and Chen Guangcheng affairs on top of the manoeuvring relating to the leadership transition. Industrial production grew by only 9.3 per cent year-on-year compared to the consensus forecast of 12 per cent. Growth in investment and retail sales were also below expectations particularly since various business surveys had been more reassuring. All this was corroborated by the slow growth in electricity sales and tax receipts.

    Particularly worrisome, bank lending has fallen off sharply – with medium and long-term loans down nearly 50 per cent from last year. Firms find profits evaporating with demand becoming increasingly uncertain for those depending on export markets. The problem is not lack of liquidity in the banking system but lack of credible borrowers.

    But the final straw came with demand from Europe collapsing last month along with the US market remaining tepid. The reality now is that external demand by itself could subtract a full percentage point from this year’s growth. China analysts have responded by lowering their growth estimates closer to 8 per cent with some even predicting a collapse. This morning the World Bank lowered its forecast to 8.2 per cent.

    Beijing still has ample financial resources, however, to avoid a crisis. The premier’s recent statement on “giving more priority to maintaining growth” signalled that decisive actions would now be taken. But with its infrastructure-cum-land sales fueled growth model under stress and exchange and interest rates still tightly managed, it does not have all the necessary policy options at its disposal.

    Prospects have worsened in part because of the legacy of China’s enormous 2008 stimulus programme. That programme, which relied heavily on credit expansion, pushed growth above sustainable levels and fostered the borrowing spree that spawned the property bubble and inflation, which has absorbed the attention of policy makers ever since. Even as macro conditions have seemingly been brought under control over the past six months, China’s longer-term strategy of becoming less reliant on external demand and investment and more dependent on consumption to drive growth is becoming harder to realise.

    Premier Wen has shown no inclination thus far to remove the lid on the commercial housing sector, which broadly defined accounted for some 10 per cent of gross domestic product in recent years. Losing this demand driver cannot be easily offset even if efforts are made to accelerate construction of social housing.

    With the apparent success of its tighter monetary policy, Beijing now finds it awkward to reverse course by lowering interest rates to keep activity on a steady course and instead has to rely on cutting bank reserve requirements to recharge the system. But if with repressed commercial demand, this option may not suffice.

    Although political pressures to appreciate the renminbi have lessened with declining trade surpluses, more flexible two way currency movements will have little impact in altering trends in the real economy over the coming months.

    Hopes that consumption can play a more dynamic role are probably unrealistic. Consumption has in fact been relatively strong accounting for 43 per cent of GDP growth in the first quarter compared with 28 per cent a year earlier. But by its very nature, consumption is not amenable to special incentives, which typically end up borrowing against the future and thus are not sustainable. Nevertheless, consumption growth averaging 8 per cent annually does provide a solid base that would help cushion all but a total collapse in the global economy triggered by events in the eurozone.

    Chastened by the explosive growth of credit-financed expenditures from the past stimulus programme, China’s system now has to rely on the recently announced fiscal efforts to accelerate expenditures on infrastructure projects including roads, rail and power plants. While more transparent and less prone to waste, the fiscal channel is more bureaucratic with its expansionary impact less readily felt compared with the banking channel. Thus there continues to be a risk that Beijing’s fine-tuning of macro policies will fail to keep growth on the desired trajectory.

    The relationship between Greece and the rest of the eurozone is increasingly reminiscent of the cold war’s balance of terror. We are of course speaking only of financial terror and Greece is not the Soviet Union, but the mechanics are strikingly similar.

    Start with the options for Athens. It is important to distinguish between budgetary and external aspects. Greece is forecast to record a slight primary budget deficit in 2012, so should it default, forcing European partners to unplug assistance, it would have to tighten more, but only marginally. However the current account deficit is still expected to be close to 8 per cent of gross domestic product. Without assistance and in the absence of significant private capital inflows, the European Central Bank would have to increase its exposure even further. Should it refuse, as likely, Greece would be forced into an exit and it would have to close its external deficit precipitously. What remains of the economy would fall into chaos. Financial disruption would be massive, resulting in a chain of bankruptcies. Currency depreciation would substantially overshoot, making foreign goods unaffordable, especially as policy institutions have no credibility. Eventually, depreciation would help rebuild competitiveness, but in the meantime the damage would be severe.

    A unilateral Greek default would undoubtedly be costly to its partners. Official exposure to Greece through assistance loans, ECB claims on the national central bank and ECB holdings of government bonds amount to more than €250bn. To this sum must be added private sector exposure through bank loans and equity, roughly another €100bn.

    Additionally, a Greek exit would signal that there is nothing irrevocable with participation in the euro, turning the European currency into a sort of magnified fixed exchange-rates system; equally importantly, it would force to set rules for converting euro-denominated claims into the new currency, thereby indicating to every business or household what assets and liabilities would become in the case of a euro break-up. No doubt this would trigger massive precautionary moves and undermine the rest of the eurozone.

    What this suggests is that a Greek threat to default within the euro is not be credible if the ECB is ready to stop extending liquidity. The next government could wish to renegotiate some aspects of the programme but it will still need it, until it completes the largest part of its adjustment.

    The EU official line – no renegotiation of the programme, no exit at any price – is however not credible either. For if the price it puts on exit is infinite, the EU cannot deter Greece from making use of its leverage. To strengthen its hand, it has to be ready to contemplate a forced exit. But it can only do that if equipping itself to limit potential damages. This means beefing-up firewalls and speeding-up preparations for banking union and the issuance of common bonds. Here, it is Berlin that lacks consistency. Signals that it is not ready to pay any price to keep Greece within the euro are only credible if accompanied by willingness to consider bold moves to preserve the common currency.

    A lesson from the Cold War is that ultimately, rational behaviour proved to be the best insurance against disaster. Today also, both partners have a common interest in behaving in cool blood. They have to set red lines credibly and unambiguously, as well as to indicate where there is room for discussion. This can only happen after June 17, when a new coalition emerges from the election and forms a government in Athens. In the meantime, we are bound to live dangerously.

    If the eurozone is to save itself, it will have to face the real crisis: its banking sector. Far too much time has been spent on fiscal policy when the existential threat to the eurozone is the ongoing collapse of bank lending in the weak economies, as Gavyn Davies recognises. Yes, fiscal policy counts, but the debate commonly framed between “austerity” (more deficit reduction) and “growth” (more deficit spending) is a serious distraction to the survival of the currency union.

    The 2008 financial crisis in Europe and the US arose from excessive bank lending during the 2000s caused by deregulation and excess liquidity from the Federal Reserve and the European Central Bank. The excess liquidity found its way to a variety of sub-prime borrowers. There was a housing bubble in the US, UK, Ireland and Spain; a corporate-acquisitions bubble in Iceland; and a public sector spending binge in Greece.

    When the easy credit stopped in 2008, the banking sector was over-leveraged and under-capitalised. Bank assets – including mortgage-backed securities, corporate acquisitions, and government bonds – were heavily impaired, so that bank capital plummeted. A financial panic ensued after the Lehman collapse, with banks ceasing to lend to one another or to blue-chip companies. Liquidity dried up. The US and Europe plunged into a very steep downturn.

    This was not a typical Keynesian downturn resulting from a fall of aggregate demand, though aggregate demand certainly declined as net worth in housing and equities also fell sharply. The dramatic decline in output in late 2008 and early 2009 resulted mainly from the lack of working capital at enterprises rather than inadequate aggregate demand. Non-financial companies slashed their workforces and sold off inventories in order to replenish liquidity that the banks were no longer providing.

    The Fed correctly flooded the economy with liquidity after the Lehman collapse, thereby ending the banking panic by the spring of 2009. The US banks gradually recapitalized through the infusion of public funds (the Troubled Asset Relief Program), the profits on near-zero-interest loans from the Fed, the recovery of asset prices, and the infusion of new equity. The US fiscal stimulus may have played a small role in the start of the US recovery in 2009 but the Fed’s effort to reverse the financial panic was the dominant factor.

    The eurozone, by contrast, failed to redress its equally severe banking crisis, especially in the weakest eurozone economies. The Greek banks, with their large holdings of Greek government bonds, suffered a catastrophic loss of capital. When rumors began in December 2009 that Greece might default on its sovereign debt and leave the eurozone, Greece’s banks could no longer float securities or attract deposits or inter-bank lines of credit.

    From early 2010 onward, the Greek banks looked to the ECB as their lender of last resort, yet the ECB was constantly ambivalent about its responsibility in this arena. Rumours swirled that Greek would be pushed from the eurozone and that the ECB would reject collateral offered by the Greek banks. Depositors began to flee the Greek banking sector, with bank deposits in Greek monetary institutions peaking in the spring of 2010 and declining thereafter. As deposits fell, and without access to the international capital markets, Greek banks slashed their loan portfolios, leading to a devastating economic contraction that continues to deepen.

    The Greek economy is collapsing not mainly from fiscal austerity or the lack of external competitiveness but from the chronic lack of working capital. Greece’s small and medium-sized enterprises can no longer obtain funding. Since 2010, Greece has been trying to stabilize a sophisticated modern economy while its banking sector is shrinking dramatically. It just doesn’t work. The shutdown of Greece’s banking sector brings to mind the dramatic shrinkage of bank lending during 1929-33 in the Great Depression.

    Europe’s banking squeeze extends beyond Greece. Overnight deposits have declined since mid-2010 in the banking sectors of several other eurozone countries, including Ireland, Portugal, and Spain. In response, bank lending in those economies has also been cut, causing the current double-dip recession. And the reduction of bank loans could easily intensify if eurozone banks now try to raise their capital-asset ratios by cutting lending rather than by raising fresh capital.

    There is still no evidence that European authorities, and notably German politicians, recognize the priority of rescuing the eurozone banks, and especially the banks in Greece and other weak economies. The European Banking Authority is tightening capital adequacy standards without paying enough attention to the ensuing steep credit squeeze. The focus on budget cutting in these circumstances is not only misguided but tragically inapt. Governments cannot close their budget deficits if payroll taxation is plummeting because payrolls themselves are being deeply squeezed.

    The bank panic is Greece is now accelerating, and could easily push Greece out of the Eurozone unless decisive actions are taken to prevent a massive run on the Greek banks. If such a run occurs, and drives Greece to leave the euro, Greece’s exit would most likely create an even greater calamity, as Portugal, Spain and perhaps Italy, suffer rapid withdrawals of bank deposits as well. The Eurozone’s unwillingness to keep Greece in the union would create a powerful one-way bet against the survival of the currency union in several other countries as well.

    The eurozone has one last chance. Here are the key steps. Re-establish working capital in the weak economies; re-capitalize the banks, using ample public funds as needed; insist that the ECB be a more vigorous lender of last resort for the banking sector. In short, Europe must fight the ongoing banking collapse with the resolve needed to save Europe from a self-inflicted collapse. Credible fiscal policies and increased investments in human capital and infrastructure are surely part of long-term recovery, but the fiscal crisis can be addressed only after Europe’s tottering banking sector has been rescued.

    The G8 begins this evening, overshadowed by the eurozone crisis. But while the US spends time with stricken European leaders, it should also look back to a recent summit attended by the Secretary of State.

    When she was in India this month, Hillary Clinton proposed a new dialogue between China, India and America (CIA). Some in Beijing are likely to reject this suggestion instinctively. Yes, it is possible that two of the world’s largest democracies may gang up against China. However, before rejecting this idea, they should think twice. Indeed, Ms Clinton may have presented a wonderful geopolitical opportunity for all three countries. It is not a given that America and India will see eye to eye against China on the main global challenges. It is equally likely that India and China, or even America and China, may see eye-to-eye on some issues.

    Press reports of Ms Clinton’s proposal noted the American belief that consultations among the three countries are crucial to resolve issues such as climate change and global trade. China and India may see eye-to-eye on these two challenges. For example, China and India agree that it is unfair for America, which has contributed a greater stock of greenhouse gas emissions than any other country, to ask relatively poorer countries like China and India to limit their emissions. Both agree that America should first pay an economic price for its contribution to this stock of greenhouse gas emissions and also make a commitment to reduce its the current flows. This is why Xie Zhenhua, the head of the China delegation, lost his temper at the Copenhagen climate change summit. Hence, China and India would find that a trilateral dialogue provides a wonderful opportunity for them to explain their point of view to America.

    Similarly, on the efforts to revive the Doha round, China and India can remind America that there was a clear understanding at the end of the Uruguay round that both America and Europe would agree to reduce their agricultural subsidies as part of a comprehensive deal in the following round. One reason why Doha has failed so far is because America and Europe have walked away from this commitment. Now with fiscal deficits haunting America and Europe, these agricultural subsidies are no longer sustainable. Hence, a CIA meeting could put together a trade deal that no other global meeting could possibly achieve.

    The Islamic world presents another challenge to America. The Chinese and Indian civilisations have had a longer connection with the Islamic world and can help America deal wisely with this world. An Iranian deal worked out by the new CIA is more likely to stick and could even be acceptable to Iran.

    On other issues, America and China may see eye to eye. Historically, at different points in time, both have been allies of Pakistan when Pakistan provided a big challenge to India. Both America and China have a vested interest in a stable Pakistan. Now, fortunately, so does India. Both China and America could brief India on how the Taiwan issue, which once bedeviled Sino-American relations, has disappeared under the radar screens. India could learn a lesson or two from America and China on using the Taiwan approach to solve its own Pakistan problem. Let me quickly emphasize here that any such suggestion is politically explosive now. Yet it is precisely because the CIA can now meet in private to discuss politically sensitive issues that all such previously unthinkable and unmentionable approaches can be quietly deliberated on.

    Of course, on domestic political issues like democracy or Tibet and the Dalai Lama, there will be greater commonality of views between America and India. However, it is also in China’s interest to reach a long-term understanding on Tibet while the Dalai Lama is still alive. Time is not necessarily on the side of China on this issue. It may be in China’s interest to work out soon a long-term win-win deal of autonomy for Tibet. Again, sensitive issues like democracy and the Dalai Lama can only be discussed after a series of private CIA meetings have built a community of trust among the three powers. In short, Ms Clinton’s proposal to convene a new CIA meeting is geopolitically brilliant. It can lead to three sets of win-win propositions on all three legs of the triangle and the world would be better off too.

    Understandably, other powers, especially Europe, Japan, and Russia, will be miffed that a major dialogue is being created without their participation. However, the good news here is that there is no shortage of fora which link Europe, Japan, Russia and even Brazil to the CIA. The G20 meetings bring them all together, with heavy European over-representation. In addition, President Putin is now invited to attend East Asian Summit meetings with President Obama. The record shows that the larger the group is, the lesser the results are likely to be. A new CIA could therefore make a huge difference.

    A long time ago, Goldman Sachs projected that by 2050 or earlier, the number one economy in the world would be China, the number two economy would be India, and the number three economy would be America. Clearly, the world would be a better place if these three powers start to cooperate as early as possible. Both India and China should respond positively to Ms Clinton’s brilliant proposal.

    On May 15, John Boehner, speaker of the US House of Representatives and the highest ranking Republican in government, gave a speech in which he promised a replay of last summer’s debt limit showdown.

    Mr Boehner said: ”Yes, allowing America to default would be irresponsible. But it would be more irresponsible to raise the debt ceiling without taking dramatic steps to reduce spending and reform the budget process.

    “We shouldn’t dread the debt limit. We should welcome it. It’s an action-forcing event in a town that has become infamous for inaction.”

    Under US law, legislation creating debts and deficits is treated separately from the legislation that funds them. From time to time, Congress must raise the debt limit to permit the Treasury to borrow money to pay the expenses Congress has previously written into law. It’s not uncommon for members of Congress who voted for large tax cuts and/or large spending increases to later vote against raising the debt limit, claiming, nonsensically, that it would be fiscally irresponsible to do so.

    When the debt limit is not raised, it threatens a debt default because the Treasury would lack the legal authority to borrow to raise cash to repay maturing securities or pay interest on them. Thus, unlike the debt problems of countries such as Greece, a US debt crisis resulting from failure to raise the debt limit would not be market-driven, but would result solely from partisan gamesmanship.

    Political observers are curious about why Mr Boehner would throw down the debt limit gauntlet now, especially since last year’s showdown is often credited for disturbing investor confidence – something Republicans attach great importance to. It also led Standard & Poor’s to downgrade US Treasury debt, citing the fact that the debt limit had become a political bargaining chip between the two parties.

    Senator Mitch McConnell, the Senate Republican leader, confirmed the purely political nature of the debt standoff. Shortly after a last-minute deal was reached, he said that some of his members actually favoured default on the debt – “a hostage you might take a chance at shooting”, as he put it. However, Mr McConnell went on to say: “What we did learn is it’s a hostage that’s worth ransoming.”

    Some observers speculate that congressional Republicans are not so sure they will take back the White House next year. If they were confident of doing so, it would make more sense for them to wait, especially since the debt limit is not expected to expire until early 2013, according to a statement by Treasury secretary Timothy Geithner on May 15.

    Others think that Mr Boehner, whose position is threatened by right-wing “tea party” members, is simply trying to demonstrate resolve on the budget for their benefit. But it runs the risk of alienating independent voters, who were widely displeased with last summer’s brinksmanship.

    The reality is that there are many other “action-forcing events” on the horizon, especially the expiration of temporary tax cuts at the year’s end, as well as large automatic spending cuts previously enacted into law. Although there is a strong case to be made for allowing this fiscal tightening to take effect on schedule, there is widespread fear that it would be too much, too fast and risk pushing the US economy back into recession.

    President Obama’s visit to Afghanistan on May 1 and his signing of a strategic partnership agreement with President Karzai in theory sets the terms for the kind of presence the US will have after the “withdrawal” of its forces in 2014. Of course, the US is not really going to withdraw by this date; it will leave behind Special Forces, drones, trainers and other assets that will still give it residual military capabilities in Afghanistan. Nonetheless, the departure of the bulk of its forces that came in with Mr Obama’s 2010 surge will be gone and the US will consequently face a vastly diminished capacity to shape events on the ground.

    It seems obvious that we need to start thinking through the political dimensions of a post-Nato Afghanistan and, specifically, what a negotiated settlement with the Taliban might look like. Among the dumber things Mitt Romney has said during the primary campaign (and there’s lots of competition for that) is that he doesn’t intend to negotiate with the Taliban but to defeat them. Lots of luck. Political support for continuation of the war is vanishing daily in both parties and regardless of who is elected president in November, a substantial US withdrawal will occur within the next few years. Until the election happens, there will be no overt discussion of what a political settlement might look like.  But early 2013 will be a very late moment to begin thinking about this issue; better to begin now.

    We can start by going back to basic US interests in Afghanistan. Our goals there have drifted over time and are now disconnected from any strategic purpose our presence may have once served.

    The US invaded Afghanistan in the autumn of 2001, quite legitimately, in order to dismantle the nearly two dozen large training bases that al-Qaeda operated there and from which the September 11 attacks were organised and run. This goal has been achieved already. Al-Qaeda still exists, but the most dangerous parts of the organisation are now intribal belts in Pakistan, Somalia, Yemen and other places further afield. Their ability to re-establish themselves in Afghanistan will increase after a US withdrawal, but our residual air assets and Special Forces will very likely be more than sufficient to guarantee that the country will never become a major staging ground again.  (At any rate, it won’t pose more of a threat than what we already face in Pakistan.)

    So why are we continuing to fight the Taliban?  The reasons are much clearer on their side than on ours.  They are fighting us because NATO forces are occupying their country, setting up a presence in their villages and are perceived to be pulling the strings behind a weak and illegitimate government in Kabul.  The Taliban at this point represents the religio- ethno-nationalism of the Pushtun communities in Afghanistan (religion, ethnicity, and nationalism are all intertwined in that part of the world today).  As far as I can see they have no beef with the United States that would motivate them to attack us where we live, if we actually were to leave them alone.  They cooperate with groups like the Haqqani network in Pakistan, but that’s because the Haqqanis are useful to them, and not because they share agendas.  The Haqqanis are more a creature of the Pakistan’s intelligence services, our nominal ally.

    Our reasons for fighting them are more complex. We feel that we derive some marginal anti-terrorism benefit by being physically present in southern Afghanistan. The US military was given a counterinsurgency mission and it doesn’t want to appear unable to complete it. But the real issue is a moral one: if we simply depart without providing a framework for stability (much as we did after the Soviet withdrawal in 1989), Afghanistan is likely to return to chaos and yet another phase of the civil war that has been ongoing since the 1970s.

    The US has actually done a lot of good things in Afghanistan since 2001, in terms of building schools, education and stimulating some economic development. In the process, we have enlisted many Afghan allies, telling them that if they signed up with us we would protect them and make their lives better. If we leave these pro-Western groups to the Taliban we will be repeating the same disgraceful pattern of intervention and subsequent betrayal that has played out in many of our previous involvements, from Nicaragua in the 1930s to Vietnam, Laos and Cambodia in the 1970s. So we have an obligation to try to create some stable balance through political means.

    If I am correct in assessing the Taliban’s basic motivations, then their main political objective should be to gain power in areas with large Pushtun populations. It is not clear that they would have a strong interest in trying to seize power in Kabul, as they did in the 1990s, nor is it evident that they would want to take on the Tajiks, Uzbeks, Hazaras and others if they didn’t have to. They are all watching and waiting; the Northern Alliance could quickly reconstitute itself as a fighting force if they felt a direct threat from the Taliban.

    This means that any political settlement would have to be built around a strongly decentralized Afghanistan, in which there is a nominal government in Kabul, but in which the different regions are given a much higher degree of de jure autonomy than they have now.  In this respect, the main obstacle to a political settlement is the 2004 constitution that came out of the Bonn agreement and the constitutional loya jirga.  For reasons that are now only of historical interest, the parties to that process agreed to make Afghanistan on paper one of the most unitary, centralized states in the world.  The president has the power to appoint provincial governors; the Karzai family’s control over Kandahar is one of the biggest complaints that southern Pushtuns have about present arrangements.  (The constitution also enshrined a single non-transferrable vote electoral system, another feature that the international community should have tried to block back in 2004.)  So it is conceivable that the Taliban might sign up to a system that gave them de facto political control of southern Afghanistan, leaving other parts of the country to the other ethnic groups.

    There are at least five big problems in getting to this kind of settlement.  The first is how to actually get around the 2004 constitution.  One could try to call another loya jirga, but it is hard to see this coming about under present conditions of insecurity.  Even if it could meet, it is not clear that it could come to a consensus on a new system; article 150 of the constitution mandates a two-thirds majority for any changes and gives Karzai a veto.  It might be possible to leave the current constitution in place, and simply negotiate informal understandings that it would be in effect violated, by having governors for example locally selected.

    The second problem is one of minorities within minorities. Afghanistan is a patchwork of ethnicities; in particular, there are very large Pushtun communities in the north that would be stranded if the south were to become the new Pushtunistan (and vice versa).  All settlements based on rule by dominant ethnic groups risk unleashing population transfers and ethnic cleansing, as in the partition of the subcontinent in 1947, the breakup of Yugoslavia in the early 1990s, or Iraq after 2003.

    The third problem is President Karzai, who would be a big loser in such a deal because he would no longer have patronage powers very far outside of Kabul.

    A fourth problem is the Taliban itself.  The Taliban is not a unitary actor, but contains within itself different trends and is built on top of a complex tribal structure.  There are big differences of perspective between urban and rural Pushtuns. It is not clear with whom the government of Afghanistan or Nato would negotiate (Mr Karzai has already been burned talking to fake Taliban representatives), or whether a designated negotiator would be able to make an agreement stick. The Taliban has reportedly set up an office in Qatar so there is at least an address to which one could mail an invitation.

    A fifth problem concerns the international dimension. As interested parties, the US or Nato could not oversee a peace process directly; a UN framework is probably necessary for a negotiation to take place. No settlement will be successful unless Afghanistan’s neighbours, India, Pakistan, Iran and Russia, are willing to live with it. Needless to say, many of these parties are involved in bitter conflicts with one another and cannot be brought around a table easily.

    So getting to a negotiated settlement won’t be easy.  But no negotiation of a long and bitter conflict looks easy at the outset.  The United States has proven that it cannot be defeated militarily in Afghanistan.  But it does not have the public support to stay there in large numbers indefinitely, nor should it, given the nature of our underlying interests in the country.  So in addition to our military strategy we need to at least begin to think concretely about a political path towards stabilizing the country once our direct military presence has been drawn down.

    Some political analysts are starting to think about the possibility of a Romney presidency and how he would govern, given that he is unlikely to have complete control of the Senate. Although it is possible that Republicans may get a majority – Democrats now control the Senate by a 53 to 47 margin, including two independents who vote to organise the Senate with the Democrats – there is no possibility of them getting the 60-seat margin necessary to actually have control.

    Although the Senate notionally operates by majority rule, in recent years Republicans have perfected the use of parliamentary procedures that effectively require 60 votes – the threshold necessary to break a filibuster – for virtually every bill or nomination. (Under the Constitution, the Senate alone confirms nominations for senior political appointments and federal judges.)

    Obviously, should Republicans regain control of the Senate with fewer than 60 seats, Democrats would then use those same procedures to frustrate the Republicans. Thus a President Romney would face exactly the same problems in advancing his agenda that Barack Obama has faced.

    There are two ways Mr Romney could respond. First is through an obscure congressional procedure known as “reconciliation”. It applies only to measures affecting taxes and spending, but has the virtue of requiring a majority vote for passage in the Senate. By law, reconciliation measures cannot be filibustered.

    The big problem with reconciliation is that both the House and Senate must agree to a budget resolution embodying reconciliation instructions – basically, congressional committees are ordered to report legislation incorporating those instructions. Although Congress is, theoretically, required to enact a budget resolution annually, with or without reconciliation, it has not done so since 2010.

    Some American liberals have long urged Mr Obama to “embrace the most expansive reading of reconciliation”, as  Noam Scheiber, senior editor of The New Republic magazine, recently put it. In other words, push the limit of what might fall within the definition of reconciliation to break the Senate filibuster.

    This idea is impractical at the present time given the necessity of House and Senate agreement on a budget resolution containing reconciliation instructions, which is very unlikely with Republicans controlling the House of Representatives. Moreover, expanding the definition of reconciliation now might open the door for Mr Romney to use it later for his purposes.

    The other option for dealing with the problem of routine filibusters is something Republicans put forward during the George W. Bush administration, when Democratic filibusters frustrated his agenda. That is what is called the “constitutional option”, which involves changing Senate rules by majority vote to end the filibuster altogether. Although Republicans eventually dropped the idea, it could be revived if they regain control of the Senate and Democrats use Republican tactics to block Mr Romney’s agenda.


    Concern over the US’s long term fiscal situation is pervasive among policymakers and businessmen. Increasingly, commentators worry that without a sweeping “grand bargain” on deficit reduction market players will pounce, driving US borrowing costs to unsustainable levels and demonstrating diminished US leadership in the post-financial crisis world. But the doom and gloom merchants are wrong, or at least misplaced.

    Since 2008, the US has by choice and necessity reduced its international role, with the killing of Osama bin Laden a year ago punctuating the end of the 9/11 era. For the first time since the second world war we live in a world without active US leadership, and no one else is willing or able to fill the void. Slow growth and aging populations drag on Europe and Japan. Despite the rise of the rest, emerging states such as China and India resist assuming global roles, and face significant challenges of their own besides. The international order has changed profoundly, and the frequency and effectiveness of multilateral collaboration is declining. I call this world without leadership the G-zero.

    But the US is not a loser in this world—far from it. The US remains by far the most capable global actor, and the single most powerful and influential country on the planet. And as both cause and consequence of US resilience, the US remains the unchallenged and unchallengeable financial safe haven.

    As a result, the US will almost certainly not face market pressure this year, or for several years to come. But there’s a catch: the very absence of market pressure makes it much harder for US policymakers to reach difficult compromises. This safe-haven curse imperils US efforts to foster robust economic growth and fiscal sustainability.

    The safe-haven curse came to the fore last year. In 2011 the political and business communities became convinced that the US needed to get its fiscal house in order or face a financing crisis. Lawmakers in both main US political parties argued that only bold deficit reduction was essential. Republicans pressured the White House to tie a debt-ceiling hike to a deficit deal, and President Obama supported linking the issues. Fear of crisis intensified in the summer, compelling the president and House speaker John Boehner to entertain a controversial deal that would have angered both parties. Ultimately, the talks unraveled and both sides girded for the dire consequences.

    But a funny thing happened: there weren’t any. Investors continued outbidding each other to loan money to the US government at historically low yields. Standard & Poor’s downgraded the US—and market players shrugged. When investors looked around the world, they saw Europe mired in a worsening debt crisis, a Middle East unsettled by the Arab Spring, Japan dealing with the aftermath of Fukushima, and China facing an economic slowdown. A little disagreement in Washington seemed positively quaint by comparison, and Treasury bonds as safe as ever.

    Today, little has changed, and Washington’s fiscal free pass will not reverse any time soon. The dollar remains the world’s unchallenged reserve currency. US capital markets are still the world’s largest and most liquid. Truly riskless assets don’t exist, but Treasury bills are as close as anyone is going to get.

    But cheap financing has a downside: Washington faces no pressure to make tough decisions. Without market urgency or fear of a crisis, lawmakers have little incentive to do anything beyond the absolutely necessary or politically popular. Large-scale deficit reduction and investment in growth—which the US does need, even if not nearly as soon as doomsayers warn—will not be required, and so not politically palatable.

    Anyone who believes that US decline is inevitable ignores history. The US’s political and economic systems are resilient, effective, and enjoy wide support. But acknowledging US resilience should not distract from long-term challenges. The US must invest in education and infrastructure, reform entitlements and taxes, and maintain unmatched military and strategic power to protect its interests and those of its allies, especially in rising Asia. All of this will require painful political compromises from Democrats and Republicans. None of it will be cheap, and none of it will be easy. By fueling complacency, the safe-haven curse will make it all the harder.

    The US can and should enjoy the benefits of its safe-haven status. In a world without leadership, the US remains capable, resilient, and attractive to others. But for its sake and for the world’s, the US must ensure that short-term victory doesn’t sow the seeds of long-term defeat.

    This article was co-authored by David Gordon, head of research at Eurasia Group and former Director of Policy Planning at the US Department of State.

    Let’s stipulate that the $2bn trading loss at JPMorgan resulted from a strategy that was, in the words of chief executive Jamie Dimon “flawed, complex, poorly reviewed, poorly executed and poorly monitored”.

    Mr. Dimon (full disclosure: a friend of mine) was wise to flog himself before he could be flogged by others, even though his self-flagellation is unlikely to halt the broad and well-founded criticism of the bank’s failed risk management.

    But as the piling on continues, we should devote at least equal time to making this a “learnable” moment. In that spirit, here’s what I think I’ve learned:

    First, as best can be discerned, the loss was incurred not in the pursuit of hedging but in pursuit of risk. Specifically, in the credit default index positions that were ultimately responsible for the loss, the bank was apparently not buying insurance against risky loans that it had made; it was providing insurance to others.

    If ultimately confirmed, such a strategy would likely be deemed a violation of the pending Volcker rule prohibiting naked bets with a bank’s capital and a reminder that as difficult as implementing the rule has proven to be, limitations on how depositors’ money is used are necessary and prudent.

    Second, while JPM doubtless has legitimate business reasons for refusing to make public the details of its misstep (its massive positions still need to be unwound), as a quasi-public institution, it needs to be as transparent as possible as quickly as possible. We need to make the most of this learnable moment.

    Third, we shouldn’t forget that in the vast magnitude of the global financial system, this was small beer. For one thing, offsetting the $2bn loss (which Mr Dimon acknowledged could eventually be more) was at least $1bn of profits from other, similar activities.

    More importantly, even at $2bn, the loss represents only about 20 per cent of JPM’s pre-tax profit in the first quarter of 2012 alone and a bit more than 1 per cent of its equity market value.

    So this loss never endangered JPM or its depositors, let alone any other banks or financial institutions. We need to accept without panicking that a bank –particularly one as large and as well capitalised as JPM – may from time to time lose $2bn in a non-systemic misstep. Far more was lost by banks from old-fashioned corporate loans turning sour during each of the last two recessions. Banking has always involved risks and always will.

    Fourth, to those who say Wall Street never pays for its mistakes, please take note of JPM’s shareholders (many of them employees), who saw $14bn lopped off the value of their holdings in Friday’s trading.

    Meanwhile, the executive in charge of the botched operation and two of her colleagues are expected to resign Monday. Knowing Mr. Dimon, I wouldn’t be surprised if further departures follow.

    Finally – and perhaps most consequentially – we need to be careful about how this event affects the remaining steps in the implementation of Dodd-Frank and other post-crisis regulatory measures.

    With the takedown (at least temporarily) of Mr Dimon’s outsized reputation, Wall Street’s last credible voice against excessive regulation has now been effectively silenced.

    But that should not mean that foes of banks be allowed to rampage untrammeled. For example, eliminating any ability of banks to hedge would substantially impede their ability to undertake prudent risk management and would therefore have the paradoxical effect of either increasing the possibility of unexpected losses or reducing the banks’ willingness to lend or both.

    In taking down JPM’s equity value by vastly more than its projected losses from its bad bet and those of other banks by smaller amounts, the market is clearly concerned that Washington will mete out a severe punishment indeed to Wall Street.

    By all means, pile on Mr Dimon, who will likely be harder on himself over such a big misstep than most of his critics. But at the same time, let’s keep calm and carry on, because to react too violently in a way that damages the most important capital market in the world could be as costly as the reverse.

    Extreme political dysfunction is now undermining a Greek economy already hobbled by imploding consumption, explosive joblessness, accelerating capital outflows and debt insolvency. The consequences are multi-faceted and extend well beyond the country’s borders. For the longer-term stability of Europe and the global economy, European leaders need to urgently redefine their historical unity project rather than leave it in the hands of increasingly disorderly conditions on the ground.

    A week ago, the Greek electorate delivered three devastating messages to the country’s political elites: an unambiguous rebuke of traditional parties; unusual migration to fringe parties that are eager to dismantle the past but lack coherent plans for the future; and disgruntlement with economic policies that hurt but don’t work (to adapt a phrase that British politician Ed Miliband used in a different context).

    It should come as no surprise that post-elections Greece is having problems forming a government. The political landscape is now full of parties with different interpretations of the past, present and future. As a result, the three with the biggest share of the recent vote failed last week to garner sufficient support to form a ruling coalition. This was followed by President Karolos Papoulias’ inability on Sunday to coerce the major parties into an emergency government.

    Political dysfunction is the last thing that Greece needs at this historical juncture. It undermines the fulfillment of policy commitments made under the bailout provided by the Troika (European Central Bank, European Union and the International Monetary Fund). It also precludes the design of a better policy mix that would warrant disbursement of much-needed external support but under a more promising approach.

    All this puts Greece’s eurozone partners in a very difficult position. Absent an urgent and imaginative response, they face a lose-lose situation: they lose by disbursing more good money after bad and see that too evaporate with no sustained benefits for Greek citizens and their European counterparts; or they lose by not disbursing and accelerating Greece’s slide into chaos, with unpredictable consequences for Europe and the world economy.

    It is time for the eurozone to pivot away from an approach that offers little prospects of growth, jobs and financial stability. This involves a very difficult but needed redefinition of the eurozone, and a tricky combination of exit and different support mechanisms for countries that are not up to the new reality.

    Given conditions on the ground, the current 17-member eurozone needs to evolve into a smaller and less imperfect union if it is to avoid the growing risk of total fragmentation – namely a closer economic and political union among the big four (France, Germany, Italy and Spain) along with other members with similar initial conditions.

    This is a very complicated and outright awkward evolution. It only occurs in the context of a better policy mix for individual countries; stronger internal funding and coordination mechanisms, including regional firewalls; a less vulnerable banking system; and quite a bit of luck too. Moreover, as they redefine the eurozone, European leaders need to establish an off ramp to allow countries exiting the zone to remain in the 27-member EU and access post-exit stabilisation funds, as well as technical assistance to establish over time a credible monetary policy.

    None of this is remotely straightforward and success is far from assured. But what should be increasingly clear in European capitals is that the current approach is faltering badly and will be even more costly down the road – and not because of the willingness of politicians to keep the eurozone intact but because of developments on the ground.

    The eurozone’s fate is shifting from politicians and directly into the hands of the population, a portion of which is both angry and disillusioned. And having already forced a change in eight governments but still sensing an equally bleak future, the probability is increasing that they opt for a bigger mix of economic, financial, political and social rejection.

    Looking beyond Greece, European politicians and policymakers still have the ability – indeed, the obligation – to channel the more direct involvement of citizens into a redefinition of the important European project. It will be expensive and initially disorderly. But the alternative of fragmentation is much, much worse for all involved. They better hurry up if they wish to remain relevant in a proactive, rather than just reactive fashion.

    Public anger over high levels of executive pay has provoked new government proposals in Britain for binding shareholder votes on remuneration committee reports. This will mark a revolution in corporate governance as shareholders would vote both on the past year’s awards and on the coming year’s plans for salary increases, bonuses and long-term share awards. Boards will find it difficult to deal with such intervention in complex pay structures. A ‘no’ vote is a blunt instrument which will not provide a clear steer on where to go next.

    As a former chairman and member of several remuneration committees, I support the move to a binding ‘say on pay’ vote, despite its difficulties. The market for chief executives has a number of inherent flaws which can be ameliorated by regulation. There is a strong element of ‘winner take all’ behaviour in this market, just as for top athletes or musicians. They compete globally on their respective playing fields and these are jobs that require real experience, and a proven track record. The supply of such people is limited. If a board has good ones, it will want to keep them and keep them motivated. Their compensation is often tiny when compared to the overall profits of the firm, and the value at risk by losing them appears correspondingly high. Risk aversion and uncertainty about the value of alternatives are classic characteristics of winner-take-all markets where the top performers capture a disproportionately large share of the gains. The motivational considerations also explain why there is so much inertia in the bonus element of pay even during a year of poor results. That is often when the demands on the CEO to turn things around are the highest and the costs of destabilisation the greatest, should the CEO leave.

    The other side of this coin is that there is nothing more damaging to a company than a poor CEO, one who is just not up to the task or who creates a negative internal culture. But in such a case, the board’s response will not be to dock the bonus, but to find someone new. Unless there is an in-house successor, this often ratchets up the remuneration because it will be necessary to lure the preferred candidate away from their current employer. If that is in the United States, where executive rewards are on very high (and set up to lock executives in to the company), then the price will be even higher.

    These market characteristics have the effect of escalating executive compensation. To offset this, it is helpful to enhance the countervailing power of shareholders. This has already happened to some extent with the advisory vote on remuneration reports, as shown by the recent cases of large negative votes by shareholders in Barclays, Aviva and Xstrata. Boards do pay attention in such cases, even when an overall majority backing is achieved. But the level of prior engagement and consultation with institutional shareholders would certainly go up if the vote were binding rather than advisory.

    There are risks to this approach. Shareholders may simply vent their anger at other aspects of corporate strategy through the vehicle of the remuneration vote, leaving the way forward unclear. But it is also possible that giving shareholders more power will cause them to accept the responsibility that comes with such engagement. Do they really want to see a bonus linked mostly to share price performance, for example, when that is often more dependent on overall market conditions than on the chief executive’s strategy? Is it right to build so much leverage into the performance-related element of pay when the creation of sustainable performance cannot be reduced to a few financial metrics as a pay trigger? And do pay structures for senior executives have to be so complex in order to give the right balance between short- and long-term objectives?

    These are not easy questions, but they are the ones remuneration committees grapple with. If more shareholder engagement can lead to better understanding and simpler pay structures then the extra burdens on both boards and investors imposed by binding votes will be well justified.

    We may not yet have succumbed to a Great Depression but depression, in one form or another, is all around us. And we are witnessing the rise of political extremism, a nationalist backlash against a country’s obligations towards its – typically foreign – creditors. Ghosts from the 1930s have come back to haunt us.

    Recovery has either been remarkably muted or, in many parts of Europe, totally non-existent. For some eurozone nations, economic freefall threatens. Politicians and economists squabble over what needs to be done next, as noted by Jeffrey Sachs on the FT A-List (“We must move beyond growth versus austerity”, May 7, 2012).

    The emergence of Nikos Michaloliakos and his Golden Dawn party – its emblem a thinly disguised swastika – in Sunday’s Greek elections together with the bumper vote for Marine Le Pen in the first round of the French presidential elections two weeks earlier only serve to highlight the growing disillusionment of voters with mainstream political parties seemingly able to offer neither jam today nor jam tomorrow. For those on the outer fringes of the political spectrum, this is fertile ground – as it proved to be in the 1930s.

    The problem can be simply stated. With levels of national income now a lot lower than expected just five years ago, the willingness and ability of debtors to repay their foreign creditors has been seriously reduced. The new slogan for debtors is in danger of becoming “can’t pay, won’t pay”.

    To date, the response of creditors has been to demand continued austerity from the debtors: higher taxes, cutbacks in public spending and regular doses of the economic equivalent of cod liver oil, all to be washed down with cheap loans from the International Monetary Fund, the European Central Bank and other generous benefactors. In return, there is a vague promise of a return to growth at some unspecified point in the future.

    The creditors insist the debtors have only themselves to blame for the lack of growth. In the years preceding the financial crisis, southern European countries allowed their wages to rise far too quickly, thereby undermining competitiveness.

    For creditors, it’s an attractive explanation because it lets them off the hook. Yet it’s an explanation full of holes. If competitiveness in southern Europe was so bad, why did northern European creditors lend to southern European nations with such reckless abandon in the first place? If the problem is only one of competitiveness, why have “well-behaved” northern European nations also ended up back in recession? The Dutch economy is shrinking again as is the UK despite – in the latter’s case – the supposed benefits of regular bouts of quantitative easing and, in the initial stages of the financial crisis, a huge decline in sterling. And if the story is only about competitiveness, why has the allegedly competitive US economy struggled to regain its pre-crisis poise?

    Creditors typically absolve themselves from blame until it’s too late. And they demand adjustment from debtors even when the debtors no longer have the political capacity to do so. Yet, as the interwar period demonstrates, problems for debtors inevitably become problems for creditors too.

    In 1931, Austria was attempting to deliver the kind of austerity now being witnessed in parts of southern Europe. Under the Gold Standard, the only option to regain competitiveness was to force domestic prices and wages lower. In the process, businesses failed, non-performing loans rose and the banking system began to look incredibly vulnerable. The crisis culminated in the failure of Creditanstalt, a major Viennese bank – the 1931 equivalent of Lehman Brothers. What had up until then been only a Great Recession turned into the Great Depression. A handful of years later, Hitler was welcomed by cheering crowds in Vienna.

    For debtor nations, keen to escape from the clutches of their creditors, resurgent nationalism led to waves of default and, in time, to the politics of hate. For creditor nations – the US and France were the key players at the time – it was a rude awakening. Their own economies suffered more than most, a reflection of their adherence to economic orthodoxy – notably their continuing devotion to the Gold Standard – in the wake of an extraordinary economic and financial upheaval.

    François Hollande has been elected president of France on a pro-growth platform. This may be no more than wishful thinking unless there is voluntary adjustment from both creditor and debtor nations. To achieve this – and to allow the euro to survive – there needs to be more, not less, Europe. The single currency will need to be buttressed by some kind of federal fiscal policy, including the issuance of common bonds. Lower wages in the periphery will need to be offset by higher wages in the core, prompting German capital to head south and Spanish and Greek workers to head north. And creditors must stop thinking about a world of only saints and sinners. Creditors and debtors are two sides of the same coin. Berlin should take note.

    None of this will be easy. Perhaps the success of the far Right will spur mainstream politicians into action. The irony, though, is obvious. A successful resolution of the eurozone crisis needs “more Europe” but growing numbers of voters are beginning to demand less of it. The ghosts have returned.

    No one can pretend to know whether Spain is illiquid or insolvent without gauging the size of the black hole that is the country’s banking sector. The Spanish government is finally starting to do this: Bankia and other banks are reportedly set to receive a capital injection from Madrid. With the Spanish economy contracting sharply and with unemployment soaring, it was inevitable that the government had to bail out the banks. But this only deals with one piece of the puzzle. Without growth, the Spanish sovereign will need a bailout as well.

    Spain’s credit boom peaked in 2008 when the supply of cheap, external finance began to fall sharply. Four years later, Spanish banks’ asset quality continues to plummet. The sector will require €100-250bn in recapitalisation later this year to maintain a 9 per cent core tier one capital ratio, the minimum stipulated by the European Banking Authority. In the meantime, there are concerns about the capacity and appetite of Spanish banks to support the sovereign, particularly amid rating downgrades and deposit withdrawals.

    Ideally, a bailout for Spanish banks should come immediately and in the form of direct capital injections from the EU bailout funds. Germany remains staunchly opposed to this, as it would mean giving up the stick of conditionality and feeding Spain the funding carrot. Such an option is also resisted by the Spanish authorities as the EU taxpayer will effectively take over their banks.

    Instead it looks like a bailout for Spanish banks has been postponed until the very last minute. The cost of a bank bailout would then be foisted on to the Spanish sovereign’s balance sheet.

    Bank bailouts on this scale may well bring the Spanish state to its knees. If they don’t, Spain’s public and external debt positions will.

    In order to stabilise its public debt levels after a bank recapitalisation, Spain would have to generate a swing in its public finances that is not only unrealistic, but also self-defeating. The tax hikes and spending cuts required would make the recession deeper and cause the primary balance to deteriorate.

    In order to put itself on a path towards external debt sustainability, Spain would need to see a huge adjustment in its trade balance. In the short-run, a fall in domestic demand could quickly improve the trade balance. However, in the medium-term, Spain can only service its foreign debt if it finds balanced and sustainable growth, which requires a real-terms depreciation that will not occur unless the value of the euro falls sharply.

    Anyone who has closely followed developments in the eurozone will be struck by déjà vu looking at Spain’s current predicament. The corrosiveness of banking sector uncertainty for investor confidence in Spain is reminiscent of Ireland in 2009 and 2010. Spain’s austerity-recession feedback loop is similar to the process that fed the economic contraction in Greece and Portugal.

    And yet despite the clear signs of failure in the existing bailout countries, the EU looks set to pursue an unchanged plan in Spain. But the crucial difference between Spain and the bailout countries is size. If things go wrong in Greece, Portugal and Ireland, a second bailout is affordable. But there can only be one roll of the dice for a country as large as Spain.

    A bailout package would buy some time for Spain, but time will only help if it is used to generate economic growth. By making private claims on the sovereign junior to the claims of the troika (European Commission, European Central Bank and International Monetary Fund) even a bailout risks reducing the chances of it regaining market access. Moreover, with economic indicators showing Spain sinking further into recession, a turnround in the country’s economic performance would require a significant shift in policy: monetary easing by the ECB, a weaker euro, fiscal stimulus in the core, less front-loaded austerity in the periphery, more international firewalls and debt mutualisation.

    The only way for there to be a happy ending in Spain is if action is taken swiftly in Brussels, Frankfurt and other European capitals. But that is not likely to happen. The eurozone periphery and Spanish crisis look like a slow motion train wreck.

    The writer is chairman of Roubini Global Economics and a professor at the Stern School of Business, New York University. He co-authored this piece with Megan Greene, director of European economics, Roubini Global Economics.

    Neither the pomp and ceremony of the Queen’s Speech nor its accompanying bills can hide the fact the UK requires urgent action to restart economic growth.

    So too does Europe as a whole.  A European recovery would help the UK greatly. But Europe will take time to agree a strategy: the UK can and must get on with it. There is a clear way forward – kick-start investment now through strong, clear and credible measures that reduce so-called ‘policy risk’ and mobilise private savings and liquidity.

    Tax cuts to generate consumption-led growth will not be fiscally credible. Structural reform of the UK economy to increase productivity is essential, but takes time. The recovery must be investment-led and place only modest demands on the public finances. But without the recovery any attempt to achieve fiscal balance, however defined, any time soon will be unacceptably destructive, both economically and politically, a lesson which the last few weeks and days in the UK and Europe have surely demonstrated dramatically.

    Investment has slumped mainly because households, businesses and banks are nervous about future demand, and have responded by forgoing more risky investment in physical capital. Instead, companies and households are squirrelling away private saving into ‘risk-free’ assets such as solvent sovereign bonds. As a result, annual private sector surpluses over the past few years have been at record levels, and amounted to £99bn last year, equivalent to 6 per cent of UK gross domestic product. When everyone cuts spending simultaneously, fear of recession becomes self-fulfilling.

    Desired saving has exceeded desired investment in many advanced economies to such a degree that real ‘risk-free’ interest rates for the next 20 years have been pushed to zero and below. Savings are losing value by the day as pension funds and financial institutions pay real interest to (rather than receive interest from) governments; a truly perverse state of affairs given the need for productive investment. These low rates do not reflect a collapse in the underlying returns to capital, but instead reflect desperately depleted confidence.

    With short-term interest rates close to zero, the effectiveness of monetary policy to stimulate growth is reaching its limits. Fiscal policy is tightly constrained. What is needed to restore confidence is a strategic vision, the rationale for which businesses clearly understand, with supporting policies to guide investors.

    In the past, we have seen Roosevelt’s New Deal or rearmament. In this case, recognising the inevitable transition to a low-carbon economy, and helping drive forward investment in resource-efficient, innovative sectors, could restore growth and leave a lasting legacy. As well as bringing energy security, tackling climate change, and saving consumers and businesses costs in the long run, these sectors offer long-term returns for investors.

    Standard macroeconomics tells us that the best time to promote investment is during a protracted economic slowdown. Resource costs are low and the potential to crowd out alternative investment and employment is small. In addition, while public budgets are stretched, there is no shortage either of private capital available for investment, or of investment opportunities with potential profitable returns. There is, however, a shortage of perceived opportunities. The longer that recovery is delayed, the more skills will be lost and potentially valuable capital is scrapped.

    This is about more than correcting market failures, such as those associated with greenhouse gas emissions; it is about restoring confidence through creating new markets which spur innovation. Policies to encourage low-carbon investment would provide new business opportunities, would generate income for investors, and would have credibility in the long term both because they address growing global resource challenges, while tapping into a fast-growing global market for resource-efficient activities, and there is a recognition that actions cannot be delayed indefinitely.

    The most recent figures published by the Department for Business, Innovation and Skills show that the UK low-carbon and environmental goods and services sector had sales of £116.8bn in 2009-10, growing 4.3 per cent from the previous year and placing us sixth in the global league table for such sales.

    But the private sector is not investing as heavily as it could in green innovation and infrastructure because of a lack of confidence in future returns in this policy-driven sector. Only the government can reduce this policy risk. Thus, by backing its own low-carbon policies, the Government can stimulate additional net private sector investment, and make a significant contribution to economic growth and employment.

    The government can do this, for instance, by introducing in the next Parliamentary session a bill to reform the electricity market, and by allowing the Green Investment Bank to operate as a lending institution, offering loans to private companies so that it shares some of the risk of private investments in green infrastructure. The UK should also work with other member countries to increase the European Union’s target for emissions reductions for 2020 to 30 per cent from 20 per cent, providing a boost for the carbon price within the Emissions Trading System. And it should support additional investment from the European Investment Bank, and encourage the development of a European supergrid.

    But the prime minister and his cabinet colleagues also need to be strong advocates for the green economy. If they convey the false impression that we have to make a choice between environmental responsibility and economic growth, they will undermine the confidence of private sector investors in the direction and consistency of future policy.

    Nicholas Stern (an independent cross-bench peer) and his co-author Dimitri Zenghelis are respectively chair and senior visiting fellow at the Grantham Research Institute on Climate Change and the Environment at London School of Economics and Political Science. A recent lecture on green investment by Mr Zenghelis, who is also a senior advisor to Cisco, can be read  here.

    Ian Bremmer, president of Eurasia Group, talks to Alec Russell, the FT’s comment and analysis editor, on why US investors are less perturbed about the eurozone crisis than last year, and on the perils of an increasingly isolationist America

    On the face of it, this is good news for the little man. The most closely watched initial public offering in years – that of social media group Facebook – will reportedly include a dollop of shares earmarked for small investors.

    Here is my advice: do not buy any. Facebook is an extraordinary company and its shares could easily march upward but its IPO is a timely reminder that amateurs should not be picking stocks (or even money managers such as mutual funds).

    The temptation to plunge into Facebook is understandable. It is a familiar and sexy company with soaring revenues and a stranglehold on its market. Google, the last supersized Silicon Valley darling to go public, has worked out well: its shares have increased more than sevenfold since their launch in 2004.

    But for every Google or Facebook, several more lie in the dustbin of Wall Street history. One-time go-go stocks such as, Webvan and eToys are all just painful memories for those who took the plunge.

    Indeed, when an early social media company,, went public in 1998, its shares enjoyed the largest first-day gain in history up to that point, before collapsing the next year. (It ceased operations in 2008.)

    Poor investor returns have not been limited to Silicon Valley progeny. Notwithstanding their more durable business models, private equity firms have failed to reward buyers of their IPOs. Shares of Blackstone Group, which went public in 2007 at $31 per share, enjoyed a brief run-up, plummeted during the financial crisis and are now parked at about $13. Fortress, Och-Ziff and others have performed similarly.

    The fascination of individuals with trying to manage their own money is peculiar. No sentient person would perform their own appendectomy or write their own will.

    Yet millions blithely buy hot new offerings, hand over savings to underperforming mutual funds, trust inexpert stockbrokers in search of commissions, try to time market movements by shifting money in and out of shares and even day trade, more often than not with poor results.

    The temptation to speculate – and that is what it is when practised by amateurs – has been fuelled by the profusion of magazines, books and television shows offering ideas of what to buy, but rarely when to sell.

    Remember that in the US, peddlers of investment products are generally not subject to what is known as the “fiduciary standard of care”, meaning that, unlike doctors and lawyers, they are glorified salesmen, not professionals obligated to recommend only what is in the best interests of their clients.

    Just last month, the research firm Dalbar published a study that found that the average American equity fund investor achieved returns over the past 20 years that were less than half of the overall market gains (3.5 per cent versus 7.8 per cent).

    Some of that underperformance results from the propensity of individuals to market time. That is an approach that has worked poorly, particularly in the wake of sharp market declines. In early 2009, individuals moved massive amounts out of equities, just as the stock market was hitting bottom.

    Of course, the law of averages dictates that for every underperforming mutual fund or individual, another investor must be doing well. Many are, but they are principally hedge funds and institutional firms that cannot be accessed by the average investor.

    With small investors frustrated with their mutual funds and perhaps even with following famous money managers such as Warren Buffett, it is easy to understand the temptation to do it yourself, particularly with the increasing role of self-directed retirement plans. But that is one temptation that should be resisted.

    Instead, put your money in low-cost index funds and leave it there. For those furthest from retirement, emphasising equities offers the best bet; over any reasonably long period, history and finance theory teach us that they will almost certainly outperform bonds and cash.

    Once the golden years draw closer, moving money into less volatile fixed income and money market funds will provide certainty.

    As for Facebook, buy it as you would any collectable – for the joy of owning it or for an ornate stock certificate to put on your wall – but do not buy it because you are counting on it to fund your retirement.

    The writer is an American financier and a former head of the US government taskforce that oversaw the federal bailout of Chrysler and General Motors


    Poor Ben Bernanke! He has gone further than any other central banker in recent times to try to stimulate the economy through monetary policy. He has cut interest rates to the bone. He has adopted innovative new methods of monetary easing such as quantitative easing. Again and again he has repeated that while inflation is contained, his main concern is the high level of unemployment in the United States. And yet he is chastised by progressive economists for not doing enough.

    What could they possibly want? Raise inflation, they say, and all will be well.  Of course, this would be a radical departure for the Fed, which has worked hard to convince the public that it will keep inflation around 2 per cent. The inflation credibility it has acquired over the years has allowed it to be aggressive – it is hard to imagine the Fed could have expanded its balance sheet to the extent it has if the public thought it could not be trusted on inflation. So why do these economists want the Fed to sacrifice its hard-won gains?

    The answer lies in their view of the root cause for continued high unemployment – excessively high real interest rates. Their logic is simple. Pre-crisis, demand in the US was buoyed by the spenders, who borrowed heavily against their rising house prices. Post crisis, these households are heavily indebted and cannot borrow and spend any more.  An important source of aggregate demand has evaporated. As the spenders stopped buying, real interest rates (which equal nominal interest rates less inflation) should have fallen to encourage thrifty households to spend. But real interest rates did not fall enough because nominal interest rates cannot go below zero. By increasing inflation, the Fed will make real interest rates seriously negative and coerce thrifty households into spending instead of saving. With rising demand, firms will hire and all will be well.

    The logic seems persuasive but it has some serious weaknesses. First, while low rates may increase spending if credit were easy, it is not at all clear that lower rates today will encourage traditional savers to go out and spend. Think of the soon-to-retire office worker.  She saved because she wanted enough to retire on. Given the terrible returns since 2007, the prospect of continuing low interest rates may make her put even more money aside to give her enough to retire on. Moreover, it could also push her (or her pension fund) to reach for yield by taking more risk with her money, buying long maturity risky bonds. Given these bonds are already aggressively priced, such a move may set her up for a fall when interest rates eventually rise. We may well be in the process of adding a pension crisis to the unemployment problem.

    Second, household over-indebtedness in the US, as well as the fall in demand, is localised, as my colleague Amir Sufi and his co-author, Atif Mian, have shown.  Hairdressers in Las Vegas lost their jobs, in part, because households there have too much debt stemming from the housing boom and in part because many local construction workers and real estate brokers were laid off. But even if we can coerce traditional debt-free savers to spend, it is unlikely enough of them are in Sin City. Instead, many of them may be in New York City, which did not experience as much of a boom and a bust. So even if cutting real interest rates further encourages spending on haircuts, it will do so in New York City, which already has plenty of demand, but not in Las Vegas, which has too little. Put differently, real interest rates are too blunt a tool, even if they work.

    Third, we have very little idea of how the public forms its expectations about the central bank’s future actions. If the Fed announces that it will tolerate 4 per cent inflation, could the public think the Fed is bluffing? Or will it think that if an implicit inflation target can be broken once, it can be broken again? Will expectations reform at a much higher rate? How will the added inflation risk premium affect long term interest rates? What kind of recession will we have to endure to bring inflation back to comfortable levels? We really don’t know very much about what could happen. Given the dubious benefits of still lower real interest rates, we should not give up central bank credibility in a hurry.

    Finally, it is not even clear that the zero lower bound is primarily responsible for the high unemployment. Traditional Keynesian frictions like the difficulty of reducing wages and benefits in some industries, as well as non-traditional frictions such as the difficulty of moving when one cannot sell (or buy) a house, may all share the blame.

    We cannot ignore high unemployment. Clearly, easing the ability of indebted households to refinance at the low current interest rates could help lower their debt burden, as would writing off some of the debt of those that are deeply underwater. More could be done here. The good news is that household debt is coming down through a combination of repayments and write-offs. But it is also important to recognise that the path to a sustainable recovery does not lie in restoring irresponsible unaffordable pre-crisis spending, which had the collateral effect of creating unsustainable jobs in construction and finance. With a savings rate of barely 4 per cent of GDP, the US household is unlikely to be over-saving. Sensible policy lies in improving the capabilities of the workforce across the country so that they can get sustainable jobs with steady incomes. That takes time, but it may be the best option left.

    The writer is a professor at Chicago’s Booth School of Business

    Response by Michael Konczal

    In 1926, John Maynard Keynes attacked socialist ideas for being “little better than a dusty survival of a plan to meet the problems of fifty years ago, based on a misunderstanding of what someone [Karl Marx] said a hundred years ago.” Right now the monetary policy debate in the US is centered on answering the problems of 30 years ago – when inflation and unemployment were both at high levels – based on a misunderstanding of what someone said 50 years ago: Milton Friedman.

    The problem at the core of the US economy is that interest rates have been too high since the recession started. However, the Fed is not in a straightjacket. It has the tools to get the economy going again and must put them to use. The absence of pressure on the Fed, which has received only one dissenting vote demanding more stimulus but several to tighten earlier, to do more to reduce unemployment speaks to an intellectual paralysis as challenging as the orthodoxy of the gold standard and balanced budgets in the Great Depression.

    The Fed uses monetary policy to balance unemployment and inflation. It has typically done this with an inflation “target”. But the target metaphor is inaccurate; it functions far more like a “ceiling.” People aim for targets but can go over them. Yet what we’ve seen over the last five years is that rather than a balance between its two goals, the Federal Reserve supports the economy up until the point where it is near the inflation target, and thereafter backs down from monetary stimulus. The market understands this and output remains equivalently depressed.

    The Fed is fighting the last war: against 1970s stagflation. It is of course essential that the Fed maintains its hard-won credibility against runaway inflation. But the best way to do so isn’t to keep the economy in a perpetual state of high unemployment. It is to be explicit in what it wants to see accomplished and what it is willing to tolerate in order to get it. As Charles Evans, President of the Chicago Federal Reserve, recently pointed out, the Fed could “make a simple conditional statement of policy accommodation relative to our dual mandate responsibilities.” An “Evans Rule” would mean the Fed would agree to keep interest rates at zero and tolerate 3 per cent average inflation until unemployment went down to 7 per cent, setting market expectations in such a way that would allow aggregate demand to surge.

    If conventional monetary policy was available – if interest rates were at 1 per cent instead of zero per cent – Mr Rajan’s argument suggests he wouldn’t lower interest rates further. Even though inflation has been lower than the target for several years, and unemployment is significantly higher than it should be, his editorial suggests he believes interest rates are already too low. Lower rates will not help the unemployed, since unemployment is localised. As he puts it, people are out of work in Las Vegas, but lower interest rates will increase demand in New York. So we won’t see increased employment, just savers “coerced” into buying risky bonds.

    Contrary to Mr Rajan’s argument, the crisis is a national one. The median state’s unemployment rate is 1.65 times higher than it was before the recession began. New York has an unemployment rate of 8.5 per cent, up from its pre-recession rate of 4.7 per cent. Meanwhile, as Edward Luce wrote in the Financial Times yesterday, “risk capital is far harder to come by”. If lower rates would, as Mr Rajan says, increase demand for riskier assets, that’s exactly what the economy needs.

    This would help with our current dilemma, but the Fed must also change its future approach to monetary policy. It has failed to balance inflation and growth, especially in periods of low inflation. Our low inflation target doesn’t work precisely at the moment when we most need it. Changing the target to inflation and growth added together, or what economists call NGDP (nominal gross domestic product), would better balance these goals. Alternatively, moving to a higher inflation target, say 4 per cent a year, would give the Fed much more room to fight recessions. Four per cent was the average annual rate during much of the past 30 years. The costs of a higher target would be minimal. Given that the cost of the current recession is in the trillions of dollars, this demands serious reconsideration.

    It seems like a radical statement to some to note that the Fed has the ability to bring us closer to full employment with little risk and is simply choosing not to do it. They believe the Fed is full of disinterested technocrats doing the best they can. No doubt those at the Fed believe they are trying hard, but if the situation was reversed, with unemployment at ultra-low rates and inflation well above what anybody could possibly want, they would be working overtime to try and fix the problem. Chairman Bernanke, when he was a scholar of Japan, understood that a central bank could end up in a situation of “self-induced paralysis,” like where our current Federal Reserve is. And Milton Friedman himself, who people arguing against looser monetary policy would like to invoke, also understood that the Bank of Japan had “no limit” on closing output gaps if “it wishes to do so.”

    Commentators would like to argue that monetary policy rewards some people over others, forgetting that mass unemployment is the most regressive policy imaginable. But beyond that, monetary policy is not a morality play, and it’s not about rewarding the good people and punishing the bad ones. It’s about stabilising growth, prices and maximum employment without overheating the system or letting it choke to death from a lack of oxygen. Now, more than ever, a commitment to both goals is necessary for the good of our economy.

    The writer is a fellow with the Roosevelt Institute

    French and Greek voters have rejected Europe’s current macroeconomic framework.  The headlines cry that voters demand growth rather than austerity.  Yet growth is not a policy but an outcome. A vote rejecting the incumbents does not define the policy alternatives.

    There are four main schools of macroeconomic thought.  Keynesians focus on boosting aggregate demand through temporary budget deficits followed by a gradual return to budget balance as the economy returns to full employment.  Free-marketers (confusingly called “liberals” in Europe and “conservatives” in the US) advocate business deregulation plus cuts in government spending and taxes to spur private sector hiring and investment.  Deficit hawks emphasise budget cuts to eliminate the deficit and restore the government’s creditworthiness. Structuralists call for increased public spending paid for with tax increases rather than deficits, to increase the role of government in education, jobs and banking recapitalisation.

    To put some names to these categories, Paul Krugman and Ed Miliband are Keynesians.  Martin Feldstein and Mitt Romney are US free-marketers, joined by various Thatcherites and Hayekians on the continent. Deficit hawks include George Osborne, Angela Merkel, and Mario Draghi. I count myself among the structuralists and perhaps Francois Hollande will turn out to be as well. President Barack Obama has dallied with three of the four schools, all but the free-marketers, at different times calling for budget stimulus, deficit cutting and public investments.

    The Keynesians are mistaken, I believe, on four counts. First, aggregate demand in practice is not a stable function of budget deficits as in the textbooks. Temporary tax cuts and increased transfer payments to individuals and local governments are often saved rather than spent; deficits undermine financial-market confidence. For both reasons, multipliers are erratic and can be close to zero.

    Second, Europe’s double-dip recession has less to do with aggregate demand than with its zombie banks, a credit squeeze and the still-poorly defined role of the European Central Bank.  Europe’s banks continue to deleverage, making the survival of Europe’s small-and-medium enterprises very difficult. Europe needs a bolder recapitalisation of its banking sector, but this requires more public financing and has been rejected by the budget wary politicians.

    Third, the disappearance of manufacturing jobs also results from inadequate skills of much of today’s young people making them uncompetitive with low-wage Asia. The US and much of Europe (especially southern Europe) need a scaled-up programme of public investments in pre-school; education; job training; and active labour market policies.  This is the essence of northern Europe’s path: train young people well so that they can compete internationally.

    Fourth, the rising burden of public debt as a share of national income matters more than Keynesians acknowledge. Debt servicing is mounting and thereby squeezes out other vital spending by government. Capital markets know this as well and foresee the fiscal train wreck ahead following a “temporary” stimulus.

    The free-marketers and deficit hawks also turn their back on our increasingly unequal societies. Children in poor households in the US and Europe can’t make it without public support. In the US, social mobility has collapsed: affluent households get their kids through college; working class and poor households do not. The budget and tax cutters also deny the vital role of public spending on science, technology and competitiveness.

    Macroeconomic debates are mostly ideological rather than empirical. This is a shame.  The diverse experiences across the OECD economies can clarify a lot about the various schools of thought. Of all the high-income countries, it is the northern European countries, including social democratic Scandinavia and the Netherlands, and social-market Germany, that have the most favourable combination of low budget deficits, high employment and global competitiveness. Of course the specific challenges and current conditions differ by country and so too will the best packages.

    Northern Europe, including Germany itself, rejects the swingeing budget cuts that Chancellor Merkel has advocated for the rest of Europe. The northern European countries balance their budgets through high taxation, not low government spending.  They use ample public outlays to ensure universal access to education, job training, and modern infrastructure.  They insist on environmental standards, not environmental deregulation.

    Ironically, Germany lives according to the norms of the social market but has preached rampant budget cutting instead.  One reason is this: German politicians have refused to acknowledge the role of the unregulated German banks in creating Europe’s boom and bust.  If they acknowledged the role of the German banks in this mess, the politicians would be under more pressure to recapitalize the banks.

    Northern Europe shows that social democratic (or social market) structuralism – an active government that is socially oriented, environmentally friendly and skill promoting – works best. Scandinavia was also exemplary a generation ago when it decisively cleaned up its bank sector after an ill-fated cycle of liberalisation, boom and bust. Today’s tired debates between Keynesians and free-marketers greatly oversimplify the real options, especially now that banking reform, job training and inequality are the key issues.  Perhaps Mr Hollande will facilitate a new growth orientation based on structural changes rather than a doomed flirtation with fiscal profligacy.

    Friday’s US jobs data sound a warning that should be heard well beyond economists and market watchers.

    With just 115,000 new jobs in April, the US economy is not creating enough employment opportunities to make a dent in the 12.5m jobless Americans in the labour force, of which a stunning 5.1m are long-term unemployed. Moreover, the disappointing monthly number managed to fall short of analysts’ massively subdued consensus expectation of 160,000, highlighting yet again the unusual sluggishness of the labour market.

    Americans that do have jobs are experiencing no wage growth. Measures for both April hourly earnings and hours worked came in flat, confirming that purchasing power for most workers is failing to keep up with inflation. This is consistent with earlier data on the personal savings rate, which has fallen to levels that suggest a quickly eroding precautionary cash cushion for too many Americans.

    And then there is the labor participation rate which measures the number of adults in the labor force. This declined yet again and, at 63.6 per cent, is at a level last seen in 1981. In addition to highlighting the secular headwinds to income and wealth generation, this makes a mockery of the published unemployment rate of 8.1 per cent —  a number that would be over 10 per cent if discouraged Americans had not dropped out of the labour force in their millions over the last few years.

    The economic implications are clear. On current trends, consumption (by far the largest component of gross domestic product) is in no position to be a sufficiently dynamic engine of growth  – and this at a time of considerable headwinds emanating from a recession-hit Europe. Moreover, the balance of risks is tilted to the downside given a potential year-end “fiscal cliff” that, absent proper political reactions, would suck out some 4 per cent of GDP in purchasing power, and do so in a disorderly fashion.

    Friday’s disappointing jobs report will also worsen Washington’s highly polarised politics. Already, initial reaction from there suggest that, rather than act as a catalyst to bring the political class together to address a persistent national problem, the numbers are fueling conflicting political narratives and greater polarisation – thereby reducing further the probability of any timely convergence towards the type of common analysis and common vision that are needed.

    With virtually all government entities essentially paralysed by political gridlock, the Federal Reserve will soon confront yet another lose-lose policy dilemma. Does it renew its unconventional activism using inevitably blunt tools that involve a growing set of collateral damage and intended consequences; or does it stick to the sidelines and watch the economy weaken further in the summer?

    And then there are the social consequences. Friday’s numbers speak to the growing stress on America’s already-stretched safety nets, as well as its growing income inequality. It also points to the possibility (though, fortunately, not yet a probability) of a lost generation. With teenage joblessness stuck at 25 per cent, too many young people face the risk of going from being unemployed to becoming unemployable.

    To many, this analysis will seem overly downbeat. It is not. It is a reflection of a multi-faceted unemployment crisis that politicians, both in America and Europe, are failing to comprehend, unite around, and respond to.

    Let us hope that this latest set of data becomes a call for action. If not, I worry greatly that facts on the ground will unfortunately warrant future analyses to be even more disheartening.

    Here’s how to start an argument in Britain. Suggest that far from being inherently flawed, the euro is fixable and could succeed in the long run. Suggest Britain should even consider joining it at some point. This last idea is a proposition with which the majority of British people disagree, strongly. I know this because the think-tank Policy Network has today published new polling that tells you that eight in 10 British people believe Britain should never join the euro, in any circumstances, even if it costs Britain influence in Europe. I am going respectfully to disagree. Why?

    The results of the Policy Network polling suggest that over half of the British people support membership of the European Union, only as it is now or as a looser free trade area. A third would simply leave. With the exception of leaving the EU, none of these choices are actually available to Britain. The EU, or a large part of it, is about to enter a phase of further evolution, based on closer integration, because the survival of the eurozone depends on it. Britain’s choice is how it responds to this change, not a fantasy version of British policy in which we define the Europe we want and the terms of our membership.

    Against a backdrop of crisis, we are busy patting ourselves on the back for not joining the European single currency in the 1990s. Plenty of investors are betting on the total failure of the eurozone under the pressure of the sovereign debt crisis, and they may well be right. But the political will to preserve the currency bloc is intensely strong incontinental Europe. Indeed the current crisis may well provoke the institutional and political innovation that was lacking in the eurozone’s design a decade ago.

    So whatever our current scepticism, it is worth contemplating what a revived and salvaged Eurozone might mean for Britain. Saving the single currency is about to push the 17 states of the eurozone into attempting an ambitious new level of political integration. The UK government itself argues that the eurozone’s future now depends on it following what UK Chancellor George Osborne calls “the remorseless logic” of fiscal and political integration.

    The eurozone, to survive, has no alternative but to try to follow that logic. Most other EU states, for reasons that are a mix of conviction and strategic calculus, are likely to follow. The obstacles to this process are legion, but that does not mean it is bound to fail. Nor is it inconceivable that Britain could find itself a decade from now the only state – or at least the only large state – in the EU but outside the Eurozone as a matter of policy. The single currency and the currency zone will be the defining criteria of ‘core’ Europe. Britain would be a European annex. The EU will have been rebooted, with the UK on the outside.

    British public opinion, at the moment, seems sanguine about this. It is true that at first it may not matter too much. Cooperation on defence, foreign and energy policy will have their own centres of gravity that will not at first be anchored in the eurozone. But, as the core group increasingly caucuses on questions of economic governance without us, it will matter. As Norway does now, we will have free trade with these states, but not on terms we have had much of a hand in writing.

    For British business and the City there will be a short and long-term price attached to being outside the single currency, intransaction costs, exchange rate volatility, liquidity and influence over single market rule-making. You sometimes hear people confidently describe a future Britain as Hong Kong to Europe’s China. It is worth remembering that Hong Kong’s two centuries of strength and influence were a function of China’s weakness and insularity. For all its problems, Europe hardly fits that picture.

    For 30  years, the UK’s European policy has been based on the principle of supporting the widening of the EU as a check on its deepening. We can see now that the creation of EMU in the 1990s meant that this policy was living on borrowed time. Europe may be about to start a new political journey without us. That journey may stall. It may be abandoned. There must be a good chance of both. But it may not. In our relief at avoiding the current euro debacle, we nevertheless need to recognise that ruling out ever joining a repaired single currency as a matter of principle is likely to be the same as choosing a peripheral role in the development of a European political union. We should not do this lightly.

    Why not? Because I believe that the facts of life for Britain in a globalised economy are European. I believe it is not just our biggest market, but also our intellectual and political hinterland. It is our only prospect of sustained global influence in a world of continental-sized powers. The majority of British people who cannot imagine a future for Britain outside the EU need to think and debate about what this may mean. If the eurozone survives as part of a re-shaped, more integrated Europe, I believe that none of the political parties, by themselves, will be able to re-establish a national consensus and that we will need a referendum to do so instead. This will not come soon but the stakes are high. Let’s get ready for the national debate.

    Amid the eurozone cacophony, the growth rhetoric sounds nicer than the austerity refrain.

    But the challenge is to translate rhetoric into facts, especially in countries where market conditions provide no room for deficit spending. Structural reforms are a well-known recipe. While necessary, they take time to produce their effects on growth and employment. So they might not be sufficient to pull the eurozone economy out of stagnation over the next couple of years and to restore market confidence.

    The debate needs to take place at a broader level. The foreign exchange market has not worked properly over the past few years and it is increasingly creating obstacles for the European recovery.

    The eurozone economy is projected to be in recession this year and to barely stabilise in 2013. The US and Japan have now been growing again for some time, although modestly, and emerging markets are experiencing a soft landing from the crash. This should provide grounds for a depreciation of the euro against other major currencies. The private capital outflows from the eurozone periphery also seem to be pointing in the same direction. A gradual depreciation of the euro would be justified by the loss of competitiveness accumulated by several member countries and the need to reduce the pain associated with the current account adjustment.

    Yet such a depreciation is not happening. The reason is that several foreign official institutions, notably the central banks of emerging markets such as China, are continuing to intervene in the foreign exchange market to buy euro-denominated assets at a pace which more than compensates the sales of private market participants.

    These interventions are producing two types of distortions. First, they do not allow the external value of the Euro to adjust to underlying fundamentals and thus contribute to a further worsening of economic conditions in the euro area. Second, by investing mainly in low yielding euro assets, the interventions contribute to widen the spreads among eurozone Government bonds and thus fuel financial instability.

    These issues can only be addressed directly with the major counterparties, notably China and other Emerging markets, and also other advanced European economies which are pegging to the euro. At times of crises like the one we are currently experiencing, there is a need for stronger cooperation among major economies to avoid beggar-thy-neighbour policies and competitive devaluations.

    The eurozone needs to equip itself for such enhanced international cooperation. Unlike  the US and Japan, for example, the competence for the external value of the euro is shared between the European Central Bank and the eurogroup, which comprises eurozone finance ministers. The former is responsible for deciding and implementing foreign exchange interventions, the latter for defining the guidelines of the exchange rate policy of the euro.

    Given that the main objective is to convince some of Europe’s partners to change their foreign exchange policies and promote a better functioning of the international financial system, a stronger political stance by European authorities is required. The eurogroup needs to take leadership in in the various international forums where such issues are discussed, bilaterally, trilaterally or in the G7, G20 or the International Monetary Fund. This requires a more efficient functioning of the Eurogroup, in line with the provisions of the Lisbon Treaty.

    The problem is that the Eurogroup is currently without leadership, following the resignation of Luxemburg’s Prime and Finance Minister Jean Claude Juncker. Such a vacuum cannot last long. A new President needs be appointed rapidly, with a clear mandate. The selection process should take into account the candidates’ ability to stand up to the other major global powerhouses and defend the interests of the euro area, including by promoting a better functioning of the international financial system.

    For the euro to seriously get back on a growth path, it needs to get its interest better represented in the global scene. This requires stronger political institutions, whether comprising finance ministers or Heads of Government, and beginning with the eurogroup. The good news is that it doesn’t require any institutional change. The bad news is that it requires political leadership.

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

    “Our banks earn profit too easily—because a small number of large banks have a monopoly position”

    – Wen Jiabao

    When China’s premier said this recently it was taken as a signal that financial reform is finally on the agenda. But his comments are misleading. The big four state commercial banks now command less than 50 per cent of banking assets compared with 75 per cent 20 years ago. The inevitable defaults from the 2008 stimulus program will eventually force the system to take a major write-off. These banks neither enjoy a monopoly position nor earn excessive profits.

    More importantly, Mr Wen’s comments are not really about weaknesses in the financial system but about how China’s economic system secures and channels resources to serve the state. And the state appears increasingly out of sync with what is needed to serve the private sector.

    Many critics blame “financial repression”—keeping interest rates paid to savers below the rate of inflation, therefore discouraging consumption; encouraging investment; and distorting growth.

    But the focus on negative real interest rates is misplaced. Negative real interest rates are not unusual. What makes China’s form of financial repression unique is the limited investment alternatives for household savings, a situation reinforced by capital controls. This makes it easier for the state to capture resources for its own spending purposes.

    Financial repression has been exceptionally effective as an instrument to serve the government’s objectives. The choice was made decades ago when Beijing sought resources to jumpstart the economy. The challenge then was that government revenues had collapsed to a low of 11 per cent of gross domestic product by the mid-1990s from over 30 per cent in the late 1970s when the country opened up. Profits of industrial state enterprises, 15 per cent of GDP at one time, had also evaporated.

    The easy and only feasible option was using financial repression to transfer resources from households through the banking system to the state. Judged as a tax on savings, this was more attractive compared with the alternative of higher consumption based taxes.

    The implicit tax on savings was cheaper to collect, harder to evade, and progressive since the larger one’s savings, the more one paid. The hard option—relying more on the budget—would have meant heavier consumption based taxes that would have been more costly to collect, easier to evade, and regressive. The choice was simple.

    Whether or not financial repression was worth it depends on how well the government used the easy option to meet its twin objectives—accelerating growth and maintaining stability. Against this yardstick, few would quibble with China’s double-digit growth rates over the previous three decades.

    It probably led to a more rapid increase in the incomes of households than would have been the case otherwise. Moreover, this approach proved especially effective in propping up domestic demand during the various global financial crises and disasters with a timeliness and certainty that probably could not have been achieved through fiscal channels. Thus the easy option is now seen by many in the Communist party of China as an essential tool in reinforcing the credibility it needs as the unifying force for the state.

    But continuing this policy is undesirable. Interest rates are now more important in influencing decisions, as China moves to an economy driven by an increasingly sophisticated private sector. Chinese households searching for higher yields from their savings have strayed into shadow banking and property speculation with unstable consequences. And the lack of transparency in bank lending has encouraged a culture of reckless and rent-seeking activities.

    Thus the Mr Wen’s comments are not really about breaking the monopoly of the state banks, but the willingness of the government to give up financial repression to achieve its objectives in a modernising China. This means relying more on the budget to channel resources in a transparent and less distortionary way. The result would be less implicit support at the national level for state banks to fund strategic state enterprises and it would rein in the tendencies of local officials to rely on loans for expenditures. In the process, this would free up banks to support the private sector.

    Mr Wen’s predicament is that turning to the hard option would not necessarily make life easier for the CPC. To the contrary, the process would become more bureaucratic and sacrifice some timeliness. But the change would encourage more representative, accountable, and transparent decision making, curb opportunities for corruption, and reduce the likelihood of waste—all issues that are now being debated more seriously in the wake of the Bo Xilai scandal.

    China’s incoming leadership must come to terms with this politically charged question as it’s the prerequisite for acting on the much-needed reforms for both the financial and state enterprise sectors.

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

    For all the handwringing at the time, Nato’s assault on Muammar Gaddafi came off pretty well. In the end, the allies pushed Libya’s megalomaniacal strongman from power without a single US or European casualty and compared with the wars in Iraq and Afghanistan, it didn’t cost very much.

    The US and European search for a new, more cost-effective approach to managing turmoil abroad makes sense, particularly in the conflict-prone Middle East. In America, troops are only beginning to return home from two of the longest wars in US history. The federal debt continues its rapid rise. Historically high numbers of economically insecure US voters are telling pollsters that, when it comes to other countries and their problems, America would do better to mind its own business.

    In Europe, the fight rages on to restore confidence in the eurozone — and in the entire European project. Whether today’s focus is on Greek public anger, Spain’s austerity plans, Italy’s labour laws, French campaign promises, or Germany’s local elections, policy makers know well that markets are watching for signs of weakness — and that Europe’s governments are in no position to accept new risks and burdens abroad.

    Complicating matters further, emerging powers such as China, India, the Gulf states and Brazil are too focused on the next stages of their own delicate development plans to accept a significantly larger share of global leadership. In fact, for the first time in many decades, there is no single country or durable alliance of countries ready to lead on the international stage. This is not a G7 or G20 but a G-zero world.

    Nowhere will this lack of global leadership allow for more near-term turmoil than in the Middle East. In recent years, for good and for ill, self-interested outsiders, mainly Americans and Europeans, have imposed a stable status quo across the Arab world. They have promoted and protected autocrats, but they have also helped maintain a sometimes tenuous balance of power.

    But today, foreign powers have less leverage across the region than they’ve had in many years. Outsiders remained mainly on the sidelines during last year’s Arab world upheaval. Libya proved an exception, but only because Gaddafi had no real friends to help save him. Nato won’t receive many more Arab League invitations to drop bombs on an Arab country.

    If Libya is the exception, Syria proves the rule. President Bashar al-Assad probably won’t survive, but his government has more than enough loyalty from the country’s military and support from its political and business elite to kill many more of Syria’s citizens before damage to its economy forces his supporters to cut him loose. The west will make offers and issue warnings, but this fire will burn a lot longer before it dies.

    Nor are US and European governments likely to force Iran to renounce its nuclear ambitions. Sanctions have imposed considerable pain on Iran’s economy — and will inflict plenty more. But China and India will continue to buy Iran’s crude oil, albeit at a discount, and Tehran’s best insurance against Israeli airstrikes remains the reality that the western allies won’t support strikes that will drive oil prices higher and sink their still struggling economic recoveries. The diplomats will continue bargaining and the centrifuges will continue to spin.

    In addition, outsiders don’t have much leverage with the Egyptian generals and Muslim Brothers who will shape that country’s near-term future and reorient its approach to the region and the west. Across the Middle East, growing competition among Turkey, Saudi Arabia and Iran will heighten the risk of proxy conflicts—in Iraq, Syria, Lebanon and Bahrain.

    Will even Libya be remembered as a success? For some time to come, this violence-plagued country will remain a loose collection of semi-independent local strongholds where militias and tribal leaders provide what passes for governance.  In fact, in the context of the Arab Spring, only Tunisia is maintaining a definitively positive trajectory — a country of little importance to the region at large.

    As Washington refocuses its attention on Asia and Europe’s leaders struggle with political pressures at home, this is the region where the G-zero will be most obvious — where hotspots will get hotter and problems are most likely to become crises

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